Surging ahead

SPECIAL REPORT

While demand continues to be robust, cement prices may soften sometime in mid-2008 due to huge capacity additions.

In the past year, the cement sector has consistently outperformed the market. While the BSE Sensex returned over 53 per cent, the Business Standard Cement Index, has surged by a whopping 100 per cent.

That's not really surprising given the performance of cement companies on the ground. Consider: for the first nine months of this year, Gujarat Ambuja turned in a sales growth of nearly 50 per cent while its profit after tax was up by a handsome 133 per cent. During the same period, ACC's operating profit margins increased from 17.7 per cent to 27.7 per cent.

In a sweet spot

With demand growing at about 10 per cent a year in the past two years, cement prices have been on an upward trend rising by over 32 per cent in the last 18 months. This has translated into strong margins for companies. With the economy in fine fettle and expected to stay this way, the party, it would appear, has just begun.

However, capacity additions are taking place and supply is tipped to increase by about 70-75 million tonnes a year by 2009-10 from the current levels of around 142 million tonnes a year. 
 

PLANNED CAPACITIES
Above 3 mn tonnes
Grasim	9.80
Jaiprakash Associates	8.20
India Cements	5.00
UltraTech Cement	5.00
Madras Cement	4.00
Mysore Cement	4.00
Gujarat Ambuja	3.50
Shree Cement	3.50

Meanwhile, consolidation has picked up in the recent past powered both by Indian majors like Grasim Industries and also international majors. That's proved by the stakes acquired by Holcim and Heidelberg.

The top five enterprises today account for more than 50 per cent of the capacity. The rest of the industry, however, remains fragmented with 55 companies in the sector. Nonetheless, the opportunity for further consolidation is evident.

Homing in on demand

Demand from the housing segment, currently around 80-85 million tonne per annum will continue to remain the biggest driver of demand, specially in the light of National Housing Board data referring to requirement for 20 million dwellings, though there are concerns about the rise in interest rates and escalating real estate prices.

However, the growing infrastructure sector is expected to chip in the near term. "There is no doubt that RBI would attempt to cool down the situation in real estate but we expect cement demand from housing to be strong though there may be a compositional shift towards infrastructure," explains Rakesh Valecha, director, Corporate Tradings.

Industry experts believe that the share of infrastructure will go up marginally to 25-30 per cent within the next two years from the present level of around 20 per cent. With increased focus on NHDP III and IV as also the completion of the North-South-East-West corridor scheduled over the next five years, the demand estimate of around 8-9 million tonne a year over the medium term from various road projects may well turn out to be conservative.

A significant driver could also be the power sector with 36 per cent of the 60,896 MW required for the Eleventh Plan to be produced in the hydel sector which has higher relative demand for cement as compared to other conventional segments of the power sector. The icing on the cake could be capital expenditure by corporates currently at 15 per cent of demand but which could also play an important role in regional dynamics.

Supply side story

What could restore the demand-supply balance is the cement capacity addition which would come on stream in the next three years. But with robust GDP growth predicted in the same period, would increased capacity really influence price movements? With capacity utilisation already shooting above 94-95 per cent and blending increases nearing potential, expansion of new capacities would ease the situation.

But several issues remain. "We will also have to factor in delays for land acquisition, equipment supply bottlenecks and the likes," an expert tracking the sector points out. Recent reports from leading cement equipment suppliers have suggested an increase in the delivery time from 12-15 months to 20 months.

Prices yet to peak?

The addition to supply is however a medium term story. Till then, prices are expected to remain firm. "We expect prices to soften by FY2009," says Manish Balwani, research analyst, Emkay Research/PCG.

In the next 10-15 months however, prices could appreciate due to the tight demand-supply situation and move up from the current levels of an average of around Rs 200 nationwide. "Prices could increase by Rs 10-15 per 50 kg by March 2007," says Balwani.

The chances of imports dampening prices in the domestic market are also being talked about, though experts believe the odds are low. "Imports, by our reckoning, would not be economically viable because the cost will be higher," concludes an analyst.

As such, most analysts believe that prices will not soften in the next 15-20 months. Meanwhile, in a bid to sustain margins, several companies are resorting to cost-cutting measures.

