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Crumbling Foundation: Low Possibility Of Recovery In Demand, Fall In Rural Demand And Slow Growth In The Housing Segment Do Not Justify Relatively Expensive Valuations Of Large Cement Companies

India's cement sector has been the darling of markets since the past two-and-a-half years. Factors such as pick up in infrastructure projects, implementation of projects related to smart cities, Swachh Bharat mission of the government and more importantly, new capital expenditure from the government in terms of allocating road and construction projects had convinced the markets that cement demand would pick up in the coming months. This, however, has yet not transpired.

Besides, mergers and acquisitions in recent months have also slowed down. Such is the case that today analysts are waiting for the demand to pick up and then give their views for companies in the sector. So, what exactly is ailing the sector? Why have deals slowed down? And in these times of low demand, which companies tend to benefit? Here is a low-down on these facts:


In the past two years, cement stocks such as Ultratech Cement, Shree Cement, ACC, Ambuja Cements and Grasim Industries have run up in the range of 23% to 160%. This is despite the fact that cement demand growth has been less than 2%. This rally had a rationale in the fact that cement stocks are a proxy play to recovery in housing and infrastructure sectors.

In the same period, cement prices also rose in anticipation of uptick in overall demand. But demand growth did not follow cement price increase. Analysts tracking the cement sector say quality of demand will have an impact on the growth of earnings unlike in the past.

They say that this time, price did not follow demand in a similar or higher degree given capacities and institutional demand. They further point out that recommending cement stocks as proxy to infrastructure sector was a norm in the past. But this does not hold good in present times. Today, analysts are comfortable recommending infrastructure stocks instead of cement stocks.

One of the chief reasons for low cement demand is the fall in housing and construction activities, especially in rural areas. It is estimated that over 60% of cement demand comes from housing and construction activities of which rural housing demand has a large share.

A smaller rise in minimum support prices compared with that of previous years has affected rural income this year, which in turn has impacted rural housing demand. Due to this, analysts cite limited scope for cement demand growth in 2016. They say premium valuations of large cement companies do not warrant further exposure to cement stocks. It is estimated that cement sector leaders are trading at near-historic high valuations.

According to various industry experts, their forward enterprise value(NYSE:EV) is 12 times earnings before interest, depreciation, tax, and amortisation (EBITDA) and EV per tonne of $200 despite several quarters of disappointing demand.

While future expectations of demand remain robust, it is believed that current multiples leave little scope for surprises in terms of earnings' growth. Due to this, analysts do not expect large-cap cement stocks to outperform in the coming quarters.

They say that the magnitude of demand recovery is uncertain and, hence, investors should be averse to paying expensive valuations for hopeful growth.

On the operational front, analysts point out that increasing gestation period and costs involved in setting up a cement plant, and issues related to acquisition of limestone reserves are a few major challenges because of which capacity expansion at least in the next one year would be limited.

Analysts have adopted a bearish stand on cement stocks for 2016 as low possibility of recovery in demand, fall in rural demand due to low growth in rural income and slow growth in the housing segment do not justify relatively expensive valuations of large cement companies.


In times of low demand in a given cycle, cement industry prepares a good capacity inventory either by expanding organically or acquiring capacities. In the past three years, organic expansion has become expensive given the increase in the time taken to build a cement plant right from land acquisition to getting mine reserves.

The return on capital employed (RoCE) on a new cement plant comes at a single digit 4.2%, which is not lucrative for a cement player. Hence, setting up a new cement plant does not seem a viable option for cement players at present.

This is one of the key reasons why cement players would go for inorganic way of expansion since it will save more than six years of gestation period for them and also help them cater to cement demand. However, this is not transpiring.

While cement sector was impacted by low demand, another major issue, which cropped in the past oneand-half years is the amendment in Mines and Mineral Development and Regulation (MMDR) 2015 Act. Due to this, most mergers and acquisitions have not transpired.

