Entry into a benchmark index is a milestone event for any listed company. However, the inclusion may hold a cautionary message for Shree Cement Ltd’s investors. As pointed out earlier in this column, index inclusions tend to happen after a sharp rally in the stock, potentially capping subsequent returns.

Shree Cement, which will join the Nifty index next month, gained 59% in the past one year. It is trading at a whopping 43 times one-year forward price-to-earnings multiple, according to Bloomberg estimates. At 18 times FY21 enterprise value/Ebitda estimate, the stock is at a 40% premium to industry leader UltraTech Cement Ltd, said Motilal Oswal Financial Services Ltd. Ebitda is earnings before interest, tax, depreciation and amortization.

Graphic by Satish Kumar/Mint
Graphic by Satish Kumar/Mint

Several factors are going for the stock. The company has one of the best cost structures in the industry, which helps it deliver superior operating earnings. Operating profit (Ebitda) per tonne at 1,365 is notably higher than 1,075 at UltraTech last quarter.

Shree Cement is adding capacity of six million tonnes per annum by the end of FY21. It raised 2,400 crore through a qualified institutional placement. So, capital expenditure is not expected to have a bearing on its leverage or return ratios.

But many fear the new capacities may dilute the operating profit metrics, undermining its premium valuations.

Currently, the company is a market leader in north India. Comparatively, new capacities are coming up in western and eastern markets, where demand and pricing trends are not that favourable.

“We expect pricing growth to remain muted in East as 25% capacity expansion by various players (including Shree Cement) is lined up over the next 18 months, which could create a fight for market share," analysts at Motilal Oswal said in a note.

The new capacities can help the company maintain volume growth. But unfavourable prices can soften margins and return ratios. “Thus, we estimate its return on capital /return on equity to marginally cool off by 100-200bps in FY21/22E," said HDFC Securities Ltd in a note. A basis point is 0.01%.

Seen from the other side, the premium valuations reflect investors’ faith in the Shree Cement stock, particularly in its low-cost production model. While the recent December quarter results underscore this, the valuations leave no room for error.

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