Budget 2011: Cement

The year 2010 was quite challenging for the entire cement industry. On the one
hand, demand off-take was weaker than expected due to lower realty and
infrastructure spending. Prolonged monsoons and logistical constraints further
dampened the construction activity. On the supply front, overcapacity continued to
plague the industry. Cement prices remained under pressure and caused margins
to contract severely. The industry is expected to end the current fiscal at about
75% capacity utilisation. And this does not seem to be the end yet. The demand-
supply mismatch is here to stay for quite some time as the total industry cement
capacity is expected to increase even further over the next 18-24 months. Excess supply would reach its
highest level (about 126 mtpa) in FY13 with capacity going up to 393 mtpa. On the cost front, key raw
material costs, especially prices of coal show no signs of abating. Going forward, rising interest costs
remain a challenge for the construction industry. Much will depend on government’s housing and
infrastructure initiatives. Given this backdrop, over the next couple of years, the margins of the cement
companies will continue to remain under strain.

 Budget Expectations
The value-added tax (VAT) on cement should be brought on par with other building materials like steel.
While steel attracts 4 % VAT, for cement it is as high as 12.5%.
A uniform rate of excise duty should be levied on cement. Currently, different rates of Excise Duty are
levied for bagged Cement
An abatement of 55% if the duty is based on retail sale price, as recommended by NCAER (National
Council for Applied Economic Research) in their Report of 2005, should be given to the cement
industry on excise duty.
Import duty on coal, pet coke, gypsum and other fuels should be scrapped. All the three inputs attract
5% duty if imported, while there is no duty on cement import. So this is contrary to the established
principle that import duty on inputs should not be higher than on the finished product.
The cement industry should be granted "declared goods" status like steel, which would enable the
sector to reduce expenditure on taxes. The State governments are restricted to levy sales tax of
maximum 4% on these goods. If “declared goods” are sold inter-State, tax paid within the State is
reimbursed to seller.

 Budget Measures
Incentives have been doled out for end users of cement such as the housing sector and development
of infrastructure.
To replace excise with ad valorem duties on cement:

- In case of packaged cement, retail price per 50 kg bag not exceeding Rs 190 per bag (equivalent to
Rs 3,800 per tonne) would entail 10% ad valorem duty plus Rs 80 per tonne from Rs 290 per tonne
earlier. In case of retail price per 50 kg bag exceeding Rs 190 per bag, there would be an ad valorem
 duty of 10% plus Rs 160 per tonne from just 10% of retail sales price earlier.

-10% ad valorem duty for all goods other than those cleared in packaged form.

-For cement clinker, there would be an ad valorem duty of 10% plus Rs 200 per tonne from flat Rs 375
per tonne earlier.
To reduce basic custom duty on two critical raw materials of the cement industry viz. petcoke and
gypsum to 2.5%
Rate of minimum alternate tax (MAT) on book profits has been increased from 18% to 18.5%.

 Budget Impact
Increased budgetary allocation towards infrastructural development and housing is likely to boost
demand for cement. Thus, cement manufacturers will continue to benefit owing to increase in volumes.
Impact of cut on customs duty on key raw materials such as petcoke and gypsum would bring some
relief to cement manufacturers who have been facing margin pressures due to rising input costs.
The new excise duty structure will increase the tax incidence on the cement industry.

 Company Impact
With more incentives being spelled out for the infrastructure and housing sector, cement manufacturers
will continue to benefit. This is beneficial to all cement companies, specifically the top layers catering to
eastern region such as ACC and Ultratech Cement.
Lower duties on key materials will aid the profitability of large players like ACC, Ambuja Cement and
Ultratech Cement.

Cement
[Key Points | Financial Year '10 | Prospects | Sector Do's and Dont's]
The Indian cement industry is the 2nd largest market after China. It had a total
capacity of about 260m tonnes (MT) in FY10. Consolidation has taken place with
the top five players alone controlling over 60% of the total industry capacity.
However, the balance capacity still remains quite fragmented.

Despite the fact that the Indian cement industry has clocked production of more
than 100 MT for the last five years, registering a growth of nearly 9% to 10%, the
per capita consumption remains poor when compared with the world average
and is almost 7 times lower than that of China. This underlines the tremendous
scope for growth in the Indian cement industry in the long term.

Cement, being a bulk commodity, is a freight intensive industry and transporting

it over long distances can prove to be uneconomical. 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. While the southern region always
had excess capacity in the past owing to abundant availability of limestone, the
western and northern regions are the most lucrative markets on account higher
demand and production shortfall. However, with capacity addition taking place at
a faster rate as compared to demand, prices have remained southbound,
especially in the recent past. Nevertheless, considering the government's thrust
on infrastructure long term demand remains intact.

