Case 074Long pitches and valuationHard

Kalvora Cement has 20 mtpa of capacity at 70% utilisation, EBITDA of Rs 900 a tonne and an EV of Rs 9,000 crore. Management plans a 5 mtpa expansion costing Rs 6,000 crore. The stock looks cheap against replacement cost of Rs 1,200 crore per mtpa. Is it, and does the expansion create value?

The situation

Kalvora Cement operates 20 million tonnes a year of capacity (mtpa) in one region and runs it at 70% utilisation, selling 14 million tonnes. EBITDA is Rs 900 a tonne. Its enterprise value is Rs 9,000 crore. Building a new cement plant costs about Rs 1,200 crore per mtpa.

Management has announced a 5 mtpa expansion costing Rs 6,000 crore, arguing that the region's demand will grow. The stock screens as cheap on EV per tonne of capacity against replacement cost, and a colleague wants to pitch it as a long. Use a pre-tax cost of capital of 12%.

Your task

Is Kalvora cheap against replacement cost, what does the new capacity earn, does the expansion create value, and what is your view on the stock?

Quick check

At Rs 900 a tonne and 70% utilisation, roughly what pre-tax return does the Rs 6,000 crore expansion earn on EBITDA?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Kalvora trades at Rs 450 crore per mtpa, well under the Rs 1,200 crore it costs to build, but that discount is deserved while new capacity earns only 5.25% before tax. The expansion adds Rs 315 crore of EBITDA for Rs 6,000 crore; at Kalvora's own 7.1x multiple that is worth about Rs 2,250 crore, destroying about Rs 3,750 crore. The existing plants may be cheap; the plan to build more is the reason not to own the stock yet.

Step 1Is the stock cheap against replacement cost?

On the screen, yes. Rs 9,000 crore of EV over 20 mtpa is Rs 450 crore per mtpa, 37.5% of the Rs 1,200 crore it costs to build the same capacity today. The logic of replacement costWhat it would cost to build the same productive capacity from scratch today; a common floor for valuing heavy-asset businesses such as cement, steel and shipping. is that a buyer should not pay more than it costs to build, and a business trading far below it should attract buyers or at least stop competitors building. That logic holds only if new capacity earns its cost of capital. Check that before calling the stock cheap.

Step 2What does a new tonne of capacity earn?

Apply today's economics to the new plant. 5 mtpa at 70% utilisation sells 3.5 million tonnes; at Rs 900 a tonne that is Rs 315 crore of EBITDA on Rs 6,000 crore, 5.25% before depreciation and tax, against a 12% cost of capital. Even full utilisation gives only 7.5%. The existing plants earn the same 5.25% on their replacement cost, which is why the market values them at a fraction of it: a flat that rents for Rs 5,000 a month is not worth its construction cost just because building it cost Rs 25 lakh.

Kalvora's EV is Rs 450 crore per mtpa against a Rs 1,200 crore cost to build, but new capacity at 70% utilisation and Rs 900 a tonne earns only 5.25% before tax against a 12% cost of capital, so the discount to replacement cost is deserved.

Step 3Does the expansion create or destroy value?

Value the new plant the way the market values the old ones. Kalvora trades at 7.1x EBITDA; Rs 315 crore of new EBITDA at that multiple is worth about Rs 2,250 crore, against Rs 6,000 crore spent, so the expansion destroys about Rs 3,750 crore, 42% of today's enterprise value. Adding supply to a region already running at 70% may also push down prices for the existing 20 mtpa, which would make it worse. The plant only earns its cost of capital at about Rs 2,057 of EBITDA a tonne at 70% utilisation, more than twice today's level.

Rs crore	Existing 20 mtpa	New 5 mtpa
Tonnes sold, million	14.0	3.5
EBITDA at Rs 900 a tonne	1,260	315
Cost to build	24,000	6,000
Return on cost to build	5.25%	5.25%
Value at 7.1x EBITDA	9,000	2,250

Kalvora's existing and new capacity both earn 5.25% on the cost to build it; valued at the company's own 7.1x EBITDA, the Rs 6,000 crore expansion is worth about Rs 2,250 crore.

At 70% utilisation, Kalvora's expansion earns 5.25% before tax at today's Rs 900 of EBITDA a tonne and reaches a 12% cost of capital only at about Rs 2,057 a tonne.

Step 4So what is the view on the stock?

Separate the assets from the capital allocation. The existing plants look cheap only if the industry stops adding capacity, utilisation rises and prices recover, because that is what would lift returns toward the cost of capital. Kalvora's own expansion is the opposite bet. A long case would need management to defer or cancel the plan, or evidence that regional prices are about to rise sharply; without either, the discount to replacement cost is the market pricing poor returns correctly, not a bargain. Say what would change the view: a cancellation, a price increase that holds for two quarters, or a competitor shutting capacity.

Where candidates lose it

The common loss is stopping at EV per tonne against replacement cost and pitching the stock as a bargain. Replacement cost is only a floor when new capacity earns its cost of capital, and here it earns under half of it.

The second is praising the expansion because capacity is cheap to add relative to the stock's valuation per tonne. Buying capacity at Rs 1,200 crore per mtpa when the market values yours at Rs 450 crore is spending rupees to create forty paise.

What the interviewer asks next

Regional utilisation rises to 85% in three years. Redo the return on the expansion.
What if Kalvora bought a rival's plant at Rs 600 crore per mtpa instead of building?
How would you short the capital allocation while keeping exposure to a cement upcycle?

Company names and figures are illustrative.