Analysis: Heidelberg Cement India Ltd

The current section of the “Analysis” series covers Heidelberg Cement India Ltd, a cement manufacturer in India, which is a subsidiary of HeidelbergCement AG, Germany.

The “Analysis” series is an attempt to share with all the readers, our inputs to the company analysis submitted by readers on the “Ask Your Queries” section of our website.

In order to benefit the maximum from this article, an investor should focus on the process of analysis instead of looking for good or bad aspects of the company. She should learn the interpretation of different types of data and transactions and pay attention to the parts of annual reports etc. used to get the information. This will help her in improving her stock analysis skills.

Heidelberg Cement India Ltd Research Report by Reader

Dear Vijay,

I hope you are doing great. Please find attached the analysis of Heidelberg Cement India Ltd. Please provide your input on the same.

Best regards,

Harshit Solanki

Key Timeline of Heidelberg Cement India Ltd:

• The parent MNC (HeidelbergCement AG) is one of the top four cement companies by market share globally with a presence in over 60 countries. HeidelbergCement entered the Indian market in 2006.
• 2006 to 2008: the company acquired majority stakes in Mysore Cements, Cochin Cements & Indorama Cement.
• 2011 to 2013: it used debt for brownfield expansion of its facilities increasing its production capacity from 2MT to 5.4 MT.
• 2016: the company acquired Italcementi and the current capacity stands at 6.2MT.
• The company has four cement plants, four Grinding plants, and one cement terminal. The company’s manufacturing locations are mostly in Central India (UP, MP, Karnataka, and Telangana).
• Debt: Since 2013, the company has been reducing its debt regularly.
• 2017: the company installed India’s longest overland conveyor belt to transport limestone from its mines to the facility at Narsingh, Damoh. It significantly reduced transport costs and time.
• It installed a waste heat recovery plant at the same facility in MP and made a 25 years’ solar power agreement for another facility in Karnataka; thereby, saving significantly on power cost.

Improvements in Heidelberg Cement India Ltd since 2013:

• Debt to Equity ratio has come down from 1.65 to 0.32 consistently
• Operating Profit Margins have grown from 8% to 24% one of the best in the segment
• NPM from -ve 3.3% to 12% consistently, no sharp ups and downs
• Interest paid down from 136cr to 74cr
• Inventory turnover from 6.6 to 14.5
• Debtor Days improved from 9 to 4
• Corporate Tax payout is inline
• Positive Free Cash Flow for the last 5 years
• Negative Cash Conversion Cycle
• Has started paying dividends since 2017
• Promoter’s stake unchanged at 70% with ZERO pledge
• Remuneration extracted is very reasonable much below the allowed limit
• ROCE has grown smoothly from 1% to 25% and ROE from -ve 5.5% to 20% both are among best in sector
• Current Ratio > 1
• PBT/Fixed Asset = 19.6%
• Related Party Transactions: All looks ok nothing seems to be doubtful

Shareholding pattern of Heidelberg Cement India Ltd:

• Public holding is down from 14.1% in 2015 to current 11.7%
• Mutual fund holding is up. The FPI holding is also up marginally.

Key observations for Heidelberg Cement India Ltd

The company is currently running at 90% utilization and earning EBITDA of ₹981 per MT second to Shree Cements only, with cement demand expected to grow @7% per annum in the medium-term, the Industry’s capacity utilization is bound to improve. Management has not spoken about any major capex in the near future.

All parameters talk about efficiency, consistency, and commitment. Moreover, the company is a good capital allocator, be it from debt or operating profits.

Consider this growth in a small-cap during rough times that we have seen in the last 3 years where even large players are fizzling out, all this is available at a very reasonable PE of 13, whereas 10 years avg PE is 20.

Pros & Concerns for Heidelberg Cement India Ltd:

Sales growth CAGR for the last 3 years has been slow and below 10%, all the profits that the company has secured, are due to the realization of improved operating and net margins. This may be due to a slowdown in infra growth in the last 3 years, but this needs to improve going forward to give a cushion to dips in margins if any.

However, cement business for most is low margin and high volumes business however the company has proved its pricing power through margins. If sales growth kicks in bottom line will keep growing and eventually the market will take notice of it.

This was my short analysis of Heidelberg Cement India Ltd. I request your valuable views on the same. How do you see the company? Are there any red flags in the balance sheet or in the cash flows?

Regards,

Harshit

Dr Vijay Malik’s Response

Hi Harshit,

Thanks for sharing the analysis of Heidelberg Cement India Ltd with us! We appreciate the time & effort put in by you in the analysis.

While analysing the past financial performance of the company, an investor notices that it used to have a financial year from January to December until FY2013. However, thereafter, the company changed its financial year from April to March. As a result, Heidelberg Cement India Ltd reported its financial performance of 15 months from January 2014 to March 2015 to align its financial year from April to March.

Therefore, an investor should note that in FY2015, the financial data of the company represents a performance of 15 months whereas for all other years from FY2009 to FY2020, the data represents the performance of 12 months.

With this background, let us analyse the financial and business performance of the company over the last 10 years

Financial and Business Analysis of Heidelberg Cement India Ltd:

While analyzing the financials of Heidelberg Cement India Ltd, an investor would note that in the past, the company has been able to grow its sales at a rate of 10%-12% year on year. Sales of the company increased from ₹936 cr. in FY2009 to ₹2,170 cr in FY2020.

An investor would notice that in the last decade (FY2009-2020), the sales growth of the company has not been consistent and it faced periods of decline in its sales.

The company witnessed a decline in its sales in FY2010 and FY2012.

• In FY2010, the sales of the company declined from ₹936 cr in FY2009 to ₹866 cr in FY2010, a decline of 11%.
• In FY2012, the sales of the company declined from ₹988 cr in FY2011 to ₹870 cr in FY2010, a decline of 12%.
• In FY2016, it may look like the sales of the company declined from ₹2,044 cr in FY2015 to ₹1,648 cr in FY2016; however, the investor would remember that FY2015 contains data for 15 months. Therefore, a simple deduction of data for 12 months can be done in the following manner: ₹2,044 * 12/15 = ₹1,635 cr. Therefore, it turns out that in FY2016, the sale of 1,648 cr did not represent a decline in the sales, if compared to 12 months’ performance. Moreover, an investor would also appreciate that this calculation is a quick back-of-the-envelope method. To be more specific, an investor may add the sales of four quarters, from June 2014 to March 2015, to get the exact sales for the 12 months ending in March 2015.

Nevertheless, an investor observes that in the last 10 years, Heidelberg Cement India Ltd had witnessed fluctuating sales performance with a decline in sales in FY2010 and FY2012.

Similarly, when an investor analyses the profitability of the company over the last 10 years (FY2009-FY2020), then she notices fluctuating cyclical patterns in the profit margins as well. The operating profit margin (OPM) of the company used to be 18% in FY2009, which consistently declined to 7% in FY2011. Thereafter, the OPM increased to 16% in FY2015 and then again declined to 14% in FY2016. The OPM has since then improved to 24% in FY2020.

While an investor observes the net profit margin (NPM), then she notices that for most of the years, the NPM followed the pattern of OPM. However, in FY2013, Heidelberg Cement India Ltd reported net losses.

Such kind of fluctuating performance of sales revenue and profitability indicates that the business performance of Heidelberg Cement India Ltd is exposed to cyclical factors.

When an investor notices such kind of cyclical performance in both the sales as well as profitability, then she acknowledges the need for a deeper understanding of the business of Heidelberg Cement India Ltd. She needs to understand the factors influencing the business performance of the company. This is because, once an investor has understood the key factors for Heidelberg Cement India Ltd, then she would be able to have a view of the expected future performance of the company.

From our previous analysis of multiple such companies that faced cyclical performance in the sales and profit margins, an investor would remember that most of these companies operate in commodity product businesses with intense competition and lower barriers to entry. Such companies usually have large suppliers with huge bargaining power and customers with many choices to buy. Therefore, such companies tend to face tough business phases and have to take a hit on their profit margins during business down phases.

Let us see if Heidelberg Cement India Ltd has such a business model.

An investor gets to know about the cyclicity of the cement industry when she reads the credit rating report of Heidelberg Cement India Ltd prepared by India Ratings in March 2020, page 3:

Exposure to Industry Cyclicality: HCIL’s EBITDA/tonne remains vulnerable to the company’s ability to maintain its operating parameters amid the inherent cyclical trends in the demand and supply of cement.

