Driven by a structural shift in demand drivers, the cement industry is at an inflection point. Its growth trajectory is estimated to shift upwards from its historical average of 8% to 10-12% over the next 5-10 years. Higher cement consumption (~1.5x from 1.25x of real GDP growth)is expected in the next trillion dollar phase of GDP , as was the case with China. We believe all ingredients are in place for the cement industry to move from a cyclical to a secular growth story.
Cement demand to enter new growth trajectory: In 2008, India achieved the landmark of $1 trillion GDP and it is on its way to creating another trillion dollars. While it took 60 years since India?s Independence to achieve the first trillion dollars in GDP, it would take 5-6 years to add the next trillion dollars. And, the next trillion dollars of GDP is expected to have a higher intensity of cement consumption driven by a) a significant increase in infrastructure investment, and b) significant impetus to housing, especially rural/mass housing, as per capita income crosses $1,000.
Capacity addition to slow
We expect 100mt of capacity addition over FY10-12. We estimate a fall in the pace of capacity addition, with ~36mt of capacity addition over 18 months from 3QFY11 against ~61mt addition over 18 months from 1QFY10 to 2QFY11. This is particularly relevant to the southern region, which is worst impacted, as only 4mt capacity addition is expected over 18 months from 3QFY11 (against 21mt over 18 months from 1QFY10 to 2QFY11 and 20mt in FY09). However, stabilisation and ramp-up of new capacities added in the past 6-9 months would still imply overcapacity in the near term.
Based on announcements of capacity additions so far, we estimate a maximum of 20mt of new capacity addition in FY12 (barring a push back of capacities expected to be commissioned in FY10-11). Besides, no major capacity addition has been announced in the past 6-12 months. An announcement of capacity addition would take at least three years to become operational, which would not be before FY13. Capacity utilisation is estimated to improve sharply after FY12, assuming no major capacity addition takes place over FY12-14. We estimate new capacity additions, beyond current announcements, to commence from FY12. This underinvestment (like in FY02-07) beyond FY12, coupled with strong demand will lay the foundation for the next big up-cycle (like in FY04-08). Historically, a long phase of underinvestment has been a catalyst for the return of pricing power to the industry.
Capacity utilisation will surprise positively: With most of the capacity addition expected to be operational by FY11, we estimate the industry?s capacity utilisation will bottom out by 2HFY11. With strong demand growth, excess capacity is expected to be absorbed faster by FY12. This will lay a solid foundation for the next growth phase as no major capacity additions have been planned beyond FY12. We estimate capacity utilisation will bottom-out at 75% in 2QFY11 against 71% in 2QFY02 (the previous cycle). Given strong volume growth (10-12% v/s flat in FY01) and higher consolidation (the top five groups control 56% of capacity v/s 48% in FY01) will result in better operating parameters than in previous cycles.
The residential segment recovered strongly in CY09 as indicated by a sharp increase in new launches. According to Jones Lang LaSalle Meghraj, the number of new launches in 1QCY09 across 7 key metro cities was ~24,400 units, and 42,458 new units were launched in 2QCY09. The tier-1 cities of Delhi and Mumbai accounted for almost 64% of the launches in 2QCY09. While the residential vertical is growing strongly, we expect other verticals such as the retail and commercial sectors to recover faster than expected. Increasing consumer confidence bodes well for real estate verticals such as retail, which is a pure play on domestic consumption. Besides, the demand outlook for commercial offices from IT companies is also improving, with indications of a pick-up in hiring by key IT companies.
Strong secular growth, higher consolidation and a stronger balance sheet would act as a catalyst for rerating of the cement sector. We estimate cement stocks will bottom-out at higher valuations (than pervious cycles) over the next 2-3 quarters as cement prices remain volatile due to the impact of new capacities. Current valuations, which are at par with replacement costs and at a 35-40% discount on
P/E basis to the Sensex, offer a good entry point for the next up-cycle. Large cement companies are available at valuations of US $100-120/tonne and 6-7x EV/EBITDA, which are reasonable considering the imminent up-cycle. We prefer companies offering strong volume growth, cost saving possibilities and strong balance sheets. We value large cement stocks at US $150/tonne on FY12E capacity, and tier-2 cement companies at US $100-120/tonne (at 20-30% discount to tier-1 companies). Among large cap stocks, ACC and UltraTech are our top picks and we prefer Birla Corp, India Cement and Shree Cement among mid-caps.