Orient Refractories - Initiating Coverage

Orient Refractories - Initiating Coverage

Rating: Buy; Target Price: Rs110; CMP: Rs87.2; Upside: 26.1%



Key ‘flow control’ of RHI; initiate with Buy



We initiate coverage on Orient Refractories Ltd (ORL) with a Buy
rating on the back of superior earnings trajectory vis-a-vis peers,
industry leading ROIC, robust margins, brownfield expansion scope and
parentage from RHI - second largest refractory producer globally.
RHI’s revenue growth track record in India has been very strong (~20%
CAGR) and we expect clearly articulated strategy of RHI for ORL to i)
help diversify revenues and expand client base across domestic and
export markets, ii) lead to new product developments through
technology sharing and iii) allow further leverage of low capital and
operational cost base of ORL for pursuing accelerated growth.

$ Low capital and operational costs key strengths: ORL boasts of
higher turnover ratios (more than double of peers’) on the back of
very low capital costs and its leadership position in ‘tundish’
management of steel flow control segment with a niche in servicing
mini steel mills. An existing plant of ORL spread over 27 acres with a
dedicated R&D centre still has ~50% free land which ensures
continuation of growth at a low capex. In addition, ORL’s gross
margins are 300-600bps higher than that of domestic peers due to much
larger proportion of raw material procurement from local sources.

$ Focus of RHI and change in sales mix to add glow to revenue growth:
RHI, in its clearly articulated strategy for ORL intends to i) double
ORL’s revenues by 2020 and increase exports to emerging markets, ii)
share R&D to leverage the low cost base of ORL and iii) realise
complementary benefits from ORL for RHI’s existing business in India.
ORL’s sales mix is likely to change with new revenue from sales to RHI
group starting FY15E and growth in exports using RHI’s sales network.
This will diversify ORL’s revenues, which have largely been dependent
on mini steel mills with ~70% share in domestic manufactured sales. We
expect overall revenue CAGR of 17.1% during FY14-17E led by robust
volumes in the shaped segment.

$ Superior return ratios led by operating leverage; free cash flow
improving: ORL surpasses peers in terms of return ratios both at
global and domestic levels due to low capital costs, locally developed
R&D and strong margins in its product segment of shaped refractories.
While ROE for ORL is 30%+, for other domestic peers it is below 20%.
In terms of ROIC, ORL stands out with post tax ROIC of 40%+ while
domestic peers have ROIC in the range of 20-25%. We see free cash flow
yield improving to ~4.5% and free cash flow/EBITDA going up to 0.4x by
FY17E.

$ Valuation and risks – deserves premium: We expect earnings momentum
to continue with an EBITDA/PAT CAGR of 15.2%/15.9% during FY14-17E led
by volume growth from expansions, new revenue streams and sales
support from RHI. Despite rerating in the past 9-12 months, we believe
that it deserves premium to peers on fundamentals (based on our
calculations of ‘justified P/BV’ – see page 14) as well as the
exciting prospects on account of clear focus of its parent, RHI. We
value the stock at an average of 18x P/E and 9x EV/EBITDA on FY17E
earnings to arrive at a TP of Rs110. Key risks are sharp drop in
margins due to change in revenue mix and extreme stress in the steel
industry in India.