Advised reading: Credit Rating Reports: A Complete Guide for Stock Investors

The investor gets a good understanding of the business model of the company when she puts a special focus on the analysis of the company during the periods in which its sales and profit margins declined.

In FY2010, when Heidelberg Cement India Ltd witnessed a decline in sales by 11% and a decline in OPM from 18% to 11%, then the company explained many aspects of its business to the shareholders.

FY2010 annual report, page 6:

The main characteristics of this industry is that it is highly fragmented, regional, cyclical and capital intensive.

Further, during the second half of the year the demand for cement also declined due to heavy rains in most parts of the Country resulting in subdued construction activity. The oversupply coupled with the poor off take of cement created demand supply mismatch puting pressure on prices. This lead to decline in the capacity utilization throughout the industry. Significant rise in costs, especially the price of coal, petroleum products, power and freight cost further eroded the profitability.

FY2010 annual report, page 17:

Rising input costs continue to be a serious threat to the industry. Reserve Bank too has raised its March 2011 WPI forecast from 5.5% to 7%. Prices of all key raw materials, fuel and power have increased substantially over the last year and have adversely impacted the margins.

Key threats to the industry are:-

• Excess capacity build up, which may impact prices in the short run.

From the above information shared by Heidelberg Cement India Ltd, an investor would appreciate that the cement industry faces intense competition because it is highly fragmented with many suppliers who have created an overcapacity i.e. supply of cement is more than its demand. In addition, the industry is cyclical because its demand is impacted by factors like monsoon. Good monsoon leads to a rise in agricultural income, thereby leading to higher demand from the rural area. However, lesser rains or draught decreases the demand for cement. Similarly, higher rains lead to floods, crop damage, and in addition, difficulty in constructing houses. Therefore, both lesser and excessive rains lead to lower demand.

The demand for the cement industry also depends a lot on infrastructure spending by the government.

FY2009 annual report, page 4:

The industry is cyclical in nature and to a great extent depends on the infrastructure spending by the Government.

Therefore, an investor would notice that the factors controlling the demand for cement, housing demand and infrastructure spending have a cyclical behaviour. When an industry has periods of alternate high and low demand and in addition, it has too many players (fragmented industry), who have created an oversupply situation, then an investor would appreciate the negotiating, pricing or bargaining power of the cement manufacturers would remain low.

Therefore, an investor would appreciate that the cement industry is facing such intense competition. Moreover, when such an industry faces an increase in raw material costs like coal, petroleum products, power, transportation costs etc. as explained by Heidelberg Cement India Ltd in the FY2010 annual report shared above, then it is obvious that the cement manufacturers would not be able to pass on the increase in the raw material costs to their customers. As a result, the companies would have to take a hit on their profit margins.

In the FY2009 annual report, Heidelberg Cement India Ltd explained how intense competition makes situations difficult for the manufacturers.

FY2009 annual report, page 6:

the scenario changed during the second half of the year since not only did the demand recede to some extent but the supply also increased as the additional capacities came on stream. This led to a temporary demand supply mismatch leading to fall in cement prices almost throughout India. Moreover the cement was also brought in from the distant markets into the markets in which we operate. Consequently, it was difficult to protect the margins during the second half.

The company explained that due to overcapacity in the cement industry, manufacturers from far areas started transporting cement to the markets, which had some demand. As a result, the prices of cement declined and the profit margins were reduced.

Over the years, the company has considered the inability to pass on the increase in the costs to the customers as one of the biggest threats.

FY2009 annual report, page 13:

Rise in input costs due to the high rate of inflation is a serious threat for the industry since it may not be possible to proportionately increase the selling price of cement thus affecting the profit margin.

…the new capacities coming on stream there would be pressure on prices, thereby eroding margin to some extent and also leading to reduction in capacity utilisation.

In FY2011, when Heidelberg Cement India Ltd reported its lowest OPM of 7%, then it indicated the inability of the cement manufacturers to increase prices in the light of numerous adverse developments as the reason for low profitability.

FY2011 annual report, page 4:

During the year sharp rise in input costs without any significant increase in realizations impacted margins. During February 2011, linkage coal prices increased in the range of 30% to 150% for various grades. Besides the price of coal, its shortage also troubled the industry…. During the year power tariff was also increased as a result of increase in coal prices.

Shortage of coal affected power generation adversely, thereby reducing the fly ash availability.

Poor quality and unavailability of gypsum locally, forced your Company to import gypsum. The weakening of Rupee increased the cost of imported Gypsum by about 10%. Significant cost increases were also witnessed in pet coke, slag and bags. Freight cost for transportation by road increased due to increase in diesel price. Railway freight for Cement and Coal was also increased during the year. Imposition of excise duty on fly ash & coal, enhancement of excise duty on cement and HSD price hike further aggravated the position.

In light of the above-detailed explanation by the company about the different aspects where the company faced an increase in raw material prices that it could not pass on to the customers, an investor would appreciate that the company had to take a hit on its profitability margins. In FY2011, Heidelberg Cement India Ltd reported its lowest ever operating profit margin.

The company reported that large capacity buildup in the industry is the reason for such a tough business phase.

FY2011 annual report, page 15:

There has been significant capacity addition during the last three years. Cement demand has not been able to keep pace with the additional supply in the market. The resulting demand supply mismatch in certain regions may continue to affect the cement prices and realisations for a few more quarters.

In FY2013, the company reported its poorest performance and reported net losses. If an

FY2013 annual report, page 23:

Owing to the sluggishness in demand, the high prices of power & fuel, freight and other raw materials could not be fully absorbed by the industry leading to a drop in profitability.

In FY2015, even though the company reported a significant jump in its OPM from 8% in FY2013 to 16% in FY2015, still, it reported that the condition of the industry is still poor with large underutilized capacity and inability to pass on the increase of raw material costs to the customer.

FY2015 annual report, page 31:

Supply overhang due to large capacity additions in the past few years continues to put pressure on prices. This has led to a drop in capacity utilisation throughout the industry.

All cost increases will burden the industry as it has not succeeded in passing these to the customers over the past few years.

FY2016 annual report, page 42:

..the overall scenario remains one of over-capacity. Industry estimates put the capacity utilisation levels in the financial year 2015-16 (FY16) in the range of 71% to 72%. Further, the industry’s inability to pass on the input cost increases to the customers during the past few years have led to a steady erosion of margins.

FY2017 annual report, page 46:

The supply side continues to stare at over-capacity resulting in lower capacity utilization. A significant increase in the power & fuel cost impacted the margins since the industry was unable to pass on the increases to the consumers mostly due to competitive environment.

FY2018 annual report, page 61:

Industry operated at an average capacity utilization of ~65% during FY18, flat to marginally positive over the previous year.

Over the next two years, about 43 million tonnes of capacity addition is expected, mostly through brown field expansion projects.

Low demand with increased availability took away the pricing power making it difficult for the industry to pass on the increased input costs to the market

Read: How to do Business & Industry Analysis of a Company

Therefore, an investor notices that the company has clearly stated to its investors that the position of overcapacity in the industry is hurting the profit margins. As a result, an investor notices that Heidelberg Cement India Ltd has taken many steps to reduce its costs in order to improve its profit margins.

a) Control of power and fuel costs:

While analysing the operating costs of Heidelberg Cement India Ltd, an investor notices that over the years, the power & fuel costs of the company had been increasing year after year. In FY2012, power & fuel costs increased to the level of 35% of sales.

In the FY2012 annual report, the company recognized power & fuel costs as an important area to focus on. Therefore, it started exploring ways to reduce power costs.

a.i) Waste Heat Recovery Plant:

One of the ways to reduce power was to install a waste heat recovery (WHR) power plant.

FY2012 annual report, page 21:

The Company is setting up a Waste Heat Recovery based Power Generation Plant at its clinker unit at Narsingarh, Damoh (M.P.) which will generate power for captive consumption reducing dependence on grid power and also the amount spent on power.

The WHR plant was completed in FY2016.

FY2016 annual report, page 7:

The commissioning of our Waste Heat Recovery based power plant at Narsingarh is a major step in the direction of reducing the power cost of the company.

An investor gets to know the true benefits of the WHR plant in the conference call conducted by Heidelberg Cement India Ltd in February 2018, when she reads that the cost of power generated by the WHR plant is ₹0.5 per unit. In comparison, the cost of power from the grid was ₹5.5 to 6 per unit.

February 2018 conference call, page 5:

Management: Your question is with respect to waste heat recovery power generation cost vis-à-vis the grid cost?

Sanjay Nandi: Exactly. I just wanted to know how much cost we can save.

