Cement - high seasonal volatility here to stay; Edelweiss

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All-India effective capacity utilisation is estimated to remain depressed at ~80% (against over 90% in FY06-10), assuming consumption growth of 10.5% Y-o-Y in FY12-13 (higher than past five year average growth of 9.2%), due to capacity additions. The ~35 mn tonnes of fresh capacity expansion orders, expected to be placed in FY12-13, augur depressed industry scenario for a longer period. Pricing environment across regions is expected to remain highly volatile over the next two years. Sharp decline in utilisation ratios of surplus regions (North, South) during the lean season (Q2, Q3) is estimated to put pressure on prices across deficit regions (East, West, Central) due to continued high inter-regional movement (IRM). With no respite from operating costs, margins are likely to decline Y-o-Y. We remain negative on the sector.

           

n  Low utilisation in North, South to put pressure on all-India prices 

Effective capacity utilisation in South (including IRM) is estimated to decline to 63% in FY12 and 61% in FY13 against 94% and 77% in FY09 and FY10, respectively. This is likely to keep an overhang on prices not only in South, but also in West and East. In North, utilisation levels are estimated to decline to ~70% in Q2 and ~82% in Q3 of each of the next two fiscals, impacting prices not only in North but also in Central and West regions. With busy season (Q1 and Q4) expected to see firm prices (subject to high demand growth), we estimate the pricing environment to be highly volatile over the next two years.

n  IRM currently on the rise; however, likely to decline going ahead

The inter-regional movement (IRM) continues to rise Y-o-Y, despite all the noise of rail wagon shortage. Against 22 mn tonnes in FY08 (including Holcim Group), volumes increased to 26 mn tonnes in FY10 (ex Holcim Group). In H1FY11, IRM is up ~7% Y-o-Y with net IRM into East rising 56% and into West by 35%. Owing to likely capacity additions in deficit regions, we however estimate IRM to dip going ahead. If it doesn’t, there will be additional pricing pressure in deficit regions.

n  No respite from costs; EBITDA/tonne to dip 4-9% in 2 years

With no coal linkages for new capacities coming on board over the next two years, companies will be forced to procure coal from the high-cost open market and imported sources. Imported coal is up ~50% in the past quarter and open market coal prices are rising. Rail freight has also being revised up by 4% w.e.f December 27, 2010; also, cost of major inputs like gypsum, fly ash and slag are up ~10-30% Y-o-Y, thereby putting pressure on operating margins. We estimate companies’ EBITDA/tonne of to decline by 4-9% over the next two years. 

n  Outlook and valuations: Negative

We are valuing the stocks on an EV/tonne basis, since we are in the middle of a downtrend with expected decline in profitability and ROE over the next two years. We have assumed the discount to replacement cost based on region-wise exposure of companies (eg: higher discount for South exposure and lower for East). With current valuations being expensive, we downgrade our recommendation on ACC to ‘REDUCE’ from HOLD, while we maintain ‘REDUCE’ on Ambuja Cements, UltraTech, and India Cements. We maintain ‘HOLD’on Grasim due to VSF cycle uptrend and reasonable valuations.