Cement Sector Update

Cost reliefs – sector due for re-rating
Key Highlights

n Recent events like cut in central excise duty from 12% to 8%, 60% fall in prices of international coal from its July peaks, 70% fall in crude prices (relevant for packaging cost) and cut in diesel prices has significantly moderated the cost pressures witnessed by cement companies over last one year.

n We estimate that total cost of sales of cement to have come down by Rs461/ ton, i.e. a reduction of Rs23 per bag as compared to cost in Q2FY2009. Out of this Rs200/ton is the reduction on account of cut in excise duty rate and the balance is on account of reduction in cost of production.

n With cost of production likely to come down by Rs12.5/bag and cement prices softening by Rs4/bag, we estimate that profitability of cement companies to have improved by at least Rs8-10/bag i.e. Rs180-200 per tonne. Consequently we could see a significant 20% improvement in profitability of cement in Q42009 itself.

n In our earnings estimate for cement companies for FY2010 we had earlier estimated cement prices to drop by Rs20 per bag and cost of production to reduce by close to Rs5 per bag. However with recent events, even if cement companies were to cut prices by Rs20/bag, their EBIDTA margins in FY2010 might not drop significantly. For example average EBIDTA margin of top 5 pure play cement companies in our coverage might just drop by 120 bps yoy as against 440 bps drop expected earlier.

n We expect Ambuja Cement (CY2009 earnings upgrade of 26%), India Cement (FY2010 earnings upgrade of 32%), Ultratech Cement (FY2010 earnings upgrade of 33%) and Madras cement (FY2010 earnings upgrade of 31%), to be the biggest beneficiary of the recent moderation in cost pressures.

n Over past month cement stocks have underperformed broader market. We believe that the street has not yet factored in the significant improvement in profitability that cement companies could witness in Q42009 as compared to Q2209.

n We had been negative on the sector on account of sharp moderation in cement consumption and impending oversupply situation in FY2010. However we believe that the recent moderation in cost pressures has improved business fundamentals and on account of the same sector valuations which are close to multi year lows are due for re-rating. We expect Ambuja Cement, Ultratech Cement and India cement to outperform in near term.