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Replacement Cost in Indian Cement Industry

Keynote Capitals presents research of Indian Cement Industry.

The cement industry in India has undergone a major shitt over the last 6 years. The increased industrial investments, infrastructure boom and revival of the real estate sector in the last 3-4 years (till a couple of quarters ago) caused the demand for cement to grow at a CAGR of 10.6% over the last 5 years. In addition, cement prices kept heading north due to the supply crunch and cement stocks remained in the limelight.

In response to the spurt in demand and supply constraints, the industry added annual production capacities of 40mn tonnes during FY07-09.

The Indian cement industry attracts investors primarily for two reasons:
- Low per capita consumption of cement in India (just 110Kg, vis-a-vis world average of 230Kg), and
- direct correlation of the industry with the national GDP (1.2 - 1.3x GDP)

The cement industry which offers high visibility of revenues and earnings in phases of high growth, typically loses its sheen during times of economic slowdown. Cement stocks in India outperformed the broader market indexes during the high growth period of FY04-06, while they underperformed in the last 3 bleeding years (FY07-09), much ahead of the eventual deterioration in margins and overall profitability of the underlying companies.

Replacement cost - not an ideal valuation tool in the current times

We reviewed the performance of the cement industry during FY04-09, which covers the high growth phase of FY04-06 and the recent bleeding years FY07-09. Our finding are summarised as follows.

Conclusions

1. Replacement cost (EV / tonne) is losing its significance as a valuation parameter for the cement industry in the current scenario of slowdown in demand, as investors' focus shifts to the earnings potential of individual companies and the payback on investments.

2. High promoter holdings are a major deterrent to opportunities for M&A in the cement industry. It is difficult to imagine that a promoter would be interested in selling out at the low valuations, prevalent currently. In spite of strong balance sheets, Indian cement companies are trading at discounts to their global counterparts, viz., Lafarge and Cemex.

3. We believe high visibility of revenues and earnings will ultimately get reflected in cement stock prices. The bear phase in cement stocks began much ahead of the deterioration of financials of cement companies.

4. The current cement industry scenario is hardly exciting, due to the situation of demand slowdown and anticipated oversupply.

5. Valuations are dominated by the quality of earnings and the leverage of individual companies.

Cement stocks underperformed broad market indexes

Post-January 2008, most cement stocks have underperformed broad market indexes, the Sensex and the Nifty.

Most cement companies have been trading in the $20 - $110 (EV / tonne) range, well below their replacement cost or cost of setting up a green-field cement plant, estimated at $120/tonne, i.e., at a discount of 17% -96%. The only exception is Chettinad Cement, which is trading at a premium of 152%.

Apart from the slowdown in demand for cement, a few other reasons which led to the "rationalization" of valuations include:
- the anticipated de-growth in earnings,
- high promoter stakes (rendering hostile takeovers difficult) and
- the impending over-supply situation over the next 2-3 years.

All these factors can also be considered as key barriers to the consolidation in the industry.

Download full report here