Cement demand set for a take-off
ACC Limited and Ambuja Cements - the two Indian units of building materials manufacturer LafargeHolcim - have posted their Q3 results. ACC's Q3 numbers have surprised positively, while Ambuja's operating results in Q3CY17 were marginally below estimates.
ACC: Breaks the trend of disappointment in Q3
ACC breaks the trend of disappointment in Q3 which was a much-awaited development. Operating results beat our estimate by 19 per cent; consensus by 10 per cent. Volume growth remains robust (+18 per cent YoY; -11 per cent QoQ) driven by expansions in East India and buoyant demand in this region. We reiterate, rather than the growth numbers, trends of absolute volumes will hold more meaning from here-on for the sector.
Cement realisations improving sequentially (+1 per cent) was a key positive surprise. We had expected the cement realisations to correct by 3 per cent which has not happened. This should mean positive surprises in operating results of other cement companies as well. We had been highlighting in our previous notes that a positive surprise in Q3 by ACC will be a much-awaited development for ACC to rerate. This has happened in Q3CY17.
Also, any further news flow with regards ACC/Ambuja merger will be a further positive sentiment trigger. Our checks suggest strong possibility of a reverse merger of Ambuja with ACC as the transaction cost in this scenario should be lower. This is because the number of mining leases with Ambuja is lower than with ACC. The bottlenecks (1) playoff between high transaction cost and synergies of the merger and (2) making the parent's Board (at LafargeHolcim) understand of these merger synergies and get their approval to execute this merger despite the high transaction cost. Despite valuing ACC at 16.0x EBITDA (peak multiple factoring in the possibilities of merger of ACC/Ambuja) we see limited upside given the stock price run-up. We continue to maintain Neutral with revised PO of Rs 1,950 (vs Rs 1,725 earlier).
Key highlights: ACC's Q3 numbers have surprised positively driven by stable realisations and better than expected volume growth. EBITDA/tonne at Rs 592 was 12 per cent higher than what we expected. There were cost increases but no fall in cement realisations helped ACC partially offset the cost-push impact. While realisations were 5 per cent better than expected, costs were 6 per cent higher than our expectation, largely nullifying the impact. We are not changing estimates.
Outlook and valuation: ACC should hold on the operating performance in Q4 to sustain its rerating. Merger news flow, if any will also be a positive trigger but more sentimental in nature. A much awaited trigger in our opinion (and as per our ground checks) will be the brand consolidation which can structurally help both companies deliver material cost savings in distribution channel. Given the stock price run-up, despite factoring the peak of valuation multiples, we see limited upside in ACC from here-on. The stock currently trades at $155/tonne and target it will trade at $170/tonne. ACC continues to command significant discount to peers on EBITDA/tonne and this must improve for meaningful upside.
Ambuja: Marginally below estimates, most positives
Ambuja's operating results in Q3CY17 were marginally below estimates despite adjusting for one-offs. EBITDA was 8 per cent /5 per cent below our/consensus estimates. Eight volumes were in line; realisations were better, but higher-than-expected opex/tonne took toll. While we have seen better realisations converting to better EBITDA/tonne for other cement majors, Ambuja disappointed on this front.
EBITDA/tonne was Rs 691 (adjusted) - 7 per cent below our estimates. We have cut our volume estimates for Ambuja by 5 per cent resulting in cut in EBITDA estimate of 8 per cent / 7per cent for CY17/18.
In our opinion, improving the efficiencies and operating parameters of ACC will remain Ambuja's immediate focus. However, if Ambuja starts disappointing on a standalone basis, it will hurt consolidated numbers (unless ACC structurally improves on operating parameters). ACC's surprise in Q3CY17 was more realisation-driven, and we are yet to see structural changes in operating parameters. Given the stock price run-up and cut in our estimates, we downgrade Ambuja to Neutral from BUY. We value it at par with peers at 16x EBITDA, despite which we fail to see any meaningful upside.
