Cement Cracks in the concrete

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1 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F mt (%) Construction and Materials India Equity research November 23, 2016 Sector Note Alpha series India Neutral Highlighted companies Ambuja Cements ADD, TP Rs257.0, Rs193.6 close Ambuja Cements is placed favourably geographically and could benefit from high utilisation in the north/west and growth potential in east. The company has good brand equity and better cost control than other players in the industry. The recent correction is an opportunity to add the stock. Shree Cement REDUCE, TP Rs12,430, Rs14,395 close Shree Cements is the market leader in the north and is expanding its footprint aggressively across regions. It has better project execution capability among peers, in our view. Rising fuel prices and lowerthanexpected capital cost in the industry are risks to its outlook. Ultratech Cement HOLD, TP Rs3,430, Rs3,322 close UltraTech is the largest domestic cement player and excluding China, the fourth largest in the world. We believe it is likely to maintain market share. Rising fuel prices and lowerthanexpected capital cost in the industry are risks to its outlook. Summary valuation metrics P/E (x) Dec16F Dec17F Dec18F Ambuja Cements Shree Cement Ultratech Cement P/BV (x) Dec16F Dec17F Dec18F Ambuja Cements Shree Cement Ultratech Cement Dividend Yield Dec16F Dec17F Dec18F Ambuja Cements 1.50% 1.99% 2.64% Shree Cement 0.18% 0.17% 0.17% Ultratech Cement 0.27% 0.27% 0.27% Cement Cracks in the concrete The next capex cycle could start earlier than expected as c.90% of ongoing projects have capital cost of less than US$100/t and are viable at current profitability. The current recovery cycle lags the last cycle on important parameters such as inflationadjusted profitability, utilisation, and return ratios. Sharply rising pet coke and coal prices are nearterm headwinds for the sector. We expect a recovery in demand growth but utilisation likely to remain suppressed. A potential rerating catalyst is doubledigit demand growth. Our top pick is ACEM. Next capex cycle could start earlier than anticipated The market believes that the resumption of the capex cycle is far away, in our view. However, our analysis, based on 1) capital cost of expansion, 2) land and mining clearances available for the companies and 3) the current EBITDA/tonne for the industry, indicates that a capex recovery could be earlier than anticipated.. Current recovery lags last recovery cycle on important parameters The last recovery cycle in FY0609 showed 1) high utilisation at more than 90%, 2) demand growth of 910% p.a. and 3) bigticket consolidation. As a result, cement prices exceeded WPI by 25 ppts in FY0609 and cement companies ROE/ROCEs rose above 30%. The current recovery cycle could have 1) high singledigit demand growth, 2) utilisation at sub80% and 3) a relatively lower pace of consolidation. These factors could curtail pricing flexibility and we expect return ratios to be lower than the last cycle. Emerging cost pressure to contain profitability Savings in power & fuel costs, driven by higher usage in pet coke, were primary drivers of increased profitability in the last couple of years. However, pet coke prices rose c.90% YTD and seaborne coal prices 4050% in the last 34 months. Mitigating steps include 1) a change in the fuel mix to include more domestic fuel and 2) technology investment in waste heat recovery and alternative fuels, though these steps may only partially cushion the impact. Split grinding units could add logistics efficiency, but only in the long term. Healthy demand growth but low utilisation is a concern Indian cement demand normally grows at 1x the real GDP growth rate. Based on the consensus GDP growth rate forecast of % in FY1719F we estimate Indian cement demand to grow at 6.4%/7.2%/8.0% in FY17/18/19F (YTD growth has been c.5%). Despite that the Indian cement sector could have ~120mt surplus capacity in FY19F and capacity utilisation could remain at ~74%, in our view. Recent correction provides attractive entry points We initiate with a Neutral on the sector. The industry has entered a gradual recovery phase and we believe there should be low volatility in earnings. Hence, we value the companies in the sector using a 1yr forward EV/EBITDA multiple based on the previous recovery cycle. We are not using assetbased valuations as there is a large dispersion in capital cost for expansion. The recent correction has provided attractive entry points. We initiate with a Reduce on SRCM, Hold on UTCEM and Add on ICEM, ACC and ACEM. Analyst(s) Saurabh PRASAD T (91) E saurabh.prasad@cimb.com Satish KUMAR, PGDM T (91) E satish.kumar@cimb.com [ X ] Figure 1: Large surplus capacity created in the past 10 years Annual increase in capacity (LHS) Annual increase in production (LHS) Utilization (RHS) SOURCES:CIMB, CMA, COMPANY REPORTS Note: FY means year ending March of the relevant calendar year IMPORTANT DISCLOSURES, INCLUDING ANY REQUIRED RESEARCH CERTIFICATIONS, ARE PROVIDED AT THE END OF THIS REPORT. Powered by the IF THIS REPORT IS DISTRIBUTED IN THE UNITED STATES IT IS DISTRIBUTED BY CIMB SECURITIES (USA), INC. AND IS CONSIDERED THIRDPARTY AFFILIATED RESEARCH. EFA Platform

2 FY03 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F % mt Jan05 Jun05 Nov05 Apr06 Sep06 Feb07 Jul07 Dec07 May08 Oct08 Mar09 Aug09 Jan10 Jun10 Nov10 Apr11 Sep11 Feb12 Jul12 Dec12 May13 Oct13 Mar14 Aug14 Jan15 Jun15 Nov15 Apr16 USD/t USD/t Construction and Materials India Cement November 23, 2016 KEY CHARTS Capital cost of almost 90% of greenfield projects is below US$100/t Our analysis of c.80 ongoing projects seems to indicate a large number of greenfield projects that have lower than US$100/t capital cost. At the current profitability, these projects could have ROCE of 910% No of projects and brownfield projects below US$80/t Most of the brownfield projects have capital cost of less than US$80/t. The brownfield grinding unit expansion at Shree Cements has a capital cost of c.us$20/t No of projects Cement prices lagging Wholesale Price Index (WPI) in the current cycle During the previous recovery cycle, the industry had significant pricing power due to 1) very high utilisation of >90% and 2) increased consolidation due to the acquisition of major cement companies. The current cycle is unlikely to reach this level, in our view. Although consolidation is still happening, the industry s size is much larger which has materially lowered its role in price discovery WPI data Cement wholesale inflation Surplus capacity at high of c.120mt in FY19F Even after assuming healthy demand growth of 7.2%/8.0% in FY18/19F, the industry would still have more than 100mt surplus capacity and would operate at c.74% utilisation Surplus capacity Utilization SOURCE: CIMB RESEARCH, COMPANY REPORTS 2

3 Cement consumption (Kks) FY05 FY06 FY07 FY08 FY17F FY18F FY19F % Jan16 Feb16 Mar16 Apr16 May16 Jun16 Jul16 Aug16 Sep16 Oct16 INR/t FY06 FY07 FY08 FY17F FY18F FY19F % Construction and Materials India Cement November 23, 2016 KEY CHARTS Return ratio lower than previous cycle Given the low utilisation and lower profitability (adjusted for inflation) in the current cycle, return ratios are unlikely to reach the same levels as those of the previous cycle, in our view Average RoE Average RoE Rising fuel prices another headwind Pet coke prices have increased by c.90% YTD. During the past 34 months imported coal prices have also increased by 4050%. A couple of months ago, our Indonesia commodity team also increased its coal price estimate for 2017 by 21%, indicating cost pressure could persist for some time Pet coke prices Expect cement demand growth of 7.2%/8.0% in FY1819F We are structurally positive on cement demand growth. In the high GDP growth period there is significant correlation between GDP growth and cement demand growth. We believe that the gradual recovery has already started in the sector and we should see a demand revival in the next 34 years Cement demand growth Longterm positive on demand growth Comparing per capita cement consumption with developing countries in our region, we see significant longterm potential for cement demand in the country India Thailand Indonesia Malaysia Vietnam Sri Lanka SOURCE: CIMB RESEARCH, COMPANY REPORTS 3

4 USD/t USD/t Construction and Materials India Cement November 23, 2016 Cracks in the concrete Investment summary Next capex cycle could start much earlier than anticipated We analysed c.80 projects being implemented (with cumulative cement capacity of c185mt) to find the average capital cost and noted that a large majority of the projects had capital costs lower than US$100/t. Further analysis revealed that a large majority of brownfield and greenfield projects had capital costs of less than US$80/t and US%100/t, respectively Figure 2: Capital cost of brownfield expansion at subus$80/t Figure 3: Greenfield projects have capital cost below US$100/t No of projects No of projects SOURCES: CIMB, CMIE SOURCES: CIMB, CMIE At the prevailing profitability, we think that a modern plant would operate at EBITDA of Rs1,0001,200/t (US$1518/t). At this profitability, and with capital costs of lower than US$100/t, we expect the next capex cycle to start sooner than expected. Current recovery lags last cycle on important parameters The previous recovery cycle in FY0609 (we assume a FYE of March for the sector) was characterised by high utilisation of >90% and significant industry consolidation involving almost onethird of industry capacity (HolcimACC, HolcimAmbuja, GrasimL&T). Both of these factors resulted in significant pricing power and consequently enhanced the profitability of the sector. In the ongoing recovery cycle, we expect utilisation to reach c.74% in FY19F and given the relatively large size of the industry, the ability of consolidation to impart pricing power has become fairly limited. Hence, we do not expect return ratios to be the same as in the previous cycle. 4

5 Jan16 Feb16 Mar16 Apr16 May16 Jun16 Jul16 Aug16 Sep16 Oct16 Nov14 Dec14 Jan15 Feb15 Mar15 Apr15 May15 Jun15 Jul15 Aug15 Sep15 Oct15 Nov15 Dec15 Jan16 Feb16 Mar16 Apr16 May16 Jun16 Jul16 Aug16 Sep16 Oct16 Nov16 Rs/t USD/t Jan05 Jun05 Nov05 Apr06 Sep06 Feb07 Jul07 Dec07 May08 Oct08 Mar09 Aug09 Jan10 Jun10 Nov10 Apr11 Sep11 Feb12 Jul12 Dec12 May13 Oct13 Mar14 Aug14 Jan15 Jun15 Nov15 Apr16 FY06 FY07 FY08 FY17F FY18F FY19F % Construction and Materials India Cement November 23, 2016 Figure 4: Cement prices (rebased) lagging inflation in current cycle Figure 5: Return ratios unlikely to trace previous cycle WPI data Cement wholesale inflation Average RoE Average RoE SOURCES: CIMB, DIPP Emerging cost pressure to contain profitability During the past two years, savings in power and fuel costs were the primary drivers of cost savings and the resultant rising profitability of the cement industry. However, pet coke prices have increased by c.90% YTD and seaborne coal prices by 4050% in the last 34 months. We do not believe that such a steep increase will be passed on to the end consumer. Consequently, cement companies may disappoint consensus earnings estimates, in our view. Figure 6: Pet coke prices have moved up sharply YTD Figure 7: Seaborne coal prices have also increased sharply 7,000 6,500 6,000 5, ,000 4,500 4, , ,000 2, , Pet coke prices 6000 kcal CNF India SOURCES: Steelmint SOURCES: SteelMint Cement demand to grow at high singledigits Our analysis of historical data shows that the correlation coefficient of cement demand with the real GDP growth rate has not been consistent through the years. However, during periods of high growth, the correlation improves significantly. The GOI has renewed its push for infrastructure creation. Our bottomup analysis on major infrastructure projects also indicates significant incremental demand. The topdown approach of linking GDP growth and cement demand growth suggests demand growth of 7.2%/8.0% in FY18/19F 5

6 FY04 FY05 FY06 FY07 FY08 FY03 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F mt % mt FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F % Construction and Materials India Cement November 23, 2016 Figure 8: Demand growth to real GDP growth correlation Timeperiod Correlation coefficient (before GFC) (After GFC) (after liberalization) growth phase in 90s growth phase in 2000s 0.69 Figure 9: Demand growth expectations (2.0) Cement demand growth Utilisation should improve, albeit slowly During the past 10 years, capacity grew at a CAGR of 10.3% but could slow down to 2.7% during FY19F due to multiple factors, including a) slowerthanexpected pickup in demand, b) a need to repair the balance sheet (for smaller companies) and c) constraints from the parent company (for the LafargeHolcim group companies). However, despite healthy demand growth assumptions, there is large surplus capacity within the industry keeping utilisation under pressure. Figure 10: Large surplus capacity created in past 10 years Figure 11: which will result in utilisation of c.74% even in FY19F, in our view Annual increase in capacity Annual increase in production Surplus capacity Utilization SOURCES: CIMB, CMA SOURCES: CIMB, CMA Our channel checks paint a mixed picture In Nov, we checked with dealers in 1516 cities across regions to understand the demand and pricing environment. The feedback helped us to get a sense of the nearterm demand outlook and the underlying risks. The feedback suggests a mixed demand outlook in the near term. Dealers in the eastern, northern and western regions were more optimistic in their observations than in the southern and central regions. After the demonetisation, organised housing construction has taken a significant hit and is likely to remain depressed for a 12 quarters. Interestingly, pricing seems to have converged across regions. The western and eastern regions witnessed some upward movement in prices but others showed 6

7 Construction and Materials India Cement November 23, 2016 flattish growth. Barring a few cities, dealers are not expecting an increase in price given the mediocre demand growth outlook and effects of demonetisation. After the correction, valuation is supportive for ACC/ACEM We value the companies using a 1year forward EV/EBITDA and compare it with valuations during the previous recovery cycle. Adjusted for inflation, the profitability in this cycle could be significantly lower than the previous cycle. However, earningsbased valuations take into account lower profitability and value a company on its existing earnings profile. We use a 12.5x 1year forward EV/EBITDA multiple for all the large caps in our coverage. We have referenced the sector valuation with the valuation of major cement companies during previous recovery cycle. During previous recovery cycle both ACC (ADD, Rs 1,598) and Ambuja (ADD, Rs 257), at their peak, traded in the range of x. The recent correction provides attractive entry points and we initiate with an Add on ACC, Ambuja and India Cements. 7

8 USD/t Construction and Materials India Cement November 23, 2016 The next capex cycle could start much earlier than anticipated The market believes that the resumption of the capex cycle is far away, in our view. However, our analysis suggests that a capex recovery could be earlier than anticipated, given 1) lower recent capital costs for expansion, 2) land and mining clearances available for companies and 3) the current healthy EBITDA/tonne for the industry. New project capital cost is lower than US$100/tonne We analysed c.80 projects under implementation (with cumulative cement capacity of c.185mt) to find the average capital cost. Our methodology entails the following steps: We collected the list of all projects under implementation and excluded completed/stalled/announced projects. Projects under implementation are more reflective of the current cost structure, in our view. We only studied projects where costs have been updated in the past 56 years. We also converted the costs into US$/t to account for inflation. We note that the distribution of capital cost has not changed materially in recent years compared to 45 years ago. Figure 12: Capital cost of projects under implementation at subus$100/t No of projects SOURCES: CIMB, CMIE Most of the greenfield projects are at subus$100/t We further divided the projects into two categories; brownfield and greenfield capital expansion. The majority of brownfield projects had capital cost of less than US$80/t and the majority of greenfield projects had capital cost of less than US$100/t. Hence, we would not expect project costs to be much higher than US$100/t, at least in the next 34 years. 8

9 Jun11 Sep11 Dec11 Mar12 Jun12 Sep12 Dec12 Mar13 Jun13 Sep13 Dec13 Mar14 Jun14 Sep14 Dec14 Mar15 Jun15 Sep15 Dec15 Mar16 Jun16 Jun11 Sep11 Dec11 Mar12 Jun12 Sep12 Dec12 Mar13 Jun13 Sep13 Dec13 Mar14 Jun14 Sep14 Dec14 Mar15 Jun15 Sep15 Dec15 Mar16 Jun16 Rs/t Rs/t USD/t USD/t Construction and Materials India Cement November 23, 2016 Figure 13: Capital cost of most brownfield expansion at sub US$80/t Figure 14: Most greenfield projects have capital cost below US$100/t No of projects No of projects SOURCES: CIMB, CMIE SOURCES: CIMB, CMIE At US$100/t, projects are viable even at the current profitability At this capital cost, new capacity becomes viable even at the current profitability. Our analysis of quarterly data released by listed companies suggests the average sector EBITDA/tonne was c.rs850/t (US$13/t) in 2QCY16. It had increased sequentially in the previous two quarters due to falling costs and stable realisation. Figure 15: ASP in a 10% band in past 5 years Figure 16: Profitability recovering gradually in past 3 years 4,600 4,400 1,100 1,000 4,200 4,000 3,800 3,600 3,400 3, , ASP, ACE Equity EBITDA per tonne, ACE Equity We note that this EBITDA/tonne is from a mix of legacy and modern plants. Hence, we believe we can safely assume that the profitability of a wellmanaged new plant could be ~Rs1,0001,100/t. Assuming capital cost of US$100/t, new projects would have a healthy return profile, in our view. In our calculation, we assume the following: Plant life of 30 years Interest cost at 9% (given the falling interest rate environment) D/E of 1:1 Tax rate at 30% 9

10 Utilisation US$/t Utilisation Construction and Materials India Cement November 23, 2016 Figure 17: ROCE profile of a new cement plant EBITDA (Rs/t) % 5.6% 6.7% 7.9% 9.0% 10.1% 80% 6.2% 7.4% 8.6% 9.8% 11.0% 85% 6.8% 8.1% 9.4% 10.6% 11.9% 90% 7.4% 8.8% 10.1% 11.4% 12.8% 95% 8.0% 9.4% 10.8% 12.3% 13.7% SOURCES: CIMB Figure 18: ROE profile of a new cement plant EBITDA (Rs/t) % 1.6% 3.1% 4.7% 6.3% 7.8% 80% 2.4% 4.1% 5.7% 7.4% 9.1% 85% 3.2% 5.0% 6.8% 8.6% 10.3% 90% 4.1% 6.0% 7.8% 9.7% 11.6% 95% 4.9% 6.9% 8.9% 10.9% 12.9% SOURCES: CIMB 185m tonnes of capacity expansion are in various stages of progress There are projects of an aggregate 185mtpa under execution. In our capacity projection, we assume 35mtpa capacity will be completed between now and FY19F. This leaves c.150mtpa at various stages of completion. Out of 185mtpa of capacity expansion projects, c.150mtpa have received environmental clearances and several of them have land acquisition under way. At a higher EBITDA/t, these projects could go live and could be completed in 23 years, in our view. However, our demandsupply analysis assumes only 35m tonnes of incremental capacity by FY19F Our demandsupply analysis indicates 74% utilisation (83% excluding the south) by FY19F and we expect a gradual recovery in the next 23 years. However, as profitability improves further, we could see the fasttracking of these dormant projects, which would put pressure on the profitability and utilisation outlook, in our view. Reported numbers of listed large cement players also indicate capex cost of <US$100/tonne We analysed historical capital expenditure data of the publicly listed cement companies, which indicated average capital cost of US$7080/t for the majority of publicly listed companies. The new capacities included greenfield, brownfield and split grinding units. This is much lower than the perceived replacement cost of a greenfield plant at US$140/t and is in line with brownfield expansion at c.us$80/t (see Annexure 01). We also tried to check these numbers against the companies sources and the numbers were in line with our expectations. Dalmia Cement reported average capital cost of US$91/t across its projects (both organic and inorganic). Belgaun (a greenfield capacity) and Kadapa/Ariyalur were organic expansions and the others were acquisitions. Figure 19: Dalmia Cement had capital cost of c.us$91/t Belgaun (Dec 2015) OCL (2015) Jaypee Bokaro (2014) Adhunik (2013) Calcom (2012) Kadapa/Ariyalur (2008 Capital cost per tonne SOURCES: CIMB, Dalmia Cement presentation 10

11 Construction and Materials India Cement November 23, 2016 Shree Cement reported capital cost of US$21/t for increasing the grinding capacity at its Aurangabad unit. Although it is a brownfield expansion of a grinding unit, capital cost was still low. Prism Cement, in its May 2016 presentation, talked about capital employed at <US$38/t. It set up a 2.0mtpa plant in 1997 and a 3.6mtpa plant in Sep Assuming all capex incurred during FY0710 was towards the execution of the 3.6mtpa plant, capital cost comes in at US$75/t. CMIE reported project cost of Rs8.75bn (Apr 2010), which translates into US$54/t. This looks plausible given that Prism also has other segments where a part of capex would be spent. We also analysed UltraTech s acquisition of the Jaypee cement plant in Gujarat (Sep 2013) at a reported cost of c.us$125/t. Apart from the 4.8mtpa cement capacity, the acquired assets included land area of 5479 ha and limestone reserves sufficient for 90 years. Assuming plant life of 30 years, there is potential to triple the capacity and the eventual weighted average capital cost would come in at c.us$90/t for 15mtpa capacity greenfield plants. Figure 20: Capital cost assuming full potential of Gujarat plant USD/t Jaypee Gujarat capacity mtpa a 4.8 Enterprise value INR m b 38,000 Exchange rate USD/INR c 64 Enterprise value USD m d=b/c 594 Limestone reserves years e 90 Plant life years f 30 Potential capacity mtpa g=e/f 14.4 Incraese in brownfield capacity mtpa h=ga 9.6 Cost of brownfield capacity USD/t i 70 Extra capex required USD m j=i*h 672 Total theoretical cost of expanded capacity USD m k=d+j 1,266 Capital cost of expanded capacity USD/t l=k/g 88 11

12 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F mt % Construction and Materials India Cement November 23, 2016 Current recovery lags last recovery cycle by quite a distance We have witnessed a gradual recovery in cement demand in the past two years which is likely to continue for the next 23 years, in our view. However, the current structural recovery lags the fundamentals of the previous recovery in FY0610. Hence, we believe the price recovery which was the hallmark of the last cycle may not play out during the current cement cycle. Thus, although we are positive on a demand recovery, we do not expect return ratios to return to the levels seen during the last upcycle. Last cement upcycle was characterised by high utilisation and industry consolidation The disparity is mainly due to the high price realisation in the previous cycle. The sharp rise in cement prices was mainly due to two reasons: The utilisation in the previous recovery cycle was much higher (in excess of 80%). The industry was becoming fairly consolidated during the previous cycle with ACC and Ambuja coming under the Holcim (200506) group and L&T cement being acquired by Grasim (2004). These three together formed almost onethird of capacity at the time. However, in the current cement cycle, we are unlikely to see either high utilisation or consolidation at the margin level During the ongoing cycle, we do not expect utilisation to go beyond 74% until FY19F. The consolidation continues with Jaypee, Reliance and Lafarge, but this still only forms c.10% of industry capacity. Hence, the effect of consolidation on price discovery has diminished materially since the last cycle. At our demand growth assumption, we do not expect utilisation beyond 74% even in FY19F, much lower than the 8590% seen in the last cycle. Figure 21: Surplus capacity accumulation since FY08 Figure 22: FY19F utilisation is much lower than the previous cycle Annual increase in capacity Annual increase in production Utilization SOURCES: CIMB, CMA, CMIE, COMPANY REPORTS SOURCES: CIMB, CMA, CMIE, COMPANY REPORTS Role of M&As in pricing discovery is diminished We believe another factor that helped cement companies during the previous cycle was consolidation in the sector. We continued to witness deals in the interim (200815) but it appears they were not significant enough to alter pricing strategy. Recently, however, we have seen announcements regarding some large deals, but these are still not large enough to provide pricing power, in our view. Major deals during the past 1012 years are summarised below: 12

13 FY03 FY04 FY05 FY06 FY07 FY08 mt Construction and Materials India Cement November 23, 2016 Figure 23: Major M&A during the past 12 years Acquired Acquirer Capacity EV (INR b) EV/t (INR) Year Region Comments L&T Cement Grasim , Across India Renamed as UltraTech Cement ACC Ltd Holcim , Across India Holcim got foothold in Indian market Ambuja Cement Holcim , Mainly west Holcim consolidated its position and became largest player in India Mysore Cement Heidelberg , UP, MP and Karnataka My Home Industries CRH , South AP Capacity was to increase to 4.2 mtpa in a year Shri Digvijay Cement CIMPOR , West Gujarat Paid Euro 70m for 73.6% stake Bharathi Cement VICAT , South AP Capacity was to increase to 5.0 mtpa in a year Sree Jayajyothi CRH , South AP Jaypee Cement UltraTech , WestGujarat Land area of 5,479 ha and limestone reserves of 500 mt Jaypee Cement Dalmia Cem , EastJharkhand Twostep transaction with Dalmia acquiring 74% stake in march 2014 Jaiprakash Associate Shree Ceme , North Haryana Grinding unit only LafargeHolcim was directed to to sell 5.2 mt of east India capacity to Lafarge India Nirma Ceme , Mainly east comply with competition laws Reliance Cement Birla Corp , Mainly central 5.1 mtpa in MP/UP and 0.5 mtpa in Maharshtra Jaiprakash Associate UltraTech , Across India 6 integrated units and 5 grinding units under acquisition Figure 23 shows that during , three major deals totalling c.50mtpa were executed. FY06 nameplate capacity was at c.157mt. Hence, these three deals involved almost onethird of capacity. M&A activity continued after that, but was primarily for foreign players to obtain a foothold in India s growing cement market. Moreover, nameplate capacity increased sharply after that as shown below. Figure 24: Cement capacity increased sharply after FY07, mitigating the impact of M&A on industry consolidation India nameplate capacity SOURCES: CIMB, CMA, COMPANY REPORTS With increasing capacity, the role of big ticket acquisitions in affecting pricing behaviour diminished greatly. Cement is a fragmented market with close to 70 players which does not help either, in our opinion. In 2016, we witnessed three large deals involving 37mt capacity but these accounted for only c.9% of nameplate capacity. Hence, we do not believe that consolidation would help in increasing prices. Return ratios/profitability unlikely to trace previous cycle Our analysis of the operational and financial parameters of listed cement companies has revealed that the industry is prudent with its cashflow and has maintained a healthy balance sheet since the previous recovery cycle. However, since, the industry has added c.200mtpa of capacity and production has increased by only c.90mtpa, adding c.110mtpa in surplus capacity. Hence surplus capacity increased from c37mtpa in to c146 mtpa in The resultant low utilisation will likely keep profitability under pressure and EBITDA/t is unlikely to reach the level last seen in the previous cycle (adjusted for inflation), in our view,. 13

14 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 D/E ratio (x) FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 Rs m Rs m Construction and Materials India Cement November 23, 2016 Though the industry invested heavily in organic capacity addition, it funded this primarily through internal accruals. We analysed 14 cement companies to look at the trend in capex and free cashflow. The industry has slowed down in capacity addition and free cashflow is rising. The recent capacity expansion has mostly been through internal accruals without much dependence on external debt. Figure 25: Aggressive capex in past 78 years. Figure 26: mostly incurred through internal accruals 100,000 90,000 80,000 70,000 60,000 70,000 60,000 50,000 40,000 50,000 30,000 40,000 20,000 30,000 20,000 10,000 10, ,000 20,000 Capex Industry free cash flow SOURCES: CIMB, Ace Equity SOURCES: CIMB, Ace equity Given that the industry did not depend significantly on outside funds for its cashflow needs, the balance sheet remained healthy and capacity to service debt remained comfortable. Figure 27: Sector balance sheet in good shape D/E, Ace Equity However, the return ratios are much lower than in the previous cycle. ROEs which rose to >35% in FY0708 were down to high singledigits during the past three years. We believe that ROEs/ROCEs have troughed and should improve, but are unlikely to reach the same levels as in FY07. As discussed in the previous section, the lack of pricing flexibility is the primary reason for the lower return ratios. We also note that others (mid and smallcap cement companies) are closing the gap with largecap companies, suggesting a convergence of fundamentals. 14

