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); +91 22 3982 5416 Sandipan Pal (Sandipan.Pal@MotilalOswal.com); +91 22 3982 5436 1 Investors are advised to refer through disclosures made at the end of the Research Report.
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 2013. 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
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
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) -20-10 -5 0 5 10 20 Cement EBITDA/ton 122 322 422 522 622 722 922 RoE (%) -3.7 1.1 3.5 5.9 8.3 10.7 15.5 RoI (%) 0.1 2.7 4.0 5.3 6.6 7.9 10.5 Interest Coverage (x) 0.0 1.0 1.5 1.9 2.4 2.9 3.8 Net debt/ebitda (x) 7.8 4.4 3.6 3.1 2.7 2.4 1.9 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 (%) 5.3 15.0 5.3 15.0 11.7 15.0 11.7 15.0 Gross block (US $/ton) 71 71 110 110 77 77 130 130 Utilization (%) 74 74 74 74 84 84 84 84 NOPLAT (INR /ton) 285 808 441 1,252 420 771 1,014 1,303 EBIT (INR /ton) 407 1,154 630 1,788 600 1,102 1,449 1,862 Other business EBITDA (INR /ton) 136 136 136 136 97 97 97 97 Depreciation (INR /ton) 251 251 339 339 267 267 267 267 EBITDA (INR /ton) 522 1,269 833 1,991 770 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) 0 37 11 68 0 25 42 63 *Assuming lower capex for ISM players and INR5/bag cost efficiencies for their new plant 4
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 30.7 30.7 30.7 24.1 25.4 27.4 816 551 706 17.7 12.3 14.7-31.5-35.7-37.0 Ambuja 28.0 28.8 29.6 22.0 23.0 24.8 1,122 795 968 25.5 18.8 21.3-38.7-29.0-33.9 Ultratech 49.3 59.1 62.0 41.3 46.4 50.8 1,095 1,029 1,185 22.6 21.3 22.9 1.6 10.1 3.4 Shree Cement 15.5 17.5 19.0 12.6 13.6 15.0 1,033 1,037 1,249 27.0 26.2 28.9-14.1-15.3-20.0 Large Cap 123.4 136.1 141.3 99.9 108.3 118.0 1,026 868 1,036 22.6 19.3 21.4-82.7-70.0-87.5 Birla Corp 9.3 9.3 9.3 6.5 6.9 7.5 547 451 660 13.8 11.3 15.4-3.7-4.6-6.4 Century Textile 9.3 10.0 12.8 8.0 8.4 9.4 554 444 610 8.4 7.1 9.5 48.9 59.1 61.2 Dalmia Bharat Ent. 10.6 12.3 15.0 5.6 5.9 6.4 1,037 1,015 1,139 21.6 22.3 24.2 24.0 24.9 22.6 India Cements 15.1 15.1 15.1 10.7 11.6 12.5 890 848 997 20.8 19.5 21.7 29.1 27.7 24.4 JK Cement 8.0 8.6 11.6 6.1 6.4 7.3 905 961 1,399 18.9 19.2 22.7 8.4 19.2 20.2 JK Lakshmi Cement 5.3 5.3 9.2 5.3 5.6 6.2 812 761 929 20.9 19.5 22.2 9.5 13.0 15.4 Madras Cement 13.6 13.6 13.6 8.4 8.9 9.7 1,061 1,148 1,317 25.4 26.2 27.9 25.2 20.3 11.8 Prism Cement 5.6 5.6 5.6 4.8 5.5 6.0 334 528 722 4.9 8.4 10.1 15.7 14.2 13.1 Mid-caps 81.8 84.9 97.3 59.4 63.6 69.6 785 788 978 16.8 16.7 19.0 162.0 180.9 172.5 Aggregate 205.2 221.0 238.5 159.3 