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1、,Construction MaterialsIndiaIndia CementPapering over the cracks,abcGlobal Research Contrary to popular opinion,productiondiscipline undermines the sector Valuations above replacement cost notjustified for a sector with only 20%ROE,Summary of rating and target price changesCompany Ticker Price NewIN
2、R/sh Rating,Old New TP Old TPRating INR/sh INR/sh,Downgrade UTCEM to UW(from N);reiterate UW on ACC and ACEM,and Non SRCM,ACC Ltd ACC IN 1,362.5Ambuja Cmt ACEM IN 198.8Ultratech Cmt UTCEM IN 1,952.1Shree Cmt SRCM IN 4,454.7,UWUWUWN,UWUWNN,1,3101701,6104,790,1,2601501,5601,840,Oversupplied and over-r
3、eliant on production discipline:Investors value the top three players based on USD185/t of,Source:Bloomberg,HSBC estimatesPriced as of 22 January 201325 January 2013Jigar Mistry*,CFAAnalystHSBC Securities and Capital Markets(India)Private Limited+91 22 2268 1079 jigarmistryhsbc.co.inRuchi Burde*Asso
4、ciateBangaloreView HSBC Global Research at:http:/*Employed by a non-US affiliate of HSBC Securities(USA)Inc,and is not registered/qualified pursuant to FINRA regulationsIssuer of report:HSBC Securities and Capital Markets(India)Private LimitedDisclaimer&DisclosuresThis report must be read with thedi
5、sclosures and the analyst certificationsin the Disclosure appendix,and with theDisclaimer,which forms part of it,available capacity,well above the replacement cost ofUSD135/t.This incentivises players to add capacity,even in anoversupplied market and rely on cartel-like productiondiscipline to prop
6、up prices.In our view,this preventssustainable pricing,while encouraging inefficiency andfragmentation.Thanks to production discipline,cement is theonly basic materials market we cover where product prices havebeen maintained above cost despite oversupply.In othermarkets,where such practices exist,i
7、nvestors have been smartenough not to value stocks above replacement cost.Cement is not the new FMCG;rerating unlikely:Cementstocks trade at higher multiples than most other stocks in IndiasNIFTY Index,except fast-moving consumer goods(FMCG)and pharma.Therefore,we think it is a useful exercise toben
8、chmark cement against FMCG.We find that aside fromhaving fewer structural challenges,FMCG offers betterexpected return ratios and free cash flow.In our model,weassume cement companies can pass on rising costs but notsignificantly expand EBITDA margins.This leaves us c14-20%below consensus for FY14/1
9、5e.The consensus appears to beforecasting a rise of c12-20%for individual producers throughFY15e but achieving this hinges on their willingness tocontinue to exercise production discipline,in our view.Webelieve this creates downside risk to current valuations.Downgrade UTCEM to UW;adjusting target p
10、rices:After astrong rally,we downgrade UTCEM to UW with a higher TP ofINR1,610 and reiterate UW on ACEM with a higher TP ofINR170 and on ACC with a higher TP of INR1,310,and N onSRCM with a higher TP of INR4,790.Our target prices imply ac7.5x CY14e EV/EBITDA for ACC and ACEM,and an 8xFY15e EV/EBITDA
11、 for UTCEM.,3,3,4,6,6,8,8,11,13,13,14,Construction MaterialsIndia25 January 2013ContentsInvestment summaryProduction indiscipline weakens the sectorForecasts and valuationsProduction disciplineundermines prospectsRich valuation multiples make the sector vulnerableThe only industrial commodity market
12、 where all companiesgenerate positive EBITDAIs the system constrained?Per-capita cement consumption doesnt tell the storyEarnings and valuationsCement is not the new FMCGEarnings outlook:we build in cost recovery,not marginexpansion into our forecasts,abc,Valuation and risksAppendixDisclosure append
13、ixDisclaimer2,16242731,Construction MaterialsIndia25 January 2013Investment summary Investors willingness to assign premium valuations to players withexpanded capacity leaves sector persistently oversupplied Cement is unlikely to become the new FMCG the significantpremium to replacement cost is not
14、justified,given it is a c20%ROE business Downgrade UTCEM to UW;reiterate UW on ACC and ACEM,andN on SRCM,abc,Production indisciplineweakens the sectorRich valuations,fragile growthThe market currently assigns an average valuation ofcUSD185/t for capacity to the top three cementproducers,a 27%premium
15、 to the replacement costof USD135/t(despite the sector being in anoversupply situation,which,in our view,is likely tocontinue for the next three years).Companiesannouncing capacity additions get valued higher afact amply demonstrated by the outperformance ofUTCEM over ACC and ACEM(despite the latter
16、sbetter operating results on a trailing 12-month basis).High valuations incentivise cement manufacturersto keep adding capacity in an already oversuppliedmarket,making continued cartel-like productiondiscipline rather than sustainable pricing powerbased on high utilisation rates the primary driver o
17、fvaluations.At current levels,we see more,The only basic material sector whereall companies generate positiveEBITDAAmong the basic materials sectors under ourcoverage(aluminium,zinc,copper,steel andcement),cement is the only one where:1)available capacity is greater than demand,and2)all companies al
