Ground checks and interactions with various stakeholders in the cement industry suggest that significant potential upsides exist for mid-cap stocks over the medium to long term. Given a favourable demand scenario, we understand cement prices have been raised across pockets by ~10 per cent and further price hikes of 3-5 per cent cannot be ruled out in May 2017.
After the monsoon arrives, cement prices are unlikely to be increased until the end of H1FY18. Even if prices drop, we expect them to remain 5-6 per cent higher than March prices. The Goods and Services (GST) tax regime is unlikely to make an unfavourable impact on cement prices; if it benefits due to GST, the industry may pass on some of those gains. EBITDA may surge in FY18/19 if robust cement price hikes sustain. Rerating of valuations is imminent for mid-cap stocks and we do not rule out potential target upgrades in the medium to long term.
Positive Volume Commentary
Even assuming flat volumes in Q1, this will be a rerating quarter for the sector. We have seen volume commentary turning positive, but volume concerns persist in a few pockets (Tamil Nadu, Kerala and parts of Central India). Despite assuming flat volume growth for the sector, Q1 earnings are likely to surprise quite positively, driven by price hikes. In a conservative scenario (0 to -5 per cent), year-on-year (y-o-y) volume growth and with the current cement prices, Q1 sectoral EBITDA/tonne is likely to improve by 20-40 per cent quarter-on-quarter (q-o-q), 15-20 per cent y-o-y; absolute EBITDA could shoot up by a minimum of 15-20 per cent. With volumes turning favourable and no rollbacks in cement prices over the next two months, the potential is huge.
Mid-cap cash flows are robust and likely to accelerate debt repayments. Mid-cap stock valuations have always had the overhang of higher debt versus large caps. However, debt repayment for most mid-caps is likely to accelerate in Q1 as the sector sees robust cash generation. This will be a key rerating factor and is likely to drive valuations. We expect good sense will prevail in the sector and players will not rush in with fresh capex announcements.
Players are evolving and this makes prices more stable over the long run. Historically, price hikes have always been a call for concern (break in price discipline). We do not rule out intermittent price disturbances, but we understand that players are evolving.
Even newcomers to the industry understand the need for stable prices; they are also debt-ridden and cannot afford to operate in an unfavourable price scenario. This gives us confidence that price hikes are more sustainable than in the past. FY18 should be a turnaround year for stock valuations; we do not rule out the possibility of a partial rollback of the recent price hikes. However, even in a conservative scenario (if only 4-5 per cent price hikes sustain in FY18), EBITDA/tonne has the potential to improve by 10-15 per cent or even higher in certain cases.
The largest major of the sector trades at a per tonne valuation of $200, while most mid-caps trade at $70-120. As the scenario turns favourable and as mid-caps get rid of debt faster than expected, this valuation gap could narrow, to say, about 25 per cent discount to large-caps. The potential upsides can be huge.
We do not rule out potential target upgrades in the medium to long term; our current price targets for most mid-caps have built-in target valuations of $70-120/tonne. We see the valuation gap between mid-caps and large caps narrowing as sectoral dynamics turn favourable. We see further re-rating of mid-caps over the medium to long term.