Stress test: Weak capital servicing ratios to drive pricing discipline

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1 Stress test: Weak capital servicing ratios to drive pricing discipline Operating performance near trough; expect gradual improvement 20 Update Cement Our analysis of a cross-section of cement companies (21 companies representing ~67% of industry capacity) indicates limited scope to bear further pricing pressure, especially for inefficient, small and marginal (ISM) players. We have examined key operational and financial trends for the industry in general and ISM players in particular to gauge the sustainability of current operations, financial capability for future expansion, and future pricing trends. We present our key takeaways: March quarter cement profitability in FY13 was the lowest in three years, with EBITDA/ton for ISM players down 25% YoY to INR522 against ~INR853 for tier-1 players. PAT/ton for ISM players was INR172. ISM players earned 5-8% RoIC/RoE (on historical capex of USD60-70/ton) and would barely break even at current capex cost (assuming lower capex cost and benefit of efficiencies), suggesting limited incentive for putting up new capacity at current pricing. Considering the ISM players' higher operating and financial leverage, and their weak capital servicing capability based on 4QFY13 performance, we believe there is limited headroom for cement price correction. For a greenfield plant, at current capex of USD130/ton and operating cost, to achieve 15% RoIC, the industry/ism player needs ~INR63/68 per bag increase in cement prices from 4QFY13 level. Weakest profitability in three years for seasonally best quarter The March quarter is seasonally the strongest for the cement companies. March quarter cement profitability in FY13 was the lowest in three years, despite benefits from energy cost savings. EBITDA/ton for ISM players declined 25% YoY to INR522 against ~INR853 for tier-1 players. PAT/ton for ISM players was INR172. This was largely due to dilution of rationality in key markets. Pricing aggression of ISM players (realization differential vis-à-vis tier-1 players widened to INR10/bag v/s INR7/ bag in 4QFY12) resulted in 70bp YoY increase in market share, but at the cost of PAT/ton, which declined 40% YoY. Capital efficiency for ISM players very weak even at historical capex ISM players are making 5-8% RoIC/RoE, based on 4QFY13 profitability run-rate (v/s blended average RoIC of 11-12% for the 21 companies under analysis) and historical capex of USD60-70/ton (which is significantly lower than the prevailing cost of over USD140/ton). At current capex (assuming lower capex for ISM players and benefit of efficiencies), new capacities by ISM players would barely achieve PAT breakeven at current pricing. The industry needs INR55-70/bag increase in cement prices from 4QFY13 levels to deliver 15% RoIC. Price discipline should return; else, ISM players will bleed Pricing discipline is likely to return for the industry, driven by ISM players' weak capital servicing ratios, forcing them to prefer profitability over market share. Weak profitability, though higher than the lows of 2QFY11, seems concerning, especially if it is impacted further during the monsoon season downtrend. Considering the ISM players' higher operating and financial leverage, and their weak capital servicing capability based on 4QFY13 performance, we believe there is limited headroom for cement price correction. Further, current pricing offers limited incentive for putting up new capacity. Valuation and view We expect cement demand and pricing to recover from 2HFY14. While we estimate INR1/bag decline in realization and INR4/bag decline in EBITDA for FY14, we estimate INR15/bag improvement in realization and INR9/bag increase in EBITDA for FY15. Recovery in demand, lower capacity addition and price resilience would drive sustainable improvement in operating performance. Revival in cement demand would be the key catalyst for stock performance. Prefer UltraTech/ Grasim and Shree Cement in large caps, and Birla Corp, JK Cement and Dalmia Bharat in midcaps. Note: ISM players include India Cement, Prism Cement, JK Cement, Heidelberg India, Sagar Cement, Mangalam Cement, Mehta Group, Shree Digvijay and Sanghi Ind Jinesh Gandhi (Jinesh@MotilalOswal.com); Sandipan Pal (Sandipan.Pal@MotilalOswal.com); Investors are advised to refer through disclosures made at the end of the Research Report.

2 Trend in utilization and realizations (%) Weak demand, dilution in rationality reflected in weak realizations in seasonally strong quarter Weak demand in the seasonally strong March quarter coupled with dilution in rationality of ISM players led to unusual pricing pressure. ISM players preference for market share over pricing has been evident for the last 2-3 quarters. Pricing aggression of ISM players (realization differential vis-à-vis tier-1 players widened to INR10/bag v/s INR7/bag in 4QFY12) resulted in 70bp YoY increase in market share. Price aggression of ISM players reflecting in market share gains resulting in pressure on profitability Unlike the historical trend, there was no major sequential improvement in profitability in the March quarter in FY13. This was due to unusual corrections in cement prices in February/March 2013, after increase in January EBITDA/ton for ISM players declined 25% YoY to INR522 against ~INR853 for tier-1 players. March quarter cement profitability in FY13 was the lowest in three years, despite benefits from energy cost savings and operating leverage. ISM players PAT/ton declined 40% YoY to INR172 in 4QFY13. While current dynamics are still better than the lows of 2QFY11, further worsening during the weaker monsoon season could lead to severe pressure on ISM players. EBITDA/ton for ISM players down 25% YoY to INR522 EBITDA margin (%) down 4pp YoY for ISM players 2

