Cementing the road ahead

INVESTMENT COUNTER/ SECTOR REVIEW

Strong demand promises concrete future for cement sector.

The dynamics of Indian cement industry is undergoing a gradual shift. From an oversupply situation not so long ago, we are now witnessing a scenario where demand growth is outstripping supply.

Demand grew by about six per cent last year and is expected to grow at about eight per cent going forward. What's more, there is a likelihood that some areas could even see demand overtaking supply in near future.

According to analysts, cement industry in India is poised for strong growth going forward, driven by continued investments in the housing and infrastructure sectors.

Rising demand

Analysts hold a positive outlook about the sector. The cement industry grew by 8.5 per cent in FY05, while the economy grew by only seven per cent. The future could be a lot better. According to Merrill Lynch, cement demand in the country in FY06 will outpace the long-term estimated CAGR of eight per cent.

Even as energy costs remain a cause of concern, the changing demand-supply dynamics will drive cement prices higher benefiting the industry across the board.

Says Manak Gaushal, Fortis Securities, "Now the demand-supply situation is more or less in equilibrium and prices could move up further as the demand growth will be much faster than the supply growth."

There are good reasons for their optimism. Analysts add that housing, which accounts for 55-60 per cent of the demand, remains the consistent driving force behind sector growth. 
 

Demand Vs Supply
(Million tonnes)	Incremental demand	Incremental supply
FY01	-0.50	7.00
FY02	8.00	10.80
FY03	8.70	7.90
FY04	5.90	7.50
FY05	8.90	5.10
FY06E	11.10	4.70
FY07E	10.60	6.80
Source: CMA

Besides, demand from infrastructure projects and industrial/commercial ventures account for 20 per cent each. An incremental demand of two million tonnes is expected per year from infrastructure projects in the country. So, even as the Golden Quadrilateral project nears completion, demand in the port and airport segments may pick up, keeping demand buoyant.

While demand side look bright, analysts do not see any large capacity additions in near future, even as India would need 8-9 million tonnes additional capacity every year till FY08 to meet the incremental demand.

Moreover, consolidation is expected to bring rationality in capacity addition. This would keep the cement prices favourable for the companies.

Regional dynamics

Shirish Rane of SSKI Securities points out that cement dispatches witnessed an exceptionally strong growth in August due to extremely low base of last year and a surge in demand after the rain deluge in western India in July.

Companies with higher exposure in the western region like Grasim, Ultratech and GACL, benefited more from this. Overall, the western region is expected to show a 7-8 per cent growth on back of construction activity, in line with the all India average.

The scenario in the eastern and southern region looks better than ever before. According to Merrill Lynch, the demand growth witnessed last year in the eastern region continues. The eastern region, which experienced 16-18 per cent growth in past five months on a smaller base, is expected to post 22 per cent growth going forward.

South India has also witnessed a turnaround in demand, while northern Indian markets witnessed weak growth. Gaushal expects the demand in the north Indian market to grow at eight per cent per annum, while southern regions could grow at 18 per cent as seen in the past 4-5 months on a smaller base.

Cement demand in south India has been sluggish over the past two years. However, the situation seems to be changing for the better driven by strong growth in retail, housing and infrastructure projects. This is expected to continue over the next year or so.

Moreover, irrigation projects in Andhra Pradesh (accounting for 33 per cent of demand in the state) and infrastructure projects in Karnataka are gathering speed. The over supply in this region has reduced, which only points to firm prices going forward.

Obviously, south-based companies are likely to benefit from the upturn. Some large companies have been even offsetting their weaker sales in the north against the surge in the south.

Northern India may see some supply short-fall this year end. Thus, players in this region are likely to add some capacity. The rest of the country may experience some supply crunch in December 2006.

Predicting demand-supply situation in a single quarter may be difficult say analysts, but in general the gap is minimum in the North, while it is maximum in the South and West. East and Central regions are considered well-placed.

Plants in the North operate at 100 per cent capacity utilisation, while those in the East have been operating at 70 per cent capacity. In South, West and Central regions, capacity utilization is currently at 85 per cent, 68 per cent and 78 per cent respectively.

Most of these are expected to go up to about 90 per cent in April-May 2006. This leaves limited scope for squeezing out additional capacity from the existing plants. The current capacity in the country is about 145-150 million tonnes. 
 

Valuations
	Price (Rs)	Trailing P/E	FY07E
ACC	486	15.60	11.8
Gujarat Ambuja*	76	21.90	12.9
Grasim	1321	12.10	11.8
UltraTech	469	24.30	19.1
*Year ending June

Encouraging financials

The financial performance of cement companies also make for encouraging reading. In the quarter ended June 2005, cement majors posted good results. While ACC recorded a 69 per cent increase in net profit to Rs 147 crore, Grasim (up 14.5 per cent to Rs 251 crore) and Gujarat Ambuja Cement (up 37 per cent to Rs 171) also performed well. However, it was UltraTech Cement that upstaged the others by posting a 434 per cent growth in net profit to Rs 60 crore.

