Cement firms face downgrade risks

Unless there is a pick-up in demand, realisations and profitability of companies could be hurt

While the stocks of ACC, Ambuja Cements and UltraTech Cement have surged 20-35 per cent from their 52-week lows in August, there is a risk of correction if the demand improvement does not happen as expected. The rise was in anticipation of a demand improving after rains, led by pre-election spending and an increase in rural spend. But after monsoon, low demand was being attributed to non-availability of labour due to festive season. However, one month  after Diwali, there are little signs of an increase in demand, say analysts.

Though there has been some improvement in demand in Gujarat, parts of Maharashtra and Karnataka, Karvy’s analysts say, “Overall demand improvement over the last month remains subdued, with recovery seen during the latter half of November.”

K C Birla, chief financial officer, UltraTech Cement (the country's largest cement producer), adds, "The demand has not been up to our expectations. However, we expect it to pick up, led by an increase in rural demand by December-end and increased infrastructure activity."

If the situation remains grim, the stocks can see downgrades, say analysts.

In terms of realisations, the price rises in November have been taken in the western and central regions. Whereas the northeast and south saw a decline in prices, by ICICI Securities’ channel checks, leading to flat all-India average realisations.

Central regions’ steep rises of Rs 21 a 50-kg bag have been possible as the region had not seen rises since September in spite of prices rising in other regions. Amit Srivastava at Nirmal Bang Institutional Equities adds the rise was led by strong production discipline rather than an improvement in demand. Hence, dealers are uncertain about the sustainability and expect a rollback.

Analysts at Kotak Institutional Equities in a report dated November 28 say the resilience of cement stocks in the face of continued earnings downgrades raises questions on the investment horizon of the Street. They add though the earnings can turn fast, there has been a continued deterioration in most fundamental metrics in five years. The growth has declined from nine per cent to five per cent, the sector growth reduced from 10 per cent to -1 per cent leading to low cement utilisation (utilisation rates have dropped gradually from 86 per cent to 79 per cent). Thus, after factoring in tepid realisation growth of two per cent year-on-year and volume growth of a per cent year-on-year in FY14, with cost inflation of five per cent, profitability of most is likely to see pressure.

Analysts at Barclays feel the stocks have seen a strong rally in three years on improving return ratios, a sharp jump in free cash flows, stable utilisations, an increase in replacement costs and, consequently, expansion of earnings multiples. However, the free cash flows and return ratios are declining. Thus, even as Bloomberg consensus estimates have seen downgrades of late, they expect further downgrades.

Stocks are discounting a sharp rebound in profitability and are trading near all-time high PE valuations. Barclays analysts expect stocks to correct. Looking at elusive demand recovery, they have targets of Rs 1,043 and Rs 156 for ACC and Ambuja, trading at Rs 1,094 and Rs 184, respectively.

However, analysts at ICICI Securities expect a gradual rise in realisations and profitability considering likely improvement in demand in H2FY14 on good monsoon and progress in the execution of stalled projects, which, in turn, will improve margins sequentially. They continue to maintain their neutral rating, with a positive bias on large caps like UltraTech and ACC. By Bloomberg, of the 10 analysts polled since November 1 for ACC, four have buy, three sell and three neutral, with a consensus target of Rs 1,191, which means a marginal upside from current levels. For Ambuja, two have buy, three neutral and nine sell, with an average target of Rs 168 (a downside of eight-nine per cent). For UltraTech, two have buy, five hold and three sell, with a target of Rs 1,936 (an upside of two per cent from the current levels of Rs 1,896).