Indian Cement Sector - A Contrarian Buying Opportunity

Shares of cement companies started rallying higher after reports that the Maharashtra based cement companies have hiked price by Rs 10-20 per 50 kg bag from today. Leading domestic brokerage house Religare has upgraded outlook on the Cement sector from Neutral to Positive and reset recommendation to BUY on UltraTech, ACC and Ambuja Cement among large caps. Religare believe the cement sector downcycle is close to bottoming out, and investors should accumulate stocks in order to ride the upcycle that will follow over the next 3–4 years. FY11 was the trough year for cement as prices likely to bottom out in Q2, following which the sector would turn a corner, as – a) the demand environment improves, backed by higher infrastructure and real estate offtake, b) capacity utilisation rises as incremental additions ease off, and c) cement prices firm up. We find current valuations appealing – stocks have corrected 8–28% over the past four months – and the downside limited. M&A activity in the sector could also fuel a re-rating. 

 

1. Demand to revive in FY12 even as supply pressure ebbs: Past trends suggest that cement industry dynamics depend more on the demand environment than on supply. We expect in FY12, demand could surprise positively on account of: 1) an increased government thrust on infrastructure; 2) new project launches and deliveries in real estate; 3) rising urbanisation; and 4) the low base effect. Even as the demand trajectory rises, we expect capacity additions to ease, leading to improved utilisation and pricing – a confluence of factors that will lead the sector into a sustained, structural cyclical uptrend in cement: 3–4 years of strong demand from FY12 onwards. The 11th Five Year Plan envisages a total investment of Rs 20.5tn in India’s infrastructure sector, of which a bulk of the investment is likely to be made in FY12 since it is the last year of the plan period. Planning commission of India has envisaged an investment of Rs 27tn in infrastructure development over the 12th plan period (FY13-FY17); 65% of this investment is estimated to be in sectors like power, roads, and railways. Based on the above, infrastructure demand for cement would increase to 25–30% of total demand, in the next 4–5 years. Construction intensity is the highest for roads and bridges (at 95%), with cement accounting for 20% of the raw material requirement. Of the overall Rs 27tn spend, expenditure of Rs 4.6tn will be spent on roads and highways over the 12th plan. The continued increase in per capita income and rising urbanisation to boost demand for housing (and hence cement consumption) in the next 3–4 years.The first quarter of FY11 has seen a flurry of new property launches in key cities, which will increase construction activity in the coming years. Further, the expected project deliveries in residential and commercial real estate are pegged at 515mn sq ft and 61mn sq ft respectively over the next three years in major cities, which would lend a significant fillip to demand for cement as real estate remains the largest cement consumer in India. Indian cement industry is expected to add 35–40mn tonnes (mt) of cement capacity in FY11, leading to supply pressure during the year. Thereafter, however, incremental capacity addition is likely to be lower (10–15mt in FY12) compared to demand growth. With the demand-supply gap likely to reduce, capacity utilisation rate is likely to increase going forward. Capacity utilisation levels will bottom out in FY11 and thereafter it will strengthen over the next 3–4 years as the pace of capacity addition slows down.
2. Downward spiral in prices to be arrested for the most part: Cement prices have witnessed a sharp correction in recent times in the range of Rs 20–80/bag as overcapacity and sluggish offtake during monsoon season resulted in price erosion. While prices could decline further in certain markets, the downside is limited. Some of the Maharashtra based cement companies have hiked price by Rs 20 per 50 kg, as the busy construction season setting in.
   
3. EBITDA/tonne falls but not as hard as the last downcycle: Cement majors will see the lowest EBITDA/t for FY11 compared to the last 4–5 years, mainly on account of lower realisations and higher costs in terms of freight and fuel expenses. From FY12 onwards, cement majors will witness a healthy improvement in demand and pricing, leading to stronger profitability. Most cement players, particularly large caps, are likely to report better return ratios in FY11 despite lower near-term profitability. Further, a majority of these companies are debt-free as they have utilised cash earned during the last bull cycle (FY04-FY09) to clean up their balance sheets by repaying debt.
4. Valuations attractive; under-ownership provides room for upside: During the last cement downcycle (FY01-FY02), the sector witnessed increased M&A activity as smaller players found it unviable to operate their plants. A similar situation could emerge in FY11-FY12 where smaller players could be potential M&A targets. This could be a key trigger for a sector-wide re-rating as EV/t increases post acquisitions.

We believe most of negative news are largely factored into stock prices and any further decline in stocks will be a buying opportunity as a sector re-rating sets in.