Ceramics Tiles. Equity Research INDIA. Structural and sustainable play. Reason for report: Initiating coverage. May 20, 2016 BSE Sensex: 25400

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1 Equity Research May 20, 2016 BSE Sensex: Kajaria Ceramics (Rs1,074 HOLD) Target price Rs1,060 Somany Ceramics (Rs442 BUY) Target price Rs526 Research Analysts: Nehal Shah INDIA Ceramics Tiles Structural and sustainable play Reason for report: Initiating coverage The Indian ceramic tiles sector witnessed strong traction over FY08-FY14 with the industry growing at 15-18% CAGR, led particularly by: 1) new construction demand, 2) rising cost of real estate making tiles more affordable, 3) new technologies in ceramic and vitrified tiles segment, 4) imposition of anti-dumping duty on all tiles, and 5) increasing replacement to traditional flooring materials. Though the growth has seen some deceleration to 8-10% since FY15, we believe it would start picking up post-q2fy17 with the macro-economic recovery expected to play out gradually. Further, increasing adoption of the outsourcing model, steep correction in LNG prices and the recent imposition of anti-dumping duty would result in firm margins and strong RoCEs particularly for the branded players. Within the space, Kajaria Ceramics (KJC) and Somany Ceramics (SOMC) are best poised to play the theme considering their strong brand equity, widespread distribution network and sound management capabilities. We initiate coverage on the sector with a HOLD rating on KJC (target price: Rs 1,060 per share, valuing it at 25x FY18E earnings) and a BUY rating on SOMC (target price: Rs526 per share, valuing it at 20x FY18E earnings). Expect ceramic tiles industry to grow at 10-12% over FY16-FY18. The growth of the ceramic tiles industry (size currently pegged at Rs240bn) has decelerated from 15-18% CAGR in FY10-FY14 to 8-10% over the past few quarters largely due to the sustained slowdown in real estate, particularly in the metros and tier-1 cities. Interestingly, the high value-added glazed vitrified tiles (GVT) segment is still growing at 15-20% CAGR (despite sluggish demand in the metros and tier-1 cities) largely due to increasing penetration in the tiers-2&3 cities. With gradual economic recovery in sight post Q2FY17 along with the recent imposition of anti-dumping duty across the vitrified tiles category, we expect the overall tiles industry growth to accelerate to a CAGR of 10-12% over the next two years. Margins expected to remain firm. After three years of consecutive rise in LNG prices, gas prices finally started gradually declining since Mar;15 with the Japanese Crude Cocktail formula (based on 5-year average crude prices) tilting downwards. However, post the renegotiations between Petronet LNG and RasGas Company in Dec 15, LNG prices have come off steeply by US$6-7 per mmbtu thereby resulting in sharp reduction in fuel costs for the tile players from Q4FY16. Since the entire savings is unlikely to be passed on, we expect margins for the branded players to remain firm or even improve going forward. Outsourcing theme to further accelerate. With over 15-20% of capacity in Morbi, Gujarat, still remaining idle due to the current slowdown and incremental capacity addition by Morbi-based players, we expect the outsourcing theme to continue and expect the branded players to continue acquiring strategic stakes in these unorganised units and outsource from them at lower costs. This would not only enable the branded players to focus on brand and distribution, but would enhance their RoCEs as well. Valuation Summary Companies CMP (Rs) TP (Rs) Reco MCap (Rs bn) EPS (Rs) P/E (x) RoCE (%) FY17E FY18E FY17E FY18E FY17E FY18E Kajaria Ceramics Hold Somany Ceramics Buy Source: I-Sec research Please refer to important disclosures at the end of this report

2 Ceramics Tiles sector, May 20, 2016 TABLE OF CONTENTS Global tiles industry... 3 Evolution of the Indian tiles industry... 6 Indian tile industry at a glance... 9 Demand drivers for tiles industry Government policy reform A key trigger Increasing replacement to traditional materials Higher disposable income Increasing preference over natural stone Shift towards nuclear families Increasing applications Industry moving towards joint-venture model Benefits of joint-venture model Threat from Chinese imports negligible post the imposition of anti-dumping duty on vitrified tiles Anti-dumping duty on vitrified tiles: Much-needed relief to branded players Steep fall in gas prices a big relief for the industry Decoding the top brands in the industry; Competitive landscape Consolidation in tiles industry over FY06-FY Kajaria (KJC) vs Somany (SOMC): Comparison between the top-2 industry brands Index of tables and charts COMPANY Kajaria Ceramics Somany Ceramics Prices as on May 19,

3 Ceramics Tiles sector, May 20, 2016 Global tiles industry World ceramic tiles production has been growing at a healthy rate of 6.5% CAGR over CY10-CY14 and is estimated to have reached 12,409mn-sqm in CY14. Global consumption too has grown at a CAGR of 6.1% over the same period with total consumption pegged at 12,095mn-sqm. China is currently the largest producer and consumer of ceramic tiles in the world having a global share of 48% and 40%, respectively. Brazil and India remain the second and the third largest global producers and consumers of ceramic tiles. Table 1: Top 10 tile producing countries Countries CY11 CY12 CY13 CY14 CAGR % of CY14 world production China 4,800 5,200 5,700 6, % 48.4% Brazil % 7.3% India % 6.6% Spain % 3.4% Indonesia % 3.4% Iran % 3.3% Italy % 3.1% Vietnam % 2.9% Turkey % 2.5% Mexico % 1.9% Top 10 countries % 82.8% Global production 10,630 11,230 11,973 12, % 100.0% Table 2: Top 10 tiles consuming countries Countries CY11 CY12 CY13 CY14 CAGR % of CY14 World consumption China 4,000 4,250 4,556 4, % 40.5% Brazil % 7.1% India % 6.3% Indonesia % 3.4% Vietnam % 2.6% Iran % 2.3% Saudi Arabia % 2.0% USA % 1.9% Russia % 1.8% Turkey % 1.8% Top 10 countries 7, % 69.5% Global consumption 10,486 10,978 11,604 12, % 100.0% Table 3: Top 10 tiles exporting countries Countries CY11 CY12 CY13 CY14 % of CY14 % of CY14 world exports National production China 1,015 1,086 1,148 1, % 18.5% Spain % 82.7% Italy % 82.2% Iran % 26.6% India % 11.1% Turkey % 27.0% Brazil % 7.6% Mexico % 27.0% UAE % 54.1% Poland % 31.3% Top 10 countries 1,961 2,103 2,248 2, % 23.4% Global exports 2,346 2,520 2,655 2, % 21.6% 3

4 Ceramics Tiles sector, May 20, 2016 Table 4: Top 10 tiles importing countries Countries CY11 CY12 CY13 CY14 % of CY14 world imports % of CY14 National consumption USA % 68.8% Saudi Arabia % 61.0% Iraq % 99.0% France % 86.1% Germany % 79.2% Nigeria % 89.1% South Korea % 63.3% Russia % 33.3% UAE % 54.5% Philippines % 63.1% Top 10 countries % 66.2% Global consumption % 22.2% Chart 1: Global tile production and consumption by region Global production mix (CY14) Central south America 9.6% Other Europe 4.6% Africa 3.2% North America 2.5% Global consumption mix (CY14) Europe 7.0% Africa 6.2% Other Europe 4.5% Central America 3.8% Ocenia 0.4% Europe 9.6% Asia 70.5% North America 10.6% Asia 67.5% Table 5: Top 10 global players (CY15) Rank Company Country Capacity Production No of plants 1 Mohawk Industries Inc Location USA North America, Mexico, Europe, Russia and China 2 SCG Group Thailand Thailand, Vietnam, Indonesia and Philippines 3 Lamosa Mexico Mexico 4 RAK Ceramics UAE UAE, India, Bangladesh, Sudan, China and Iran 5 Incefra Brazil Brazil 6 Grupo Cedasa Brazil Brazil 7 Saudi Ceramics Saudi Arabia Saudi Arabia 8 Mulia Indonesia Indonesia 9 Cecafi Brazil Brazil 10 Rovese Poland Poland, Russia, Romania, UK and Germany Source: Ceramic World Review According to Ceramic World Review, Mohawk, the US is globally the largest player in ceramic tiles followed by SCG Group of Thailand. RAK Ceramics, the only global brand operating in India, is the fourth largest global player. Kajaria Ceramics (KJC), the Indian leader in tiles is positioned at the 14 th place as per the latest report released by Ceramic World Review. 4

5 Ceramics Tiles sector, May 20, 2016 Global per capita tiles consumption India stacked the lowest Despite strong growth by the Indian tiles industry over the past few years, the per capita consumption of ceramic tiles in India is only a seventh of Brazil s and a sixth of China s. Chart 2: Per capita consumption of tiles (in mn-sqm) globally (sq. m) Brazil China Turkey Veitnam Russia Indonesia USA India India currently has one of the lowest per capita consumption of 0.59sqm as against the world average of 1.4sqm. This represents a huge opportunity for the Indian ceramic tile industry in terms of higher penetration going forward. 5

6 Ceramics Tiles sector, May 20, 2016 Evolution of the Indian tiles industry Phase I: Last leg of Mosaics The Indian ceramic tiles industry grew at a modest CAGR of 10.7% from 1991 to At that point in time, usage of mosaic tiles was most prominent and had a market share of 70% of the flooring tiles industry. The ceramic industry (wall and floor) started to take off from 1995 with phase-wise reduction in excise duty which stood at 55% in The increasing awareness and reducing pricing differential between the ceramic and mosaic tiles led to strong growth for the ceramic tiles industry over the period Phase II: Fast-growing ceramic wall and floor tiles The reduction in excise duty structure from 55% in 1994 to 25% in 1998 and further to 16% in 2001 on ceramic tiles resulted in strong replacement to traditionally preferred mosaic tiles as the pricing differential between the two reduced considerably. In March 2000, the government lifted quantitative restrictions on imports of tiles, which marked the entry/import of vitrified tiles into India. As a result, the ceramic tile industry (ceramic wall, floor and vitrified floor) grew at 18% CAGR from 1997 to

7 Ceramics Tiles sector, May 20, 2016 Phase III: Huge success of soluble salt vitrified tiles With the flood of imports from China, prices of ceramic and vitrified tiles started decelerating, resulting in lower margins and profitability for domestic players. The industry grew stronger in volumes (over 18%) but in value terms, it grew 14% during the period. From 2006, the domestic industry got a strong push from better availability of natural gas, which reduced their cost of production. Domestic players started concentrating on in-house manufacturing of vitrified tiles (hitherto imported) which revolutionised the industry. It may be noted that mosaic tiles almost lost relevance during the period with the government imposing an 8% excise duty in 2006, which was increased to 16% in Phase IV: Era of digitisation Domestic manufacturers got a big fillip from lower capital cost of equipment, which were now imported from China instead of Italy, bringing costs down by ~50%. This, along with increasing natural gas availability, resulted in domestic industry becoming far more competitive compared to Chinese imports. The imposition of anti-dumping duty (Rs137 per sqm for ceramic wall and floor tiles and Rs155 per sqm for vitrified tiles) on Chinese tiles in and advent of new digital technology in tiles digital ceramic tiles, double-charged vitrified tiles and glaze-vitrified tiles boosted the domestic industry in a big way. All these developments resulted in strong industry growth of 18% from 2007 to

