Uneven Road Ahead

While the Indian cement industry will see better demand and utilisation rates thanks to government-led infrastructure projects, the gains will be unequal for players based on size and location

On December 15, two biggest players in the sector — ACC and Ambuja Cement — announced that they plan to increase their production capacity in north, east and central India. ACC stated that it will beef up its capacity by 5.9 million tonne per annum (mtpa) in the north and east India and 3 mpta in central India, while Ambuja said that it would add 1.8 mtpa in the north. These expansions will add to Ambuja Cement’s current production capacity of 29.65 mtpa and ACC’s installed capacity of 33.41 mtpa. 

Similarly, down south, Ramco Cements announced on December 14 that it is setting up a cement plant of 3.15 mtpa capacity in Kurnool district of Andhra Pradesh. Once the expansion is completed, the production capacity of Ramco Cements will increase to 20 mtpa in the two years by the end of 2020.

Even smaller players such as Dalmia Bharat, JK Cement, Penna Cement and Sagar Cements have also been expanding their facilities.

The cement makers in India are on an addition spree. According to CRISIL, India’s cement companies are expected to add 48-50 mtpa of capacity through fiscal 2020 – or 1.6 times incremental demand growth expected in the period. After battling lower demand and having little pricing power over the past of couple years, cement companies are finally seeing some recovery in demand and utilisation in FY19, and the glimmer of hope is what’s probably driving some of the expansion plans. However, with the real estate sector, which accounts for 60% of the cement consumption, still not out of the woods, the road to recovery is still a long one. As the industry waits for the up cycle to kick in with full vigour, small regional players are likely to emerge as the early gainers

Kunal Shah Research analyst, YES Securities

Infra gains

With the real estate segment facing a downturn, the demand for cement has been fuelled by government-sponsored infrastructure projects. While the contribution of government infrastructure projects and roads to cement consumption is to the tune of 25-30%, affordable housing accounts for 5-6% of overall demand currently. Over the past several years, a weak macro weighed on cement demand, which reported growth of around 5% CAGR over FY11-18. But in FY19, there was a trend reversal as demand grew to around 9%, the fastest growth in almost a decade thanks to a boost from pre-election spending, states a CLSA report (see: Striking the right balance). “The beleaguered sector has relished some tailwinds, emanating from the government’s thrust on infrastructure and affordable housing projects. Accordingly, investments in cement intensive infrastructure segments have grown by 13% annually over FY15 and FY19,” says Kunal Shah, research analyst, Yes Securities.

Low on utilisation

For the cement industry, it has always been a problem of plenty. While the cement industry is highly fragmented, the top four companies — UltraTech Cement, Shree Cement, Ambuja Cement and ACC — account for 44% of capacity share, according to Yes Securities. Driven by an efficient manufacturing process generating healthy cash flow and a strong balance sheet, the top four have constantly added capacity to take their share from 34.3% in FY08 to 44% currently.

As the big four grew, there was a continuous decline in the market share of the smaller players. “It obviously made the latter restless and insecure about their prospects. Therefore, they have put in place major capex plans to ramp up capacities and attempt levelling the playing field,” says Shah.

The industry’s capacity addition of 93 mtpa in the last five years was higher than the incremental demand of 53 mtpa during the period, according to a UltraTech Cement investor presentation, leading to excess supply and lower capacity utilisation. The slowdown in demand amid steady capacity addition severely restricted the pricing power of cement manufacturers over the past five years. According to CRISIL, while demand has grown at a moderate pace of 4.5-5% CAGR over FY13-18; pricing has only seen a modest annual increase of only 1.2% with capacity utilisation at a sluggish 66%. On the other hand, cement prices saw a 6.3% increase annually during FY08-13 with average capacity utilisation at a healthier 72%.

However, UltraTech, India’s largest cement maker said an 81 mtpa increase in demand is expected to outpace expansion of 51 mtpa of cement capacity between FY18-21 leading to better capacity utilisation. Shah says he believes that the demand situation should improve structurally within 1.5-2 years primarily due to gradual recovery in real estate sector, post which cement demand should consistently outperform GDP (as the case has been over last 57 years wherein the ratio has been 1.23x). He also adds that biggest driver for prices would be higher demand from rural areas which are currently distressed.

CLSA predicts better demand growth and utilisation rates for the overall industry in the next couple of years. Utilisation rates are expected to improve from 69% in FY19 to 73% in FY21 (see: Steady trot). According to the report, there will be regional disparity with the south continuing to see the lowest utilisation rates, and the north and the central seeing the strongest gains.

But the market share fight among the large and the mid-sized players will keep the prices range bound. While the pricing on a blended basis is expected to improve by a modest 1% in FY19, CLSA is factoring a 4% yoy increase in cement prices by FY20. 

Rahul Prithiani Director, CRISIL ResearchExperts believe that the companies have to control their capacity additions in order to firm up prices. “If you keep adding capacity more than the demand obviously pricing and capacity utilisation will be lower. If you want prices to improve along with demand growth, you need to have some control over capacity additions. Only when the utilisation level moves up, the capacity should move up. What has happened is that capacity additions have moved up faster than demand growth,” says Rahul Prithiani, director, CRISIL Research.

Central focus

Analysts believe that investing in cement stocks will now turn into a geographical play. Thanks to a relatively better demand conditions coupled with limited capacity additions in the central region, cement companies catering to customers in Uttar Pradesh and Madhya Pradesh will be better placed. According to Shah, demand in the region will outstrip supply by a huge margin leading to higher realisations. “Incremental capacity addition in central India will be around 8 mtpa by 2021 and the incremental demand should be around 13 to 15 mtpa,” he predicts. Ravi Sodah an analyst with Elara Securities says that limited availability of limestone (raw material) in central India has lead to lower capacity additions compared to other parts of the country.

Already the favourable demand-supply scenario has resulted in prices for cement players in central India compared to the north and south. In the third quarter of FY19, the prices in central India were up by Rs.13 per bag (yoy). Whereas the prices in north declined by Rs.9 and, in the south, the prices marginally inched up by Rs.2. Apart from government infrastructure projects, analysts believe that one of key growth drivers for the cement industry over the next two to three years will be affordable housing. According to the Yes Securities report, central India accounts for 22.2% of the total urban housing shortage in the country, almost equivalent to 4.17 million units.

Valuation play

No wonder then, analysts prefer players in the central region. “We expect companies focused on central India to regain pricing power in the next couple of years, due to a gradual improvement in the utilisation levels. So, we prefer companies such as Birla Corporation, Prism Johnson and HeidelbergCement India who have a larger presence there,” says Sodah. Riding on higher demand and realisations all three companies reported improved margins and significant growth in net profit during the first nine months of FY19. 

On the other hand, in the first week of January, CLSA downgraded shares of top Indian cement companies due to a muted outlook on price realisations. The foreign brokerage trimmed earnings estimates of large-cap companies under its coverage by around 3-15% for FY20 and FY21. 

What makes the deal sweeter is the fact these smaller players are available at very attractive valuations. For instance while Birla Corporation, Prism Johnson and HeidelbergCement India trade at an attractive valuation of 7.5x, 9.5x and 6.8x EV/ EBITDA for FY20, UltraTech, ACC, Ambuja, Shree and Ramco are a lot more expensive trading at an EV/EBITDA valuation of 12x-17x. With decent earnings growth and favourable demand-supply scenario, the mid and small-sized cement makers in central region are in a sweet spot. And for those looking for a pure cement play till upcycle kicks in, these companies would make the perfect bet.