Layers In The Cement Mix: Demand, Capex Vs Pricing And CostsBloombergQuintOpinion
The common refrain in the market is that in a cyclical industry, capital expenditure happens at the peak of the cycle. If that were indeed to be true, does the start of India Inc.’s capex announcements mean that we are nearing the peak of the cycle? Talk to any management, and most say that we are mid-cycle. Their optimism about growth prospects seems to build from multiple aspects, one of which is a possible demand recovery.
So, in a traditionally busy construction season, we may see heightened activity due to the lacklustre first half of FY21 that was impacted by the lockdown. Yes, migrant labour is back, the economy is showing a sequential uptick, and the base effect will ensure optically good growth numbers in the quarters to come. The caveat, though, is that the biggest infrastructure spender, the government, is mindful of the best use of its cash kitty. That variable might play differently this time from the previous years.
The positive trend started after the ‘unlock ki prakriya’ began, with cement industry dispatches picking up swiftly. Steady demand from the rural, retail, and housing segments boosted cement demand in the northern, central, and eastern markets in Q2FY21. Demand from the infrastructure sector continues to improve steadily in the third quarter as well, aided by return of migrant labour. These beliefs are corroborated by statements from other sectoral leaders too, like steel and transport.
What The Managements Say
The commentary around demand in Q3 and beyond is largely bullish.
- The Shree Cement management said on an analyst call that demand has picked up strongly since September, led by rural and semi-urban areas, a pick-up in government infrastructure projects, supported by the return of labour.
- A similar sentiment was expressed by north and central India players like JK Cement and JK Lakshmi Cement, for whom all operating geographies witnessed YoY growth in volume terms. They saw the trend continuing in October as well.
- Dalmia Bharat expressed confidence in the demand scenario in East India. While the belief was that November volumes would have gotten impacted due to Diwali, a channel check by a local brokerage unit suggests that cement demand and prices remained strong in November owing to a pick-up in demand in the non-trade (infra) segment and a continuation of demand from the individual house-building segment.
The confidence of the industry is borne out by the expansion plans announced and initiated.
- Industry leader Ultratech became the latest in the race, with the capex announcement of an organic expansion of 12.5 mtpa. These capex plans provide visibility and show the confidence of the leader in the strength of the cycle.
- JK Cement has sought board approval for a capex plan in FY22, which would entail spends of Rs 1,300 crore each in FY22 and FY23, fairly sizeable for its size.
- Dalmia Bharat has guided for Rs 400 crore worth of capex in the east and Rs 500 crore for cost improvement projects.
- Companies like Birla Corp have announced sizeable capex as well.
These numbers show that the capex plans are not incremental in nature, but sizeable, which points to confidence in the cycle.
Unlike some other sectors where large organised players are gaining from the smaller ones, in cement, we largely have only have players of scale, all of whom have been around for a number of years. So, the capex is not for market share-capturing opportunity from unorganised players, as much as due to the confidence in the cycle.
The other interesting aspect of the plans announced is that the capex is happening at a much better cost structure and IRRs, due to various factors including the cost of debt and state incentives.
Ultratech’s capex seems to be incrementally positive for Return on Capital Employed as the expansion is at a cost of only around $55/tonne. This implies an RoCE of around 14% against 10% currently. Lower costs and tax incentives for companies like Dalmia Bharat and Birla Corp, for example, are beneficial for IRRs. Add to that, the expansion plans are happening when the balance sheet is in good health.
Companies that are in the midst of already-announced capex (Ramco, Birla Corp, Dalmia Bharat) or the ones which have announced new capex Ultratech, JK Lakshmi, JK Cement), do not suggest any substantial deterioration of their leverage position from FY20 levels. UltraTech’s capacity addition, for example, would not impact its ongoing deleveraging programme, which is on track and is expected to make the company debt-free by March 2023, according to its media statement.
A note by brokerage house Edelweiss suggests that the only highly-geared company undertaking capex plans is Sanghi Industries, whereas all the others have comfortable gearing.
Pricing And Costs
If the companies believe the demand scenario is on the upswing, do they have pricing power? It would stay strong if the industry observes discipline and demand remains healthy. At the start of the busy season, murmurs of price hikes across geographies have started to emerge. South India, for example, despite an aggregate drop of 29% in demand in H1, saw steady pricing. In October 2020, the North witnessed a marginal price hike while prices remained flat in the East and Gujarat, as per the management of JK Lakshmi Cement.
Cement companies are also being investigated for alleged cartelisation, which if proven can be a key negative. Mind you, this is not new for the industry. Twice in the past, (2012 and 2016) cartelisation investigations and penalties have occurred, but did not dampen the prospects of the stocks over a longer time frame.
Costs are rising though. Do note that in FY21, despite Covid-related headwinds, the industry registered a record EBITDA/tonne of Rs 1,300 on aggregate, backed by healthy pricing and aggressive cost cuts. The recent surge in fuel inflation is expected to impact costs. The impact of higher petcoke prices will be visible from Q4FY21. And the benefits of belt-tightening exercise done by most companies will start to wane a bit, as some normalcy returns in the cost structure too. On average, both internal and external costs are likely to inch up, and likely to impact EBIDTA negatively on a relative basis. This may lead to a moderation of profitability from the record high margins seen in Q2FY21.
The Valuation Picture
The combination of strong demand and higher capacity utilisation, better pricing, lower debt, and lower interest costs as well as the likelihood of a stronger economy augurs well for the sector, even if profitability per tonne dips a bit. The capex plans address capital allocation concerns, as cash flows over the next two years are deployed in the core business. While most of these factors may invite an upward revision in estimates, there are small, company-specific concerns. Ultratech’s large foray in East India soured the mood on Dalmia Bharat’s prospects.
Rumours of higher royalty that ACC and Ambuja might have to pay to Holcim impacted the stock prices in early December. Higher fuel costs or lack of pricing discipline could also come back to haunt the space. And the sector has reverted back to average valuations after the runup seen since September, so cement stocks are no longer as cheap as they were three months ago.
The sector may, however, have scope for a further re-rating as it enters the seasonally strong January to June period, which accounts for around 60% of total volumes. Historically, trades in cement stocks in the period of December to March have yielded good returns. And if the commentary around demand continues to improve, then the average EV/EBIDTA multiples could inch higher and give a leg-up to prices. That is what the short- to medium-term trader is hoping for anyway. The next few months will tell us if the cement sector’s fortunes are promising enough for the positional trader’s assumptions.
Niraj Shah is Markets Editor at BloombergQuint.