Cement sector: Cementing a new tomorrow

Nirmal Bang has come out with its report on cement space. The research firm believes the cement sector has gradually started to gear up for the cyclical upturn in the next two years.

We believe the cement sector has gradually started to gear up for the cyclical upturn in the next two years. The key reasons behind our view are narrowing demand-supply gap (incremental demand of 38mt and slowdown in incremental capacity with effective addition of 25mt), likely improvement in effective capacity utilisation to 80% by FY14E and moderation in cost inflation. All this would lead to improvement in operating profit and a re-rating of the valuation multiple. Hence, investors should accumulate cement stocks in order to derive the benefits from upturn in the cement cycle. We initiate coverage on six companies in our cement universe with a Buy rating on Ambuja Cement, ACC, Grasim Industries, India Cements and Shree Cement and a Hold rating on UltraTech. 

Improving demand-supply matrix: In FY08-12, the cement industry’s installed capacity increased by ~140mt and incremental demand increased by just 55mt. This led to an unfavorable demand-supply scenario and effective capacity utilization rate declined from 96% in FY09 to 76% in FY12. However, lack of fresh aggressive capex announcement due to unattractive returns over the past two years and improvement in demand (drivers discussed on page 3), leads us to believe that the demand-supply equation would start gradually improving from FY13E. This would lead cement prices to remain stable in the near term and witness an upside in the coming years (we expect a CAGR of 8% over FY12-14E).

Strong balance sheet to fund future growth: In FY08-12, our cement universe’s installed capacity increased from 90mt to 130mt (capex of ~Rs200bn). However, despite such a massive capex, unfavorable demand-supply matrix and economic slowdown, most cement companies (barring India Cements) were debt free or having a lower leverage, driven by strong free cash flows during the upcycle. Looking at the current free cash flow trend and leverage; we believe cement companies would be able to finance the next phase of their capex through internal accruals and comfortable leverage. This would keep the growth momentum intact in the long run.

Good entry at inflexion point of uptrend: Share prices of most cement companies are trading at below their past 10 years’ historical average EV/EBITDA multiple, which provides a good entry point on the valuation parameter and close to a replacement cost or on discount, thereby limiting the downside risk. Apart from this, the cement industry is gradually gearing up for the next cyclical upturn, with narrowing demand-supply gap, improving capacity utilisation and rising operating performance. This would lead to a re-rating of the valuation multiple in the coming years. Hence, we believe cement stocks offer a good entry point for investors.

Competition Commission of India (CCI) may impose penalty: As per media reports, the CCI has found cement companies guilty of cartelisation and may impose a penalty to the extent of 8% of their average revenue of the past three years, or three times the profits made via cartelisation. The penalty of 8% of average revenue of the past three years impacts 38-95% of FY13E PAT and 2-13% of current market cap. of respective companies in our coverage. The penalty at three times the profits made via cartelisation is harsh, subjective in nature and may not materialise. If cement stocks correct on CCI’s verdict, investors should treat it as a buying opportunity.

FIIs holding more than 30% in Indian cos

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