Most companies saw a 200 - 500 basis point increase in operating margins, except ACC, whose OPM remained stable at 20 per cent. There was a 400-600 basis points increase in net profit margins too. In the case of UltraTech Cement, net margins went up from just 1.6 per cent last June quarter (FY05) to seven per cent this time (FY06).

The expansion in margins had mostly to do with effective cost management by the companies, say analysts. Going forward, costs are likely to come down.

While power costs are likely to come down from the previous quarters, coal prices are stabilising which is good news for cement companies. Also lower interest rates and tax incentives are helping. 
 

Financials Figures are for June quarter of 2005 (In Rs crore)
Company	Net sales	% change yoy	Operating profit	% change  yoy	OPM %	Net profit	% change yoy	NPM %	P/E
ACC	1211	12.86	245	13.43	20	147	68.97	12	15.6
Gujarat Ambuja	745	-0.67	240	5.73	32	171	36.8	23	21.9
Grasim	2495	55.74	565	26.12	23	251	14.61	10	12.1
Ultratech	815	19.85	150	44.23	18	60	445.45	7	24.3

Analysts anticipate some cost pressures due to rising power cost. But they add that the big players would be able to tackle the same with focus on captive power, which remains a better option to grid power as long as coal prices are reasonable.

Grasim for instance, plans to tackle rising costs by debottlenecking, captive power, alternative fuels and leveraging synergies with Ultratech. Apart from this, higher diesel prices may result in increased freight expenditure. Cris Infac expects an impact of about Rs 7-15 per tonne due to a deficit in non-coking coal, used as fuel. But price hikes could cushion the same.

Prices likely to go up

Post-monsoon, prices are likely to go up by 5-6 per cent. Analysts say that this monsoon, the prices did not crash as much as in other years, as the demand-supply situation was not so bad. The fall in prices was only about Rs 5-10 per bag as compared to the Rs 20-25 fall that happens normally.

Analysts expect consolidation in the sector to bring some discipline in cement prices, as happened in the east, after the entry of Lafarge. The entry of foreign players like Holcim is viewed as a positive, which may bring greater price stability and operational rationality.

Outlook

Further consolidation is expected in the sector at a slow pace, but not big ticket acquisitions. Some plants that are shut down or are in bad hands may find takers in big players, something that is being talked about for quite some time.

But most attractive capacities have been already bought, according to analysts. Moreover, valuations are high at present and M&A activity may slow down due to sellers quoting very high prices.

But one thing is clear. Consolidation or no consolidation, the cement sector growth story is here to stay on back of increasing demand in housing, infrastructure and commercial construction sectors. Moreover, since capacity additions take 2-3 years to complete, firm cement prices could be expected till 2007-08.

Analysts note that the current valuations of cement companies at Gujarat Ambuja (21.9x), ACC (15.6x), Grasim (12.1x) and UltraTech (24.3x), are slightly on the higher side. However, based on FY07 estimates, they look reasonable -- ACC is valued at 11.8x while the valuation for UltraTech stands at 19.1x.

"We expect prices to be stable to firm"

On demand-supply scenario
There is a limited capacity addition in the industry till FY07 and no greenfield project is expected. Hence, on an overall basis we anticipate that the incremental demand would be higher than the additional supply from 2006-07.

On cement prices
We have seen that during the monsoon, cement prices have remained stable and not come down. Infrastructure activities would definitely pick up post monsoon and we expect prices to be stable to firm.

On future growth drivers
Housing sector is and would remain the main cement growth driver. There is a huge shortage of houses, which contribute over 70 per cent in the cement consumption. Recently, much emphasis has been put on infrastructure, housing and road development.The government has allowed 100 per cent investment through FDI route in construction, which would help the sector. This would provide an added impetus to the cement demand.

On entry of Holcim
Holcim is one of the largest cement producers in the world. With it's expertise in various fields such as waste heat recovery and use of alternative fuels, we expect Indian cement industry to benefit with the entry of a serious global player.

Demand & supply to grow at 8-10 per cent

On demand-supply scenario
We expect both demand and supply of cement to register a healthy rate of growth of the order of 8-10 per cent in the next few quarters. Supply is likely to be generally commensurate with demand on a countrywide basis barring some exceptional mismatch situations.

On capacity expansion plans
We have an ongoing project for the expansion of our cement plant at Lakheri in Rajasthan together with the establishment of a captive power plant. We are examining the feasibility to augment capacity at our other units.

Our capacity utilization during April-August 2005 was 94 per cent. It could have been higher but for constraints on account of the heavy monsoons this year. We expect it to pick up in the remaining months of the year.

On consolidation
With more than half of the industry's capacity still fragmented, there is no doubt about scope for acquisitions and mergers .

On cost pressures
We are concerned that the overall cost of energy is still high despite the many strides we have made in achieving higher efficiencies and productivity. Government administers the prices of many of our inputs. And if you add to this the cost of various statutory taxes and levies, the burden continues to be excessively high and one on which we can exercise little or no control. It directly constricts our global competitiveness.