15 Jun11 Sep11 Dec11 Mar12 Jun12 Sep12 Dec12 Mar13 Jun13 Sep13 Dec13 Mar14 Jun14 Sep14 Dec14 Mar15 Jun15 Sep15 Dec15 Mar16 Jun16 Rs/t FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 Construction and Materials India Cement November 23, 2016 Figure 28: Sector ROE/ROCE unlikely to reach previous levels Figure 29: Others (midcaps) closing gap with large caps 40% 35% 30% 25% 20% 15% 25% 20% 15% 10% 10% 5% 0% 5% 0% 5% 10% Sector RoE Sector RoCE 5% Gap (RoE) between large cap and others Gap (RoCE) between large cap and others SOURCES: CIMB, Ace Equity Note: Sector average is simply average of publicly listed companies excluding outliers SOURCES: CIMB, Ace Equity Note: large caps include ACC, Ambuja, UltraTech and Shree Note: Others include mid caps with market cap below US$ 2bn Emerging cost pressure to contain profitability During the past two years, savings in power and fuel costs were the primary drivers of cost savings and the resultant rising profitability of the cement industry. However, pet coke prices have increased by c.90% YTD and seaborne coal prices by 4050% in the last 34 months. We believe that such a steep rise will not be passed on to end consumers. Consequently, cement companies may disappoint consensus earnings estimates, in our view. Power and fuel costs of cement plants declined The cement industry enjoyed a declining cost structure for the past 23 years due to 1) falling seaborne coal prices, 2) stable diesel prices and 3) stable domestic thermal coal prices. These factors kept power and fuel cost and freight cost (c.50% of total cost) in check. With commodity prices rising, we expect cost pressure to build up in the sector. Figure 30: Power and fuel cost per tonne down steadily since Sep ,200 1,100 1, Power and fuel cost per ton This led to the stabilisation of overall costs SOURCES: CIMB, ACE EQUITY The cost savings in power and fuel offset inflationary pressure in other costs and helped to stabilise operating cost. 15

16 FY03 FY04 FY05 FY06 FY07 FY08 (%) Jun11 Sep11 Dec11 Mar12 Jun12 Sep12 Dec12 Mar13 Jun13 Sep13 Dec13 Mar14 Jun14 Sep14 Dec14 Mar15 Jun15 Sep15 Dec15 Mar16 Jun16 Construction and Materials India Cement November 23, 2016 Figure 31: Power and fuel costs helped stabilise cost ((rebased, per tonne Total variable cost Ex power and fuel cost Power and fuel cost, ACE Equity As the industry used more pet coke compared to coal Plants using pet coke derived benefits from multiple sources. At times, pet coke is cheaper than imported coal on a per kcal basis. Some plants are far from the coalfields but near the coast. For these plants, using pet coke/imported coal is more convenient and costeffective logistically. Pet coke is more tax efficient. There is no green energy cess (Rs400/t on thermal coal). Figure 32: Linkage coal share has come down c.34% pts since FY Linkage coal Imported coal Open market purchase Pet coke Lignite and other SOURCES: CMA, CIMB Note: and data not exhaustive and just captures the trend. data not available Both pet coke and coal prices have risen in the last 45 months During the past 34 months, both pet coke and seaborne coal prices have increased sharply. Imported coal prices have increased by c.30% and domestic pet coke prices also witnessed sharp revisions. In Oct, domestic pet coke prices increased to Rs6,550/t (up c.87% YTD). The import offer from Saudi Arabia (9% sulphur) was at US$86/t CFR India and from the US (6% sulphur) was US$90/t CFR India. 16

17 Jan16 Feb16 Mar16 Apr16 May16 Jun16 Jul16 Aug16 Sep16 Oct16 Nov14 Dec14 Jan15 Feb15 Mar15 Apr15 May15 Jun15 Jul15 Aug15 Sep15 Oct15 Nov15 Dec15 Jan16 Feb16 Mar16 Apr16 May16 Jun16 Jul16 Aug16 Sep16 Oct16 Nov16 Rs/t USD/t Construction and Materials India Cement November 23, 2016 Figure 33: Pet coke prices have moved up sharply Figure 34: Seaborne coal prices have increased sharply 7,000 6,500 6,000 5, ,000 4,500 4,000 3,500 3,000 2, , Pet coke prices 6000 kcal CNF India SOURCES: Steelmint SOURCES: SteelMint Cement companies could start feeling the cost pinch in the coming quarters For companies located far away from coal mining areas, increased pet coke and imported coal costs could affect profitability. We expect a 1012% rise in power and fuel cost for these cement plants. For plants located near coal mining areas, we expect the fuel mix to change in favour of domestic coal. Their costs are likely to increase at a CAGR of c.5% over the next couple of years, in our view. Mitigation of higher power and fuel costs is unlikely There are mitigating steps but they may only partially cushion the impact: Pet coke substitution with domestic coal: Domestic linkage coal prices have increased by only c.6% on average and there has not been a sharp increase in eauction coal prices either. Substituting pet coke and imported coal with domestic coal would cushion the impact of rising prices for plants located near coal mining areas. For plants located near the coast or far away from coal mining areas, there is no respite and we think rising prices could lower profitability. Waste heat recovery and alternative fuels: We believe investment in alternative fuels and waste heat recovery plants could provide healthy returns. Alternative fuels can be used as a substitute for coal and are much cheaper than the landed cost of coal. In waste heat recovery systems, the cost of electricity production is less than Rs0.5/unit but the potential is limited to c.18 units per tonne of cement (78% of power and fuel cost). Other power and fuel cost mitigating measures have limited potential The usage of waste heat recovery (WHR) and alternative fuel has limited potential, in our view. Waste heat recovery: WHR systems harness waste heat in the manufacturing process (discharged as exhaust gases), channel it into a waste heat boiler that runs a steam turbine and converts it into electrical energy. It requires no additional fuel and thus the operational costs are very low. In a typical Indian cement plant, the potential generation of power from waste heat is at 2530 units/t clinker. It would save 2025% of power consumption and Rs6080/t in cost. This amounts to roughly 710% savings on power and fuel costs of a modern cement plant. The additional benefits of using such a system is that there are no incremental greenhouse gases. As at 2013, India had c.200mw of 17

18 Construction and Materials India Cement November 23, 2016 waste heat recovery capacity installed which is 1520% of the potential capacity for the cement industry. Waste heat recovery In a cement plant, only 55% of the total heat input is utilised for clinkerisation and the rest is lost in radiation and exhaust gases. c.35% of energy is lost in exhaust gases which translates into 7075MW for a 2mtpa clinker plant. This energy can be tapped into by a waste heat recovery system. Installation cost of a WHR plant is c.us$1.5m 2.0m/MW Operating cost is less than Rs0.5/unit WHR potential of a 4/6/10 ktpd clinker plant is at 5.6/7.5/12.5 MW. A 6 ktpd plant translates into 2mtpa. Hence, at the current clinker capacity of mtpa, the WHR potential is more than 1 GW in the country For a 2mtpa clinker plant, 70 kt of CO2 emission can be reduced per annum Thermal to electrical conversion efficiency of a typical WHR plant is 1820% Case Study UltraTech Cement installed a 4.2mtpa WHR plant at cost of Rs330m in A few years ago, the company reported 98% availability with power generation cost of Rs0.2/unit. At the prevailing power generation rate and the cost of power, the annual savings were at Rs80m. This translates into ROCE of c.20% and a payback period of four years. Both these metrics point towards a healthy investment opportunity, in our view. Alternative fuel: Currently, the thermal substitution rate in the Indian cement industry is at %, whereas it is 10% in Japan and more than 30% in some European countries. Based on the current fuel mix, the domestic cement industry would need 4045mtpa coal rising progressively with cement production. Alternative fuels are much cheaper than coal (on landed cost) and thus the rising share results in incremental cost savings. Moreover, with a population of 1.3bn and increasing urbanisation, there could be huge waste generation and we believe the cement industry could be one of the favoured destinations for waste disposal. Alternative fuels are generally waste products for other industries and hence are cheap relative to fossil fuels. The major potential sources of alternative fuels are surplus biomass (availability of >150mt, 10% substitution also would yield c.15mt fuel), fuel from municipal waste (availability of >7mtpa, 20% availability would mean c.1.5mt fuel), used tyres and hazardous waste. The calorific value of these wastes are comparable to coal with biomass at kcal/kg, fuel from municipal waste at kcal/kg and plastic waste at kcal/kg. Below is the analysis for fuel derived from municipal waste used in a cement kiln. The key assumptions for the investment are: Waste would be gathered from nearby municipalities with a calorific value of 2800 kcal. Municipal waste would be processed by cement companies and transported to the plant. Total cost would be Rs1,500/t. Domestic coal would have calorific value of 4000kcal/kg and the landed cost would be Rs3,000/t. The capex for a 45 kt per year system would be Rs100m Based on the assumptions above, the payback period would be close to 3.7 years and the ROCE, c.23%. Both of these point towards a healthy investment opportunity, in our view. 18

19 Construction and Materials India Cement November 23, 2016 Capacity distribution change could bring selling efficiency Freight and costs increased by c.20% during the last five years due to 1) increased diesel rate and 2) rising lead distance. The industry has tried to increase logistics efficiency by using technology and changing the geographic capacity distribution (split grinding units). However, these are ongoing longterm measures and are not expected to alter the sector s fundamentals in the next 1218 months, in our view. Split grinding units lower logistics cost but are not an immediate solution Historically, the capacity distribution was primarily governed by the proximity to limestone mines which are concentrated in a few states. One tonne of cement requires 1.1 tonnes of limestone (assuming 30% blending by fly ash). Weight wise, this is the biggest component of the raw materials used and thus minimising the transportation cost of limestone needs to be considered in the location of a cement plant. Figure 35: Limestone reserve distribution Figure 36: Limestone production 6% 5% 10% 27% 7% 5% 4% 5% 22% 6% 8% 6% 7% 15% 9% 19% 7% 11% 9% 12% AP Rajasthan MP Karnataka HP Chhattisgarh Odisha Maharashtra Gujarat Rest of India SOURCES: Indian Bureau of Mines Note: Latest available reserves are of 2010 AP Rajasthan MP Gujarat Tamil Nadu Karnataka Chhattisgarh HP Maharshtra Rest of India Indian bureau of Mines Note: Production share as of The reserve distribution and production captures the cement capacity distribution () as shown in the Figure below. Figure 37: Capacity distribution () AP and Telangana Rajasthan Karnataka Tamil Nadu MP Gujarat Maharashtra Chhattisgarh UP Rest of India 19

20 Construction and Materials India Cement November 23, 2016 However, if we observe the new capacity addition during 19F, we note that they are not in the usual locations. During FY05, the states with 90% limestone reserves accounted for threefourths of new capacity but in 19F, we believe these same states are likely to account for c.60% of new capacity. The argument for cement plants being located near a limestone mine is becoming weaker given: The limestonerich southern region is operating at a very low capacity utilisation of c.55% and thus aggressively adding capacity there would not provide investment returns, in our view. Both the eastern and central regions have low per capita consumption. At the same time, these are mineral rich regions with stable governments. The GOI s focus on raising mineral production (and thus more royalty income to the respective governments) could provide fiscal room to invest in infrastructure. Companies are opting for split grinding unit structures where there is a centralised clinker manufacturing location serving multiple grinding units situated closer to the end markets. Figure 38: New capacity (19F) disconnected from limestone reserves 70% 60% 50% 40% 30% Many plants are coming up in states with very little limestone reserves Less new capacity are coming up in limestone rich regions 20% 10% 0% Karnataka West Bengal Rajasthan Bihar Chhattisgarh Maharashtra UP Rest of India New capacity share Limestone reserve share, IBM The split grinding unit structures are logistically efficient too, especially for the eastern and central region. These regions are rich in coal and hence many power plants are situated there. This ensures the availability of limestone, in our view. The calculation below shows how the split grinding units improve accessibility to the newer markets. The example below shows that for the same lead distance, a split grinding unit structure is c.18% more cost efficient. Figure 39: Cost economics of a split grinding unit Integrated plant Split grinding unit Distance covered Kms Freight cost INR/t/km ton clinker transportation INR/t 686 Flyash transportaion cost INR/t 49 Freight for transporting 1 ton cement to end market INR/t 392 Total freight cost INR/t 1,372 1,127 Cost savings 18% SOURCES: CIMB 20

21 Construction and Materials India Cement November 23, 2016 Utilisation increasing, albeit slowly Capacity addition slowed down but utilisation may not rise meaningfully Cement capacity addition has witnessed sizeable growth during the last 10 years. This seems to be slowing down, at least for the next 23 years, due to multiple factors including a) slowerthanexpected pickup in demand, b) repairing the balance sheet (for smaller companies) and c) constraints from the parent company (for LafargeHolcim group companies). During the past 10 years, capacity grew at a CAGR of 10.3% but could slow down to 2.7% during FY19F. The capacity growth CAGR diverged across regions in both of these time periods. During FY05, the southern region accounted for c.40% of incremental capacity addition and during FY19F, the eastern region could account for c.47% of incremental capacity. Figure 40: Divergent capacity growth in two time periods 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Central Region Eastern region Northern Region Southern Region Western Region FY F Concurrently, we expect healthy cement demand growth of 6.4/7.2/8.0% during FY17/18/19F. This implies consumption CAGR of 7.1% vs. capacity CAGR of 2.7% during 19F. Hence, utilisation could rise to c.74% by FY19F from c.67% in. The south is operating at a fairly low capacity utilisation of 50 55%. Excluding that, India could operate at 83% utilisation in FY19F. Northern region: Capacity utilisation to trend up but unlikely to reach peak in last cycle During the last 10 years, capacity CAGR was at 11.8% which could decline to 0.6% in 19F. This is a high cement consuming region with per capita consumption of c.300kgs. Ongoing infrastructure projects such as DFC and DMIC are likely to drive healthy demand growth. We expect utilisation at c.80% in FY17F, increasing to c.93% in FY19F. Such high capacity utilisation offers some pricing flexibility to the industry, in our view. 21

22 FY03 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F % mt FY03 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F % mt Construction and Materials India Cement November 23, 2016 Figure 41: Northern region utilisation to rise sharply Figure 42: Rajasthan accounted for twothirds capacity in Uttarakhand 5% Haryana 8% Delhi 1% Himachal Pradesh 12% Jammu and Kashmir Punjab 1% 5% Rajasthan 68% 60.0 (5.0) Surplus capacity Utilization SOURCES: CIMB, CMA During FY03FY08, the region was operating at near 100% capacity utilisation. Hence, the industry started investing heavily in capacity addition, raising it from 41.9mtpa in FY08 to 71.4mtpa in (14.3% CAGR). Nevertheless, the region experienced healthy demand growth in the same period. Hence, utilisation did not fall below a respectable 75%. Figure 43: Northern Region mt FY03 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F Year end capacity Production Utilization (%) Demand Demand growth (%) Western region: Capacity utilisation to surpass previous peaks Similar to the north, the west is also a high cement consuming region with per capita consumption at 320kgs per annum. The capacity addition here has also slowed down from a 6.9% CAGR during FY0616F to 3.9% in 19F. Weakness in organised housing is slightly negative for cement demand, but we believe large infrastructure projects, including DFC/DMIC/Metro, could outweigh the weakness and the region is likely to witness demand growth of c.7% during 19F. Figure 44: Western region utilisation more than 80% in FY19F Figure 45: Capacity evenly distributed Maharashtra 52% Gujarat 48% Surplus capacity Utilization 22

23 FY03 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F % mt Construction and Materials India Cement November 23, 2016 During the previous high growth phase of FY0609, the industry operated at a healthy capacity utilisation of >85%. Hence, like the north, the west also aggressively added capacity, increasing it from 32.8mtpa in FY08 to 50.2mtpa in (CAGR of 11.3%). Capacity addition has declined materially with cumulative capacity addition of c.7mtpa during 19F (c.12% of capacity). Hence, utilisation is likely to reach 84% by FY19F, in our view. We expect demand of 18mt more than production. We believe inflow from the south is likely to primarily fulfil that demand. Figure 46: Western Region mt FY03 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F Year end capacity Production Utilization (%) Demand Demand growth (%) Central region: Utilisation to reach 90% by FY19F The central region, comprised of Uttar Pradesh (UP) and Madhya Pradesh (MP), is a low cement consuming region with per capita consumption () at c.150kgs. There is very little capacity addition (0.8mt) expected in the next three years. In contrast, during FY0616F, the capacity addition CAGR was c.8%. Given the low base, the region has relatively better potential for demand growth, in our view, and we expect demand growth of c.8% during 19F. Figure 47: Central region utilisation to reach c.90% by FY19F Figure 48: MP had 60% share in Uttar Pradesh 40% Madhya Pradesh 60% 60.0 Surplus capacity Utilization Like other regions, the central region also witnessed utilisation at >90% during FY0610, resulting in heavy investment. Capacity increased from 27.9mtpa in to 46.1mtpa in (CAGR of 13.4%). Given the very low incremental capacity addition until FY19F, we expect utilisation to scale back to 90% by FY19F. Figure 49: Central region operating at healthy utilization mt FY03 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F Year end capacity Production Utilization (%) Demand Demand growth (%) SOURCES: CIMB, CMA Eastern region: The eastern region is the lowest cement consuming region in the country with per capita consumption at c.140kgs. The region is also deficient in various infrastructure parameters and thus offers attractive growth potential, in our view. Stable governments with rich mineral resources are likely to act as a catalyst and hence we expect 9.6% demand growth CAGR during 19F. Given the high growth potential, the region is adding c.47% of 23

24 FY03 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F % mt Construction and Materials India Cement November 23, 2016 incremental capacity during the next three years. Although companies are aggressively adding capacity, the pace of capacity addition at a 7.7% CAGR during 19F is still lower than 11.0% during FY0616, signifying caution from the sector. Figure 50: Surplus capacity to increase in eastern region Figure 51: Chhattisgarh accounts for a third of capacity in Assam 6% Bihar 5% Orissa 15% West Bengal 22% Chhatisgarh 33% Meghalaya 7% Jharkhand 12% Surplus capacity Utilization SOURCES: CIMB, CMA SOURCES: CIMB, CMA Per capita consumption at c.140kgs per annum is much lower than the west and north at >300kgs. Thus, the demand potential is more than in other regions. The region continues to add capacity at a higher pace than other regions due to 1) availability of coal, 2) availability of fly ash and 3) a fast growing end market. Figure 52: Eastern region demand growth to outperform other regions mt FY03 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F Year end capacity Production Utilization (%) Demand Demand growth (%) Southern region: No respite The southern region is the largest region, with capacity share of 37% (155mt). The region has been most aggressive towards capacity addition (on a relatively higher base) and accounts for c.40% of incremental capacity addition during FY0616. The reasons for such sharp capacity addition include 1) high utilisation in FY0608 and 2) easy availability of limestone the region accounts for more than a third of limestone reserves in the country. Falling demand growth and aggressive capacity addition has resulted in weak capacity utilisation of 5354% in the region. Recent stability in the political environment (bifurcation of AP) could trigger a demand cycle, in our view. 24

25 FY03 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F % mt Construction and Materials India Cement November 23, 2016 Figure 53: Southern region facing tough times on surplus capacity Figure 54: AP accounts for onethird of capacity () Kerala 1% Tamil Nadu 24% Andhra Pradesh 34% Karnataka 24% 40.0 Telangana 17% Surplus capacity Utilization The southern region s growth deteriorated materially after the previous growth period. After experiencing doubledigit growth during FY03, the industry has yet to recover. Erstwhile, Andhra Pradesh (including Telangana) experienced maximum demand decline due to a fall in irrigation projects and low cost housing. In addition, political unrest further aggravated the situation, in our view. With political unrest now over, there could be a renewed push for cement consumption and we expect it to rise slowly from hereon. Figure 55: Southern Region Southern Region FY03 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F Year end capacity Production Utilization (%) Demand Demand growth (%)

26 Construction and Materials India Cement November 23, 2016 Cement demand to grow at high singledigits We believe Indian cement demand is likely to grow at high singledigits over the next few years. Our assumption is based on the analysis of historical growth patterns, government projects, housing demand and large infrastructure projects. Demand correlation with GDP has not been consistent through the years Our analysis of historical data shows that the correlation coefficient of cement demand with the real GDP growth rate has not been consistent through the years. As evident from Figure 56 below, the demand to GDP growth rate correlation has declined significantly since 2009 due to 1) a slowdown in gross fixed asset creation in the economy and 2) a change in GDP calculation methodology. Weakness in the economy lowered the priority for infrastructure creation; hence cement demand suffered more than expected. A change in the GDP calculation methodology further affected the correlation. Figure 56: Demand growth to real GDP growth correlation Timeperiod Corelation coefficient (before GFC) (After GFC) (after liberalization) growth phase in 90s growth phase in 2000s 0.69 SOURCES: CIMB, World bank However, we expect the correlation to revert to mean With the economy again looking up and given the high emphasis on infrastructure creation, we expect demand to see a structural recovery and follow GDP growth. Government increased emphasis on infrastructure building We expect the GOI s emphasis on infrastructure creation to help raise cement demand. Multiple projects such as roads, housing, metro rails, etc. would increase the demand for cement. In most of the infrastructure projects, materials account for c.50% of costs and cement accounts for a significant share of costs (for example, 810% of construction cost for houses is related to cement). Figure 57: Breakdown of construction cost % Materials Construction Equipment Labour Finance Large infrastructure projects in pipeline Enabling expense Admin expense Buildings Roads Bridges Dams Power Railway Mineral Plant Medium Industry Transmission SOURCES: CIMB, CONSTRUCTION INDUSTRY DEVELOPMENT COUNCIL SURVEY The GOI is aggressively pursuing some large infrastructure projects with big investment outlays with the potential to generate significant cement demand. 26

27 Construction and Materials India Cement November 23, 2016 Figure 58: Large infrastructure projects are in the pipeline Government housing plan Roads Investment outlay (US$ bn) Comments Housing for all envisage 20m units in urban areas and 40 m units in rural areas by Execution remains a challenge Target of 15,000 kms in FY k kms in progress Dedicated Freight Corridor 13 Likely to be commissioned by Dec 2019 Smart cities Swachh Bharat Mission Metro rails Power projects 1516 Proposed to be operated as centrally sponsored scheme with investment of Rs 1 tr in next 5 years 32 Plans to construct 110 m toilets in next 5 years 17 Development of metro in tier 2 cities 16 5 new projects of 4GW each in plug and play mode Port development 15 Double port capacity by 2025 Lowcost housing is another potential big boost for cement demand Residential housing currently makes up c.60% of cement demand. The GOI has an ambitious plan to construct 20m units in urban areas and 40m units in rural areas by The programme was conceptualised in 2015 and in the last year, execution has not yet picked up. We think that these are early days and we could see better execution in the next 34 years. This could be a significant driver of cement consumption in the country. Given the weak execution, we expect c.20m houses of average carpet area of 3040 sqm to be constructed in the next five years. This would result in mt of cement demand. Figure 59: Incremental cement demand from mass housing project Drivers Units Bags per sq foot Bags/sq feet 0.4 Carpet area sq m 30 Built up area sq m 33 Built up area Sq feet 355 Number of houses in 7 years mn 20 Cement consumption potential mt 142 Road building is likely to pick up SOURCES: CIMB India s road construction has picked up significantly during the last 23 years and going forward, the targets are quite ambitious, in our view. NHAI/MORTH plans to construct 3,000/15,000kms in FY17F, up 52%/37% yoy. Figure 60: NHAI road execution (km) Figure 61: MORTH road execution (km) 3, ,000 3,000 2,500 2,000 1,500 1, ,684 2,205 2,693 1,783 2,248 2,844 1,901 1,501 1,987 3, ,942 5,013 5,732 4,260 4,410 6, FY07 FY08 FY17F target 0 FY17F target NHAI length completion (km) MoRTH roads completed (km) SOURCES: CIMB, NHAI SOURCES: CIMB, NHAI In addition, new roads are being made with cement, boosting cement demand. A one lane road requires 400t500t of cement per km. If 10,000kms of fourlane roads are constructed using cement, it could account for c.6% of FY18F cement 27

28 Construction and Materials India Cement November 23, 2016 demand. We expect cement roads to consume c.20mt of cement every year for the next few years. Figure 62: Incremental cement demand from road projects Cement road constructed (kms) Figure 63: Cement demand growth in upward trajectory (%) Cement/lanekm (tonnes) Lanes Cement demand (mt) Swachh Bharat Mission is also likely to boost cement demand % of FY18F Cement demand % % % % % SOURCES: CIMB For a typical housing project, cement accounts for 810% of the total cost. Taking the same benchmark, cement cost in the Swachh Bharat Mission would be between US$2.6bn3.2bn. Assuming bulk purchases, the average cement cost would be at Rs40004,500/t. At this price, the estimated cement consumption would be at 4050mt. Similarly, our interaction with companies/industry participants suggest aggressive cement demand from various other projects. We believe: Dedicated Freight Corridor would have a potential demand of 30mt. Delhi Mumbai Industrial Corridor would have demand of 15mt from each city. Port and airport developments would raise cement demand of c.3035mt until Irrigation projects would need c.100mt until Demand growth CAGR of c.7% during 19F We have witnessed similar aggressive targets in the past and we note slippage in the current project as well. However, the pace of execution has improved lately. This is also reflected in the rising cement demand growth from 2.6% in to 4.7% in. Taking the same trajectory of growth, our assumption of FY1718F cement demand growth of 6.4%/7.2% is very realistic. Figure 56 suggests a significant correlation between cement demand growth and GDP growth during times of high growth. We have entered a period of increasing growth and thus expect the correlation to improve progressively. Based on these assumptions, we expect cement demand CAGR of c.7% during 19F, which is still lower than longterm demand growth of c.8%. FY17F FY18F FY19F India cement consumption growth to real GDP growth India cement consumption growth India real GDP growth PCC growth to real GDP per capita growth India PCC growth India real GDP per capita growth India poulation growth SOURCES: CIMB In light of this, even if we compare India s per capita consumption across countries, we see a significant gap. India s per capita consumption at c.210kgs is significantly below the world average of 580kgs. 28

29 Per capita consumption (Kgs) Kgs Construction and Materials India Cement November 23, 2016 Figure 64: Per capita consumption in India much lower than world average 1,800 1,600 1,400 1,200 1, China South Korea Turkey World Russia Brazil USA India Per capita cement consumption SOURCES: CIMB, Country reports Even if we compare the developing countries in our region, India lags behind other developing countries. We believe this indicates that there could be significant potential for growth if policy making moves in the right direction. Improving macro and a stable government are two very important catalysts that could spur demand growth, in our view. Figure 65: Per capita consumption in India is much lower than peers in the region India Thailand Indonesia Malaysia Vietnam Sri Lanka SOURCES: CIMB, World bank, Country reports We believe in an ongoing structural recovery and expect high singledigit growth in cement demand but low capacity utilisation, rising cost pressure and the lack of pricing power, as major headwinds persist in the next 23 years. 29

