Supply woes

The concerns of an over-supply situation in the domestic cement industry and the consequent impact on prices and profitability are back again. But, this time around, the threat looks more prominent and thus, suggests that the heydays enjoyed by the sector in recent years in the form of improving operating rates, prices and profitability may well become history. And thus, the resultant impact on stock valuation, going ahead. For now, while the cement dispatch numbers for August 2009 have been good and those for year-to-date healthy, the fall in cement prices across different regions is a cause for concern.

Surplus situation, a reality
In the past, on the back of healthy demand and relatively lower capacity expansions, the industry operated at high rates enabling it higher realisations. But, things may be in for a change. Industry experts are now expecting the industry to witness new capacity additions of 30-58 million tonnes (mt) in 2009-10 and another 31-39 mt in 2010-11. Even at the lower band, over 60 mt is projected to be added by March 2011. The top four players alone are expected to add about 20 mt between January 2009 and mid-2010. On the other hand, overall demand is expected to grow at 9-10 per cent annually during 2009-10 and 2010-11. Thus, the capacity utilisation for the industry, which fell to around 90 per cent in 2008-09, may decline further. “In 2009-10, the operating rate of the industry will decline further because of 52 million tonnes of new capacity was added in the last two years and more will be added going ahead. We expect the operating rate to decline to levels of 80 per cent in 2009-10 and 75 per cent in 2010-11,” says Revati Kasture, head-Industry Research, CARE Research. CRISIL Research, too, shares a similar view. “Due to significant capacity additions over the next two years, we expect cement operating rates to fall from 88 per cent in 2008-09 and bottom out at 77 per cent in 2010-11 before recovering to 87 per cent 2013-14. In terms of regions, south and east will face the maximum decline in operating rates; they are expected to fall below 75 per cent,” says Ajay D’Souza, head, CRISIL Research.

Lower prices and profitability?
Lower utilisation rates may translate into lower pricing power. And, this (cement price) is a key bone-of-contention. A few experts believe that the decline in cement prices since July 2009, ranging Rs 5-20 across different regions, is temporary due to factors like monsoon and should look up post-November. “With the debt-equity ratio of larger players, which control nearly half the market, at lower levels, we expect them to adopt pricing discipline by not selling at un-remunerative prices,” says an analyst.

Some others believe that prices will remain under pressure due to lacklustre demand from housing sector (accounts for about 60 per cent of cement demand), subdued rural spending (lag effect of weak monsoons to reflect in 2-3 months) and new capacities leading to surplus situation. They expect the prices to fall the most in the South, where capacity addition is the largest.

Says Gaurav Dua, head Research, Sharekhan, “The recent decline in prices is due to seasonal weakness. Prices do soften a bit during monsoon. We see some pricing pressure in second half due to commissioning of new plants, wherein it will be more in south and west. However, prices should remain firm in north, central and east.” In a recent report, Edelweiss analysts wrote that the robust pricing situation in the North has started reversing following the twin impact of capacity addition and inter-regional movement.

The other point is that if prices do come down, what will be the extent of decline and its impact on profitability. “Unlike in 2008-09, lower input prices will provide relief to cement companies in 2009-10 and the relatively high break-even cushion means that industry can operate at low capacity utilisation rates and avoid substantial price cuts. While we don’t foresee a notable drop in average realisations, with a 5 per cent cut in average realisations, PBDIT of the industry is expected to drop by about 400 basis points (bps) in 2009-10,” says Kasture.

Outlook
Unless demand from the infrastructure or housing sectors rises beyond estimates, experts believe that the industry could face a surplus situation, in light of the planned capacity additions and demand growth of 9-10 per cent, leading to lower utilization rates, prices and margins. The second half of 2010 onwards is likely to be tough for the industry as most of the new capacities will get stabilised and operational. Also, a global recovery could mean higher costs of inputs like coal. Likewise, with Coal India’s demand for an 11 per cent hike in coal prices for 2009-10, expect some pressure on margins going ahead.

Overall, even as analysts believe that the longer-term (2-3 years) prospects look good, they expect cement stocks to underperform the broader markets in the near to medium-term. Dua is neutral on the sector and advises to be selective. “We like companies operating in the north like Shree Cement and UltraTech.” Analysts prefer companies with cost-saving potential and ones that are ahead of the curve in adding capacity. They also prefer companies with a larger presence in north, east and central India. To know more on the individual companies, read on.

ACC
India’s largest cement player with a capacity of 23.23 mt per annum (mtpa) as on March 2009, ACC sells about 70 per cent of its cement in northern, eastern and central regions, with South and West accounting for the remaining 30 per cent. The company will see its capacity rise to 30.58 mtpa by December 2010. However, most of its new capacities are back-ended; 3 mtpa in December 2010 (Maharashtra), 1 mtpa in March 2010 (Karnataka), 2 mtpa in December 2009 (Karnataka) and 1.4 mtpa in September 2009 (Orissa).