3 Trend in operating leverage (fixed cost as percentage of total cost) Trend in PAT/ton Trend in interest coverage ratio for ISM players and weak capital efficiencies, especially for ISM players ISM players are making 5-8% RoIC/RoE, based on 4QFY13 profitability run-rate (v/s blended average RoIC of 11-12% for the 21 companies under analysis) and historical capex of USD60-70/ton (which is significantly lower than the prevailing cost of over USD140/ton). At current capex (assuming lower capex for ISM players and benefit of efficiencies), new capacities by ISM players would barely achieve PAT breakeven at current pricing. Further, weak capital servicing ratios would also force rationality among ISM players further cement price correction would impact their interest servicing. Our analysis indicates that ~INR10/bag decline in cement prices (from 4QFY13 levels) would result in EBITDA barely covering interest obligation. There is limited headroom for current profitability to worsen, given the operating leverage and high interest coverage ratios, especially for ISM players. Trend in Net Debt/EBITDA Trend in Net Debt/Equity RoIC for ISM players weakens significantly 3

4 Trend in capital efficiency for Aggregate Trend in capital efficiency for ISM players INR10/bag decline in cement prices would lead to PAT loss for ISM players based on current economics Cement Price Increase (INR/bag) Cement EBITDA/ton RoE (%) RoI (%) Interest Coverage (x) Net debt/ebitda (x) indicating limited decline in cement prices from current levels For existing capacities to generate 15% RoIC, cement prices need to be higher by INR25/bag (~INR37/bag for ISM players). For a greenfield plant, at current capex of USD130/ton and operating cost, to achieve 15% RoIC, the industry/ism player needs ~INR63/68 per bag increase in cement prices from 4QFY13 level. Pricing discipline is likely to return for the industry, driven by marginal players preferring profitability over market share. RoIC sensitivity to cement pricing ISM Players Aggregate Historical Capex Cost Current Capex Cost* Historical Capex Cost Current Capex Cost Implied RoIC (%) Gross block (US $/ton) Utilization (%) NOPLAT (INR /ton) , ,014 1,303 EBIT (INR /ton) 407 1, , ,102 1,449 1,862 Other business EBITDA (INR /ton) Depreciation (INR /ton) EBITDA (INR /ton) 522 1, , ,272 1,619 2,032 Normative cost 3,417 3,417 3,317 3,317 3,275 3,275 3,275 3,275 Net Realization (INR /ton) 3,939 4,686 4,150 5,308 4,045 4,547 4,894 5,307 Implied price increases (INR/bag) *Assuming lower capex for ISM players and INR5/bag cost efficiencies for their new plant 4

5 Operating Matrix Valuation and view We expect cement demand and pricing to recover from 2HFY14. While we estimate INR1/bag decline in realization and INR4/bag decline in EBITDA for FY14, we estimate INR15/bag improvement in realization and INR9/bag increase in EBITDA for FY15. Recovery in demand, lower capacity addition and price resilience would drive sustainable improvement in operating performance. Revival in cement demand would be the key catalyst for stock performance. Prefer UltraTech/Grasim and Shree Cement in large caps, and Birla Corp, JK Cement and Dalmia Bharat in midcaps. Capacity (MT) Volumes (MT) EBITDA (INR/Ton) EBITDA (%) Net Debt (INR b) FY13 FY14E FY15E FY13 FY14E FY15E FY13 FY14E FY15E FY13 FY14E FY15E FY13 FY14E FY15E ACC Ambuja , Ultratech ,095 1,029 1, Shree Cement ,033 1,037 1, Large Cap , , Birla Corp Century Textile Dalmia Bharat Ent ,037 1,015 1, India Cements JK Cement , JK Lakshmi Cement Madras Cement ,061 1,148 1, Prism Cement Mid-caps Aggregate , Financial Matrix EPS (INR) RoE (%) RoCE (%) Net Debt:Equity (x) OCF yield (%) FCF yield (%) FY13 FY14E FY15E FY13 FY14E FY15E FY13 FY14E FY15E FY13 FY14E FY15E FY13 FY14E FY15E FY13 FY14E FY15E ACC Ambuja Ultratech Shree Cement Large Cap Birla Corp Century Textile Dalmia Bharat Ent India Cements JK Cement JK Lakshmi Cement Madras Cement Prism Cement Mid-caps Aggregate

6 Valuation summary Reco CMP TP Upside PE EV/EBITDA EV/Ton (USD) EV/ Blue Upside (INR) (FY15) (%) (x) (x)* at CMP * Ton -sky (%) FY13 FY14E FY15E FY13 FY14E FY15E FY13 FY14E FY15E at TP TP ACC Neutral 1,217 1, Ambuja Neutral Ultratech Buy 1,842 2, Shree Cement Buy 4,739 4, LARGE CAP Birla Corp Buy Century Textile Neutral , Dalmia Bharat Ent. Buy India Cements Neutral JK Cement Buy JK Lakshmi Cement Buy Madras Cement Buy Prism Cement Neutral MID CAPS AGGREGATE * EV adjusted for CWIP 6

7 N O T E S 7

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