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Updated: Jun 23 2014, 13:37pm hrs
Rating: Underweight - Ultratecht, Ambuja Cement; neutral - ACC, Overweight - Grasim

We are more constructive on the outlook for cement demand and raise our FY16/17 demand estimates to 10%, but highlight that it is not going to be an easy climb from here as we reduce FY15 estimates. We now build in strong demand and pricing for the companies and give a higher multiple, but even then struggle to justify current valuations of 11x FY17 EV/Ebitda (enterprise value/earnings before interest, taxes, depreciation, and amortisation) for Ultratech Cement (UTCEM) and Ambuja Cement (ACEM).

Outlook improves, but..: Our cement stock calls have been wrong even as we got the earnings call right, as we underestimated the multiples investors were willing to pay for an industry where returns declined, overcapacity rose, and earnings were consistently cut. Indian cement stocks are now among the most expensive in the world on two-year forward earnings, even as the RoE (return on equity) profile is relatively weak compared to SE Asian companies. Even on FY17e (estimated) earnings, which are the highest in each companys history, stocks are near peak multiples. We downgrade UTCEM to UW (underweight) with a revised PT (price target) of R2,300 (R1,750 earlier) and maintain UW on ACEM with a revised PT of R190 (R155 earlier). Our top OW (overweight) remains Grasim with a revised PT of R4,680, as we expect the holding company discount to narrow (currently at 50%). We maintain N (neutral) on ACC as we increase our target multiple closer to ACEM.

Industry unlikely to cross 75% utilisation in FY17e: Even after building in strong 10% demand estimates for FY16-17, industry utilisation would remain <80%. On the margin, we expect South India demand growth to pick up after a multi-year slowdown and benefit from new state creation. While we are building in declining capacity additions, we would not be surprised to see this pick up if demand actually grows at 10%.

We would revisit our calls: Our current estimates build in near lifetime high earnings for FY16e. We would revisit the sector on corrections. While investors are currently willing to discount FY17/18, given ongoing weakness in FY15e, we would not be surprised to see a meaningful correction from current levels. As we enter a demand upcycle, our view is that holding company discounts should narrow; hence, we remain Overweight on Grasim.

What are the risks from here Downside risk is clearly a more gradual demand recovery instead of the sharp increase we are building in now. The upside risk comes less from the operating environment, but more from the willingness of investors to bid these stocks further up from already stretched levels on expectations of a multi-year double-digit demand increase.

Demand-supply updateexpect south to catch up: We update our cement demand-supply model and build in a much more improved demand environment, although we have cut our FY15 demand estimates given the way the financial year has started. We have not built in any impact from the possibility of the monsoon rains being lower this year and that is a material downside risk to our estimates.

Regionally, while demand should pick up across the country, we would highlight that over the past three to four years, Southern India demand has been relatively weaker, given the sharp slowdown in the critical state of Andhra Pradesh which in the 2004-10 period, contributed a third of the incremental demand seen in India. Post the creation of two new states from the erstwhile Andhra Pradesh, we expect demand to pick up. Overcapacity is the highest in South India, and a demand pick-up over there would ease pricing pressures.

Increase earnings estimates: We upgrade our earnings estimates across the board, as we now build in higher demand and more pricing power, which translates into record Ebitda for the companies under our coverage. Cost pressures are expected to remain benign, although steady diesel price increases should translate into freight cost increases.

Historically, Ebitda/tonne has sustained above R1,000/t when overall industry utilisation was 100%, which is unlikely to be the case for the foreseeable future, hence, we expect Ebitda/t to come from pricing power as the industry maintains supply discipline.

Current valuations expensive: The past three years have been remarkable for the sector, as earnings kept on disappointing, but stocks continued to move up. While the bull argument is that Indian cement stocks should trade on par/premium to the South East Asian companies, we struggle with that logic given that the large cap Indian cement companies would generate RoE still significantly below SE Asian companies, while the former are trading at P/B (price-to-book) multiples >3x (times).

JP Morgan