8 Ceramics Tiles sector, May 20, 2016 Phase V: 2015 onwards Moving towards large-format tiles With the persistent slowdown in the real estate sector and slowdown in infrastructure activities, the ceramic tiles industry started witnessing deceleration in growth since early Since then, growth rates have decelerated to higher single digits in the range of 8-10%. However, during the period, the industry graduated towards largeformat sizes, which have been finding increasing acceptance. Also, during this period, Chinese imports witnessed significant traction largely due to: a) hefty duty imposed by Brazil on Chinese tiles imports from Jul 14, and b) lapse in anti-dumping duty imposed on Chinese vitrified tiles since Jun 13. Post the duty imposed by Brazil, which made Chinese tile uncompetitive in the region, Chinese manufacturers started looking at India as an alternative destination for their tiles. This resulted in significant increase in imports from China in a short period of time, which touched 55mn-sqm (8% of the overall market) in FY16. However, with the recent imposition of anti-dumping duty on Chinese vitrified tiles, we expect the domestic players to gain sizeable market share vs Chinese imports. 8

9 Ceramics Tiles sector, May 20, 2016 Indian tile industry at a glance The Indian tiles industry is currently estimated to be at 756mn-sqm per annum in terms of volumes and Rs240bn in value. It has been growing at 12-14% CAGR over the past five years. The top-10 players, which include players based out of Morbi account for over 45% of the industry. The organised industry currently accounts for 30% of overall volumes and 50% of industry value while the unorganised players account for ~70% of total volumes and 50% of the industry value. Majority (90-95%) of the unorganised tiles industry is based out of Morbi in Gujarat with the balance being based out of Himatnagar (also in Gujarat) and Andhra Pradesh. Morbi over the past few years is increasingly becoming an outsourcing hub for the organised players. The installed capacity of Morbi (which houses close to 550 units) currently stands at 700mn-sqm per annum with nearly 15-20% of it being idle at this point in time. Table 6: Segment-wise break-up and growth of the tiles industry Segments Industry size FY15 Mix 5-year Volume Value CAGR (mn sq. m) (Rs bn) Volume Value Ceramic wall and floor % 44% 10-12% Polished vitrified tiles % 44% 12-14% Glazed vitrified tiles % 12% 20-25% Total % 100% 12-14% Chart 3: Tiles industry volume mix Chart 4: Tiles industry value mix GVT 7% GVT 12% PVT 35% Ceramic wall and floor 58% PVT 44% Ceramic wall and floor 44% The ceramic wall and floor segment currently accounts for 58% of industry volumes and 44% of the overall value. On the other hand, Polish Vitrified Tiles (PVT), which includes soluble salt vitrified tiles and value-added double-charged vitrified tiles, accounts for 35% of the overall volumes and 44% of the value. GVT, the fastest growing value-added tiles, accounts for 12% of the industry value and 7% of industry volumes. 9

10 Ceramics Tiles sector, May 20, 2016 Demand drivers for tiles industry Government policy reform A key trigger Tiles as a category constitute 5-10% of the total building/real estate cost. The following policy reforms set forth by the Union government are expected to stimulate strong demand for tiles: Swachh Bharat Abhiyaan Target is to construct 100mn toilets by 2019 to eliminate open defecation Cost of implementation is estimated at Rs620bn This program will drive demand for bathroom solution products sanitaryware, tiles and faucets Creation of 100 Smart Cities Focuses on city improvement / redevelopment / extension of 100 classified cities Disbursement of Rs960bn over the next five years to be shared equally by the Union and state governments This program will drive demand particulary for premium branded building material products Housing for All Target is to construct of 110mn urban and rural housing units by 2022 Housing shortage is currently at at 60mn units; incremental housing need is for 50 mn units by 2022 Focus on affordable housing for the Economically Weaker Sections (EWS) and Lower Income Groups (LIG) This program will stimulate demand for all building material products generally Implementation of GST Would reduce the pricing gap between branded and unbranded products Shift from unbranded to branded products to accelerate. Currently, 50% of the tiles industry is unorganised the shift to branded products, which would accelerate post GST implementation, is thus expected to benefit the branded tiles players 10

11 Ceramics Tiles sector, May 20, 2016 Increasing replacement to traditional materials In India, 47% of the population lives in houses with mud flooring, 37% with cement flooring and 11% with mosaic and tile flooring. With higher disposable incomes and tiles being of superior quality and durability, its increasing acceptance in both rural and urban India is expected to result in sustained demand for ceramic tiles. Table 7: Percentage of households by flooring material Flooring options India Rural Urban Mud 67% 57% 47% Stone Cement Tiles/Mosaic Others Higher disposable income Higher disposable incomes and increasing discretionary spends continue to be a major growth driver. It has been noticed that increasing aspirations levels are leading to consumers scaling up the value chain. There is a growing appetite for new styles and aesthetics. India seems to be moving from a price-conscious market to a value for money market. Increasing preference over natural stone Tiles have been replacing natural stone due to ease in laying, competitive costs, varying sizes and attractive designs. Like paints, but with a more time lag, there is also a shift being noticed to replace the older set of tiles with newer ceramic (digital) and vitrified tiles such as double-charged and digital glazed. The replacement cycle has considerably shortened (once or twice in a lifetime earlier to once in 10 years due to value addition). Shift towards nuclear families The shift towards nuclear families from joint families is also adding to the need for housing. This is expected to be a major driver for real estate, hence building materials going forward. Increasing applications New tiling applications that are opening up include exterior cladding, interior walls (apart from bathroom and kitchen) and paver tiles all of which would incrementally drive demand for ceramic tiles. 11

12 Ceramics Tiles sector, May 20, 2016 Industry moving towards joint-venture model Over the last decade, the manufacturing model for the branded players has undergone a sea change. The focus over the last decade has been shifting towards tying up with unorganised players (particularly in Morbi, Gujarat) for ensuring capacities with minimum gestation period and at lower costs. H&R Johnson (HRJ) was the first company in the tile industry to adopt the JV model way back in FY04. Kajaria Ceramics (KJC) on the other hand started getting aggressive towards the JV model only since Feb 11 while SOMC was the third company which entered into this model in Jan 12. Benefits of joint-venture model For the branded player Minimises gestation period for revenue generation Efficient operations run by promoters Leverages efficient manufacturing with brand equity and distribution Complementing the range of product offerings Low cost of production Superior return on investment For the unorganised JV partner Enables unorganised players to utilise their otherwise idle capacities Upfront monetisation by divesting partial or controlling stake Assured of optimum capacity utilisation as the JV s organised counterpart is committed to buy the entire capacity Assured cashflow/receivables from the branded players Table 8: Joint-venture arrangements by branded players so far H&R Johnson Kajaria Ceramics Somany Ceramics Nitco Tiles Asian Granito Orient Bell New Ceramic Tile Mfg. Silica Ceramica Soriso Ceramics Vintage Tiles Crystal Ceramics Vardhman Co. Sentini Ceramica Jaxx Vitrified Commander Vitrified Vennar Ceramics Antique Marbonite Vicon Ceramic (AP) Spectrum Johnson Cosa Ceramics Acer Granito Small Johnson Taurus Tiles Amora Tiles Floera Ceramics Somany Fine Vitrified With the idle capacities in Morbi at 15-20% and considering the new units in the pipeline, we expect the branded players to keep increasing their capacities through the joint-venture route. This would enable the branded players to keep focusing on brand and distribution while shifting their production base to Morbi units. Besides increasing their capacities at lower costs and without any gestation period, the JV model would also enable the branded players to improve their return ratios going forward. 12

13 Ceramics Tiles sector, May 20, 2016 Threat from Chinese imports negligible post the imposition of anti-dumping duty on vitrified tiles While Chinese imports currently account for 9-10% of volumes in India s tiles market, they no longer pose a threat to the industry, particularly with the imposition of antidumping duty on vitrified tiles w.e.f. Mar 16. However, imports from China would continue due to it being more economical in terms of logistics to feed the South Indian market. Table 9: Segment-wise break-up of tile imports Imports Volume (mn-sqm) Value (Rs bn) Share of overall size Ceramic wall and floor % Polished vitrified tiles % Glazed vitrified tiles % Total % A decade ago, imports accounted for 15-20% of the industry volumes, but have sharply fallen due to the following factors: With quality of Morbi-based players improving considerably, sourcing from Morbi has become a more viable option and more so with their economies of scale Lower capital costs in India, with machines now being imported from China instead of Italy, and increase in production costs in China due to lower natural gas availability and higher labour cost Imports at current INR/USD exchange rates are unviable as their landed cost would be higher than the Indian manufactured ceramic or vitrified tiles except for few categories of value addition where China enjoys significant economies of scale, hence is cheaper Imports of categories like double-charged vitrified tiles from China have been on a significant rise over the past couple of years post Brazil s imposition of antidumping duty on Chinese imports. However, the imposition of anti-dumping duty by India on Chinese imports w.e.f. Mar 16 would make Indian tiles competitive, and shift the tide towards Indian manufactured tiles. Anti-dumping duty on vitrified tiles: Much-needed relief to branded players The much needed anti-dumping has finally been imposed (though provisional) on all the categories of vitrified tiles polished and glazed vitrified tiles on 29-Mar 16 vide notification no. 12/2016-Customs (ADD). The duty levied at US$1.37 per sqm is for a period not exceeding six months unless revoked, amended or superseded earlier. We expect the anti-dumping duty to give an interim relief to domestic manufacturers and the same is likely to get reviewed and extended post the expiry of six months. With the ADD imposition now, we expect the domestic players to gain market share vs Chinese imports and also take a marginal price hike in PVT prices, which in turn would be margin-accretive. 13