30 Construction and Materials India Cement November 23, 2016 Our channel checks paint a mixed picture In Nov, we checked with dealers across regions to understand the demand and pricing environment. The feedback helped us to get a sense of the nearterm demand outlook and the underlying risks. However, we believe that this is unlikely to provide a medium or longterm perspective on the sector. The feedback suggests a mixed demand outlook in the near term. Dealers in the eastern, northern and western regions were more positive in their outlook than dealers in the southern and central regions. Interestingly, pricing seems to have converged across regions. The western and eastern regions witnessed some upward movement in prices but others show flattish growth. Barring a few cities, dealers were not expecting an increase in price given the mediocre demand growth outlook. Eastern region stable demand but a crowded place Demand has stagnated in the region. Many new players such as Shree Cement are aggressive in pushing out volumes. Companies are trying to push volumes and hence prices are unlikely to rise. The benefits of increased mining activity are limited. Except for Chhattisgarh, prices are in the range of Rs300320/bag and dealers expect prices to remain flat over the next 12 months. Figure 66: Eastern region dealer channel checks Current price (Rs/50 kg Price City State bag) trend Expectation Dealer commentary Patna Bihar Kolkata West Bengal Bhubneshwar Odisha Raipur Chhattisgarh ` ` ` Demand not very strong but not weak either. Sand shortage was huge problem six months back but has resolved now. Gap between trade and non trade segment at cinr 50/bag. Dealers are reluctant to raise prices despite push by the companies Stagnated demand. Companies are trying to push volumes and hence prices are unlikely to rise. Government projects coming in interiors but not in city areas. Gap between trade and non trade is at INR 60/bag Weak demand. Organized housing is not picking up due to lack of planning permission. Apartment sales are down significantly. Prices can go down further. The benefit of increased mining activity is not broad based and is only in limited areas. Decent demand but the market is very crowded. Many companies have entered the region and consolidation has decreased materially. The consumer is not very brand conscious and there is decent acceptability of Bgrade cement. Consequently, despite volume increase, prices are suppressed. Gap between trade and nontrade is at INR 3040/bag. Non trade is eating into trade volumes since even order for two truckloads of material qualify as nontrade. Sand shortage is episodic SOURCES: CIMB Western region concerns rising with demonetising currency The western region is experiencing low demand as organised housing has not picked up. In addition, the recent demonetising of existing Rs500 and Rs1,000 currency notes has further aggravated the situation. However, the feedback suggests that this is a shortterm concern and could benefit the construction sector in the long term. Cities such as Mumbai and Ahmedabad have worryingly high levels of finished housing inventory which could keep pressure on the demand from housing, in our view. Figure 67: Western region dealer channel checks City State Current price (Rs/50 kg bag) Price trend Expectation Dealer commentary Mumbai Maharashtra Pune Maharashtra Ahmedabad Gujarat Stable demand but no sign of high growth. There is lack of government support in increasing construction activity. There is no shortage of sand and other raw materials. Recently companies tried to increase prices but this sudden decision of demonetizing INR 500 and INR 1,000 currency notes pushed them back. This move is likely to affect construction sector Decent demand. During past 23 months prices increased by cinr 100/bag. Don t think that the recent decision of demonetizing current INR 500 and INR 1,000 currency note will have longterm effect. Rather it would be a short term disturbance Demand not increasing. Gap between trade and nontrade is at INR 30/bag. BGrade cement trades at discount of INR 1015 to AGrade cement. There is sufficient housing inventory of 3 years near Ahmedabad. In short term, there would be slowdown in construction activity due to demonetization of existing INR 500 and INR 1,000 currency notes 30

31 Construction and Materials India Cement November 23, 2016 Northern region government projects to the rescue The northern region is experiencing a mixed outlook. In Delhi, the conflict between the state and central governments is affecting the construction projects. Additionally, bad weather is affecting demand negatively. Rajasthan shows encouraging demand growth. Although organised housing has not picked up, support from government projects is helping to raise demand. Figure 68: Northern region dealer channel checks City State Current price (Rs/50 kg bag) Delhi Delhi Jaipur Rajasthan Price trend Expectation Dealer commentary ` Low demand due to conflict between state and central government. Gap between category 'A' and category 'B' cement has widened to INR 4050/bag in place of usual INR 1520 per bag. Consequently, Bgrade cement is witnessing healthy volume growth but Agrade is struggling. We could see some increase in B grade cement prices but Agrade cement prices are unlikely to increase Demand is good. Gap between trade and nontrade at INR 2030/bag. Sand shortage is episodic and largely due to absence of coherent government policy making. Organized housing is not picking up but the government projects are going strong and are main demand driver. Private consumption is stable Southern region elusive demand growth The southern region continues to wait for elusive demand growth. During the past 34 years, the political uncertainty in the region kept demand low. After the bifurcation of Andhra Pradesh and the announcement of the new capital at Amravati, the industry expects healthy demand growth. However, it is not yet visible. Figure 69: Southern region dealer channel checks City State Current price (Rs/50 kg bag) Bangalore Karnataka Price trend ` Expectation Dealer commentary Low demand. Construction activity not picking up since workers have not yet returned from holidays. There is no sand availability issue in Karnataka and Andhra Pradesh. Tamil Nadu sometimes face sand shortages. There is some activity due to government projects and demand is likely to increase in near term Hyderabad Telangana Low demand and the prices also are flat for some time Goa Goa Chennai Tamil Nadu Low demand. Organized housing is not picking up. Government projects are there but payments are irregular. This discourages developers from participating actively in government projects. Recently companies have started opening offices in various locations and are dealing with clients directly affecting cement dealers negatively. These representative offices sometimes sell at a discount of INR 2030/bag. Low demand. Government projects are not coming. Absence of Chief Minister due to health issues created some gaps in decision making. Gap between trade and non trade is at INR 20/bag Central region not performing to potential The central region has per capita cement consumption at c.150kgs vs. India s per capita consumption of 210kgs. We believe that the region has very high growth potential. However, during the past few months, demand has not picked up. In Utar Pradesh, there has been a shortage of stones. Hence, despite the election season, demand has not picked up. Real estate activity is stable in Madhya Pradesh and we believe demand should increase from hereon. Figure 70: Central region dealer channel checks City State Current price (Rs/50 kg bag) Lucknow Uttar Prad 290 Bhopal Madhya P 300 Price trend ` Expectation Dealer commentary Low demand despite the election period. There is shortage of stones affecting construction activity. Recently, companies tried to increase cement prices but market was not willing to absorb it. Gap between trade and non trade normally is INR 2025/bag but since there is little sales activity the gap has increased to INR 5060/bag Low demand. There could be some impact of recent decision of demonetizing INR 500 and 1,000 currency notes. During past two years, real estate has been stable. Gap between trade and non trade is at INR 50/bag. Slight increase in prices don t curb demand. Contrary to popular perception, people start buying cement in the fear that prices could go up further 31

32 FY05 FY06 FY07 FY08 FY17F FY18F FY19F % Construction and Materials India Cement November 23, 2016 Valuation recent correction opens up attractive entry points We value the cement companies using oneyear forward EV/EBITDA multiples. We believe that this is a suitable method in the current scenario as: The sector is entering a gradual recovery phase. Volatility in earnings is a major weakness of this approach to valuing cement companies, and there should not be significant volatility in earnings profiles, in our view. We believe there is ambiguity in replacement costs and it differs widely in the industry. Hence, giving a premium/discount to replacement cost based on return ratios might not be the right strategy. Nevertheless, we use EV/tonne as a secondary check on our valuation. We have not used a DCF method in our valuations. In a cyclical commodity such as cement, forecasting longterm cashflow in a growth market such as India is fraught with far greater uncertainty than a stable business. Nevertheless, the DCF method provides us with a sense of broader assumptions that the current price and our target price build in. Demand growth recovery in line with previous cycle ACC (Add, Rs 1,598) and Ambuja (Add, Rs 257) were the two major players during the last recovery cycle and we compare valuations then to the current cycle. In comparing the industry from the previous cycle with the current cycle, we note that demand growth is slowly reaching high single digits, similar to that of the previous cycle. We expect a gradual recovery and that there should not be sharp volatility. Figure 71: Demand growth recovering gradually Cement demand growth Return ratio unlikely to trace previous cycle As discussed earlier, the industry would have much lower pricing power relative to the previous cycle. Hence, adjusted for inflation, the profitability in this cycle would be lower and the return profile would be much weaker, in our view. Nevertheless, balance sheet strength and free cashflow generation would be similar to the previous cycle. We also note that the previous cycle was the start of aggressive capital investment and capacity creation in the economy whereas we believe this cycle should see more prudent capital spend. 32

33 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 D/E ratio (x) Construction and Materials India Cement November 23, 2016 Figure 72: Sector balance sheet remains healthy Figure 73: but return ratios unlikely to reach previous levels % 35% % 25% 20% 15% 10% 5% 0% % 10% D/E Sector RoE Sector RoCE SOURCES: CIMB, ACE EQUITY SOURCES: CIMB, ACE EQUITY EV/EBITDA multiple of previous cycle as reference One of the major weaknesses of an earningsbased valuation method is the unpredictability of the earnings profile at inflexion points. However, Figure 71 indicates that we crossed the inflexion point a couple of years ago and the industry is in a gradual recovery phase. Hence, we decided to use an earningsbased valuation as our primary valuation method and assetbased valuation (replacement cost) as a secondary check on those numbers. During the previous recovery cycle, ACC and Ambuja were major players and we chose their valuations as representatives for Indian cement players. We note that in the previous cycle, both of these companies reached valuations at x 1year forward EBITDA multiples. Figure 74: ACC Current valuation at near mean Figure 75: ACEM EVEBITDA multiple at mean Jan06 Jan08 Jan10 Jan12 Jan14 Jan Jan06 Jan08 Jan10 Jan12 Jan14 Jan16 EV/EBITDA (x) Mean +1 sd 1 sd, Bloomberg EV/EBITDA (x) Mean +1 sd 1 sd We also compared assetbased valuations of both these companies from the previous cycle to the current cycle and realised that the companies are trading at a significant discount in the current cycle. That is justifiable since even though we assume that capital cost would remain the same, the lack of pricing power could suppress the earnings potential of these assets, in our view. 33

34 USD/t USD/t Construction and Materials India Cement November 23, 2016 Figure 76: ACC Assetbased valuation below mean Figure 77: ACEM Assetbased value below mean Jan06 Jan08 Jan10 Jan12 Jan14 Jan16, BLOOMBERG 0 Jan06 Jan08 Jan10 Jan12 Jan14 Jan16 As shown in the Figures above, major companies reached the valuation multiple of 12.0x13.0x 1year forward EV/EBITDA. Hence, we used the multiple of 12.5x for all the largecap cement companies in our coverage. India Cements is a regional player operating in the southern region. We expect the south to operate at sub60% capacity utilisation in the next 23 years compared to c.90% during the previous cycle. Hence, we do not believe that it is prudent to give the company the same upcycle multiple of FY0608. We have used the average EV/EBITDA multiple of the last 10 years for the company (7.8x). With this framework, we initiate with a Reduce on SRCM, Hold on UTCEM and Add on ICEM, ACC and ACEM. ACEM is our top pick in the sector. The sector comparison is shown in the table below. Figure 78: Sector comparison Rating Mkt Cap Net Debt Capacity EV/tonne EV/EBITDA (x) P/E (x) P/B (US$ m) (US$ m) mt US$ FY17F FY18F FY17F FY18F FY17F FY18F ACC Add 3,610 (189) Ambuja Add 5,793 (721) Ultratech Hold 13, India Cem Add Shree Cem Reduce 7, Ramco Cem Non Rated 1, JK Cement Non Rated JK Lakshmi Non Rated Heidelberg Cement Non Rated NA Orient Non Rated NA Dalmia Bharat Non Rated 2, OCL Non Rated 646 (27) Mangalam Cement Non Rated NA Birla Corp Non Rated 762 (46) NA SOURCES: CIMB, BLOOMBERG We have not taken into consideration the ongoing demonetization wherein as per the government order existing Rs 500 and Rs 1,000 currency notes ceased to be a legal tender. The construction sector could be hit and this could have a consequential effect on cement demand for the next 12 quarters, in our view. However, these are very early days yet, and we have not quantified the impact in our financials. 34

35 US$/t Construction and Materials India Cement November 23, 2016 Annexure 01 capex analysis of publicly listed companies Our methodology to compute expansionary capital cost derived from reported capital expenditures of publicly listed companies is explained below: We have taken the endofyear capacity during FY04 and for large publiclylisted companies with cement as the main segment. Capex during FY0516 was summed up for individual companies. We then took depreciation expenses during those years and subtracted that from capital expenditures of individual companies. In doing so, we assumed that depreciation would equal maintenance and modernisation capex. After deducting depreciation, we divided the number by a change in capacity during FY0416 to arrive at per tonne capital cost. While calculating the change in capacity, we excluded mergers and acquisitions such as UltraTech s merger with Samruddhi and acquisition of Jaypee s Gujarat units and Shree s acquisition of the Panipat grinding unit from the Jaypee Group. We converted the numbers in US$ to account for the cost inflation. Figure 79: Capital costs lower than US$80/t ACC Ambuja UltraTech Madras Cement JK Cement JK Lakshmi India Cements Birla Corp Heidelberg Capital cost per tonne, ACE Equity The Figure above shows several interesting observations: It denotes that the companies had capital costs at <US$80/t except for UltraTech and Madras Cement. UltraTech s numbers are slightly higher since the company invested heavily in modernisation capex. As at Apr 2011, the company had planned capex for logistics/modernisation of US$1.3bn1.4bn which adds US$3540/t in our calculation. We tried to capture it in depreciation expenses, but believe that the effect has not been fully accounted for, increasing the effective capital cost for organic expansion. Even if we had taken maintenance capex at Rs100/t and ignored modernisation capex, the average sector capital cost per tonne would not be more than US$100/t; still much lower than the perceived US$140/t. We have not taken Shree Cement s data since it uses an accelerated depreciation method. Even including maintenance/modernisation capex, it would still be at c.us$80/t, suggesting better capital efficiency than the peer group. Excluding maintenance and modernisation capex, Shree s capital cost would come in c.us$20/t lower. 35

36 Construction and Materials India Cement November 23, 2016 Annexure 02 impact analysis of rising fuel cost On the map below, we tried to analyse two cement plants. One is in Gujarat and the other is in MP. We have also tried to analyse the current prices with prices six months ago. We concluded that the attractiveness of pet coke has significantly reduced for the hinterland plant and those situated there could consider switching to thermal coal. However, plants away from coal mining areas would have to bear increased costs since ferrying coal for long distances is not logistically efficient. Key underlying assumptions in our analysis are: For a plant near a port in Gujarat, the distance from the port is 300kms and the distance from the coal mining area is 1,200kms. For a plant in the Satna cluster, domestic coal has to travel 500kms whereas imported coal/pet coke has to travel 1,000kms. Domestic/imported coal would have calorific value of 4,000kcal/kg whereas imported coal/pet coke would have calorific value of 5,800/8,200kcal/kg. The final cost is computed in Rs/ 000 kcal. Figure 80: Plants away from coal mining areas would have to bear increased cost SOURCES: CIMB We believe our analysis clearly shows the following points: In both the cases, the relative advantage of pet coke has declined significantly. We also note that logistics costs play a meaningful role in an individual plant s decision to use a particular fuel. 36

37 Construction and Materials India Cement November 23, 2016 For plants located far away from coal mining areas and dependent on pet coke/imported coal, the costs would rise, affecting profitability, in our view. Unless the fuel mix changes, companies would face pressure on power and fuel cost. Companies based near the coast that found a clear cost advantage using pet coke would lose that advantage. We think better access to domestic fuel would only partially cushion the impact of this cost increase. 37

38 Vol m Cement India Equity research November 23, 2016 Company Note India ADD Consensus ratings*: Buy 14 Hold 18 Sell 10 Current price: Rs1,272 Target price: Rs1,598 Up/downside: 22.0% CIMB / Consensus: 0.6% Reuters: Bloomberg: Market cap: Average daily turnover: ACC.NS ACC IN US$3,505m Rs238,912m US$9.65m Rs648.2m Current shares o/s: 188.0m Free float: 38.6% *Source: Bloomberg Key changes in this note N/A 1,700 1,500 1,300 1, Price Close Relative to SENSEX (RHS) Nov15 Feb16 May16 Aug Source: Bloomberg Price performance 1M 3M 12M Absolute (%) Relative (%) Major shareholders % held Ambuja Cements 50.1 Life Insurance corporation of India 11.3 J P Morgan Chase 4.9 ACC Limited Hope ahead We expect the company to recover from the muted operational performance of CY1115 and maintain market share of c8.5% in the next 23 years. Ongoing cost control initiatives should keep costs in check, in our view. Rising profitability and volume growth could result in CY1518F EBITDA/PAT CAGR of 13%/23%. Low capex should generate c.rs28bn in FCF in CY1518F. The recent correction, with the stock down 25% in last three months despite improving sector fundamentals, presents a buying opportunity. Initiate with ADD. Recovering from the lows Over previous quarters, ACC underperformed large cap peers on operational parameters due to 1) low capital investment resulting in suboptimal volume growth and 2) increasing cost due to factors including delays in optimising fuel mix dynamically. There was flattish volume growth in CY1115 whereas industry demand grew at a c.4% CAGR, resulting in loss of market share from 10.2% in CY11 to 8.7% in CY15. With the reorganisation completed at parent company, we expect more cost optimization. Cost control could be another driver for profitability Opex/t increased at a CAGR of 7.4% in CY1115, pushing profitability down by c.30% during the period. ACC has taken multiple steps to control costs, including introducing 1) capability to change fuel mix dynamically, 2) waste heat recovery, 3) alternative fuels and 4) improving logistics efficiency. In addition, the ongoing restructuring between ACC and Ambuja could generate synergies of c.us$130m150m over next 34 years split almost equally between both companies. These synergies are not in our estimates. Rising fuel prices could be a nearterm spoiler Pet coke prices have increased c.90% YTD and imported coal prices have also increased by 4050% during the past 34 months. About 60% of the company s fuel mix consists of pet coke. Unless the company shifts its fuel mix to domestic coal, we believe we could see cost pressure in the next 34 quarters. Improving financials with strong balance sheet In past few years, sector ASP growth has been lower than inflation, but we expect sector utilisation to rise to c.74% in FY19F (YE March) and realisation to rise with inflation. We assume ASP changes of 1.0/+5.0/+5.0% for CY1618F. The realisation increase of c.5% in CY17/18F would be higher than cost increases, implying EBITDA/PAT CAGR of 13%/23% in CY1518F. Low capex requirement should drive free cashflow of c.rs28bn in CY1518F and improve net debttoequity from 0.15x in CY15 to 0.25x in CY18F. Recent correction is an opportunity, initiate with Add We value ACC at 12.5x 1year forward EV/EBITDA multiple, in line with the previous cycle during which the share price reached 1213x 1year forward EBITDA. Our TP equates to EV/t of US$135 (near 10year mean). Sustained low profitability due to rising fuel prices or falling ASP would be downside risks. A 10% increase in fuel price or 1% decrease in realisation would lower TP by 8.6% and 5.5%, respectively. Nevertheless, the recent correction presents a buying opportunity, in our view. Initiate with Add. Analyst(s) Saurabh PRASAD T (91) E saurabh.prasad@cimb.com Satish KUMAR, PGDM T (91) E satish.kumar@cimb.com Financial Summary Dec14A Dec15A Dec16F Dec17F Dec18F Revenue (Rsm) 114, , , , ,025 Operating EBITDA (Rsm) 15,073 15,372 15,433 18,462 22,528 Net Profit (Rsm) 11,683 5,916 7,972 9,953 13,062 Core EPS (Rs) Core EPS Growth 6.6% (36.3%) 7.0% 24.9% 31.2% FD Core P/E (x) DPS (Rs) Dividend Yield 2.67% 1.33% 1.53% 1.91% 2.51% EV/EBITDA (x) P/FCFE (x) Net Gearing (19.3%) (14.9%) (15.7%) (20.2%) (25.8%) P/BV (x) ROE 14.5% 8.9% 9.2% 11.0% 13.6% % Change In Core EPS Estimates CIMB/consensus EPS (x) SOURCE: COMPANY DATA, CIMB FORECASTS IMPORTANT DISCLOSURES, INCLUDING ANY REQUIRED RESEARCH CERTIFICATIONS, ARE PROVIDED AT THE END OF THIS REPORT. IF THIS REPORT IS DISTRIBUTED IN THE UNITED STATES IT IS DISTRIBUTED BY CIMB SECURITIES (USA), INC. AND IS CONSIDERED THIRDPARTY AFFILIATED RESEARCH. Powered by the EFA Platform

39 Cement India ACC Limited November 23, 2016 Figure 1: Key assumptions Hope ahead Investment summary We initiate coverage on ACC with an Add rating and target price of Rs1,598, implying upside potential of 22% from current levels. Our investment thesis is based on structural recovery in Indian cement demand and rising profitability due to cost control initiatives. However, we believe a thin capacity pipeline might constrain the company s ability for volume growth after 23 years. Cement demand cycle to recover gradually: India s cement demand grew at a suboptimal c.4.0% during 16 (YE March), much lower than the long term demand growth of 78%. However, we believe that the industry has entered a gradual recovery phase and expect demand growth of 7.2% in FY18F and 8.0% in FY19F. Concurrently, capacity addition CAGR which was 10.3% during the past 10 years is likely to come down to 2.7% CAGR in 19F, in our view. This would improve capacity utilisation from 6667% in F to c.74% in FY19F. ACC is trying to capitalise on this structural recovery and consolidate its position with two newly commissioned cement plants in Jamul and Sindri. Given that ACC has operations across all regions, we see the company as well placed to benefit from this structural recovery in the cement sector. CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Cement ASP (Rs/t) 3,663 3,585 3,981 4,339 4,259 4,421 4,425 4,381 4,600 4,830 % change 8.7 (2.1) (1.8) (1.0) Capacity (mt) Sales (mt) % change 2.5 (1.8) (0.7) 1.2 (2.4) Capacity utilisation (%) Freight cost (Rs/t) ,073 1,153 1,153 1,210 1,271 % change Power & fuel cost (Rs/t) ,009 1, ,025 % change (5.2) (9.0) Core EBITDA/t (Rs/t) 1, % change 43.9 (36.0) (3.3) 4.5 (23.8) (8.9) (3.8) Note: Core EBITDA excludes other operating income Cost control initiatives would improve profitability: Legacy plants with high cost structures resulted in relatively worse profitability for the company. The operating expenses per tonne increased at a CAGR of 7.4% during CY1115. Hence, EBITDA per tonne (excluding other operating income) declined by c.30% from CY11 to CY15. After the LafargeHolcim merger we expect a more focused approach, resulting in accelerated improvement in operational performance of the company. The company has started to adjust its fuel mix dynamically. Apart from that, there are multiple ongoing cost initiatives, including waste heat recovery and alternative fuels which we estimate, together, can drive cost savings of c.rs100/t. In addition, we believe the ongoing restructuring between ACC and Ambuja has the potential of generating synergy benefits of c.us$130m150m over the next 34 years split almost equally between the two companies. We have not built the synergy benefits into our estimates. Strong balance sheet: ACC has a deleveraged balance sheet with net cash of Rs12.6bn at endcy15. The company is not embarking on any new expansion plans and will only undergo maintenance capex, in our view. We expect the company to incur capex of Rs5bn in each of the coming three years. This would result in free cashflow generation of c.rs28bn over the next three years ending CY18F. This would improve the balance sheet too, with net debt to equity improving from 0.15x in CY15 to 0.24x in CY18F. 39

40 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F (%) Cement India ACC Limited November 23, 2016 Margin expansion: Apart from power and fuel costs, we expect other costs to rise moderately. With rising capacity utilisation, we also expect cement prices to increase in line with inflation. Given that the company recently switched to pet coke and has relatively better access to domestic coal, we do not believe the rise in pet coke prices is likely to significantly affect its cost profile. Realisation increase at c.5% in CY17F and CY18F would be better than cost increase, raising profitability. We expect EBITDA/t to increase from Rs651 in CY15 to Rs807 in CY18F. Figure 2: ACC has just started recovering from lows of the past 5 years (10) (20) (30) (40) (50) EBITDA growth PAT growth Initiate coverage with Add: We value the company at a 1year forward EV/EBITDA multiple of 12.5x, in line with the multiple from the previous recovery cycle, to arrive at our 1year forward price target of Rs1,598 which translates into EV/t of US$135 (near the mean of the last 10 years). This is at significant discount to Ambuja/UltraTech/SRCM which trade at cus$ 185/204/220. ACC has lower profitability given legacy plants and thus trades at a material discount to the peers. At the current stock price, our target price implies upside potential of 26%. We initiate coverage with an Add rating. Figure 3: EV/EBITDA based valuation Valuation EBITDA (CY18F) Rs m 22,528 Multiple x 12.5 EV (CY17F) Rs m 281,606 Net debt (CY17F) Rs m (18,768) Market capitalisation (CY17F) Rs m 300,374 Target price(cy17f) Rs 1,598 40

41 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F % % Cement India ACC Limited November 23, 2016 Gradually recovering from the lows Over the previous quarters, ACC has underperformed other large cap peers on operational parameters. It has added just 2.5mtpa of new capacity in the past five years ending CY16F (UltraTech: 18 mtpa, Shree: 14 mtpa). There was no volume growth in CY1115 whereas industry demand grew at c.4% CAGR, resulting in loss of market share from 10.2% in CY11 to 8.7% in CY15. Relatively lower share of new plants in its capacity mix affected both volume growth and profitability. The merger of Lafarge and Holcim kept the management attention diluted, in our view, resulting in lower and delayed capital spend. With the reorganisation complete, we expect accelerated improvement in operational performance of the company. Low sales during past 4 years; may reverse in CY1718F Over the past four years, ACC witnessed low sales revenue growth due to multiple reasons including: Low demand growth keeping the sales volume at a similar level for past five years. In contrast, its peers UltraTech and Shree increased sales volume by 20% and 24% respectively in 16 (YE March). Realisation underperformed wholesale price index over past 34 years. As discussed in the sector note (with YE March), we expect GoI s emphasis on infrastructure building to aid in rising cement demand. Multiple projects such as road, housing, metro rail etc. are likely to increase the demand for cement. Consequently, we expect India cement demand growth of 6.4% in FY17F, 7.2% in FY18F and 8.0% in FY19F, in contrast to CAGR of c.4.5% during the past five years. ACC is trying to capitalise on this structural recovery and consolidate its position with two newly commissioned cement plants in Jamul and Sindri. These cement plants would allow ACC to serve the high potential eastern region at a lower cost. In CY1115, the cement industry grew at a CAGR of c.4% but the sales volume of the company remained flat resulting in loss of market share from 10.2% in CY11 to 8.7% in CY15. With the reorganisation complete at the parent level, we expect ACC to grow in line with industry growth and report shipment growth of 78% during the next two years, stabilising its market share. Figure 4: Volume growth to pick up from lows of past 5 years Figure 5: Market share fell since CY07 but likely to stabilise (2.0) 6.0 (4.0) Sales volume growth ACC market share ACC is also well diversified geographically with a presence in every region in India. This insulates the company from regional volatility in business fundamentals, in our view. 41

42 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F % Cement India ACC Limited November 23, 2016 Figure 6: ACC well diversified across regions 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% FY17F Eastern region Western Region Southern Region Central Region Northern Region Note: FY year end March Realisation has underperformed the wholesale price index for the past 34 years due to tepid demand growth. With gradual recovery in the cement sector, we expect a reversal of trend with prices rising along with inflation. Figure 7: Realisation underperformed WPI (rebased) in past 34 years Figure 8: Realisation growth in line with expected inflation CY06 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY (2.0) (4.0) Realisation WPI inflation, DIPP Realisation growth With both realisation and volume growth in line with the industry, we expect sales CAGR of 8.8% from CY1518F. Cost control could be another driver for profitability As discussed earlier, the company reported weak volume and realisation growth in the previous 34 years. In addition, the operating expenses per tonne increased at a CAGR of 7.4% in CY1115. Hence, EBITDA per tonne (excluding other operating income) declined by c.30% from CY11 to CY15, in line with other major players including Shree and Ambuja (UltraTech performed better with a profitability decline of c.10% in the same period). We expect, with the LafargeHolcim transaction now concluded, there would be renewed emphasis on improving operations. As expected, the management is focusing less on capacity expansion and more on efficiency improvement as stated in its 2015 annual report: 42

