Cement: Lower imported coal prices to enhance profitability

Motilal Oswal has come out with its report on cement space. The research firm prefers Ambuja Cements and UltraTech/Grasim in large-caps, and Shree Cement in mid-caps. 

Lower imported coal prices to enhance profitability: Global thermal coal prices (in INR, benchmarked by Richards Bay Coal Index) have declined 13% in YTDCY12. Cement companies that depend on imported coal should benefit, although benefit would come in phases and sizably from 2QFY13. If these coal prices sustain, we expect EPS upgrade of 18-25% for India Cements and Shree Cement and 2-10% for the rest of our cement coverage over FY13/14.

Demand, prices remain strong: The recovery in cement dispatches during YTDFY13, despite headwinds, is encouraging. There are initial signs of pick-up in construction activity. We see volume growth of 9.8% YoY in 1QFY13 v/s our full-year estimate of 8%. After a temporary blip in late April/early May, cement prices have continued to improve. Our models (which factor in YoY increase of INR13/10 per bag in FY13/ 14 realizations) assume stable realizations at 1QFY13 level – upgrade potential could be meaningful if price sustains in seasonally weak 2Q and improves thereafter.  

Cost push peaking out; expect gradual margin uptick from 2HFY13: We expect the higher cement realizations to be partially negated by industry-wide cost push in 1HFY13, driven by (a) higher energy prices, (b) full impact of rail freight increase, and (c) negative operating leverage. However, moderation of the inflationary impact, softening imported coal prices (the benefit of which will be evident from 2QFY13), and improvement in operating leverage will drive up profitability from 2HFY13 onward. We expect EBITDA/tone to increase from ~INR889 in FY12 to INR967/INR1,011 in FY13/14, with further potential boost from sustenance of cement and coal prices.

Valuation & view: At the cusp of the next up-cycle Post the CCI (Competition Commission of India) ruling and penalty on the cement industry for alleged cartelization, which we believe is not tenable in court, we the expect focus of investors to return to business fundamentals. The worst is behind and we expect gradual improvement in operating performance. Though the sector will continue to be plagued by over-capacity in short run, we expect gradual and consistent improvement in capacity utilization, pricing and profitability. Albeit sector is trading at historical average valuations, we expect strong earnings growth to be key driver of stock performance. We prefer Ambuja Cements and UltraTech/Grasim in large-caps, and Shree Cement in mid-caps. 

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