Cement companies may be riding high on the potential for growth considering the big infra push, but analysts at Kotak Institutional Equities are underwhelmed. In a report dated April 15, Kotak analysts said they were “baffled” over the market's perennial optimism regarding the sector's profitability, despite recurrent earnings downgrades.
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The fiscal year 2024 witnessed substantial earnings revisions, with EPS adjustments ranging from an increase of 4 percent to a staggering decrease of 68 percent. This trend, according to Kotak, mirrors previous years' experiences, indicating a recurring pattern rather than an anomaly. Besides, “…earnings downgrades also have the unintended consequence of ‘inflated’ valuations, based on actual reported earnings versus estimated earnings, becoming the benchmark for target multiples,” the report said.
Also read: Cement rules Moneycontrol list of 7 stocks with potential to double earnings in FY25
For the current fiscal (FY25), consensus estimates project a notable surge in EPS compared to the previous year. However, Kotak remains cautious, attributing the optimism to “conditioned behavior fed by perennial optimism” rather than substantial shifts in fundamentals. Kotak analysts said a more realistic approach to the sector, particularly concerning the notion of 'price discipline', as a driver of enhanced profitability, which it deems dubious given persistent supply-demand imbalances.
“The oft-repeated argument about ‘price discipline’ resulting in higher profitability seems rather tedious and is dubious anyway, as hopes of ‘cartel’ pricing (whether or not) should not be a basis for any rational investment thesis, especially in light of the continued large supply-demand imbalance in the sector through FY2026E,” the report said.
Recalibration advocated
Emphasising the capital-intensive and commoditised nature of the cement business, Kotak underscores a significant disconnection between prevailing market sentiment and its valuation methodology. While the market appears fixated on earnings growth and is inclined towards assigning high price-to-earnings multiples for volume-driven expansion, Kotak advocates a recalibration grounded in fundamental principles.
According to Kotak's analysis, the sector's low asset turnover ratio, especially for expansion and greenfield projects, will naturally constrain valuations. However, many cement stocks currently trade at multiples, significantly higher than warranted by their return on equity metrics, despite assumptions of reasonable profitability.
Kotak asserts that a 'first-principle' approach suggests that multiples of cement stocks should be half of their current levels. “However, most cement stocks trade at 2.5-5X FY2025E BV, which is clearly very high.”
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