The cement industry is likely to hit the pause button on the backdrop of recent developments like demonetisation, pending legislations like RERA & GST, and rising crude oil prices.
Housing and construction are the sectors most impacted by demonetisation. While market participants aver things will normalise in three-six months, the impact is enough to postpone the much-awaited recovery in cement demand by another year or so. Further, we fear a longer slump in secondary/unorganised real estate markets which drive a large proportion of cement sales (IHB). We also do not believe that a rebound in infrastructure demand will be enough to offset the above-mentioned slump in housing.
Given the impending slowdown in secondary/unorganised real estate markets, the vulnerability is higher for companies which derive bulk of their profitability from higher realisations (higher trade sales).
Cement sector valuations were pricing in a strong recovery pre-November 8, when demonetisation was announced (EV/EBITDA 12-17x 1yr Fwd). Despite recent correction, they still trade at 10-15x 1yr Fwd EV/EBITDA, once the impact of lower demand is factored in. We suspect some more downside as 3QFY17 will represent the confluence of negatives as both volumes and costs get hit.
We expect cement multiples to de-rate further. However, sector leaders (UltraTech/Shree Cement) should continue to command premium to historical averages and will be attractive when multiples approach historical averages (10x or so).
Till October, cement apparent demand had grown by ~5.1% year-on-year. Further, strong monsoons had lifted the possibility of a strong revival in demand, especially from some of the drought-hit regions in Maharashtra, Telangana and Karnataka. However, post demonetisation, things have taken a turn for the worse.
Our recent channel checks suggest sharp cuts in volumes across regions. The impact is more severe in regions with rural/IHB bias. We hear 25-50 per cent demand declines in north/central and Chhattisgarh. The more urbanised west/south are reporting ~15-30 per cent lower volumes. Parti¡cipants maintain that December volumes will be worse hit compared to November. These numbers may be overstated, given extreme prevalent pessimism, but the downside is still significant. Earnings in past two-three quarters were driven by cheap pet coke. Things are likely to flip at the most inopportune time for cement firms, as spiking energy costs begin to sting at around the same time when volumes are likely to be low.
As a result 3QFY17 will be one of the worst quarters for cement companies in recent times. Upcoming elections in five states, including UP and Punjab, will likely further weigh on demand, given that the election code of conduct weighs on government spending. As a result, we remain cautious. Domestic demand growth has registered a double digit de-growth exactly once, in 4QFY01 (-10.4 per cent). This was an outcome driven by a number of factors: drought in four states, slowdown in real estate and the Gujarat earthquake.
With almost a month into the demonetisation exercise, we suspect cement demand could see a repeat of 4QFY01.
Source: HDFC Securities
Mangesh Bhadang, Analyst at brokerage Nirmal Bang, said, ´We expect demand disruption to push down cement demand recovery by at least a year and hence capacity utilisation will be lower for a longer period than what was expected earlier.´The industry is expected to be impacted not only by the slowdown caused by the cash crunch, but also the impasse over the Goods and Services Tax (GST) Bill and the regulatory legislation for the Real Estate (Regulation and Development) Act or RERA. The impact, according to the analyst, is phenomenal: from an estimated growth rate of 6 per cent for the current fiscal made in September 2016, it now actually stands at a decline of 1.3 per cent. Fiscal 2018 is likely to see a growth rate of 6.7 per cent, making the years of high growth a thing of the past.
´We also believe that the golden period of demand growth witnessed between FY06 to FY10 is unlikely to be repeated in the near future,´ Bhadang wrote in his note.
Impact of rising crude oil prices
As if the domestic headwinds were not enough, the industry has also to contend with the end of low input costs, giving the trend of rising crude oil prices globally. ´Cement companies´ earnings were aided by softening of input prices over the past two years, predominantly coal/pet coke and freight rates through lower diesel prices. We believe that this period of decline in input costs is largely over, as prices of various input products like international coal, pet coke and diesel are on the rise. With demand expected to be low, we believe that cost inflation will test pricing power in the industry,´ Bhadang said.
Cement manufacturing companies in India include Ambuja Cement, ACC, UltraTech, JK Cement, Prism Cement and Shree Cements. India is the second-largest producer of cement in the world, after China.
Capacity utilisation to remain stagnant: ICRA
In the first seven months of FY17, demand growth in the cement sector was already modest at 4.8 per cent. After the note ban, the sector is likely to be affected negatively by disruption to the real estate sector, says the rating agency.