172.0 187.6 936 839 1,015 20.4 18.3 20.5 79.3 110.9 85.0 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 68.7 49.5 72.8 17.7 12.3 17.1 17.4 10.4 16.0-0.4-0.5-0.4 7.7 11.8 12.2 8.6 5.3 4.9 Ambuja 10.0 8.0 10.6 18.3 13.6 16.9 27.6 19.6 24.2-0.4-0.3-0.3 8.6 6.3 9.2 5.8-0.4 5.2 Ultratech 96.8 94.6 125.7 18.9 15.8 18.1 21.6 18.8 21.9 0.0 0.1 0.0 8.3 7.7 10.1 0.3-0.4 2.7 Shree Cement 283.6 270.0 379.5 31.5 24.1 25.6 25.6 23.3 25.7-0.4-0.3-0.4 9.1 10.8 13.6 2.5 2.8 5.4 Large Cap 20.2 16.1 19.5 22.4 17.5 21.5-0.2-0.2-0.2 Birla Corp 35.0 30.0 47.3 11.0 8.8 12.6 10.8 9.6 13.1-0.2-0.2-0.2 20.3 35.8 45.6 6.0 17.0 28.3 Century Textile -3.7-12.5-5.7-0.6-1.7-0.7-1.9-6.7-3.4 2.7 3.6 4.0 11.1 6.6 8.8-18.5 6.2 3.1 Dalmia Bharat Ent. 24.3 27.1 37.2 6.6 7.0 8.9 9.2 8.5 10.2 0.8 0.8 0.6 2.5 25.6 29.5-42.3 5.5 13.6 India Cements 6.2 7.9 14.0 4.3 5.3 8.9 8.4 8.7 11.6 0.7 0.6 0.5 14.7 17.9 25.5 4.7 11.6 19.8 JK Cement 33.0 31.0 52.5 14.4 12.3 17.9 16.6 14.5 18.2 0.5 1.0 0.9 20.7 13.1 20.8 8.5-23.4 6.0 JK Lakshmi Cement 16.0 14.4 17.7 15.4 12.8 14.2 13.8 11.5 12.7 0.8 0.9 1.0 20.4 17.2 19.1-7.8-5.5-1.8 Madras Cement 17.0 20.2 28.0 18.3 18.7 21.8 15.8 17.9 22.3 1.1 0.7 0.4 13.1 15.9 20.3 9.4 14.6 18.8 Prism Cement -1.2 1.5 4.2-5.4 6.9 17.4 4.1 11.5 17.8 1.4 1.2 1.0 1.1 15.1 15.2-6.8 11.5 11.4 Mid-caps 10.1 11.2 15.8 9.6 9.7 12.8 1.0 1.1 1.0 Aggregate 16.9 14.6 18.4 17.6 14.6 18.3 0.2 0.3 0.2 5
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 1,144-6.0 17.7 24.6 16.7 9.9 13.0 8.7 108 102 95 87 Ambuja Neutral 184 157-14.5 18.3 23.0 17.3 9.6 13.2 9.7 145 143 134 111 Ultratech Buy 1,842 2,073 12.6 19.0 19.5 14.6 10.4 10.1 7.9 163 139 131 149 Shree Cement Buy 4,739 4,818 1.7 16.7 17.5 12.5 9.7 8.8 6.9 140 119 113 115 LARGE CAP 18.2 20.7 15.3 9.8 10.7 8.1 142 129 122 Birla Corp Buy 233 352 50.9 6.6 7.8 4.9 3.7 4.0 2.1 24 23 19 36 0-100 Century Textile Neutral 295 373 26.2-79.7-23.7-51.5 13.1 16.0 11.6 48 53 47 124 1,092 270 Dalmia Bharat Ent. Buy 130 299 130.3 5.4 4.8 3.5 5.3 3.6 3.2 51 37 35 51 753 480 India Cements Neutral 63 91 45.5 10.1 7.9 4.5 5.0 4.7 3.4 54 52 48 58 185 195 JK Cement Buy 243 483 98.5 7.4 7.8 4.6 4.2 4.3 3.7 58 61 62 78 689 183 JK Lakshmi Cement Buy 111 176 58.0 7.0 7.7 6.3 3.4 3.1 4.7 48 43 50 64 0-100 Madras Cement Buy 233 300 28.4 13.7 11.6 8.3 8.1 6.7 4.8 98 93 82 102 394 69 Prism Cement Neutral 37 41 10.8-31.0 24.4 8.9 14.6 7.2 5.0 86 64 54 102 0-100 MID CAPS 10.1 8.5 5.5 5.8 4.7 3.7 58 54 50 AGGREGATE 16.7 17.8 12.7 8.7 8.6 6.6 111 102 95 * EV adjusted for CWIP 6
N O T E S 7
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