Larger cement companies better placed despite higher valuations

The second quarter or the July-September period is usually a weak one for the construction sector and by extension, for the cement industry. The monsoon slows down construction activity and prices tend to soften. The current financial year, however, could be different because of the low base effect and also the fact that economic activity seems to be picking up.

The housing industry is doing better and public expenditure as outlined in the Budget has been focused on infrastructure, which means more construction projects. Hence Q2 is expected to deliver good results, with both volume expansion and better price realisations despite a delayed monsoon.

Also the second half of 2021-22 is expected to see an acceleration in construction activity and cement offtake. Based on the estimates of monthly dispatches, volumes are up 44 per cent year-on-year for Q2, and realisations are up 6.5 per cent sequentially over Q1FY22. Prices are down about 5 per cent sequentially.

Balanced against the positive factors, there is the matter of rising costs. Cement production is an enormously power-intensive process. That cost component has seen a sharp spike. Merchant power units have witnessed a jump in costs and so have fuel, such as coal, petcoke, diesel, and natural gas, which means that even cement plants with their own captive power face much higher costs on this front. In addition, transport costs have risen. This would have eaten into the margins and would continue to affect costs negatively until cement manufacturers take price hike and pass on costs. According to industry-watchers, this may not happen until November. 

Investors appear to have paid heed to the negative aspects in the recent past. Prices and valuations have underperformed the overall market over the past month. This correction has not been deep but it can add to the potential upside. Industry experts estimate that there can be 10-12 per cent growth in cement volumes in FY21 over FY21.

Scale definitely counts in the industry. The higher the capacity, the better the enterprise value per tonne; it’s also important to have a large geographical footprint. Big cement manufacturers, namely UltraTech, Shree Cement, Ambuja, ACC and Dalmia Bharat are estimated to have valuations in the P/E range 38-39 times for 2021-22. Smaller companies — such as Birla Corp, JK Cement, Indian Cement —have P/E valuations of about 21-22 times.

The upside risks to the positive advisories come from the possibility that companies will be able to pass on rising costs with price hikes (or that fuel and power costs will moderate) and still generate strong volume growth. The downside risks, of course, will be weaker-than-expected demand that, in turn, will make it hard to pass on higher costs.

The current correction may bring in investors, who are buying the dips, anticipating a cyclical improvement as the monsoon recedes. Larger companies are likely to do better in terms of profit expansion through the second half. 

Despite higher valuations, bigger cement companies can yield strong returns in terms of capital gains.