Better times ahead for Kajaria, Somany

Lower gas prices and capacity additions will aid growth for both firms, though upside potential seems higher for the latter

Tile makers Kajaria Ceramics and Somany Ceramics have gained market share in recent years on the back of higher than industry volume growth. Capacity expansions and higher investment in brand-building are key factors.

Lower natural gas prices have aided operating margins, as this is a key raw material used by these companies. In fact, the ongoing renegotiations with Qatar-based RasGas on sourcing agreements and gas pricing are crucial for India, as it can lead to higher supplies at significantly lower prices. Likely imposition of anti-dumping duties on tiles imported from China will also allow these companies to take price increases (offsetting potential cost pressures) and aid their volumes, as Chinese imports impact eight to nine per cent of industry volumes in coastal regions such as Mumbai, Kolkata and Kochi, among others. This and implementation of a national goods and services tax (GST) will be key catalysts for these companies.

Kajaria and Somany plan to increase capacities of their facilities and joint ventures over the next two years, as they try to capture a larger part of the unorganised tiles market, nearly half the domestic industry. In this backdrop, analysts expect Kajaria and Somany's revenues and earnings to grow at a compounded annual rate (CAGR) of 20-25 per cent over the next two years.

While the Street remains positive on both stocks, Kajaria appears fairly valued from a short-term perspective. On the other hand, a recent qualified institutional placement (QIP) by Somany will enable it to reduce its net debt to equity ratio to 0.4, from 0.6 in FY15. The share price of Somany, third largest entity in the tiles market, trades at a discount to that of the industry leader Kajaria but this could narrow a little.

"We believe the discount between Somany and Kajaria's one-year forward price to earning (PE) will narrow down to 17 per cent, to align with the historical average, driven by strong earnings growth and an improvement in balance sheet of the former," says Deepak Purswani, analyst at ICICI Direct. At current levels, this discount has widened to about 35 per cent. Kajaria trades at 27 times its FY17 consensus earnings estimates, this ratio stands at about 18 for Somany. Analysts on an average expect Somany's share price to rise about 16 per cent from current levels, which in the case of Kajaria is pegged at three per cent. Thus, investors could consider Kajaria on corrections from a one to two year perspective.

Under-penetration of tiles, especially in rural areas, along with increasing trend of nuclear families, will be key demand drivers for the sector. The managements of Kajaria and Somany remain confident of delivering better performance in the second half of this financial year, on the back of continued softness in input costs and likelihood of price increases in certain products. A falling proportion of outsourced volumes will also aid the margins of Kajaria though it will continue to invest in advertising and brand-building. The company enjoys industry-leading Ebitda (earnings before interest, tax, depreciation and amortisation) margins and that trend is likely to continue with a host of margin triggers in place.

For Somany, sanitaryware and faucets, as well as the exports business, though small, are expected to clock healthy growth and help diversify revenue streams. The rising proportion of vitrified tiles and potential price increases could improve realisations of the company.

On the whole, the long-term story of the two companies looks good, given India's demographic advantage. In fact, riding on improving market share and revenue base, the two companies have been multi-baggers on the bourses. Even after looking at some brief periods (like the post-Lehman crisis, and in 2011), the stocks have delivered a CAGR of 37 per cent each in the past 10 years. Though sustaining these could be difficult, the road ahead looks good.

On the flip side, recent times have witnessed slowing demand from private real estate companies. However, this has been offset to some extent by buoyant demand from the companies, government, retail and exports segments. Any delay in capacity expansion, further slowdown in the real estate sector and higher volatility in natural gas prices are among the key downside risks.