14 Ceramics Tiles sector, May 20, 2016 Steep fall in gas prices a big relief for the industry During the period FY10-FY14, the tiles industry faced a double whammy with: i) spot gas prices nearly doubling to over US$19/mmbtu from US$10/mmbtu witnessed in Jan 10, and ii) steep INR depreciation during the period, which further increased domestic gas prices. Chart 5: Trend in spot LNG prices SPOT LNG PRICES - (USD/mmbtu) Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 Chart 6: Trend in INR/USD exchange rate USD/Rs Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 Sharp decline in spot LNG prices since Mar 15 Since Mar 15, the decline in fuel cost for the branded players was gradual even as the spot prices witnessed a sharp fall. This was largely due to sourcing of gas by branded players on long-term contract basis. Long-term LNG contract prices witnessed only a gradual fall in rates with the Japanese Crude Cocktail (JCC) formula, based on 5-year average crude prices, gradually tilting downwards. However, post the renegotiations between Petronet LNG and RasGas Company in Dec 15, LNG prices have come off by US$6-7 per mmbtu, thereby resulting in sharp reduction in fuel costs for the tile players from Q4FY16 onwards. Revision in price formula of RasGas LNG: Great relief for ceramic tile players RasGas LNG prices were determined on the basis of a formula taking into account the slope of the 12-month average JCC crude oil prices, with a lag of a quarter, subject to floor and cap based on 60-month average of JCC. As the average crude oil prices of the last 60 months have been significantly higher than the current crude oil prices (due to the sharp fall in crude oil prices over the past one year), the floor of the formula kept RasGas LNG prices at materially higher levels than spot LNG prices. However, on 31-Dec 15, Petronet LNG and RasGas Company Limited, Qatar, entered into a binding agreement for making major adjustments in their existing long-term LNG sale and purchase agreement (SPA) of 7.5mmtpa. As per the revised agreement, the FOB price of 7.5mmt of LNG would now be linked to the most recent 3-month average price of Brent crude oil, without any floor and cap, as opposed to the earlier price, which was linked to 12-month average price of JCC 14

15 Ceramics Tiles sector, May 20, 2016 subject to floor and cap linked to 60-month average of JCC. With the prevailing crude oil prices, FOB price of RasGas LNG is now estimated to be US$6.5-7/mmbtu since 1- Jan 16, as against the earlier price of ~US$12.5/mmbtu based on earlier formula. Table 10: Impact of RasGas renegotiation on the ceramic industry Region Vendor Gas prices for 9MFY16 (per scm) Gas prices Jan 16 (per scm) Gas prices Apr 16 (per scm) North India GAIL Rs38 Rs26 Rs24 Morbi units, Gujarat GSPC Rs29 Rs26 Rs24 We believe part of the fuel savings would be passed on by the industry players and/or utilised towards incremental brand spends, particularly by the branded players, while retaining the balance, which would aid expansion in margins. 15

16 Ceramics Tiles sector, May 20, 2016 Decoding the top brands in the industry; Competitive landscape Consolidation in tiles industry over FY06-FY15 The tiles industry over the past decade has witnessed huge consolidation among the branded players. While the market share of top-6 branded players has remained at 34-35% levels over the past decade, there have been a few brands that have done exceedingly well but at the cost of other brands. Chart 7: Consolidation phase among top-6 brands in the last decade FY06 FY15 14% 12% 10% 8% 6% 4% 2% 6% 10% 12% 8% 4% 6% FY06: Top 6 players market 35% FY15: Top 6 players market 34% 5% 4% 3% 3% 3% 2% 0% Kajaria Ceramics H&R Johnson Somany Ceramics Nitco Tiles Asian Granito Orient Bell HRJ, the biggest player until 2013 has seen its market share declining steadily over the last three years led by its overdependence on commodity segments. Similarly Nitco, too has been losing market share largely due its financial woes and overdependence on imports model. KJC and SOMC on the other hand has gained market share over the period. Table 11: Kajaria Ceramics and H&R Johnson Top two ceramic companies by revenues (Rs mn) FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 Kajaria Ceramics 5,289 6,912 7,668 10,051 14,072 17,336 20,225 24,041 H&R Johnson 10,310 11,060 11,580 14,290 16,580 17,270 17,416 20,853 Somany Ceramics 3,528 4,670 5,685 7,577 9,274 11,128 13,309 15,341 Nitco Tiles (ex-marbles) 5,236 5,400 3,890 5,315 8,045 7,912 7,471 7,955 Asian Granito (excomposites) 2,029 3,509 4,090 4,811 5,900 6,800 7,030 7,626 Orient Bell 4,040 4,393 4,343 4,257 5,835 6,205 6,335 7,497 Currently, Kajaria Ceramics (KJC) tops the chart in terms of revenues. Fast increasing brand equity and dealer loyalty of KJC resulted in its supassing H&R Johnson (HRJ) in FY13 and the gap between the two has since been widening. 16

17 Ceramics Tiles sector, May 20, 2016 Chart 8: KJC and SOMC post impressive 5-year revenue CAGRs led by growing brand equity Tiles industry Orient Bell Asian Granito Nitco Tiles 13.9% 11.5% 13.3% 15.4% Somany Ceramics 22.0% H&R Johnson 11.8% Kajaria Ceramics 25.7% 0% 5% 10% 15% 20% 25% 30% Table 12: Market share trend among top branded players (%) FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 Kajaria Ceramics H&R Johnson Somany Ceramics Nitco Tiles Asian Granito Orient Bell Total share of 6 players Chart 9: KJC and SOMC gain traction; HRJ and Nitco lose market share 14% Kajaria Ceramics H&R Johnson Somany Ceramics Nitco Tiles Asian Granito Orient Bell 12% 10% 8% 6% 4% 2% 0% FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 17

18 Ceramics Tiles sector, May 20, 2016 Table 13: Comparing top listed tile brands Parameters Kajaria Somany Nitco H&R Johnson Asian Granito Orient Bell Tiles turnover (FY15) Rs 24bn Rs 15.3bn Rs 8bn Rs 21.9bn Rs 7.6bn Rs 7.5bn EBIDTA Margins (FY15) 16.20% 7.00% -2.40% -0.10% 7.20% 7.30% Last 10 years CAGR 23% 23% 16% 15% 24% 10% Last 5 years CAGR (value addition) 26% 22% 15% 12% 13% 12% Business Inception : UK 1958 (Merged 1977 collaboration; 1997 with Prism 2000 (acquired Bell 1995: Full Cement in FY10) in FY11) control Brand Equity Presence Commodity & Value addition Dealer Strength Brand leader by a big margin as compared to peers Presence across segments; market leader in value addition Very strong & well distributed. Most of the big dealers already under their fold Steadily increasing Brand equity Aggressively moving towards value addition Too many dealers facing undercutting issues Last 3 years: brand value has come off A strong value-add player in ceramic floor tiles only Well distributed dealer network Oldest tile player. Brand value still remains strong but in commodity products Strong presence in commodity segments only Too many dealers lot of undercutting issues resulting in dilution of brand Average brand equity Presence across value chain. Focus however remains an issue Average dealer network Below average brand equity Limited value addition portfolio Weak distribution network Pricing Premium No. 1 No. 2 No. 3 No. 4 No. 5 No. 6 Innovation Very strong Strong Average Weak Average Weak 18

19 Ceramics Tiles sector, May 20, 2016 Table 14: Comparable income statements - FY15 KJC SOMC AGL OBL Revenues Cost of goods sold RMC Stock in trade Stores and spares Power and fuel Gross margin Other expenditure Employee expenses Administration expenses Freight A&P spends Commission/discount Other Selling & distribution EBIDTA margin Other income Finance costs Depreciation PBT Tax PAT Add: Share in profit of associates Less: Minority Interest Reported PAT

20 Ceramics Tiles sector, May 20, 2016 Kajaria (KJC) vs Somany (SOMC): Comparison between the top-2 industry brands Capacities KJC s capacities currently stand at 74.3mn-sqm per annum as compared to SOMC s 51.3mn-sqm. KJC s share of own manufacturing to total available capacity stands at 61% vs 50% in case of SOMC. Over the past six years, KJC s capacity has grown at 18% CAGR compared to SOMC s 16% CAGR. Also, KJC prefers controlling stake in acquired companies while SOMC initially acquired companies with 26% stake but has now moved to buying controlling stake in its last couple of acquisitions. Table 15: KJC capacities (mn-sqm) FY11 FY12 FY13 FY14 FY15 FY16 FY17E Gailpur and Sikandrabad Malootana, Rajasthan Soriso Ceramics (51% stake) Jaxx Vitrified (61% stake) Vennar Ceramics (51% stake) Cosa Ceramics (51% stake) Taurus Tiles (51% stake) Floera Ceramics (51% stake) Total capacities Table 16: SOMC Capacities (mn-sqm) FY11 FY12 FY13 FY14 FY15 FY16E FY17E Kadi Kassar Amora Tiles Pvt Ltd (51% stake) Somany Fine Vitrified (51% stake) Vintage Tiles Pvt Ltd (26% stake) Commander Vitrified Pvt Ltd (26% stake) Vicon Ceramic Pvt Ltd (26% stake) Acer Granito Pvt Ltd (26% stake) Total capacities Tiles revenue mix KJC has 61% of its revenues coming from PVT and GVT segments while SOMC is expected to close FY16 with ceramic and vitrified tiles both contributing equally. KJC is the largest player in GVT, the most premium value-add segment with GVT constituting 21% revenues as compared to 15% for SOMC. With SOMC s 4mn-sqm GVT line at Kassar recently commencing production, its GVT capacity has now increased to 9mnsqm, which is now in line with KJC s GVT capacity. We thus expect SOMC s GVT share of revenues to increase significantly over the next 2-3 years. 20

21 Ceramics Tiles sector, May 20, 2016 Chart 10:Kajaria s FY16 revenue mix Ceramic Tiles PVT GVT Sanitaryware and fittings Others 100% 7% 11% 14% 19% 20% 21% 80% 60% 43% 40% 40% 36% 38% 40% Chart 11:Somany s FY16E revenue mix Ceramic Tiles PVT GVT Sanitaryware and fittings Others 100% 4% 7% 15% 15% 15% 15% 80% 21% 23% 23% 27% 29% 60% 32% 40% 40% 72% 67% 20% 49% 46% 44% 44% 40% 36% 20% 58% 53% 50% 47% 0% FY11 FY12 FY13 FY14 FY15 FY16 0% FY11 FY12 FY13 FY14 FY15 FY16E Revenue mix sourcing-wise KJC has 49% of its revenues coming from own manufacturing and 40% from its subsidiaries. SOMC on the other hand has 35% and 8% of the revenues coming from own manufacturing and subsidiaries respectively, apart from having 35% of revenues from the 26% JV model. Vanilla outsourcing constitutes 9% and 16% of revenues for KJC and SOMC respectively. Chart 12:KJC sourcing strategy Chart 13:SOMC sourcing strategy 100% 80% 60% 40% 20% 0% Own manufacturing Subsidiaries Vanila outsourcing Allied products Others 46% 26% 20% 13% 8.7% 33% 4% 18% 27% 34% 39.1% 0% 52% 60% 55% 52% 52% 49.2% FY11 FY12 FY13 FY14 FY15 FY16 Own manufacturing Subsidiaries Associates Vanilla outsourcing Allied products 100% 4% 3% 4% 5% 6% 80% 35% 27% 19% 16% 42% 60% 35% 1% 14% 24% 38% 0% 0% 0% 40% 2% 8% 53% 48% 20% 45% 37% 35% 0% FY12 FY13 FY14 FY15 FY16e Net realisation The gap between KJC and SOMC realisations has narrowed down significantly with the latter getting aggressively focused on the vitrified segment GVT in particular. We expect the gap to further narrow down with SOMC s GVT segment expected to grow at a strong CAGR of 26% over FY16-FY18. 21

