Jigar Shah

The north-east region has been in the thick of action over the past five years, thanks to the central government’s renewed focus on building the region’s infrastructure network. And one of the biggest beneficiaries of the spend has been Star Cement, a stock that was relisted in June 2017, following a reverse merger with Star Ferro & Cement, formerly a part of Century Plyboards.

Today, Star Cement has cornered over 23% market share in the north-east, where demand has been consistently been higher than the growth seen at a pan-India level. With a capacity of close to 5 mtpa across Meghalaya, Assam and West Bengal, nearly two-third of the company’s sales come from the region. Star Cement’s product range includes ordinary portland cement, portland pozzolana cement, portland slag cement and anti-rust cement, in line with evolving customer needs.

Cement demand nationally is expected to grow at 7-8% in FY19, as per a Crisil estimate, while in the north-east, the upper estimate of cement demand growth is expected to be around 8-10%. There are several catalysts for demand to sustain at a higher rate of growth in the region — which makes up for 3% of the country’s total cement offtake — driven by favourable government policies and increasing home ownership. 

Solid Edge 

Over FY14-17, Star’s volume growth has compounded at 18%. But in FY18, volumes fell by 11% year-on-year, owing to floods in the north-east and Star’s exit from the Jharkhand market following unfavourable pricing. We forecast cement volume in the region to increase by 15% per annum over FY19-21, driven by two prominent factors. One, there will be robust growth in housing demand in Assam and Meghalaya, second, commissioning of a 2 million tonne grinding unit at Siliguri in FY20, leading to higher sales in the eastern region, which is seeing a big push across infrastructure verticals such as roads, highways, railways and airports.

Given that the north-east is a land-locked, hilly region, the location of Star’s cement plants give it an unparalleled competitive moat for doing business in the geographically inaccessible region. The company’s grinding units at Lumshnong and Guhawati provide it with easy access to customers with a lead distance of just 285 km as against 1,000 km for competitors. 

In terms of input costs, Star has control over these costs by virtue of its captive power plant and limestone mine, which is one of the best with a calcium oxide content of 49% against the national average of 42%. The mine is located at Lumshnong ,at a distance of less than 3 km from clinker plant, and also the reserves are sufficient to meet the needs of the company’s current cement capacity. 

Having its own power plant has also resulted in considerable cost savings for Star. As against buying electricity off-the-grid at Rs.5.5/kwh, the company is sourcing in-house power at a cost of Rs.4/kwh, besides ensuring uninterrupted supply. The plant is also located less than 20 km from the coal-rich Assam, and the eastern coal fields of Coal India. 

Brand Strength

Over the past 13 years, Star has firmly established its brand ‘Star Cement’ in the north-east with a distribution network, comprising 870 exclusive dealers, spread across the region. This exclusive distribution channel enables the company to have a deeper penetration in rural areas. The company’s retail network is 25% larger than its nearest competitor Dalmia Bharat — Star’s retail segment contributes 83% of sales versus 50% for Dalmia. Given its strong presence in the retail segment, Star’s strategy is focused on branding so as to garner a higher premium — Rs.5-10/bag higher than its peers. As a result, Star’s spend on advertising is Rs.111/tonne in other parts of India against less than Rs.50/tonne for peers.

To boost investment in the north-east, the government had provided numerous subsidies on capital, freight, and taxes (rebates). The revenue subsidy (freight and tax) for most players, including Star has varied from Rs.500 to Rs.600/tonne. In FY17, freight subsidies contributed 23% to the company’s operating profit. However, the company’s freight subsidy (Rs.300-350/tonne) lapsed in January 2018, while the tax subsidies (Rs.200-250/tonne) for two other plants expire in 2023 and in 2027. 

During the current fiscal, we expect operating profit per tonne to decrease by Rs.368/tonne to a level of Rs.1,795/tonne, following the cessation of the freight subsidy and a marginally higher contribution of eastern region sales to total sales at 29% against 27% in FY18. Star’s operating profit in the eastern region is Rs.1,200/tonne compared with Rs.2,200/tonne in the north-east. These factors account for only 1.8% of FY19 earnings increase, despite a 15% rise in sales volume.

What’s interesting to note is that despite the withdrawal of freight subsidy, Star will still command the highest profitability of Rs.1,795/tonne against Rs.900 for peers in FY19. Again, the superior profitability is owing to the company’s captive limestone mine, power plant and premium pricing.

Strong Balance Sheet 

Star is in a healthy financial position to fund its future growth with a FY18 net debt to equity ratio of 0.3x, which is also below the 1.0x for mid-cap peers. Over FY19-FY21, we forecast strong operating cash flow of Rs.6-9 billion driven by rising net income, and release of the freight subsidy payment. At Siliguri, the company is building a brownfield grinding plant at a cost of Rs.4.5 billion. In Meghalaya, it is expanding clinker capacity by 2 mtpa to a total of 5 mtpa, at a cost of Rs.10 billion by FY22. The new grinding unit at Siliguri is aimed at increasing sales outside the north-east. Meghalaya’s capex of Rs.10 billion includes Rs.1.2 billion for a 20 MW waste heat-recovery power plant and Rs.8.8 billion for the clinker plant. Star is targeting a payback period of around five years for both units with funding from internal cash accruals and possibly debt, if the need arises.

Premium Justified

Our fair value for the company is Rs.147 a share, based on 10x EV/Ebitda for FY20 as against the current 6.5x. We prefer EV/Ebitda since it enables comparison with peers, which have differing leverage and cash on balance sheet. Our target multiple of 10x for FY20 is at a 25% premium to its mid-cap peers. At our target price, the P/E multiple works out to 14x its estimated FY20 earnings per share and a replacement cost of $142/tonne compared with 15x FY20 earnings per share and $84/tonne for the peer group.

Aided by volume growth and strong profitability, we forecast 27% and 17% earnings growth in FY20 and FY21. Despite the strong future growth and 20%-plus return on equity, Star’s valuation of 6.5x its estimated FY20 EV/Ebitda is 20% below peers and also below the stock’s two-year average of 10.8x.

The author does not hold the stock in his personal capacity, but has recommended it to clients of Maybank Kim Eng Securities