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India cement sector
Costs, capacity & cartel = cash out
Cash out time
Cement stocks have witnessed a strong rally in the last 12 months,
outperforming the Nifty by 36%, driven by the longevity of pricing discipline. With
stocks trading at 18-19x PER and the chances of a hefty penalty from the
Competition Commission of India (CCI) looming ahead, the risk/reward appears
unfavourable. Moreover, with continued capacity additions and rising costs,
earnings growth should remain elusive for at least another two years. We remain
Underweight on the Indian cement sector.
Cement price at all-time highs – where is the money?
Our study of 16 cement companies shows that since 1996, i.e. in the last 15
years, the incremental EBITDA made by these companies cumulatively was just
US$2bn, and the bulk of this came just in the three years from 2006-08. We
believe that the cement industry is again in a phase where the fight will be to
sustain earnings, and we don’t see things changing over the next three years.
Costs, costs, and costs – and will keep rising
In the past four years, production costs have risen 50%, and this includes
subsidies, like diesel and coal from Coal India. Rising costs have helped improve
price discipline, and the industry has been able to raise cement prices by 35%,
but this is not enough for margin expansion. Unfortunately, the cost rises have
been structural and may require substantial changes like captive coal mines, etc
to reverse; we think this is at least three years away.
Capacity still outpacing demand
We are expecting 50mt of additional capacity in the next two years, while
incremental demand is likely to remain less than 35mt. This will keep cement
capacity utilisation below 80%. Also the installed capacity share of the top three
companies in the country has fallen from 45% (in FY08) to just 38% now. On the
other hand, demand growth has declined from an average of 10% pa in the past
four years to around 6-7%. With our muted view of the investment cycle and
reduced affordability of real estate, we don’t see demand growth exceeding 8%
pa over the next two years.
CCI on the verge of levying penalties for cartelisation
CCI finished hearings against 42 cement companies in late February and should
be ready with penalties by April. We expect penalties of about 7% of total
revenue (last three years’ average), equal to 5-6% of market cap for every year
of investigation. Global experience tells us that stocks correct by 20%+ on such
penalties. See our report Investigations & Oversupply (June 23, 2011).
Costly – Valuations expensive and building in a bull cycle
Cement stocks are now trading at all-time high valuations, with well above
trough-cycle earnings. To justify current valuations, we need EBITDA margins to
improve by 50%, which looks highly unlikely given oversupply. Moreover, we are
not sure if the companies will be able to retain these earnings in view of the
possible penalties. We would sell into this rally. Our key sell ideas are ACC,
Ambuja and Ultratech.
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