22 Ceramics Tiles sector, May 20, 2016 Chart 14: Realisation differential between KCJ and SOMC 400 SOMC KJC FY12 FY13 FY14 FY15 FY16E Net fixed asset turnover With the increasing share of outsourced revenues from 44% in FY12 to 51% in FY16E, SOMC s fixed asset turn is expected to increase from 4.7x in FY12 to 5.9x in FY16. KJC on the other hand has its fixed asset turn remaining flat with the increasing share of revenues from own manufacturing and subsidiaries. Chart 15: Fixed asset turn (x) KJC SOMC 0.0 FY11 FY12 FY13 FY14 FY15 FY16 Working capital management SOMC has considerably improved its working capital over the past five years. While both the companies had same working capital days in FY15, KJC s working capital is expected to have deteriorated vis-a-vis SOMC in FY16. SOMC has been reporting higher debtor days compared to KJC, but has been better off in managing its inventories over KJC. 22

23 Ceramics Tiles sector, May 20, 2016 Table 17: Working capital days KJC FY11 FY12 FY13 FY14 FY15 FY16 Receivable days Inventory days Payable days Working capital days SOMC FY11 FY12 FY13 FY14 FY15 FY16E Receivable days Inventory days Payable days Working capital days Debt/Equity Both KJC and SOMC have shown significant reduction in debt and debt/equity ratio over the past five years led by higher profitability, increasing free cash from operations, and sound working capital management. Chart 16: Declining debt/equity KJC SOMC (x) FY11 FY12 FY13 FY14 FY15 FY16E RoCE KJC posted an impressive RoCE of 31.4% while SOMC is expected to report RoCE of ~19.6% in FY16. However we expect the gap to narrow significantly with SOMC expected to improve its RoCE by 540bps over the next two years compared to improvement of 110bps in RoCE for KJC over the same period. 23

24 Ceramics Tiles sector, May 20, 2016 Chart 17: Improving RoC (%) KJC SOMC 0.0 FY11 FY12 FY13 FY14 FY15 FY16E 24

25 Ceramics Tiles sector, May 20, 2016 Index of tables and charts Tables Table 1: Top 10 tile producing countries... 3 Table 2: Top 10 tiles consuming countries... 3 Table 3: Top 10 tiles exporting countries... 3 Table 4: Top 10 tiles importing countries... 4 Table 5: Top 10 global players (CY15)... 4 Table 6: Segment-wise break-up and growth of the tiles industry... 9 Table 7: Percentage of households by flooring material Table 8: Joint-venture arrangements by branded players so far Table 9: Segment-wise break-up of tile imports Table 10: Impact of RasGas renegotiation on the ceramic industry Table 11: Kajaria Ceramics and H&R Johnson Top two ceramic companies by revenues Table 12: Market share trend among top branded players Table 13: Comparing top listed tile brands Table 14: Comparable income statements - FY Table 15: KJC capacities Table 16: SOMC Capacities Table 17: Working capital days Charts Chart 1: Global tile production and consumption by region... 4 Chart 2: Per capita consumption of tiles (in mn-sqm) globally... 5 Chart 3: Tiles industry volume mix... 9 Chart 4: Tiles industry value mix... 9 Chart 5: Trend in spot LNG prices Chart 6: Trend in INR/USD exchange rate Chart 7: Consolidation phase among top-6 brands in the last decade Chart 8: KJC and SOMC post impressive 5-year revenue CAGRs led by growing brand equity Chart 9: KJC and SOMC gain traction; HRJ and Nitco lose market share Chart 10:Kajaria s FY16 revenue mix Chart 11:Somany s FY16E revenue mix Chart 12:KJC sourcing strategy Chart 13:SOMC sourcing strategy Chart 14: Realisation differential between KCJ and SOMC Chart 15: Fixed asset turn Chart 16: Declining debt/equity Chart 17: Improving RoC

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27 Equity Research May 20, 2016 BSE Sensex: INDIA Kajaria Ceramics HOLD Tiles Target price Rs1,060 Shareholding pattern Sep 15 Dec 15 Mar 16 Promoters Institutional investors MFs and UTI FIs/Banks Insurance FIIs Others Source: NSE Price chart (Rs.) May-13 Nov-13 May-14 Nov-14 May-15 Nov-15 May-16 Research Analysts: Nehal Shah nehal.shah@icicisecurities.com Scalable and structural play! Rs1,074 Reason for report: Initiating coverage We are structurally positive on business prospects for Kajaria Ceramics (KJC) due to its leadership position in India s ceramic tiles industry backed by sound management credibility, comprehensive product range, superior design capability, high brand recall, loyal and widespread dealer network, and strong marketing capabilities all of which give it a distinct edge over competitors. With its ongoing capacity addition in ceramic tiles and its recent foray into sanitaryware and faucet segments, scalability of the business model is expected to improve further over the next 2-3 years. Besides, declining gas prices, higher margins from the recently commissioned Rajasthan greenfield unit and the recent imposition of anti-dumping duty on vitrified tiles, is expected to keep margins firm at ~20% levels. We expect the topline and bottomline to grow at CAGRs of 13.1% and 21.2% respectively, over FY16-FY18E with RoCEs expected to improve 100bps to 32.4%. At the current market price of Rs 1,050 per share, the stock trades at 25.3x FY18E earnings of Rs We initiate coverage on KJC with a HOLD rating and a target price of Rs 1,060 per share valuing it at 25x FY18E EPS. Leadership in tiles unabated; scalability to improve with foray into allied products: KJC s leadership in tiles continues to stand unabated given its strong brand equity. Its overall market share in tiles is ~10%, which we expect to significantly improve going forward with the company likely to gain share not only from unorganised players but also from its organised counterparts. Further. KJC s recent foray into allied products such as sanitaryware and faucets is expected to provide further scalability to its business model. We expect the allied products to contribute Rs1.5bn (5% of net revenues) by FY18. Margins expected to remain firm: Over the years, KJC s margins have been significantly better than its industry peers led by: i) fast-increasing brand equity, ii) pricing premium, iii) superior product mix, and iv) higher focus on retail. Despite the fuel prices more than doubling over FY11-FY14, KJC s margins have seen a consistent uptick led by its growing brand equity and increasing focus on higher value-addition. With the declining LNG prices, the higher margins expected from the new Rajasthan unit and the recent imposition of anti-dumping duty on vitrified tiles, we expect KJC s margins to remain firm at ~20% levels. Sound balance sheet with high return ratios: KJC, with its increasing thrust towards the joint venture model and strict working capital management, has managed to keep its balance sheet sound and healthy. Despite its aggressive capex across product segments, we expect the debt-equity ratio to be significantly lower at 0.1x largely led by increasing free cash from operations. The RoCEs are thus expected to improve further by 100bps to 32.4% in FY18, thereby likely to sustain higher valuations. Market Cap Rs85bn/US$1.3bn Year to Mar FY15 FY16E FY17E FY18E Reuters/Bloomberg KAJR.BO/KJC IN Revenue (Rs mn) 21,869 24,185 27,085 30,924 Shares Outstanding (mn) 79.5 Rec. Net Income (Rs mn) 1,795 2,292 2,852 3, week Range (Rs) 1075/649 EPS (Rs) Free Float (%) 52.8 % Chg YoY FII (%) 26.7 P/E (x) Daily Volume (US$/'000) 1,272 CEPS (Rs) Absolute Return 3m (%) 23.8 EV/E (x) Absolute Return 12m (%) 37.8 Dividend Yield (%) Sensex Return 3m (%) 7.5 RoCE (%) Sensex Return 12m (%) (6.7) RoE (%)

28 Kajaria Ceramics, May 20, 2016 TABLE OF CONTENTS KJC s leadership in tiles continue unabated Thrust on outsourcing model: Perfect strategy to leverage brand and profitability34 Scalability to improve further with recent foray into allied products Sanitaryware unit commenced operations in Apr Faucets launched in Jul 15 through KJC s own manufacturing set-up Margins to remain firm despite volume pressures Volume growth expected to witness a gradual uptick Aggressive capex plans largely internally funded Financials: Moving from strength to strength Key risks Valuation and recommendation Company background Innovation KJC leads the way Financial summary Index of tables and charts

29 Kajaria Ceramics, May 20, 2016 KJC s leadership in tiles continue unabated Kajaria Ceramics (KJC) surpassed HR Johnson in FY15, and gained the numero uno slot last year. We expect its leadership in ceramic tiles to continue unabated, led by its comprehensive product range, superior designing capability, extensive focus on value addition, high brand recall, loyal and widespread dealer network, and strong marketing capabilities, thereby providing the company a distinct edge over its competitors. We expect KJC to continue to gain market share from unbranded as well other branded players. Chart 1: Brand Kajaria: Distinct edge over its peers Pricing premium Widespread and extremely loyal distribution network Increasing number of exclusive dealers Increasing brand spends creating strong brand recall Aggressive capacity addition over the past 6 years Innovative and comprehensive product range Brand 'Kajaria' Increasing thrust on value addition Source: I-Sec research Leading player with comprehensive product range: KJC is currently the largest player in the Indian ceramic tiles industry. It has over the years developed a comprehensive range of products including ceramic wall and floor, vitrified (soluble salt and double charge), and high-end designer tiles (ceramic digital and digital glazed vitrified tiles). The company sells tiles in varying sizes, starting from 20x20cm (8"x8") to 120x240cm. It is thus present across the entire size and price value chain, ranging from affordable tiles to the upper-end glaze vitrified tiles. These are either manufactured in-house or through joint ventures, outsourced from third-parties, or imported from overseas. Over the past 3-4 years, the share of value-added products has considerably increased. The company focuses on innovation in designs and concepts. It introduces new designs and variants almost every day. At any given point in time, KJC has more variety than any other player, giving it a unique selling point. High brand recall: Over the past five years in particular, KJC has been able to successfully create a strong pull for its products. It currently enjoys the highest brand equity in the industry with all three requisite pillars quality, innovation (in designs and launching new categories) and availability coming to the fore. It has also been conferred with the Superbrand status for the eighth year in a row. Superbrands is an 29