Given the high potential for growth, quite a few foreign transnationals have been
eyeing the Indian markets and are planning to acquire domestic companies.
Already, while companies like Lafarge, Heidelberg and Italicementi have made a
couple of acquisitions, Holcim has increased stake in domestic companies
Ambuja Cements and ACC to gain full control. After acquiring stakes in big
companies, transnationals shifted focus towards the median capacity producers.
The global players put together account for a quarter share of the domestic
market. Further, turning around few of these piecemeal acquired capacities at a
time when the cycle is at its peak would be a difficult task. During the first half of
FY11, UltraTech Cement merged itself with Samruddhi Cement to become the
largest cement company in the country. Considering the long term growth story,
fair valuations, fragmented structure of the industry and low gearing, another
wave of consolidation would not come as a surprise.
 Key Points

Supply The demand-supply situation is tightly balanced with the latter

being marginally higher.

Demand Housing sector acts as the principal growth driver for cement.
However, recently industrial and infrastructure sectors have also
emerged as demand drivers.

Barriers to High capital costs and long gestation periods. Access to

entry limestone reserves (key input) also acts as a significant entry
barrier.

Bargaining Licensing of coal and limestone reserves, supply of power from

power of the state grid etc are all controlled by a single entity, which is the
suppliers government. However, nowadays producers are relying more on
captive power, but the shortage of coal and volatile fuel prices
remain a concern.

Bargaining Cement is a commodity business and sales volumes mostly

power of depend upon the distribution reach of the company. However,
customers things are changing and few brands have started commanding a
premium on account of better quality perception.

Competition Intense competition with players expanding reach and achieving

pan India presence.
TOP
 Financial Year '10
In FY10 the industry added nearly 50 MT of capacity taking the total capacity to
nearly 260 MTPA. While the demand was steady during the fiscal, average
industry realisations (average price per bag of cement) witnessed a modest
growth. The growth in realisations slowed down as additional capacities coming
 on stream resulted in oversupply.

Owing to the general economic slowdown financial institutions tightened their

credit norms. This led to a credit crunch and impacted upcoming real estate,
infrastructure and other projects. With that, demand for cement moderated.
However, stimulus packages announced by the government and agricultural
income gave a fillip to the demand for the commodity.
TOP
 Prospects

The cement industry is likely to maintain its growth momentum and continue
growing at around 8% to 9% in the medium to long term. Government initiatives
in the infrastructure sector and the housing sector are likely to be the main
growth drivers.

During the first half of FY11, a series of huge capacity expansions (through the
brownfield or greenfield route) against a corresponding poor offtake in cement
demand due to subdued construction activity created excess supply, thus putting
downward pressure on realisations. This has been coupled with significant rises
in input costs, especially prices of coal and petroleum products. As a result, both
the topline and bottomline have been badly hit. Though an excess supply
scenario may prevail for sometime to come, the worst seems to be over
following the good monsoon witnessed across most parts of the country.

Good agricultural income will support demand for the commodity despite
slowdown in the real estate sector. The importance of the housing sector in
cement demand can be gauged from the fact that it consumes almost 60%-70%
of the country's cement. If this support wanes, it would impact the growth in
consumption of cement, leading to demand supply mismatch.

In the Budget 2010, the government increased the excise duty from 8% to 10%
on cement and clinker. However, the government has also increased budgetary
allocation for roads under NHDP. Further, with more incentives being spelled out
for the infrastructure and housing sector, cement manufacturers will continue to
benefit. The budget measures such as increasing excise duties have proved to
be futile and in the future too, we believe that it is the market dynamics that will
determine these variables. Going forward, we believe the government's
initiatives in the infrastructure and housing sectors are likely to be the main
drivers of growth for the industry in the long run.

Identifying a cement stock: Do’s and don’ts

One of the key factors that seem to have a major say on stock price movements of cement companies
are cement prices! Given the volatility and
seasonality involved in the same, should one place
such high weightage on cement prices to ascertain investment decision in cement stocks? Here is an
attempt to simplify the analysis of a cement company.
Profile
Since cement is essentially a commodity, brand premium is almost non-existent in the industry. In
terms of value-addition, this sector ranks below even steel and aluminium. It is a highly capital-
intensive industry. A green field project for 1 MT requires capital expenditure to the tune of Rs 3 bn (2
MT is a ideal size for a company to have some kind of economies of scale). The sector operates with a
high level of fixed cost (maintanence cost is around US$ 5 per tonne annually) and therefore volume
growth is critical. Access to raw materials (limestone and coal) and consuming markets are equally
important in the long term.

The Indian cement industry has to be viewed on a regional basis viz. northern, western, southern and
eastern. Since demand is unfavorable in certain regions, cement companies that focus on these regions
are affected if there is a decline in prices. The Indian cement industry is also highly fragmented with the
top six accounting for about 60% of industry capacity. The rest 40% is distributed among 40 small
players. The cement industry in India has emerged as the second largest in the world, boasting of a total
capacity of around 144 m tonnes (including mini plants). However, on account of low per capita
consumption of cement in the country (110 kgs/year as compared to world average of 260 kgs) there is
still a huge potential for growth of the industry.

