Possible CCI penalty overhang for cement stocks: Edelweiss

Even if the companies don’t actually pay a penalty, Baji believes this will adversely impact cement stocks because it will be the first time the CII has taken such a step against the sector. “To some extent, the kind of pricing discipline that we have seen could get affected” he explained.

However, according to Baji, the bigger problem will be the entrance of new competitors in the market and how they will behave.

On the positive side, Baji says cost pressures in FY13 are reducing for cement names. “In FY12, what happened is you had the full impact of the Coal India price increase and the general cost inflation was also much higher,” he said. However, he added that cost pressure will still remain, albeit lesser.

His top picks in the space are ACC and India Cements .

Below is an edited transcript of his interview with Udayan Mukherjee. Also watch the accompanying video.

Q: What are your thoughts on what the Competition Commission of India (CCI) ruling might be like and whether the news on that front is fully priced in?

A: CCI seems to be moving closer to releasing a report on their findings. Now obviously this is not completely new, the investigations are well-known publicly, but we are not sure if it is fully priced in. The final outcome is unclear because the companies will contest it, so there could be some kind of overhang on the stocks.

Actual penalty may not be paid and it may go into a long litigation, but it will be somewhat of an overhang on the cement stocks because this will be the first time that CCI will be doing something of this nature in cement at least.

Q: What kind of penalties are you expecting?

A: Hard to say right now, we will wait for the report as such. We have not taken a call on that right now.

Q: But do you think it might rob the cement companies of significant pricing power going forward, if there is indeed a proven cartelization and some kind of penalties imposed, which could have medium-term ramifications for these companies?

A: Yes, to some extent the kind of pricing discipline that we have seen could get affected. But honestly, it will still be largely demand-supply driven. I think one of the challenges this fiscal year is going to be the additional 30 million tonne of more capacity coming on board. There are a few newer players who are coming on stream such as ABG Shipyard, Wonder Cement etc and to some extent therefore while they are not very big, there is a little bit of nervousness about how they will behave. So that could be the bigger challenge in this fiscal year.

Q: ACC’s margin performance did not go down very well with the street. Do you see margin issues cropping up going forward, given the cost structure of these companies?

A: I think what is going to happen is for Q4, as in the March quarter and the June quarter, the margins will be good because the prices have been increased in the month of March and therefore the full impact of it will be in the June quarter.

But post that in the monsoon quarter, we expect prices to decline. Last two years, we have seen very sharp cuts in prices in the monsoon, so 5-6% kind of decline is easily on the cards.

Also, the full impact of the railway freight increase, which was also in March, will start flowing through in June. But when the prices decline, unfortunately costs don’t decline. Peak of the EBITDA per tonne has already reached in the June quarter and then there onwards we will see margins declining for the rest of the year.

Q: Is cost going to be a significant issue for the sector for the rest of the year because all the cement companies have been talking about significant cost increases?

A: The extent of cost increases will be lesser in FY13 than in FY12, but it will still be an issue. In FY12, what happened is you had a full impact of the Coal India price increase and the general cost inflation was also much higher such as the fuel expenses etc, crude oil prices went up.

In FY13, I think we will have to watch how coal and diesel prices behave. We are expecting diesel prices to go up by 8%. Coal prices are a little uncertain because Coal India has deferred their price hike. But to an extent of what one can say, perhaps the extent of cost pressure will be a little lesser than FY12 but nevertheless it will be there, no doubt.

Q: What kind of pricing trends do you see in FY13 across different geographical zones in the country?

A: To take up that before that if you look at the capacity utilization, it will be sub-80%, it will be around 77%. So pricing may go up but the moot point is we don’t think that pricing will significantly outperform cost increase. I think we have to look at it in that context rather than absolute prices.

For example, even today when prices are at their all time peaks, it is not as if the margins are at all time peaks, the margins are below their all time peaks and indeed, after that as we said there will be a little bit of a trough. So prices may move up 4-5% but cost will be a spoilsport in that sense.

Q: What are your top buys and sells from the cement space now for FY13?

A: Yes, our top buy is India Cement and our top sell would be ACC.

Q: Why India Cement?

A: Partly because it’s a valuation call; the stock is much cheaper. Also, we are seeing that prices are much more stable in the south, whatever be the reasons. Secondly, on the cost side, the captive coal mine in Indonesia should start sometime in the future , so that could be a trigger.

Honestly, I would say the valuation call is a key word because the others we find way too expensive. Some of the largecap stocks are trading at 10 times EV/EBITDA which is not very comfortable.