India Cement EV/T metrics might be misleading when utilizations are expected to remain low; Earnings metrics more relevant:: JPMorgan

One common ‘bull’ argument for cement is that stocks are 'cheap' as they are
trading close/below current replacement costs of ~$120-140/T. Historically large
cap stocks have traded at a significant premium to replacement costs, however,
those years were marked by peak utilization rates, M&A and increasing
profitability. With utilizations expected to remain below ~85% for the next few
years, M&A largely absent, and earnings range bound, we believe earnings based
metrics (EV/EBITDA) are more relevant and not replacement costs (EV/T).
Cement stocks DO NOT look cheap on earnings metrics as they do on EV/T.

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 Stocks look cheap on ‘Replacement Cost’….: The 3 large cap names (ACC,
ACEM, and UTCEM) are trading below (ACC at $114/T) or marginally above
replacement costs (ACEM $160/T, UTCEM $163/T). Historically the large cap
cement names have delivered strong returns over an 18-24 month period from
such levels of valuations (discount/parity to replacement costs).
 …. But the operating environment was significantly different in 2005-08:
The cement operating environment of 2005-08 (when stocks surged to large
premiums v/s replacement cost) was characterized by 3 events: a) large M&A
taking place with Holcim buying Ambuja, Heidelberg buying Mysore Cements,
CRH buying My Home Industries. The acquisitions were primarily done by
foreign cement companies which paid significant premium to prevailing
replacement cost; b) capacity utilization rates in excess of 90%, as industry was
coming from a period of under investment in capacity build out, while demand
was booming at 8-10%; c) large cement price increases (without cost increases)
which drove EBITDA/T and earnings.
 How does the current environment differ? Against tight demand supply
conditions earlier, as of now we estimate excess capacity of +110MT in the
industry with headline utilizations of <75 2-3="" from="" here="" nbsp="" next="" over="" p="" the="" years="">utilization levels are unlikely to sharply increase given that capacity addition
should be over 50MT and demand growth of >10% looks unlikely as of now.
M&A has been largely absent as MNCs’ balance sheets remain stretched. There
have been many media reports (ET, Business Standard) of the PE funds looking
at the sector and evaluating multiple transactions, but so far nothing has
materialized, and given the sheer overcapacity, we doubt if the premiums of
2005-08 would come through. Profitability is seeing sharp swings from quarter
to quarter, and even with demand revival, we find it difficult to see EBITDA/T
increasing sharply from Rs1100/T levels.
 Earnings metrics like EV/EBITDA more relevant than asset metrics like
EV/T: In the new operating environment, we argue that earnings based metrics
like EV/EBITDA become more relevant than asset based metrics. On the latter,
the market effectively values the entire capacity even though operating capacity
would be smaller. With profitability unlikely to break out of its current range,
earnings growth effectively would depend on volume growth which should
broadly track industry growth. In our view, large cap cement names like ACEM
and UTCEM with likely earnings disappointment could underperform from
current levels. Other than a sharp increase in demand, the other risk is that of
Holcim increasing stakes in its subs - ACC and ACEM.