Let us throw some light on the various operating parameters presented in the flow chart above:

Operating profits:  The operating profit of a cement company is nothing but the difference between the
revenues earned and the expenses incurred. We shall now focus on the revenue side first. Revenues
generated, is a function of volumes i.e. the quantity of cement sold multiplied by the price realisations.
Volumes:   Cement selling, which was previously a 50 kg bag affair only, is now also being sold in the
form of bulk cement as well as RMC (Ready Mix Concrete). Bulk cement (selling of cement in specially
designed rakes) is especially useful for regular users of cement such a builders of large housing projects,
as it ensures a continuous supply of pure cement, not touched by human hands.

RMC, on the other hand is a factory made concrete and a value added product that can be used for
large construction projects, thus obviating the need to make concrete on the site and it also leads to quick
delivery of fresh factory made concrete. However, these modes of selling still have a long way to go
before making any impact and as a result, the majority of the cement (over 70%) is still sold in bags.

The cement industry in the country is entirely domestic driven. As a result, exports account for very
small percentage of the total cement off take in the industry. So, we focus more on domestic factors in
this article. As far as the demand is concerned, more than half of the demand for cement comes from the
housing industry. Infrastructure projects such as highway construction and construction of flyovers and
ports also contribute towards the demand for cement. Moreover, certain calamities such as war and
earthquakes can sometimes provide a short-term boost to the demand for cement in the country.

Apart from these external triggers, the company’s strategy of locating its plants and the level of
competition also has a bearing on the quantity of cement sold. Since cement demand is closely linked
with the economic development, companies that have plants in regions of high urbanization and
industrialization are better placed than their counter parts. Also, the larger the number of players, the
more difficult it would be to grab a larger pie of the market share.

Realisations:

Among the different factors that affect the realisations of a company, the demand-supply mismatch is the
most important. The cement industry in the country has not been able to realise its full potential mainly on
account of the high demand supply mismatch in the country. In FY03, the excess capacity in the country
stood at more than 30 m tonnes and this resulted in the prices touching an all time low. This, more than
anything, highlights the importance of the demand supply mismatch in the fortunes of the industry.
Therefore, a retail investor has to keep a tab on demand growth and capacity expansion plans for
players.

The level of fragmentation and competition also play an important role in determining the prices since
the larger the number of players, the more difficult it would be to ensure stability in prices. Institutional
sales or big government contracts are normally won through bidding and this can also help determine the
level of prices for specific projects. Lastly, cement like any other commodity business is cyclical in nature
and hence its realisations also depend upon the position of industry in the business cycle.
Having gone through the revenues part of the flow chart let us now glance through the expenses involved
in the manufacturing of cement.

Expenses:

Capacity utilisation:  Since the industry operates on fixed cost, higher the capacity sold, the wider the
cost distributed on the same base. But one should also keep in mind, that there have been instances
wherein despite a healthy capacity utilisation, margins have fallen due to lower realisations.

Power:  The cement industry is energy intensive in nature and thus power costs form the most critical
cost component in cement manufacturing (about 30% to total expenses). Most of the companies resort to
captive power plants in order to reduce power costs, as this source is cheaper and results in
uninterrupted supply of power. Therefore, higher the captive power consumption of the company, the
better it is for the company.

Freight:  Since cement is a bulk commodity, transporting is a costly affair (over 15%). Companies, that
have plants located closer to the markets as well as to the source of raw materials have an advantage
over their peers, as this leads to lower freight costs. Also, plants located in coastal belts find it much
cheaper to transport cement by the sea route in order to cater to the coastal markets such as Mumbai and
the states of Gujarat and Tamil Nadu.

On account of sufficient reserves of raw materials such as limestone and gypsum, the raw material
costs are generally lower than freight and power costs in the cement industry. Excise duties imposed
by the government and labor wages are among the other important cost components involved in the
manufacturing of cement.

Let us have a look at some of the key points that should be borne in mind while investing in a
cement company:

Operating margins:  The company should have a consistent record of outperforming its peers on the
operational performance front i.e. it should have higher operating margins than its competitors in the
industry. Factors such as captive power plants, effective capacity utilisation results in higher operating
margins and therefore these factors should be looked into.

Geographical spread:  Since cement is a regional play on account of its high freight costs, the company
should not have all its plants concentrated in one region. It should have a geographical spread so that
adverse market conditions in one region can be mitigated by high growth in the other region.
Important valuation parameters:  Apart from the P/E ratio, the other important valuation metric to be
considered while investing in a cement stock is the PCF ratio (Price to Cash flow). This ratio is important
because cement is a capital-intensive industry and hence depreciation forms a huge part of the total
outgo.

In the past decade, the growth in the cement industry has always been 2%-3% greater than the GDP
growth rate and as a result a cement stock should be given a P/E, which is a couple of percentage points
higher than the GDP growth rate in the country. However, a company with consistently higher operating
margins than its peers should command a higher valuation.