Cement stocks underperform Cement stocks have corrected sharply over the past couple of months, due to growing macro concerns over weakening GDP growth, low infra and realty spends, and unbridled INR depreciation, further dimming the outlook for cement demand. INR depreciation is likely to increase costs (fuel and freight) for cement companies, though their limited US$ debt exposure insulates the balance sheet. While the rupee has corrected upwards against the USD, its sustainability is still in doubt.

Q1FY14 lower EBITDA/tonne
Cost remained flattish to moderately higher in Q1FY14 with marginal push in energy cost and raw material cost coupled with negative operating leverage. Due to the high base of last year, EBITDA for companies dipped in the 18% – 31% range. The current quarter too, is high base and with no improvement in demand and prices so far, earnings are expected to be disappointing in Q2FY14 as well.

Increased clinker consumption
Clinker consumption in the cement manufacturing process typically goes up during periods of high moisture content such as the monsoons. Early monsoons this year have driven clinker consumption higher YoY in Q1FY14, leading to an increase in power and fuel cost per tonne for manufacturers.

Coal India pricing
Effective June 2013, Coal India increased prices of C, D and E-grade coal by ~10%, while lowering prices for Grades A and B by a similar percentage (~12%). A major chunk of domestic coal purchased by the cement industry constitutes C, D and E-grade coal, which is used both for cement manufacture and for captive power generation. Further, higher petcoke prices would have also impacted fuel costs. However, the recent decline in e-auction prices could bring partial relief to major players.

Higher freight cost from rail surcharge
The Indian Railways increased rail freight by 5% effective 1 April, leading to higher landed cost of coal for manufacturers.

Pricing power holds key
Pricing power is essential for the companies to improve profitability. During the first quarter, while ACC saw flat volume growth, UltraTech and Ambuja saw their volumes decline by three per cent each, compared to the year ago quarter. The per- tonne realisations declined five-seven per cent for most companies, with the exception of UltraTech that saw flat realisations.

Diesel price hike
State-owned oil companies demanded a one-time steep increase in diesel prices to make for the widening losses, with the value of rupee dropping by 12 per cent against the US dollar making imports costlier. In the first week of September, diesel prices were increased by 50 paise a litre, excluding local taxes. The increase in diesel prices was the eighth since January. This recent diesel price hike will increase freight costs for ACC, Ambuja, India Cements, UltraTech and Grasim by Rs.70-100/tonne. Since, diesel is mainly used for transportation of cement and raw materials like coal and fly ash, industry experts say it will be adding up to the cost of sales and not the production cost. Taking into account the costs involved in transportation in terms of per- tonne- per- kilometre, on industry´s level it would result in a hike of Rs 1 on a 50 kg bag of cement. Transportation of cement through road accounts for 55 per cent while the rest is shipped largely by rail and to some extent, by sea. Companies will have to pass it on to consumers..

As and when the government bites the bullet and raises diesel prices at one shot, cement companies will have to take more of a burden. Limited visibility on recovery of the investment cycle could continue to dampen the prospects of demand revival. Cement is among the sectors that can see downgrades as the RBI is unlikely to reverse its tightening stance in a hurry and government spending cuts are likely. A good monsoon is expected to bring some respite as cement demand may start improving in October. Volumes are expected to rise in the second half, led by election-led government spending. Now with the INR free-fall resulting in a higher oil subsidy burden, government capital spending may not increase appreciably in H2FY14. Reduced odds of cheaper funding in the system also put in question any sizeable increase in private investments during H2FY14..

While there are no signs of a recovery in demand due to absence of corporate capex and low infra spend, companies will need to further improve efficiencies in order to minimise the impact of weak cement prices. Additionally, with cash flows being impacted in the near term due to challenging macro environment, there will be a slowdown in new project announcement, especially from regional players..

UltraTech Cement, a Birla group company, is our preferred exposure in the large-cap cement space. One, its all-India exposure helps negate fluctuations in offtake and prices in regional markets. Two, the company is growing sales by expanding its market reach. Three, the company controls its costs well, a key advantage in the current scenario of high input costs and drop in realisation for cement players..

ACC – highlights:
ACC is coming up with a Rs.600- crore cement plant in Kharagpur town of West Bengal. It has started the construction for the new unit. The new cement factory will start production after three years and it would produce 15 lakh tonnes of cement daily. It is also planning to invest Rs.3,000 crore to expand its capacity by nearly four million tonnes a year in three eastern region States in the next three years.

ACC plans are afoot for expanding capacities at two existing plants Jamul in Chhattisgarh and Sindri in Jharkhand – the company expects to start construction of a 1.5 million tonne grinding unit at Kharagpur by next January next. The company plans to increase its capacity 10 mt a year from the existing 6 mt a year in three years in the east. This will entail an investment of about Rs.3,000 crore. The projects will be financed through internal accrual.

UltraTech Cement – highlights:
UltraTech Cement announced acquisition of Jaiprakash Associates´ cement assets in Gujarat (4.8 mTPA) for ~Rs 38billion (US$125/t). This is not a big climb-down from a year ago, when media reported likely valuation of Rs 42billion. However, there are definite positives:

1)Removal of a substantial volume-driven competitor,
2)Addition of 4.8 mTPA at ~Rs 8,000/t which can generate ~Rs 550/t of EBITDA straightaway in UTCEM´s hands,.
3)Limestone reserves worth 90 yrs at present capacity and option to scale up substantially in Kutch. Given its own substantial capex commitments (~Rs 78bn in FY14-15), the leverage (0.41x net D/E in FY14E) may border on uncomfortable.
Breakeven requires an EBITDA/t of ~Rs1,200, and the deal will result in EPS dilution for sure.

Concerns
Additional capacities coming on stream and/or fall in growth of demand could lead to decline in cement prices and in turn, lower realisations. There could also be a pressure on margins, which may have to be offset by control in costs. Rise in input costs like coal, slag, fly ash and gypsum could put pressure on margins as could increase in freight costs. Final resolution of the Competition Commission´s order if negative, could impact ACC´s and UTCL´s cash flows and profits. The latest restructuring proposal by Holcim could impact valuation of ACC in the interim.

Conclusions
CY13 could remain a challenging year due to a slowdown in demand, rise in cost pressure and inability to pass on the hike fully to consumers led by weak demand. Demand has continued to remain sluggish at the pan-India level during June-July. UTCL still has been the best performing large cap cement stock with outperformance of 16% in the last one year. As Ultratech is one of the most geographically diversified players in the Indian cement space, it could be the least impacted from ongoing slow-down seen across the industry.

Further, UTCL is valued the lowest in terms of EV/ton among its peers. On the back of weak topline growth trends, inability of the company to pass on any increase in operating expenses would lead to continued pressure on near-term EBITDA margins. The proposed deal of Holcim´s ownership in both ACC and Ambuja may result in UTCL enjoying premium valuations in the sector. However, a sharp revival in profitability is needed for UTCL stock price to perform.

Disclaimer: This document has been prepared by HDFC securities Limited. Publishers of ICR or HDFC securities Limited do not represent that it is accurate or complete and it should not be relied upon as such.