30 Kajaria Ceramics, May 20, 2016 independent organisation evaluating brands in many countries based upon a method that considers feedback from consumers as well as a set of experts. KJC s focus over the past decade has been in building its brand image. It undertook a massive TV advertising campaign in Star, Zee, Sony and CNBC-TV18 in and to create a mind recall for the brand. KJC was also the first company to introduce organised display product protocol at dealer showrooms in and to showcase its range and concepts, which was instrumental in improving its brand equity. Post that, the company has been consistent in spending towards brand promotion activities, which in turn has enhanced the brand equity of the company. Chart 2: Branding spends as percentage of revenues Advertisement and Sales Promotion (Rs mn) % of Revenues 1, % 3.1% 2.8% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E KJC spent 2.5% of revenues in FY15 towards brand-building, which included the following: Television campaigns on select national and regional channels Advertisements on TV during prime sporting events Social and digital media campaigns Enhancing brand visibility at dealer and sub-dealer outlets Participating in large trade exhibitions Increasing visibility in national and regional newspapers and magazines Opening more exclusive showrooms for each or all the product segments With the company expected to benefit from declining power and fuel costs due to sharp decline in gas prices, the management is likely to utilise some part of these savings for incremental brand spends, which could propel the brand spends/revenues share to 3% going forward. Branding for every tile category: KJC has developed category brands such as Kajaria Vitro for its own-manufactured vitrified tiles, Kajaria Eternity for glass vitrified (GVT) tiles, Kajaria Eternity HD for DGVT tiles, Kerrogres for tiles imported from China, and Kajaria World for imported high-end tiles imported from Spain and Italy. 30

31 Kajaria Ceramics, May 20, 2016 Kajaria The mother brand Kajaria: Brand for ceramic wall and floor tiles Kajaria Vitro: Brand for vitrified tiles Kerrogres: Brand for Chinese imported tiles Kajaria Eternity: Brand for glaze vitrified tiles Source: Company data Kajaria Eternity HD: Brand for high dimension GVT tiles Kajaria World: Brand for high-end digital tiles Strong brand equity gives KJC a pricing power / premium: With the brand comes pricing power. With the substantial increase in the brand equity over the past five years, KJC has been able to charge a premium over other organised brands. Currently KJC tiles are priced higher by 3-7% in case of ceramic and polished vitrified tiles and by 5-15% in case of glaze vitrified tiles. The premium is clearly reflected in its margins, which are way above the margins of the other organised brands. Apart from commanding a price premium as compared to any other competing brand, KJC s resilience in maintaining its margins despite costs pressures clearly suggests that the brand does command a strong pricing power. Chart 3: Trend in KJC s margins vs peers (%) Kajaria Ceramics Somany Ceramics Asian Granito Orient Bell FY09 FY10 FY11 FY12 FY13 FY14 FY15 M9FY16 31

32 Kajaria Ceramics, May 20, 2016 Strong and extremely loyal dealer network A strategic advantage: KJC has a strong and widespread dealership network of 1,100 dealers, up from 600 in The strategy of adding dealers in a relatively slow manner since 2002 compared to its peers has actually had a positive impact. Dealer loyalty has increased as they have been allowed to grow in size along with the company (as they are able to maintain their territories). Apart from having an exhaustive and nationwide dealer network, KJC also has 25 display/orientation centres largely located at its regional offices, where customers / architects come to select tiles. The distribution network is divided in such a way that it leads to lower cannibalisation, thereby limiting undercutting and does not lead to brand dilution. The company has the strongest distribution reach in metros and major cities. KJC follows a transparent and consistent policy with dealers. Our channel checks suggest that dealers are continuously kept motivated through attractive promotional schemes, apart from being ensured of adequate stock levels or quick availability of products across the range and design, which is a key advantage over its competitors. This has resulted in KJC building up a financially strong set of dealers, thereby keeping its working capital cycle largely under check. Dealer size along with their strong retail presence also ensures better realisations and margins for KJC as compared to its peers. KJC s distribution network could be broken up into five categories: Kajaria multi-brand dealers: A dealer in ceramic and vitrified tiles of various brands including the Kajaria brand Kajaria Studio dealers: A dealer that dedicates space for display of PVT vertical of Kajaria without keeping any other PVT brands. However, he could deal with any tile brand in the ceramic tiles segment Kajaria Prima dealers: A dealer that dedicates space to display ceramic wall and floor tiles of Kajaria without keeping any other ceramic tile brands. However, he could deal with any tile brands in the vitrified tiles segment Kajaria World dealers: A dealer that dedicates space to display high-end tiles manufactured or imported by Kajaria Kajaria Galaxy: An exclusive dealer shop that dedicates space to all tile verticals of Kajaria without dealing with any other brand. Further, the showroom space needs to be at least 3,500sqft for the dealer to be called a Galaxy dealer Kajaria Star: A dealer who has exclusivity for at least two of the following three divisions of Kajaria a) Ceramic wall and floor, b) polished vitrified tiles, and c) GVT Source: Company data 32

33 Kajaria Ceramics, May 20, 2016 Aggressively adding capacities over the FY10-FY16 period: KJC has been aggressively adding capacities, particularly over the past six years since it forayed into manufacturing of vitrified tiles in FY10. The trend in capacity addition is illustrated in the Chart 4. Chart 4: Aggressive capacity addition over the last six years Ceramic tiles PVT GVT FY10 FY11 FY12 FY13 FY14 FY15 FY16 Since FY10, KJC s capacities (own manufacturing and capacities built-up through the joint venture model) have increased at a CAGR of 19.6% over FY10-FY16. While ceramic wall and floor capacities have increased at 5.5% CAGR, PVT and GVT capacities have increased manifold over the same period. With this, KJC has become the largest manufacturer of tiles in India. Increasing thrust on value-addition: KJC s supremacy in tiles over the past five years is largely attributed to its dominance in the value-added tiles category, viz. GVT and double charged vitrified tiles. KJC is also a leading player in digital ceramic wall and floor tiles segment with the largest range of offerings (over 1,200 SKUs in FY15) in the segment. The company enjoys the strongest brand equity in fast growing and high value-added glazed vitrified tiles (GVT) segment. KJC s offerings in this segment, has grown 6-fold from 60 SKUs (format/designs) in FY11 to 360 SKUs in FY15. KJC s GVT segment now accounts for 21% of its overall tiles revenues as compared to 10% of revenues in FY11. KJC commands over 14% market share of the fast growing GVT market. 33

34 Kajaria Ceramics, May 20, 2016 Thrust on outsourcing model: Perfect strategy to leverage brand and profitability Kajaria Ceramics (KJC) three factories, located at Rajasthan (Gailpur and Malootana) and Uttar Pradesh (Sikandrabad), have a total manufacturing capacity of 40.8mn-sqm of ceramic and vitrified tiles. While facilities at Gailpur and Sikandrabad have been operating at full capacity over the past few years, the unit at Malootana commenced commercial production in Jan 16. Apart from its own manufacturing capacity, KJC, over the past five years, has been focusing on adding capacities aggressively through a 51% JV model with units in Morbi, Gujarat. This has ensured readymade capacities without loss of time and reduces dependence on imports, apart from reducing logistic costs particularly while servicing the West and South Indian markets. Over the past five years, KJC has acquired seven JVs and has expanded capacities in a couple of its JVs (Soriso and Cosa). Benefits of joint ventures: Minimise gestation period for revenue generation Efficient operations run by promoters (technicians) Leverage efficient manufacturing with brand equity and distribution Complementing the existing range of products Reducing logistic costs Superior returns on investment Profile of JVs acquired in the past: Joint venture arrangements thus far... Acquired Soriso Ceramics (Morbi) in Feb'11 Capacity of 2.3 MSM of ceramic floor tiles initially; further stands expanded to 4.6 MSM in Mar'12 Acquired Jaxx Vitrified (Morbi) in Feb'12 Capacity of 3.1 MSM of PVT - Soluble salt Acquired Vennar Ceramics (Hyderabad) in Apr'12 Capacity of 2.3 MSM of ceramic wall tiles to target South India market Acquired Cosa Ceramics (Morbi) in Oct'12 Capacity of 2.7 MSM of PVT - Double charge Acquired Ozzy Ceramics (Morbi) in Apr'13 Capacity of 2.6 MSM of PVT - Soluble salt initially; further stands expanded to 7.1 MSM in Mar'14 Acquired Taurus Tiles (Morbi) in May'14 Capacity of 5 MSM of PVT - Soluble salt Source: Company data 34

35 Kajaria Ceramics, May 20, 2016 Apart from the acquisition of the aforementioned joint ventures, KJC has recently acquired a 51% stake in Floera Ceramics, which is putting up a manufacturing facility for polished vitrified tiles in Andhra Pradesh, with a capacity of 5.70mn-sqm, the land for which has already been acquired. The management expects the plant to get commissioned by FY17-end. Chart 5: Rapidly increasing joint-venture capacities JV capacities (mn-sqm) % of total capacity (RHS) 42% 45% 41% 31% 33% 21% 8% % 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% FY11 FY12 FY13 FY14 FY15 FY16 FY17E Post the commissioning of the Floera Ceramics unit (by FY17-end), total capacity through the joint-venture model would increase to 33.5mn-sqm. This would account for 45% of KJC s total manufacturing (100% owned and JV) capacity. Chart 6: Joint-venture revenues and contribution to revenues JV turnover (Rs mn) JV revenues as a % to overall revenues (RHS) 14,000 12,000 10,000 8,000 6,000 4,000 2, % 40% 37% 34% 27% 18% 4% % 40% 35% 30% 25% 20% 15% 10% 5% 0% FY12 FY13 FY14 FY15 FY16E FY17E FY18E Revenues from the JV model is likely to touch Rs12.4bn by FY18, which would be equivalent to 40.1% of the overall FY18E tile revenues. On the other hand, owned manufacturing turnover is expected to contribute 48.7% to the overall revenues with the balance (10.8% of FY18 revenues) expected to be derived from the third party outsourcing model. 35

36 Kajaria Ceramics, May 20, 2016 Scalability to improve further with recent foray into allied products Kajaria Ceramics (KJC) leadership in tiles continues to stand unabated given its strong brand equity and widespread and loyal distribution network. Its overall market share in tiles is ~10%, which we expect to improve going forward with the company likely to gain share not only from unorganised players but also from its organised counterparts. Apart from this, KJC s recent foray into allied products like sanitaryware and faucets is expected to provide further scalability to its already robust business model. Table 1: Addressable market widens with foray into allied products Categories Industry size (Rs) Our assessment Ceramic tiles 240bn KJC currently has ~10% overall market share. Apart from the market growing by 8-10% annually, KJC is expected gain from taking share not only from unbranded players but also from its branded peers Sanitaryware 30bn Sanitaryware industry has grown at a CAGR of 12-15% over the past five years. KJC s entry into this segment would not only ensure scale but also strong margins Faucetware 50bn Total opportunity 320bn Faucetware industry has grown at a CAGR of 15-18% over the past five years. KJC is expected to leverage its strong brand and distribution in tiles for penetrating one of the fastestgrowing bathroom solutions market Brand Kerovit and brand ambassador Ms. Nargis Faqri Source: Company KJC has roped in Ms. Nargis Faqri as its brand ambassador for promoting its brand Kerovit. The company has earmarked Kerovit as a brand for both sanitaryware and faucet segments. It is now taking active steps to increase its distribution network across both the categories (sanitaryware and faucets) and expand the product range over the next couple of years. 36

