The return on capital employed in the cement industry has been declining over time, while the capital employed has been increasing
A study by Stern Stewart Research shows that the Indian cement sector has shown a consistently negative and a largely declining EVA (economic value added) trend over the ten year period between 1992 and 2001.
EVA is basically a measure of wealth created by a company for its shareholders. Simply defined, EVA is the economic profit obtained after deducting the cost of all the capital employed (both equity and debt) in the business to generate operating profits.
The study indicates that the return on capital employed in the cement industry has been declining over time, while the capital employed has been increasing steadily. Both the profit margins and the capital returns of the Indian cement sector are declining. Other observations in the study are as follows:
* The EVA metric has been declining for most cement players.
* Birla Corp, Dalmia, Grasim, Shree and Gujarat Ambuja are the few exceptions, showing a trend of improving EVAs over the past three years.
* Gujarat Ambuja is the only player to earn positive EVAs. In contrast, major international players like Lafarge and Blue Circle Plc have earned positive EVAs.
* This is even more startling as the returns on capital employed by these international companies are comparable to the players in the Indian cement sector.
* The higher cost of capital in India is the bane, and is reflected in the Indian players' negative EVAs.
So what are the implications? The study points that the industry needs better prices and ways to improve the supply-demand imbalances. The question, then, is whether the industry will be able to consolidate sufficiently and quickly enough to improve the operating performance. Will the players attempting to drive consolidation be able to earn sufficient returns over their incremental capital invested? The industry would clearly benefit from a dose of value management disciplines to improve focus on delivering better returns to shareholders.
Traditionally, cement companies have enjoyed little power in terms of pricing. While the key issue is a demand-supply mismatch, a highly fragmented industry structure has only worsened matters.
With about 40 players in the industry with a total capacity of around 125 million tonnes, companies have suffered due to price undercutting in good and bad times.
While smaller players are condemned for playing the spoilsport, in an attempt to keep themselves afloat, the larger ones have shown little unity till recently.
After the dream run in 2001 when the big five players in the industry got together to jack up prices by regulating supplies through informal production agreements, companies have relented in the last two quarters due to tough market conditions.
Except in northern India where the Ambuja-ACC combine is in a price dictating position with a significant marketshare, all other markets have suffered. Says Anil Singhvi, managing director, Gujarat Ambuja, "Today, the most stable market is the north, where we enjoy a large portion."
Sluggish demand and the commissioning of new capacities by some players have inevitably led players to go with their own independent pricing decisions rather than follow any production or pricing discipline.
The result: prices have slipped badly in the last two quarters. The average retail price level across the country has been Rs 125 per 50 kg bag.
Again, despite the fact that the two large combines command a market share of about 70 per cent in the Maharashtra region, cement prices have fallen drastically to double digit figures. No wonder, cement companies have continued to earn a low return on capital.
For fiscal 2001, the best year for the cement industry thus far, the return on capital employed (ROCE) was just about seven per cent. At the same time, the weighted average cost of capital was 15 per cent making them wealth destroyers.
Clearly, the industry cannot improve its returns unless consolidation gathers pace. In the past four years, the cement industry has witnessed much faster consolidation: A total of 15 million tonnes, representing around 14 per cent of the total cement capacity in the country, changed hands.
But in FY01, there was a marked slowdown and only 2.3 million tonne of capacity was acquired and the same trend has continued in later years. There are several reasons that have contributed to the slowdown in consolidation. Analysts feel that the acquisition of a strategic stake by Grasim and Gujarat Ambuja in the L&T and ACC respectively has dampened the consolidation activity in the sector.
Moreover, the local biggies Grasim and Gujarat Ambuja have been constrained because of their financial ability to pursue further acquisitions, after their big bang strategic acquisitions. Three years after acquiring the 14 per cent stake in ACC, Gujarat Ambuja is now is a comfortable position to contemplate further acquisitions.
The same is the case with the international players. Cement majors like Lafarge and Blue Circle are not in the pink of health, after spending huge sums on acquiring capacities in the rest of Asia.
More importantly, international players were pitching for L&T's cement business to give them a strong foothold. Since L&T doesn't look like a strong option now, these companies may look at smaller players, say analysts. But it is as easy to acquire small companies.
Industry officials say that promoters of small companies often ask for 'unreasonable' valuations. Since many of these companies are bleeding heavily, the valuations demanded by the sellers often turn out to be unviable.
Even in case of small listed companies, serious acquirers have been unable to close deals due to the pricing issues. Even though the past one year has been turbulent for the sector, sellers' expectations still rule high. The only way out is hostile take-overs, but regulations are not really in favour of hostile bids, argues an official.
Some analysts argue that the way in which the big players have consolidated has changed the industry dynamics. Ideally, the attempt should have been to buy out the smaller players and then consolidate at the top. By indulging in big buys, the issue of small players remains unaddressed.
Having said that, the market share of the top five companies has improved significantly compared to what it was four years ago. Their market share then was about 30 per cent, which has now gone up to 55 per cent, and should improve in the coming years. We think a high gearing will prevent further acquisitions by any of these larger players for the next 12 months.
