Every fund manager we meet these days are bullish on the cement sector. When asked why, we get a reply that prices are expected to be strong over the next three to six to eight months! While we do concur with such views to an extent, we do not believe that buying cement stocks (or for that matter, any stock) with a short-term view is warranted. In our view, things are not as rosy as it seems for the sector, if one takes a medium-term view.
While the demand supply gap is narrowing resulting into better realisations, input costs are also on a rise. Though companies have shifted most of their plants to fuel-efficient dry process, they still have to bear the brunt of higher liquid fuel prices. This is putting pressure on their margins. As a large part of the capacity addition will be completed by 2008, there might again be a glut situation in the cement market.
Cement is a product of high volumes and therefore, transporting it over large distances can prove to be uneconomical. This makes it imperative for the plants to be located near markets. In some cases, the plants also tend to be located near the limestone reserves (a major raw material for cement) from where the cement is transported to nearby states.
With the rising liquid fuel prices, transportation, raw material extraction and grinding costs are rising. While deciding on the plant location, there is a trade-off between proximity to raw material sources and proximity to markets. This has resulted in cement being largely a regional play with the industry divided into five main regions viz. north, south, west, east and the central region. Let us understand the dynamics of each region.
Northern region: The northern region comprises of Punjab, J&K, Himachal Pradesh, Haryana, Uttaranchal, Haryana, Chandigarh, Delhi and Rajasthan states. The region forms 18% of the total cement production capacity in the country. In FY05, the region had 28 million tonnes (MT) of installed capacity and produced 26.7 MT of cement. Thus, the capacity utilisation stood at 95.5%, which is a good improvement over the 88% levels of FY01. Going forward, demand for cement in the Northern region is likely to come from the housing sector and infrastructure projects as planned by the government. Since Gujarat Ambuja and ACC dominate these markets, their alliance has resulted in some stability in prices.
Western Region: This region comprises of the states of Maharashtra and Gujarat. The region, with an installed capacity of 29.4 MT, contributes to 19% of the total capacity in India. In FY05, the capacity utilisation was at 77.6% as the total production was 22.8 MT. The demand for cement was 24.6 MT, implying a shortage of 1.8 MT that was met by inter-regional transfers. Gujarat Ambuja is the market leader in Gujarat whereas ACC, Gujarat Ambuja and Ultratech are the major players in Maharashtra. The region has always had a problem of short supply owing to demand rising faster then capacity expansion. The shortage is being met by inter-regional transfers, mainly from the southern region (Andhra Pradesh).
Central Region: The region comprises of Madhya Pradesh and Uttar Pradesh. In FY05, the region produced 20.4 MT of cement, equating the demand and thus leading to a balance in demand and supply. The installed capacity is 25 MT and the capacity utilisation is at 81.6%. Prices are virtually flat on the back of demand-supply balance.
Southern Region: The southern region comprises of Andhra Pradesh, Karnataka, Tamil Nadu, Kerala, Goa and Andaman states. This region is the largest market in the country with an installed capacity of around 48.6 MT and production of around 39 MT, indicating a capacity utilization of around 80%. The demand for cement in FY05 was 33.2 MT resulting into a surplus of 4.4 MT. The state of Andhra Pradesh is rich in limestone reserves and as a result, produces surplus cement, which is transported to states of Maharashtra and other nearby regions. The capacity utilisation has improved over the years from 74% in FY01 to the current levels. This is on account of narrowed demand-supply mismatch due to no new major capacity additions. Although regional players like India Cements and Madras Cements are strong in these markets, national players like ACC and Grasim also have a key presence in the region.
Eastern Region: The eastern region mainly comprises of Orissa, Bihar, Chhattisgarh, Jharkhand, West Bengal and Northeast. The eastern region has a total capacity of 23 MT and produced around 18.7 MT of cement in FY05 indicating a capacity utilisation of around 81.6%. Most of the states like Orissa and West Bengal are cement deficit and source their requirements from the limestone rich Bilaspur belt. The demand for cement in FY05 was 20.4 MT resulting into a deficit of 1.7 MT.
The oversupply is largely in the Southern and Northern regions. By contrast, there is a supply shortage in Eastern and Western regions. There is significant inter-regional movement of cement, which plays a crucial role in the regional demand-supply dynamics. Most of the cement movement across regions takes place from North to Central, South to West, Central to North, and Central to East.
Thus, regional disparity is on account of the nature of commodity. Proximity to raw material and markets is the issue. Going forward companies that are able to derisk the geographical spread will sustain. Consolidation is a reality. It has led to the formation of two large alliances in the country. Companies like Gujarat Ambuja (GACL), ACC, Grasim and Ultratech have large cement plants spread across the country due to which cement demand can be catered to across the country. Companies in the south like Madras Cements and India Cements need to increase their market share outside the region they are catering to, to have sustainable business model.
While we are positive on the sector growth, we are uncomfortable with the valuations at the current level. We believe that, at the current level the growth has been factored in, on an EV/tonne basis. Thus suggest a word of caution.