43 3QCY14 4QCY14 1QCY15 2QCY15 3QCY15 4QCY15 1QCY16 2QCY16 3QCY16 % Cement India ACC Limited November 23, 2016 At LafargeHolcim, free cashflow (FCF) generation and operating EBITDA are the central financial measures for success. Our aim is to combine superior cash flow generation with a strict capital allocation policy as this is a critical determinant of value creation in our industry. ACC has started to adjust fuel mix dynamically ACC faced rising costs in the past five years due to the higher commodity prices. There were opportunities to significantly lower fuel cost by substituting thermal coal with pet coke, but the company changed its fuel mix late in the game, unlike its competitors who switched to the lower cost fuel at a much earlier stage, for instance: Shree Cement has been running both its kiln and CPP on pet coke for the past 810 years; and UltraTech was already using 50% pet coke in its fuel mix in. In contrast, ACC has only substantially increased pet coke in its fuel mix as of CY16 but may not be able to fully capitalise on the lower cost per kcal of pet coke due to the sharp hike in coke prices YTD. Figure 9: ACC only recently increased pet coke share in fuel mix UltraTech ACC This sharp rise in the pet coke share in its fuel mix resulted in lower power and fuel cost and reenforced the strategy of increasing profitability despite keeping capex under control. Although the benefit of increased pet coke in fuel mix is decreasing due to c.90% rise in prices YTD, we expect the company to be more efficient in optimising its fuel mix going forward depending on the market prices of different constituents. 43

44 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 Cement India ACC Limited November 23, 2016 Figure 10: Increased pet coke share in fuel mix is helping lower cost 20% 15% 10% 5% 0% Impact of increasing pet coke share in fuel mix 5% 10% 15% 20% yy change in power and fuel cost In addition, the freight costs were also coming down over three quarters to 2Q16 due to a) lower diesel prices (not in management control) and b) lower lead distances (in management control). In 3Q16, freight costs increased due to increased lead distance and longlead interunit clinker movement. We believe that both these factors are cyclical in nature. We believe rising demand, coupled with the commissioning of Jamul and Sindri cement plants would partially negate cost pressures. Diminishing benefits due to rising pet coke prices and increased freight due to cyclical factors have lowered profitability in 3Q16. However, renewed effort on cost control and ongoing structural recovery would normalise profitability to historical levels, in our view. Other costcutting initiatives could save up to Rs100/t The company has taken several costcutting initiatives in the last 23 years. However, apart from fuel mix change from coal to coke and vice versa, the other initiatives have limited potential, in our view. Waste heat recovery: The company derives 4% of its power from waste heat recovery, wind mills and diesel generators. Both waste heat recovery and wind mills have variable rates of power production at lower than Rs0.5/unit. Assuming no diesel genset production, this power mix would contain costs by Rs1520/t. Alternative fuels: YTD, the company has increased the share of alternative fuels in the fuel mix from 2% to 3% yoy. Assuming landed cost of alternative fuel at half the rate of normal fuel, the savings would amount to Rs810/t. Together with waste heat recovery, this amounts to c.4% of power and fuel cost savings. Pet coke substitution with coal and vice versa: As discussed in the sector note, with the rise in pet coke prices the benefits have reduced substantially. However, the company has better access to domestic coal and hence, we believe it should not be materially affected by the said price rise. Logistics efficiency initiatives: Usage of GPS and RFID improves tracking and logistical efficiency with potential gain of c.rs50/t. Realisation growth and cost control would push EBITDA/t to c.rs800 in CY18F. That is still much lower than other large cap peers such as UltraTech (c.rs 1,200/t) and Ambuja (c.rs1,150/t), suggesting the need for capital investment, in our view. 44

45 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Rs Cement India ACC Limited November 23, 2016 Figure 11: Profitability to rise but still lower than peers 1,200 1,100 1, EBITDA/t Restructuring should provide long term synergies LafargeHolcim concluded the ACCAmbuja restructuring in Aug After the restructuring, LafargeHolcim held a 61.39% stake in Ambuja Cements and Ambuja Cements owns 50.01% in ACC. In addition, LafargeHolcim would own 0.29% in ACC. The restructuring is shown in the figure below. Figure 12: Previous organisational structure Figure 13: Current group structure 61.39% 40.79% 61.39% 0.29% 24.00% 50.01% 50.01% 9.76% Management expects total synergy of US$130m150m over 34 years. Primary benefits would come from cement swaps and logistics. Lead distance reduction of 273km and 71km would result in freight savings of Rs256/t and Rs156/t for ACC and Ambuja, respectively. 45

46 US$ m Cement India ACC Limited November 23, 2016 Figure 14: Potential synergy benefits from restructuring Logistics Clinker Swaps Procurment Fix Cost Reduction Shared Services Total Management expects US$70m80m savings from procurement, fixed cost and shared services benefits: Procurement: US$45m50m from process standardisation, service cost reduction and vendor consolidation. Fixed cost reduction: Guidance of US$25m30m from achieving global benchmarks and reducing fixed cost by 56%. Shared services: Savings of up to US$1m from expanding IT model to join transactional backend processes. We have not built these synergy benefits into our assumptions. The transaction has just concluded and we will wait for some time for these synergy benefits to accrue to the company. Improving financials; low capital investment a worry EBITDA and PAT CAGR of 13% and 23% in CY1518F During the past few years, the sector ASP growth has been lower than inflation. However, with sector utilisation rising to c.74% in FY19F, we expect realisation to increase with inflation. Hence, we assume ASP changes of 1.0%/+5.0%/+5.0% in CY16/17/18F. We also assume ACC s cost increase will be lower than the increase in realisation due to efficiency initiatives as detailed in the previous section. 46

47 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F (%) CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Rs/t Rs/t Cement India ACC Limited November 23, 2016 Figure 15: Better cost control would aid profitability 6,000 1,400 5,000 1,200 4,000 3,000 2,000 1,000 1, EBITDA (RHS) Net sales realisation (LHS) Total Operating expenses (LHS) The figure above indicates a cost increase of 9.1% CAGR in CY0915 which would decline to a to 1.7% CAGR in CY1518F. Given that the company recently switched to pet coke and has relatively better access to domestic coal, the rise in pet coke prices is not likely to significantly affect its cost profile, in our view. We believe realisation increase of c.5% in CY1718F should be better than the respective cost increase, raising profitability. We expect EBITDA and PAT CAGRs of 13% and 23%, respectively, in CY1518. Figure 16: ACC has just started recovering from the lows of past 5 years (10) (20) (30) (40) (50) EBITDA growth PAT growth Rising profitability would strengthen balance sheet further Rising profitability would result in healthy free cashflow and a stronger balance sheet. After the commissioning of Jamul and Sindri plants, there is not much capex in the pipeline. We expect the company to incur capex of Rs5bn in each of the next 23 years. This would result in free cashflow generation of c.rs28bn over the next three years ending CY18F. This would improve the balance sheet too with net debt to equity improving from 0.15x in CY15 to 0.24x in CY18F. 47

48 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F % CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Rs m x CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Cement India ACC Limited November 23, 2016 Figure 17: Low capex to help FCF rise in next 2 years Figure 18: Balance sheet gaining strength on low capex 30,000 25,000 (0.05) 20,000 15,000 10,000 5,000 (5,000) (10,000) (15,000) (20,000) (0.10) (0.15) (0.20) (0.25) (0.30) (0.35) (0.40) (0.45) Cash Flow from operations Capex Free cash flow Net debt/equity Return ratios unlikely to trace previous cycle Since CY10, ACC has not invested adequately in capacity creation, neither organically nor inorganically, in our view. As a result, the gap between the company and industry leader (UltraTech (Hold, Rs 3,430/sh)) has widened considerably. During the five years ending CY16, the capital employed increased by only 8%, whereas for UltraTech, the capital employed has increased by c.70%. We expect ACC to reach 90% utilisation in CY18F. After that, the company could face constraints in volume growth. Although we expect healthy EBITDA/PAT growth during the next 23 years, we believe it is unlikely that return ratios will trace those of the previous highgrowth phase. Low capital investment have helped improve the return ratios but also limit growth potential. ACC needs to increase investment in modernising its old plants. This would raise its profitability to a level comparable with its peers, in our view Figure 19: Return ratios unlikely to trace those of previous cycle RoAvE RoAvCE Working capital is stable after some squeeze earlier Working capital witnessed some squeeze in CY1213. Creditor days declined steadily whereas debtor days were increasing. We believe weak macroecomic conditions resulting in low demand growth was partly responsible for this. Inventory was stable for the most part and did not show sharp volatility. This suggests the processes were adjusted according to external market conditions. However, the cement sector operates mostly on negative working capital and 48

49 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F % Rs CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Cement India ACC Limited November 23, 2016 barring some of the smaller companies in the south, working capital is not much of a problem for major cement companies. Figure 20: Working capital was squeezed in CY Creditor days Debtor days Inventory days Expect strong dividend payout to stay intact ACC s net cash as of CY15 was Rs12.6bn. With c.rs28bn in free cashflow over the next three years, we expect the strong dividend payout ratio to remain at c.46%. Over the past 56 years, the company consistently paid c.50% of net profit as dividends. Figure 21: Dividend payout has remained near 50% for six years Figure 22: Book value per share rising steadily Dividend payout Book Value per Share Our DuPont analysis is shown in the figure below. It indicates that profitability would be the main driver of ROE in the next 23 years. It has come down steadily from CY0915 and is likely to inch up going forward, based on our analysis. Financial leverage has been coming down steadily since CY10 despite capex, implying low requirement of external funding. Falling leverage has a negative effect on ROE. 49

50 Cement India ACC Limited November 23, 2016 Figure 23: Profitability should be the primary driver of the rise in ROE DuPont analysis CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Profitability (%) Asset turnover (x) Financial leverage (x) ROE (%) Recent correction an opportunity; Initiate with Add We value ACC on one year forward EV/EBITDA multiple. We believe that this is a suitable method in the current scenario as: The sector in entering a gradual recovery phase and we do not believe there will be significant volatility in ACC s earnings profile. Volatility in earnings is a major weakness of the EV/EBITDA multiple approach for valuing cement companies. We believe that there is ambiguity in replacement cost and it differs widely in the industry. Hence, giving a premium/discount to replacement cost based on return ratio might not be the right strategy. Nevertheless, we have used EV/tonne as a secondary check on our valuation. We have not used DCF method in our valuation. For a cyclical commodity such as cement, forecasting longterm cashflow in a growth market such as India is fraught with far greater uncertainty than a stable business, in our view. Nevertheless, the DCF method provides us with a sense of broader assumptions that the current price and our target price is building in. Previouscycle multiples used for valuation ACC and Ambuja were the two major companies during the past recovery cycle and their valuations then can be compared to their valuations in the current cycle. We believe that the current recovery cycle can be compared to the previous recovery cycle. Comparing them, we note the following: During the current cycle, the return profile will likely be much weaker. Adjusted for inflation, the profitability in this cycle would be significantly lower than the previous cycle. An earningsbased valuation method takes into account lower profitability of the companies and values the company according to its existing earnings profile. Our industry growth expectations are similar to that of the previous business cycle. The industry experienced high single digit growth then and during the current cycle as well. We expect 8% industry growth in FY19F, increasing thereafter. Thus, the multiple should be comparable to the previous cycle. Balance sheet and free cashflow generation is in line with the previous cycle. However, the previous cycle was the start of aggressive capital investment and capacity creation in the economy whereas this cycle should see more prudent capital spending, in our view. We analysed both the earnings and assetbased multiples during the past cycle. During the previous cycle, the valuation reached x 1year forward EBITDA. Asset based valuation reached highs of c.us$250/t. 50

51 x USD/t Cement India ACC Limited November 23, 2016 Figure 24: Current valuation is near mean Figure 25: Asset based valuation below mean Jan06 Jan08 Jan10 Jan12 Jan14 Jan16 ACC EV/EBITDA (x) Mean +1 sd 1 sd, Bloomberg 50 Jan06 Jan08 Jan10 Jan12 Jan14 Jan16 ACC EV/tonne Mean, BLOOMBERG We value ACC at 12.5x 1year forward EV/EBITDA multiple, similar to other largecaps and in line with the valuation reached in previous cycle. Figure 26: EV/EBITDA based valuation Valuation EBITDA (CY18F) Rs m 22,528 Multiple x 12.5 EV (CY17F) Rs m 281,606 Net debt (CY17F) Rs m (18,768) Market capitalisation (CY17F) Rs m 300,374 Target price(cy17f) Rs 1,598 At our targeted multiple, our 1year forward target price is Rs1,598 which translates to EV/t of US$135 (near the mean of the last 10 years). This is at significant discount to Ambuja/UltraTech/SRCM which would trade at cus$ 185/204/220. ACC has lower profitability given legacy plants and thus trades at a discount to the peers. At the current share price, our target price implies upside potential of 26%. We initiate coverage on ACC with Add. Our secondary check with DCF analysis indicates fair value of INR1,352 and the underlying assumptions are: 1) Volume growth rate in the explicit period at 8% 2) EBITDA/t growth rate in the explicit period at 5% 3) Tax rate of 30% 4) WACC of 13% 5) Terminal growth rate of 5% 51

52 Cement India ACC Limited November 23, 2016 Figure 27: DCF method CY17F CY18F CY19F CY20F CY21F CY22F CY23F CY24F Sales mt 130, , , , , , , ,310 ASP Rs/t 5,054 5,270 5,270 5,270 5,270 5,270 5,270 5,270 Sales (mt) mt EBITDA/t Rs/t ,031 1,082 EBITDA margins (%) % 14% 15% 16% 17% 18% 19% 20% 21% EBITDA Rs m 18,462 22,528 25,547 28,971 32,853 37,255 42,247 47,908 Taxes Rs m (3,237) (4,248) (5,679) (6,706) (7,871) (9,192) (10,689) (12,388) Capex Rs m (5,000) (5,000) (5,000) (5,400) (5,832) (6,299) (6,802) (7,347) Change in working capital Rs m (964) (958) (1,035) (1,117) (1,207) (1,303) (1,408) (1,520) Free cash flow Rs m 9,261 12,322 13,833 15,747 17,943 20,462 23,348 26,654 Years for discounting Discount rate DCF based Valuation (Rs m) NPV of explicit period 86,567 NPV of terminal value 148,700 Total Value 235,267 Net debt (18,768) Equity value 254,035 Fair Value (Rs) 1,352 Our target price builds in a terminal growth rate at c.7% which is possible, in our view, given the longterm volume growth rate of 78% in India. Risks to our Add rating and target price Key risks to our Add rating and target price include 1) increased competition putting pressure on prices, 2) lowerthan expected demand growth, 3) risk of penalty from Competition Commission of India (CCI), and 4) increase in commodity prices. Volume and realisation sensitivity: The cement industry is highly fragmented and there is generally always risk of volume push from marginal players. This can lower the average realisation of all cement players. In addition, lowerthanexpected volume growth can impact both EBITDA and EPS. Our analysis shows that a 1% decrease in realisation and 1mt decrease in sales volume can decrease CY18F EBITDA by 5.8% and 3.3%, respectively. This, in turn, would lower our target price by 5.5% and 3.1%, respectively, as well. Increase in fuel prices: YTD pet coke prices have increased by c.90%. Seaborne coal prices have also increased by 4050% in the past 34 months. Volatility in fuel prices is a key risk to our estimates. Based on our analysis, a 10% increase in fuel prices would lower our CY18F EBITDA and target price by 9.2% and 8.6%, respectively. Risk of penalty from CCI: In its order dated 31 Aug 2016, CCI reaffirmed a fine of Rs11.5bn on the company which is c.50% of our CY18F EBITDA. Although it is a onetime charge, it could affect realisation negatively in the next 23 years, in our view.. 52

53 Cement India ACC Limited November 23, 2016 BY THE NUMBERS P/BV vs ROE Jan12A Jan13A Jan14A Jan15A Jan16F Jan17F 21.0% 19.4% 17.9% 16.3% 14.8% 13.2% 11.7% 10.1% 8.6% 7.0% 12mth Fwd FD Core P/E vs FD Core EPS 48.0 Growth Jan12A Jan13A Jan14A Jan15A Jan16F Jan17F 30% 19% 7% 4% 16% 27% 39% 50% Rolling P/BV (x) (lhs) ROE (rhs) 12mth Fwd Rolling FD Core P/E (x) (lhs) FD Core EPS Growth (rhs) Profit & Loss (Rsm) Dec14A Dec15A Dec16F Dec17F Dec18F Total Net Revenues 117, , , , ,825 Gross Profit 99, , , , ,933 Operating EBITDA 15,073 15,372 15,433 18,462 22,528 Depreciation And Amortisation (5,576) (6,521) (5,626) (6,301) (6,616) Operating EBIT 9,497 8,851 9,807 12,161 15,912 Financial Income/(Expense) 451 (77) Pretax Income/(Loss) from Assoc NonOperating Income/(Expense) 1, Profit Before Tax (preei) 11,352 9,371 10,565 13,190 17,310 Exceptional Items Pretax Profit 11,352 9,371 10,565 13,190 17,310 Taxation 331 (1,924) (2,593) (3,237) (4,248) Exceptional Income posttax 0 (1,532) Profit After Tax 11,683 5,916 7,972 9,953 13,062 Minority Interests Preferred Dividends FX Gain/(Loss) post tax Other Adjustments posttax Net Profit 11,683 5,916 7,972 9,953 13,062 Recurring Net Profit 11,683 7,447 7,972 9,953 13,062 Fully Diluted Recurring Net Profit 11,683 7,447 7,972 9,953 13,062 Cash Flow (Rsm) Dec14A Dec15A Dec16F Dec17F Dec18F EBITDA 15,073 15,372 15,433 18,462 22,528 Cash Flow from Invt. & Assoc. Change In Working Capital (50) (964) (958) (Incr)/Decr in Total Provisions Other NonCash (Income)/Expense Other Operating Cashflow (233) Net Interest (Paid)/Received (491) (415) (673) (673) (673) Tax Paid (2,354) (2,289) (2,593) (3,237) (4,248) Cashflow From Operations 12,826 14,198 12,617 14,088 17,149 Capex (15,270) (11,681) (8,001) (5,000) (5,000) Disposals Of FAs/subsidiaries (853) 1, Acq. Of Subsidiaries/investments Other Investing Cashflow 9, ,203 1,571 Cash Flow From Investing (6,937) (9,930) (7,070) (3,797) (3,429) Debt Raised/(repaid) (350) Proceeds From Issue Of Shares Shares Repurchased Dividends Paid (7,530) (6,750) (4,289) (5,354) (7,027) Preferred Dividends Other Financing Cashflow Cash Flow From Financing (7,880) (6,395) (4,289) (5,354) (7,027) Total Cash Generated (1,991) (2,128) 1,259 4,936 6,693 Free Cashflow To Equity 5,539 4,623 5,547 10,291 13,720 Free Cashflow To Firm 6,380 4,683 6,221 10,964 14,393 SOURCE: CIMB RESEARCH, COMPANY DATA 53

54 Cement India ACC Limited November 23, 2016 BY THE NUMBERS cont d Balance Sheet (Rsm) Dec14A Dec15A Dec16F Dec17F Dec18F Total Cash And Equivalents 15,864 12,928 14,187 19,123 25,817 Total Debtors 4,107 4,844 4,902 5,510 6,229 Inventories 12,556 11,886 12,031 13,521 15,285 Total Other Current Assets 3,985 4,049 3,541 3,979 4,498 Total Current Assets 36,511 33,706 34,660 42,133 51,829 Fixed Assets 75,130 76,559 78,934 77,633 76,017 Total Investments 2,909 2,746 2,746 2,746 2,746 Intangible Assets Total Other NonCurrent Assets 12,163 15,397 15,397 15,397 15,397 Total Noncurrent Assets 90,202 94,702 97,076 95,775 94,159 Shortterm Debt Current Portion of LongTerm Debt Total Creditors 7,502 8,741 8,847 9,943 11,241 Other Current Liabilities 20,967 22,598 22,067 22,067 22,067 Total Current Liabilities 28,469 31,694 31,269 32,365 33,663 Total Longterm Debt Hybrid Debt Debt Component Total Other NonCurrent Liabilities 1,159 1,199 1,199 1,199 1,199 Total Noncurrent Liabilities 1,159 1,199 1,199 1,199 1,199 Total Provisions 14,728 11,085 11,155 11,631 12,379 Total Liabilities 44,357 43,978 43,623 45,195 47,240 Shareholders' Equity 82,356 84,430 88,114 92,713 98,748 Minority Interests Total Equity 82,356 84,430 88,114 92,713 98,748 Key Ratios Dec14A Dec15A Dec16F Dec17F Dec18F Revenue Growth 5.2% (0.4%) 1.2% 12.4% 13.1% Operating EBITDA Growth (7.5%) 2.0% 0.4% 19.6% 22.0% Operating EBITDA Margin 13.1% 13.4% 13.3% 14.2% 15.3% Net Cash Per Share (Rs) BVPS (Rs) Gross Interest Cover Effective Tax Rate 0.0% 20.5% 24.5% 24.5% 24.5% Net Dividend Payout Ratio 54.6% 42.9% 46.0% 46.0% 46.0% Accounts Receivables Days Inventory Days Accounts Payables Days ROIC (%) 13.1% 11.1% 12.0% 14.5% 18.9% ROCE (%) 12.7% 10.7% 11.8% 14.0% 17.3% Return On Average Assets 9.07% 5.90% 5.93% 6.99% 8.57% Key Drivers Dec14A Dec15A Dec16F Dec17F Dec18F Domestic ASP (% Change) 3.8% 0.1% 1.0% 5.0% 5.0% Domestic Vol. Sales Growth (%) 1.2% 2.4% 1.1% 7.8% 8.4% Export ASP (% Change) N/A N/A N/A N/A N/A Export Vol. Sales Growth (%) N/A N/A N/A N/A N/A Utilisation Rate (%) 79.5% 78.2% 84.0% 92.0% 97.0% Unit Raw Material ASP (% Change) N/A N/A N/A N/A N/A Export Sales/total Sales (%) N/A N/A N/A N/A N/A SOURCE: CIMB RESEARCH, COMPANY DATA 54

55 Vol m Cement India Equity research November 23, 2016 Company Note India ADD Consensus ratings*: Buy 20 Hold 11 Sell 11 Current price: Rs193.6 Target price: Rs257.0 Up/downside: 32.7% CIMB / Consensus: 3.4% Reuters: Bloomberg: Market cap: Average daily turnover: ABUJ.NS ACEM IN US$5,640m Rs384,421m US$11.82m Rs792.7m Current shares o/s: 1,552m Free float: 32.2% *Source: Bloomberg Key changes in this note N/A Price Close Relative to SENSEX (RHS) Nov15 Feb16 May16 Aug Source: Bloomberg Price performance 1M 3M 12M Absolute (%) Relative (%) Major shareholders % held Holcim 61.1 Life Insurance Corporation of India 6.6 Genesis Asset Managers 2.6 Ambuja Cements Geographically well placed Ambuja Cements operates primarily in the north, west and east of India. It is likely to benefit from high utilisation in the north and west, and growth potential in the east. It has better cost control from modern plants and cost efficiency measures. Synergy benefits from the restructuring of ACC and Ambuja could lower costs further. Rising profitability and volume growth would result in CY1518F EBITDA/PAT CAGR of 23%/33%. We expect c.rs44bn in FCF generation over the next 3 years. The recent correction, with the stock down c.30% in the past three months despite improving sector fundamentals, presents a buying opportunity. Initiate with Add. Geographic advantage to help in ASP and volume growth The company is geographically well spread. About 70% of its capacity is in the high cementconsuming regions of India s north and west, and 25% is in the highpotential east. We expect both the northern and western regions will likely operate at > 80% utilisation in the next two years. While the east, with a per capita consumption of 140kgs of cement p.a. (India: 210kgs), provides volume growth potential. Both factors would drive healthy ASP and volume growth, and hence c.10% sales CAGR over CY1518F. Cost control helps profitability Ambuja Cements exercises good cost control due to: 1) modern plants, 2) better grade limestone mines, and 3) early adoption of logistics efficiency (seabased freight along western coast). Initiatives such as dynamically changing fuel mix and investments in waste heat recovery, cushions cost inflation. With reorganisation completed at parent co level, we expect more investments in process improvements and cost optimisation. Hence, cost CAGR of 5% in CY0915 would fall to 3% in the next two years, in our view. Profitability to increase on cost control Sector ASP growth has been below inflation in the past few years. However, with utilisation in the north and west likely rising to more than 80% in FY18F (YE March), we expect pricing flexibility. Hence, we assume ASP increases of 6.0/6.0% for CY17F/18F. We believe increases in ASP would be greater than cost increases, implying EBITDA and PAT CAGR of 23% and 33%, respectively, during CY1518F. Strong balance sheet despite outflow for Holcim India stake Rising profitability and low capex requirement should drive free cash flow generation of Rs44bn over the next three years ending CY18F, in our view. While there is a cash outflow of Rs35bn for buying a stake in Holcim India, net debttoequity should still be at healthy 0.34x in CY18F. Valuation supports fundamentals; Initiate with Add Our target price is based on 12.5x CY18F EV/EBITDA, in line with the previous cycle. Lowerthanexpected profitability on a sustained basis due to high fuel costs would be a derating catalyst. A 1% fall in realisation or 1mt lower sales volume would cut our TP by 2.9% and 2.4%, respectively. Our target price of Rs257 translates to EV/t of c.us$185 (c.5% above the mean of 10 years) and has upside potential of 33%. Initiate with Add. Analyst(s) Saurabh PRASAD T (91) E saurabh.prasad@cimb.com Satish KUMAR, PGDM T (91) E satish.kumar@cimb.com Financial Summary Dec14A Dec15A Dec16F Dec17F Dec18F Revenue (Rsm) 99,107 93,683 93, , ,446 Operating EBITDA (Rsm) 19,284 15,315 17,536 22,410 28,721 Net Profit (Rsm) 14,964 8,076 10,806 14,340 18,969 Core EPS (Rs) Core EPS Growth 17.5% (46.0%) 17.0% 17.9% 32.3% FD Core P/E (x) DPS (Rs) Dividend Yield 2.58% 1.45% 1.50% 1.99% 2.64% EV/EBITDA (x) P/FCFE (x) NA Net Gearing (44.5%) (47.9%) (21.5%) (27.5%) (34.2%) P/BV (x) ROE 15.3% 7.9% 10.2% 13.0% 16.2% % Change In Core EPS Estimates CIMB/consensus EPS (x) SOURCE: COMPANY DATA, CIMB FORECASTS IMPORTANT DISCLOSURES, INCLUDING ANY REQUIRED RESEARCH CERTIFICATIONS, ARE PROVIDED AT THE END OF THIS REPORT. IF THIS REPORT IS DISTRIBUTED IN THE UNITED STATES IT IS DISTRIBUTED BY CIMB SECURITIES (USA), INC. AND IS CONSIDERED THIRDPARTY AFFILIATED RESEARCH. Powered by the EFA Platform

