Cautious, not concrete, on cement stocks outlook

Publish Date: September 14, 2018

The demand for construction material due to rapid urbanisation is one of the biggest business drivers for cement companies. As the Indian economy grows, the cement sector is poised to play catch up. Yet, most major cement stocks have been down in the 10–50% range over the last year.

Why are investors not ready to pay top dollar for cement stocks in the world’s fastest-growing major economy? Various factors are at play, and these are forcing investors to adopt a cautious stance. Sluggish cement prices, anticipated cost pressures, and expensive valuations have formed a troublesome troika. Let’s do a deep-dive.

Slippery prices

Cement firms make money by selling cement. If product prices do not grow, that is never good for the business. According to Kotak Institutional Equities, all-India cement prices declined in September 2018 by Rs 3/bag month on month to Rs 328/bag. Weakness has persisted as heavy rains have held up construction work.

The sluggish prices are a nationwide phenomenon. The East region has seen a correction of Rs 9/bag, leading to a price of Rs 336/bag. In the North, cement became cheaper by Rs 2/bag, closing at Rs 304/bag. The price in the West fell to Rs 311/bag, a drop of Rs 4/bag. The only light at the end of the tunnel was in the form of steady rates in the South and Central regions.

Related read: Real estate sector to be hit hard if construction ban is prolonged

Currency conundrum

Cement companies are not immune to cost pressures. If the cost pressure is from a depreciating domestic currency, then there is only so much a cement company can do. The operating costs of companies are largely driven by logistic costs, courtesy higher lead distances and fuel expenses. Energy costs also account for a large expense in sync with the rise in pet-coke prices.

The spot Indian rupee/US dollar rate is already down 13% for the year. This will increase the costs of cement companies, although there may be a lag. Our analysis shows that nearly 35% of the costs are at parity to the US dollar. Besides, imported pet-coke prices have increased by 9% in the second quarter. We estimate that close to 40% of pet-coke usage by domestic cement companies is through imports. Alongside higher energy prices, rising diesel prices may also add to existing cost pressures. With demand not strong enough to lift prices, margins will be under pressure as costs spike.

Related read: 4 questions you may have about rupee depreciation

Valuations elevated

Despite a healthy correction in the stock prices of most major cement firms, valuations remain a concern. A price correction generally makes an investment cheaper and attractive. Not this time.

On a price/earnings (PE) valuation basis, most large-cap cement stocks trade between 30–70 times of FY2018 profit. On an enterprise value/EBITDA (EV/EBITDA) basis, cement stocks are trading at 12–23 times.

Usually, valuations become much cheaper over two years. Yet, cement stocks do not show those trends. We expect only moderate improvement in earnings over the next two years. As a result, the valuations seem expensive. Also, the cost headwinds mentioned above will likely arrest any meaningful earnings improvement. Use of capacities is unlikely to shoot up.

Related : NCLAT upholds CCI's verdict on cement cartelisation

Summing up

The cement sector remains unattractive at this point. There may be growth, but the cost of buying cement stocks to gain from that growth may not be justifiable. Thus, it is better to have a cautious outlook, especially on large-cap cement stocks, unless there are visible signs of improvement that change the fundamentals.

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