The last few years have been difficult for cement companies. The reasons are stalled real estate projects due to poor sales and fall in spending on infrastructure.
But things seem to be looking up. "The formation of a stable government at the Centre has revived hope that economic reforms will trigger a rise in spending on infrastructure," says Mayuresh Joshi, vice president, institutions, Angel Broking.
The Planning Commission estimates that spending on infrastructure will be 10% of gross domestic product, or GDP, during the 12th Five-Year Plan (2012-17), up from 7.6% in the 11th Plan.
Clearly, this has impacted industries that provide inputs for infrastructure. The rise in spending on infrastructure is likely to increase domestic cement demand by 10.2% a year until 2016-17 to 398 million tonnes. The present figure is 290 million tonnes. A Confederation of Indian Industry forecast has pegged annual demand at 550-600 million tonnes by 2025.
Cement stocks, reflecting this hope, have risen 30-170% in the last one year. Allocation by mutual funds to the sector, too, rose from Rs 4,700 crore in January to Rs 8,300 crore in July (3.16% of equity funds' assets).Joshi says when the economy picks up, increase in sales of real estate, the biggest source of demand, and revival of capital expenditure by companies will help the sector. According to a report by the Indian Brand Equity Foundation, the housing sector accounts for 67% cement consumption, followed by infrastructure (13%), commercial construction (11%) and industrial construction (9%).
"In a nutshell, with demand improving, volume growth stabilising, realisations looking up and input costs remaining benign, margins and cash flow should improve for cement companies," says Joshi.
But not all companies will gain equally. For instance, large-caps ACC, Ambuja Cement and Ultratech Cement returned 50%, 30% and 66%, respectively, in the one year to August. In contrast, mid-cap companies JK Cement, JK Lakshmi Cement and Shree Cement returned 160%, 400% and 122%, respectively. The reasons are the valuation gap between large-cap and mid-cap companies. According to analysts, most mid-sized cement companies are trading at a 40-50% discount to their replacement cost while the large ones are trading 40-50% above the replacement cost.
For instance, JK Lakshmi Cement, a mid-cap company, was trading at an enterprise value (EV) per tonne of $75 for 2014-15, 50% less than the replacement cost of setting up a plant, which is $140-150 per tonne.
There is a wide variation in performance of companies in different regions. Sandeep Raina, senior research analyst, Edelweiss Financial Services, says companies in North India have been gaining from higher realisations. In contrast, South India has massive overcapacity. The companies there have been operating at less than 60% capacity. India Cements' sales, for instance, fell 1% in the June quarter due to weak demand and rising production cost. "The stock has benefited from the revival in sentiment," says Raina. Ramco Cement, too, saw volumes fall by 3% to 2.13 million tonnes due to slow offtake in its key markets of Tamil Nadu and Telangana.
Companies based in North India such as JK Cement, JK Lakshmi Cement and Shree Cement have done much better. JK Cement, for instance, increased sales by 21% and profit after tax by 23% in the first quarter of 2014-15. Shree Cement expanded volume by 15% and EBITDA by 14%. EBITDA, or operating profit, stands for earnings before interest, tax, depreciation and amortisation.
Due to supply shortage in the north-east, a number of companies are rushing to build plants there. This has kept their realisations stable. For instance, JK Cement's expansion in the eastern region has given a big push to its valuation. Then there are geographically diversified companies such as UltraTech Cement, India's largest producer, which saw a 14% rise in net sales, though profit declined by 7%, mainly due to rising operating costs.
"Being the largest pan-India player, it will be the prime beneficiary of acceleration in demand for building materials as construction activity revives and the government commences its large infrastructure building programme," says Piyush Jain, equity analyst, Morningstar India.
"Also, we expect UltraTech to lead industry consolidation as smaller competitors struggle to expand capacity and manage rising power and freight costs," he says.
Cement is a freight-intensive industry. Transport over long distances can be uneconomical. This has made cement largely a regional play. The southern region accounts for one-third of the country's installed capacity. However, demand growth there has lagged, largely due to political uncertainty in Andhra Pradesh.
However, things are likely to change soon. "We think that the creation of Telangana will be a key catalyst for demand revival in South India," says Joshi.
Hence, companies that sell big time in South India will gain. India Cements, whose 60% capacity is in Andhra Pradesh, will be the main beneficiary.
"Another company, Ramco Cement, is one of the most efficient players in the southern region. As the market revives, it will be gain from the formation of the new state, which will see a lot of infrastructure building. The stock is also available at a discount to frontline cement stocks," says Raina.
As per the Indian Cement Industry Outlook 2016, demand is set to increase by 8% a year between 2013-14 and 2015-16. The growth is likely to spread across the country. Having said that, investors must tread carefully considering that stock prices have already risen significantly in the last one year.