Monday, November 28, 2016

Cementing recovery gradually

Not many cement mixing trucks are plying on the highways these days. The rotating drums that mix cement, sand, gravel and water to make concrete are lying idle — post the announcement of demonetisation by the Modi government. “Without sand and gravel, what’s the use of cement,” asks a Chennai-based cement dealer.
Demonetisation effect
The procurement of sand and gravel — where transactions are largely done on a cash basis — took a big hit last week on account of demonetisation. This, in turn, had repercussions for off-take of cement – which requires sand and gravel to produce concrete. Moreover, given the liquidity crunch faced by individual house builders — a large demand driver for cement — cement sales were down 40-80 per cent in the last 10 days.
While the fall in demand due to liquidity crunch is expected to recover from next January, there are concerns as to the long-term impact on cement demand from a crackdown on black money.
According to Ambit estimates, demonetisation could affect 15 per cent of the cement market — with volume growth reducing to 0-4 per cent between December 2016 and March 2017 and 5 per cent in FY ‘18. North and Central markets are expected to bear the maximum brunt, given the higher extent of cash-based transactions as compared to the South.
Market break-up
About 60-65 per cent of cement demand comes from individual housing — which is equally split between rural and urban markets. Rural demand, dependent on agriculture and allied activities, is expected to be unaffected by demonetisation (30 per cent). Another 25 per cent demand from infrastructure and industrial capex would also remain immune. So it is 30 per cent of urban and semi-urban housing demand as well as another 15 per cent demand from organised real estate — 45 per cent in all — which could be affected by the demonetisation move. While two-thirds of these transactions are currently in ‘white’, the remaining that accounts for 15 per cent of the overall demand is expected to be vulnerable to crackdown on black money.
With uncertainty looming large over the long-term impact of curbs on black money on the cement sector, investors have turned bearish. Cement stocks have fallen anywhere from 13 to 28 per cent in the last one month.
While the demonetisation could have a long-term impact on cement demand, its effect on the economic recovery is to delay it by 5-6 months, at worst, according to experts. So, those investing with expectation of a cyclical upturn in the sector still have reasons to stay put. Moreover, with some of the stocks shedding their flab, there are opportunities to buy stocks at reasonable valuations as compared to the past.
To zero-in on such companies, we analysed the cement businesses across five parameters — capacity utilisation, market lucrativeness, valuation, cost efficiencies and financial leveraging.
Companies with a cement production capacity of 10 million tonnes or more were considered for the analysis.
Capacity utilisation
Improvement in capacity utilisation is a good trigger for cement stocks since it contributes to profits at a rapid clip after recovery of fixed costs. Capacity utilisation of the cement industry is currently at 66 per cent — close to the lowest in the last decade. During the last boom witnessed in the cement industry, capacity utilisation had touched 94 per cent levels (2007).
Cement demand has a strong correlation to economic growth — with a 1 percentage growth in economy resulting in a 1.2 per cent growth in demand for cement. Since 2001, cement demand has grown at about 8 per cent annually.
However, the last four years have been an anomaly — when cement demand clocked average annual growth rates of only 4 per cent. With demonetisation playing spoilsport this year, both FY 17 and FY 18 could be bad.
However, over the years, industry players have added capacity at a rapid clip in anticipation of recovery in economic growth and upturn in the cement cycle. And the industry is now almost done with its capex. Over the next three financial years FY 17- FY 20, capacity addition would halve to about 33 million tonnes (mt) as against 70 mt added in the last three years.
At current capacity of 410 mt, about 138 mt are lying idle — half of which is in the southern market. While bigger players like UltraTech Cement, ACC and Ambuja Cement had capacity utilisation in the range of 73-77 per cent in 2015-16, it was lower (54-58 per cent) for some regional players like Ramco Cement and Dalmia Bharat.
