Despite a glut in the system, realizations have been improving as firms cut output
On Wednesday, a foreign institutional investor bought shares worth $50 million in a cement company. Even if one does not read too much into it, it’s apparent that a turnaround in perception has begun for the cement sector. Since the second half of FY11, cement companies have been under intense pressure due to excess capacity, high input costs and poor realizations. The demand for cement grew only 4.5 per cent in the nine month period ended December 2010 and capacity utilisation levels stagnated at 75 per cent, which impacted realizations by Rs 35 a bag.
While the demand disappointed in the first nine months of FY11, analysts are confident that the long-term drivers of demand are in place. The government is committed to higher infrastructure spend on one hand and strong growth in rural housing are likely to be main catalysts for the sector to turnaround. Motilal Oswal believes that while short-term visibility is limited, levers in the form of assembly elections, pent-up demand and low base of FY11 could help to bring the growth momentum back on track. Also, as FY12 is the terminal year of the Eleventh Five Year Plan, projects which have been pending will see commissioning in this year.
In addition to the demand revival, analysts are also bullish on the sector as capacity additions are nearly over and only 66 million tonnes of new capacity will be added between FY11 and FY14, compared to 105 mt added over FY08-11. As demand picks up and the pace of capacity addition falls, the Street expects capacity utilisation to gradually improve. The second reason for the upgrade of the sector is improved realization. Cement prices have recovered by Rs 30-40 a bag. It is expected that production discipline during peak construction season would lead to further price rise till the second half of FY12 which will offset any cost inflation. Motilal Oswal expects earnings before interest, taxes, depreciation and amortisation (Ebitda) to improve to Rs 894 a tonne in FY12 and Rs 993 a tonne in FY13 compared to FY11’s average of Rs 760 a tonne.
So what are the best bets in the sector? Due to the overhang of overcapacity, cost inflation and sluggish volume growth most of the domestic cement stocks have underperformed the broader market in the past 12-15 months. However, as the players undertook price rise after the first quarter of FY11, cement stocks have witnessed a mixed trend. The larger players like ACC, Ambuja Cements and UltraTech Cement have marginally outperformed the broader market whereas the mid-sized players have continued to underperform the broader market. Hence, the valuation gap between the large players and the mid-sized players has widened considerably.
According to Sharekhan, historically, mid-sized players traded at a discount to the large players. On an average, this discount has been in the range of 22 per cent in the past 11 years. However, at present the mid-sized cement companies are trading at a higher discount of around 39 per cent, closer to the discount recorded in the previous down cycle (in FY2004). Sharekhan expects the gap to narrow, making some of the stocks in the sector good picks.