Cement: RoE-valuation divergence widens

Sector Update | 19 August 2015

Cement

RoE-valuation divergence widens

Analyzing 1Q operational trends; betting on quantum of positive surprise



In this report we highlight the following key operational trends from 1QFY16 earnings:

Trend 1: System stress still high, but regional contrast altered

Trend 2: Demand pie unaltered—market share gain drove growth

Trend 3: Regional price dichotomy widens—downside limited in north/central

Trend 4: Cost inflation fades, barring freight; currency a risk

Trend 5: Margin goes southward—literally!

Earnings downgrade cycle is settling down with better acknowledgement of reality.

Large caps’ RoE is at a decadal low, further widening the divergence with valuations.

Sluggishness in on-ground activity to lead to short-term time corrections. However, we

remain positively biased on medium term outlook and bet on the quantum of positive

surprise the recovery cycle can bring in.

Prefer stocks with high degree of preparedness—UTCEM among large caps and JKLC,

JKCE and DBEL among mid caps.

Dismal pricing and financial

leverage kept operational

stress at high

Trend # 1: System stress still high, but regional contrast altered



We analyzed operating and financial performances of 22 listed cement

companies (covering ~70% of Industry capacity). It highlights that almost 27% of

sample set capacity reported negative PAT in 1QFY16, which close to 5-years

peak (Exhibit 1).

However, only 11-13% of these capacities have posted negative cash PAT or

(EBITDA-interest) v/s 25% during the previous peak of Sep-13. (Exhibits 2 & 3)

Therefore, the visible stress in the system is more due to financial leverage

(higher depreciation and interest outgo)—which started percolating post the

conclusion of multiple expansions in recent quarters.

However, better cash PAT or EBITDA-interest is more attributable to moderating

cost inflation and pricing resilience in the south and east; otherwise, the

competitive pricing scenario remains dismal in other regions.

Exhibit 2: …but improved on negative (EBITDA – Interest)…

% of Capacity

No of players

4 4

Exhibit 1: Mix of players posting negative PAT is still high…

% of Capacity

No of players

5 5 5

5 18 8 8

1 1

9 3 2 1 3 5 2 7 28 23 16 21 14 21 12 27

2 2

1 21 5 1 0 8 1 3 1 3 7 2 4 25 22 12 18 15 20 12 13

Source: Company, MOSL

Sandipan Pal

(Sandipan.Pal@MotilalOswal.com); +91 22 3982 5436

Jinesh Gandhi

(Jinesh@MotilalOswal.com); +91 22 3982 5416/

Anchit Agarwal

(Anchit.Agarwal@MotilalOswal.com)

Investors are advised to refer through disclosures made at the end of the Research Report.

Motilal Oswal research is available on

www.motilaloswal.com/Institutional-Equities,

Bloomberg, Thomson Reuters, Factset and S&P Capital.

Cement | Sector Update

Regional contrast altered

with higher stress in north,

while discipline brought

south out of stressed zone



These led to regional contrast altering significantly over past 12 months with

north-south divergence widening in reverse direction. While northern region

recorded highest number of capacity making negative PAT (in our sample

universe) in 1QFY16, strong pricing discipline led southern capacities out of the

huge stress witnessed 3-4 quarters back. (Exhibits 4, 5 & 6)

Pricing discipline in south is now steady for almost 8-9 months and attributable

to abysmally weak natural profit dynamics, due to (a) high gearing (exhibit 7 &

8), and (b) low utilizations. South players have DER of 0.9x, net debt/EBITDA of

4-4.5x compared with north players at DER of 0.3x, net debt/EBITDA of 1.5-2x.

Exhibit 4: North-South dichotomy at a height of contrast

North capcity (mt)

Capacity (MOSL universe)

making PAT-loss

South capcity (mt)

Exhibit 3: …or delivering negative cash PAT

1 1 1

2 2

% of Capacity

No of players

1 2 2 1 0 7 1 2 1 1 3 1 3 6 4 1 1 1 14 11 11

Source: Company, MOSL

Exhibit 5: Per ton dynamics of north players in sample set

EBTIDA

1000

800

600

400

200

EBTIDA-Int

PAT

Cash PAT

Exhibit 6: Per ton dynamics of south players in sample set

EBTIDA

1200

900

600

300

EBTIDA-Int

PAT

Cash PAT

Source: Company, MOSL

Exhibit 7: South-based players have higher gearing burden (x) Exhibit 8: Trend in net debt/EBITDA