Management: It is very negligible, waste heat recovery power cost is variable cost, it is nothing, it is hardly 50 paisa per unit power generation cost.

Sanjay Nandi: 50 paisa per unit compared like normal generally comes at Rs. 4 – Rs. 4.5, right sir?

Management: It is more, in MP it invariable power cost from the grid is Rs. 5.5 – Rs. 6.

In the FY2018 annual report, an investor notices that the power from the WHR plant meets about 40% of the power needs of the Narsingarh Plant, Madhya Pradesh.

FY2018 annual report, page 11:

The first and foremost initiative was to reduce our dependence on costly grid power and therefore installed Waste Heat Recovery (WHR) Plant and successfully substituted close to 40% of the grid power requirements of Narsingarh Plant.

a.ii) Sourcing of solar power for Ammasandra plant, Karnataka:

In FY2019, Heidelberg Cement India Ltd entered into a contract to source solar power for about 50% of the total power requirement of the Ammasandra plant, Karnataka.

FY2019 annual report, page 9:

The Company also entered into a 25-year solar power purchase agreement for its Ammasandra Unit, which will meet close to 50% of its energy requirements.

Advised reading: How to do Business Analysis of Solar Power Plants

a.iii) Sourcing power from alternate sources instead of contracted power from the grid:

The company started looking for alternate avenues for power other than the contract demand from the distribution companies.

FY2018 annual report, page 11:

Another initiative that has made a remarkable difference to our power cost is reducing the Contract Demand with the Discom. With due diligence, our teams have progressively optimized Contract Demand for power across all plants. This has helped us save substantial amount on account of contract demand charges levied by Discom.

In the conference call conducted by Heidelberg Cement India Ltd in February 2020, the company intimated to the analysts that the power sourced from outside sources is 20-25% cheaper.

February 2020 conference call, page 9:

Mangesh Bhadang: Two, three questions: Firstly, the power that you said, sourcing outside, if we may know the rate of the power that you are purchasing for? And again for your Ammasandra unit, I think you have a solar PPA. What could be the rate for that?

Management: At least 20%, 25% the power sourced from outside is cheaper.

In February 2020 investor presentation, page 6, an investor notices that the company is dependent on the grid for only 65% of its power requirements. It indicates that it is able to meet about 35% of the power needs from the WHR plant, solar power, and alternate outside sources.

HCIL’s dependence on grid power decreased to 65%.

Therefore, an investor observes that the initiatives taken by the company to reduce its power and fuel costs have resulted in good benefits. In FY2012, the power & fuel costs increased to 35% of sales, which steadily declined to 24% in FY2019. It is one of the major reasons leading to the improvement of the profitability margins of the company over the years.

b) Lower transportation costs:

While analysing the company, an investor notices that the company has undertaken other initiatives to reduce its transportation costs.

b.i) Higher focus on road transport:

After the company reported its lowest ever OPM of 7% in FY2011, Heidelberg Cement India Ltd undertook many initiatives to reduce its operating costs. One of the initiatives taken was to reduce its reliance on railway freight and increase the share of road transport.

FY2012 annual report, page 6:

Our strategy to increase road dispatches, in view of the steep hike in railway freight towards the end of the first quarter of 2012, has yielded results and during the year your Company crossed the initial target of one million tonne road dispatches in Central India

The company also took other steps like direct dispatches of cement to customers from its plants instead of warehouses to reduce transportation costs.

FY2019 annual report, page 09:

Steps like route rationalisation, reduction in turnaround time and direct dispatches from plant instead of warehouse resulted in significant savings.

Further advised reading: Understanding the Annual Report of a Company

b.ii) Overland conveyor belt to reduce the cost of limestone transportation:

The company installed a 21 km long conveyor belt to transport limestone from the mine to the plant, which reduced transportation costs.

FY2019 annual report, page 9:

The transportation of limestone from Patheria Mines to Narsingarh Clinkerisation Plant is done in a sustainable manner via a 21 km long Over Land Belt Conveyor (OLBC). Despite being capital intensive, OLBC has helped in reducing our carbon footprint and transportation cost as well.

b.iii) Optimization of logistics:

In addition, the company undertook other optimization initiatives like for transportation of fly ash to reduce costs by 21%.

FY2018 annual report, page 38:

The Company was also able to reduce fly ash cost by 21% through optimization of logistics at Damoh and Jhansi Plants.

c) Use of cheaper pet coke as fuel instead of costlier coal:

In order to control its operating costs, the company shifted from using coal in its kiln to using pet coke, which is a cheaper source. Pet coke is so cheaper when compared to coal that in FY2017, despite a doubling of pet coke prices, it was still cheaper to use than coal.

FY2017 annual report, page 44:

Despite the doubling in prices from USD 40 per tonne, pet coke still continues to be economical compared to coal, though this increase has impacted the margins of the industry.

d) Reverse auction of bags to reduce packaging costs:

In FY2016, the company initiated a reverse auction to source packaging bags, which resulted in additional savings.

FY2016 annual report, page 18:

Packing costs were low due to fall in polypropylene granule prices. Additionally, the Company managed to lower cost by about 7% by conducting reverse auctioning of bags.

e) Different ways of sourcing gypsum to save costs:

In FY2018, Heidelberg Cement India Ltd started the e-auctioning of gypsum to reduce costs by about 18%.

FY2018 annual report, page 38:

The Company procured natural gypsum through e-auction route and achieved cost reduction of 18% despite the uptrend witnessed in international price of gypsum.

In FY2019, the company entered into long-term contracts to source gypsum, which resulted in an additional cost savings of about 5% over FY2018.

FY2019 annual report, page 9:

During the financial year, the Company entered into a long-term contract for procurement of gypsum leading to reduction in cost by 5% over the previous year.

f) Reducing the interest expense on the loans:

While reading the annual report of Heidelberg Cement India Ltd, an investor notices that the company did a debt-funded capital expenditure in 2011-2013 to expand its manufacturing capacity.

While analysing the financial performance of the company, an investor witnesses that until FY2012, when the company’s capital expenditure was under execution and the interest costs were being capitalized; it was reporting profits. However, in FY2013, when the capital expenditure was completed and the interest cost on the entire loan was deducted in the profit & loss statement (P&) as an expense, then Heidelberg Cement India Ltd reported net losses. In FY2013, the interest expense in the P&L increased to ₹106 cr from ₹10 cr in FY2012.

It seems that the company acknowledged high-interest costs on the debt as one of the reasons for the loss. Therefore, as a solution, it issued non-convertible debentures to the parent company at a comparatively lower interest rate.

FY2013 annual report, page 10:

In order to curtail the finance costs, your Company issued Debentures aggregating to INR 3700 million to its ultimate holding company HeidelbergCement AG of Germany thus facilitating repayments of high interest bearing term loans of INR 3700 million taken from banks for Damoh and Jhansi expansion projects. These Debentures carry a fixed interest rate of 10.4% per annum which will lead to a saving of around 3% per annum in the interest costs.

As a result, the company could save about 3% per year on loans of ₹370 cr, which is a saving of about ₹11.1 cr per year.

g) Increase in the capacity utilization levels:

Perhaps the most important factor that has led to the lowering of operating costs and the increase in profitability margins of Heidelberg Cement India Ltd from FY2015 to FY2019 is the sustained increase of capacity utilization levels over these years.

FY2019 annual report, page 12:

Over the years, we have consistently and steadily increased the capacity utilisation from about 78% in FY15 to about 91% in FY19.

The increase in capacity utilization in a capital-intensive industry like cement has a huge impact on profitability margins. This is because all the fixed costs of the company are divided over a higher production volume of cement. As a result, the costs per tonne of cement come down and the profitability per tonne of cement goes up.

Therefore, apart from the cost reduction measures discussed above, the significant increase in the capacity utilization of the plants seems one of the major steps that has led to the increase in the profitability of Heidelberg Cement India Ltd.

However, at this stage, an investor would remember the above discussion about the cement industry in which we could observe that it is suffering from high installed capacities resulting in low capacity utilization.

Heidelberg Cement India Ltd has stressed year after year that the significant underutilized vacant capacity has led to a tough situation for the industry. The industry is not able to pass on the increase in raw material costs to its customers due to its oversupply situation. This has been true for almost the entire previous decade.

A reading of the FY2011 annual report indicates the extent of overcapacity in the cement industry when an investor notices that the average capacity utilization of the industry is 73%.

