Cement industry: 'Neutral' rating for UltraTech Cement Ltd shares, says J P Morgan

Updated: Jan 20 2014, 20:14pm hrs
In line with our view on steel, we expect cement demand to improve in H2FY15 and FY16. We are more circumspect on cement prices, given the sheer over capacity (130mt) with many smaller and newer players sitting on excess capacity and hence expect margin expansion to be muted (Ebitda/t Rs 1,000/t).

FII holding in large caps (Ambuja Cements Ltd, UltraTech Cement Ltd and ACC Ltd) is near all time highs, albeit concentrated with a few investors. We cut our FY15e earnings estimates given the lower base of the recovery and upgrade Ultratech to Neutral (previous UW--underweight) on valuations.

We would wait and see if the markets build in a holding company discount in Ambuja for its ACC stake similar to what is being seen in Grasim, which remains our top pick.

Demand recovery is very much possible...: FY14e is likely another washout year for cement demand (+3-4%), with the much anticipated pre-election spending not coming through. Sand unavailability has also hit demand in many states. Average demand growth over the last four years has been about 5%, the lowest four-year rolling average growth since we have data for the last 25 years with the cement demand/GDP multiplier also at similar a low level (0.8). Given this backdrop, a demand recovery from H2FY15 is likely, though we do not expect double digit growth anytime soon.

... But margin recovery could be muted given the sheer over-capacity: We build in price and margin increases for FY15-16e, but we differ from the bulls on the gradient of margins. Admittedly, utilisations are at 20-year lows and should pick up, but given the way the cost base is evolving (coal, freight and materials should continue to trend up), cement prices need to rise very sharply from current elevated levels in order for Ebitda/t (earnings before interest, taxes, depreciation and amortisation/tonne) to break out of previous highs of R1,000/t. Given the overcapacity and the fact that it is well distributed across companies, we find very large price increases and hence margin expansion difficult. Given cement has little fixed costs, some pick up in utilisations is not enough.

Capacity addition has slowed, but should cross 400mt by FY16e: We are not building in capacity additions from power companies but this remains a medium-term risk for the industry. Even in the current demand environment, 60mt of capacity addition is underway.

Stocks are expensive v/s historical averages and well owned by FIIs: We expect the next two quarters to be challenging. With ownership concentrated and at record highs, and valuations not having built in the operating weakness, further upside from current levels would require very high margin and earnings expansion.