56 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Cement India Ambuja Cements November 23, 2016 Figure 1: Key Assumptions Geographically well placed Investment summary We initiate coverage on ACEM with an Add rating and target price of Rs257, implying upside potential of c33% from the current level. Our investment thesis is based on a structural recovery in India s cement demand and rising profitability due to cost control initiatives. However, a thin capacity expansion pipeline might constrain the company s ability for volume growth after 23 years. Cement demand cycle to recover gradually: India s cement demand grew at a suboptimal c.4.0% during 16 (year ending March), much lower than longterm demand growth of 78%. However, we believe the industry has entered a gradual recovery phase and expect demand growth of 7.2%/8.0% in FY18/19F. Concurrently, capacity addition CAGR, which was 10.3% during the past 10 years, is likely to come down to 2.7% CAGR during 19F. This would improve capacity utilisation from 6667% in to c.74% in FY19F. ACEM would likely capitalise on this structural recovery, in our view. CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Cement ASP (Rs/t) 3,677 3,591 4,014 4,445 4,249 4,522 4,324 4,324 4,583 4,858 % increase 5 (2) (4) 6 (4) Capacity (mt) Sales (mt) % increase (2) 2 (0) Capacity utilization (%) Freight cost per ton ,062 1,123 1,132 1,167 1,167 1,202 1,238 % increase Power & fuel cost per ton , , % increase (10) 7 (8) (7) 5 5 Core EBITDA/t (Rs/t) , ,091 % increase (6) (8) 5 22 (40) 15 (18) Geographically well placed: Ambuja Cement is geographically well spread. About 70% of its capacity is concentrated in the high cement consuming regions of the north and west of the country, and another 25% is in the high growth potential eastern region. The company has no exposure to the southern region where utilisation is at sub60% levels now. Figure 2: Operations concentrated in North and West 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Western Northern Eastern Central 56

57 % CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Cement India Ambuja Cements November 23, 2016 Cost control initiatives would improve profitability: One of the reasons behind the better profitability of Ambuja Cements over ACC is that Ambuja has modern plants. More than 80% of its nameplate capacity has constructed since However, high commodity prices and regulatory actions drove operating expenses higher by c.7% CAGR during CY0715. Nevertheless, multiple cost control initiatives such as 1) dynamically changing fuel mix, 2) waste heat recovery, and 3) logistics optimisation should mean that operating expenses would rise at only a CAGR of 2.9% in CY1518F, in our view. Additionally, the ongoing restructuring between ACC and Ambuja has the potential of generating synergy benefits of c.us$130m150m over the next 34 years split almost equally between the two companies. We have not built the synergy benefits into our estimates. Strong balance sheet: ACEM has a deleveraged balance sheet with net cash of c.rs49bn (endcy15). The company is not embarking on any new expansion plans and will only undergo maintenance capex, in our estimation. We expect the company to incur capex of Rs4bn in each of the next three years. This would result in free cash flow generation of c.rs45bn over the next three years ending CY18F. Thus, despite Rs35bn outflow for the stake in Holcim India, net debttoequity would still be a healthy 0.34x in CY18F, in our view. Margin expansion: Apart from power and fuel costs, we expect other costs to rise moderately. With high capacity utilisation in the north and west, we expect cement prices to increase slightly ahead of inflation. Realisation increases of c.6% in CY17/18F would be greater than cost increases, raising profitability. We expect EBITDA/t to increase from Rs712 in CY15 to crs1,140 in CY18F. Figure 3: Recovering from the lows of past 5 years (10) (20) (30) (40) (50) (60) EBITDA growth PAT growth Initiate coverage with Add: We value the company at 12.5x CY18F EV/EBITDA, in line with the multiple from the previous recovery cycle, to arrive at our 12month target price of Rs257. This translates to a standalone EV/t of US$185 (5% above the mean of last 10 years). On asset based valuation, it is at 10% discount to UltraTech and 15% discount to Shree Cement primarily due to lower profitability compared to them. It is at c35% premium to ACC. That is justified given better profitability and favourable locational advantage. At the current stock price, our TP implies an upside potential of c33%. Initiate with Add. 57

58 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Cement India Ambuja Cements November 23, 2016 Figure 4: EV/EBITDA method based valuation EV/EBITDA based valuation EBITDA (CY18F) Rs m 28,721 Multiple x 12.5 EV (CY17F) Rs m 359,009 Net debt (CY17F) Rs m (31,226) Market capitalization (CY17F) Rs m 390,235 ACC market cap at our price target (CY17F) Rs m 300,374 ACEM's share in ACC % 50 ACEM's share in ACC market cap Rs m 120,174 Ambuja's consolidated market cap (CY17F) Rs m 510,409 Per share value (CY17F) Rs 257 Enjoys healthy profitability Of the two Holcim group companies in India, Ambuja Cements has better profitability and compares well with the peer group, in our view. The betterthanaverage profitability is due to 1) strong brand equity, 2) cost efficiency, and 3) operations in traditionally high growth regions. Modern plants, better grade limestone mines, along with the early adoption of logistics efficiency (seabased freight along western coast), have helped the company to deliver better returns. Although weakness in the broader economy affected its profitability during the past 34 years, we expect recovery in the next 23 years. Geographical advantage to help in ASP and volume growth Ambuja Cement is geographically well spread. About 70% of its capacity is concentrated in the high cement consuming regions of the north and west of the country, and another 25% is in the high growth potential eastern region. The company has no exposure to the southern region where utilisation is at sub 60% levels now. Figure 5: Operations concentrated in North and West 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Western Northern Eastern Central Northern and western exposure provides pricing flexibility due to high utilisation Both northern and western regions are high cement consuming regions and we believe are likely to operate at more than 80% utilisation in the next two years. This would provide companies located in those regions with some pricing flexibility. 58

59 CY06 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F % FY03 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F % Cement India Ambuja Cements November 23, 2016 Figure 6: Northern and western regions should have high sector capacity utilization North West South, CMA Realisation has underperformed the wholesale price index (WPI) for the past 3 4 years due to tepid demand growth. With the gradual recovery in the cement sector, we expect a reversal of this trend, with prices rising in line with inflation. Figure 7: Realisation (rebased) underperformed WPI for past 3 4 years Figure 8: Expected realisation growth in line with inflation (2) 80 (4) (6) Realization WPI inflation, DIPP Realization growth East is likely to experience better growth than other regions Additionally, the company is present in the high growth potential eastern region. As discussed in the sector note, the eastern region has a per capita cement consumption of 140kgs p.a. vs. India s average of 210kgs. We believe the growth potential of the region would help the company with shipment growth. We also expect a gradual recovery in the sector across regions. This would help Ambuja Cements achieve shipment growth of 6.8%/9.0% in CY17F/CY18F, based on our estimates. 59

60 FY03 FY04 FY05 CY06 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 mt CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F % Cement India Ambuja Cements November 23, 2016 Figure 9: Shipment growth aided by geographical spread and economic recovery (2) (4) Shipment growth Cost control helps profitability One of the reasons for the better profitability of Ambuja Cements over ACC is its modern plants. Ambuja Cements saw major capacity expansion in the past 15 years more than 80% of its nameplate capacity has been constructed since In contrast, only half of ACC s capacity has been built in the past 1213 years. Figure 10: Ambuja has more modern plants compared to ACC Ambuja incrased capacity at CAGR of 10% Vs ACC at 5% to reach comparable capacity now Ambuja capacity ACC capacity During the past 34 years, weak realisation growth coupled with higher expenses affected the profitability of the company. EBITDA/t was down 38% during CY1215 due to 1) rising commodity prices, 2) weak demand growth (lowering operating leverage), and 3) low realisation growth. 60

61 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Rs/t Rs/t Cement India Ambuja Cements November 23, 2016 Figure 11: EBITDA/t down sharply since CY12 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,300 1,200 1,100 1, EBITDA (RHS) Net sales realisation (LHS) Total Operating expenses (LHS) The figure above indicates operating expenses rising by c.7% CAGR during CY0715 whereas realisation increased at c.3% CAGR. As a result, profitability was down 40% since CY07. However, the company continues to invest in costcutting initiatives, including: Substitution of coal with pet coke: As discussed in the sector note, after the 90% increase in pet coke prices YTD, the cost advantage is no more. However, the company has developed the ability to switch to the most economical fuel mix and that would partially cushion the impact of rising fuel prices, in our view. Alternative fuels: The usage of alternative fuels rose 2% pts yoy in CY15 to 6% of total thermal energy consumption. Freight optimisation: Ambuja is the first Indian cement manufacturer to build a captive port with three terminals along the western coastline. Restructuring should provide longterm synergies LafargeHolcim concluded the ACCAmbuja restructuring in Aug After the restructuring, LafargeHolcim holds a 61.39% stake in Ambuja Cements and Ambuja Cements owns 50.01% of ACC. Additionally, LafargeHolcim would own 0.29% in ACC. The restructuring is shown in the figures below. Figure 12: Previous organisational structure Figure 13: Current structure 61.39% 40.79% 61.39% 0.29% 24.00% 50.01% 50.01% 9.76% Management expects total synergistic benefits of US$130m150m over the longterm. Primary benefits would come from clinker swaps and logistics. Lead distance reduction of 273/71kms would result in freight savings of Rs256/t and Rs156/t for ACC and Ambuja, respectively. 61

62 US$ m Cement India Ambuja Cements November 23, 2016 Figure 14: Potential synergy benefits from restructuring Logistics Clinker Swaps Procurment Fix Cost Reduction Shared Services Total Management expects an additional US$70m80m savings from procurement, fixed costs and shared services as follows: Procurement: US$45m50m from process standardisation, service cost reduction and vendor consolidation. Fixed cost reduction: Guidance of US$25m30m from achieving global benchmarks and reducing fixed costs by 56%. Shared services: Savings of up to US$1m from expanding IT model to combine transactional backend processes. We have not built in these synergy benefits into our forecasts. The transaction has just concluded and we would wait for some time for these synergy benefits to accrue to the company. Improving financials and strong balance sheet EBITDA and PAT CAGR of 23% and 33% during CY1518F During the past 45 years, the sector ASP growth has been lower than inflation. However, with the sector utilisation likely rising to c.74% in FY19F, we expect realisation to increase in line with inflation. Hence, we assume ASP increases of (0.0)/5.0/6.0% in CY16F/17F/18F. We also assume Ambuja s cost increase would be lower than the increase in realisation due to efficiency initiatives detailed in the previous section. 62

63 % CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16E CY17E CY18E CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Rs/t Rs/t Cement India Ambuja Cements November 23, 2016 Figure 15: Realisation and better cost control aid profitability 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,300 1,200 1,100 1, EBITDA (RHS) Net sales realisation (LHS) Total Operating expenses (LHS) The figure above shows cost increases at 5.0% CAGR during CY0915 which should go down to 3.0% CAGR during CY1618F, based on our estimates. The company is flexible in changing its fuel mix and should be able to mitigate rising pet coke costs. We expect realisation increases of c.5.0/6.0% in CY17F/18F to be higher than cost increases, raising profitability. We expect EBITDA and PAT CAGR of 23% and 33%, respectively, during CY1518F. Figure 16: Recovering from the lows of past 5 years (10) (20) (30) (40) (50) (60) EBITDA growth PAT growth Rising profitability would strengthen balance sheet further The rising profitability would result in healthy free cash flow and a strengthened balance sheet, in our view. There is no significant capex left for the company, according to management. We expect the company to incur capex of Rs4bn in each of the coming three years. This would result in free cash flow generation of c. Rs44bn over the next three years ending CY18F. ACEM would be investing Rs35bn to secure a 24% stake in Holcim India. This would affect the balance sheet negatively, in our opinion, with net gearing increasing from 0.48x in CY15 to 0.34x in CY18F. 63

64 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F % CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Rs m x CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Cement India Ambuja Cements November 23, 2016 Figure 17: Low capex would increase free cash flow Figure 18: Net debt adversely impacted by restructuring 25,000 20,000 15,000 10,000 (0.10) (0.20) 5,000 (5,000) (0.30) (0.40) (10,000) (15,000) (20,000) (0.50) (0.60) Cash Flow from operations Capex Free cash flow Net Debt / Equity Return ratios unlikely to trace previous cycle Since CY10, ACEM has not invested adequately in capacity creation, neither organically nor inorganically. During the five years ending CY16F, ACEM invested c.rs35bn in capex, similar to ACC. However, the business is still better positioned financially as: FCF was c.rs43bn compared to c.rs23bn for ACC and hence capital employed increased by c.38% vs. 8% for ACC over the period. The higher profitability and consequently superior cash generation keeps the company in better financial health. Given that ACEM s plants are more modern, the need for modernisation capex is significantly less than for ACC. The rise in capital employed and absence of a commensurate increase in profitability and volume growth results in lower return ratios relative to the prior recovery cycle. Figure 19: Return ratios rising but unlikely to trace previous cycle RoE RoCE Working capital facing little pressure Working capital was squeezed somewhat during the past 56 years due to the weak external environment. Creditor days declined from 56 in CY10 to 26 in CY15, whereas debtor days increased from 6 to 11. This indicates that the bargaining power of the company with both buyers and suppliers reduced during the period, in our view. However, with the gradual recovery underway, we do not expect the working capital situation to deteriorate further. The cement 64

65 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F % Rs CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Cement India Ambuja Cements November 23, 2016 sector operates mostly on low working capital, and barring some of the smaller companies in the south, we do not believe it is much of a problem for major cement companies. Figure 20: Working capital to remain stable due to gradual recovery in the sector Creditor days Debtor days Inventory days Expect strong dividend payout to stay intact ACCM s net cash as of CY15 was at Rs49bn. With c.rs44bn in free cash flow over the next three years, we expect the strong dividend payout ratio to remain at c.53%. Over the past two years, the company has consistently paid dividends at c.50% of net profit. Figure 21: Dividend payout likely to remain at 53% Figure 22: Book value per share should fall in CY16F due to increase in shares Dividend payout Book Value per Share Our DuPont Analysis is shown in the figure below. It suggests that the profitability should be the main driver of ROE in the next 23 years. ROE has fallen steadily from CY0915 and is likely to inch up going forward, in our view. Given that we expect cement demand growth of 810% during the next two years, the asset turnover should increase, positively affecting ROE. We do not see the leverage situation affecting ROE materially. 65

66 Cement India Ambuja Cements November 23, 2016 Figure 23: Profitability ably assisted by asset turnover Dupont analysis CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16F CY17F CY18F Profitability (%) Asset turnover (x) Financial leverage (x) RoE (%) Recent correction an opportunity; Initiate with Add We value ACEM on a oneyear forward EV/EBITDA multiple. We believe this is a suitable method in the current scenario as: The sector is entering a gradual recovery phase. There should not be significant volatility in its earnings profile, in our view. We believe earnings volatility is a major weakness of this approach while valuing cement companies. We believe there is ambiguity on replacement cost and it differs widely in the industry. Hence, applying a premium/discount to the replacement cost based on return ratio may not be the right strategy. Nevertheless, we have used EV/tonne as a secondary check on our valuation. We have not used the DCF method in our valuation. In a cyclical commodity such as cement, forecasting longterm cash flow in a growth market such as India is fraught with far greater uncertainty than a stable business, in our opinion. Nevertheless, the DCF method provides us with a sense of broader assumptions that the current price and our target price are building in. Previous cycle multiples used for valuation ACC and Ambuja were the two major players during the past recovery cycle and we believe the valuations then can be compared to the current cycle. Comparing them, we note that During the current cycle, the return profile should be much weaker. Adjusted for inflation, the profitability in this cycle would be significantly lower than the previous cycle. Earningsbased valuation takes into account lower profitability of the companies and value the companies on their existing earnings profiles. The growth expectations are similar to that of the previous cycle. The industry experienced highsingledigit growth back then and during the current cycle too, we expect 8% growth in FY19F (YE march), and increasing thereafter. Thus, the multiple should be comparable to the previous cycle. We expect balance sheet and free cash flow generation to be in line with the previous cycle. However, the previous cycle was the start of aggressive capital investment and capacity creation in the economy whereas this cycle should see more prudent capital spending, in our view. We analysed both the earnings and assetbased multiples during the past cycle. During the previous cycle, the company reached a valuation range of x 1year forward EBITDA. Asset based valuation reached highs of c.us$300/t. 66

67 USD/t Cement India Ambuja Cements November 23, 2016 Figure 24: EV/EBITDA multiple is close to mean Figure 25: Asset based value has fallen below mean level Jan06 Jan08 Jan10 Jan12 Jan14 Jan16 EV/EBITDA (x) Mean +1 sd 1 sd, BLOOMBERG 50 0 Jan06 Jan08 Jan10 Jan12 Jan14 Jan16, BLOOMBERG We value ACEM at 12.5x CY18F EV/EBITDA multiple and arrive at a TP of Rs257. Figure 26: EV/EBITDA method based EV/EBITDA based valuation EBITDA (CY18F) Rs m 28,721 Multiple x 12.5 EV (CY17F) Rs m 359,009 Net debt (CY17F) Rs m (31,226) Market capitalization (CY17F) Rs m 390,235 ACC market cap at our price target (CY17F) Rs m 300,374 ACEM's share in ACC % 50 ACEM's share in ACC market cap Rs m 120,174 Ambuja's consolidated market cap (CY17F) Rs m 510,409 Per share value (CY17F) Rs 257 At our targeted multiple, our 12month price target is Rs257 which translates into a standalone EV/t of US$185 (c.5% above the mean of last 10 years). On asset based valuation, it is at 10% discount to UltraTech and 15% discount to Shree Cement primarily due to lower profitability compared to them. It is at c35% premium to ACC. That is justified given better profitability and favourable locational advantage. At the current stock price, our TP implies an upside potential of 30%. Initiate with Add. Our secondary check with DCF analysis indicates a fair value of Rs237/sh and the underlying assumptions are: 6) Volume growth rate in the explicit period at 8% 7) EBITDA/t growth rate in the explicit period at 5% 8) Tax rate of 30% 9) WACC of 13.5% 10) Terminal growth rate of 5% 67

68 Cement India Ambuja Cements November 23, 2016 Figure 27: DCF valuation CY17F CY18F CY19F CY20F CY21F CY22F CY23F CY24F Sales Rs m 106, , , , , , , ,306 ASP Rs/t 4,583 4,858 4,858 4,858 4,858 4,858 4,858 4,858 EBITDA Rs m 22,410 28,721 32,569 36,934 41,883 47,495 53,859 61,076 Sales (mt) mt EBITDA/t Rs 969 1,140 1,197 1,256 1,319 1,385 1,454 1,527 EBITDA margin % 21% 23% 25% 26% 27% 29% 30% 31% Taxes Rs m (5,714) (7,558) (7,666) (8,975) (10,460) (12,144) (14,053) (16,218) Capex Rs m (4,000) (4,000) (4,320) (4,666) (5,039) (5,442) (5,877) (6,347) Change in working capital Rs m (130) (187) (202) (218) (235) (254) (274) (296) Free cash flow Rs m 13,559 18,141 20,382 23,075 26,149 29,655 33,655 38,215 Years for discounting Discount rate x DCF valuation (Rs m) NPV of explicit period 124,138 NPV of terminal value 194,549 Total Value 318,686 Net debt (31,226) Equity value 349,913 ACC market cap at our price target (CY17F) 300,374 ACEM's share in ACC 50% ACEM's share in ACC market cap 120,174 Ambuja's consolidated market cap (CY17F) 470,086 Per share value (Rs) 237 Our price target builds in a terminal growth rate of slightly above 6% which is possible, in our view, given the longterm volume growth rate of 78% in India. Risks to our Add rating Key risks to our Add rating include 1) increased competition putting pressure on prices, 2) lowerthanexpected cement demand growth, 3) risk of penalty from the Competition Commission of India (CCI), and 4) increase in commodity prices. Volume and realisation sensitivity: The cement industry is highly fragmented and we see risk of volume push from marginal players at any given time. This lowers the average realisation for all cement players. Additionally, lowerthanexpected volume growth can negatively impact both EBITDA and EPS. A 1% decrease in realisation and 1mt decrease in sales volume can reduce CY18F EBITDA by 4.1% and 3.4%, respectively, lowering our target price by 2.9% and 2.4%. Increase in fuel prices: YTD pet coke prices have increased by c.90%. Seaborne coal prices have also increased by 4050% in the past 34 months. Volatility in fuel prices is a key risk to our estimates. A 10% increase in fuel prices would lower CY18F EBITDA and target price by 6.1% and 4.4%, respectively. Risk of penalty from CCI: In its order dated 31 Aug 2016, the CCI reaffirmed a penalty of Rs11.6bn on the company, which is c.40% of CY18F EBITDA. Although it is a onetime charge, it has the potential of affecting realisation negatively in the next 23 years, in our view. 68

69 Cement India Ambuja Cements November 23, 2016 BY THE NUMBERS P/BV vs ROE Jan12A Jan13A Jan14A Jan15A Jan16F Jan17F 20.0% 17.7% 15.3% 13.0% 10.7% 8.3% 6.0% 12mth Fwd FD Core P/E vs FD Core EPS 57.0 Growth Jan12A Jan13A Jan14A Jan15A Jan16F Jan17F 40% 29% 18% 7% 4% 16% 27% 38% 49% 60% Rolling P/BV (x) (lhs) ROE (rhs) 12mth Fwd Rolling FD Core P/E (x) (lhs) FD Core EPS Growth (rhs) Profit & Loss (Rsm) Dec14A Dec15A Dec16F Dec17F Dec18F Total Net Revenues 99,781 94,614 94, , ,672 Gross Profit 91,354 86,388 87,065 98, ,403 Operating EBITDA 19,284 15,315 17,536 22,410 28,721 Depreciation And Amortisation (5,095) (6,257) (6,543) (6,789) (7,016) Operating EBIT 14,189 9,058 10,993 15,621 21,705 Financial Income/(Expense) 1,667 1,072 1,419 1,733 2,123 Pretax Income/(Loss) from Assoc NonOperating Income/(Expense) 1,978 1,592 2,700 2,700 2,700 Profit Before Tax (preei) 17,834 11,722 15,112 20,054 26,527 Exceptional Items Pretax Profit 17,834 11,722 15,112 20,054 26,527 Taxation (2,871) (3,647) (4,306) (5,714) (7,558) Exceptional Income posttax Profit After Tax 14,964 8,076 10,806 14,340 18,969 Minority Interests Preferred Dividends FX Gain/(Loss) post tax Other Adjustments posttax Net Profit 14,964 8,076 10,806 14,340 18,969 Recurring Net Profit 14,964 8,076 10,806 14,340 18,969 Fully Diluted Recurring Net Profit 14,964 8,076 10,806 14,340 18,969 Cash Flow (Rsm) Dec14A Dec15A Dec16F Dec17F Dec18F EBITDA 19,284 15,315 17,536 22,410 28,721 Cash Flow from Invt. & Assoc. Change In Working Capital ,392 (130) (187) (Incr)/Decr in Total Provisions Other NonCash (Income)/Expense (1,172) (1,185) Other Operating Cashflow 1,382 1,592 1,200 1,200 1,200 Net Interest (Paid)/Received 1,612 2,246 2,919 3,233 3,623 Tax Paid (2,889) (422) (4,306) (5,714) (7,558) Cashflow From Operations 18,365 17,775 18,741 21,000 25,798 Capex (8,234) (6,214) (4,000) (4,000) (4,000) Disposals Of FAs/subsidiaries Acq. Of Subsidiaries/investments 735 2,704 (35,000) 0 0 Other Investing Cashflow Cash Flow From Investing (6,531) (3,465) (39,000) (4,000) (4,000) Debt Raised/(repaid) (113) Proceeds From Issue Of Shares Shares Repurchased Dividends Paid (7,225) (8,941) (6,760) (8,971) (11,867) Preferred Dividends Other Financing Cashflow Cash Flow From Financing (6,853) (8,580) (5,892) (8,971) (11,867) Total Cash Generated 4,980 5,730 (26,151) 8,029 9,931 Free Cashflow To Equity 11,720 14,346 (20,259) 17,000 21,798 Free Cashflow To Firm 12,152 14,699 (19,341) 17,918 22,716 SOURCE: CIMB RESEARCH, COMPANY DATA 69

70 Cement India Ambuja Cements November 23, 2016 BY THE NUMBERS cont d Balance Sheet (Rsm) Dec14A Dec15A Dec16F Dec17F Dec18F Total Cash And Equivalents 45,251 49,676 23,525 31,554 41,485 Total Debtors 2,280 2,864 2,861 3,240 3,743 Inventories 8,884 8,955 8,946 10,132 11,704 Total Other Current Assets 3,537 3,992 3,359 3,805 4,395 Total Current Assets 59,952 65,486 38,691 48,730 61,326 Fixed Assets 69,173 65,062 62,519 59,729 56,713 Total Investments 1,057 1,069 36,069 36,069 36,069 Intangible Assets Total Other NonCurrent Assets 8,826 10,003 10,003 10,003 10,003 Total Noncurrent Assets 79,056 76, , , ,785 Shortterm Debt Current Portion of LongTerm Debt Total Creditors 6,185 6,798 6,792 7,692 8,885 Other Current Liabilities 13,428 14,519 14,519 14,519 14,519 Total Current Liabilities 19,613 21,317 21,310 22,211 23,404 Total Longterm Debt Hybrid Debt Debt Component Total Other NonCurrent Liabilities Total Noncurrent Liabilities Total Provisions 17,653 16,492 17,247 18,228 19,513 Total Liabilities 37,975 38,551 39,299 41,180 43,658 Shareholders' Equity 101, , , , ,453 Minority Interests Total Equity 101, , , , ,453 Key Ratios Dec14A Dec15A Dec16F Dec17F Dec18F Revenue Growth 9.1% (5.5%) (0.1%) 13.3% 15.5% Operating EBITDA Growth 16.8% (20.6%) 14.5% 27.8% 28.2% Operating EBITDA Margin 19.5% 16.3% 18.7% 21.1% 23.5% Net Cash Per Share (Rs) BVPS (Rs) Gross Interest Cover Effective Tax Rate 16.1% 31.1% 28.5% 28.5% 28.5% Net Dividend Payout Ratio 51.5% 53.5% 53.5% 53.5% 53.5% Accounts Receivables Days Inventory Days Accounts Payables Days ROIC (%) 20.0% 12.4% 15.8% 23.5% 33.5% ROCE (%) 16.4% 10.2% 13.3% 17.0% 21.4% Return On Average Assets 9.9% 5.0% 6.5% 8.4% 10.6% Key Drivers Dec14A Dec15A Dec16F Dec17F Dec18F Domestic ASP (% Change) 6.4% 4.4% 0.0% 6.0% 6.0% Domestic Vol. Sales Growth (%) 2.4% 0.2% 0.7% 6.8% 9.0% Export ASP (% Change) N/A N/A N/A N/A N/A Export Vol. Sales Growth (%) N/A N/A N/A N/A N/A Utilisation Rate (%) 74.5% 72.6% 73.0% 78.0% 85.0% Unit Raw Material ASP (% Change) N/A N/A N/A N/A N/A Export Sales/total Sales (%) N/A N/A N/A N/A N/A SOURCE: CIMB RESEARCH, COMPANY DATA 70

