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India: Construction: Cement
Equity Research
The worst is behind, supplier discipline prevails; Grasim up to Buy
The worst is behind, raise sector stance to neutral from cautious
We turn incrementally positive on the India Cement sector based on: 1)
Utilization has troughed: We believe capacity utilization has bottomed in
3QFY11 and will see a gradual improvement to 77%/80% in FY12E/FY13E (vs.
76% in FY11E) as we expect capacity addition to slow down—41 mtpa to be
added in FY12E/FY13E vs. 80 mtpa in FY10/ FY11E. 2) Pick up in demand:
After a weak 4.6% growth in FY11 ytd, we expect consumption to be stronger
in FY12E (+10% yoy) driven by increased public spending before state
elections, improved execution in the last year of Eleventh Five-Year Plan and
pent up real estate demand. 3) We expect pricing to remain robust (+3%/4%
in FY12E), led by supplier discipline as cement mills cut production.
Supplier discipline is the key to healthy pricing
We believe the recovery in cement prices over the past 2 quarters (prices close
to all-time highs) is driven by supplier discipline, as reflected in trough
utilization. The key to healthy pricing, in our view, would be governed by the
extent to which suppliers maintain this discipline—if the most fragmented
South India market can turn rational (after a period of cash burn), we expect it
would be easier for other regions, where top 5 companies control about 70%
of the market. Given the strong seasonal demand, we believe the discipline
could be sustained, at least till the monsoons begin in June/July.
Margin recovery subdued, FY12E margins 25% below peak margins
In spite of a better pricing environment, we expect margin recovery to be
subdued amid cost inflation. While margins troughed in 2QFY11, we believe
the recovery would be gradual, with FY12E margins likely to remain about
25% below peak levels, as we expect cost inflation to persist in the medium
term, driven by high coal/energy prices (spilling over to freight/packing costs).
Upgrade Grasim to Buy on valuations; ACC off CL, retain Sell
We upgrade Grasim to Buy with a revised 12-m SOTP-based TP of Rs2,984
(Rs2,265 earlier). At 5.1X FY12E EV/EBITDA, Grasim is trading at a 10% disc to
mid-cycle and at a 36% disc to Indian peers. This implies that either: (1) the
VSF business is trading at a 40% disc to peers, despite superior margins/
returns, or (2) implied holding company disc for the cement division is a steep
40%, both of which we believe are unjustified. We remove ACC from CL, but
retain Sell, on lack of near-term catalysts. For cement stocks under coverage,
we revise FY11E-FY13E EPS by -15% to +14%, and raise 12-m TPs by 11%-32%.
Utilization to remain low in FY12E, despite improving demand
Utilization has troughed, but supply pressure to continue till FY13E
In our view, capacity utilization has troughed in 3QFY11 and we expect a gradual
improvement in utilization levels—77%/80% in FY12E/FY13E—as the pace of capacity
addition slows down in FY12E/FY13E and demand picks up after a disappointing FY11.
We expect 41 mn tons of new capacity in FY12E/FY13E vs. 80 mn tons added since March
2009. On the demand side, we expect 46 mn tons of incremental demand in FY12E/FY13E,
with cement consumption growing at 10%/11% in FY12E and FY13E.
Demand growth to be incrementally stronger in FY2012E
After a strong growth of 11% in FY10, FY11 witnessed a slowdown in cement consumption,
with ytd growth at a disappointing 4.6%. In addition to prolonged monsoons, this was
driven by weak infrastructure and real estate spending, with southern markets such as
Andhra Pradesh experiencing yoy decline.
While we note that there is a lack of visibility in the short term, we expect demand to see a
10% growth in FY12E on:
Higher infrastructure spending: After a subdued FY2011 which saw a
slowdown in government reforms and public spending, we expect execution to
improve in FY12. Further, FY12 is the fifth year of the Eleventh Five-Year Plan, the
year which generally witnesses the maximum spending, and consequently strong
cement consumption growth.
Pre-election spending to drive growth: Historically, public spending and
infrastructural development tends to pick up before state-elections. FY2012E will
see elections in 5 states (about 20% of All-India consumption) which could
positively impact cement consumption growth, in our view.
Supplier discipline is the key to healthy pricing
Since Sep 2010, prices have risen by 15%-30% across India, especially the past 2 months
witnessing a sharp rise, amid trough utilization. We attribute this to a pick up in seasonal
demand and suppliers exercising production discipline. Currently prices are close to alltime
highs, with 10-year low utilization rates and more than half of the cement companies
in India operating at less than 80% capacity utilization (as of January).
