Valuation in Motion: Kajaria Ceramics Valuation: Regaining Lost Ground?

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I was recently touring the beautiful hill station of Munnar in Kerala. To my surprise, the way to Munnar and back was covered with several hoardings of Kajaria Ceramics, the market leader in the Tiles segment. I had been following it earlier on and off, and with the recent slide in its share price, I thought I should whip out my Valuation model to see if the correction was justified.

The Company

Kajaria Ceramics is the market leader in the Tiles segment in India, commanding a 20% Market Share in Organized Tiles and a 10% Market Share in Tiles. Being in the space for more than 3 decades has helped them pioneer automation in their manufacturing process, allowing them to control costs to an extent. However, the spiking gas prices has put most Tiles manufacturers in a tight spot. The slowdown in Real Estate across the country presents itself as a double-whammy. Therefore, this will be a very simple story of an efficient Tiles manufacturer going through a rough spot in the industry and regaining its lost ground.

The Industry

I studied several research reports before writing this, but the one by Motilal Oswal is detailed and accurate, so I will be using a lot of material from there for illustration.

The Indian Tiles Industry is yet another benefactor of the GST regime. The value shift from the Unorganized to the Organized segment has only been sped up.

The growth, clocking in a 9.50% for the last decade, has far outpaced India’s own GDP growth rate at 6-7% and change.

We now know that there has been a slowdown in growth due to rumors of structural issues in the Real Estate sector. Whatever be the truth, it does not bode well for Tiles manufacturers, who are a part of parcel of the home-building experience.

What more? Natural Gas plays a major role in the manufacturing of Tiles. So, the Industry is faced with a double-whammy because of spiking Raw Material prices.

Of course, everything works in a cycle. This too shall pass and the Tiles industry will muscle its way towards regaining the lost ground.

The Numbers

I have to note something here. In fact, I should have noted this when I valued CCL Products (India) in my earlier blog post. It looks like Indian companies have started reporting their Financial Position (Balance Sheet) as well during Quarterly filings. Just a while back, they didn’t. There’s a long way to go to meet the standards set by the USA’s 10-K, but this a minor victory nonetheless.

Kajaria Ceramics has a few, smaller subsidiaries. Since we’re taking Kajaria’s Consolidated financial numbers, we should ideally remove the Minority Interest from the final value (i.e. The value of the stake which Kajaria does not hold in its subsidiaries):

As usual, I have evaluated Kajaria’s Beta (Required to calculate its Cost of Capital) and Standard Deviation (Required in Option Valuation), along with NIFTY 50’s CAGR (Once again, required to calculate the Cost of Capital) over a 5-year period (2013-2018).

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Feel free to download the excel file and verify the calculations for yourself.

The Capital Conversions

Kajaria Ceramics has all of R&D, Debt, Operating Lease and Equity Options, so this section is fully utilized.

R&D and Debt

The R&D expenses are quite normal, which I have capitalized. However, I noticed something interesting regarding the Debt held by Kajaria Ceramics. At the Book level, Kajaria holds a Debt of Rs. 94.19 Crores. The interest payment on the Debt is around Rs. 18.60 Crores or 19.70% or so. This is too high an interest to pay. Even if we assume that a part of it is principal repayment (Which seems to be the case, actually), a 13-14% interest rate is still on the higher side, considering how Kajaria has been rated AA by CARE. If anyone knows the reason behind this, do let me know in the comments below. However, Kajaria’s D/E Ratio is too low for any of this to matter. Let’s move ahead.

Operating Lease and Equity Options

Kajaria has given the following details in their 2017-18 Annual Report, regarding Operating Lease Payments and Equity Options:

I have converted the above details into my model as such:

It looks a little weird to me that the current Lease expense is Rs. 17.40 Crores, whereas future Lease expense have only been touted at Rs. 6 Crores. Once again, because of immateriality due to size, we will ignore this too.

The Assumptions

This is the portion where I will attempt to portray my story about Kajaria Ceramics as numbers.

High Growth Period: A 20-year High Growth Period is justified, because Kajaria Ceramics is indeed the largest Tiles player in India. They have distribution networks in place and have pioneered the automation process in Tiles manufacturing, which will provide them with the necessary moat to fend off competition.

Sales Growth: As per our story, I have assumed that the short term average Growth of Kajaria (5.98%) will continue, as the Real Estate sector rebuilds itself. Growth will pick up soon afterwards and fall back to earlier levels.

Operating Margin: The spike in Natural Gas prices will continue to eat away Margins from most Tiles manufacturers (16.22%), post which a revival to normal levels could be seen (19%-22%), finally settling down on the Industry Average of 7.85% (Courtesy of Prof. Aswath Damodaran’s ‘Useful Data Sets’).