North

0.7

0.5

0.2

0.3

0.5

0.3

0.6

0.4

0.5

0.4

0.3 0.3

South

0.6

0.2

0.6

0.3

0.7

0.3

0.7

3.0

0.3

1.1

1.2 1.4

0.7

2.1

1.6

1.3

0.9

North

South

4.3

4.2

Mar-11

Source: Company, MOSL

Mar-12

Mar-13

Mar-14

Mar-15

Source: Company, MOSL

19 August 2015

Cement | Sector Update

Trend #2: Demand pie unaltered, market share gain drove growth

Fight for the pie continues -

only the companies adding

new capacities grew by

gaining market share



Resilience only on new capacity:

1QFY16 was yet another quarter where only

players with new capacity addition posted substantial volume growth. Among

the large-cap players, UTCEM (+4% YoY) and SRCM (+17%) outperformed Holcim

viz. ACC (-2.4% YoY) and Ambuja (+1.8% YoY) on the back of ramp-up of new

capacity addition in recent quarters.

Non-expanding players post ~4pp market share loss:

In MOSL coverage

universe, players who added capacity (say Type B; UTCEM, SRCM, JKLC, JKCE)

gained ~4pp market share in the past three years from those who didn’t add

capacity (say Type A). Exhibit 10.

East best performer, south having double-digit whammy:

East was the best

region (volume up 7-8% YoY), followed by north (2-4% YoY). South posted ~12%

YoY volume de-growth while west was a mixed bag, with Maharashtra posting

muted demand and Gujarat showing near-double-digit growth.

Green shoots not yet strong:

Government activity w.r.t. Infrastructure spending

(especially toward roads) witnessed some uptick in north and east, while

housing and rural segments are witnessing growth only in east and Gujarat.

Exhibit 11.

Exhibit 9: New capacity key to growth in the current scenario Exhibit 10: Capacity setters gain 3% market share (%)

Jun-14

Sep-14

Dec-14

Mar-15

1719

8 6

-2

-10

ACEM

UTCEM

SRCM

Top 4

Source: Company, MOSL

-3

-5

Jun-15

Type A

Type B

-10

ACC

Source: Company, MOSL

Exhibit 11: Prevailing regional demand scenario

Green shoots are limited to

select regions and select

segments; broad-based

momentum yet to show

visibility

Source: UTCEM

19 August 2015

Cement | Sector Update

Management commentary and industry feedback

Hope

hinges on pick-up in

government activity from

2HFY16, southern players

expects AP/Telengana

recovery by 4QFY16



Short-term pain to continue:

Pan-India players (UTCEM, ACC and Ambuja)

expect sluggish demand to persist in near term on the back of monsoon and

adverse macro factors.

Recovery in sight from 2H:

The scenario is expected to improve from 2HFY16

owing to heightened government focus on infrastructure development and

other initiatives (‘Housing for All’, ‘Smart Cities’, concrete roads, etc.) and

potential softening of interest rates to provide impetus to private participation.

AP benefits expected by year-end:

The southern companies are hopeful that

benefits of Andhra Pradesh’s (AP) bifurcation will start percolating by FY16-end,

with monthly demand increasing to 1.8-1.9mt/month v/s ~1.2mt now.

North-Central pricing bottomed out:

Pricing has bottomed out in north, central

and Maharashtra post 1Q. Central players faced severe supply pressures from

north (especially Rajasthan), impacting realizations in 1QFY16. All the said

regions saw an increase of INR10-25/bag in August-15, though sustainability is

yet to be proven.

East showing healthiest dynamics:

Despite the entry of new players (Shree

Cement, JKLC) in 1QFY16 in east, the dynamics of the region were stable as

demand grew 7-8% YoY due to (a) an uptick in government infrastructure

projects, especially in Bihar (ahead of state elections) and Orrisa, and (b) double-

digit growth in rural housing.

Trend #3: Regional price dichotomy widens —downside limited in north

Our estimates factor in 3-

4pp higher price growth

(from current base) in north

v/s south by FY17



North pricing severely underperformed:

Despite double digit volume de-growth

in south, production discipline keeps pricing artificially high. Conversely, north

witnessed severe competitive pressure—with non-trade pricing in select regions

(in Rajasthan) touching operational break-even. East continued to witness good

volume growth and resilient overall pricing despite the entry of Shree Cement,

which sold at a discount to frontline brands.

