Credit Suisse expects the supply glut pressure to ease up, with north India benefitting the most from the accretive price increase in cement. However risks like paying the penalty of $1.2 billion levied by CCI and government support remains
When the infrastructure boom was happening between 2000 and 2009, cement companies, in anticipation of huge demand started ramping up their capacities. However, this proved to be a costly mistake and they paid the price for it, when infrastructure development slowed down considerably (thanks to the policy paralysis of the government coupled with corruption and global slowdown). This left the cement industry with a supply glut as well as drastic price reductions and wafer-thin margins (and in some cases even outright losses) and poor performance, especially over past few years.
However, according to Credit Suisse, the cement industry is expected to pick up steam in the next two years with supply pressure easing and improved demand. “We expect the cement upcycle to continue at least for the next two years with accretive price increases leading to margin expansion. Capacity additions should peak out in FY14 and production discipline should imply a recovering FY14 and a stronger FY15,” it said in a research report.
Government support crucial
Credit Suisse feels one of the key drivers for the expected outperformance of these cement companies is the higher outlay announced in the recent Union Budget for rural infrastructure development vis-a-vis Prime Minister’s Rural Roads Programme (PMGSY) and rural housing (Indira Awas Yojna) as well as a pick up in general demand. Credit Suisse expects ACC and Grasim to outperform in the next 12 months while it is neutral on UltraTech Cement and Ambuja Cement. None of the south-based cement companies were covered though.
However, Credit Suisse said, one of the key risks to the recovery is the implementation of the Competition Commission of India’s (CCI) order against cartelisation that could see an outflow of as much as $1.2 billion, which will severely impact future capacity expansions.
Capacities added in FY10 still not breaking even
In fact, according to Credit Suisse, some small- and mid-cap companies are not even breaking even on RoIC (or return on invested capital). Not only is cement capital intensive, it is also extremely competitive which tips the scales in favour of large-cap cement companies. It is quite possible that consolidation could happen; or there is even the possibility of small-cap cement companies winding up since the economics are stacked against them.
Even among large-cap cement players, production has slowed down, thanks to the rapid capacity expansion that happened between 2005 and 2010. According to Credit Suisse, “Greenfield capacities commissioned in FY10-12 are still not breaking even on cost of capital as these capacities are operating at ~70%-75% utilisation. 60% of new capacities commissioning during FY13-15 are greenfield capacities with higher break-even utilisation.” In other words, new plants take longer time to break even as opposed to brownfield plants (or simply boosting existing capacities. But supply pressure is expected to cool off, leading to inventory take off and higher sales, as well as meet 65% of the demand, according to the report.
Production discipline holds the key
Credit Suisse says its views on cement upcycle assume production discipline to continue where volume growth of existing players is expected below industry average to accommodate new capacities. The economic rationale for the production discipline is higher sensitivity of profits to prices (5% profit change for 1% change in prices) versus volumes (2%). "We expect production discipline to be sustained, as the pace of new capacity additions has slowed, which reduces supply pressure, majority of capacity addition in last four years was with mid-caps and small-caps where overall RoIC is still below cost of capital due to low utilisation and profitability and 60% of new capacities commissioning during FY13-15 are greenfield capacities with higher break-even utilisation," it said.
North to have the maximum accretive price increases
Credit Suisse said it expect overall accretive price to increase but regional performances could come out as different. It said, “We expect maximum accretive price increase in the northern region over next two years followed by eastern and southern regions. We expect no accretive price increases for western and central India, given the higher supply pressure. However, if ABG’s or Reliance’s commissioning is delayed in FY14, supply pressure could be lower in western and central regions. Of the two regions, central is likely to face the maximum supply pressure where Madhya Pradesh and Uttar Pradesh caters to 15% of India’s cement demand.”
Cost to go up over next two years
According to Credit Suisse’s analysis over past two decades, cement price increase have not exceeded inflation unless cost increases were more than inflation and cement companies have been able to pass on increases in cost unless demand growth was weak as was the case in FY11 when the demand in southern India turned negative.
However, Credit Suisse expects cost to increase by about 8% over the next two years against inflation of 7-8%. “As per the feedback from the industry there are two factors leading to cost increase. One increase in cost of linkage coal as Coal India starts importing coal and implement pooling process to average coal costs. We expect cost of linkage coal to increase at a 10% CAGR over the next two years; and diesel price deregulation for bulk purchasers such as Railways and periodical increase in diesel price which impacts road freight,” it said.
“The extent of accretive price increases depends on whether the demand is strong (if south recovers) or moderate (low accretive price increase). We build in higher increase in EBITDA/t in FY15 only as we expect southern India demand to recover by FY15 and supply pressure to moderates in FY15,” it added.
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