The cement sector is one of the worst hit by demonetisation. Despite limited capacity addition, capacity utilisation of the cement industry is likely to remain stagnant in fiscal year 2017 as demand growth is expected to be weak, rating agency ICRA said in a report. In the first seven months of FY17, demand growth in the cement sector was already modest at 4.8 per cent and after the note ban, is likely to be affected negatively by disruption to the real estate sector.
The cement sector is one of the worst hit by demonetisation; volumes have been dented severely and a pick-up in consumption may not happen anytime soon. Hence, the outlook for the second half of FY17 is unlikely to be as bright as anticipated earlier by many analysts.
Uncertainty remains on demand, pricing and margins, says Vivek Maheshwari, Investment Analyst.
The Indian cement sector is on a shaky foundation and there are multiple uncertainties as we start the seasonally strong period (Jan-May) of 2017.
Demonetisation has impacted demand, although flattish production volume (year-on-year) in November 2016 is a positive. The industry is hopeful of a recovery through 2017, though monthly trends could be quite volatile. Demonetisation has, however, impacted prices, which are down 1-5 per cent month-on-month in December 16, as per our channel checks. The timing of demonetisation is quite inappropriate for the industry, as energy costs (pet coke, coal and diesel) have been steadily trending up. We expect heightened volatility in margins ahead, as several variables are at play and we are negative on all the stocks except UltraTech which is our only relative pick.
Concerns on demand
Cement volumes across regions have been impacted, particularly in December 16. While liquidity issues will ease gradually, the channel is still concerned on demand due to factors like impact on end-user industry and supply-chain issues in case of ancillary industries (sand, aggre¡gates, etc.) and hence, demand trend may be weak. The government´s thrust on social housing and infrastructure should support cement demand but we are unsure if this could fully offset the impact.
Demand pressures may deter the cement industry from increasing prices significantly, which is typically expected during 1H-2017 due to seasonality. While the industry has shown strong discipline in the past few quarters, a potentially weak demand trend may change dynamics and result in pricing pressures. Prices have actually declined by 1-5 per cent across regions, though the industry would attempt to reverse these in the coming months.
High volatility in margins ahead
For example, pet coke prices are up 140 per cent from the bottom, while imported coal prices are up 79 per cent and rupee depreciation further exacerbates the impact; diesel prices are also up 31 per cent from the recent lows. This would impact sector margins in the near term and would also delay the margin recovery by a few quarters.
Negative view stays
This has taken multiples to above-historical averages, also partially on expectations of a strong recovery in margins, which we believe are at risk in the current context, as volumes are weak, pricing power is impaired, and costs are rising.
A majority of cement demand (55-65 per cent) comes from the housing sector. It is important to see how the sector is going to fare in 2017. The end of 2017 is most likely to see the initiation of a robust and sustainable growth trajectory for India´s real estate industry and will be recognised as the base for the future growth of this sector, says Shishir Baijal, Chairman and Managing Director, Knight Frank (India) Pvt. Ltd.
In the first week of November 2016 the overall positive sentiment was attributed to a host of factors including the political stability, regulatory environment, enhanced infrastructure, strong investments, approval to the GST bill, and amendments to REITs.
Just when the industry was was gearing up to meet the deadlines set by the government for Real Estate (Real Estate Regulation & Development Act Act 2016 (RERA) and Goods and Services Tax (GST),) it received a jolt in the form of demonetisation of the INR 500 and 1000 currency notes with immediate effect.
Another imminent change that will impact the sector in the days to come is the partial implementation of RERA. RERA, once implemented, will increase transparency, which in turn will bring back buyer confidence. Developers, on the other hand, will have to adjust to the new environment and more specifically, they have to change their business model whilst adhering to stricter compliance norms.
The impact of demonetisation is a transient one and the economy will undergo structural changes for the first three quarters of 2017. The industry awaits the implementation of policy reforms like RERA & GST, medium term impact of demonetisation and listing of REIT. During this phase, enterprises are expected to streamline their business processes and implement international best practices to adhere to the upcoming changed business environment. There will be a greater influence of FDI (Foreign Direct Investment) that will help create jobs and revitalise growth within the sector. Overall, institutional participation-both domestic and global markets-will help the sector in getting high quantum of funds at competitive rates. In view of the various procedural changes adopted by the government, it is also expected to be an important facilitator in bringing back stability within the real estate sector.
The end of 2017 is most likely to see the initiation of a robust and sustainable growth trajectory for India´s real estate industry and will be recognised as the base for the future growth of this sector.