South India: A good example of production discipline, lesson learnt the hard
way
The trend in the South Indian cement industry in the past 6 months demonstrates how low
profitability and negative operating cash flows triggered supplier discipline. South India—
which has seen the maximum capacity addition of 45 mn tons (74% growth, 50% of all-
India capacity additions) in the past 2 years—witnessed a 20%-40% decline in prices in
2QFY11 with most cement companies in South not being able to recover their costs,
leading to all-time low EBITDA. Since then, prices have recovered by as much as 100%
(Andhra Pradesh), in spite of muted demand as producers cut production to maintain
prices.
In our view, the key to healthy pricing would be governed by the extent to which suppliers
maintain this discipline – If the most fragmented market such as South India can turn
rational (top 5 companies controlling 45% of market share), we expect that it would be
easier for other regions, where top 5 companies tend to control 70%-80% of the market.
Given the strong seasonal demand, we believe that the discipline could be sustained, at least
till the monsoons which begin in June/July.
Margin recovery to be subdued, despite healthy realizations
Despite a better pricing environment, we believe margin recovery would be subdued amid
cost inflation. Although we believe that margins troughed in 2QFY11, the recovery would
be gradual.
While prices are close to all-time highs, variable costs have almost doubled in the past 5
years, led by coal and energy prices (which have a spiraling impact on freight and
packaging costs.)
With Coal India having raised its prices by 30% recently (the full impact to come in FY12)
and imported thermal coal costs close to all-time highs, we believe that fuel costs, which
constitute 25%-30% of the total variable costs) would remain the main driver of cost
inflation. Moreover, as Coal India is finding it tough to meet its production targets,
allocation to cement companies has reduced over time as the power sector continues to be
the priority for Coal India (80% of Coal India’s sales). As such, as and when companies
install new capacity, the dependence on imported coal increases, which is at 50%-60%
premium to linkage coal.
With most state elections getting over by June, we think a potential increase in diesel
prices could exert further pressure on freight costs.
Valuations reasonable, supplier discipline breakdown an overhang
Cement stocks under coverage have outperformed the broader market by 7%-10% ytd, led
by strong pricing due to supplier discipline and expectations of parent company (Holcim)
hiking its stake in ACC/Ambuja. The cement stocks are on an average trading close to midcycle
valuations, which is fair, in our view, given that we expect a gradual improvement in
margins going forward despite robust realizations. Moreover, with excess capacity to
remain till early CY12 (capacity utilization of 77% in FY12E), we believe that the risk of
breakdown in supplier discipline, would continue to be an overhang on the sector,
especially during the seasonally weak demand period of July- Sep.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
India: Construction: Cement
Equity Research
The worst is behind, supplier discipline prevails; Grasim up to Buy
The worst is behind, raise sector stance to neutral from cautious
We turn incrementally positive on the India Cement sector based on: 1)
Utilization has troughed: We believe capacity utilization has bottomed in
3QFY11 and will see a gradual improvement to 77%/80% in FY12E/FY13E (vs.
76% in FY11E) as we expect capacity addition to slow down—41 mtpa to be
added in FY12E/FY13E vs. 80 mtpa in FY10/ FY11E. 2) Pick up in demand:
After a weak 4.6% growth in FY11 ytd, we expect consumption to be stronger
in FY12E (+10% yoy) driven by increased public spending before state
elections, improved execution in the last year of Eleventh Five-Year Plan and
pent up real estate demand. 3) We expect pricing to remain robust (+3%/4%
in FY12E), led by supplier discipline as cement mills cut production.
Supplier discipline is the key to healthy pricing
We believe the recovery in cement prices over the past 2 quarters (prices close
to all-time highs) is driven by supplier discipline, as reflected in trough
utilization. The key to healthy pricing, in our view, would be governed by the
extent to which suppliers maintain this discipline—if the most fragmented
South India market can turn rational (after a period of cash burn), we expect it
would be easier for other regions, where top 5 companies control about 70%
of the market. Given the strong seasonal demand, we believe the discipline
could be sustained, at least till the monsoons begin in June/July.
Margin recovery subdued, FY12E margins 25% below peak margins
In spite of a better pricing environment, we expect margin recovery to be
subdued amid cost inflation. While margins troughed in 2QFY11, we believe
the recovery would be gradual, with FY12E margins likely to remain about
25% below peak levels, as we expect cost inflation to persist in the medium
term, driven by high coal/energy prices (spilling over to freight/packing costs).
Upgrade Grasim to Buy on valuations; ACC off CL, retain Sell
We upgrade Grasim to Buy with a revised 12-m SOTP-based TP of Rs2,984
(Rs2,265 earlier). At 5.1X FY12E EV/EBITDA, Grasim is trading at a 10% disc to
mid-cycle and at a 36% disc to Indian peers. This implies that either: (1) the
VSF business is trading at a 40% disc to peers, despite superior margins/
returns, or (2) implied holding company disc for the cement division is a steep
40%, both of which we believe are unjustified. We remove ACC from CL, but
retain Sell, on lack of near-term catalysts. For cement stocks under coverage,
we revise FY11E-FY13E EPS by -15% to +14%, and raise 12-m TPs by 11%-32%.