18、ong the cost-curve generatepositive EBITDA.Production discipline undermines the systembecause:1)with all companies being profitableregardless of their actual competitiveness,inefficiencies creep in and the impetus fortechnological advancement is weakened;and2)consolidation is delayed as weak compani
19、esthat may be looking for a buyer are more inclinedto hold out for higher valuations(resulting infragmentation and undermining the prospects ofachieving sustainable pricing).,downside than upside in this approach to valuation.3,Construction MaterialsIndia25 January 2013Exhibit 1:Cement is the only c
20、ommodity with surplus capacity forwhich the market is paying more than the replacement cost2011-2011 Position on PE PBsurplus/(d Excess C1 cost(CY14e)(CY14e),This increases investment risk in the cementsector materially when companies desiring highermarket capitalisation keep adding cement capacity,
21、abc,eficit)-mt capacity,curve,in an already oversupplied market.,SteelCopperAluminiumZincCement,138(8)1,552382100,30%90 percentile-1%Above20%65 percentile3%97 percentileAbove,13.311.29.78.915.0,0.92.40.81.42.9,Forecasts and valuationsCement is not the new FMCG,Source:HSBC estimatesProduction discipl
22、ine is not unique to cement,butinvestors have been smart not to value companiesabove replacement cost in other industrialcommodity and basic materials markets.Capacity expansion faces fewconstraintsWe looked at the bottlenecks in the system(rawmaterials,transportation and fuel supply)to gaugewhether
23、 cement companies are constrained andhence cannot produce more,or whether they aresimply not producing more to match demand.We did not find that the system is constrained bya lack of raw material supply or transportation(onthe contrary,the system has too much),but webelieve that cheap domestic coal
24、would bedifficult to source.Domestic coal,however,canbe replaced by imports,albeit at higher prices.Downside risk to cement consumptionforecastsWith no available data providing a breakdown ofcement consumption in India,the market tends tobase cement consumption growth expectations onGDP and the expe
25、riences of economies that arefurther along in their industrialisation,like China.Yet,given that the Chinese economy is different interms of the level of contributions it generates fromindustrials and fixed asset investment growth,wethink these forecasts may be overestimating thepotential growth in c
26、ement consumption.4,Cement stocks trade higher than most stocks inIndias NIFTY Index,except for fast-movingconsumer goods(FMCG)and pharmaceuticalstocks.Therefore,we think it is useful tobenchmark cement against FMCG,despiteadmittedly different businesses,to see if thecement sector as a whole has mor
27、e upsidepotential.What we find is that besides havingfewer structural challenges(sustainability ofdemand,control over margins and overallbusiness model),FMCG is materially superior inreported return ratios and free cash flowgeneration.This suggests that there is less of achance of a rerating in the
28、cement sector.Market is pricing in over-optimisticrealisations growth through FY15eBased on a 7x EV/EBITDA multiple,c10%volume growth and our assumption of cost push,the market seems to be pricing in c12-20%peryear increases in realisations for individual listedcement makers in the next two years.Th
29、is looks high to us,given that the sectorremains fragile(as pricing power is derived fromthe continued willingness to exercise productiondiscipline rather than strategic bottlenecks alongthe production or distribution chain).We assumethe companies will be able to pass on costs,butthey will not be ab
30、le to expand EBITDA margins.We are c14%and 20%below consensus EBITDAestimates for FY14 and FY15,respectively.,Construction MaterialsIndia,abc,25 January 2013Downgrade UTCEM to UW;reiterateUW on ACC and ACEM,and N onSRCM;increase target pricesAfter a strong rally,we downgrade UTCEM toUW with a higher
31、 target price of INR1,610(fromINR1,560)and reiterate UW on ACEM with ahigher target price of INR170(from INR150)andon ACC with a higher target price of INR1,310(from INR1,260)and N on SRCM with a highertarget price of INR4,790(from INR1,840).Ourtarget prices imply a c7.5x CY14e EV/EBITDAfor ACC and
32、ACEM,and an 8x FY15eEV/EBITDA for UTCEM.5,1993,1995,1997,1999,2001,2003,2007,2009,2011,2015e,2005,2013e,175,125,75,25,-25,Construction MaterialsIndia25 January 2013Production disciplineundermines prospects Cement is currently the only basic material segment in Indiawhere all players generate positiv
33、e EBITDA Production discipline does not lead to sustainable pricing butrather promotes inefficient expansion and fragmentation Capacity additions based on projected per capita cementconsumption growth could keep the sector oversupplied for longer,abc,Rich valuation multiples makethe sector vulnerabl