In terms of potential improvement in capacity utilisation, ballpark estimates hint at Ambuja Cement and Shree Cement topping the charts among large players. UltraTech Cement, in contrast, was only 9 per cent away from its peak levels of 2007. Among regional players, Dalmia Bharat and JK Cement look attractive with further potential to improve capacity utilisation by 24 per cent and 19 per cent respectively. The JK group’s capacity utilisation had touched 90 per cent levels in 2007 as against 78 per cent for Dalmia Bharat. It needs to be noted that the regional footprint of players would have changed since 2007 and not strictly comparable.
In all, Ambuja Cement and Dalmia Bharat look to have greater potential to benefit from pick-up in capacity utilisation. Many regional players, including Dalmia Bharat, recently added capacities which, in turn, lowered their utilisation rates. They have further scope for improving capacity utilisation rates. On the other hand, JK Lakshmi Cement is already running at a higher capacity utilisation rate of 82 per cent — with relatively less headroom for further improvement.
Market lucrativeness
The market lucrativeness of a region is a function of various factors — size, demand, pricing and the extent of fragmentation. In terms of size (as measured by volume despatches), the North is the biggest market with a market share of 40 per cent, followed by the South (28 per cent), the East (19 per cent) and the West (13 per cent).
And thanks to strong growth in demand for cement in the North and the East, capacity utilisation has been higher at 80 per cent and 85 per cent respectively in these markets. Western and southern markets, in turn, have lower rates of 70 per cent and 55 per cent respectively.
Going forward, the NDA government’s focus on boosting rural income — by increasing allocation to IAY (Indira Awaas Yojana), PMGSY (Pradhan Mantri Gram Sadak Yojana) and MGNREGA (Mahatma Gandhi National Rural Employment Guarantee Act) — is expected to boost cement demand for the country. Moreover, this year, after two years of successive drought, monsoons have been normal. If it is followed by a bumper winter crop, rural spends could increase — boosting cement demand. However, it needs to be seen to what extent rural spends would get into big-ticket housing — as against that of consumption items.
Also, a significant part of the government projects — especially roads and railways — is happening in the north, central and eastern region.
In all, north, central and eastern region are expected to benefit from the expected boost in rural income with some of these markets, central, for instance, being primarily retail-driven. Western region, in contrast, which is driven by urban housing, is expected to witness a lull — thanks to higher residential property prices and lack of demand.
Demonetisation, however, could play spoilsport over the short term in the markets of north and central India due to high share of cash transactions while the south market remains resilient.
In terms of pricing, southern players top the charts followed by East, West, North and Central. As per latest data, cement prices are hovering at ₹310-330 for a 50-kg bag across the country. Since January of this year, cement prices were up in the North, Central and Western markets, while they remained flat in the South. In the East, cement prices were down as compared to the beginning of the year.
Also, there are signs of consolidation in the industry – which is bringing pricing power back to the hands of market leaders. For instance, with the merger of cement business of Jaiprakash Associates with that of UltraTech, there has been consolidation in the Central market – with the top six players commanding a market share of 87 per cent. In the last few months, Nirma acquired Lafarge and Orient – the Jaypee’s cement business in MP, while Shree Cement is now actively bidding for Shiva Cement.
Eastern market is the most consolidated with 90 per cent market share among six players, followed by the West, South and North at 80 plus, 67 and 70 per cent respectively.
At this juncture, the Central and the Eastern market look attractive– when all the four parameters are taken into consideration. Among the large-cap players, Ambuja Cement (45 per cent of sales) and ACC (38 per cent of sales) currently have higher exposure to both these markets. Among the regional stocks Dalmia Bharat has the highest exposure at 50 per cent of its sales.
Financial leveraging
Many of the regional cement players have ramped up capacity by taking additional debt to expand capacity, JK Lakshmi Cement, JK Cement and Prism Cement being among them. With cement demand not growing commensurately, interest costs have weighed heavy on the profitability of these players. For instance, interest to operating profit ratio for JK Lakshmi Cement rose from 17.9 per cent in 2012-13 to 60.4 per cent in 2015-16. During the same period, it rose from 23.1 per cent to 51 per cent for JK Cement.