71 Vol th Cement India Equity research November 23, 2016 Company Note India REDUCE Consensus ratings*: Buy 17 Hold 10 Sell 8 Current price: Rs14,395 Target price: Rs12,430 Up/downside: 13.6% CIMB / Consensus: 27.3% Reuters: Bloomberg: Market cap: Average daily turnover: SHCM.NS SRCM IN US$7,357m Rs501,477m US$3.70m Rs247.9m Current shares o/s: 34.84m Free float: 35.2% *Source: Bloomberg Key changes in this note N/A 18,600 16,600 14,600 12,600 10,600 8, Price Close Relative to SENSEX (RHS) Nov15 Feb16 May16 Aug16 Source: Bloomberg Price performance 1M 3M 12M Absolute (%) Relative (%) Major shareholders % held Bangur family 64.8 FLT Ltd Shree Cement Positives abound, but more than priced in SRCM is the most aggressive cement player, in our view, having tripled its capacity in 19F. It is the market leader in north and has become a major player in east. Rising seaborne coal and pet coke prices would put pressure on profitability. Nevertheless, it is well placed to benefit from the ongoing recovery in the sector. Despite aggressive expansion, it is likely to have net cash positions in FY1719F. Positives more than reflected in the stock price. Initiate with Reduce. Profitable and aggressive growth SRCM is the most aggressive player in terms of organic capacity addition, having almost tripled its capacity since. By FY19F, it should have 21% market share in the north, c.10% in the east and presence in both central and the south. North and west regions are likely to have > 80% utilisation in FY18F. Given it is a market leader in the north, it would have pricing flexibility, and also benefit from the growth potential of the east, in our view. We expect 6% realisation growth and 13%/10% volume growth in FY18/19F. Cost leadership in the sector SRCM is one of the most profitable cement companies in the country due to: 1) its modern plants (90% of capacity was built in past 12 years) and 2) investments in cost optimisation. The company is an early adopter and pioneer of pet coke usage in cement plants. It has also invested in waste heat recovery plants and synthetic gypsum to keep its costs low. Its costs/t registered a CAGR of only 1.9% during 16. Rising fuel prices could be a nearterm spoiler However, pet coke prices have increased c.90% YTD and imported coal prices have increased by 4050% during the past 34 months. The company does not have easy access to domestic coal and we believe it will likely be affected by high fuel prices. It keeps an inventory of 34 months and thus the full impact of high prices should be felt in 3Q4QFY17F. Strong balance sheet despite aggressive expansion During the past 45 years, the sector ASP growth was lower than inflation. However, with north/west utilisation projected to rise to >80% in FY18F, we expect pricing flexibility to increase. We assume an ASP increase of 9.0/6.0/6.0% in FY17/18/19F, driving EBITDA/PAT CAGR of 25%/45%, respectively, in 19F. Despite the ongoing capex, we expect FCF of c.rs41bn over the next three years., keeping a healthy balance sheet, with net debttoequity likely falling from 0.1x in to 0.38x in FY19F. Positives more than reflected in the price; Initiate with Reduce We value the company at 12.5x FY19F EV/EBITDA, in line with the multiples of major players during the previous cycle. Sustained earnings outperformance would be the key rerating catalyst. Upside risk to our TP comes from better pricing power and consequently higher profitability. A 1% increase in ASP would raise our TP by c.3%. Our target price of Rs12,430 translates to EV/t of US$220 (c.20% above the mean of past 10 years) and reflects downside potential of c14%. Analyst(s) Saurabh PRASAD T (91) E saurabh.prasad@cimb.com Satish KUMAR, PGDM T (91) E satish.kumar@cimb.com Financial Summary Jun15A Mar16A Mar17F Mar18F Mar19F Revenue (Rsm) 64,536 55,678 87, , ,442 Operating EBITDA (Rsm) 13,438 13,203 22,983 27,112 34,150 Net Profit (Rsm) 4,263 4,549 11,202 13,753 18,763 Core EPS (Rs) Core EPS Growth (47%) (1%) 145% 23% 36% FD Core P/E (x) DPS (Rs) Dividend Yield 0.167% 0.167% 0.167% 0.167% 0.167% EV/EBITDA (x) P/FCFE (x) NA NA Net Gearing 8.3% 8.1% (7.5%) (22.5%) (38.1%) P/BV (x) ROE 9.2% 8.0% 16.7% 17.5% 20.0% % Change In Core EPS Estimates CIMB/consensus EPS (x) SOURCE: COMPANY DATA, CIMB FORECASTS IMPORTANT DISCLOSURES, INCLUDING ANY REQUIRED RESEARCH CERTIFICATIONS, ARE PROVIDED AT THE END OF THIS REPORT. IF THIS REPORT IS DISTRIBUTED IN THE UNITED STATES IT IS DISTRIBUTED BY CIMB SECURITIES (USA), INC. AND IS CONSIDERED THIRDPARTY AFFILIATED RESEARCH. Powered by the EFA Platform

72 FY07 FY08 FY17F FY18F FY19F FY07 FY08 FY17F FY18F FY19F Capacity distribution (%) % Cement India Shree Cement November 23, 2016 Figure 1: Key Assumptions, FY18F Positives abound, but more than priced in Investment summary We initiate coverage on SRCM with a Reduce rating and a target price of Rs12,430, implying downside potential of 14% from the current level. Although we believe the company is well placed to benefit from the ongoing structural recovery in the Indian cement sector, the positives look more than priced in, in our view. Additionally, we expect sharp fuel price increases to be major headwinds over the next 12 years. Cement demand cycle to recover gradually: India s cement demand grew at a suboptimal c.4.0% during 16, much lower than the longterm demand growth of 78%. However, we believe the industry has entered a gradual recovery phase and expect demand growth of 7.2%/8.0% in FY18/19F. Concurrently, capacity addition CAGR, which was 10.3% during the past 10 years, is likely to come down to 2.7% during 19F. This would improve capacity utilisation from 6667% in to c.74% in FY19F. SRCM would likely capitalise on this structural recovery, in our view. FY17F FY18F FY19F Cement ASP (Rs/t) 3,457 3,233 3,636 3,666 3,698 3,583 3,503 3,818 4,047 4,290 % change 8 (6) (3) (2) Cement capacity (mt) Cement sales (mt) % change (10) Capacity utilization (%) Power sales (MU) ,322 2,610 1,860 1,804 1,550 1,878 1,671 1,671 Freight cost per ton % Increase (7) EBITDA/t (Rs/t) Cement only 1, ,007 1,084 1,255 Transforming from regional to national player: SRCM is arguably the most aggressive cement player in terms of organic capacity addition. Since, it has almost tripled its capacity. Despite the aggressive capacity addition by the industry, we expect the company s market share in the northern region to rise to c.21% in FY19F from c.19% in, maintaining its leadership position in the region. Besides, it is likely to become a major player with 8.2 mtpa capacity (c.10% market share) in the eastern region and have a presence in both central (2 mtpa capacity) and southern (4 mtpa capacity) regions by FY19F. Figure 2: SRCM expanding across regions Figure 3: but not ceding market share in the North North East Central South Market share North Market share Central Market share East Market share South 72

73 Jan16 Feb16 Mar16 Apr16 May16 Jun16 Jul16 Aug16 Sep16 Oct16 Nov14 Dec14 Jan15 Feb15 Mar15 Apr15 May15 Jun15 Jul15 Aug15 Sep15 Oct15 Nov15 Dec15 Jan16 Feb16 Mar16 Apr16 May16 Jun16 Jul16 Aug16 Sep16 Oct16 Nov16 Rs/t USD/t Cement India Shree Cement November 23, 2016 Rising fuel prices could be a nearterm spoiler: During the past 34 months, both pet coke and seaborne coal prices have increased sharply. Imported coal prices have increased by c.30% and domestic pet coke prices have also witnessed sharp upward revisions. In Oct, domestic pet coke prices were at Rs6,550/t, up c.87% YTD. The import offer from Saudi Arabia (9% sulphur) was at US$86/t CFR India and from the US (6% sulphur) was at US$90/t CFR India. Figure 4: Pet coke prices have moved up sharply YTD Figure 5: Seaborne coal prices have increased sharply 7,000 6,500 6,000 5, ,000 4,500 4, ,500 3,000 2,500 2, Pet coke prices 6000 kcal CNF India SOURCES: Steelmint SOURCES: SteelMint Balance sheet to remain strong despite continuing capex: Rising profitability would result in healthy free cash flow and strengthened balance sheet. We expect the company to have a capex of Rs10bn in each of the coming 23 years to provide for the ongoing projects. Despite that, we estimate SRCM would generate free cash flow of c.rs41bn over the next three years. This would improve its balance sheet, with net debt likely falling from 0.1x in to 0.38x in FY19F. Initiate with Reduce: We value the company at 12.5x FY19F EV/EBITDA multiple, in line with the multiples of major players during the previous cycle. We did not use SRCM s multiple during that cycle as it has grown significantly larger with presence across all regions. We used assetbased method as a secondary check to our target price as there is ambiguity in replacement costs, and hence applying a premium/discount to the replacement cost based on the return ratio may not be the right strategy. Our target price of Rs12,430/sh translates into EV/t of US$220 (c.20% above the mean of past 10 years) and has downside potential of 12%. In comparison ACC/UltraTech/Ambuja should trade at cus$ 135/185/205 per tonne based on our target prices. SRCM should trade at a better asset based value, in our view, due to its ability for faster project execution and higher asset utilisation. Initiate with Reduce. Figure 6: EV/EBITDA based valuation EV/EBITDA based valuation EBITDA (FY19F) Rs m 34,150 Multiple (x) x 12.5 EV (FY18F) Rs m 426,874 Net debt (FY18F) Rs m (19,036) Cement equity value (FY18F Rs m 445,910 Fair Value Rs 12, year forward price target Rs 12,430 73

74 FY07 FY08 FY17F FY18F FY19F FY07 FY08 FY17F FY18F FY19F Capacity distribution (%) % Cement India Shree Cement November 23, 2016 Profitable growth; petcoke could be nearterm spoiler Transforming from regional to national player Shree Cement is arguably the most aggressive cement player in terms of organic capacity addition. Since, it has almost tripled its capacity. Despite the aggressive capacity addition by the industry, we expect the company s market share in the northern region to rise to c.21% in FY19F from c.19% in, maintaining its leadership position in the region. Besides, it is likely to become a major player with 8.2 mtpa capacity (c.10% market share) in the eastern region and have a presence in both central (2 mtpa capacity) and southern (4 mtpa capacity) regions by FY19F. Figure 7: SRCM expanding across regions Figure 8: but not ceding market share in the North North East Central South Market share North Market share Central Market share East Market share South We believe this is a prudent strategy for both realisation and volume growth. Maintaining market share in the north: A presence in the north would help the company to serve both northern and western regions. Both these regions have traditionally been high cement consuming regions and are likely to have high utilisation rates, in our view. A leadership position in a high utilisation region would allow the company some pricing flexibility. Consolidating presence in the east: As discussed in the sector note, both east and central regions have low cement per capita consumption of 140kg and 150kg, respectively, vs. India s average consumption of 210kg. Hence, these regions have better growth potential relative to other regions, in our view. Suitable plant location to have access to west: The southern Indian region has not been attractive for the past 45 years and we believe it is unlikely to operate at high capacity utilization rates. However, SRCM s proposed plant location is near the Maharashtra border and we think it is likely to benefit from the demand growth in the state. Geographical advantage in both volume and ASP growth As discussed in the sector note, many of the large infrastructure projects such as the Western Dedicated Freight Corridor, Delhi Mumbai Industrial Corridor, bullet trains etc. are being constructed in the northern and western regions. We believe SRCM is likely to experience significantly better shipment growth than India s overall demand growth, aided by its newly commissioned capacity and a strong pipeline of new capacity projects. 74

75 FY07 FY08 FY07 FY08 FY17F FY18F FY19F % % FY07 FY08 FY17F FY18F FY19F FY07 FY08 FY17F FY18F FY19F % % % Cement India Shree Cement November 23, 2016 Figure 9: North and west operate at high utilisation rates Figure 10: Shipment growth has historically been above India's demand growth North West India SRCM capacity utilization (RHS) SRCM shipment growth (LHS) India demand growth (LHS) SOURCES: CIMB, CMA, DIPP Over the past 45 years, the North has been operating at sub80% capacity utilisation rates due to aggressive capacity additions. As such, SRCM s realisation growth trailed the broader Wholesale Price Index (WPI). However, with the utilisation rising to a level above 90% in FY19F, we expect SRCM to have betterthaninflation realisation growth next 23 years. Figure 11: Realisation trailed wholesale inflation Figure 12: Weak realisation growth in past four years (5) (10) Realization growth Wholesale Inflation, DIPP Net realization growth One of the most costefficient players, but pet coke could be a spoiler SRCM is one of the most profitable companies in the country due to: 1) its modern plants and 2) investments in cost optimisation. Around 90% of its capacity was built in the past 12 years, resulting in modern and costefficient plants. Most modern plants among peers During FY0519F, SRCM is likely to add capacity equivalent to the capacity added by ACC and Ambuja combined. This is despite SRCM being much smaller than ACC and Ambuja in FY05, and reflects the fast project execution capability of the company. 75

76 FY07 FY08 Rs/t Rs/t FY05 FY06 FY07 FY08 FY17F FY18F FY19F mt Cement India Shree Cement November 23, 2016 Figure 13: SRCM likely to surpass ACC/Ambuja in FY19F SRCM likely to increase capacity by 13 timesduring FY0519E whereas ACC/Ambuja would do 1.8/2.2 times Ambuja capacity ACC capacity SRCM capacity SRCM invested heavily in cost control initiatives During the past 34 years, weak realisation growth affected the profitability of the company. The company has kept costs firmly in control. Costs recorded a CAGR of only 1.9% during 16 but realization declined at 0.6% CAGR during the same period. As a result, its EBITDA/t declined at a CAGR of 8.1%. Figure 14: Falling profitability despite strict cost controls 4,000 1,300 3,500 3,000 2,500 1,200 1,100 1, ,000 1, , EBITDA (RHS) ASP (LHS) Operating expense (LHS) The figure above shows operating expenses rising by c.2% CAGR during 16 whereas realisation fell by c.0.6% CAGR. As a result, the profitability is down 30% since. The company continues to invest in costcutting initiatives including: Substitution of coal with pet coke: As discussed in the sector note, after the 90% increase in pet coke prices YTD, the cost advantage has been lost. Moreover, there is little access to domestic coal and the company has to depend upon imported coal/pet coke. Hence, SRCM is likely to be impacted the most by the sharp increase in fuel prices, in our view. Nevertheless, the ability to switch fuels depending on prices gives the company the flexibility to choose the most economical fuel mix. Waste heat recovery: SRCM has 612MW of power generation capacity that includes 111MW of a waste heat recovery plant. The cost of power from the waste heat recovery plants is less than Rs0.5 per unit compared to c.rs2.5 from a thermal plant. Assuming 70% plant load factor, the capacity could result in benefits of Rs6070/t at a projected sales volume of 24mt (FY18F). Synthetic Gypsum: SRCM was the first Indian cement manufacturer to replace natural Gypsum with synthetic gypsum. 76

77 Jan16 Feb16 Mar16 Apr16 May16 Jun16 Jul16 Aug16 Sep16 Oct16 Nov14 Dec14 Jan15 Feb15 Mar15 Apr15 May15 Jun15 Jul15 Aug15 Sep15 Oct15 Nov15 Dec15 Jan16 Feb16 Mar16 Apr16 May16 Jun16 Jul16 Aug16 Sep16 Oct16 Nov16 Rs/t USD/t Cement India Shree Cement November 23, 2016 Pet coke could be a nearterm spoiler During the past 34 months, both pet coke and seaborne coal prices have increased sharply. Imported coal prices have increased by c.30% and domestic pet coke prices have also witnessed sharp upward revisions. In Oct, domestic pet coke prices were at Rs6,550/t, up c.87% YTD. The import offer from Saudi Arabia (9% sulphur) was at US$86/t CFR India and from the US (6% sulphur) was at US$90/t CFR India. Figure 15: Pet coke prices have moved up sharply YTD Figure 16: Seaborne coal prices have increased sharply 7,000 6,500 6,000 5, ,000 4,500 4,000 3,500 3,000 2, , Pet coke prices 6000 kcal CNF India SOURCES: Steelmint SOURCES: SteelMint Plants using pet coke have derived benefits from multiple sources: At times, pet coke is cheaper than imported coal on per kcal basis. Some plants are far from the coalfields but near the coast. For them using pet coke/imported coal is more convenient and costeffective logistically. Pet coke is more tax efficient. There is no green energy cess (Rs400/t on thermal coal). At current prices, pet coke is not the cheapest fuel available to the domestic producers (on landed cost basis). During the last 12 months, the attractiveness of pet coke has reduced significantly and there is incentive to switch back to thermal coal. However, SRCM does not have access to domestic coal and is dependent primarily on imported coal/petcoke. Prices of both these commodities have increased sharply in the past six months. The company keeps an inventory of 34 months and thus the full impact of the high prices would only be felt in 3Q4QFY17F, in our view. 77

78 FY07 FY08 FY17F FY18F FY19F Rs/t Rs/t Cement India Shree Cement November 23, 2016 Strong balance sheet despite aggressive expansion EBITDA and PAT CAGR of 25% and 45% during 19F During the past 45 years, the sector ASP growth has been lower than inflation. However, with utilisation projected to rise to c.74% in FY19F, we expect the sector realisation to increase in line with inflation. In addition, SRCM would be operating primarily in the northern and western regions, where capacity utilisation is higher than the rest of the country. This would provide the company with pricing flexibility. We assume an ASP increase of 9.0/6.0/6.0% in FY17F/18F/19F. Despite the rising fuel prices, we assume the cost increase would be lower than the increase in realisation due to the efficiency initiatives detailed in the previous section. Figure 17: EBITDA/t coming off the lows of past four years 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 1,300 1,200 1,100 1, EBITDA (RHS) ASP (LHS) Operating expenses (LHS) The figure above show that costs increased at 7.3% CAGR during FY0814 due to the rising commodity prices. From 17F, operating expenses have been stable on lower commodity prices and cost efficiency initiatives, in our view. We believe the rising pet coke and imported coal prices would materially start affecting the company in 2HFY17F and the full impact would be visible in FY18F. Despite the sharp rise in power and fuel costs per tonne, we expect the operating expense per tonne to increase at a 3.6% CAGR during FY1719F. The realization increase of c.6.0/6.0% in FY18/19F should be much better than the cost increase, raising profitability. We expect EBITDA and PAT CAGR of 25% and 45%, respectively, during 19F. 78

79 FY08 FY17F FY18F FY19F % Cement India Shree Cement November 23, 2016 Figure 18: PAT and EBITDA likely to report healthy growth (50) (100) EBITDA growth PAT growth Note: was 15 month period and was 9 month period 79

80 FY07 FY08 FY17F FY18F FY19F FY07 FY08 FY17F FY18F FY19F Rs m x Cement India Shree Cement November 23, 2016 Rising profitability would strengthen balance sheet further Rising profitability should result in healthy free cash flow and a strengthened balance sheet, in our view. We expect the company to have a capex of Rs10bn in each of the next 23 years to provide for the ongoing projects. This would result in free cash flow generation of c.rs41bn over the next three years ending FY19F. This should improve its balance sheet, with net debttoequity likely falling from 0.1x in to 0.38x in FY19F. Figure 19: Rising profitability and volumes to drive FCF growth Figure 20:...improving net debttoequity 35,000 30, , ,000 15,000 10,000 5, (5,000) (10,000) (0.2) (15,000) (0.4) (20,000) (0.6) Cash flow from operations Capex FCF Net Debt / Equity Despite impressive growth, return ratios unlikely to trace previous cycle SRCM continues to invest aggressively towards increasing its capacity. In addition, better profitability adds cash on the balance sheet, thereby increasing capital employed and equity. During FY0716, the capital employed increased at a CAGR of c.21% but EBIT increased at a CAGR of only 13%, resulting in lower return ratios. We believe the company will likely increase its capital employed by 47% during 19F (14% CAGR). SRCM has the most modern plants in the industry and hence the need for modernisation and maintenance capex is significantly lower than other companies, in our view. We believe any increase in the asset base would be almost entirely towards increasing capacity. Although we expect a sharp increase in profitability, we do not think the return ratios in the current cycle are likely to trace the previous cycle. 80

81 FY07 FY08 FY17F FY18F FY19F % Cement India Shree Cement November 23, 2016 Figure 21: Return ratios improving but unlikely to trace previous cycle RoE RoCE 81

82 FY08 FY17F FY18F FY19F FY08 FY17F FY18F FY19F Rs Rs FY08 FY17F FY18F FY19F Days Cement India Shree Cement November 23, 2016 Working capital easing a bit Working capital was squeezed somewhat during 14 due to the weak external environment. Creditor days declined from 46 in to 40 in, while debtor days increased from 11 to 18, and further to 27 in. This indicates that the bargaining power of the company with both buyers and suppliers reduced during that period, in our view. However, with the gradual recovery underway, we see some improvement in the company s bargaining power. Given the gradual recovery, we do not expect SRCM to face working capital issues. Figure 22: Working capital to remain stable Creditor days Debtor days Inventory days The cement sector operates mostly on negative working capital, and barring some of the smaller companies in the south, it is not much of a problem for major cement companies, in our view. Not meaningful dividend policy During the past few years the company has maintained payout at Rs2024/sh. However, this amounts to c.0.2% dividend yield at current prices and not very meaningful for the minority shareholders. SRCM has said it plans aggressive capacity expansion, and thus we do not expect a material increase in its dividend payout. Hence, the payout ratio which was 18% in is likely to go down to 4% in FY19F, in our view. Figure 23: Dividend stable at Rs2024/sh Figure 24: Book value rising at a fast pace ,500 3,000 2,500 2,000 1,500 1, DPS Book Value per Share Our DuPont Analysis is shown in Figure 26. It indicates that the profitability would be the main driver of ROE in the next 23 years. ROE has fallen steadily from CY0915 but we believe it is likely to inch up going forward. Given that we 82

83 Jan06 Jul07 Jan09 Jul10 Jan12 Jul13 Jan15 Jul16 Jan06 Jul07 Jan09 Jul10 Jan12 Jul13 Jan15 Jul16 x USD/t Cement India Shree Cement November 23, 2016 expect demand growth of 810% during the next two years, the asset turnover should increase, affecting ROE positively while cash accumulation would lower leverage affecting ROE negatively. Figure 25: DuPont Analysis ROE being pulled down by lowered financial leverage Dupont analysis FY08 FY17F FY18F FY19F Profitability (%) Asset turnover (x) Financial leverage (x) RoE (%) Valuation trumps fundamentals; Initiate with Reduce We value SRCM on a 1year forward EV/EBITDA multiple. We believe this is a suitable method in the current scenario as: The sector is entering a gradual recovery phase, and there should not be significant volatility in earnings, in our view. We believe earnings volatility is a major weakness of this approach while valuing cement companies. We believe there is ambiguity in replacement cost and it differs widely in the industry. Hence, applying a premium/discount to the replacement cost based on the return ratio might not be the right strategy. Nevertheless, we have used EV/tonne as a secondary check for our valuation. We have not used the DCF method in our valuation. For a cyclical commodity such as cement, forecasting longterm cash flow in a growth market such as India is fraught with far greater uncertainty than a stable business, in our opinion. Nevertheless, the DCF method provides us with a sense of broader assumptions that the current price and our target price is building in. Previous cycle multiples of major players used in valuation We analysed both earnings and assetbased valuations during the past 10 years and arrived at an average oneyear forward EV/EBITDA of 10.4x. Currently, the stock is trading at c.us$270/t which is c.40% higher than the mean value. Figure 26: SRCM is currently trading at near +2 s.d. Figure 27: At US$270/t, valuation is at a c.40% premium to the mean EV/EBITDA (x) Mean + 1 SD 1 SD, BLOOMBERG EV/tonne Mean 83

84 Cement India Shree Cement November 23, 2016 SRCM has transformed in scale from the previous recovery cycle. It was a regional company with a market share (northern region) of c.15% in FY07. Since then it has invested aggressively in capacity addition and is now almost six times its size in FY07. Moreover, it is gradually becoming a panindia player. Thus, the company should be given a similar multiple as other panindia players, in our view. We believe the current recovery cycle can be compared to the previous recovery cycle. Comparing them, we note that: During the current cycle, the return profile should be much weaker. Adjusted for inflation, the profitability in this cycle would be significantly lower than the previous cycle. Earningsbased valuations take into account the lower profitability of the companies and value the companies on their existing earnings profiles. The growth expectations are similar to that of the previous cycle. The industry experienced highsingledigit growth back then and during the current cycle too, we expect 8% growth in FY19F (YE march), and increasing thereafter. Thus the multiple should be comparable to the previous cycle. We expect balance sheet and free cash flow generation to be in line with the previous cycle. However, the previous cycle was the start of aggressive capital investment and capacity creation in the economy, while this cycle should see more prudent capital spending, in our view. ACC and Ambuja were the two major players during the past recovery cycle and their valuations from back then can be compared to the current cycle. We analysed both the earnings and assetbased multiples during the past cycle. During the previous cycle, the companies valuations were in the range of x 1year forward EBITDA. We value SRCM at 12.5x FY19F EV/EBITDA, in line with other large cap peers. Valuing SRCM at this multiple, we arrive at our TP of Rs12,430, a 12% discount to the current stock price. Initiate with Reduce. In comparison ACC/UltraTech/Ambuja should trade at cus$ 135/185/205 per tonne based on our target prices. SRCM should trade at a better asset based value due to its ability for faster project execution and higher asset utilisation. Figure 28: EV/EBITDA based valuation EV/EBITDA based valuation EBITDA (FY19F) Rs m 34,150 Multiple (x) x 12.5 EV (FY18F) Rs m 426,874 Net debt (FY18F) Rs m (19,036) Cement equity value (FY18F Rs m 445,910 Fair Value Rs 12, year forward price target Rs 12,430 Our secondary check with DCF analysis indicates a fair value of c.rs10,000/sh and the underlying assumptions are: 11) Volume growth rate in the explicit period at 8% 12) EBITDA/t growth rate in the explicit period at 6% 13) Tax rate of 30% 14) WACC of 13.5% 15) Terminal growth rate of 5% 84

85 Cement India Shree Cement November 23, 2016 Figure 29: DCF valuation FY17F FY18F FY19F FY20F FY21F FY22F FY23F FY24F Sales (Rs m) 80,870 96, , , , , , ,024 Sales (mt) EBITDA/t (Rs) 1,070 1,119 1,286 1,363 1,445 1,531 1,623 1,721 EBITDA (Rs m) 22,983 27,112 34,150 39,095 44,756 51,236 58,655 67,149 Taxes (Rs m) (2,459) (3,019) (4,119) (8,264) (9,962) (11,907) (14,132) (16,680) Capex (Rs m) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) Change in working capital (Rs m) (601) (689) (714) (771) (832) (899) (971) (1,048) Free cash flow (Rs m) 9,923 13,404 19,318 20,060 23,961 28,431 33,552 39,420 Years to discount Discount rate (x) DCF based valuation NPV of explicit period (Rs m) 116,415 NPV of terminal value (Rs m) 235,748 Total Value FY18F (Rs m) 352,164 Net debt FY18F (Rs m) (19,036) Equity value FY18F(Rs m) 371,200 Fair Value FY18 F (Rs) 10,655 Our price target builds in a terminal growth rate of above 7% which is possible, given the longterm volume growth rate of 78% in India. Risks to our Reduce rating Key risks to our Reduce rating include 1) higherthanexpected realisation due to its market leadership position, 2) higherthan expected demand growth from a sudden increase in demand in the economy, and 3) a fall in commodity prices. Volume and realisation sensitivity: SRCM is the market leader in the north and has strong brand equity. Additionally, higherthanexpected volume growth can impact both the EBITDA and EPS. A 1% increase in realisation and 1mt increase in sales volume can increase FY19F EBITDA by 3.0% and 3.1% respectively, increasing our price target by 3.0% and 3.1%. Decrease in fuel prices: YTD pet coke prices have increased by c.90%. Seaborne coal prices have also increased by 4050% in the past 34 months. The volatility in fuel prices is a key risk to our estimates and it cuts both ways. Our current estimates build in a further increase in prices in line with inflation. However, the opposite can happen too. A 10% decrease in fuel prices would increase FY19F EBITDA and price target by 5.7% and 5.8%, respectively. 85