FY2011 annual report, page 14:

During CY 2011 approx. 20 Million t of cement capacity was added by the industry taking the overall installed cement capacity to approx. 296 Million t as on 31 st December 2011.

Capacity utilization during CY 2011 averaged at 73% against 76% for CY 2010.

While reading the development of the cement industry by way of analysis of Heidelberg Cement India Ltd over the years, then she notices that the intensely competitive position of the industry along with huge oversupply has worsened over the years.

By 2019, the condition of the industry as measured by total manufacturing capacity and its utilization has worsened further. From 2011 to 2019, the total capacity increased from 296 MTPA to 495 MTPA whereas the utilization declined from 73% to 68%.

February 2020 investor’s presentation, page 4:

All India installed cement capacity estimated to be c. 495 Mn T.

During calendar year 2019, cement Industry reported production volume growth of 3.5%. The cement Industry operated at an average utilization of c. 68%.

In addition, as per the FY2019 annual report, the investor notices that the cement industry is planning to make substantial capacity additions.

FY2019 annual report, page 57:

Over the next two years, ~45 million tonnes additional capacity is expected to get commissioned

This comes in a sharp contrast to the common assumption that any industry usually adds capacity when the utilization levels increase to a high level. Then why is it that the cement industry is continuously adding capacities despite low capacity utilization levels?

An investor would appreciate that more capacity additions in an industry, which is facing an oversupply will further erode the pricing power of the manufacturers. Therefore, in a normal market, it is in the favour of the suppliers to use their existing capacities fully before they resort to capacity addition.

However, an investor would notice that in the cement industry, this normal market assumption has not worked.

The failure of normal market forces of supply and demand and their impact on the price of cement was noticed many years back by the Builder Association of India (BAI), which primarily consisted of the consumers of the cement industry. BAI noticed that despite significant underutilized capacity, the cement manufacturers are not producing cement in sufficient quantities. As a result, there was an artificial shortage situation for cement in the market, which led to an increase in the price of cement.

Therefore, the BAI complained against the cement industry to the Competition Commission of India (CCI) about the cement manufacturers acting as a cartel by producing a lower amount of cement and keeping the prices higher. CCI asked the Director General (DG) to conduct an investigation. After the investigation, CCI found that indeed, the cement manufacturers were coordinating with each other to restrict supply and keep the prices higher.

As a result, CCI held the cement companies guilty of acting in collaboration with each other to distort the market and in turn hurt the consumers, the market, and the economy. CCI put a steep penalty of about ₹6,700 cr on various cement manufacturers as well as their industry body, Cement Manufacturers’ Association (CMA). CMA was held guilty of providing the platform where the cement players met and coordinated their production and pricing strategies in order to keep the prices higher.

Competition Commission of India’s order on the Cement Manufacturers:

The CCI order on August 31, 2016, downloadable from the CCI website (click here) is very interesting reading. We have incorporated the key aspects from the order below, as the order is a very important resource to understand the cement industry and its dynamics.

Key aspects of the complaint by the Builders’ Association of India (BAI):

• Page 10: Cement manufacturing units had deliberately reduced their production and produced much less than their installed capacity to create an artificial scarcity and raise the prices of cement in order to earn abnormal profits.

Key findings of the investigation conducted by the Director General (DG)

• Page 22: The nature of product being almost homogeneous in nature facilitates oligopolistic pricing. Further, the cement industry has witnessed a lot of consolidation and concentration of market in the last decade. However, in terms of market power, none of the companies has the strength to operate independently. The DG has submitted that the price of cement charged by all the companies is not at competitive levels and the cement manufacturers have been operating at a profit margin of more than 25%.
• Page 22: there has been a continuous divergence between the cement price index and the index price of various inputs like coal, electricity and crude petroleum and the gap has widened since 2000-01. The price of cement is rising faster than input prices.
• Page 23: It has been noted by the DG that the price of cement has been on rise since 2004-05 from about Rs.150/- per bag to close to Rs.300/- in March 2011, whereas during the same period, the cost of sales has only increased about 30%. As such, the price of cement has been independent of the cost of sales. The price of cement is changed frequently by all the companies. Sometimes, the price changes are made twice a week.
• Page 27: The Opposite Parties were not able to substantiate reasons for low capacity utilisation even during the period when the demand was high.
• Page 27: According to the DG, reduction in capacity utilisation is not in line with the overall growth of Indian Economy. Further, as far as consumption is concerned, whatever is produced by the cement manufacturers is consumed in the market. Therefore, the argument of cement manufacturers that the capacity utilisation has been lower in recent years because of low demand is not tenable.
• Page 29: Hence, the DG has concluded that the reduction in capacity utilisation during 2009-10 and 2010-11 was deliberate in order to limit the supply of cement in a concerted manner to charge a higher price.
• The DG, during the investigation found instances where the prices of cement were increased after the cement manufacturers met in their industry body (CMA) meetings. Page 106:

Key parts of the order by CCI:

• Page 144: The Commission notes that evidently the growth rate in production lagged substantially in 2010-11 as against the growth rate of capacity additions. Installed capacity witnessed an increase in growth rate by 16.06%, but the production grew marginally by 2.85% only. In comparison, in the year 2009-10, the growth rate in capacity addition was 19.80% and growth rate in production was 12.87%.
• Page 151: From the data tabulated above, it is evident that during November 2010, all the cement companies including the Opposite Parties had reduced production, although in 2009, in some cases, there was drop in production and in many cases there was increase also.
• Page 161: The Commission further observes that the third and fourth quarter of 2010-11 witnessed a GDP growth rate of 8.3% and 7.8% at factor cost respectively and the construction industry witnessed a growth of 9.7% and 8.2% in Q3 and Q4 of 2010-11 respectively. However, the cement industry registered a negative growth rate of 5.43% and 3.41% in cement production in November and December of 2010-11, respectively.
• Page 161: Thus, the Commission observes that the cement companies reduced production and dispatches of cement in a period when the demand from the construction sector was positive during November and December, 2010 and thereafter raised prices in the months of January and February, 2011,
• Page 161: Thus, it is evident that the cement companies have been limiting and controlling supply in periods just before the peak demand season to create artificial scarcity in the market in order to sell cement at higher prices in the peak season.

As a result, the CCI observed that:

• Page 175: The Commission notes that the impugned action of the Opposite Parties was not only detrimental to the interests of the consumers but the Opposite Parties also earned huge profit margins by acting in concert and co-ordination upon prices, production and supplies. Such conduct deprives not only the consumers but the economy also from exploiting the optimal capacity utilisation and thereby reducing prices. Further, the act of the Opposite Parties is also detrimental to the whole economy since cement is a critical input in construction and infrastructure industry vital for economic development of the country.

From the above order of CCI on the cartelization of the cement industry, an investor notices that:

• The cement manufacturers reduced production even when there was a demand. After all, whatever they were producing was getting completely sold in the market.
• Cement manufacturers reduced cement production even at times when the India GDP as well as the construction industry was growing at a fast pace.

The cement companies appealed against the CCI order in National Company Law Appellate Tribunal (NCLAT). However, the NCLAT dismissed their appeal in July 2018. (Source: Cement firms lose cartel case: The Telegraph).

Currently, the cement companies have appealed against the CCI order in the Supreme Court of India (Source: SC stays CCI penalty of ₹6300 crore on cement firms: Livemint)

Investors would notice that the CCI order explains the unique situation observed in the cement industry where there was continuously low capacity utilization. However, still, the cement manufacturers were adding new capacities. This goes against the normal market behaviour where any company first attempts to utilize its existing manufacturing capacities fully before it puts up a new manufacturing plant.

An investor may notice that in the case of Heidelberg Cement India Ltd, the company has increased its manufacturing capacity only when it has reached almost 100% capacity utilization in its existing plants.

At the time of capacity expansion in FY2013, the company’s existing plants were running at near full capacity utilization.

FY2012 annual report, page 19:

Despite the challenging times and slowdown in GDP growth, the Company achieved a healthy capacity utilization of 93% as against the industry average of around 75% to 80%.

Similarly, in FY2020, the company announced plans to expand its capacity when its existing plants reached near full utilization levels.

February 11, 2020, corporate announcement by Heidelberg Cement India Ltd to the Bombay Stock Exchange (BSE), page 1:

Moreover, an investor would also recollect from the above discussion that the capacity utilization of Heidelberg Cement India Ltd has increased over FY2015-FY2019:

FY2019 annual report, page 12:

Over the years, we have consistently and steadily increased the capacity utilisation from about 78% in FY15 to about 91% in FY19.