Since the company is operating at over 93 per cent capacity utilisation and has little new capacity going on stream anytime soon, it is not surprising that its cement dispatches have grown in single digits since January 2009 till August (up just 4.5 per cent). Notably, most of ACC’s new capacities will come up during 2010 (when the industry is expected to see a surplus) besides, in western and southern states, two markets where the pricing pressure is expected to be the highest, say analysts. Although analysts have projected an increase in margins (due to lower costs and higher prices, y-o-y) and EPS for CY09, these are expected to decline by 13-15 per cent in CY10. Most analysts are not positive on the stock.

Ambuja Cements
Ambuja Cements, the second largest cement player in India with total capacity of 20 mtpa, is a part of the Holcim group that owns ACC. The company is relatively better placed due to its presence in north, west and eastern markets. The recent decline in the cement prices in the range of Rs 3-5 per 50 kg bag in the western and eastern regions could have some impact on the realisations. However, that could be compensated from the northern markets, where prices are still relatively better. Its cement dispatches have grown at 7.6 per cent y-o-y between January-August 2009, with August reporting a stronger 15.3 per cent growth.

The company is increasing its capacity to 25 million tonne by end-CY09 and further by 1.5 million tonne in CY10. However, analysts believe that due to the supply side concerns, the new capacity might not generate revenues immediately. Additionally, the company’s cost of production has gone up recently due to higher cost of clinker. Further, in case of decline in cement prices the company’s margins might come into pressure. During CY09, the revenue is expected to grow at 12 per cent while net profit growth is pegged at 5.5 per cent. At current levels, analysts believe that the stock is expensive at 13.6 times CY09 and 13 times CY10 estimated earnings. Even on the basis of EV per tonne of $121 for CY09, they say it is among the highest within peers.

Grasim
Excluding the sponge iron business that was sold in May 2009 for Rs 1,030 crore, Grasim’s standalone cement operations (19.65 mtpa capacity) accounts for 70 per cent of sales and 75 per cent of profits in FY09; rest accounted largely by the VSF (viscose staple fibre) and chemicals. In cement, most of its capacities are focused on central and northern markets, which provide comfort. The business also benefits from captive power (total capacity 268 mw; 144 mw added in FY09), which now meets 80 per cent of the power needs. Grasim is also among the largest ready-mix concrete and white-cement players in India.

Timely capacity additions in cement, including 2.9 mtpa in FY09 and another 2.9 mtpa in Q1FY10 (another 3.15 mtpa by December 2009), should help capture incremental demand say analysts. They believe that the cost cutting measures (logistics and power related) initiated by Grasim should stand it in good stead. Along with UltraTech, the group controls nearly 50 mtpa of domestic cement capacity. Positively, Grasim’s VSF business is expected to do well in 2009-10 led by better realisations. Overall, analysts are neutral on the stock as the upside from current levels is projected at only 5 per cent.

Shree Cement
With all its plants located in Rajasthan, Shree Cements largely caters to the northern markets. From a mere 3 mtpa in FY05, its capacity has rapidly risen to 9 mtpa in FY09. The expansions have helped it clock robust volume growth, which along with better realisations led to strong topline and bottomline growth in the last three years. Notably, Shree Cements is among the few companies to have sustained EBIDTA margins of about 40 per cent in the last 2-3 years, thanks to its cost efficiencies, high utilisation rates (over 100 per cent) and availability of captive power. The only recent exception was FY09, wherein most cement players saw margins contract due to high cost pressures.

For June 2009 quarter, too, Shree Cements did well led by 33 per cent volume growth and strong rise EBIDTA margins (due to depressed prices of input; pet coke). The company has signed a 2-year deal with IOC for supply of pet coke (about 35 per cent of its requirements), which should support margins in future.

Its capacity is expected to rise to 12 mtpa by March 2010. Likewise, its power capacity, which has risen from 39 mw in FY05 to 119.5 mw in FY09, is expected to rise by 93 mw by March 2010 and by another 50 mw by September 2010. This should enable the company to sell surplus power at higher rates in the market—an activity started since August 2008. Adjusted for the Rs 1,300 crore of cash and investments it had as on March 2009, it is virtually debt-free generating operating profit of over Rs 1,300 crore annually. Overall, given its presence in northern region, it should be among the least impacted. The stock is on the buy list of most analysts.
 

MARGINS UNDER PRESSURE
in Rs crore	2007-08			2008-09			June 2009 quarter			Latest					EBIDTA
	Net Sales	EBIDTA (%)	PAT	Net Sales	EBIDTA (%)	PAT	Net Sales	EBIDTA (%)	PAT	D-E (x)	ROCE (%)	Price (Rs)	Mkt Cap	PE (x)	FY10E (%)	FY11E (%)
ACC #	6,941	27.8	1,427	7,588	21.9	1,100	2,188	35.0	471	0.09	36.0	773	14,518	9.8	27.0	24.0
Ambuja Cem. #	5,685	35.8	1,846	6,209	28.4	1,390	1,847	28.2	325	0.06	30.8	98	14,994	13.0	28.3	29.0
Birla Corp	1,721	33.3	393	1,790	23.7	324	498	36.7	155	0.24	32.4	291