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Lockdown hurts quarter; strong demand momentum

India’s leading ceramic players posted weak volumes (2yr CAGR basis) in 1QFY22 as business was impacted by stringent lockdowns led by second wave of Covid-19, while EBITDA margins contracted sharply QoQ due to adverse operating leverage, though gross margins were higher due to price hikes and higher closing inventories (to impact gross margins in 2QFY22).

Demand scenario has been improving from mid-June’21 while July’21 has been impressive as sales has reached c.100% of normal levels. Fuel costs continue to post challenge with a) Gujarat Gas hiked gas price by 12% to c.INR 38/scm (excl taxes; +31% YTD), and b) Ras Gas price already jumped to INR 37-38 (assuming current Brent and USDINR, it will be INR 36.5/scm).

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 demandsupply and consequently tile pricing scenario in near term.

We maintain BUY on Somany Ceramics (SOMC) on account of its balance sheet improvement, receding governance concerns and attractive valuation (21.6x FY23E EPS) while we have HOLD on Kajaria Ceramics (KJC) given rich valuations (37.7x FY23E EPS). We maintain HOLD on Cera Sanitaryware as we await better price for entry.

* Tile volume growth impacted by Covid-19 second wave (8-12% decline on 2yr CAGR); underlying demand remains healthy: KJC/SOMC posted tile volume decline of 12%/8% respectively on 2yr CAGR basis due to stringent lockdowns across the country led by second wave of Covid-19, while the demand scenario has been improving from midJune’21 while performance in July’21 has been impressive as sales has reached c.100% of normal levels for large tile players. Companies estimate tile exports from India to grow c.20% in FY22 and FY23 each driven by a) anti-dumping 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. Companies expressed optimism on the business momentum on the back of a) strong underlying demand, b) healthy real estate launches and c) Morbi players focus towards exports.

* Gross margins improve QoQ while operating margins contract due to adverse operating leverage: KJC/SOMC/CRS posted gross margin (post power and fuel for tile players) expansion of 130bps/250bps/860bps QoQ respectively in 1QFY22 mainly on account of price hikes, better product mix and high closing inventories (absorption of manufacturing and storage costs into inventory valuation) while EBITDA margins contracted sharply by 570bps/770bps/570bos QoQ due to adverse operating leverage (1QFY22 volumes were severely impacted by lockdowns cuased by Covid-19 second wave). We expect margins for ceramic companies to normalise from 2QFY22 onwards as a) companies have taken required price hikes to negate the raw material cost inflation and b) volumes come back to normal levels.

* Increase in gas prices may have modest negative impact on the exports momentum: Morbi, which constitute 65-70% of the country’s tile manufacturing capacity has been witnessing strong exports momentum in recent months as 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 are up 20% YoY in FY21 despite the washout in Apr-May’20 due to Covid-19 lockdown (+26% 2yr CAGR in Apr-May’21). 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. We also highlight that c.60-70 large greenfield plants (mostly in GVT segment) are expected to commission over next 2-3 quarters to cater to export demand. As a result, we expect stable pricing scenario in domestic market in near term and continue to watch out on exports momentum.

* Ras gas to be slightly cheaper than Gujarat Gas in interim: Gujarat Gas Limited (GGL) today announced a sharp price increase of c.INR 4/scm in industrial gas price (assuming similar increase for Morbi cluster will result into gas price of INR 38.2/scm). Cumulative price increase has been c.31% (INR 9/scm) in CY21. Ras gas price, direct function of Brent and USDINR, is expected to be around INR37/scm in 2QFY22. At current Brent (USD68.4/barrel) and USDINR (74.21), we estimate Ras Gas price to be c.INR 36.5/scm in 3QFY22, thus slight 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.

* Channel check summary- Demand pick-up robust (ex-South): Our channel checks suggest that non-south regions demand scenario started improving from mid-June’21 and July’21 saw sharp improvement has it came to c.100% of normal levels (partially aided by pent up demand), while Aug’21 performance has also been healthy (till third week of Aug’21). For Southern regions, demand pick-up started improving from mid-July’21 as markets opening was delayed, though Aug’21 has been strong in (c.70-80% of normal levels).

Companies have taken price hikes in range of c.5-10% for tiles and c.15-25% for bathware in the past 6 months in order to offset raw material inflation. Though there was no major supply issues from organised players, supplies from Morbi region was impacted in the first half of Aug’21 on the back of truckers strike. Channel inventory levels have reduced on overall basis as dealers prefer to work on lean inventory models and demand based ordering which helps them to reduce working capital investment.

* 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 (21.6x FY23E EPS) while we maintain HOLD on Kajaria Ceramics given a) rich valuations (37.7x 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 better performance in core sanitaryware segment.

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