Therefore, an investor may think that Heidelberg Cement India Ltd is not part of the cartel. Moreover, its name does not feature in the list of the companies on which CCI has put a penalty in its order. Therefore, an investor may believe that Heidelberg Cement India Ltd is immune to the outcome of the appeal of cement manufacturers pending in the Supreme Court of India.

However, an investor would appreciate that the intention of the regulatory action by CCI and the penalty of about ₹6,700 cr put by it on the cement manufacturers is to break their cartel. The message from CCI to the cement manufacturers and their industry body, CMA, is to follow normal market behaviour where different players attempt to maximize their production even if they have to give discounts to the customers to sell higher volumes. If CCI/the govt. were to succeed, then an investor would appreciate that the supply of cement would increase and the prices of cement may decline.

Considering the 68% capacity utilization of the cement industry in 2019, an investor can understand that cement production can increase to 1.5 times of the current production without any additional investment in the industry only by making the cement manufacturers follow the fair market principles.

An investor should not forget that Heidelberg Cement India Ltd is a part of an industry where the product is a non-differentiable commodity. If there is a price difference, then the consumer can easily switch to another supplier without any impact on the building or the road it is constructing.

Therefore, if the cement industry starts to follow the fair market principles of demand & supply, and in turn, starts to utilize its underutilized capacity, then the price of cement for the entire industry will decline. The reduction in the selling price of cement will affect all the players in the industry. The current high operating profit margins may not be sustainable in the normal market scenario.

Therefore, an investor should keep a close watch on the developments related to the appeal of the cement manufacturers in the Supreme Court of India. In addition, she should keep a close watch on the signs of the return of the fair market principles in the cement industry like:

• Cement manufacturers trying to offer discounts to the customers in order to fully utilize their installed cement capacity.
• Cement manufacturers installing new capacities only after their existing capacities are fully utilized.

It is important to monitor these dynamics. This is because a return of fair market principles in the cement industry would lead to a sharp increase in the supply of cement along with a possible decline in its prices.

To understand more about the cement industry, an investor may read the analysis of the following article where we discuss the business analysis of cement companies in detail: How to do Business Analysis of Cement Companies

While looking at the tax payout ratio of Heidelberg Cement India Ltd., an investor notices that for most of the last 10 years (FY2010-2019), the tax payout ratio of the company has been in line with the standard corporate tax rate prevalent in India.

For the years in which the tax payout ratio is different from the standard corporate tax rate like FY2013 & FY2015 (50%) and FY2016 (22%), the investor notices that it is primarily due to deferred tax charges. For example in FY2016, the major difference in the tax payout ratio is due to certain expenses that are deductible as per the Income Tax Act.

FY2017 annual report, page 93:

Further advised reading: How to calculate Deferred Tax

Operating Efficiency Analysis of Heidelberg Cement India Ltd:

a) Net fixed asset turnover (NFAT) of Heidelberg Cement India Ltd:

When an investor analyses the net fixed asset turnover (NFAT) of Heidelberg Cement India Ltd in the past years (FY2009-19), then she notices that the NFAT of the company has declined from 2.91 in FY2011 to 0.89 in FY2016. Thereafter, the NFAT increased to 1.20 in FY2019.

The sharp decline in the NFAT from FY2011 to FY2013 from 2.91 to 1.12 seems to be due to the capacity expansion done by the company in 2013.

FY2012 annual report, page 7:

The expansion project at Jhansi Unit in U.P. has been successfully completed and commercial production from the new plant at Jhansi commenced on 16 th January 2013. Trial runs at the new plants at Narsingarh and Imlai in Damoh (M.P.) have started and commercial production is expected to commence shortly.

From FY2016, the NFAT has increased steadily from 0.89 to 1.20 in FY2019. The increase in NFAT seems due to steadily increasing capacity utilization over FY2015-FY2019.

FY2019 annual report, page 12:

Over the years, we have consistently and steadily increased the capacity utilisation from about 78% in FY15 to about 91% in FY19.

Nevertheless, an investor would notice that in FY2019, the NFAT of Heidelberg Cement India Ltd is 1.20 at more than 90% capacity utilization levels. The low NFAT indicates that the cement industry is a very capital-intensive industry where companies need to invest a lot of money in fixed assets to produce sales.

If an investor appreciates that the current cement prices that are leading to the NFAT of 1.20 at near full utilization are artificially inflated due to cartelization of cement manufacturers, and the real market price of cement should be lower, then she would notice that the NFAT of the cement industry would be even lower. It may even be less than one if the cement industry operates with fair market principles.

An investor may use another method of calculating asset turnover. From the FY2012 annual report, page 7, an investor gets to know that Heidelberg Cement India Ltd spent about ₹1,570 cr on expansion projects.

Capital expenditure on the entire expansion project is about MINR 15700 (including interest during the construction period that has been capitalized), which has been funded through a mix of internal accruals, External Commercial Borrowings (ECB) from the promoter group and term loans from Indian Banks.

Advised reading: Understanding capitalization of Interest

The expanded capacities became functional in FY2013. Therefore, an investor would be right to assume that the sale of ₹870 cr in FY2012 is from the previously installed capacities. When an investor notices the sale of the company at ₹2,170 cr in FY2020 at a near 100% capacity utilization level, then she can assume that the incremental sales of ₹1,300 cr (= 2170-870) from FY2012 to FY2020 is due to:

1. Full utilization of newly created capacities in FY2013 and
2. Utilization of previously unutilized parts of the old capacities.

Therefore, an investor would appreciate that the investment of ₹1,570 cr done by the company in the capacity expansion has led to less than ₹1,300 cr of sales after full utilization. This indicates that at the current cement prices, the investment in the cement industry leads to an NFAT of less than one.

This low asset turnover of less than one has serious implications as a huge amount of incremental investment is needed to show future growth. For the below illustrations, we assume that the cement industry has an NFAT of 0.8 (1,300 / 1,570 = 0.828)

For example, let us assume that in the first year, a cement company targets to achieve ₹1,000 cr. of additional sales.

• As per the NFAT of 0.8 then it would need to invest INR 1,250 cr. in fixed assets (1,000/0.8, because the fixed asset turnover ratio is 0.8).
• This ₹1,000 cr. of additional sales would provide additional net profits of ₹120 cr. (assuming 12% NPM of Heidelberg Cement India Ltd in FY2020).
• If the cement company retains entire profits and invests in its operations, then this incremental investment of ₹120 cr. of entire profits would generate only ₹96 cr. of incremental sales in the second year (as the fixed asset turnover ratio is 0.8, 120*0.8 = 96).
• If the cement company wishes to grow sales by another ₹1,000 cr. in the second year as well, then it would have to generate ₹904 of sales (=1,000 – 96) by investing an additional ₹1,130 cr. (=904/0.8 or can be calculated as ₹1,250 cr of total requirement – ₹120 cr. of net profits reinvested). This ₹1,130 cr. needs to come from either fresh equity infusion or debt.
• Please note that these calculations would give the same inference even if an investor assumes that the new capital investment in the first year will take about 3 years to reach full utilization and the company will plan a new capital expenditure only after about 3 years of last capacity addition.

Thus, we may see that with a very low fixed asset turnover of 0.8, a cement company would have to keep on relying on additional sources of funds to maintain its growth. We observe this aspect of the growth of the cement manufacturers when we analyse their self-sustainable growth rate (SSGR) discussed below.

Such industry dynamics indicate that the cement industry is very tough to operate where the manufacturers produce a non-differentiable commodity product after putting in a lot of investment.

In light of this, the regular news of different cement manufacturers going out of business should not come as a surprise to investors. There has been a lot of consolidation in the cement industry over the years where a few large cement manufacturers dominate the industry and keep buying the outgoing manufacturers. It has been the case in India as well as in overseas markets where a few large players like Ultratech, Holcim, Lafarge, Heidelberg etc. are dominating the markets.

In the above discussion, an investor would appreciate that the basis of sales and profits is the current market price, which as per CCI and the Builders’ Association of India, is artificially inflated by the cement manufacturers through cartelization.

If the cement industry starts following fair market principles and starts utilising their underutilized capacities; then as a result, the supply would increase and the cement prices will decline. In such a scenario of lower cement prices, many more inefficient players will go out of business who are currently surviving due to cartelization.

An investor would appreciate that the cement industry may need to do a complete overhaul with bringing in a lot more efficiency in its operations if it has to make good profits while following fair market principles.