86 Cement India Shree Cement November 23, 2016 BY THE NUMBERS P/BV vs ROE Jan13A Jan14A Jan15A Jan16A Jan17F Jan18F 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 12mth Fwd FD Core P/E vs FD Core EPS 80.0 Growth Jan 13A Jan 14A Jan 15A Oct 15A Apr 16F Apr 17F Apr 18F 110% 84% 59% 33% 7% 19% 44% 70% Rolling P/BV (x) (lhs) ROE (rhs) 12mth Fwd Rolling FD Core P/E (x) (lhs) FD Core EPS Growth (rhs) Profit & Loss (Rsm) Jun15A Mar16A Mar17F Mar18F Mar19F Total Net Revenues 64,536 55,678 87, , ,442 Gross Profit 59,799 51,069 80,553 94, ,651 Operating EBITDA 13,438 13,203 22,983 27,112 34,150 Depreciation And Amortisation (9,248) (9,084) (10,888) (11,548) (12,978) Operating EBIT 4,190 4,118 12,095 15,564 21,172 Financial Income/(Expense) ,566 1,208 1,709 Pretax Income/(Loss) from Assoc NonOperating Income/(Expense) Profit Before Tax (preei) 4,363 4,568 13,662 16,772 22,881 Exceptional Items (355) (23) Pretax Profit 4,008 4,545 13,662 16,772 22,881 Taxation (2,459) (3,019) (4,119) Exceptional Income posttax Profit After Tax 4,263 4,549 11,202 13,753 18,763 Minority Interests Preferred Dividends FX Gain/(Loss) post tax Other Adjustments posttax Net Profit 4,263 4,549 11,202 13,753 18,763 Recurring Net Profit 4,618 4,572 11,202 13,753 18,763 Fully Diluted Recurring Net Profit 4,618 4,572 11,202 13,753 18,763 Cash Flow (Rsm) Jun15A Mar16A Mar17F Mar18F Mar19F EBITDA 13,438 13,203 22,983 27,112 34,150 Cash Flow from Invt. & Assoc. Change In Working Capital (229) (2,059) (601) (689) (714) (Incr)/Decr in Total Provisions Other NonCash (Income)/Expense Other Operating Cashflow Net Interest (Paid)/Received (470) (15) 1,566 1,208 1,709 Tax Paid (906) (985) (2,459) (3,019) (4,119) Cashflow From Operations 11,983 10,315 21,490 24,611 31,027 Capex (11,317) (7,364) (10,000) (10,000) (10,000) Disposals Of FAs/subsidiaries Acq. Of Subsidiaries/investments Other Investing Cashflow 572 (6,135) Cash Flow From Investing (10,745) (13,499) (10,000) (10,000) (10,000) Debt Raised/(repaid) (2,832) (526) Proceeds From Issue Of Shares Shares Repurchased Dividends Paid (893) (1,592) (1,006) (1,006) (1,006) Preferred Dividends Other Financing Cashflow 2,387 5, Cash Flow From Financing (1,339) 3,377 (1,006) (1,006) (1,006) Total Cash Generated (100) ,483 13,605 20,021 Free Cashflow To Equity (1,594) (3,709) 11,490 14,611 21,027 Free Cashflow To Firm 2,485 (2,292) 12,424 15,545 21,961 SOURCE: CIMB RESEARCH, COMPANY DATA 86

87 Cement India Shree Cement November 23, 2016 BY THE NUMBERS cont d Balance Sheet (Rsm) Jun15A Mar16A Mar17F Mar18F Mar19F Total Cash And Equivalents 4,762 3,630 14,060 27,666 47,686 Total Debtors 4,764 3,286 3,877 4,555 5,256 Inventories 9,189 8,152 9,617 11,299 13,039 Total Other Current Assets 4,617 4,939 4,939 4,939 4,939 Total Current Assets 23,331 20,008 32,494 48,458 70,920 Fixed Assets 35,153 33,147 32,312 30,764 27,786 Total Investments 14,939 22,862 22,862 22,862 22,862 Intangible Assets Total Other NonCurrent Assets 6,554 11,874 11,874 11,874 11,874 Total Noncurrent Assets 56,646 67,882 67,047 65,499 62,521 Shortterm Debt 2,150 1,958 1,958 1,958 1,958 Current Portion of LongTerm Debt Total Creditors 8,645 8,095 9,550 11,220 12,948 Other Current Liabilities Total Current Liabilities 10,795 10,053 11,508 13,178 14,906 Total Longterm Debt 7,017 6,672 6,672 6,672 6,672 Hybrid Debt Debt Component Total Other NonCurrent Liabilities 8,714 9,339 9,339 9,339 9,339 Total Noncurrent Liabilities 15,731 16,011 16,011 16,011 16,011 Total Provisions Total Liabilities 27,215 26,088 27,543 29,212 30,940 Shareholders' Equity 52,763 61,802 71,998 84, ,501 Minority Interests Total Equity 52,763 61,802 71,998 84, ,501 Key Ratios Jun15A Mar16A Mar17F Mar18F Mar19F Revenue Growth 9.6% (13.7%) 56.9% 17.5% 15.4% Operating EBITDA Growth (3.3%) (1.8%) 74.1% 18.0% 26.0% Operating EBITDA Margin 20.8% 23.7% 26.3% 26.4% 28.8% Net Cash Per Share (Rs) (126) (144) ,121 BVPS (Rs) 1,515 1,774 2,067 2,433 2,942 Gross Interest Cover Effective Tax Rate 0.0% 0.0% 18.0% 18.0% 18.0% Net Dividend Payout Ratio 18.1% 18.3% 7.5% 6.1% 4.5% Accounts Receivables Days Inventory Days Accounts Payables Days ROIC (%) 9.8% 8.0% 22.7% 29.3% 40.6% ROCE (%) 9.2% 8.0% 19.3% 20.4% 23.3% Return On Average Assets 5.8% 4.9% 10.3% 11.8% 13.8% Key Drivers Jun15A Mar16A Mar17F Mar18F Mar19F Domestic ASP (% Change) 3.1% 2.2% 9.0% 6.0% 6.0% Domestic Vol. Sales Growth (%) 11.9% 10.4% 52.3% 12.8% 9.6% Export ASP (% Change) N/A N/A N/A N/A N/A Export Vol. Sales Growth (%) N/A N/A N/A N/A N/A Utilisation Rate (%) 77.0% 84.0% 88.0% 89.0% 89.0% Unit Raw Material ASP (% Change) 0.7% 10.4% 2.1% 2.2% 2.2% Export Sales/total Sales (%) N/A N/A N/A N/A N/A SOURCE: CIMB RESEARCH, COMPANY DATA 87

88 Vol m Cement India Equity research November 23, 2016 Company Note India ADD Consensus ratings*: Buy 11 Hold 7 Sell 1 Current price: Rs106.6 Target price: Rs140.0 Up/downside: 31.4% CIMB / Consensus: 5.3% Reuters: Bloomberg: Market cap: Average daily turnover: ICMN.NS ICEM IN US$480.2m Rs32,730m US$10.61m Rs710.8m Current shares o/s: 307.2m Free float: 81.0% *Source: Bloomberg Key changes in this note NA Price Close Relative to SENSEX (RHS) Nov15 Feb16 May16 Aug16 Source: Bloomberg Price performance 1M 3M 12M Absolute (%) Relative (%) Major shareholders % held EWS Finanace and Investments 9.0 Prince Holdings Madras 8.3 Subramanian Vidya The India Cements Slow grind We expect India Cements to operate at a capacity utilisation of c65% in FY19F, higher than the region which is likely to operate at sub60%. Marginal players in south provide support to cement prices but given low utilisation, ASP growth will only cover increase in cost. We expect ASP to rise with inflation. Rising cash flow should keep leverage under control. We project 7% reduction in net debt over 19F with a decline in net gearing by c.18% to 0.66x. Being the market leader, we expect ICEM to benefit from recovery in south. Initiate with Add. Benefits from gradual recovery in South India Cements reported cumulative volume declines during 16 of c.20%. Political instability and absence of public investments resulted in a sharp plunge in demand in the south. Nevertheless, recent stability in the political environment (bifurcation of Andhra Pradesh) will gradually restart the demand cycle, in our view. We believe India Cements, being the market leader, is better prepared to benefit from the recovery in the region. We project shipment growth of 6.8%/5.2%/6.6% in FY17/18/19F. Marginal players provide support to cement prices in south A marginal player in the south has to operate at better profitability than other regions to be cash neutral due to 1) low utilisation, 2) low consolidation and leverage, and 3) elevated cost. Our analysis indicates that at Rs700/t EBITDA, a marginal player is just cash flow neutral. This provides support to cement prices. We believe increase in prices will cover the increase in cost keeping ICEM EBITDA at a healthy level of c Rs1,000/t. Hence, we lift our ASP by 6%/4%/3% in FY17/18/19F, in line with inflation expectations. Rising fuel prices could be a nearterm spoiler Pet coke prices have increased c.90% YTD and imported coal prices have jumped by 4050% during the past 34 months. The company does not have easy access to domestic coal and will be affected by high fuel prices, in our view. Assuming an inventory of 34 months, we expect the full impact of high prices to be felt in 3Q 4QFY17F. Improving financials but leverage a concern We project a marginal increase in profitability, with EBITDA/t climbing from Rs990 in to Rs1,018 in FY19F. Hence, EBITDA growth will largely be driven by volumes. Given its high leverage, even modest EBITDA CAGR of c.6% in 19F drives EPS CAGR of c.20%. We project 7% reduction in net debt over 19F. However, net gearing at 0.66x is still higher than that of the large cap cement companies. Recent correction an opportunity; initiate with Add We value India Cements at 7.5x 1year forward EV/EBITDA, near the mean of the past 10 years, to arrive at our target price of Rs140. At our price target, ICEM trades at EV/tonne of US$70 and has upside potential of c.31%. Sustained low profitability due to rising fuel prices or falling ASP is a downside risk to our call. A 10% increase in fuel price or 1% decrease in ASP will lower our target price by 15% and 5.4%, respectively. Nevertheless, the recent correction presents a buying opportunity. Initiate with Add. Analyst(s) Saurabh PRASAD T (91) E saurabh.prasad@cimb.com Satish KUMAR, PGDM T (91) E satish.kumar@cimb.com Financial Summary Mar15A Mar16A Mar17F Mar18F Mar19F Revenue (Rsm) 44,236 42,268 46,725 51,048 55,963 Operating EBITDA (Rsm) 6,825 7,697 8,050 8,603 9,088 Net Profit (Rsm) 294 1,378 1,743 2,082 2,391 Core EPS (Rs) Core EPS Growth 375% 24% 19% 15% FD Core P/E (x) DPS (Rs) Dividend Yield 0.00% 0.94% 1.06% 1.27% 1.46% EV/EBITDA (x) P/FCFE (x) 3, Net Gearing 89.0% 80.4% 76.8% 71.9% 66.4% P/BV (x) ROE 0.79% 3.87% 4.69% 5.39% 5.93% % Change In Core EPS Estimates CIMB/consensus EPS (x) SOURCE: COMPANY DATA, CIMB FORECASTS IMPORTANT DISCLOSURES, INCLUDING ANY REQUIRED RESEARCH CERTIFICATIONS, ARE PROVIDED AT THE END OF THIS REPORT. IF THIS REPORT IS DISTRIBUTED IN THE UNITED STATES IT IS DISTRIBUTED BY CIMB SECURITIES (USA), INC. AND IS CONSIDERED THIRDPARTY AFFILIATED RESEARCH. Powered by the EFA Platform

89 FY07 FY08 FY17F FY18F FY19F FY07 FY08 FY17F FY18F FY19F % % Cement India The India Cements November 23, 2016 Slow grind Investment summary We initiate coverage on ICEM with an Add rating and target price of Rs140, implying upside potential of 31% from current levels. Our investment thesis is based on pricing support due to cost push and gradual recovery in the south. India Cements, being the market leader, is better prepared to benefit from the recovery in the region. Southern region to operate at sub60% utilisation: The southern region is the largest region (in terms of cement capacity), with capacity share of 37% (155mt). The region has been the most aggressive in capacity addition (on a relatively higher base) and accounts for c.40% of incremental capacity addition during FY0616. Falling demand growth and aggressive capacity addition have resulted in weak capacity utilisation of 5354% in the region. Recent stability in the political environment (bifurcation of AP) will gradually restart the demand cycle, in our view. Figure 1: Key assumptions India Cements FY17F FY18F FY19F Cement ASP (Rs/t) 3,304 3,375 4,217 4,354 4,168 4,552 4,753 5,048 5,251 5,409 % increase (8) (4) Sales (mt) % increase 15.2 (5.4) (4.8) 5.0 (1.3) (12.1) (1.6) Capacity utilization (%) Freight cost per ton , ,051 1,103 1,159 % increase (7) Power & fuel cost per ton 912 1,024 1,149 1,248 1,272 1,247 1,088 1,184 1,244 1,278 % increase (7) (2) (13) Core EBITDA/t ,001 1,021 1,018 Marginal players provide support to cement prices: India Cements, being a regional player, is affected by the fundamentals in the region. The region is characterised by 1) low utilisation, 2) fragmentation and leverage, and 3) elevated cost structure. Our analysis indicates that at Rs700/t EBITDA, a marginal player is just cash flow neutral. This provides support to cement prices. We believe any increase in prices will cover the increase in cost and maintain ICEM profitability at a healthy INR 1,000/t. Hence, we lift ASP by 6%/4%/3% in FY17/18/19F, in line with inflation expectations. Figure 2: ICEM volume growth to benefit from gradual recovery Figure 3: ASP increase in line with inflation expectation (5.0) (10.0) (15.0) 5 (5) (10) Sales volume growth % increase 89

90 FY07 FY08 FY17F FY18F FY19F FY07 FY08 FY17F FY18F FY19F Rs m x Cement India The India Cements November 23, 2016 Figure 4: Stable free cash flow in next 3 years Improving financials but leverage is a concern: We expect the incremental rise in ASP to cover the increase in cost and have hence assumed ASP growth of 6%/4%/3% in FY17/18/19F. This will improve profitability marginally. ICEM is highly leveraged. Hence, even a marginal increase in profitability and rise in volume have a disproportionate effect on PAT. We project 19F EBITDA and PAT CAGR of 5.6% and 19.9%, respectively. Although ICEM generates healthy FCF, given its significant interest burden, this is unlikely to result in material incremental cash flow for the company. We project 7% reduction in net debt over 19F. We believe rising reserves could lower gearing from 0.8x in to 0.66x in FY19F. Figure 5: Leverage coming down from rise in accumulated reserves 15, , , (5,000) (10,000) 0.10 (15,000) Cash Flow from operations Capex Free cash flow Net Debt / Equity Recent correction an opportunity; initiate with Add: We value India Cements at 7.5x 1year forward EV/EBITDA to arrive at our target price of Rs140. Given its regional nature, the company is likely to be affected by regional volatility and hence trade at a discount to national players. Large caps such as ACC and Ambuja have traded at 10year mean of c11.0x and 11.5x, respectively compared to c7.5x for ICEM. Unlike other companies in our coverage universe where we use the multiple from previous recovery cycles, for ICEM, we use the average of the past 10 years. We believe the fundamentals in the south are not comparable to previous cycles. At our price target, ICEM trades at EV/tonne of US$70 and has upside potential of 31%. Initiate with Add. Figure 6: Valuation according to EV/EBITDA method EV/EBITDA valuation EBITDA (FY19F) Rs m 10,088 Multiple x 7.5 EV (FY18F) Rs m 75,662 Net debt (FY18F) Rs m 31,335 Market capitalization (FY18F) Rs m 44,327 Target price (FY18F) Rs 144 1year forward Rs 140 Note: EBITDA and net debt includes our estimates for subsidiaries 90

91 FY03 FY04 FY05 FY06 FY07 FY08 FY17F FY18F FY19F % mt Cement India The India Cements November 23, 2016 Stuck in a low utilisation region Southern region to operate at sub60% utilisation The southern region is the largest region (in terms of capacity), with capacity share of 37% (155mt). The region has been the most aggressive in capacity addition (on a relatively higher base) and accounts for c.40% of incremental capacity addition during FY0616. Reasons for such sharp capacity addition include 1) high utilisation in FY0608, and 2) easy availability of limestone; the region accounts for more than a third of limestone reserves in the country. Falling demand growth and aggressive capacity addition have resulted in weak capacity utilisation of 5354% in the region. Recent stability in the political environment (bifurcation of Andhra Pradesh into Andhra Pradesh and Telangana) will gradually restarted the demand cycle, in our view. Figure 7: Southern region facing tough times on surplus capacity Figure 8: Andhra Pradesh accounts for onethird of capacity () Kerala 1% Tamil Nadu 24% Andhra Pradesh 34% Karnataka 24% 40.0 Telangana 17% Surplus capacity Utilization The southern region experienced significant growth decline after the previous growth period. After experiencing doubledigit growth during FY0309, the industry is yet to recover. Erstwhile Andhra Pradesh (including Telangana) experienced maximum demand destruction due to a fall in irrigation projects and low cost housing. Political unrest further aggravated the situation, in or view. With the political unrest now behind us with the bifurcation of erstwhile Andhra Pradesh, there could be a renewed push for cement consumption and we expect it to rise slowly from hereon. India Cements to see shipment growth of 5.2%/6.6% in FY18/19F Since, India Cements has reported volume declines in all years except. The cumulative volume decline during 16 was at c.20%. We believe the worst is over and the company should regain the lost volume in the next 3 years. Being the major player in the region, we think India Cements will benefit most from political stability and the infrastructure push in the south. 91

92 FY07 FY08 FY17F FY18F FY19F FY07 FY08 FY17F FY18F FY19F % % Cement India The India Cements November 23, 2016 Figure 9: ICEM volume growth to benefit from recovery in south Figure 10: but utilisation continues to be low (5.0) 20 (10.0) (15.0) Sales volume growth Capacity uilization 92

93 Cement India The India Cements November 23, 2016 Marginal players provide support to cement prices Financial leverage and low utilisation constrain cash flow India Cements, being a regional player, is affected by the fundamentals in the region. The region is characterised by: Low utilisation: After reaching a high of 93% in FY07, utilisation has come down to sub60%. Although we expect demand growth to improve, significant overcapacity will keep utilisation under pressure. Fragmentation and leverage: The industry is highly fragmented in the region. Additionally, many of the companies in the region have relatively poor balance sheets, with high debt on the books. In the past 10 years, the region has tripled the capacity, stretching the balance sheet. Elevated cost structure: Even major players operating in the southern region do not have access to domestic coal and are dependent on costlier imports. Grid power prices are also higher in the region. Additionally, due to low utilisation, the lead distance is higher, increasing freight cost. All these factors affect the cash flow generation potential of the companies. We note that cement prices in the southern region (taking ICEM s ASP as reference) have performed better than other regions but that is a function of economic survival rather than sound fundamentals, in our view. At low utilisation, smaller players barely EBITDA positive We believe a marginal player in the region has to operate at better profitability compared to other regions to be cash flow neutral. We arrive at this conclusion keeping the following assumptions in mind: Energy intensity per tonne cement is 550 kcal/kg. Most of the players do not have access to linkage/domestic coal. Even major players, such as India Cements, rely primarily on imported coal and pet coke. Power required for grinding at 90 units/t. Average lead distance to sell is 600km. Given that utilisation is low, companies have to travel longer distances to sell cement. Average transport cost at c.rs2.0/t. Companies based in the region transport more by road due to the nonavailability of rakes. Limestone mining cost at c.rs300/t. This includes royalty, cess and DMF (District Mineral Foundation) charges. Fixed staff cost at Rs600m for a 3mtpa plant. Average fly ash cost at Rs600/t, which is spent on transporting fly ash from power plants to cement plants. We reference ASP from India Cements s reported numbers. The assumptions outlined above result in average variable cost of c.rs3,300/t and thus cement prices appear to be moving according to the prevailing cost structure. Additionally, since the south operates at low utilisation, we believe any attempt to push volume by one company will be followed by other companies. This would depress ASP in the region. For our calculation, we assume ASP drops by 23% for every 5% increase in utilisation. Keeping these factors in mind, we have the following profitability scenarios: 93

94 Cement India The India Cements November 23, 2016 Figure 11: Profitability profile of a marginal cement plant in the south Plant capacity mtpa Utilisation % Volume sold mt Realisation Rs/t 4,462 4,600 4,761 Variable cost Raw material cost Rs/t Power and fuel cost Rs/t 1,114 1,114 1,114 Freight cost Rs/t 1,200 1,200 1,200 Other variable cost Rs/t Fixed cost (INR m) Employee cost Rs m Fixed other cost Rs m 1,200 1,200 1,200 Fixed cost (INR/t) Employee cost Rs/t Fixed other cost Rs/t Total cost Rs/t 4,365 4,274 4,197 EBITDA Rs/t EBITDA INR m ,100 Players low cash flow provides support to cement prices At the existing profitability profile, a small cement producer will not be generating any cash and the return ratios will be suboptimal. We assume: Replacement cost at US$100/t, as discussed in the sector note Plant life of 30 years Financing mix of 1:1 Marginal tax rate of 30% Figure 12: Cash generation potential scenario analysis Utilisation % Replacement cost US$/t D/E x Exchange rate Rs/US$ Replacement cost Rs/tonne 6,700 6,700 6,700 Replacement cost of 3 mtpa plant Rs m 20,100 20,100 20,100 Debt Rs m 10,050 10,050 10,050 Equity Rs m 10,050 10,050 10,050 EBITDA Rs m ,100 Plant life Years Depreciation Rs m EBIT Rs m Interest rate % Interest cost Rs m 1,005 1,005 1,005 PBT Rs m 1,514 1, RoCE % 3% 0% 2% Indicated cash flow Rs m Our cash generation potential scenario analysis indicates that even at EBITDA/t of Rs550, a marginal capacity will barely be cash positive, that too at 65% capacity utilisation. Given that the south operates at sub60% utilisation, we believe minor players will not be able to operate at more than 55%. Hence, smaller players will have to achieve profitability of at least c.rs700/t to be barely positive on cash flow. This provides support to cement prices in the region. Hence, India Cements ASP is better than that of the other large caps in our coverage universe, in our view. 94

95 FY07 FY08 Cement India The India Cements November 23, 2016 Figure 13: India Cements ASP (rebased) relatively better than other companies WPI inflation Realization ACEM Realization ACC Realization SRCM Realization ICEM, DIPP The figure above indicates that India Cements ASP is higher than that of other cement companies. However, we note that higher ASP is a function of cost push and high leverage rather than better utilisation and higher growth. High leverage means high interest cost and hence a need to keep the prices higher to service not only operating costs but also interest cost. We believe ASP growth will be sufficient to cover increases in cost and hence will move with inflation. 95

96 FY08 FY17F FY18F FY19F % FY07 FY08 FY17F FY18F FY19F Rs/t Rs/t Cement India The India Cements November 23, 2016 Improving financials but leverage a concern EBITDA and PAT CAGR of 6% and 20% during 19F As discussed in the previous section, we expect incremental ASP to only cover the increase in cost and hence assume ASP growth of 6%/4%/3% in FY17/18/19F. Leaving out power and fuel cost, we also project a benign cost environment and thus expect profitability will increase only marginally. Figure 14: Profitability to rise marginally in next 3 years 6,000 1,400 5,000 1,200 4,000 1,000 3, , , Core EBITDA (RHS) Net sales realization (LHS) Total Operating expenses (LHS) Unlike other largecap players that operate at the panindia level, ICEM is highly leveraged. Hence, even a marginal increase in profitability and volume have a disproportionate effect on PAT. We project 19F EBITDA and PAT CAGR of 5.6% and 19.9%, respectively. Figure 15: Volatile earnings profile (100) (200) (300) EBITDA growth PAT growth Large interest burden to constrain cash flow We expect rising profitability and low capex requirements to result in healthy free cash flow. However, given the significant interest burden, we do not expect it will result in material incremental cash flow for the company. We project 7% reduction in net debt over 19F. Accumulating reserves could improve net debt to equity from 0.80x in to 0.66x in FY19F. 96

97 FY07 FY08 FY17F FY18F FY19F % FY07 FY08 FY17F FY18F FY19F FY07 FY08 FY17F FY18F FY19F Rs m x Cement India The India Cements November 23, 2016 Figure 16: Stable free cash flow in next 3 years Figure 17: Leverage coming down 15, , , (5,000) 0.20 (10,000) 0.10 (15,000) Cash Flow from operations Capex Free cash flow Net Debt / Equity Return ratios likely lower than largecap peers While we expect profitability to rise, low capacity utilisation will likely result in lower return ratios, in our opinion. We expect capital employed in the company to likely witness muted growth due to 1) low capital investment in past 34 years, and 2) low profitability adding minimally to the cash balance. We expect capital employed in FY19F to be at a similar level as that of. Slowly rising profitability should drive improvement in return ratios but they will not be close to those of previous recovery cycle of FY0609. Figure 18: Return ratios improving gradually (5.0) (10.0) RoE RoCE South operates at relatively higher working capital Given the weak business fundamentals, companies operating in the south have relatively higher working capital requirements compared to companies operating in other regions. Compared to UltraTech, which had creditor/debtor days of 25/22 in, India Cements had 77 and 44 days, respectively. However, with the improving macro environment, we do not project a deterioration in these parameters. 97

98 FY07 FY08 FY17F FY18F FY19F FY07 FY08 FY17F FY18F FY19F % Rs FY07 FY08 FY17F FY18F FY19F No of days Cement India The India Cements November 23, 2016 Figure 19: Working capital to remain stable Creditor days Debtor days Inventory days Inconsistent dividend policy The company did not pay any dividend in 15 owing to losses and very low income. Prior to that, it maintained a variable dividend policy but has never given dividends higher than Rs2/share in the past 10 years. We expect the company to maintain the dividend payout ratio of which was c20%. Figure 20: Dividend payout Figure 21: Book value per share Dividend payout Book Value per Share Our DuPont analysis is shown in Figure 22. It indicates that the financial leverage is a significant driver of profitability for the company and will aid profitability materially. Given low utilisation, the asset turnover continues to be low, dragging the ROE downward. ROE has fallen steadily from FY07 to but is likely to inch up going forward, in our view. Figure 22: DuPont analysis FY07 FY08 FY17F FY18F FY19F Profitability (%) (3.7) Asset Turnover (x) Financial leverage (x) ROE (%) (4.2)

