Cement’s $100 billion illusion: Kotak says current valuations devoid of logic

Kotak noted that while the cement sector's profitability could exceed Kotak's assumed figure of US$5 per ton, historically however, it has often fallen short of market expectations.

The trouble for cement firms is far from over as expects expect the companies to end the first-half FY25 with higher than expected raw material costs, amid weak pricing and sluggish demand.

Amid this, the current valuation of Indian cement companies appears increasingly unreasonable, according to Kotak Institutional Equities, especially considering the staggering $100 billion market capitalization of listed firms in the sector.

This figure raises serious questions about the underlying fundamentals of the industry, particularly regarding the volume of cement these companies would need to sell to justify such valuations, the brokerage said in a recent strategy report.

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Kotak's analysis revealed that to match this market cap, Indian cement companies would need to sell approximately 20 billion tons of cement on an undiscounted basis, over 150 billion tons on a discounted basis (assuming a cost of equity of 12 percent), or an astronomical figure of 40 to 60 billion tons over the next 30 years, depending on the discounted cash flow (DCF) calculations.

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The implied volumes necessary to support these valuations are incredulous, according to Kotak. In fact, analysts noted a near-zero probability of achieving such sales levels, particularly when they examine the context of India’s GDP growth trajectory.

To put this into perspective, China sold 44 billion tons of cement from 1995 to 2023 when its GDP grew at a rapid CAGR of 12 percent. It sold 34 billion tons during its peak growth phase from 2007 to 2023,  when GDP registered a growth of 10 percent CAGR.

Kotak identified 1994 as a key starting point for comparison, as China's cement sales volumes at the time were around 400 million tons—similar to India’s projected FY24 volumes of 419 million tons.

The year 2007 also served as a significant benchmark, with China’s GDP per capita at US$2,700, closely aligned with India’s FY24 GDP per capita of US$2,600.

Kotak noted that while the cement sector's profitability could exceed Kotak's assumed figure of US$5 per ton, historically however, it has often fallen short of market expectations. Nevertheless, cement companies have achieved a decent Cash Return on Capital Invested (CRoCI) during this time, suggesting that the assumed profit per ton is not unreasonably low.

Cement firms' PE multiples devoid of valuation logic

The analysis revealed strongly that the current market dynamics for Indian cement companies suggest a severe disconnect between valuation and underlying business fundamentals. In fact, the brokerage has challenged the street's approach to valuing cement stocks.

It argued that a capex-intensive commodity business with a low fixed-asset turnover ratio of around 1x should not command high P/E or EV/EBITDA multiples. Each additional unit of volume requires significant investment, which negatively impacts free cash flow (FCF) and results in a low FCF-to-profit-after-tax (PAT) ratio. Given these factors, the current 30-40x P/E multiples for cement stocks lack sound valuation logic, Kotak said.

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