Why the cement sector rally is far from over

Strengthening demand, slower capacity ramp up to boost utilisation in existing units, improve pricing; up-cycle seen lasting 5 years

With the infrastructure push from the government, the rub-off was expected to trickle down to the cement sector, which it did. Since their lows in February, cement companies have been among the top performers in the market.

S Krishna Kumar of Sundaram Mutual Fund said in an interview,"If you look at the India story and the sort of things the Indian government has been doing to boost infrastructure investment and public spending, the unique way would be to play the growth theme through the cement sector. The cement sector gives you great exposure to the kind of construction activities happening in the economy and you have the government-sponsored housing for all scheme. The cement sector allows dual play on both the domestic housing story and infrastructure stories."

What seems to have caught investor fancy is the point when non-cement players started investing in the sector. Consumer companies such as Emami announced their presence by initiating a project to manufacture cement in the eastern part of the country. But the big shocker was when detergent giant Nirma bought out international cement major Lafarge’s business in India.

Entry of new players in an established sector like cement suggested that they are chasing high growth. Timing of the new players could not have been better. Normal monsoon is expected to kick in demand from the rural market. The cement sector has already posted a 6.5 per cent growth in the first quarter of the current year, which is likely to increase further. Strong monsoon saw demand slowing down, but the same is expected to pick up, say analysts.

Such is the confidence of analysts in the sector, that a sharp increase in some key raw materials has not prevented them from raising the warning flag. Average fuel prices for cement companies have risen 18-30 per cent in the second half on account of firming up of coal prices globally. Analysts however, feel that cement companies will be able to pass on the hike given the demand surge.

The rally in cement stocks seems to be far from over. Morgan Stanley in a report on the sector have said that they foresee the longest ever upcycle ahead. Their optimism is generated from the fact with improving demand growth and slowing capacity addition, capacity utilization will improve, thus lend pricing power to the industry. More importantly, the upcycle will be the longest relative to history (during the past two decades), which the research paper says can last for five years, versus the historical average upcycle duration of around two years.

Since the time taken to set up a cement unit has increased from 2-3 years to 4-5 years, according to Morgan Stanley, the muted announcement on new capacity addition will bridge the gap between supply and demand, thereby pushing cement companies' performance. Even though cement stocks seem richly valued on near-term earnings, Morgan Stanley says investors should focus on the robust earnings growth that the industry can generate for the next 3-5 years. Its reports point to a handsome 31 per cent EBITDA CAGR growth over FY16-19.

Precedents from other markets -– China and Indonesia -- also suggests a scenario of improving utilisation and cement stocks have commanded substantial premiums to historic valuations.