Will the surprise be higher in north?

Headroom for realization growth is better

in north, with limited downside. Our estimates factor in 3-4pp higher price

uptick in north than south in FY17 (from current base). Given commodity price

has the ability to surprise positively in demand upturn, we expect the magnitude

of surprise to be higher in north.

Exhibit 13: Price trends (100 indexed): South-mix-led UTCEM

Exhibit 12: Price differential between north and south at peak and ACC post better realization trends

350

300

250

200

150

100

North

South

110

105

100

Jun-14

Sep-14

Dec-14

Mar-15

Jun-15

Source: Company, MOSL

19 August 2015

Source: Company, MOSL

Cement | Sector Update

Trend #4: Cost inflation fades, barring freight; currency a risk

Lower pet coke price the

show-stealer, though

currency could be a risk

ahead



Energy:

Rising pet coke usage in the fuel mix is now a common industry-wide

trend and declining pet coke prices enable cost savings for cement players.

However, ‘currency’ (rupee depreciation) could pose a risk to the

competitiveness of imported fuel in 2Q.

Freight:

Cost increased for the second successive quarter on account of (1) rise

in rail freight, (2) lower ex factory sales and (3) increase in lead distance.

RM cost:

Lower gypsum and packaging costs helped cost savings. However,

royalty-linked DMF provision (only UTCEM, ICEM, TRCL provided for in 1QFY16)

can increase raw material cost in coming quarters. Exhibit 15.

Staff cost:

Minor impact in select companies witnessed in 1QFY16 due to wage

board revision, viz. JKLC and Birla Corp.

Exhibit 15: Deflationary trends in key inputs (100-indexed)

105

100

Gypsum

Source: Company, MOSL

Flyash

Packaging

Petcoke

1HCY14

1QCY15

2QCY15

Exhibit 14: Freight cost rises even as direct cost moderates

-10

Direct cost inflation

Freight inflation

Source: Company, MOSL

Exhibit 16: Trends in total cost (100-indexed): UTCEM outperforms large cap peers

UTCEM posted maximum

improvement in cost

management (among the

large-cap players) in the

past four quarters

Sep-14

105

100

ACC

ACEM

UTCEM

SRCM

Top 4

Source: Company, MOSL

Dec-14

Mar-15

Jun-15

Trend # 5: Margin goes southward—literally!

Profitability at north has

limited downside risk,

aiding for uptick in pricing



Profitability and margins of pan-India players were at a decadal low in 1Q, with

~20% YoY decline in EBITDA/ton for the top 4 players.

While Holcim and Shree Cement reported 30-40% YoY decline in EBITDA/ton,

UTCEM posted stable numbers and continues to expand its profitability gap with

peers—thus continuing its outperformance.

Southern players posted ~INR1,000-1,200/ton of EBITDA v/s pure north players’

INR300-600/ton. Even the most efficient northern players viz. SRCM and JKLC

recorded multi-year low 1Q-EBITDA/ton, implying limited downside risk ahead.

Exhibit 19 & 20.

19 August 2015

Cement | Sector Update

Exhibit 17: Margins go southwards on weak pricing (%)

Jun-11

Jun-12

2728

2323

16 14

Jun-13

Jun-14

Mar-15

Jun-15

Exhibit 18: % EBTIDA/ton gap v/s UTCEM. UTCEM expands

profitability gap with peers on better cost control

-20

-40

-60

ACC

ACEM

SRCM

2624

25 2626

2120

2121

20 19

18 18

ACC

ACEM

UTCEM

SRCM

Top 4

Source: Company, MOSL

Exhibit 19: South players post ~INR1,000/t+ of EBITDA (INR)

South

1,450

1,200

950

700

450

200

Ramco

ICEM

Orient

Dalmia

Exhibit 20: North: Weakest 1Q- profitability in a decade (INR)

North

1,250

1,000

750

500

250

Birla Corp

JKCE

JKLC

SRCM

Source: Company, MOSL

RoE-Valuation dichotomy widens; downgrade cycle

We expect stronger pricing

recovery in north and

central compared with

south



Weak recovery and wide

RoE-valuation gap may

cause short term time

corrections



Downgrade cycle seems to be settling down with better acknowledgement of

reality, as evident in consensus earnings estimates for large caps post 1QFY16

(barring Ambuja—10% cut in consensus estimates after earnings). Exhibit 21.

