Cement Sector Sep 06 Edel

Executive Summary

Executive Summary Short term play: Tight demand-supply to facilitate price and EBITDA growth till Q1FY08E Cement prices have risen sharply on an average by nearly 19% or INR 32/bag to INR 195/bag (average cement price across four metros) during the H1CY06 period from H2CY05 price levels. We expect prices on an average to increase further by about INR 20-25/bag driven by tight demand-supply scenario in the next three quarters (October 2006 to June 2007) with utilisation levels crossing 94%. The price increase during this period will, however, not be as sharp as it was in the H1CY06 period, due to the absence of a sharp cost trigger like the implementation of the truck overloading ban in February 2006. Accordingly, we expect EBITDA/tonne to increase by about 19-20% by Q1FY08E from Q1FY07 levels. Limited earnings upside thereafter from cement prices; growth dependent on efficiency and volume gains We expect prices and EBITDA to peak by Q1FY08E as supplies are expected to accrue from H2FY08E and correspondingly utilisation levels are likely to decline to 91% by FY08E. Further, nearly 70.6 mtpa of capacity additions by FY09E will lead to a cycle reversal with excess capacities arising in the North and South. Our demand-supply forecasts factor in a strong 10% demand growth scenario, incremental supplies arising from blending, and fresh capacity additions. Moreover, exports are likely to decline in the Middle East from 2007 onwards. Hence, we expect prices to soften a bit by the last quarter of FY08E and believe that earnings upside post Q1FY08E is likely to be limited, except for players lowering costs or adding capacities. Short term upside in valuations; no gains in the long term We believe that there is a close linkage between valuations, capacity utilisation levels, and EBITDA levels. (1) Valuations (EV/tonne) closely map capacity utilisation levels historically. We expect utilisation levels to rise over 100% levels in Q4FY07E and remain above 90% levels in Q1FY08E. This suggests a short term upside in valuations as well. (2) Valuations (EV/tonne) typically peak ahead of EBITDA profits peaking historically, implying that valuations factor in price/profitability increases in advance. We expect cement price gains to accrue in the successive quarters and therefore, expect valuations would also closely follow suit. Post Q4FY07E/Q1FY08E, however, price upside is limited and we expect prices to decline from Q4FY08E onwards. We expect valuations to correct ahead of EBITDA peaking in Q1FY08E and prior to the onset of the cycle reversal (we are more than two years into the current cycle upturn). Select picks In the short term (upto Q1FY08E), we like UltraTech (UTCL), Madras Cements (MCL) and India Cements (ICL) whose one year forward EV/EBITDA valuations at 8.2-9.4x are attractive relative to 12.4x and 11.9x (CY06E ending) for Gujarat Ambuja (GACL) and ACC respectively, and attractive relative to the past cycle peak (i.e. six months prior to the operating peak in April 1996). Post Q1FY08E, the operating peak, we believe that there is limited upside in valuations for the cement sector due to 70.6 mtpa capacity additions by FY09E, with a likely overcapacity scenario in South. We expect valuations to correct ahead of the cycle reversal. Hence, we initiate coverage on these companies with an ‘ACCUMULATE’. We believe that valuations for GACL and ACC are expensive as their enterprise valuation and one year forward EV/EBITDA valuations trade at a premium far higher than pan India presence for ACC or cost efficient play for GACL can command. Hence, we initiate coverage for these companies with a ‘REDUCE’ ‘REDUCE’.

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