Key highlights: Ambuja's performance in Q3 was marginally lower than expected, driven by higher opex. Though this is not a major disappointment yet, if Ambuja fails to convert better realisations into better EBITDA/tonne (like its peers), the stock performance may remain subdued. CY18 will remain a 'consolidation phase' for Ambuja, and hence, safeguarding standalone performance is the key to protect its valuation.
Merger-related news flow (with ACC) will be a sentiment-based trigger, but a more important trigger will be brand consolidation, which can add synergies of Rs 2-3 billion in the distribution channel, as per our ground checks.
Outlook and valuation: Given the stock price run up, we are downgrading our rating to Neutral. Despite valuing Ambuja at par with its peers, we do not see any meaningful upside here. Bringing Ambuja's operating performance (at a consolidated level) in line with the operating performance of its peers will be a key challenge for meaningful upside. We have valued Ambuja at par with its peers (ACC / UltraTech) at 16x EV/EBITDA. We revise our target to Rs 300 (vs Rs 290 earlier).
The government's reiteration for spends on housing / infrastructure segment augurs well for the cement sector. Recapitalisation of PSU banks should have a trickle-down effect on the construction sector. The numbers shared by the Finance Minister in his recent presentation indicate an incremental cement demand of over 100 MT (cumulative) over the next five years, which translates to a minimum demand CAGR of over 8 per cent.
Housing alone will consume 75 MT of cement with the government's target to build 22 million houses in three to five years. Road projects can add another 25-30 MT of demand. Thus, just housing and road construction can add 100 MT of cement demand over the next five years, which is sufficient for a +10per cent uptick in utilisation. Construction of other infrastructure such as airports, ports, and railway network will also help. We expect the industry utilisation to touch nearly 85 per cent (pan-India level) over the next 3- 5 years if the government delivers.
Housing and roads - How can it translate to demand?
Our recent ground checks in various regions of the country suggest positive traction in demand, except for few specific states that continue to remain hit by sand shortage (situation should improve in Q3).
Every house (built in the affordable housing category or PMAY) consumes about 70 bags of cement (3.5 tonne). At 22 million houses, it converts into an incremental demand of 77 MT. This also converges with the criteria that every square feet of construction requires 25kgs (half a bag of cement). At 70 bags, the size of such houses translates to just about 140 square feet. The actual sizes of the houses can be much larger, hence this incremental demand has an upside potential. For every 1,000 km two-lane road, the benchmark consumption is about 1 MT of cement. Of the 83,000 km of road, even assuming just 30 per cent of these would be concrete roads, the consumption will be minimum 25 MT.
Hence, it appears that the cement sector will see a demand growth of at least 100mn tonnes. These assumptions are in base-case scenarios (small houses of only 140 sq ft each and just 30 per cent of the roads being concrete). This translates to a minimum CAGR of 8per cent over the next three to five years.
What changes in the sector outlook
With demand outlook turning positive, we are likely to see a much-awaited 'sentiment change' in the sector, which will drive valuations. Entering a pre-election era - we are more confident about improving demand as government spends usually increase.
Although the growth numbers may not look very robust in percentage terms, incremental demand will support capacity utilisation. We expect a minimum incremental Rs100/tonne of scale benefits, excluding the cost push impact. Challenges
Given that most of this demand will be from government and infra-related projects, the industry may lack pricing power. Marginal upticks in pricing (say 4-5per cent ) are likely, in line with increasing capacity utilisations. Robust price upticks are unlikely.
We continue to believe that mid-caps still offer quite a lot of value. Our top mid-cap plays are India Cements, JK Lakshmi Cement, and JK Cement. Among large-caps, we continue to like UltraTech Cement and Dalmia Bharat. Both these companies have structural triggers for another leg of re-rating. With their valuation discount, mid-caps will continue to outperform large-caps in terms of returns.
The article is authored by: Vaibhav Agarwal, Vice President, Cement & Corporate Access, Institutional Equity Research, PhillipCapital (India) Pvt. Ltd.