Demand and pricing were the key dampeners in 1QFY16 in north, central and

west; therefore, on the back of abysmally low profitability, we expect stronger

pricing recovery in these regions compared with south—which offers steadiness

in near term due to continued decline in industry utilization.

During 1QFY16, large caps’ RoE dipped to almost 10-year low (Exhibit 23). The

stocks have remained range-bound (Exhibit 22) and are likely to continue time

corrections until growth visibility emerges due to the following: (a) continued

widening of divergence between RoE and valuations, and (b) on-ground

recovery lags optimism.

Average asset-based multiple (EV/ton) for large-cap players stood at ~1.3x

replacement cost (Exhibit 24); this is against our average target multiple of ~1.5x

replacement cost set with assumption of FY17E RoE and RoCE of 16-17% and 19-

20%, respectively.

Our assumptions factor in (a) ~10% of volume and 8-9% of realization growth in

FY17 after a flattish FY16 (v/s FY15), and (b) higher price growth for north-

central region than for south.

19 August 2015

Cement | Sector Update

Exhibit 21: Consensus estimates (100-index)

ACC

110

100

Ambuja

Shree

UTCEM

Exhibit 22: 100-index stock price YTD FY16 -> Holcim

companies underperformed

ACC

Shree Cement

Sensex

Ambuja Cem.

UltraTech Cem.

120

110

100

Source: Company, MOSL

Exhibit 23: Rising dichotomy between earnings multiples and Exhibit 24: EV/ton at 1.3x replacement cost v/s our estimate

RoE, which is at decades low in large cap universe

1-yr forward RoCE at ~50% premium to WACC

Source: Company, MOSL

Valuation and views: Positively biased, but acknowledge the reality!

During commodity upswing,

both demand and prices

can surprise positively with

significant quantum

Positively biased



Reducing visibility of capacity addition, bottoming out of utilizations and huge

pent up demand augur well for gradual improvement of industry dynamics.

Higher tenacity among companies compared to previous cycle with (a) stronger

B/S, (b) bigger sizes and (c) more efficiency in cost management can lead to

better-than-historical valuations in the coming up-cycle.

While direction is positive, the pace of recovery may negatively surprise over

near-term with delay in kick-start led by multiple on-ground challenges.

Therefore, valuations which are factoring in optimism of a normalized 8-10%

growth from FY17, may witness short term time correction or range-bound

performances till early signs of growth emerge.

We believe during commodity upswing, both demand and prices can surprise

with significant quantum, and thereby, diluting rich valuation discomfort at

faster pace. We stick to companies where recovery benefits can be the highest

due to high degree of preparedness in terms of capacity levers, market mix and

cost management.

Ground reality hints at short-term time correction



We stick to companies

where better recovery

benefits due to high degree

of preparedness

But, we bet on the quantum of surprise element



19 August 2015

Cement | Sector Update



UTCEM remains our preferred large-cap pick. Ambuja offers strong headroom

for earnings reversal after the recent underperformance, though re-rating

would be contingent on clarity over business integration dynamics.

Mid-caps are trading at near-peak valuation discount to large caps, with better

re-rating potential. We prefer JK Lakshmi, JK Cement and Dalmia Bharat.

Exhibit 25: Large cap v/s mid-cap valuation gap near peak, offer better re-rating headroom

-20

-60

-100

Discount (%)

Average

Source: Company, MOSL

Exhibit 26: Operating metrics

Capacity (MT)

FY15 FY16E FY17E

30.7

31.7

29.6

30.4

62.2

66.7

71.6

21.5

23.5

143.9

151.5

157.2

9.3

18.6

15.2

11.6

8.2

9.2

10.2

14.5

15.5

5.0

8.0

5.6

88.0

93.0

94.0

232

244

251

Volume (MT)

EBITDA (INR/Ton)

FY15

FY16E FY17E FY15 FY16E FY17E

24.2

24.0

25.4 516

558

851

22.2

23.5 840

684 1,002

45.5

48.9

57.3 861 1,021 1,263

16.2

18.6

21.4 823 1,037 1,328

108.0

113.6

127.6 774

860 1,144

7.7

7.8

8.4 318

313

583

7.0

13.1

14.8 648 1,114 1,325

9.9

9.5

10.4 774

960 1,103

6.3

6.8

7.8 636

698 1,076

5.9

6.9

8.0 588

524

837

7.7

7.4

8.0 809 1,212 1,431

4.1

4.5

5.8 723

725 1,073

5.6

6.2 394

543

789

54.2

61.7

69.3 618

808 1,061

162

175

197 722

842 1,115

ACC

Ambuja

Ultratech

Shree Cement

Large Cap

Birla Corp

Dalmia Bharat Ent.

