Equity markets keep springing up surprises. One such involves the current similar valuations of IT services and construction material companies, which are poles apart in returns, cashflow and dividend generation. Interestingly, cement companies, which have lower metrics, are trading at a much larger premium to IT services stocks on a 1-year forward P/E basis.
Are the two sectors same? How does this valuation math sum up? According to industry experts, this might be because the market is either applying different valuation principles to the two businesses or assuming the two businesses are similar.
The latter cannot be true as the cement business is a highly capital-intensive, cyclical and commodity business whereas the IT services business has high return ratios and cash generation. Well, if the market is applying different valuations principles to the two then that might reflect anchoring bias. (Anchoring bias occurs when people rely too much on pre-existing information or the first information they find when making decisions.)
Are the investors reading the situation wrong?
The analysts at Kotak Institutional Equities Research see two flaws with the argument of investors for using historical multiples to justify high forward multiples for cement stocks. “Cement companies’ multiples are lower on an ex ante basis compared to forward multiples on reported EBITDA/EPS, as earnings of cement companies eventually turn out to be lower than consensus estimates”.
The second flaw is that the fair value of any company is based on discounted cash flows of the future, which, in turn, depend on several variables related to the future. “The past or past multiples have little relevance in the valuation of a company/stock”, suggested the analysts at Kotak.
Is it even fair to compare the two sectors?
For now, the multiples of cement companies are exceeding those of IT services and this is despite the inferior business model of the cement business in terms of financial returns, free cash generation and dividend returns to shareholders.
“On growth, the volumes of cement companies will probably grow in line with real GDP growth (5-7 percent) and prices will largely follow raw material changes, while the revenues of IT companies will likely grow at high-single or low double-digit growth rates,” suggest a report from Kotak Institutional Equities. Hence, this provides very little or no basis for comparison between the two sectors.
Differences between the two business models
It’s a widely known fact that cement companies have lagged IT services companies on all the major financial parameters over the past decade, and there is no reason for this to change, given the nature of the two businesses.
According to an analysis done by the Kotak team, the top-4 cement companies (ACC, Ambuja Cements, Shree Cement and UltraTech) have had an average RoACE (return on average capital employed) of 11 percent and a Free Cash Flow (FCF)-to-EBITDA ratio of 38 percent, while the top-5 IT services companies (HCL Tech, Infosys, TCS, Tech Mahindra and Wipro) have had an average RoACE of 41 percent and an FCF-to-EBITDA ratio of 57 percent over the period from FY13-22.
The Kotak report highlighted that the average free cash flow conversion ratio (from FY13-22) of the top-4 cement companies was in the range of 24 to 57 while for the top-5 IT companies during the same period was in the range of 40 – 72.
Also, the IT services firms have returned more cash to their shareholders as dividends and buybacks in comparison to the cement companies. For the financial year ended March 2021, the cash returned by cement companies as percentage of profit was 30 percent and for the financial year ended March 2022, it was 19 percent. At the same time, IT services returned ~84 percent cash in proportion to their profits for the financial year ended March 2021 while for the year ended March 2022, the percentage was ~73 percent.
The analysts at Kotak argue that for the current valuations to hold, the cement companies will have to generate much higher EBITDA per ton than their historical highs as well as the FCF-EBITDA ratio (historically has been less than 40 percent) will have to improve significantly.
But given the fact that the cement sector requires high capex to grow, has an asset turnover ratio of less than 1 and is too cyclical, the current valuations will not survive and there might be a significant downside in the offing in the medium term if not in the near term. “There can be a downside of ~50 percent in the stock prices of all top-4 cement companies even at 6x EV/EBITDA of December 2023 estimated earnings”, said the report from Kotak Equities.
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