Debt to equity ratio is currently at a decade-long peak — in the range of 1.4-1.9 for some of the regional players.
In contrast, for larger players like Shree Cement, the ramp-up in operations has been done from its own cash flows. Its debt to equity fell from 0.34 per cent in 2012-13 to 0.16 in 2015-16. It has further plans to ramp up capacity from 26 mt in 2015-16 to 40 mt by FY ’20. While Ambuja Cement has no debt on books, the debt equity ratio for UltraTech Cement is expected to increase post-merger with JP’s cement operations in MP to 1.0 from 0.50 in 2015-16.
From a financial leveraging perspective, JK group companies – JK Lakshmi Cement and JK Cement – appear riskier with debt-equity ratio in the range of 1.4-1.5 . While Ramco Cement had taken to higher debt in the past, its debt equity has now reduced to 0.9. We prefer Ambuja Cement, Shree Cement among the large players and Dalmia Cement among the regional players.
In the last one month, the stock prices of large players were down 16 per cent on an average, while some of the mid-cap stocks were down by 23 per cent. Among the large players, Ambuja Cement fell the most – 20 per cent – while among the regional players, it was JK Cement (28 per cent). Post correction, some of the counters are quoting close to the replacement value.
For instance, Ambuja Cement is currently quoting at an enterprise value per tonne of $158 – which is close to the replacement value of $150 per tonne. While ACC is currently quoting at an enterprise value per tonne of $98, it is getting lower valuation for its bad operational performance. While its volumes dipped 10 per cent in the September ’16 quarter, there was also an unexpected hike in its operation costs during the quarter. While the market leader UltraTech cement is a safe bet on the cement industry it is also quoting at a hefty premium of $200 per tonne – 33 per cent above the replacement values.
Among the mid-cap counters, JK Lakshmi Cement and Dalmia Bharat are reasonably priced – quoting at $76 per tonne and $111 per tonne respectively. Interestingly, while Ramco Cements was quoting at a slight premium to replacement values ($167 per tonne), it was also quoting below its five-year historical averages – be it price to earning multiple or enterprise value to operating profits ratio.
Ambuja Cement and JK Lakshmi Cement come out as favourites on the parameter of valuation.
Cost leadership
Cost efficiency is a function of the ability to control three type of costs — power and fuel, freight and raw materials. In the past, many cement companies were able to reduce their costs (and improve profits) by substituting coal with pet coke, whose prices had fallen by 40 per cent during the August ’14 – February ’16 period. However, since February ’16, petcoke prices have been up 80 per cent, with little headroom to cut costs further by changing the fuel mix.
During the year 2015-16, Ramco Cement benefited from lower diesel prices (that lowered its freight costs) as well as lower raw material costs.
Among the large players, Shree Cement is very efficient with cost per tonne of ₹2,982 as against ₹4,035 per tonne for Ultratech and ₹4,346 for ACC. Moreover, Shree Cement had a relatively higher EBITDA per tonne than its peers – Ambuja and ACC – making it our favourite among large-cap stocks. Among mid-cap players, Ramco Cement was operationally efficient with lowest cost per tonne (₹2,481) than its peers. Moreover, it enjoyed the highest EBITDA among its peers, making it our favourite among the mid-cap stocks.
Top scorers
If all the above mentioned parameters are taken into consideration, among the large-caps, Ambuja Cement stands out – scoring on four aspects of market lucrativeness, financial leverage, capacity utilisation and valuation. Among mid-cap players, Dalmia Bharat scores on the aspect of capacity utilisation, financial leveraging and market lucrativeness, while JK Lakshmi scores on valuation.
While demonetisation has put a temporary spanner into the economic wheel, it is also expected to fill government coffers over the long term. Moreover, any signs of slag in rural income or their spends would only mean greater fiscal measures to prop up the economy. This in turn could mean higher spends on infrastructure and rural welfare schemes.

Cement mixing trucks are definitely going to be back on the road with a big vroom.
(Business Line)

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