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We Remain Underweight on Indian Cement Sector: Macquarie

  • Macquarie Research Equities has come out with a report on Indian cement sector. Following are the key highlights of the report:

Cash out time:

  • Cement stocks have witnessed a strong rally in the last 12 months, outperforming the Nifty by 36%, driven by the longevity of pricing discipline. With stocks trading at 18-19x PER and the chances of a hefty penalty from the Competition Commission of India (CCI) looming ahead, the risk/reward appears unfavourable. Moreover, with continued capacity additions and rising costs, earnings growth should remain elusive for at least another two years. We remain `Underweight` on the Indian cement sector.

  • Cement price at all-time highs; where is the money?

  • Our study of 16 cement companies shows that since 1996, i.e. in the last 15 years, the incremental EBITDA made by these companies cumulatively was just USD 2 billion, and the bulk of this came just in the three years from 2006-08. We believe that the cement industry is again in a phase where the fight will be to sustain earnings, and we don`t see things changing over the next three years.

Costs, costs, and costs and will keep rising:

  • In the past four years, production costs have risen 50%, and this includes subsidies, like diesel and coal from Coal India. Rising costs have helped improve price discipline, and the industry has been able to raise cement prices by 35%, but this is not enough for margin expansion. Unfortunately, the cost rises have been structural and may require substantial changes like captive coal mines, etc to reverse; we think this is at least three years away.

Capacity still outpacing demand:

  • We are expecting 50mt of additional capacity in the next two years, while incremental demand is likely to remain less than 35mt. This will keep cement capacity utilization below 80%. Also the installed capacity share of the top three companies in the country has fallen from 45% (in FY08) to just 38% now. On the other hand, demand growth has declined from an average of 10% pa in the past four years to around 6-7%. With our muted view of the investment cycle and reduced affordability of real estate, we don’t see demand growth exceeding 8% pa over the next two years.

CCI on the verge of levying penalties for cartelisation:

  • CCI finished hearings against 42 cement companies in late February and should be ready with penalties by April. We expect penalties of about 7% of total revenue (last three years` average), equal to 5-6% of market cap for every year of investigation. Global experience tells us that stocks correct by 20%+ on such penalties.

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