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Not yet improving, but unlikely to
worsen much, either
Product price increase unlikely to offset
cost pressures; we are c3-11% below
consensus on FY12e EBITDA
Initiate with Underweight on ACC and
ACEM; Neutral on SRCM and UTCEM
Not yet improving … We believe that (1) cement supply will
continue to outstrip demand for the next two years,
(2) operating costs will rise following elevated crude and coal
prices, and (3) strong end-demand growth is not likely, as
infrastructure projects are delayed and interest rates are high.
… but unlikely to worsen much, either, as (1) the markets
are aware of the negatives we highlight, (2) corporate
balance sheets are much stronger compared with a traditional
down-cycle, (3) the base has been adjusted after low growth
in many regions, (4) long-term cement demand prospects
remain strong, and (5) a production discipline-led cement
price increase can last for long periods.
Product price increase unlikely to offset cost pressures;
c3-11% below consensus on FY12e EBITDA. We believe
cost pressures from higher coal and crude-derivative prices
are unlikely to be passed on to the consumers, given our
expectation of a prolonged period of cement surplus.
Initiate with Underweight on ACC and ACEM, Neutral
on SRCM and UTCEM. We initiate coverage of four
cement players, with an Underweight rating on ACC
(TP: INR970) and ACEM (TP: INR110) and a Neutral on
SRCM (TP: INR1,840) and UTCEM (TP: INR1,060). Our
target price is based on a valuation methodology blending
two approaches: (1) EV/EBITDA (to capture momentum)
and (2) EV/GCI and justified PE (to capture asset values and
normalised earnings).
Risks related to input costs and cement prices. Downside
risks to our earnings estimates include higher-than-expected
increases in raw material costs and coal prices, infrastructure
spending delays. A higher-than-expected increase in cement
prices is an upside risk.
Summary
Things are not yet improving, but unlikely to worsen much, either
Product price increase unlikely to offset cost pressures; we are 3-
11% below consensus on FY12e EBITDA
Combined valuations same as in 2007; prefer UTCEM over
ACC/ACEM; N on SRCM
Things are not yet improving …
In our opinion, (1) supply will continue to outstrip
demand for the next two years, (2) revenue costs
of incremental capacity will keep increasing in the
wake of higher crude and coal prices, and
(3) strong demand growth is unlikely in the wake
of delayed infrastructure projects and the rising
interest rate cycle.
We are not yet witnessing traditional indicators
that would normally suggest a turnaround in a
cyclical commodity, namely:
Low end-product demand reflected in low
product pricing (on the contrary, despite all-
India dispatch growth of just 5% over the last
year, cement prices have moved up 26% in
recent highs)
Balance sheets being stretched after ill-timed
acquisitions or post prolonged periods of low
profitability (rather, companies under our
coverage have net cash, with an average
negative debt-to-equity ratio of 0.28x)
Management getting fed up with growing
capacities and of throwing in the proverbial
towel (anecdotally, all company management
we have met cite the willingness to grow
capacity multiple times over the long term).
Supply to outstrip demand for the
next two years
More specifically, over FY11-14, we expect 75mt
of incremental cement capacity to be created,
most of which will be in the South and Central
regions. Despite our expectation of strong demand
growth of 8.5% compounded over the same
period, we still expect excess capacity of more
than 80mt over the next three years
Costs will increase over the next
two years
In our assessment, costs for cement companies
will keep rising over the next couple of years as
(1) existing capacities face price pressure from
rising crude-related (higher freight) costs and coal
prices (both domestic and international) and
(2) new capacities will have inherently higher
costs as they do not have captive coal linkages
unlike their already-running counterparts. In
addition, limited wagon availability and already
hiked diesel prices will make transportation
costlier. Exhibit 48 has the details.
Cement despatches have been
flattish so far
After having grown just 5% in FY11, all-India
cement despatch growth for the first two months
of FY12 has been rather flat (despite stronger
growth in IP) and signs of improvement are not
visible just yet. Exhibit 4 gives dispatch growth in
cement in key states.
In the absence of accurate lead indicators of future
demand (like housing starts, infrastructure
investments, etc), we believe with rising interest
rates, demand off-take may not improve soon.