99 US$/t X Cement India The India Cements November 23, 2016 Recent correction an opportunity; initiate with Add We value India Cements on a oneyear forward EV/EBITDA multiple. We believe this is a suitable method in the current scenario since: The sector is entering a gradual recovery phase, and therefore, we do not expect there should be significant volatility in its earnings profile. Volatility in earnings is a major weakness of this approach for valuing cement companies, in our view. We believe there is ambiguity on replacement costs and it differs widely in the industry. Hence, giving a premium/discount to replacement cost based on return ratios might not be the right strategy. Nevertheless, we use EV/tonne as a secondary check on our valuation. We have not used the DCF method in our valuation. For a cyclical commodity such as cement, forecasting longterm cashflow in a growth market, such as India, is tricky as this type of market is fraught with far greater uncertainty, in our opinion, than a stable business. Nevertheless, the DCF method provides us with a broader set of assumptions than the current price and our target price are building in. Using average multiple of past 10 years for valuation For other cement companies, we used multiples from previous recovery cycles since there are some similarities between both the cycles. However, fundamentals in the southern region are distinctly different from previous recovery cycles. The utilisation is at sub60%, in contrast to >90% in the previous cycle. ASP growth will cover the increase in cost and we do not project a significant increase in profitability. Volume growth, although better than the past 45 years, will still be much lower than the previous cycle. Hence, rather than taking the peak multiple from the previous recovery cycle, we use the average multiple of the past 10 years. Figure 23: ICEM trading in band of 1 s.d. for past 23 years Figure 24: ICEM trading at below 10year mean asset based valuation Jan06 Jan08 Jan10 Jan12 Jan14 Jan16 EV/EBITDA (x) +1 sd 1 sd Mean, BLOOMBERG Jan06 Jan08 Jan10 Jan12 Jan14 Jan16, BLOOMBERG Applying the average multiple of 7.5x (average of past 10 years), we arrived at our 1year forward target price of Rs140. At our target price, ICEM trades at c.us$70/t, lower than the average asset based value of the past 10 years. Our target price implies upside potential of 31%. Initiate with Add. ICEM s valuation is at a significant discount to other large caps which we have valued at 1yr forward EV/EBITDA multiple of 12.5x. Historically, ICEM has traded at 10 year average of c7.5x compared to c11x and 11.5x for ACC and ACEM, respectively. 99

100 Cement India The India Cements November 23, 2016 Figure 25: Valuation according to EV/EBITDA method EV/EBITDA valuation EBITDA (FY19F) Rs m 10,088 Multiple x 7.5 EV (FY18F) Rs m 75,662 Net debt (FY18F) Rs m 31,335 Market capitalization (FY18F) Rs m 44,327 Target price (FY18F) Rs 144 1year forward Rs 140 Note: Our EBITDA and net debt incorporates our estimates for the subsidiary companies Figure 26: DCF method Our secondary check with DCF analysis indicates a fair value of c.rs158 (FY18F end) and the underlying assumptions are: 16) Volume growth rate in the explicit period at 5% 17) EBITDA/t growth rate in the explicit period at 3% 18) Tax rate of 30% 19) WACC of 11.5% 20) Terminal growth rate of 2% DCF method FY17F FY18F FY19F FY20F FY21F FY22F FY23F FY24F Sales (Rs m) 53,097 58,009 63,595 66,775 70,113 73,619 77,300 81,165 EBITDA (Rs m) 9,050 9,603 10,088 12,168 13,078 14,063 15,127 16,279 Sales (mt) EBITDA/t (Rs) 1,001 1,021 1,018 1,049 1,080 1,113 1,146 1,181 Taxes (Rs m) (910) (1,087) (1,248) (2,997) (3,270) (3,566) (3,885) (4,230) Capex (Rs m) (2,500) (2,500) (2,500) (2,500) (2,500) (2,500) (2,500) (2,500) Change in working capital (Rs m) (673) (563) (656) (688) (723) (759) (797) (837) Free cash flow (Rs m) 4,967 5,453 5,684 5,982 6,585 7,238 7,945 8,711 Years for discounting Discount rate (x) DCF calculation NPV of explicit period 33,661 NPV of terminal value 46,287 Total Value (FY18F) 79,949 Net debt (FY18F) 31,335 Equity value (FY18F) 48,614 Target price (FY18F) 158 Risks to our Add rating and target price Key risks to our Add rating include: 1) inability to increase ASP more than our estimate due to low utilisation, 2) lowerthan expected demand growth, and 3) rise in commodity prices. Volume and ASP sensitivity: The south is affected by low utilisation and high fragmentation. This could negatively impact the pricing power of India Cements. Additionally, less than the expected volume growth can also have a negative impact both EBITDA and EPS. A 1% decrease in ASP and 1mt decrease in sales volume can reduce FY19F EBITDA by 5.4% and 8.8%, respectively, lowering our price target by 7.9% and 12.6% in each respective scenario. Increase in fuel prices: YTD pet coke prices have increased by c.90%. Seaborne coal prices also increased by 4050% in the past 34 months. Volatility in fuel prices is a key risk to our estimates and it cuts either way. A 10% increase in fuel prices will lower FY19F EBITDA and our price target by 10% and 15%, respectively. Ongoing demonetisation drive: Starting 9 Nov 2016, the existing Rs500 and Rs1,000 currency notes ceased to be legal tender. This has caused disruptions 100

101 Cement India The India Cements November 23, 2016 to established trade practices. The construction sector could be hit and this could have a consequential effect on cement demand for the next 12 quarters. However, these are very early days and we have not quantified the impact in our financials. CCI penalty: Competition Commission of India reaffirmed the penalty of Rs1.87bn on India Cement in its order dated 31 Aug This amounts to c5% of the market capitalization. The order was first passed in June 2012 and is currently under appeal. 101

102 Cement India The India Cements November 23, 2016 BY THE NUMBERS P/BV vs ROE Jan13A Jan14A Jan15A Jan16A Jan17F Jan18F 8.0% 5.0% 2.0% 1.0% 4.0% 7.0% 10.0% 12mth Fwd FD Core P/E vs FD Core EPS 700 Growth Jan13A Jan14A Jan15A Jan16A Jan17F Jan18F 4,480% 3,766% 3,051% 2,337% 1,623% 909% 194% 520% Rolling P/BV (x) (lhs) ROE (rhs) 12mth Fwd Rolling FD Core P/E (x) (lhs) FD Core EPS Growth (rhs) Profit & Loss (Rsm) Mar15A Mar16A Mar17F Mar18F Mar19F Total Net Revenues 44,236 42,268 46,725 51,048 55,963 Gross Profit 38,229 36,044 39,587 43,316 47,477 Operating EBITDA 6,825 7,697 8,050 8,603 9,088 Depreciation And Amortisation (2,579) (2,180) (2,111) (2,177) (2,252) Operating EBIT 4,246 5,517 5,939 6,426 6,836 Financial Income/(Expense) (4,172) (3,528) (3,372) (3,342) (3,282) Pretax Income/(Loss) from Assoc NonOperating Income/(Expense) Profit Before Tax (preei) 294 2,035 2,653 3,169 3,640 Exceptional Items 0 (32) Pretax Profit 294 2,003 2,653 3,169 3,640 Taxation 0 (625) (910) (1,087) (1,248) Exceptional Income posttax Profit After Tax 294 1,378 1,743 2,082 2,391 Minority Interests Preferred Dividends FX Gain/(Loss) post tax Other Adjustments posttax Net Profit 294 1,378 1,743 2,082 2,391 Recurring Net Profit 294 1,400 1,743 2,082 2,391 Fully Diluted Recurring Net Profit 294 1,400 1,743 2,082 2,391 Cash Flow (Rsm) Mar15A Mar16A Mar17F Mar18F Mar19F EBITDA 6,825 7,697 8,050 8,603 9,088 Cash Flow from Invt. & Assoc. Change In Working Capital (816) 727 (673) (563) (656) (Incr)/Decr in Total Provisions Other NonCash (Income)/Expense Other Operating Cashflow (10) (194) Net Interest (Paid)/Received (4,781) (4,180) (3,522) (3,492) (3,432) Tax Paid (383) (48) (910) (1,087) (1,248) Cashflow From Operations 1,013 4,221 3,001 3,516 3,808 Capex (2,501) (1,535) (2,500) (2,500) (2,500) Disposals Of FAs/subsidiaries Acq. Of Subsidiaries/investments (6,397) Other Investing Cashflow 7, Cash Flow From Investing (986) (1,146) (2,320) (2,320) (2,320) Debt Raised/(repaid) (17) (2,653) 0 (500) (500) Proceeds From Issue Of Shares Shares Repurchased Dividends Paid (11) (370) (408) (487) (560) Preferred Dividends Other Financing Cashflow Cash Flow From Financing (28) (3,023) (408) (987) (1,060) Total Cash Generated (1) Free Cashflow To Equity Free Cashflow To Firm 4,808 7,255 4,203 4,689 4,920 SOURCE: CIMB RESEARCH, COMPANY DATA 102

103 Cement India The India Cements November 23, 2016 BY THE NUMBERS cont d Balance Sheet (Rsm) Mar15A Mar16A Mar17F Mar18F Mar19F Total Cash And Equivalents Total Debtors 4,661 5,134 5,675 6,200 6,797 Inventories 6,069 5,952 6,580 7,189 7,881 Total Other Current Assets 4,433 3,999 4,421 4,830 5,295 Total Current Assets 15,202 15,123 16,986 18,738 20,920 Fixed Assets 36,748 35,023 35,412 35,735 35,983 Total Investments 15,852 15,847 15,847 15,847 15,847 Intangible Assets Total Other NonCurrent Assets 15,311 16,350 16,350 16,350 16,350 Total Noncurrent Assets 67,912 67,221 67,609 67,932 68,180 Shortterm Debt 4,815 4,698 4,698 4,698 4,698 Current Portion of LongTerm Debt Total Creditors 8,253 8,916 9,856 10,768 11,805 Other Current Liabilities 2,906 2,853 2,853 2,853 2,853 Total Current Liabilities 15,974 16,467 17,407 18,319 19,356 Total Longterm Debt 27,192 24,656 24,656 24,156 23,656 Hybrid Debt Debt Component Total Other NonCurrent Liabilities Total Noncurrent Liabilities 27,910 25,433 25,433 24,933 24,433 Total Provisions 3,299 3,961 3,938 4,006 4,068 Total Liabilities 47,183 45,860 46,777 47,257 47,856 Shareholders' Equity 35,931 36,483 37,818 39,413 41,245 Minority Interests Total Equity 35,931 36,483 37,818 39,413 41,245 Key Ratios Mar15A Mar16A Mar17F Mar18F Mar19F Revenue Growth (0.4%) (4.4%) 10.5% 9.3% 9.6% Operating EBITDA Growth 35.1% 12.8% 4.6% 6.9% 5.6% Operating EBITDA Margin 15.4% 18.2% 17.2% 16.9% 16.2% Net Cash Per Share (Rs) (103.7) (95.1) (94.2) (91.9) (88.9) BVPS (Rs) Gross Interest Cover Effective Tax Rate 0.0% 31.2% 34.3% 34.3% 34.3% Net Dividend Payout Ratio NA 21.9% 20.0% 20.0% 20.0% Accounts Receivables Days Inventory Days Accounts Payables Days ROIC (%) 6.4% 9.8% 10.9% 11.5% 12.1% ROCE (%) 5.98% 8.10% 8.73% 9.26% 9.67% Return On Average Assets 5.24% 5.97% 6.13% 6.33% 6.46% Key Drivers Mar15A Mar16A Mar17F Mar18F Mar19F Domestic ASP (% Change) 9.2% 4.4% 6.2% 4.0% 3.0% Domestic Vol. Sales Growth (%) 12.1% 1.6% 6.8% 5.2% 6.6% Export ASP (% Change) N/A N/A N/A N/A N/A Export Vol. Sales Growth (%) N/A N/A N/A N/A N/A Utilisation Rate (%) 58.0% 54.0% 58.0% 61.0% 65.0% Unit Raw Material ASP (% Change) N/A N/A N/A N/A N/A Export Sales/total Sales (%) N/A N/A N/A N/A N/A SOURCE: CIMB RESEARCH, COMPANY DATA 103

104 Vol m Cement India Equity research November 23, 2016 Company Note India HOLD Consensus ratings*: Buy 37 Hold 5 Sell 6 Current price: Rs3,322 Target price: Rs3,430 Up/downside: 3.2% CIMB / Consensus: 17.0% Reuters: Bloomberg: Market cap: Average daily turnover: ULTC.NS UTCEM IN US$13,376m Rs911,765m US$17.19m Rs1,153m Current shares o/s: 274.4m Free float: 39.3% *Source: Bloomberg Key changes in this note N/A 4,400 3,900 3,400 2,900 2, Price Close Relative to SENSEX (RHS) Nov15 Feb16 May16 Aug Source: Bloomberg Price performance 1M 3M 12M Absolute (%) Relative (%) Major shareholders % held Grasim Industries 60.3 Aberdeen 2.2 J P Morgan 2.0 Ultratech Cement In a different league UltraTech is the largest domestic cement company by capacity. The Jaypee acquisition would propel capacity to 91 mtpa in FY18F or c.20% of industry capacity. UltraTech has multiple levers to increase profitability of Jaypee plants but that would take 34 years. The acquisition will only be EPS accretive in FY21F, in our view Rising seaborne coal and pet coke prices would put pressure on profitability. Our 1yr forward EV/EBITDAbased TP suggests that the current price reflects most of the positives and that the stock is trading near fair value. Initiate with a HOLD call. Continued expansion propels UTCEM into a different league The merger with Samruddhi Cement in materially increased UTCEM s capacity to 48.8mtpa, c.16% of domestic capacity. UTCEM intends to maintain its market share and thus in 17F, it is likely to have added 12.8 mtpa of organic capacity, apart from a 4.8 mtpa acquisition in Gujarat (). Currently, it is in midst of acquiring 21.2 mtpa capacity from Jaypee Group, raising total capacity to 91 mtpa. With this, UltraTech is set to become fourth largest cement company in the world (exchina) Jaypee acquisition would only be EPS accretive from FY21F The Jaypee cement sale is an example of a distressed sale. The company was operating at c.50% capacity utilisation with falling profitability. In, Jaypee posted an EBITDA of c.rs4bn (c.rs350/t), which was not sufficient to cover interest cost. UTCEM has multiple levers to increase EBITDA including 1) rebranding, 2) improved utilisation, 3) process improvements, and 4) synergy benefits. However, our forecasts suggest the acquisition would only be EPS accretive in FY21F. Rising fuel prices could be a nearterm spoiler Pet coke prices have increased c.90% YTD and imported coal prices have increased by 4050% during the past 34 months. Pet coke comprises three quarters of the fuel mix. Assuming inventory of 34 months, the full impact of rising prices would be felt in 3Q 4QFY17F, in our view. The company could increase the share of domestic coal but we believe that would only partially cushion the impact. Positive growth outlook UltraTech is well positioned to benefit from the gradual recovery in the industry and would achieve a volume growth CAGR of c.14% (including Jaypee acquisition) in 19F, in our view. Additionally, riding on the ongoing recovery in the sector, realisation growth would be better than cost inflation, resulting in an 19F EBITDA and PAT CAGR of 16% and 22%, respectively. Valuation paints a fair picture; initiate with HOLD We value the company at 12.5x 1 year forward EV/EBITDA multiple, in line with major players during the previous cycle. Our TP of Rs3,430/sh translates to an EV/t of US$205 (c.20% above the mean of the past 6 years) and has upside potential of 3.2%. Sustained earnings outperformance or underperformance, relative to market expectations, would be key re/derating catalysts. Upside risk to our TP comes from better pricing power and consequently higher profitability. A 1% change in ASP would change TP by c.4%. Analyst(s) Saurabh PRASAD T (91) E saurabh.prasad@cimb.com Satish KUMAR, PGDM T (91) E satish.kumar@cimb.com Financial Summary Mar15A Mar16A Mar17F Mar18F Mar19F Revenue (Rsm) 226, , , , ,479 Operating EBITDA (Rsm) 41,950 46,161 53,706 61,841 72,373 Net Profit (Rsm) 20,147 21,746 26,627 32,264 39,392 Core EPS (Rs) Core EPS Growth (6.3%) 7.9% 22.4% 21.2% 22.1% FD Core P/E (x) DPS (Rs) Dividend Yield 0.271% 0.271% 0.271% 0.271% 0.271% EV/EBITDA (x) P/FCFE (x) Net Gearing 24.8% 16.4% 4.2% (8.1%) (19.7%) P/BV (x) ROE 11.2% 11.0% 12.1% 13.1% 14.1% % Change In Core EPS Estimates CIMB/consensus EPS (x) SOURCE: COMPANY DATA, CIMB FORECASTS IMPORTANT DISCLOSURES, INCLUDING ANY REQUIRED RESEARCH CERTIFICATIONS, ARE PROVIDED AT THE END OF THIS REPORT. IF THIS REPORT IS DISTRIBUTED IN THE UNITED STATES IT IS DISTRIBUTED BY CIMB SECURITIES (USA), INC. AND IS CONSIDERED THIRDPARTY AFFILIATED RESEARCH. Powered by the EFA Platform

105 Cement India Ultratech Cement November 23, 2016 In a different league Investment summary We initiate coverage on UTCEM with a Hold rating and a target price of Rs3,430, implying upside potential of 1.1% from the current level. Although we believe the company is well placed to benefit from the ongoing structural recovery in the Indian cement sector, the positives look priced in already, in our view. Additionally, major headwinds over the next 12 years could come from sharp fuel price increases. Cement demand cycle to recover gradually: India s cement demand grew at a suboptimal c.4.0% during 16, much lower than the longterm demand growth of 78%. However, we believe the industry has entered a gradual recovery phase and expect demand growth of 7.2%/8.0% in FY18F/19F. Concurrently, capacity addition CAGR, which was 10.3% during the past 10 years, is likely to come down to 2.7% during 19F. This would improve capacity utilisation from 6667% in to c.74% in FY19F. UTCEM would likely capitalise on this structural recovery, in our view. Figure 1: Key Assumptions, 19F FY17F FY18F FY19F Cement ASP (Rs/t) 3,969 3,976 4,566 4,985 4,882 5,135 4,996 5,096 5,300 5,512 % increase (2) (2) 5 (3) Cement Sales (mt) % increase Cement Capacity utilization (%) Freight cost per ton ,039 1,105 1,204 1,237 1,225 1,262 1,300 % increase (1) 3 3 Power & fuel cost per ton ,056 1, , ,038 % increase (25) (6) 6 (16) Core EBITDA/t (Rs/t) 1, ,005 1, ,008 1,077 1,164 % increase 3 (31) (22) Note: Core EBITDA excludes other operating income Continued expansion would transform company to different league: The company is working towards maintaining its market share and is exploring both the organic and inorganic routes. During 17F, it is likely to have added 12.8 mtpa of organic capacity, apart from a 4.8 mtpa acquisition in Gujarat (). Currently, UTCEM is in midst of acquiring 21.2 mtpa cement plants from the Jaypee Group at an enterprise valuation of Rs161.9bn. After the acquisition, the company s cement capacity would increase to 91.1 mtpa (including overseas operations). This would account for c.20% of India s total capacity in FY18F. 105

106 FY08 FY17F FY18F FY19F % Cement India Ultratech Cement November 23, 2016 Figure 2: UTCEM s preacquisition capacity share Figure 3: UTCEM s post acquisition capacity share Southern 23% Northern 19% Southern 23% Northern 20% Eastern 17% Eastern 13% Western 32% Central 9% Western 24% Central 20% SOURCES: CIMB, UTCEM presentation SOURCES: CIMB, UTCEM presentation Emerging cost concerns but positive growth outlook: Pet coke prices have increased c.90% YTD and imported coal prices have increased by 40 50% during the past 34 months. Pet coke comprises three fourths of the fuel mix putting pressure on profitability. Nevertheless, UltraTech is well positioned to benefit from the gradual recovery in the industry and we think it would achieve volume growth CAGR of c.14% (including Jaypee acquisition) in 19F. Additionally, riding on the ongoing recovery in the sector, realisation growth would be better than cost inflation, resulting in 19F EBITDA and PAT CAGR of 16% and 22%, respectively. Figure 4: EBITDA and PAT CAGR of 16% and 22%, respectively, during 19F (20) (40) EBITDA growth PAT growth Note: and sharp rise is due to merger with Samruddhi Balance sheet to remain strong despite continuing capex: Rising profitability and healthy volume growth would result in a healthy free cash flow and strengthened balance sheet. We expect the company to incur capex of Rs8bn in each of the next three years, in contrast to Rs144bn in the previous six years. This would result in free cash flow generation of c.rs107bn over next three years ending FY19F. Healthy free cash flow would strengthen its balance sheet. Even if we include the debt from the Jaypee acquisition, net debt to equity would remain low at c.0.7x. Initiate with Hold: We value the company at 12.5x 1year forward EV/EBITDA multiple, in line with the multiples of major players during the previous cycle. We used an assetbased method as a secondary check to our target price as there is ambiguity in replacement costs. Our target price of Rs3,430/sh translates into EV/t of US$204 (c.20% above the mean of past 10 years) and has upside potential of 3.2%. On EV/T, at our TP, 106

107 Cement India Ultratech Cement November 23, 2016 UltraTech would trade at c10% premium to ACC and 78% discount to SRCM. Initiate with a Hold rating. Figure 5: Our TP is near the current price Valuation EBITDA (FY19F) Rs m 74,373 Multiple x 12.5 EV (FY18F) Rs m 929,660 Net debt (FY18F) Rs m (41,039) Market capitalisation (FY18F) Rs m 970,699 Fair Value (FY18F) Rs 3,538 1yr forward price target Rs 3,430 Note: Our EBITDA and net debt numbers include estimates from overseas operations 107

108 Cement India Ultratech Cement November 23, 2016 Continued expansion propels company into a different league UltraTech has continually been growing both organically and inorganically. After the merger with Samruddhi Cement in, the increased capacity of 48.8mtpa was c.16% of domestic capacity. The company intends to maintain its market share and has explored both the organic and inorganic routes. During 17F, it is likely to add 12.8 mtpa of organic capacity, apart from a 4.8 mtpa acquisition in Gujarat (). Currently, UTCEM is in midst of acquiring 21.2 mtpa cement plants from Jaypee Group at an enterprise valuation of Rs161.9bn. After the acquisition, the company s cement capacity would increase to 91.1 mtpa (including overseas operations). This would account for c.20% of India s total capacity in FY18F. Jaypee acquisition would only be EPS accretive in FY21F UTCEM announced the acquisition of Jaypee asset in Feb 2016 and the Board ratified it in March Key details of the acquisition are: Originally the plan was to acquire 22.4mtpa capacity at an enterprise value of Rs165bn. Later, 1.2 mtpa plant in Karnataka was dropped. Clinker capacity is at 16.2 mtpa. In addition to cement capacity, UTCEM would get 325 MW captive power capacity. Enterprise value of the acquisition was at US$110/t. As discussed in our sector note, we believe this is a fair value acquisition. The process is likely to be completed in 1HFY18. Acquisition would provide footprint in Satna Cluster Postacquisition, the company would increase its capacity significantly in the Satna cluster (Central region) where it did not have a major footprint previously. This is a good strategic move, in our opinion, since the new capacity should be able to serve both the central and eastern regions, with high growth potential. Figure 6: UTCEM s preacquisition capacity Figure 7: UTCEM s post acquisition capacity share Southern 23% Northern 19% Southern 23% Northern 20% Eastern 17% Eastern 13% Western 32% Central 9% Western 24% Central 20% SOURCES: CIMB, UTCEM presentation SOURCES: CIMB, UTCEM presentation UTCEM was most suited to execute such a large transaction The Jaypee cement sale is an example of a distressed sale for the company. The company was operating at a c.50% capacity utilisation with declining profitability. Jaypee also had debt of c.rs115bn. At an assumed interest rate of 1112%, the interest would be Rs12bn13bn per annum. During, it reported an EBITDA of Rs4bn (In JAL only). This further forced the company to look for a buyer. We believe UltraTech was most suited to execute the transaction because: 108

109 FY08 FY08 Rs/t % Cement India Ultratech Cement November 23, 2016 UTCEM is the largest company with c.63 mtpa domestic capacity. No other cement company has the size and balance sheet strength ( net D/E of 0.16x) to execute the transaction of this size. After the Lafarge and Holcim merger, the group has kept expansion plans on hold. This negated the other two major players (ACC (Add, Rs 1,598/sh) and ACEM (Add, Rs 257/sh)) with strong balance sheets too) from emerging as potential suitors. The profitability profile of Jaypee (JAL only) and UltraTech clearly shows the sliding fortunes of Jaypee. Although the ROCE profile of the whole industry fell in the past 78 years, the sharp fall in JAL made the business unsustainable. Figure 8: JAL profitability slipped sharply in past 3 years Figure 9: UTCEM always had a much better ROCE profile 1,400 1,200 1, JAL EBITDA/t UTCEM EBITDA/t JAL RoCE UTCEM RoCE Company has many levers to increase EBITDA of acquired plants UltraTech could take over Rs115bn debt from JP Associate books and hope to get it refinanced at a lower rate. We believe the current rate is c.11% and refinancing could be done at 200bps lower. The EBITDA of JAL is at c.rs400/t now. JAL s cement sells at a discount of Rs2025/bag to UltraTech s cement. Additionally, the capacity utilisation is less than 50% currently. Hence, we believe there are multiple levers with UltraTech to raise the profitability of acquired assets: Rebranding: If UltraTech manages to partially rebrand JAL s cement, it should result in increasing realisation by Rs1015/bag. Adjusted for increased selling and advertising/marketing expenses, we believe this should result in incremental EBITDA of Rs100150/t. Process improvements: JAL s plants are not very old. Hence UltraTech would not have to incur significant capital expenditure to add to profitability, in our view. We expect streamlining processes should result in significant savings in cost. Improved capacity utilisation: Currently, the company is operating at sub 50% capacity utilisation whereas UltraTech operated at a c.75% utilisation in. Increasing utilisation would add scale benefits to EBITDA. We believe there should be synergy benefits from logistics, procurements and working capital. 109

110 Cement India Ultratech Cement November 23, 2016 Acquisition to be EPS accretive only in FY21F UltraTech expects to increase JAL s profitability and bring it near the profitability of large cap peers in 34 years. Given the drivers discussed earlier, we believe this is possible. However, we do not expect the acquisition to be EPS accretive before FY21F. Our key assumptions are: Transaction would be completed in 1H FY18F and material benefits would be visible only in FY19F. Depreciation would be prorated linearly to the capacity acquired. Interest cost would come down to 9% and the debt would remain constant in the books. EBITDA should be sufficient to cover interest cost. Shortfall/surpluses in different years are ignored. Capacity utilisation would increase 10% pts every year. EBITDA/t would gradually increase to Rs1,000/t in 3 years. On the basis of the information available and aforementioned assumptions, below we have given our proforma estimates for the newly acquired plants: Figure 10: EPS accretive only in FY21F Acquisition propels UTCEM into a different league FY19F FY20F FY21F Cement capacity mt Utilization % Cement sales mt EBITDA/t Rs ,000 EBITDA Rs m 7,632 11,872 16,960 Depreciation Rs m 5,800 5,800 5,800 EBIT Rs m 1,832 6,072 11,160 Debt Rs m 115, , ,000 Interest Rs m 10,350 10,350 10,350 EBT Rs m 8,518 4, Post the acquisition, UTCEM would move in the global big league of cement companies, in our view. Excluding players in China, it would be the fourth largest cement company in the world after LafargeHolcim (390 mtpa), Heidelberh+Italcementi (200 mtpa) and Cemex (94 mtpa). In India too, the company will have presence in all the clusters which were not adequately covered previously. 110

111 Cement India Ultratech Cement November 23, 2016 Figure 11: UltraTech s geographical spread after proposed acquisition SOURCES: UltraTech company presentation Note: Shahabad GU is removed from the original plan 111