The extent of inefficiency in the operations of one segment of the cement business becomes evident to the investor when she goes through the conference call conducted by Heidelberg Cement India Ltd in February 2020. In the conference call, the management of the company explained that in India, none of the cement companies is making profits in the key segment of ready-mix concrete (RMC).

February 2020 conference call, page 12:

In Indian context, no ready mix manufacturer I would say would make money unless he gets cement at a subsidized rate. If I can sell my cement in the market easily. I would not like to give it to my RMC unit who will want a cement price close to about Rs.500, Rs.600 lower to make him itself survive.

The management intimated that the RMC units survive only when the cement-manufacturing unit gives them cement at a subsidized price.

Therefore, if normal business principles start operating in the cement industry, then it will be very tough for inefficient players to survive. As a result, an investor should closely monitor the developments related to the appeal of cement manufacturers pending in the Supreme Court of India. In addition, she should also keep monitoring the change in the business practices of the cement industry where they might start following fair market principles like:

• Cement manufacturers trying to offer discounts to the customers in order to fully utilize their installed cement capacity.
• Cement manufacturers installing new capacities only after their existing capacities are fully utilized.

Any development on these fronts may bring a large change in the manner in which the cement industry functions.

Further advised reading: Asset Turnover Ratio: A Complete Guide for Investors

b) Inventory turnover ratio of Heidelberg Cement India Ltd:

While analysing the inventory turnover ratio (ITR) of the company, an investor notices that the ITR of Heidelberg Cement India Ltd had been witnessing an improvement from 6.3 in FY2012 to 14.5 in FY2019.

This improvement reflects efficient inventory management by the company. In addition, a high inventory turnover also indicates that the company does not need to hold a lot of cement stock with itself. This indicates that whatever cement is produced gets sold in the market, which was also observed by the Director-General in the probe for CCI.

Advised reading: Inventory Turnover Ratio: A Complete Guide

c) Analysis of receivables days of Heidelberg Cement India Ltd:

While analysing the receivables days of the company, an investor notices that the receivables days of Heidelberg Cement India Ltd have been continuously low in the single digits. In addition, the receivables days of the company have improved from 10 days in FY2010 to 4 days in FY2019.

A low receivables position of 4 days indicates a very strong position of the company in the business.

Further Advised Reading: Receivable Days: A Complete Guide

Looking at the inventory turnover ratio as well as at receivables days of Heidelberg Cement India Ltd, an investor would notice that the company has been able to keep its working capital position under control and not let it deteriorate over the last 10 years (FY2009-2019). As a result, it has not witnessed a lot of money being stuck in the working capital.

An investor observes the same while comparing the cumulative net profit after tax (cPAT) and cumulative cash flow from operations (cCFO) of the company for FY2009-19.

Over FY2009-19, Heidelberg Cement India Ltd Limited reported a total cumulative net profit after tax (cPAT) of ₹742 cr. During the same period, it reported cumulative cash flow from operations (cCFO) of ₹2,119 cr. An investor notices that the company has a very high cCFO when compared to the cPAT over the last 10 years (FY2009-2019).

It is advised that investors should read the article on CFO calculation, which would help them understand the situations in which companies tend to have the CFO lower than their PAT. In addition, the investors would also understand the situations when the companies would have their CFO higher than their PAT.

Further advised reading: Understanding Cash Flow from Operations (CFO)

Learnings from the article on CFO will indicate to an investor that the cCFO of Heidelberg Cement India Ltd is significantly higher than the cPAT due to the following factors:

• Interest expense of ₹615 cr (a non-operating expense) over FY2009-2019, which is deducted while calculating PAT but is added back while calculating CFO.
• Depreciation expense of ₹738 cr (a non-cash expense) over FY2009-2019, which is deducted while calculating PAT but is added back while calculating CFO.

Therefore, an investor would appreciate that during FY2009-2019, Heidelberg Cement India Ltd has kept its working capital requirements under check. As a result, it has been able to convert its profits into cash flow from operations.

The Margin of Safety in the Business of Heidelberg Cement India Ltd:

a) Self-Sustainable Growth Rate (SSGR):

Read: Self Sustainable Growth Rate: a measure of Inherent Growth Potential of a Company

Upon reading the SSGR article, an investor would appreciate that if a company is growing at a rate equal to or less than the SSGR and it is able to convert its profits into cash flow from operations, then it would be able to fund its growth from its internal resources without the need of external sources of funds.

Conversely, if any company attempts to grow its sales at a rate higher than its SSGR, then its internal resources would not be sufficient to fund its growth aspirations. As a result, the company would have to rely on additional sources of funds like debt or equity dilution to meet the cash requirements to generate its target growth.

While analysing the SSGR of Heidelberg Cement India Ltd, an investor would notice that the company has consistently had a negative SSGR over the years. One of the key reasons for a low SSGR for the company has been its low net fixed asset turnover (NFAT) i.e. highly capital-intensive business. In the above discussion on NFAT, an investor would remember that the NFAT of the cement business is even less than one.

While studying the formula for the calculation of SSGR, an investor would understand that SSGR directly depends on the NFAT of a company.

SSGR = NFAT * NPM * (1-DPR) – Dep

Where,

• SSGR = Self Sustainable Growth Rate in %
• Dep = Depreciation rate as a % of net fixed assets
• NFAT = Net fixed asset turnover (Sales/average net fixed assets over the year)
• NPM = Net profit margin as % of sales
• DPR = Dividend paid as % of net profit after tax

(For systematic algebraic calculation of SSGR formula: Click Here)

Therefore, an investor would notice that Heidelberg Cement India Ltd has continuously had a low SSGR (negative) over the last 10 years (FY2009-2019). However, an investor would appreciate that the company has been growing at a rate of 10-12% over the years.

The historical low SSGR indicates that the company does not seem to have the inherent ability to grow at the rate of 10-12% from its business profits. As a result, investors appreciate that Heidelberg Cement India Ltd would have to raise money from additional sources like debt or equity to meet its investment requirements.

While analysing the past financial performance of Heidelberg Cement India Ltd, an investor notices that the company has to rely on additional debt. The total debt of the company increased by about ₹515 cr over the last 10 years. The total debt of the company increased from ₹2 cr in FY2009 to ₹517 cr in FY2019 indicating a net inflow of ₹515 cr (= 517 – 2) from debt.

In addition, the company has used about ₹158 cr of cash & investments during the last 10 years. The company used to have cash & investments of ₹496 cr in FY2009, which declined to ₹338 cr in FY2019 indicating utilization of ₹158 cr (=496 – 338).

Therefore, an investor would appreciate that over the last 10 years (FY2009-2019), the company used up about ₹673 cr (=515+158) of funds apart from its profits to achieve a 10-12% growth rate.

An investor reaches a similar observation when she analyses the free cash flow (FCF) position of the company over the last 10 years (FY2009-2019).

b) Free Cash Flow (FCF) Analysis of Heidelberg Cement India Ltd:

While looking at the cash flow performance of Heidelberg Cement India Ltd, an investor notices that during FY2009-19, the company had a cumulative cash flow from operations of ₹2,119 cr. During this period it did a capital expenditure (capex) of ₹2,091 cr. As a result, an investor would note that over FY2010-2019, Heidelberg Cement India Ltd reported a free cash flow (FCF) of ₹28 cr. ( = 2,119 – 2,091).

In addition to the capital expenditure, the company had to meet the interest expense of about ₹615 cr on the debt that it had for FY2009-2019. Please note that the amount of interest capitalized by Heidelberg Cement India Ltd is already reflected in the amount of capital expenditure.

As a result, the company had a total cash shortfall of ₹587 cr (= 28 – 615).

The company met this shortfall from the following sources:

• Additional debt: ₹515 cr as discussed above.
• Using its existing cash & investments: ₹158 cr as discussed above.

Therefore, an investor would notice that the growth achieved by the company during the last 10 years (FY2009-2019) surpassed the ability of the internal cash generation ability of the company from its cash flow from operations. As a result, the company had to rely on additional debt and equity to meet its funds’ requirements.

Further advised reading: Free Cash Flow: A Complete Guide to Understanding FCF

Free cash flow (FCF) is one of the main pillars of assessing the margin of safety in the business model of any company.

Further advised reading: 3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of Stock Investing

Additional aspects of Heidelberg Cement India Ltd:

On analysing HeidelbergCement India Ltd and reading its publicly available past annual reports and reading other public documents an investor comes across certain other aspects of the company, which are important for any investor to know while making an investment decision.

