Sustainable re-rating ahead?
Large caps are trading at multiple year high valuations, with several mid-caps closing in the gap too. Most importantly, valuation hierarchy has flipped with a cost leader (Shree Cement) now at the top of the band. Given an increasing proportion of non-trade sales, higher RMC penetration and bulk (i.e., not bag) cement sales, the premium pricing of brand leaders will erode gradually. Historically, the erosion of pricing premium has coincided with periods of fast demand growth (implying sudden utilisation surges). Given the low entry barriers in to the cement industry and relatively slow expansion plans of pan-India companies (Holcim/Lafarge mainly), market share for erstwhile dominant players is shrinking.
Given this scenario, single/two region cost leaders with better logistics will trump multi-region cost-laggards (op-ex and capex). Sharper growth in cement consumption will suit nimbler companies (faster execution and turnaround) better than slower ones, and will also make them better equipped to navigate periods of weak demand. These companies will see their valuations rerate substantially. The future belongs to the companies with proven operational cost leaders, who can compete with pan India players on costs. Here is a review on two of the market leaders at the moment.
Orient Cement (Orient) is catching up with the industry leaders in South. It already runs one of the most efficient operations in the country (LTM operating costs at Rs 2,945/t vs Rs 3,400-3,800 for peers ex-Shree). From its current base in Devapur (Telangana, 3 mTPA) and Jalgaon (Maharashtra 2 mTPA), the company is expanding by adding 3 mTPA cement capacity at Gulbarga (Karnataka). At a total project cost of ~Rs 17bn (~US$95/t) and a guided commissioning by 1QFY16 (within 24 months from ordering), the upcoming plant is expected to set a new benchmark in greenfield project execution.
The next key challenge before the company is to replicate its best-in-class current operations at the new plant. Two solid advantages: low landed cost of coal (due to proximity to the Singareni Collieries) and fly ash (from Ramagundam TPP) are not replicable. However, savings may accrue due to newer, more efficient equipment (new kiln, VRMs instead of ball mill-roller press combination). Further, the catchment area of new plant would include higher priced markets of Karnataka. As a result, the new plant may be able to generate similar EBITDA/t as the existing operations. At 8 mTPA capacity, operations in two regions and established cost leadership, the valuations at US$81/t are still below peers like Ramco, which trades at US$140/t.
With the Devapur operations nearly maxed out at current volumes, Gulbarga will drive the next phase of volume growth (FY14-17 CAGR: 13 per cent). While blended profitability will be dragged down to some extent due to non-replication of current advantages, we reckon EBITDA/t to be a healthy Rs 1,100/t in FY17. EBITDA/PAT can grow by a healthy 44 to 40 per cent CAGR over the same period. Debt/EBITDA will be a healthy 2.7x upon commissioning of the Gulbarga.
Key investment arguments
- Orient Cement´s current operations out Devapur (AP) and Jalgaon (Maharashtra) are best-in-class, with industry leading costs (LTM operating costs at Rs 2,945/t).
- Current profitability is driven by low energy cost (LTM Rs 940/t), which is in part driven by linkage coal available in close proximity of the plant (Singareni Collieries). Orient has linkages for its clinker lines from Singareni collieries (0.67 mT coal or ~78 per cent of consumption in FY14, including power plant requirement).
- Freight costs remain extremely competitive (Rs 745/t, ex inter unit clinker transfer) as its primary target markets in Telangana and Maharashtra are at a very low lead distance (< 350 km). Including IUCL, the freight costs (~Rs1,000/t) are in line with other cement makers.
- Ramagundam super TPP (2600 MW) is at a 60 km distance from Devapur, while Bhusaval power plant is situated at a distance of 20 km from Jalgaon GU. This ensures availability of fly ash with a low lead distance too.
- The Chittapur (Gulbarga) 3 mTPA capacity (2 mTPA clinker) is being added for a capital cost of ~Rs 17.0bn, of which ~12bn will be funded through debt and remainder via internal accruals.
- The new plant is expected to be more efficient vs the current operations due to single kiln operation (vs 3 at Devapur currently) and newer equipment. However, the advantages of low cost fuel (linkage coal at Devapur) and fly ash (Ramagundam TPP) will not be available and the company will have to ferry these ~400 km (from current sources to Gulbarga).
- A mine life of 93 years based in ~300 mTPA reserves also allows the company further scope to expand the capacity at a later stage.
- Sometime in FY16, Orient will be an 8 mTPA entity with operations in South, but with key target markets in the lucrative regions of Maharashtra.
- Orient will have a net Debt/Equity of ~1.2x and net Debt/EBITDA (FY16E) of ~2.8x upon plant commissioning in June -15. This compares well with other cement companies undertaking a ~50 per cent expansion currently.
Sanghi Industries (SNGI) operates a 3 mTPA clinker capacity (2.6 mTPA grinding) in Kutch, Gujarat. It has access to soft marine limestone spread over ~1,500 hectares (containing ~1 bnt of proven reserves). The operations are fully integrated with captive power (63 MW) and have the ability to use lignite in both kiln and CPP and a captive jetty within 1 km of the cement grinding plant. Its port terminals at Navlakhi (Rajkot) and Dharamtar (Maharashtra) are used to access their respective markets. The company also exports clinker from Kutch, opportunistically tapping the cement markets in Middle East and Africa.
SNGI´s profitability is driven by low cost raw material, essentially surface mined limestone. Proximity to lignite mines of GMDC, ability to import coal at its captive jetty and excess captive power allow it low energy costs. On the flipside, low blending (C:C ratio at 1.1 in FY14) and a very high proportion of road transport (given no option of railway) eat away large chunks of profitability. As a result, the company reports some of the highest P&F and selling costs in the industry.
The road forward
SNGI is investing in additional cement capacity (1 mTPA grinding unit) at the existing location, likely to be commissioned in FY16. Given the ample availability of fly ash in the vicinity and a gradual shift towards PPC, P&F costs can trend lower. Further, increasing focus on low cost coastal freight should lower freight, while accessing newer markets. In addition to existing terminals, SNGI is looking at setting up distribution capacity on the western coast and is acquiring vessels for transportation.
Key investment arguments
- Installed clinker capacity (~3 mTPA) is enough to support volumes of up to 4.3 mTPA, theoretically. (Implied C:C ratio of 1.43).
- However, given limited grinding capacity, SNGI has remained constrained in its volume output with a maximum cement production of 2.5 mTPA in FY08.
- To address this mismatch, SNGI is adding a 1 mTPA GU at a cost of Rs 1bn (~US$ 17/t). The GU is being added at existing site, which is close to the captive jetty. Likely to be commissioned in FY16, the cement grinding capacity will provide SNGI with additional volumes at a low cost.
- SNGI has not been able to capitalise on its coastal location and captive jetty, for domestic volumes.
- The nearest railhead, Bhuj, is ~140 km from the plant, rendering rail transport infeasible.
- The company is planning to purchase vessels for cement transport, and has earmarked a capex of Rs 1.0bn for the same. Vessels are expected to be delivered by 2HFY15 and will likely result in substantial freight cost savings.
- SNGI sells primarily OPC, given low grinding/blending capacity and brand positioning. Of late the company has attempted to foray in to PPC manufacturing.