37 Kajaria Ceramics, May 20, 2016 Sanitaryware unit commenced operations in Apr 14 KJC floated Kajaria Sanitaryware (P) Ltd in which the former currently holds 82% stake while the balance being owned by the Morbi-based partner who is responsible for the day-to-day operations of the company. KJC recently increased its stake from 64% to 82% in Q3FY16 to get a larger control over the JV. Kajaria Sanitaryware has the capacity to manufacture 700,000 pieces of sanitaryware products per annum. After the initial teething problems (a few quality issues were witnessed over the last year), the company has reached 70-75% capacity utilisation in FY16. The current business model of Kajaria Sanitaryware is to manufacture higher proportion of mass-market products so as to penetrate the market in shortest duration and then move towards the manufacturing of premium products. In the meanwhile, KJC outsources premium sanitaryware from China to have some presence in the premium market as well. The sanitaryware division s total revenues (JV model as well as outsourcing from China) is expected to touch Rs800mn by FY18. Faucets launched in Jul 15 through KJC s own manufacturing set-up The 1mn pieces per annum faucet facility at Gailpur, Rajasthan, commenced commercial production in Jul 15. We expect product quality and distribution issues to settle over the next year or so. Here too, KJC s entry-level strategy would be to manufacture mass-market products initially and then move gradually towards premiumisation. We expect this category to clock revenues to the tune of Rs 700mn by FY18. The allied products are thus likely to contribute Rs 1.5bn (5% of net revenues) to the overall revenues by FY18. We expect allied product margins to be at 20% levels by FY18 (higher margins of 25-30% in sanitaryware to get partially offset by lower margins in faucets). Chart 7: Allied product revenues to generate Rs1.5bn revenues by FY18E FY18E 1,500 FY17E 1,000 FY FY FY ,000 1,200 1,400 1,600 (Rs mn) 37

38 Kajaria Ceramics, May 20, 2016 Margins to remain firm despite volume pressures Over the years, Kajaria Ceramics (KJC) margins have been significantly superior to the margins of industry peers led by: i) KJC s fast-increasing brand equity, ii) pricing premium, iii) superior product mix, and iv) higher focus on retail. Going forward, we expect margins to remain firm or even improve considering the following: Historical evidence suggests Kajaria brand commands strong pricing power even in tough times During the period FY10-FY14, the tiles industry faced a double whammy with: a) spot gas prices nearly doubling to over US$19/mmbtu from US$10/mmbtu witnessed in Jan 10, and b) steep INR depreciation during the period which further increased domestic gas prices. KJC was however able to maintain its EBIDTA margins over the same period despite a substantial increase in fuel costs (25-30% of the cost of production) while its peers saw their margins decline during the same period. This clearly suggests that the Kajaria brand commands significant pricing power vis-à-vis its peers. Chart 8: Trend in spot LNG prices from CY10 onwards SPOT LNG PRICES - (USD/mmbtu) Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 Chart 9: Trend in INR/USD rates USD/Rs Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 Chart 10: KJC margin trend Chart 11: Trend in KJC s margin vs peers 25% 20% 15% 10% 5% 0% (%) Kajaria Ceramics Asian Granito FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E FY09 FY10 FY11 FY12 FY13 FY14 FY15 M9FY16 Somany Ceramics Orient Bell 38

39 Kajaria Ceramics, May 20, 2016 Declining gas prices to aid further margin expansion With the consistent decline in fuel costs led by declining LNG prices since Mar 15, KJC has witnessed a significant expansion in margins which clearly suggests the company has not passed on the entire benefits to customers. With gas prices still on the declining trend, we expect KJC s margins to remain firm, or further improve, considering that the company is expected to retain part of the savings while passing on the balance by way of lowering the prices and initiating higher brand spends Higher margins from new Rajasthan unit The 6.50mn-sqm polished vitrified tiles greenfield facility at Malootana (Rajasthan) commenced operation on 15-Jan 16. This has now become India s largest single location for polished vitrified tiles manufacturing, which would also ensure higher margins for KJC than its peers in this category due to the former s higher absorption of overheads. This is also expected to cater to the demands of the Northern market in particular, which is the largest consumer of polished vitrified tiles. Thus, savings in logistic costs due to its sourcing from this unit against sourcing it from Morbi as earlier, is expected to give further fillip to margins in this segment. Improving product mix Higher penetration of glaze vitrified tiles The demand for GVT has been on a significant rise over the past five years. The segment has grown at a CAGR of 25-30% over the last five years. The category saw strong penetration in metros and tier-1 cities with it finding increasing acceptance over natural stone marble and granite. GVT has also seen a decent penetration into tiers-2&3 cities and the trend is likely to accelerate going forward. Chart 12: Rising penetration of GVT (Rs mn) FY10 FY11 FY12 FY13 FY14 FY15 KJC today is the largest player in the GVT segment offering the widest range with over 400 SKUs and 8-9 formats/sizes. With the company having launched newer formats in GVT in FY16 and additional new formats likely to be launched in FY17, we expect contribution from this segment to increase further, going forward. 39

40 Kajaria Ceramics, May 20, 2016 Anti-dumping duty on vitrified tiles Anti-dumping has finally been imposed (though provisional) on all the categories of vitrified tiles polished and glazed on 29-Mar 16 vide notification No. 12/2016- Customs (ADD). The anti-dumping duty, at US$1.37/sqm, has been levied for a period not exceeding six months unless revoked, amended or superseded earlier. We expect this to give an interim relief to the domestic manufacturers and the same is likely to get reviewed and extended post the expiry of six months. With the imposition of duty now, we expect the domestic players to take a marginal price hike in PVT, which in turn would be margin-accretive. 40

41 Kajaria Ceramics, May 20, 2016 Volume growth expected to witness a gradual uptick Kajaria Ceramics (KJC) volume growth has been under pressure over the past few quarters. While the company has reported an impressive CAGR of 16.7% over FY11- FY16, it clocked a volume growth of 10.3% in FY16. The deceleration in growth is largely due to steep slowdown in the real estate sector particularly in the metros and tier-1 cities. With the economy expected to witness a gradual recovery going forward, volume growth in the tiles segment is likely to see a gradual uptick over FY16-FY18. We expect the company to exhibit an 11.7% volume CAGR over FY16-FY18. Chart 13: Trend in tiles sales volumes and volume growth (mn) Tile volumes Volume growth (RHS) ()%) FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E Chart 14: Trend in sales volume mix over FY10-FY18E Manufactured volumes JV volumes Third party outsourcing volumes 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 22% 32% 26% 23% 20% 15% 12% 10% 9% 0% 0% 6% 18% 27% 33% 37% 37% 41% 78% 68% 68% 59% 53% 52% 51% 54% 51% FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E We expect KJC s own manufactured volumes to continue contributing over 50% of the tile volumes by FY18 largely led by ramp-up of production at its recently commissioned Rajasthan greenfield facility. JV volumes too would increase their contribution to 41% by FY18E with Floera Ceramics expected to commission in Apr 17. Third party outsourcing volumes however would reduce to 9% of overall volumes from 12% in FY16. 41

42 Kajaria Ceramics, May 20, 2016 Aggressive capex plans largely internally funded Kajaria Ceramics (KJC) is likely to incur a capex of Rs7.1bn over FY16-FY18, which is expected to take its total capacity to over 74.3mn-sqm from 54.1mn-sqm in FY15. Of the stated capex, we also expect KJC to invest some portion in the allied product segments sanitaryware and faucets. The company plans to fund this aggressive capex largely through internal accruals. While KJC has recently commenced commercial production of polished vitrified tiles at its new greenfield unit in Rajasthan (in Jan 16), the management expects Floera Ceramics (the newly acquired Morbibased company through the JV model) to come on stream by end-fy17. Chart 15: KJC s aggression in capex to continue 25,000 20,000 (Rs mn) 15,000 10,000 5,000 0 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E Chart 16: Capex to intensify over FY16-FY18E FY11-FY15 (Capex of Rs 7.8bn) Expanding capacities at its existing facilities in Gailpur and Sikandrabad Acquired contrilling stake in three companies in Morbi (Soriso, Jaxx and Cosa) and Vennar in Andhra Pradesh Setting up a sanitaryware facility in Morbi FY16-FY18E (Capex of Rs 7.1bn) Expanding capacities at its Gailpur unit Seeting up a new greenfield plant in Rajasthan Acquired controlling stake in Taurus in Morbi and Floera in Andhra Pradesh Setting up a faucets unit in Rajasthan 42

43 Kajaria Ceramics, May 20, 2016 Financials: Moving from strength to strength Net revenue and revenue growth trend Realisation and realisation growth Revenues (Rs mn) Revenue growth (%) Realisation (Rs/sq-m) Realisation growth (%) 35,000 30,000 25,000 20,000 15,000 10,000 5, % 29.5% 37.7% 22.8% 18.3% 14.1% 10.8% 12.0%14.2% 40% 35% 30% 25% 20% 15% 10% 5% % 6.1% 3.9% 3.5% 0.2% -0.8% -0.6% -0.2%0.4% 12% 10% 8% 6% 4% 2% 0% 0 0% 0-2% FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E Revenue mix trend Ceramic Tiles Vitrified Tiles Allied products Others EBITDA margin trend 25% 20% 15% 10% 5% 0% FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E EBIDTA and EBIDTA growth EBIDTA margin trend EBIDTA EBIDTA growth (RHS) EBIDTA/sqm YoY growth (RHS) 7,000 6,000 5,000 4,000 3,000 2,000 1, % 29.3% 38.7% 18.6% 14.7% 30.8% 26.2% 17.4% 13.1% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% % 9.4% 4.6% 2.7% 0.7% 8.9% 20.4% 5.9% 0.7% 25% 20% 15% 10% 5% 0% FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E Source: Company, I-Sec research 43

44 Kajaria Ceramics, May 20, 2016 PAT and PAT growth Trend in PAT/sqm PAT PAT growth (RHS) PAT/sqm YoY growth (RHS) 4,000 3,500 3,000 2,500 2,000 1,500 1, % 33.4% 29.2% 18.9% 41.4% 30.5% 24.5% 18.1% 80% 70% 60% 50% 40% 30% 20% 10% 0% % 28.7% 15.8% 11.5% 12.1% 4.3% 5.2% 0.7% 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E Dividend payout and yield Trend in CFO and FCF 30% 25% 20% 15% 10% 5% 0% Dividend payout Dividend per share (Rs) Cash flow from operations (Rs mn) 5,000 4,000 3,000 2,000 1,000 - Free cash flow (Rs mn) FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E (1,000) FY11 FY12 FY13 FY14 FY15 FY16 FY17EFY18E Debt and debt/equity trend Trend in RoE and RoCE 3,500 3,000 2,500 2,000 1,500 1, Debt (Rs mn) Debt/equity (x) (%) RoE (%) RoCE (%) FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17E FY18E Source: Company, I-Sec research 44