1) Management Succession of Heidelberg Cement India Ltd:

While analysing the history of Heidelberg Cement India Ltd, an investor notices that the company was originally incorporated as Mysore Cements Ltd. In 1958 by S.K. Birla. In 2006, HeidelbergCement of Germany bought a controlling stake in the company from the promoters. Later, the company was renamed Heidelberg Cement India Ltd.

After the takeover of the company, Heidelberg Cement India Ltd appointed Mr. Ashish Guha as the Managing Director (MD).

FY2007 annual report, page 42:

Key Management Personnel:

• Ashish Guha (M.D).
• Mr. N.L. Hamirwasia (M.D), (Resigned w.e.f. 23-08-2006)

Mr. Ashish Guha worked as the MD of the company from 2006 to June 30, 2014. Thereafter, Heidelberg Cement India Ltd promoted Mr. Jamshed Naval Cooper as MD & CEO of the company.

FY2015 annual report, page 24:

Note: (a) Mr. Ashish Guha was CEO & MD up to 30th June 2014. His remuneration was directly paid by HeidelbergCement AG. The Company has not paid any sitting fees / commission/remuneration to Mr. Guha.

(b) The remuneration of Mr. Jamshed Naval Cooper, CEO & Managing Director is borne and directly paid by HeidelbergCement AG. The Company does not pay any sitting fees /commission/ remuneration to Mr. Cooper.

Since June 2014, Mr. Jamshed Naval Cooper is heading the company. Therefore, an investor would notice that Heidelberg Cement India Ltd has been able to get professional talent to lead the company.

In addition, from the above disclosure, an investor also learns that the remuneration of the MD & CEO of Heidelberg Cement India Ltd is paid directly by the parent company, HeidelbergCement AG. This may be one of the means by the HeidelbergCement AG group to make the MD & CEO directly responsible for the interests of the overall objectives of the HeidelbergCement AG group.

Nevertheless, an investor notices that Heidelberg Cement India Ltd has been able to find professional talent to lead the company over the years.

Further advised reading: Are professionally managed companies safer for shareholders?

In addition, while analysing the annual reports of the company, an investor notices that Heidelberg Cement India Ltd does not have any employee stock options plan (ESOP).

FY2019 annual report, page 73:

The Company does not have any Stock Option Scheme.

Over the years, an investor would have come across multiple instances in the companies, which relied heavily on ESOP to reward their senior management that the professional managers took decisions with the short-term objective of a higher stock price in mind. Many times, these decisions of the management to please the stock markets to increase the stock price did not create long-term value for the shareholders.

Further advised reading: Steps to Assess Management Quality before Buying Stocks

2) Integration of loans of Heidelberg Cement India Ltd with its parent HeidelbergCement AG:

From the above discussion on the initiatives taken by the company to reduce its costs, an investor would remember that in FY2013, the company availed loans of ₹370 cr from its parent company in the form of debentures to repay high-cost bank loans. In this manner, the company saved 3% per year in interest expenses.

This indicated an instance to the investor that the parent company is willing to offer money to Heidelberg Cement India Ltd whenever needed.

Previously, in the FY2011 annual report, an investor notices that the parent company had given a corporate guarantee for the loans taken by Heidelberg Cement India Ltd.

FY2011 annual report, page 33:

Term loan from Banks (Secured by 100% unconditional and irrevocable Corporate Guarantee of HeidelbergCement AG, Germany, the ultimate holding company)

From the corporate guarantee, it becomes clear to the investor that the parent company of Heidelberg Cement India Ltd has given full assurance to the lenders that the money given by them to Heidelberg Cement India Ltd is safe as the parent company will pitch in to repay the money in case the Indian subsidiary faces any issues.

Moreover, the credit rating report of Heidelberg Cement India Ltd prepared by India Ratings in March 2020 explains the extent of integration of debt facilities of Heidelberg Cement India Ltd and its parent company.

….and the presence of a centralised treasury, as the debt is initially raised in the HCAG books and then downstreamed to the Indian entity. The company’s strong legal linkage with HCAG is reflected by its working capital facilities, which are carved out of HCAG’s global limits and have a cross-default provision.

The financial position of Heidelberg Cement India Ltd and its parent company is deeply integrated to such an extent that in March 2017, the credit rating agency, India Ratings upgraded the credit rating of Heidelberg Cement India Ltd because the credit rating of its parent company, HeidelbergCement AG had improved.

March 2017 credit rating report, page 1:

The upgrade reflects an upgrade in the ratings of HCIL’s ultimate parent HeidelbergCement AG (HCAG, Fitch Ratings Ltd: Issuer Default Rating: ‘BBB-’/Stable ).

An investor would appreciate that the assurances from the parent company in the form of debt, corporate guarantee, cross-default provisions etc. give confidence to the lenders and other stakeholders in their dealings with Heidelberg Cement India Ltd, which in turn, helps the company in conducting its business.

However, such integrations of financial dealings of the entire group of companies are a two-way street. If the company benefits from these intra-group transactions on some occasions, then the investor needs to understand that at times, the company would be required to offer its financial resources for the benefit of other group companies.

In FY2018, an investor gets an indication of the possibility that Heidelberg Cement India Ltd may be asked to use its financial resources for other group companies when the board of directors asked for shareholders’ approval to give ₹50 cr as a working capital loan to its group company, Zuari Cements Ltd.

FY2018 annual report, page 128:

…consent of the members of the Company, be and is hereby accorded to give Inter-Corporate Loans to Zuari Cement Limited (ZCL), part of HeidelbergCement Group, from time to time up to an aggregate amount of Rs. 500 million (principal amount) on such terms and conditions as may be mutually agreed between the Company and ZCL for the purpose of working capital of ZCL

Therefore, going ahead, an investor should closely monitor the related party transaction of Heidelberg Cement India Ltd with its group companies to assess whether there is an attempt to shift the economic value belonging to the shareholders of Heidelberg Cement India Ltd to other group companies.

Further advised reading: How to analyse Related party transactions

3) Management of interest rate risk by Heidelberg Cement India Ltd:

While analysing the annual reports of the company, an investor notices that over the years, Heidelberg Cement India Ltd has used interest rate swaps to manage its interest rate risk.

Before FY2017, the company used interest rate swaps to convert a variable interest rate into a fixed interest rate.

FY2011 annual report, page 46:

The Company has a cross currency interest rate swap agreement with a bank for ECB Loan of USD 90,000,000 whereby the Company pays a fixed rate of interest of 7.65% to 9.55% (for various tranches of loan) and receives a variable rate equal to LIBOR 6M+250 bps on the loan amount. The swap is being used to hedge the ECB loan taken on floating interest rate of LIBOR 6M+250 bps.

The loss on account of restatement of ECB amounting to Rs. 6,293.18 lacs has been charged off to Profit and loss account and off set with a similar gain on increase in fair value of cross currency swap.

From FY2017, Heidelberg Cement India Ltd reversed the nature of the interest rate swap. Now, it started receiving the variable interest rate and paying a fixed interest rate.

FY2017 annual report, page 86:

The Company had an interest rate swap agreement whereby the Company receives a fixed rate of interest of 9.08% and pays interest at a variable rate. The swap is being used to hedge the exposure to changes in the fair value of its fixed rate unsecured loan. The decrease in fair value of the interest rate swap has been recognised in finance costs and offset with a similar gain on the bank borrowings.

The usage of interest rate swaps to measure interest rate risk indicates a prudent practice by Heidelberg Cement India Ltd.

Further advised reading: Understanding the Annual Report of a Company

4) The curious case of interest-free loans from Uttar Pradesh Govt. to Heidelberg Cement India Ltd:

While reading the annual reports of the company, an investor notices that the UP govt. has offered interest-free loans to Heidelberg Cement India Ltd.

On the face of it, these loans may seem like free money from the govt. to the company. However, when the investor analyses further, then she notices that these loans are secured by a bank guarantee. In addition, an investor would appreciate the bank providing the guarantee to the UP govt. on behalf of Heidelberg Cement India Ltd, will levy charges to cover the risk the bank is taking. Therefore, overall, the company ends up paying a price equal to its credit risk.

FY2019 annual report, page 108:

The Company has availed the facility of interest free loan from ‘The Pradeshiya Industrial and Investment Corporation of U.P. Ltd.’ (‘PICUP), Lucknow in accordance with the ‘Industrial Investment Promotion Scheme-2012′, Uttar Pradesh. This loan is secured by bank guarantee and repayable after expiry of 7 (Seven) years from the date of disbursement of loan. Effective interest rate in respect of this borrowing is 9.01% p.a for the year ended 31 March 2019 and 31 March 2018.

