Cement: Capacity additions to slowdown on lower prices:: Elara

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Capacity additions to slowdown on lower prices
After adding record capacities addition of a ~ 87mn
tonnes between FY07 and FY10, the country has
witnessed a marginal slowdown in the pace of addition.
Primarily, the capacity additions were the result of higher
operating cash flows on the back of high cement pricing
regime. However, due to cost push and low cement
prices, operating cash flows of cement companies have
come under pressure resulting in a slowdown in new
project announcement. Besides, long procedures related
to the acquisition of land and obtaining environment
clearances have delayed the commissioning of many
cement plants. Thus, after capacity additions of
whooping ~35mn tonnes by FY10, the cement industry
is expected to add ~29mn tonnes in FY11, ~24mn
tonnes in FY12 and 17mn tonnes in FY13. Between FY10-
FY13, the industry is expected to add 71mn tonnes while
in the same period, the demand is expected to increase
by only 63mn tonnes.


Demand to accelerate in second half
Growth in cement demand has been sluggish (4.9%)
during the first half of FY11 due to heavy monsoons and
a higher base effect. We believe the demand will
accelerate from H2FY11 onwards on the back of a higher
demand from infrastructure and construction sectors. As
we approach the last two years of XIth Five Year Plan, we
believe there will be a higher thrust on the infrastructure
since the Government plans to spend ~52% of the target
expenditure in the last two years. Buoyant order book of
construction companies also indicate that construction
activities will pick up in the near future. On the back of
the firm demand from the user industry, we expect the
demand to grow at 8% in FY11, followed by 10.4% in
FY12 as well as in FY13.
Therefore with the moderating pace of capacity
additions and a steady demand growth, we expect
capacity utilizations in the industry to gradually improve
going ahead. We consider that the pan India capacity
utilizations will improve to 81% in FY12 only to better to
85% in FY13. However, we expect a dip in capacity
utilizations in monsoons of FY12 (Q2 & Q3 of FY12).
Pricing : The worst seems to be over
We believe that in terms of pricing, the worst is behind
us. A gradual improvement in utilization levels on the
back of an enhancement in cement demand (supported
by an increase in cost of production) will prevent a sharp
fall in prices in future.
We believe, Q2FY11 is likely to be the worst quarter for
cement producers as low cement prices in Q2FY11 had
resulted in a negative EBITDA/tonne for some Southern
players and an RoCE of well below WACC for majority of
players. Therefore, we expect things to perk up going
ahead as cement companies are likely to opt for price
increases rather than higher volumes. Earnings of
cement companies are more sensitive to pricing changes
(~4% variation with 1% change in pricing) than volume
changes (~2% change with a 1% change in volume
sales). Due to the mature behavior of cement players,
prices have already gone up by INR20 -100 per bag in
the past two months. Further, discount in the cement
price in trade and non-trade has also been reduced from
INR40 per bag to INR20/bag. We believe, the concerted
action of the players might not be a long term
phenomenon, but with improving capacity utilizations
and a strong cost push, cement prices might have a little
downside from the current levels.
We have built in our estimates, a price increase of
~INR25/bag in H2FY11 from Q2FY11 levels. For FY12,
we have built in a decline of ~INR17/bag over H2FY11
levels (On annual basis, our cement prices for FY12 are 2-
3% higher than FY11).
Scenario to look up from FY13; Upcycle a year away
As discussed earlier, we expect utilizations to gradually
improve from FY12 before reaching a level of 85% in
FY13. The demand on the other hand, is expected to
grow at a steady pace after suffering hiccups in the first
half of FY11. The XIth 5 Year Plan envisages an
investment of INR 10,750 bn with a focus on
infrastructure activities which will ensure a steady
demand growth for cement. Therefore, we believe that
the stable pace in demand and lack of strong capacity
additions will create a healthy cement market in the
country.
Little upside in large caps, value lies in midcaps
For valuation of cement companies, we have used
EV/tonne based methodology as the earnings based
valuations have historically failed to provide a fair picture
of the stock performance.
The entire large cap pack is already trading at a premium
to its replacement cost as well as close to its peak cycle
EV/tonne valuations. As we believe, the upcycle is still
one year away, for valuing large cap players, we have
discounted the average bull cycle EV/tonne multiples at
a WACC of 13%.
However, for mid cap players, we have used a distress
case EV/tonne valuation of USD62/tonne, considering
the regional risk.
Historically, mid cap players have traded at a discount to
the large cap peers as the profitability of mid caps too
was lower than their large cap counterparts. But due to
the cost cutting initiative undertaken by mid cap cement