45 Kajaria Ceramics, May 20, 2016 Key risks Slowdown in metro and tier-1 cities KJC is currently the largest player in the value-added tile segment. This has resulted in the company reporting strong growth in realisations and higher margins. If the slowdown persists longer than anticipated, the lower offtake in GVT could negatively impact profitability. Maintaining relations with outsourcing partners Forming joint ventures and sourcing from third parties is becoming a trend among the large players as capacity becomes available quickly at lower overheads. However, maintaining good relations with JV partners and third party sourcing players, in particular, will always be a challenge. Focus on allied products KJC has recently started focusing on allied products sanitaryware through the JV model and faucets through own manufacturing. Any delay in stabilisation of product quality and creation of distribution network for these products could impact growth of the allied products segment. Increase in working capital The company has witnessed a significant increase in working capital requirement in FY16 due to sustained slowdown in the demand for tiles. If the slowdown persists longer than anticipated, this could put further pressure on working capital, which in turn would increase the debt burden resulting in higher interest costs and lower profitability. 45

46 Kajaria Ceramics, May 20, 2016 Valuation and recommendation Kajaria Ceramics (KJC) has witnessed a revenue CAGR of 20.4% over the past five years, backed by its foray into manufacture of vitrified tiles and aggressive capacity addition through the joint venture model. PAT has grown at an impressive CAGR of 30.5%, aided by strong operational performance driven by improving product mix and rising brand equity, better working capital management, rising cashflows, and consequent reduction in debt. RoCE too has increased significantly to 31.4% in FY16 from 22.1% in FY11. Over FY16-FY18, we expect the company to report revenue CAGR of 13.1% (much lower than the last 5-year CAGR despite its recent foray in the allied products segment (sanitaryware and faucets) led by expected volume pressures in its core tiles segment over the period due to slowdown in the real estate sector. PAT however is expected to exhibit an impressive 21.2% CAGR over FY16-FY18 led by declining power and fuel costs, improving product mix and operational efficiencies in the recently commissioned Rajasthan plant. Higher free cash generation is also expected to decline the debt-equity ratio to 0.1x in FY18 from the current 0.3x, thereby resulting in lower interest costs going forward. We also expect RoCE to witness a 100bps expansion to 32.4% by FY18. At the current market price of Rs1,050/share, the stock trades at 25.3x FY18E earnings of Rs42.4. We initiate coverage on KJC with a target price of Rs 1,060 per share, valuing it at 25x FY18E earnings. We thus recommend HOLD on the stock. 46

47 Kajaria Ceramics, May 20, 2016 Company background Kajaria Ceramics (KJC) is the largest manufacturer of ceramic/vitrified tiles in India. It has an annual aggregate capacity of 68.6mn-sqm, distributed across nine plants: Sikandrabad in Uttar Pradesh, Gailpur and Malootana in Rajasthan, five plants at Morbi in Gujarat, and Vijayawada in Andhra Pradesh. Over the past 28 years, it has raised its capacity to 68mn-sqm from 1mn-sqm and created a strong and widespread dealer network throughout the country. KJC is currently the largest player in the Indian tiles industry in terms of revenues, having an overall market share of 10%. It has over the years developed a comprehensive range of products including ceramic wall and floor, vitrified (soluble salt and double charge), and high-end designer tiles (ceramic digital and digital glazed vitrified). It sells tiles in varying sizes, starting from 20x20cm (8"x8") to 120x240cm (48"x96"). It is thus present across the entire size and price value-chain, ranging from affordable tiles to the upper-end glaze vitrified tiles. These are either manufactured in-house or through joint ventures, outsourced from third-parties, or imported. Table 2: Capacity break-up of facilities, category-wise (mn sq-m) Location Ceramic tiles Vitrified tiles Total Sikandrabad, Uttar Pradesh Gailpur, Rajasthan Malootana, Rajasthan Soriso JV (Morbi) Jaxx JV (Morbi) Vennar JV (Andhra Pradesh) Cosa JV (Morbi) Taurus JV (Morbi) Total Source: Company, I-Sec research Chart 17: KJC s revenue mix tiles division (%) Ceramic Tiles PVT GVT FY10 FY11 FY12 FY13 FY14 FY15 FY16 Source: Company, I-Sec research KJC had 63% of its FY16 revenues coming from the vitrified tiles segment with GVT accounting for 22% of the overall revenues. Ceramic wall and floor tiles on the other hand accounted for 37% of the FY15 revenues. 47

48 Kajaria Ceramics, May 20, 2016 Chart 18: KJC s sourcing model Own Manufacturing Joint venture model Third party outsourcing Imports (%) FY10 FY11 FY12 FY13 FY14 FY15 FY16 Source: Company, I-Sec research With the in-house manufacturing of vitrified tiles (since FY10) and adoption of the JV model (since FY11), the imports as a percentage of revenues has seen a steep decline from 38.2% in FY10 to 2.7% in FY16. On the other hand, with the recent acquisition of controlling stake in Morbi companies, JV revenue mix has witnessed a sharp jump to 39% in FY16. Manufactured turnover mix though continue to be at ~50% levels in FY16 led by adding capacities in-house over the past five years, particularly in the vitrified tiles segment. We expect the trend to continue over the next three years with KJC recently commissioning the new greenfield facility in Rajasthan for manufacturing polished vitrified tiles. Business model Tiles Allied products Products Ceramic and vitrified tiles Sanitaryware and faucets Manufacturing foray Ceramic tiles 1988 Sanitaryware 2014 Vitrified tiles 2010 Faucets 2015 Capacities FY16 Ceramic tiles Sanitaryware 700,000 pcs p.a. Vitrified tiles Faucets 1mn pcs p.a. Factory location Gailpur (Rajasthan) and Sikandrabad Morbi, Gujarat and Gailpur, Rajasthan (Uttar Pradesh) Model Own manufacturing, JV model as well as vanilla outsourcing Brand Kajaria Kerovit Revenues FY16 Rs23.4bn Rs0.65bn Revenue Mix FY16 97% 3% Dealer network FY16 1,100 dealers 70 dealers Source: Company, I-Sec research Sanitaryware JV model and vanilla outsourcing Faucets Own manufacturing and vanilla outsourcing 48

49 Kajaria Ceramics, May 20, 2016 Brand recognition by industry and consumers Management bandwidth: KJC was incorporated in 1988 and is currently into its 28 th year of operations. The company is mainly spearheaded by the Kajarias (father and two sons) and is run by a dedicated team of professionals within the organisation. Top Management Designation Age Experience Profile Ashok Kajaria Chairman and Managing Visionary and overall 66 years 38 years Director charge of operations Chetan Kajaria Joint Managing Director 39 years 14 years Head of ceramic tiles division Rishi Kajaria Joint Managing Director 35 years 10 years Head of vitrified tiles division 49

50 Kajaria Ceramics, May 20, 2016 Innovation KJC leads the way Recent launches in GVT The Beast 1,200x2,400 mm (thickness of 6mm; laying on both walls and floors) The Slim 30x120cm The Collection 40x80cm 50

51 Kajaria Ceramics, May 20, 2016 The Wood 20x120cm The Wood 13x80cm PVT: Grande 120x80cm Ceramic tiles: The Storm HD 40x80cm Source: Company 51

52 Kajaria Ceramics, May 20, 2016 Financial summary Table 3: Profit and Loss Statement (Rs mn, year ending Mar 31) FY14 FY15 FY16 FY17E FY18E Net Sales 18,388 21,746 24,088 26,978 30,801 Add: Other Operating Income Net revenue 18,400 21,869 24,185 27,085 30,924 Less: Cost of goods sold 8,252 8,334 8,464 11,629 13,352 Employee cost 1,726 2,073 2,527 3,035 3,326 Others 5,615 7,921 8,561 6,979 8,089 Total Operating Expenses 15,593 18,328 19,551 21,644 24,767 EBITDA 2,807 3,541 4,634 5,442 6,157 Depreciation Other income EBIT 2,400 2,997 3,945 4,638 5,250 Less: Financial expenses Recurring Pre-tax Income 1,992 2,703 3,577 4,312 5,031 Less: Taxation ,237 1,380 1,560 Less: Minority Interest / Subsidiary loss Net Income (Reported) 1,242 1,756 2,292 2,852 3,369 Extraordinary Items - (39) Recurring Net Income 1,242 1,795 2,292 2,852 3,369 52

53 Kajaria Ceramics, May 20, 2016 Table 4: Balance Sheet (Rs mn, year ending Mar 31) FY14 FY15 FY16 FY17E FY18E ASSETS Current Assets, Loan & Advances Inventories 1,931 3,033 3,842 4,139 4,557 Sundry debtors 1,648 2,071 2,742 3,178 3,375 Cash and bank balances Other current assets Loans and advances ,091 1,300 1,500 Total Current Assets 4,434 6,213 7,901 8,819 9,691 Current Liabilities & Provisions Current Liabilities 1,520 2,418 2,804 3,104 3,544 Provisions and other liabilities 1,455 1,915 2,492 2,746 3,065 Total Current Liabilities & Provisions 2,975 4,333 5,297 5,850 6,609 Net Current Assets 1,459 1,880 2,604 2,969 3,082 Investments Fixed Assets Gross block 10,235 12,447 15,777 17,856 20,356 Less : depreciation 3,319 3,846 4,572 5,430 6,404 Net block 6,916 8,601 11,205 12,426 13,951 CWIP Godwill Total Assets 8,781 11,260 13,888 15,396 17,034 LIABILITIES AND SHAREHOLDERS' EQUITY Shareholders Fund Equity share capital Reserves and surplus 4,890 7,251 9,064 11,226 13,765 Total Shareholders Fund 5,295 7,409 9,251 11,384 13,924 Borrowings Secured loans 851 1,965 1, Unsecured loans 1, ,511 1, Total Borrowings 2,364 2,434 2,960 2,254 1,251 Deferred Tax Liability Minority Interest Total Liabilities & Shareholders' Equity 8,781 11,260 13,888 15,396 17,034 53