India Cements

JK Cement

JK Lakshmi Cement

Ramco

Orient Cement

Prism Cement

Mid-caps

Aggregate

19 August 2015

Cement | Sector Update

Exhibit 27: Financial metrics

FY15

45.9

8.5

73.4

133.2

22.8

1.1

0.0

17.9

12.7

10.2

9.5

2.0

EPS (INR)

FY16E FY17E

41.7

71.2

5.8

10.7

93.2

128.3

242.1

423.1

21.0

50.6

8.4

12.1

4.6

16.7

8.0

2.0

45.7

89.7

12.3

51.4

24.6

23.9

16.3

7.2

FY15

10.7

13.4

11.2

9.3

13.4

6.7

0.3

0.8

7.5

11.4

9.5

21.6

9.8

6.6

11.5

RoE (%)

FY16E

FY17E

9.5

15.8

8.0

10.9

12.8

15.6

15.0

22.1

12.7

16.8

6.0

11.9

12.6

19.1

7.3

9.0

5.5

19.7

4.1

19.8

14.1

17.6

15.8

27.3

9.5

28.0

10.3

18.9

12.1

17.3

FY15

13.4

18.7

14.1

9.4

14.2

7.1

4.5

6.5

7.8

8.7

10.2

16.4

6.3

8.0

12.1

RoCE (%)

FY16E FY17E

12.2

20.4

15.2

20.2

15.5

18.6

16.7

26.4

15.0

20.6

6.6

12.4

11.3

15.7

9.6

11.6

8.2

16.0

7.3

16.5

14.5

19.0

10.6

18.5

13.0

23.2

10.1

16.1

13.3

19.0

ACC

Ambuja

Ultratech

Shree Cement

Large Cap

Birla Corp

Dalmia Bharat Ent.

India Cements

JK Cement

JK Lakshmi Cement

Ramco

Orient Cement

Prism Cement

Mid-caps

Aggregate

Source: Company, MOSL

Exhibit 28: Valuation summary

CMP

RECO.

Buy

ACC

Neutral

Ambuja

Buy

Ultratech

Buy

Shree Cement

Large Cap

Buy

Birla Corp

Buy

Dalmia Bharat

Neutral

India Cements

Buy

JK Cement

Buy

JK Lakshmi Cement

Buy

Ramco

Neutral

Orient Cement

Buy

Prism Cement

Mid Caps

Aggregate

INR

1,448

231

3,163

11,156

516

674

652

368

353

175

102

Target

price

(FY17)

1,672

260

3,744

13,011

575

923

807

454

425

199

121

Upside

(%)

PE (x)

FY15

31.6

27.1

43.1

83.7

36.6

22.6

597

-2,179.9

36.5

28.9

34.7

18.4

38.2

36.9

FY16E

34.7

39.6

33.9

46.1

34.6

24.6

13.3

10.1

53.9

80.0

21.2

22.0

50.8

23.3

32.1

FY17E

20.3

21.5

24.7

26.4

22.4

11.3

7.5

6.9

12.7

14.9

14.8

10.7

14.1

11.3

19.4

EV/EBITDA (x) *

FY15

18.7

17.6

21.9

29.2

21.5

13.4

32.0

8.2

15.3

16.5

16.6

11.5

26.4

15.5

19.7

FY16E

18.3

20.2

18.0

20.1

18.7

13.1

8.7

6.7

13.8

16.4

11.4

15.4

14.4

10.5

15.8

FY17E

11.1

12.8

13.2

12.6

6.3

6.4

5.1

7.5

8.5

7.7

7.9

6.7

10.5

EV/Ton (USD) at CMP*

FY15

113

170

212

269

192

107

116

105

190

154

FY16E FY17E

119

116

159

152

206

199

247

238

185

179

105

184

170

149

144

Source: MOSL

19 August 2015

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