Double treat

Something interesting happened in 2012. For the first time, foreign institutional investors (FIIs) have invested more money in India compared with other Asian peers (excluding China). The liquidity versus valuation theme is coming up once again as FIIs have pumped in over $21 billion in a market bereft of significant earnings change. Little wonder, then, that the Nifty rose by about 27%, the second highest after Thailand. However, this time, the action has been more stock-specific as nearly 50% of the stocks have under-performed and 15% of the stock values declined on an absolute basis.

Against such a backdrop our recommendation is to pick stocks that have: (a) strong earnings growth (more than 15% every year); (b) companies that are using their cash flow (either operating or by selling assets) to reduce their debt; and (c) companies with a high free cash flow yield (of more than 4%). 

Cement is one such sector where earnings visibility seems to be good and also most companies are debt free. Besides, this business enjoys high return on capital employed and return on equity — which can grow between 15% and 20% per annum through internal accruals. Therefore, I believe Grasim is a good proxy not only to play the cement business but also for the company’s cash generating and healthily-growing viscose staple fibre (VSF) business. 

Grasim is set to chart a steep growth trajectory over FY12-15 with an impressive consolidated operating profit and net profit CAGR of 13.8% and 12%, respectively, on the back of a $3 billion investment in beefing up capacity in its key businesses — VSF and cement. 

Hence, I value Grasim at ₹4,000 on the basis of the sum of its parts after factoring in a holding company discount of 25% on its cement business and 50% discount on its investments. Both of these fetch a value of ₹2,800. The VSF business is valued at ₹1,200 (including the cash it holds). Given the fact that its cash generation from operations is strong and it is debt free, the possibility of equity dilution is unlikely in the foreseeable future. 

Core business

Grasim’s cement business through its 60% holding in Ultratech is also expected to perform well going forward. The company’s 10 million tonne per annum (mtpa) expansion is nearing completion and is expected to be on stream by Q1FY14, taking its total capacity to 62 mtpa. This capacity is coming up without any additional requirement of funds through dilution of equity and we expect cash flows to be strong enough to fund a 15% expansion in capacity every year.

Among the important factors to recommend Grasim is a visible pick-up in strength in its VSF business. As an extremely versatile and easily blendable man-made fibre, VSF is widely used in apparel, home textiles, dress material, knitted wear and non-woven applications. Driven by the strong 8% CAGR (over CY10-15E) in global viscose demand and Grasim’s 164,000 tonne capacity expansion nearing completion, we expect the company to leverage its global VSF cost leadership (85% backward integration in pulp and 100% in caustic soda). VSF revenues will see CAGR of 16% in the coming three years and so will stand-alone operating profit with a CAGR of 15%.

The volume growth in the VSF business over the next three years is likely to be significantly higher than 7-8% growth in the cement business. The reason: global fibre consumption over the last decade has undergone a dramatic change with a shift in favour of man-made cellulosic fibres (MMCF) such as VSF due to stagnant cotton production. In fact, over CY06-11, VSF demand has seen 9% CAGR, clearly outpacing growth in cotton (CAGR of 0.3%) and significantly higher than the 4.9% CAGR in synthetic fibres.

Though VSF prices are expected to remain under pressure in the near term owing to soft cotton prices, viscose prices will bottom out over next two to three quarters. In fact, cotton acreage over the next couple of cotton seasons will decline sharply as prices are already down 60% from March 2011 peaks. Besides, increasing input costs has made cotton cultivation uneconomical. According to a regression analysis on cotton’s relative price trend and its effect on cotton acreage, the latter should decline to 31.7 million hectares over the next two years against 36.2 million hectares last season. The decline in pulp prices, though, is helping Chinese players increase VSF supply, thereby, distorting price stability. That is why Grasim is entering the specialty fibre segment, which will ensure enrichment of its product mix as specialty fibre commands significant price premium over commodity VSF.  

Trading at a discount

Grasim currently trades at attractive valuations of 9.5 times P/E and 5.8 times EV/Ebitda on FY14 consolidated numbers. Assuming a 38% holding company discount (average of last three years) for the cement business and 50% discount for investments in listed entities, implied EV/Ebitda for the stand-alone business stands at 3.4 times, which is at a discount to the valuation of its peers like Lenzing, which is trading at 5 times EV/Ebitda. 

In my view these valuations are significantly low for a lowest cost global scale viscose producer. Further, the group’s viscose business has a long track record of having high free cash generation and extremely healthy return ratios.

On account of these factors I continue to believe in the Grasim story. Along with earnings growth trajectory in its VSF business and the positive outlook for the cement division, the recent 12% correction in the stock price offers another opportunity to buy the stock. The risk on the downside is limited but offers 30% upside in just a year’s time.