34、eHow the rally startedConventional wisdom tells equity investors toavoid commodity and commoditised sectors inwhich capacity exceeds demand and the situationis likely to persist.The assumption implicit in thisis that available capacity equals supply(afteradjusting for plant availability factors).How
35、ever,in the cement sector,manufacturershave changed these market dynamics throughcartel-like production discipline,breaking thelink between available capacity and supply.,the sector had greater flexibility to begincontrolling supply to the market.Exhibit 2:Balance sheets have become significantly de
36、-leveraged over the last few yearsAv g Net Debt to Equity(x)Source:Bloomberg,HSBC estimates,Note:Average for ACC,Ambuja Cements and Ultratech CementWhile cement manufacturers have always focused,on price not volume,such production disciplinehas not always been feasible because significantdebt servic
37、ing commitments meant they needed toprioritise cash generation.However,after de-leveraging their balance sheetsduring the strong commodity cycle in 2006-09,6,Incentivising production capacityOn a pan-India basis,in 2012,the utilisation rateof the top five companies was 8.6ppt above therest of the in
38、dustry.,-,Construction MaterialsIndia25 January 2013Exhibit 3:Top 5 cement companies have c860bp higherutilisation than the rest of the sector,The rationale for assigning a valuation premiumto cement producers with leading capacity is,abc,180.0,Capacity,Production,Utilization(%),82.0,as follows:,160
39、.0,80.0,140.0120.0100.080.060.040.020.0,78.076.074.072.070.068.0,First,it takes three years for cement capacityto be commissioned.The EBITDA that thenew plant does not earn during that timeshould be added to the companys existingplants(since the existing plants earn it).Second,as it has become incre
40、asingly difficult,Top-5 players,Others,66.0,to build new capacity due to challenges in,securing new land and mining permits,any,Source:CMA,HSBC estimatesMarkets currently value the top three players(by2012 market share)at cUSD185/t of theiravailable capacity higher than replacement costof USD135/t.T
41、his implies that a companyannouncing an increase in capacity will see abigger boost in valuation than one that does notadd capacity.This is amply demonstrated byUTCEM(up 61.5%in the past 12 months)outperforming ACC and ACEM(up 19%and26%,respectively,in the past 12 months)whentrailing 12-month operat
42、ing EBITDA for ACCand ACEM outperformed UTCEM(up 38%and32%,respectively,versus 28%for UTCEM).Exhibit 4:UTCEM has outperformed ACC and ACEM despite thestrong result reporting by the latterTTM EBITDA y-o-y growth Stock returns-(INRm)(%)12m(%),capacity additions are seen as value accretive.However,we n
43、ote that these bureaucratic obstaclesaffect all industrial sectors and this is likely tohinder Indias fixed asset investment(FAI)growthin the long term.If FAI growth weakens,long-term growth in the cement sector should alsoweaken.Rural housing alone cannot drive long-term cement consumption in India
44、;FAI has to pickup,too.As for the first point,while there is some merit tothis argument,the market does not apply the samerationale to value other basic material segments,such a steel,aluminium and zinc,which suggestsit is being applied somewhat arbitrarily to cement.In Indian Metals and Mining-Valu
45、e delayed,notnecessarily destroyed,30 October 2012,weargued that markets do not even factor in the,UTCEMACCACEM,45,28220,90224,029,28.0%38.0%32.0%,61.5%19.0%26.4%,capital invested by metal companies(USD21bn intotal)into new capacity into their valuations.,Source:Bloomberg,HSBC estimatesThe problem i
46、s that this incentivises leadingcement manufacturers to keep adding capacity,preventing the sector from balancing demand andsupply,which would result in an environment ofsustainable pricing(one does not rely on the,We also argue that companies are adequatelycompensated via a high ROE in subsequent y
47、earsfor the expenditure incurred during thecommissioning period of any new project,therebyeliminating the need for the market to pay forthese capacities upfront.,willingness of incumbents to cut production tomaintain prices).7,Construction MaterialsIndia25 January 2013The only industrial commodityma
48、rket where all companiesgenerate positive EBITDAAmong industrial commodities and basicmaterials markets under our coverage(namely,aluminium,copper,zinc,steel and cement),cement is the only sector where available capacityis greater than demand,yet all players continue tobe EBITDA positive.Exhibit 5:A
49、ll companies operating in the cement sector inIndia reported positive EBITDA for FY12,By creating an environment where the companydoes not need to be the fittest to survive,production discipline fosters inefficiency andslows technological advancements that wouldultimately benefit the sector.It slows
50、 industry consolidation by encouragingweaker players looking for a buyer to hold outfor better valuations.Indeed,media reportsindicate several cement facilities that have beenput up for sale have failed to find buyers.,abc,Volumes(mt),FY12 EBITDA(INRm),Production discipline is not unique to Indian c