Utilization to remain low in FY12E, despite improving demand
Utilization has troughed, but supply pressure to continue till FY13E
In our view, capacity utilization has troughed in 3QFY11 and we expect a gradual
improvement in utilization levels—77%/80% in FY12E/FY13E—as the pace of capacity
addition slows down in FY12E/FY13E and demand picks up after a disappointing FY11.
We expect 41 mn tons of new capacity in FY12E/FY13E vs. 80 mn tons added since March
2009. On the demand side, we expect 46 mn tons of incremental demand in FY12E/FY13E,
with cement consumption growing at 10%/11% in FY12E and FY13E.
Demand growth to be incrementally stronger in FY2012E
After a strong growth of 11% in FY10, FY11 witnessed a slowdown in cement consumption,
with ytd growth at a disappointing 4.6%. In addition to prolonged monsoons, this was
driven by weak infrastructure and real estate spending, with southern markets such as
Andhra Pradesh experiencing yoy decline.
While we note that there is a lack of visibility in the short term, we expect demand to see a
10% growth in FY12E on:
Higher infrastructure spending: After a subdued FY2011 which saw a
slowdown in government reforms and public spending, we expect execution to
improve in FY12. Further, FY12 is the fifth year of the Eleventh Five-Year Plan, the
year which generally witnesses the maximum spending, and consequently strong
cement consumption growth.
Pre-election spending to drive growth: Historically, public spending and
infrastructural development tends to pick up before state-elections. FY2012E will
see elections in 5 states (about 20% of All-India consumption) which could
positively impact cement consumption growth, in our view.
Supplier discipline is the key to healthy pricing
Since Sep 2010, prices have risen by 15%-30% across India, especially the past 2 months
witnessing a sharp rise, amid trough utilization. We attribute this to a pick up in seasonal
demand and suppliers exercising production discipline. Currently prices are close to alltime
highs, with 10-year low utilization rates and more than half of the cement companies
in India operating at less than 80% capacity utilization (as of January).
South India: A good example of production discipline, lesson learnt the hard
way
The trend in the South Indian cement industry in the past 6 months demonstrates how low
profitability and negative operating cash flows triggered supplier discipline. South India—
which has seen the maximum capacity addition of 45 mn tons (74% growth, 50% of all-
India capacity additions) in the past 2 years—witnessed a 20%-40% decline in prices in
2QFY11 with most cement companies in South not being able to recover their costs,
leading to all-time low EBITDA. Since then, prices have recovered by as much as 100%
(Andhra Pradesh), in spite of muted demand as producers cut production to maintain
prices.
In our view, the key to healthy pricing would be governed by the extent to which suppliers
maintain this discipline – If the most fragmented market such as South India can turn
rational (top 5 companies controlling 45% of market share), we expect that it would be
easier for other regions, where top 5 companies tend to control 70%-80% of the market.
Given the strong seasonal demand, we believe that the discipline could be sustained, at least
till the monsoons which begin in June/July.
Margin recovery to be subdued, despite healthy realizations
Despite a better pricing environment, we believe margin recovery would be subdued amid
cost inflation. Although we believe that margins troughed in 2QFY11, the recovery would
be gradual.
While prices are close to all-time highs, variable costs have almost doubled in the past 5
years, led by coal and energy prices (which have a spiraling impact on freight and
packaging costs.)
With Coal India having raised its prices by 30% recently (the full impact to come in FY12)
and imported thermal coal costs close to all-time highs, we believe that fuel costs, which
constitute 25%-30% of the total variable costs) would remain the main driver of cost
inflation. Moreover, as Coal India is finding it tough to meet its production targets,
allocation to cement companies has reduced over time as the power sector continues to be
the priority for Coal India (80% of Coal India’s sales). As such, as and when companies
install new capacity, the dependence on imported coal increases, which is at 50%-60%
premium to linkage coal.
With most state elections getting over by June, we think a potential increase in diesel
prices could exert further pressure on freight costs.
Valuations reasonable, supplier discipline breakdown an overhang
Cement stocks under coverage have outperformed the broader market by 7%-10% ytd, led
by strong pricing due to supplier discipline and expectations of parent company (Holcim)
hiking its stake in ACC/Ambuja. The cement stocks are on an average trading close to midcycle
valuations, which is fair, in our view, given that we expect a gradual improvement in
margins going forward despite robust realizations. Moreover, with excess capacity to
remain till early CY12 (capacity utilization of 77% in FY12E), we believe that the risk of
breakdown in supplier discipline, would continue to be an overhang on the sector,
especially during the seasonally weak demand period of July- Sep.
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