In the past few months, two major cement companies, namely, Lafarge and J P Cement, are looking to sell their entire cement assets. These announcements came in after these cement companies began selling cement units in tranches to deal with their balance sheet or operational issues. There are two key factors to this development.

First, it is the amended Mines and Mineral Development and Regulation(MMDR) 2015 Act, which has forced these companies to opt for outright sale of their entire cement units. The Act says, "The transfer of mineral concessions shall be allowed only for concessions, which are granted through auction." This means that a cement company, which owns mine reserves earned not through government's auction cannot sell it to another cement company.

This has made recent acquisitions in the industry almost unviable as not a single cement company owns mine reserves through auction. Buying a cement plant without mine reserves makes it unviable because limestone is the key raw material for cement production and procuring of limestone inflates transportation costs of cement companies.

To deal with this, Lafarge announced of its entire cement assets recently. A prime reason for this is the rights to mine reserves are at the company level and not at the cement plant level. This means a cement plant does not own rights to mine reserves. But it is the company that owns it.

Hence, Lafarge announced its plans to sell its entire India operations as it will enable it to transfer the mine reserves rights, which it owns to another company rather than selling one or two cement plants.

Faced with same difficulty, even J P Cement, which had sold two of its cement units in Gujarat and Madhya Pradesh, is looking out for entire sale of its 20.3 mt cement unit.

Due to the amendment in the MMDR Act, most mergers and acquisitions in cement industry have not taken off as most companies own limestone mines through allotment process and not through auction. If some other amendment related to this Act is made, then it may trigger new deals in the industry.

Secondly, it is the tax issue because of which selling entire cement assets makes it more tax-efficient for Lafarge and J P Cement.

Taxation experts point out that there is more flexibility and tax efficiency when mergers and acquisitions transpire at the company level rather than at the cement plant level. But given various complex corporate structures, it remains to be seen how cement companies would deal with this issue.


In recent months, experts who continue to maintain a bearish view on the cement industry have formed a firm view that in the next one year cement prices would not rise and they would continue to be range-bound.

Given this scenario, select cement heavyweights would find it advantageous in terms of cost of cement production, diversified geographical presence and having light balance sheets, which may show better revenue growth in the next one year. And these cement companies in India - Ultratech Cement and Shree Cement - would be able to dictate prices in the industry.

In the past two-and-a-half years, all India average cement prices have fallen to Rs. 244 per 50 kg bag at present from Rs. 310 per 50 kg bag. In this period, only Ultratech Cement and Shree Cement have been able to keep their cost of production low by operating on multi-fuel plants.

In comparison with most large-sized cement companies such as ACC, Ambuja Cements, and The Ramco Cements, whose cost of cement production (per tonne) has increased in the range of 3%-5% in the past one year, the cost of cement production for Ultratech Cement and Shree Cement has fallen close to 2%.

In times of low demand, cement companies enhance their revenue growth through volumes. Volumes growth transpires merely on economical pricing.

In such a situation, Ultratech Cement and Shree Cement can enhance or maintain volume growth as they can afford to take a price cut due to their lower cost of cement production.

Besides, another factor that works for Ultratech and Shree Cement is their diversified presence. Ultratech with its capacity has a pan-India presence while Shree Cement has presence in North, East and Central markets, where demand is relatively better in comparison with other regions.

Lastly, both companies have light balance sheets with their debt to equity less than 1. The recent December '15 quarter of Ultratech Cement shows how well-placed companies can afford to have volume growth and enhance their revenue growth. When industry's volume has been in the range of 4% to 5%, Ultratech Cement's volume growth has been over 7%. Owing to this, the rating on Ultratech Cement has undergone change and has been upgraded by market experts.

About the Author:

Nirmal Bang Securities Pvt. Ltd. is an online share & stock trading company in India. This is one of the best trading company where you will see online share trading tips, BSE live news, Indian currency trading market, depository services, equity share market, IPO and live commodity market prices in India for stock and share trading.