These include blending, which is adding other materials like fly ash, slag, etc. Companies are also setting up captive power projects with a view to bring down costs. Power costs account for a significant portion of total costs. Such measures should help companies sustain their margins even after prices soften.

South and East to lead the way

Demand supply trends in the cement industry are typically region-specific. Thus, for example, any decline in exports would impact companies based in the western region.

However, there is expected to be limited capacity addition in the western region in the next few years, and therefore prices should remain stable. The demand is expected to be higher in the east and south, and these two regions are expected to account for a larger share of the demand by FY09.

Today they account for about 29 per cent and 16.7 per cent respectively and this should go up marginally to 30.1 and 16.8 per cent by FY09. "Investments in irrigation projects, IT parks and big ticket state sponsored infrastructure projects would continue to drive demand in the south," explains Balwani.

Significantly, 36 per cent of the planned capacity addition in the country would, according to industry sources, be in the south. Estimates say 62 per cent of this would be fully completed only by FY09, leading to an easing of the price situation that year.

Demand in the eastern region will be led by capital expenditure by corporates, given the large number of steel plants being planned in Orissa and Jharkhand by majors including international bigwigs like Mittal-Arcelor, POSCO and others. Companies in the eastern region may also show better margins in the future because of better prices.

In the northern region, demand growth will remain strong though it might not be as strong as in the east or south, say experts. The demand for cement in the north is expected to come from construction activity.

Several projects such as the Commonwealth Games and many SEZs are coming up. Approximately 40 per cent of the total number of SEZ projects in the country are tipped to come up in the north.

Margins should remain strong

Though a significant portion of the expansion will be by smaller players, recent trends in consolidation have meant a rise in the share of the top five players to 50-60 per cent market share. The merger of Ambuja Cement Eastern with Gujarat Ambuja will result in better efficiencies and geographical spreads.

Similarly high cement prices and further savings of power cost could result in significant appreciation in operating profit margins in FY07 for Gujarat Ambuja. UltraTech Cement's strategies in captive power investment and various efficiency improvement programmes including de-bottlenecking and ready mix concrete plants could drive operating profit margins to over 30 per cent by the end of this financial year. 
 

COMPARATIVE VALUATIONS
	Current  Price(Rs)	EPS		P/E
		F/C2007E	F/C2008E	F/C2007E	F/C2008E
Grasim	2758.00	160.07	178.56	17.23	15.45
UltraTech Cements	956.00	59.31	69.55	16.12	13.75
Gujarat Ambuja	141.00	7.33	8.56	19.25	16.47
ACC	1105.25	57.71	68.90	19.15	16.04

ACC's greatest asset continues to be its pan-Indian presence which makes it relatively immune to any unfavourable regional demand-supply scenario. After its debt restructuring and upcoming capacity expansion, India Cements also looks set to operate within continuing attractive valuations and prospects of rising margins.

The demand-supply equation it appears, is unlikely to be disturbed in the near term. However, there are concerns that have been voiced from within industry on the costs side, especially with regards the availability of coal and power.

With captive power plants being installed, at least some of these input problems are being addressed. If the economy continues to grow the way it is going, cement companies will not have much to worry about, at least in the near term.

Domestic consolidation, global interest

Two important elements in the consolidation process have been domestic mergers underlined by a desire to expand scale and regional reach as also interest taken by global majors.

Various acquisitions include Gujarat Ambuja and ACC stake acquisition by Holcim, Heidelberg's purchase of Indorama Cement and Mysore Cements and Grasim buying UltraTech from L&T. Gujarat Ambuja and Ambuja Cement Eastern too will be functioning as a single entity.

Moreover, given that all the top five global cement players except for Mexican giant Cemex have a presence in the country, an international angle to the consolidation process is increasingly evident.

The impact of the consolidation in the cement sector so far is summed up by an analyst: "This could imply better discipline among players thus ensuring significantly lower price volatility even after the expected capacity additions in FY09."

However the chances of a second round of consolidation are bleak at present. As Corporate Tradings' director Rakesh Valecha says, "We expect the prospects of a second round of consolidation to be weak due to high valuations and expansion based growth strategies being pursued by industry participants."