Monday 24 September 2007

CEMENT - Bolstered bags

Niren Shah / Mumbai September 24, 2007

Beaten down after the Budget, cement stocks are back in the reckoning.

From experience, people in the corridors of power have realised that even an onion can shake the foundations of a strong government. Cement, as it is, turns out to be stronger than an onion. When cement prices rose for over a year by about 15 per cent, the Ministry of Finance considered meddling with the uptrend by imposing fiscal disincentives for high-priced bags of cement.

Budget 2007 brought along a revamped excise duty structure with higher duties for expensive domestic cement as well as cuts in domestic levies on imported cement. In January, the import duty on cement was cut down to zero from 12.5 per cent in order to encourage import of cement to resolve the seemingly perennial demand-supply mismatch.

After the Budget, cement manufacturers and the government engaged in long running discussions over holding the prices, in vain. Cement prices, however, have continued to rise. Owing to such an uncertainty over the industry dynamics, investors penalised cement stocks, and the sector has continuously underperformed the broader markets over the past ten months.

The rise in the prices has been around 15 per cent y-o-y as on August. Considering the demand-supply deadlock, the infrastructure and real estate boom, as well as with the overall macroeconomic conditions looking good, it doesn`t look like the scene is changing anytime soon.

We therefore, look into the various reasons why umpteen numbers of market players have once again turned bullish on the sector. Almost all foreign brokerages, including Deutsche Bank, JP Morgan, Macquarie and UBS are bullish on the sector recommending a `buy`. Only Citigroup is an exception, which has recommended otherwise.

Price puzzle
The past one year has witnessed cement prices rising by almost 15 per cent across the country. The national average price per bag of cement was Rs 200 in July 2006, which was around Rs 230 a bag in July 2007, and analysts estimate that it has gone up further to around Rs 235-240 now.

If it were just for the mismatch between demand and supply of cement across the country, the equation would have been simpler. However, the rise in cement prices over the past 12-15 months has more to it.

Apart from growth in supply lagging behind demand growth, there are factors such as rising costs of raw materials, of which in turn, the industry is running shortages. Imports could have been a solution, if there was enough supply available. On digging a bit further, the outlook that emerges for the industry is bright enough for investors to start looking at the sector.

Demand deadlock
Between April and August 2007, cement consumption grew nearly 10 per cent y-o-y, which is quite unusual, considering that in monsoons construction activity is subdued. Normally, demand during monsoons is much lower, and cement prices too drop marginally.

However, this year, prices too have gone up. This is mainly due to the incessant demand from the infrastructure and real estate sectors. Analysts are in unison that the growth in production has fallen short of the growth in demand, which has resulted in higher prices. As monsoon comes to a close and construction activities pick speed, the demand for cement is set to take off further.

The boom in domestic cement consumption becomes evident from the fact that the exports of cement and clinker have declined from an average of about 10 million tonne a year in 2004-05 to nearly 8 million tonne a year now.

Burgeoning order books of infrastructure and engineering companies and huge project outlays of real estate players guarantee strong growth in demand for cement for the next couple of years.

The past year has demonstrated that in spite of fears of a decline in real estate prices and the resulting concern that real estate developers may postpone their projects, cement demand has only increased. Therefore, demand is expected to continue to grow at a compounded annual rate of 10-11 per cent over FY07-FY10.

Stifling supply
Over the past year, capacity utilisations at cement manufacturers have scaled to an all-time high of over 90 per cent, at times over 100 per cent. This becomes evident from the demand converging with supply over the past couple of years.

In FY08, cement production and consumption are estimated at around 163 million tonne. Last fiscal, the production was 155 million tonne, while domestic consumption was at 154 million tonne. A deficit of approximately 15-25 million tonne is expected to set in over FY09-FY10.

Collectively, cement majors have plans to add about 150 million tonne capacity by FY10. However, analysts expect just around 75-80 million tonne to actually go on-stream by FY10 due to lack of capacity at the equipment manufacturers` and project implementers` ends to finish the projects in time, as well as due to regulatory hurdles.

However, considering the growing demand, this is unlikely to suffice. Citigroup alone fears pricing pressure due to a supply surplus in the sector owing to capacity additions as well as imports.

Imports infeasible
Cement is a highly perishable commodity, with a shelf life of less than 90 days. This factor alone reduces the geographical radius of possible destinations to source cement. Some manufacturers of Pakistan have applied for approvals from Bureau of Indian Standards, as Pakistan is likely to have a cement surplus of nearly 15 million tonne in FY08.

The landed cost of this cement in India is estimated to be around Rs 205 a bag, around 15 per cent lower compared with domestic prices. Add in the logistics cost to transport the cement from port to its destination, and the imported cement should be about 5-10 per cent cheaper.

However, this route is fraught with bottlenecks. As Indian ports are running at near-full capacities, there are hardly any facilities to handle bulk of cement at ports, resulting in high demurrage. Ports in Pakistan too, are constrained by their loading capacities according to analysts.

A September 13 report in Pakistan`s Daily Times focused on another problem: despite surplus production of cement, the industry faces an acute crunch in procuring sufficient plastic bags to pack and despatch their product!

Flourishing financials
As cement companies shuffle their raw material usage from expensive imported coal to cheaper domestic coal, go for captive power plants and improve efficiencies on their logistics front, the resulting savings in various costs are likely to give a boost to their operating profit margins. For instance, a large part of coal is sourced domestically by ACC, as compared to the rest of the players.

Among the large-caps, Grasim and UltraTech are in the midst of commissioning captive power plants of over 90 MW each, while mid-cap players like JK Lakshmi and Mangalam too, have recently commissioned 36 MW and 17.5 MW captive power plants respectively.

Already, major players clock operating profit margins in the vicinity of 30 per cent and more. Going forward, this is likely to range at around 35 per cent, by FY09. Top lines will be bolstered by the string of capacity additions that every player is engaged in, as well as firm prices.

Modest multiples
The sector has underperformed the broad markets since February, and is now showing signs of recovery. At present, the sector trades at an average price-earning multiple of 10 times trailing twelve month earnings.

Going by consensus, the sector is likely to trade at estimated FY08 EV/EBITDA (earnings before interest, tax, depreciation and amortisation) multiples of around 7-9 times, and price-earnings multiples of 12-15 times estimated FY08 earnings. Larger players like ACC, Grasim and Ambuja are already trading at higher multiples compared to the industry, commanding a premium and are scaling newer highs.

On an EV/tonne basis, ACC, Ambuja and UltraTech appear slightly expensive. This will change, as new capacities are added resulting in higher production. On this parameter mid-caps appear attractive, as almost all players have their capacity additions going on-stream. Analysts foresee a scope for higher realisations for Ambuja as well as UltraTech.

Expect strong volume growth for ACC, Grasim and Shree Cements over FY08-FY09. Although growth appears assured for all the counters, Grasim among the large-caps and Shree Cements among the mid-caps appear the least expensive stocks, both by earnings and asset based multiples. Those who hold the sector are fortunate. Those who do not, may want to ride the rising trend. Investors may buy on dips.