… but are unlikely to worsen
much, either
We believe that cement stocks are unlikely to dive
off the cliff as (1) a large part of the negatives
(supply outstripping demand, rising costs) are
known to the market already, (2) corporate
balance sheets have become much stronger when
compared with a traditional down-cycle, (3) after
declines in certain regions (AP, Delhi), the base
has been adjusted and long-term cement demand
prospects remain strong, and (4) productiondiscipline-
led product price increases are known
to stick for long periods of time (we draw
parallels with the European steel industry).
Market already knows many
negatives
Most negatives are already known to the market,
in our opinion. Exhibits 69 and 70 show that
consensus EBITDA estimates have come down
more than c20% in key stocks over the past year.
In addition, consensus has more ‘sell’ than ‘buy’
ratings (see exhibit 67).
Balance sheets are much stronger
now, following low debt-gearing
Comparing to the last down-cycle in 2002-05, net
gearing for all these companies was in the range
of 121.9% to 24.9% during 2002-05 vs net cash
now (except SRCEM which has power business).
Whereas that prevents further consolidation from
happening, we believe it should result in superior
valuation multiples as there is a stronger
possibility of higher product prices through
production discipline. Exhibit 3 gives details of
net gearing of key cement companies.
Higher end-product pricing as a result of
production discipline has meant that recent
acquisitions have happened at much higher prices
when compared with the cost of setting up a new
capacity
Long-term demand growth drivers are
in place; base has adjusted after low
growth last year
In addition, we also note that whereas all-India
growth in cement consumption has been just 5% in
FY11, it is weighed down by declines in certain
states/regions, whereas growth ex-those regions has
been pretty stable (see exhibit 4). Of the top eight
states by cement consumption (accounting for 67%
We note that long-term drivers for strong cement
consumption over the next five years are in place
given the large supply gaps in the housing and
infrastructure segment. Please refer to the chapter
‘Consumption drivers’ for our analysis of longterm
Indian cement demand estimates.
We notice that cement demand in India has grown
despite issues in the global economy. Exhibit 5
gives details of cement consumption in India
during the ‘global financial crisis’ period. We
note that cement demand kept growing at 11% pa
during that time whereas other global
commodities’ (like steel and non-ferrous metals)
demand took a serious beating.
Production-discipline-led product price
increases can stick for a long time
Production discipline is critical for profitability
during times of over-supply and rising costs.
Whereas models cannot incorporate human
behaviour and hence the willingness of players to
continue with this discipline, we note that this
aspect is not unique to the cement industry.
We draw parallels with the European steel industry,
in which steel mills cumulatively produce only
c168mt of steel versus a capacity of c272mt, and
the price increase in steel products has so far been
more than the cost push. More importantly, we note
that the stocks of European steel producers have
reacted positively to this structure of arrangement.
We are c3-11% below FY12e
consensus EBITDA
We believe that cement companies will not be
able to pass on coal and crude-related cost
increases through cement price increases in FY12.
We also differ from the street on consideration of
incremental capacity costs. While our revenue
forecasts are in line with consensus expectations,
we think that the market has not priced in
additional cost burden due to capacity addition.
With a reduction in domestic coal linkages, we
estimate that energy cost per ton of additional
capacity will be 27% higher than for existing
capacity (exhibit 48).
Likewise, cost push pressure due to limited and
declining availability of railway wagons adds up
to incremental costs as companies are forced to
use costly road transport for additional production
Our valuation methodology
We value Indian cement stocks based on a
blended approach – of momentum (EV/EBITDA),
asset base (EV/GCI) and long-term earnings
potential (discount-justified PE multiple).
We believe this approach effectively captures
value because, in these uncertain times, when
reported return on invested capital is much below
long-range averages, stock prices do not fall as far
as earnings do – a trend we witnessed last year.
Our justified PE multiple takes into consideration
average expected RoE (over the next three years),
the expected long-term growth rate and cost of
capital. The EV/GCI multiple ensures reasonable
asset valuations (for further details refer to the
valuation section).
We prefer UTCEM over ACC, ACEM
and SRCM
Despite acknowledgement of a positive long-term
outlook for the cement industry, we estimate that
the short-term scenario is clouded by concerns of
supply outstripping demand and rising costs.
Consequently, we have an Underweight rating
for ACC and ACEM, and Neutral on SRCM
and UTCEM.
Relatively speaking though, we expect UTCEM’s
valuation discount versus ACC/ACEM to reduce as
we assign a lower probability of Holcim acquiring a
further stake in the latter companies (after having
crossed 50% ownership in both companies).