54 Kajaria Ceramics, May 20, 2016 Table 5: Cash Flow Statement (Rs mn, year ending Mar 31) FY14 FY15 FY16 FY17E FY18E Cash Flow from Operating Activities PAT 1,242 1,756 2,292 2,852 3,369 Add: Depreciation Add: Other Operating activities 106 (42) 18 (28) - Operating Cash Flow Before Working Capital change (a) 1,818 2,273 3,036 3,683 4,343 Changes in Working Capital (Increase) / Decrease Trade & 0th receivables (212) (423) (671) (436) (197) (Increase) / Decrease Inventories 266 (1,102) (809) (297) (418) Increase / (Decrease) Current liab and provisions 241 1, Others (285) (204) (104) (209) (200) Working Capital Inflow / (Outflow) (b) 10 (371) (620) (389) (56) Net Cash flow from Operating Activities (a) + (b) 1,828 1,902 2,416 3,294 4,287 Cash Flow from Capital commitments (c) (1,368) (2,584) (2,631) (2,000) (2,500) Free Cash flow after capital commitments (a) + (b) + (c) 460 (682) (215) 1,294 1,787 Cash Flow from Investing Activities Purchase of Investments Change in goodwill Net Cash flow from Investing Activities (d) Cash Flow from Financing Activities Equity raised/(repaid) Proceeds from fresh borrowings (837) (706) (1,004) Dividend paid including tax and others (173) (165) (332) (611) (727) Net Cash flow from Financing Activities (e) (511) (1,317) (1,731) Change in Deferred Tax Liability (f) Total Increase / (Decrease) in Cash (23) 57 (a) + (b) + (c) +(d) + (e) + (f) Opening Cash and Bank balance Closing Cash and Bank balance Increase / (Decrease) in Cash and Bank balance (23) 57 54

55 Kajaria Ceramics, May 20, 2016 Table 6: Key ratio (year ending Mar 31) FY14 FY15 FY16 FY17E FY18E Per Share Data (Rs) EPS Cash EPS Dividend per share (DPS) Book Value per share (BV) Growth (%) Net Sales EBITDA PAT Cash EPS Valuation Ratios (x) P/E P/CEPS P/BV EV / EBITDA EV / Sales Operating Ratio Raw Material / Sales (%) Employee cost / Sales (%) SG&A / Sales (%) Other Income / PBT (%) Effective Tax Rate (%) Working Capital (days) Inventory Turnover (days) Receivables (days) Payables (days) Net D/E Ratio (x) Return/Profitability Ratio (%) Net Income Margins RoACE RoAE Dividend Payout Dividend Yield EBITDA Margins

56 Kajaria Ceramics, May 20, 2016 Index of tables and charts Tables Table 1: Addressable market widens with foray into allied products Table 2: Capacity break-up of facilities, category-wise Table 3: Profit and Loss Statement Table 4: Balance Sheet Table 5: Cash Flow Statement Table 6: Key ratio Charts Chart 1: Brand Kajaria: Distinct edge over its peers Chart 2: Branding spends as percentage of revenues Chart 3: Trend in KJC s margins vs peers Chart 4: Aggressive capacity addition over the last six years Chart 5: Rapidly increasing joint-venture capacities Chart 6: Joint-venture revenues and contribution to revenues Chart 7: Allied product revenues to generate Rs1.5bn revenues by FY18E Chart 8: Trend in spot LNG prices from CY10 onwards Chart 9: Trend in INR/USD rates Chart 10: KJC margin trend Chart 11: Trend in KJC s margin vs peers Chart 12: Rising penetration of GVT Chart 13: Trend in tiles sales volumes and volume growth Chart 14: Trend in sales volume mix over FY10-FY18E Chart 15: KJC s aggression in capex to continue Chart 16: Capex to intensify over FY16-FY18E Chart 17: KJC s revenue mix tiles division Chart 18: KJC s sourcing model

57 Equity Research May 20, 2016 BSE Sensex: INDIA Somany Ceramics BUY Tiles Target price Rs526 Shareholding pattern Sep 15 Dec 15 Mar 16 Promoters Institutional investors MFs and UTI FIs/Banks Insurance FIIs Others Source: NSE Price chart (Rs.) May-13 Nov-13 May-14 Nov-14 May-15 Nov-15 May-16 Research Analysts: Nehal Shah nehal.shah@icicisecurities.com At an inflection point Filled the gaps, now raising the bar! Rs442 Reason for report: Initiating coverage After going through testing times through FY10-FY14 (revenue and PAT CAGRs of 23.5% and 9.6% respectively during the period), Somany Ceramics (SOMC) over the past two years has filled the much-required gaps in its business model by initiating major corrective steps moving aggressively towards the JV model while reducing dependence on third-party outsourcing and focusing more on value addition resulting in a healthy bottomline growth of 42.5% over FY14- FY16E. With the company further consolidating its JV model coupled with falling gas prices, increasing mix of value-added tiles (glazed vitrified tiles {GVT} in particular) and higher focus on creating exclusive franchise showrooms, we expect the company s PAT growth to comfortably outpace its revenue growth over the next two years led by a structural shift in margins. We expect SOMC s revenues and PAT to grow at CAGRs of 14.9% and 35% over FY16-FY18, with RoCEs estimated to improve 540bps to 25%. At CMP, the stock is trading at 16.8x its FY18E EPS of Rs26.3. We value SOMC at 20x FY18E earnings (20% discount to Kajaria Ceramics) and initiate with a BUY rating on the stock with a target price of Rs526 per share. Increasing brand equity and improving product mix to aid 14.9% revenue CAGR: SOMC s brand equity has been on the surge led by increasing brand spend, which has expanded to 1.9% of revenues in FY15 from 1% in FY12. The management expects the same to further increase to 2.5-3% of revenues going forward. With the fast improving brand equity, the recently commissioned 4mn-sqm GVT line at Kassar, Haryana, and the company s increasing focus on allied products (faucets and sanitaryware), we expect SOMC to register a 14.9% revenue CAGR over FY16-18 led by 11.2% CAGR in volumes and 3.4% CAGR in realisations on the back of higher contribution from GVT and other large-format tiles. Long-awaited margin expansion to finally come on display: We expect SOMC s margins to improve significantly going forward led by: a) higher focus on retail, b) increasing mix of GVT and other large-format tiles, c) falling power and fuel costs due to steep decline in LNG prices, and d) increasing traction from the recently acquired 51% JVs. With this, we expect SOMC s consolidated EBIDTA margins to increase to 9.6% by FY18, an expansion of 260bps over the next two years. Strong operational performance and lower interest costs are expected to give a strong boost to profitability, leading to a PAT CAGR of 35% over FY16-FY18. Improving balance sheet with higher dependence on the outsourcing model: We expect SOMC to generate FCF of Rs2.4bn over the next two years resulting in significant reduction of debt going forward. We expect the debt-equity ratio to reduce from 0.5x in FY16 to 0.2x in FY18. Further, higher dependence on the JV model and strong profitability over FY16-FY18 would increase the RoCE by 540bps to 25% in FY18E from 19.6% in FY16E, thereby providing scope for further rerating. Market Cap Rs18.7bn/US$278mn Year to Mar FY15 FY16E FY17E FY18E Reuters/Bloomberg SOCE.BO/SOMC IN Revenue (Rs mn) 15,431 17,299 19,651 22,837 Shares Outstanding (mn) 42.4 Rec. Net Income (Rs mn) , week Range (Rs) 445/323 EPS (Rs) Free Float (%) 48.5 % Chg YoY FII (%) 8.2 P/E (x) Daily Volume (US$/'000) 152 CEPS (Rs) Absolute Return 3m (%) 27.1 EV/E (x) Absolute Return 12m (%) 11.0 Dividend Yield (%) Sensex Return 3m (%) 7.5 RoCE (%) Sensex Return 12m (%) (6.7) RoE (%)

58 Somany Ceramics, May 20, 2016 TABLE OF CONTENTS Expect double-digit volume growth over the next two years Fast improving brand equity Steadily increasing own/jv capacities Strong innovative strategies Increasing contribution from vitrified tiles and value-added tiles Focus on value-added GVT segment Imposition of ADD on all vitrified tiles Long-awaited margin expansion expected to unfold Aggressively moving towards the joint-venture model Focus on allied products; complementing the existing portfolio Sanitaryware segment Moving towards the JV model Bath fittings segment Exploring opportunities Formidable and widespread distribution network Deleveraging balance sheet; expect return ratios to further rise Fast-improving financials Key risks Valuation and recommendation: Company background Sound management team Business Model Financial summary Index of tables and charts

59 Somany Ceramics, May 20, 2016 Expect double-digit volume growth over the next two years Somany Ceramics (SOMC) volumes have grown at a CAGR of 10.5% over FY12- FY15. The growth was imminent with the industry doing very well during that period. However, since then, despite the sustained slowdown witnessed in the real estate sector, SOMC has managed to report volume growth of 9.3% in 9MFY16. By doing so, the company has also managed to outpace the industry leader Kajaria Ceramics growth of 8.7% during 9MFY16. We expect the trend to continue and pencil-in a volume CAGR of 11.2% over FY16-FY18 for SOMC, largely attributed to the mix of several efforts initiated over the past two years. Further, with realisations trending higher due to focus on value-added tiles, we expect SOMC to register 14.9% CAGR in revenues over FY16-FY18. Chart 1: SOMC s volume growth enablers Fast improving brand equity Imposition of ADD on all vitrified tiles Steadily increasing own/jv capacities Sustainable volume growth levers Focus on value added GVT segment Strong innovation strategy Increasing contribution of vitrified tiles 59

60 Somany Ceramics, May 20, 2016 Fast improving brand equity Somany has developed as an established brand in the tiles industry in India for over four decades. The brand has been further strengthened by the quality and range of the products, its expansive pan-india network of dealers and sub-dealers, and the strategic marketing initiatives implemented by the company to grow its brand awareness among customers. SOMC s sustained marketing efforts over the years have included: a) print, electronic and other advertising media, b) participation in exhibitions and outdoor promotions, c) conducting training sessions for masons under Tile Master program, and d) developing a wide network of exclusive franchisee showrooms and display centres. Our channel checks suggest that the brand Somany is rated as the second-best brand in the tiles industry after brand Kajaria. SOMC over the last five years has started spending aggressively on branding to create strong recall in the minds of consumers. Chart 2: Brand equity likely to surge with aggressive brand spend (Rs mn) A&P spends (Rs mn) A&P spends/revenues (RHS) 1.9% 1.8% 1.6% 1.4% 1.1% 1.0% 0.9% 0.9% % 1.5% 1.0% 0.5% 0.0% FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 With the company now focusing on increasing its brand spend from 1.9% of revenues in FY15 to % over the next two years, we expect its brand equity and visibility to improve further going forward. 60

61 Somany Ceramics, May 20, 2016 Recent branding activities to enhance recall Media advertisements Somany Slip Shield: Nahi Phislenge Somany Tiles: Zindagi ko Chamakne Do Other effective modes of branding Exclusive franchisee showrooms Participation in exhibitions 61