Cement will boom but what about the stocks?
One of the most difficult things affecting a commodity business is the lack of entry barriers. When prices rise existing companies increase capacity utilization and expansion while newer ones rush to set up green field plants.
A similar situation could be witnessed in the Indian cement industry.
Many of the top companies are working under an operating margin of 30%-40%. That means an initial investment into setting up a plant is recoverable in 2.5-3 years. It would be difficult for these margins to sustain an themselves.
While Cement demand may remain robust and the industry would continue to chug along well my sense is that the days of making abnormal gains from cement stocks are nearing closure. With the kind of base these cement companies would develop in Fy 07 it would really take some doing to show y-o-y growth. A Cement bag is sold at Rs 200 right now in many parts of the country and I was told that at Rs 240 it would become viable to import the commodity from China. SO that prohibits further price increases.
Over tyhe next two years India is expected to increase its Cement capacity by around 45% to 230 million tonnes from 160 million ton .This is being done at an average cost of US $ 70 per ton on a replacement cost basis the present valuations of most of these cement companies (EV of more then twice the replacement) seem to have become unsustainable.
|
Company |
Capacity expansion over the next 2 years |
|
Grasim |
8 million tonnes |
|
UltraTech |
4 million tonnes |
|
ACC and Gujarat Ambuja |
10 million tonnes |
|
Jai Prakash |
8.5 million tonnes |
|
Shree Cement |
3.4 million tonnes |
|
JK Lakshmi |
4.0 million tonnes |
|
Madras Cement |
4.0 million tonnes |
|
Enterprise value per ton (current capacity) against the replacement cost of US $ 70 per ton. |
|
ACC |
US $ 215 |
|
Birla Corp |
US $ 80 |
|
Gujarat Ambuja |
US $ 210 |
|
Shree Cement |
US $ 195 |
|
Ultra Tech Cement |
US $ 135 |
Over the last few years the operating margins of many of these companies have expanded two fold. SO while the cement sales may go up the growth in profitability from such higher base seems difficult to sustain. The scope for further expansion in margins is limited because cement is a commodity and the pricing power that commodities command are restricted.
|
Operating margin expansion |
|
|
Fy 07 Q1 |
Historic |
|
ACC |
31.5% |
14.93 Mar 02 |
|
Birla Corp |
29.3% |
5.9% Mar 02 |
|
Gujarat Ambuja |
38.2% |
32.59% Mar 01 |
|
Shree Cement |
44.5% |
27.49 Mar 02 |
|
Ultra Tech Cement |
31.77% |
14.06% Mar 04 |
|
JK Lakshmi |
27.8% |
6.26% Sep 01 |
We may have a situation where companies report good numbers but since the market would be worried about Fy 09 it would refuse to assign a higher PE to these stocks. In fact the PE ratios might actually contract with an EPS expansion leading to market rates of return for the large cement companies.
Many investors are of the view that this rally could continue for 6 months but my argument is that when ever any thing seems so short lived the stock prices discounts it much ahead of that.
So while Cement may continue to grow the real money has been made in most of these stocks and from now on unless one is playing a company specific theme as such the stocks would tend to move more in line with the market and the sensitivity to any earnings surprise (on the downside) is high. On the other hand increase in EPS would be compensated by declining PE’s.
Generally the demand for Cement is slated in terms of 1.5 times the GDP which in this case should be 12%. But since there is a huge construction activity in progress we may see a demand increase of about 15% also. But the huge capacity buildup from FY 08 onwards is should offset any such incremental demand.
While this is not a bearish call for cement stocks it does try and set things into perspective about the changing dynamics of the cement industry.
Source: Economic Times and Company
Edited by basant - 11/Oct/2006 at 10:12pm
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