ACC (ACC.IN): TP INR970, Underweight
We initiate coverage of ACC with a target price of
INR970, which is a weighted average of
EV/EBITDA, PE and EV/GCI based calculations.
At INR970, the stock offers 3.0% potential return
implying an Underweight rating as per the HSBC
research model.
Upside risk: Greater-than-expected ramp-up of
new capacity in Maharashtra may add positive
volume surprise to our estimates.
Downside risks: Rising costs of raw materials and
challenges in streamlining new capacity addition.
ACEM (ACEM.IN): TP INR110, Underweight
We initiate coverage of ACEM with an
Underweight rating and a target price of INR110,
which is a weighted average of EV/EBITDA, PE
and EV/GCI based calculations. The stock offers
negative 10.1% potential return.
Upside risk: A higher-than-expected increase in
cement prices may improve the company’s
profitability drastically.
Shree Cement (SRCM.IN): TP INR1,840, Neutral
We value the stock at INR1,840 using SOTP
methodology assigning a value of INR1,552 for
the cement business and INR292 per share for the
power business. The stock offers 6.3% potential
return, implying a Neutral rating under our
research model.
Upside risks: Greater-than-expected
improvement in cement prices and quicker-thanexpected
commissioning of 300MW capacity
merchant power plant at Beawar (in Rajasthan).
Downside risks: Rising cost of raw materials and
uncertainties regarding adequate coal supply for
the power plant.
UTCEM (UTCEM.IN): TP INR1,060, Neutral
We initiate coverage of UTCEM with a Neutral
rating and our target price of INR1,060 is based on
a blended average of EV/EBITDA and EV/GCI
valuations, offering an 8.7% potential return.
Downside risks: Rising cost of raw materials
Upside risks: Sharp rise in cement prices
Sector risks
Pricing power to return by 2014 only
With the existing level of excess capacities, we
believe that pricing power will not return until
2014 as rational capacity additions balance the
demand - supply mismatch. As such, any
correction in cement prices will translate into a
sharp margin decline.
Uncertainties of industry production
discipline
With the government’s move to investigate
allegations of cartelisation against cement majors
UltraTech Cement, Ambuja Cements and ACC,
the practice of implied industry production
discipline may not be sustainable in the future.
Rising raw material cost a risk to our
forecasts
A higher-than-expected increase in raw material
prices will adversely affect the profitability of the
cement companies.
Valuations
Uncertain times calls for normalised valuations
Combined valuations of Indian cement companies similar to that
in 2007; USD2bn in FCF created since but multiples take a
beating following uncertain environment
Our valuation exercise takes blend of EV/EBITDA, EV/GCI and
justified PE multiples
Combined valuations of cement
companies the same as in 2007
Over the last four years, the combined market
capitalization of the top four cement companies has
not changed (between Dec-2007 and now it is
constant at cUSD20bn). During this time frame,
these companies generated operating cash flow of
cUSD5bn. India has consumed c747mt of
incremental cement and these companies generated
positive free cash flow of cUSD2bn despite setting
up c27.8mt of incremental capacity.
Exhibit 59 gives the chart of combined market
capitalization of the top four companies (ACC,
ACEM, UTCEM + GRASIM and SRCM) and
exhibit 57 gives details of operating cash flow,
free cash flow and incremental capacity growth of
the companies mentioned above.
Our methodology – blend of
momentum and long-term earnings
Our valuation methodology for ACC, ACEM and
UTCEM is a blend of EV/EBITDA (50% weight),
EV/GCI (Enterprise value to Gross Capital
Invested multiple, 25% weight) and Justified
price-to-earnings multiple (25% weight) and that
of SRCM is based on the Sum-of-the-parts
method. See exhibit 61.
EV/EBITDA captures momentum …
Whereas we believe the EV/EBITDA multiple
(tested against last 5-year average) correctly
captures momentum, we note that weakness in the
current commodity cycle implies that reported
RoE does not capture the mid-cycle earnings
capability of these companies.
… and we introduce two normalized earningsbased
multiples
We therefore introduce two normalized earningsbased
valuation approaches that capture the midcycle
earnings capacity – EV/GCI and Justified PE.
We base EV/GCI multiple on cash returns that the
company generates over and above its weighted
average cost of capital. We note that the EV/GCI
multiple scores over ROCE/EBIT and Price to
Book value multiples as the former is agnostic to
differences in depreciation policy and the age of
plant; and over EBITDA/ton as it takes into
account the difference in earnings capacity of
different capacities.
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