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Strong demand momentum; gas prices a monitorable

India’s leading ceramic players posted strong performance in 2QFY22 (volumes up 25%YoY on a low base; 2yr CAGR: +13%) on the back of major markets opening up, strong demand from smaller cities and market share gains from smaller players. EBITDA margins expanded sharply QoQ due to operating leverage benefit, though gross margins were lower due to price hikes and higher opening inventories. Ceramic companies are extremely optimistic on the business momentum owing to strong construction activity across India. Fuel costs continue to pose a challenge with a) Gujarat Gas hiked gas price sharply by 23% to c.INR 58/scm (excl taxes; +101% CYTD; likely to go up another 20% from 1st Dec’21), and b) Ras Gas price already jumped to INR 40/scm. Thus, we expect gas prices to rise sharply by 25- 30% QOQ in 3QFY22. We draw our optimism on the back of a) strong underlying demand, b) healthy real estate launches and c) Morbi players focus towards exports. However, we watch out for capacity addition by Morbi cluster, which could potentially have implication on demand-supply and consequently tile pricing scenario in medium term. We maintain BUY on Somany Ceramics (SOMC) on account of its balance sheet improvement, receding governance concerns and attractive valuation (20.5x FY23E EPS) while we have HOLD on Kajaria Ceramics (KJC) given rich valuations (35.5x FY23E EPS). We maintain HOLD on Cera Sanitaryware as we await better price for entry.

* Strong tile volume growth led by major markets opening up (+13% on 2yr CAGR); underlying demand remains robust: KJC/SOMC posted tile volume growth of +13% each on 2yr CAGR basis on the back of major markets opening up, strong demand from smaller cities and new constructions, distribution expansion and market share gains from smaller players. Managements remain extremely optimistic on the business momentum owing to a) strong underlying demand, b) healthy real estate launches, c) aggressive distribution expansion in smaller cities and d) Morbi’s focus on exports. Companies estimate tile exports from India to grow at healthy double digit driven by a) antidumping duties levied by various countries on China, b) anti-China sentiments and c) cost competitiveness of Indian manufacturers. This will lead to reduced competitive intensity and better profitability for organised players in the domestic market.

* Gross margins decline QoQ while operating margins expand due to operating leverage: KJC/SOMC/CRS posted gross margin (post power and fuel for tile players) contraction of 800bps/210bps/500bps QoQ respectively in 2QFY22 mainly on account of sharp rise I gas cost, higher RM costs and high opening inventories (absorption of manufacturing and storage costs into inventory valuation in 1QFY22) while EBITDA margins expanded sharply by 400bps/580bps/580bos QoQ due to operating leverage benefit. We expect EBITDA margins for ceramic companies to remain stable in 2HFY22 as a) companies are taking required price hikes to negate the raw material cost inflation and b) volume growth, thus driving operating leverage advantage.

* Increase in gas prices may have negative impact on the exports momentum: Morbi, which constitute 65-70% of the country’s tile manufacturing capacity, had been witnessing strong exports momentum till few months back on account of a) various countries imposed anti-dumping duty on Chinese tiles and anti-China sentiment owing to Covid-19 and b) traders have been increasing import share towards India to hedge purchases. Tile exports were up 20% YoY in FY21 despite the washout in Apr-May’20 due to Covid-19 lockdown. Export momentum continued to remain strong in Apr-Jun’21 (+25% 2yr CAGR), though slowed down in July-Sept’21 (+9% 2yr CAGR) due to container availability issues and high ocean freight. We note that Morbi players will need to take price increase in export orders given possible spike in fuel cost (gas price account for over 30% of tile realisation) as they work on thin margins in export segment. The impending hike could have modest negative impact on margins (if buyers don’t agree to this increase on existing order) and could also potentially hamper new exports momentum apart from margin contraction in the interim. Having said that, we also point out that there has been significant/similar fuel cost inflation as well as ocean freight increase even for other competing countries given it’s a global phenomenon and not particularly applicable to India. So industry players are expecting exports to revive as the inventories in consuming countries could be declining to critical levels.

* Ras gas to be significantly cheaper than Gujarat Gas in interim: Gujarat Gas Limited (GGL) announced a sharp price increase of c.INR 11/scm in industrial gas price (assuming similar increase for Morbi cluster will result into gas price of INR 58/scm). Cumulative price increase has been c.101% (INR 29/scm) in CY21. Ras gas price, direct function of Brent and USDINR, is expected to be around INR37.1/scm in 2QFY22. At current Brent (USD78/barrel) and USDINR (74.4), we estimate Ras Gas price to be c.INR 39.5/scm in 3QFY22, thus significantly cheaper to Gujarat Gas. Given the sourcing mix (ultimately linked with crude), Morbi gas price move in the same direction with Ras gas over medium to long term.

* Improvement in cash conversion cycle across ceramic companies: Ceramic companies have posted a significant improvement in net working capital days from the peak of 113 (median) in FY18 to 67 in FY21 mainly on the back of reduction in receivable days as they focussed on tightening the credit cycle and improving the collections efficiency, aptly helped by reduced competitive intensity from Morbi. This also led to significant jump in operating cash flows and consequently reduction in leverage (median net debt/equity reduced from 0.5 in FY16 to -0.1 in FY21).

* Recommendations: We maintain BUY on Somany Ceramics on account of its balance sheet improvement (net cash at standalone level), receding governance concerns and attractive valuation (20.8x FY23E EPS) while we maintain HOLD on Kajaria Ceramics given a) rich valuations (35.5x FY23E EPS) and b) downside risk to estimates due to rising fuel cost and lower than expected volume growth. We maintain HOLD on Cera Sanitaryware as we await consistent performance in core sanitaryware segment.

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