Tax Rate: The average Corporate Tax Rate paid by Kajaria (33.60%) will converge towards India’s Corporate Tax Rate (30%) first and then the Global Average Tax Rate (25%).

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Capital Turnover: I haven’t assumed much of anything here, since Kajaria’s management is already explored automation in manufacturing, the final frontier. There’s a gradual growth in production efficiency from the current levels (1.77) to the long term average (1.90) and beyond (2.09).

Reinvestment Rate: Reinvestment Rate remains stable, as I haven’t assumed any extraordinary reinvestment by the management.

Return on Capital: Return on Capital converges towards the Cost of Capital, as it should (18.95%-11.29%).

Depreciation: Depreciation remains fairly stable (2.91%).

The Cash Flows

Based on the above numbers, this is how Kajaria’s Cash Flow position will evolve over time:

We can look at this in a better, non-clustered way:

The Value

The following table shows the Value Composition of Kajaria Ceramics:

Dividing this by the number of outstanding shares, we get this:

I believe that Kajaria Ceramics is fairly valued at about Rs. 393, signifying a 10% overvaluation. In fact, it’s as good as saying that I think Kajaria Ceramics is fairly valued at CMP. This shouldn’t come as a surprise. The combination of high valuations, industry headwinds and Raw Material price hike caused the stock to crash by about 43% from its recent high of Rs. 712, to levels which happen to be the fair value according to my estimates.

The Sensitivity of Value

The Sensitivity of Value tool captures the change in final Value according to changes in Terminal Growth Rate and Cost of Capital.

On a positive note, the tool tells us that Kajaria could be worth as much as Rs. 1200 if industry headwinds clear up and the market regaining its craze for the stock. As you can guess yourself, the probability of this happening is quite low. On the negative side, a price of Rs. 253 would factor in all the hurdles facing the company (Of course, I’m in no way saying that the CMP will get there).

The Monte Carlo Simulation

A Monte Carlo Simulation is the true test of a company’s Value. It allows us to see a company’s Value as range of probabilities rather than a single number (As it should be–since the future is uncertain). I will simulate several of my assumptions in the following manner:

Sales Growth: Initial Growth between 5.98% (Short Term Average) to 10.35% (Medium Term Average) and Terminal Growth between 2.02% (A quarter of the Risk-free Rate) and 6.06 (Three-quarters of the Risk-free Rate).

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Operating Margin: Between 13.69% (Lowest ever in the last decade) to 20.21% (Highest ever in the last decade).

Capital Turnover: Between 0.89 (Lowest ever in the last decade) to 2.50 (Highest ever in the last decade)

Cost of Capital: Between 10.72% (Bottom-up Beta-based CAPM Cost of Capital) and 11.45% (Normal Beta-based CAPM Cost of Capital)

The initial result looks somewhat like this:

So, how do we better interpret the ‘Histogram of $E$76’ (Which is the cell in which the ‘Value of Equity per Share’ is displayed) in the above screenshot? Well, that would be like this:

Going with this then, at the CMP of Rs. 435, there seems to be a 31% Probability of Undervaluation. Is that enough? Only you can and should answer that question for yourself.

The Model

If you disagree with the set of assumptions I have made for Kajaria Ceramics, feel free to download the model and try for yourself:

If your Value for Kajaria Ceramics differs drastically from mine, let’s have a healthy discussion in the comments section below.

The Future is Uncertain, but..

Whenever I attempt to explain my valuation model to my friends, colleagues or other like-minded people, the most prominent question I get is, “Don’t you think assuming the numbers for a company several years down the line is a bit pretentious?” I usually just say “No” and move on. Warren Buffet once said the concept of a Discounted Cash Flow is something people either get immediately or never get for a lifetime of investing. I wouldn’t claim such extremes myself, but I would guess that he was also probably faced with several such ignorant questions.

More recently, I was binge-watching a few TED Talks when I happened upon a video titled “3 lessons on decision-making from a poker champion“. It was a short video, but the sentiment expressed and the message conveyed in the video contained perhaps the most apt response to the most annoying question facing all practitioners of Stock Valuation. See for yourself:

The future is unknown, but you can damn well try and estimate it.” – Liv Boeree, Professional Poker Player and Champion.

I’d love to know what you make of the video in the context of Valuation.

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Dinesh Sairam
Dinesh: Investor | Risk Consultant | Finance Geek | Writer @Quora | Blogger | Poet | MBA from XIME
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