An investor would notice that the effective cost of these interest-free loans to the company, 9.01% per year, is not very different from the interest rate it is paying to its parent company for its loans.

FY2019 annual report, page 108:

The Company has availed Indian rupees term loan in the form of External Commercial Borrowing (ECB) from HeidelbergCement AG, Germany, the ultimate holding company outstanding amounting to Rs. Nil (31 March 2018: Rs. 1500.0 million ) on unsecured basis. This was repaid fully in current year. Interest rate in respect of this borrowing was 10.5% p.a for the year ended 31 March 2019 and 31 March 2018.

Therefore, an investor would appreciate that the term “interest-free” may lead an investor to think that the loans are truly free of cost. An investor may think that these loans may seem like free money to the company, which it can simply invest in bank fixed deposits and earn profits. However, it does not seem to be the case because these “interest-free” loans have an effective cost of about 9.01% per year.

5) Incentives for indirect taxes VAT and GST for Heidelberg Cement India Ltd:

While reading the annual reports of the company, an investor notices that Heidelberg Cement India Ltd is eligible to receive refunds on the Value Added Tax (VAT), and Central Sales Tax (CST), which are included in the Goods & Services Tax (GST).

FY2019 annual report, page 124:

The Company is entitled to benefits under the Madhya Pradesh State Industrial Promotion Policy, 2004 and 2010 for the increased cement production facility at Damoh, Madhya Pradesh w.e.f. 18 February 2013. Under the said policy, the Company has been exempted from payment of Entry Tax on input materials for a period of 7 years and also claim refund upto 75% of VAT/CST paid ( which is now subsumed on GST) on sales for a period of 10 years within the state of Madhya Pradesh in respect of the increased production facility.

On March 31, 2019, Heidelberg Cement India Ltd had receivables of about ₹63 cr for these benefits.

FY2019 annual report, page 105:

Therefore, an investor would appreciate that on March 31, 2019, the company is eligible to receive refunds of about ₹63 cr from the govt. However, in the February 2020 conference call, the company intimated to the investors that there are many uncertainties surrounding the amount of refund since the change of taxation to GST.

February 2020 conference call transcript, page 11:

…under the VAT scheme, we have been claiming that money and we were getting from the government also in time. Now, post-GST they have given the notification that yes, company will be entitled to the benefit of the same basis. Again, they have come up in the month of August 2019 one notification which talks about the basis of the calculation differently than what we used to get under the VAT regime…..Since based on the new notification the amount has reduced significantly…..we have discontinued this benefit, difference is really huge…

Therefore, going ahead, an investor may keep a close watch on the developments related to the incentives of past taxation schemes on conversion to the GST regime. An investor may update her assumptions based on future developments.

The Margin of Safety in the market price of Heidelberg Cement India Ltd:

Currently (June 2, 2020), Heidelberg Cement India Ltd is available at a price-to-earnings (PE) ratio of about 14.5 based on FY2020 earnings. The PE ratio of 14.5 provides some margin of safety in the purchase price as described by Benjamin Graham in his book The Intelligent Investor.

However, we recommend that an investor may read the following articles to assess the PE ratio to be paid for any stock, taking into account the strength of the business model of the company as well. The strength in the business model of any company is measured by way of its self-sustainable growth rate and the free cash flow generating the ability of the company.

In the absence of any strength in the business model of the company, even a low PE ratio of the company’s stock may be signs of a value trap where instead of being a bargain; the low valuation of the stock price may represent the poor business dynamics of the company.

• Further advised reading: 3 Principles to Decide the Ideal P/E Ratio of a Stock for Value Investors
• Read: How to Earn High Returns at Low Risk – Invest in Low P/E Stocks
• Further advised reading: Hidden Risk of Investing in High P/E Stocks

Analysis Summary

Overall, Heidelberg Cement India Ltd seems a company that has been growing its business at a fast pace of 10-12% year on year for the last 10 years (FY2009-2019). However, the business performance of the company over this period has been cyclical. The company’s performance has alternated between good periods and poor performance periods. At times, the company witnessed increasing sales along with improving profit margins. However, at other times, it witnessed declining sales and profit margins.

The fluctuating performance of the company is primarily due to the non-differentiable commodity product of the company along with a fragmented industry with a large unutilized manufacturing capacity. The cement industry is exposed to many cyclical factors like general economic cycles, govt spending on infrastructure, rainfall, agricultural output, crude oil prices etc. All these parameters expose the cement industry to alternate periods of good and poor performance.

Over the years, Heidelberg Cement India Ltd has taken several initiatives to reduce its costs like installation of the waste-heat-recovery power plant, buying solar power, buying power from other sources than the distribution companies, reducing transportation costs by optimizing logistics and installing overland conveyor belt etc. In addition, the company prioritized the use of pet coke instead of coal in its plants to save on costs. The company took loans from its parent company and paid off high-cost bank loans to reduce interest costs.

Further, the company increased its capacity utilization over the years to benefit from economies of scale. As a result, the profit margins of the company witnessed a significant increase in recent years.

The near-full capacity utilization of Heidelberg Cement India Ltd is in stark contrast to the very low capacity utilization of the cement industry. An investor is left guessing the answers to this strange behaviour. However, she gets the answer when she reads about an order from the Competition Commission of India (CCI) where CCI found that the cement industry acted as a cartel to increase prices.

An investigation by the CCI found that the cement manufacturers are distorting the market by acting as a cartel. CCI held the cement manufacturers guilty of deliberately producing less cement even when there was an increase in demand in order to create artificial scarcity. CCI imposed a penalty of about ₹6,700 cr on the cement manufacturers as well as on their industry body, Cement Manufacturers’ Association (CMA) because it acted as a platform for the manufacturers to coordinate their prices, production, and other strategies. CCI held that the cement manufacturers have deliberately kept their capacity utilization low.

The findings of the CCI order explain the unique nature of the cement industry where the manufacturers are continuously increasing their capacity despite significant underutilization. This is contrary to the normal market behaviour where the manufacturers increase capacity when their existing capacities are almost fully utilized.

An investor should keep a close watch on the behaviour of cement manufacturers to monitor if the industry starts following the fair market principles when the manufacturers compete with each other in order to fully utilize their manufacturing capacities even if it involves giving discounts to the customers. This is because a return of fair market principles to the cement industry will increase the supply sharply and may lead to a decline in cement prices, which as per CCI are artificially inflated.

An investor notices that the cement manufacturing business is highly capital-consuming. It has a net fixed asset turnover of less than one. As a result, any growth plans of the companies put them under a debt burden. Heidelberg Cement India Ltd was not able to meet its growth requirements from its business profits. It had to rely on debt to increase its business.

If the cartel of cement manufacturers breaks, the supply increases, and the cement prices fall, then many inefficient cement manufacturers may go out of business. An investor should keep a close watch on the developments in the industry especially the outcome of the appeal of cement manufacturers against the CCI order in the Supreme Court of India.

Heidelberg Cement India Ltd is a professionally run company that has been able to find professionals for its leadership positions.

The financial position of Heidelberg Cement India Ltd is closely integrated with its parent group where the parent company gives it loans and gives guarantees to its lenders for the loans given by them to Heidelberg Cement India Ltd. However, such comfort comes with trade-offs as the parent group plans to use resources from Heidelberg Cement India Ltd to give working capital loans to its group company Zuari Cements Ltd.

Going ahead, an investor should keep a close watch on the developments in the cement industry to check whether the manufacturers have started following the fair market principles like:

• Cement manufacturers trying to offer discounts to the customers in order to fully utilize their installed cement capacity.
• Cement manufacturers installing new capacities only after their existing capacities are fully utilized.

It is important to monitor these dynamics. This is because a return of fair market principles in the cement industry would lead to a sharp increase in the supply of cement along with a possible decline in its prices.

In addition, the investor should keep a close watch on the profitability margins of the company, its debt levels, and its related party transactions with the group companies. If the investor finds that the parent group is using the economic benefits belonging to the shareholders of Heidelberg Cement India Ltd to its other group entities, then she may take a decision accordingly.

Further advised reading: How to Monitor Stocks in your Portfolio

These are our views on Heidelberg Cement India Ltd. However, investors should do their own analysis before making any investment-related decisions about the company.

You may use the following steps to analyse the company: “Selecting Top Stocks to Buy – A Step by Step Process of Finding Multibagger Stocks”

I hope it helps!

Regards,

Dr Vijay Malik

P.S.

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.