Stock Update ; UltraTech Cement

UltraTech Cement

Cluster: Ugly Duckling

Recommendation: Buy

Price target: Rs940

Current market price: Rs740

UltraTech-Samruddhi merger; swap ratio 4:7

Key points

The boards of directors of UltraTech Cement (UltraTech) and Samruddhi Cement (Samruddhi), a wholly owned subsidiary of Grasim Industries (Grasim), have approved Samruddhi?s merger with UltraTech. The exchange ratio recommended by the valuers and approved by both the boards is four equity shares of UltraTech of face value Rs10 each for every seven equity shares of Samruddhi of face value Rs5 each.
As per the share swap ratio, UltraTech will issue 14.95 crore new shares, thereby increasing its equity capital to Rs274.20 crore. The appointed date for the merger is July 1, 2010 and the scheme is likely to be consummated by Q3CY2010. As per the management, the merger will achieve the group?s objective of consolidating its cement business into a single entity, thereby creating a platform that will help in pursuing growth aggressively going forward.
Though the swap ratio at 1: 1.75 is marginally below our and the street?s expectation of 1:2 (ie one share of UltraTech for every two shares of Samruddhi) and would result in higher than expected equity dilution, the consolidation of the group?s cement business under UltraTech would create a cement behemoth with a capacity of 48.8 million tonne per annum (mtpa) and would eventually lead to the re-rating of UltraTech?s valuation. Moreover, in spite of the higher than expected equity dilution, we expect the merger to be earnings accretive for UltraTech in FY2011.
From Grasim?s point of view the share swap ratio would increase its stake in UltraTech from 54.8% to 60.3%, which would be earnings accretive (marginally) at a consolidated level. But from the valuation perspective, we believe the company will get a discount on its valuation as it would become just the holding company for the cement business.
Notwithstanding the marginally unfavourable swap ratio, we maintain our positive view on UltraTech and believe that the stock will eventually get re-rated and its valuation gap with the other front-line cement companies will narrow down. Currently, UltraTech trades at a ~20-25% discount to its peers like ACC and Ambuja Cement (each with a valuation of $110-120 per tonne). Thus, we maintain our price target of Rs940 and our Buy recommendation on the stock. At the current market price of Rs740 the stock trades at a price/earnings (PE) of 10.8x, an enterprise value (EV)/earnings before interest, tax, depreciation and amortisation (EBITDA) of 4.8x FY2011 earnings estimate (pre-merger) and EV/tonne of USD73 on an expanded capacity of 23.1 million tonne for FY2011.