Cement Industry : A Bond Gone Weak
One of the sectors worst affected by the virus pandemic and the ensuing lockdown in India has been cement. With infrastructure development and the housing industry screeching to a grinding halt, the cement industry has posted an 86 per cent year-on-year fall. Further, it is going to take quite some time for normalcy to return. Anthony Fernandes takes stock
Globally, the cement industry has immense forward and backward linkages with a nation’s economy. For a developing and transitioning economy like India, the value proposition of the cement industry is even more significant given that it caters to the large infrastructure requirements of a growing and urbanizing country. Accounting for over 7 per cent of the global capacity, the Indian cement industry is the second-largest in the world, second only to neighbouring China. Apart from playing a binding and pivotal role in both the infrastructure development and socio-economic development of the country, the Indian cement industry is also a major revenue contributor.
It is the fourth-largest revenue contributor to the national exchequer and second-largest revenue contributor to the Indian Railways. It contributed nearly USD 7.14 billion per annum to the government through taxes and levies, and about USD 1.29 billion to the Indian Railways via fright revenue.
What also helps is that the Government of India has a strong focus on infrastructure development with the announcement of several schemes that cut across manufacturing, housing and education. At the heart of this planned infrastructure development is the cement industry and hence its value proposition for laying the foundations of a new India is truly unique.
Impact of the Pandemic
Given its close linkage with the real estate sector in the country, it should come as no surprise that stalled real estate projects and delayed infrastructure developments due to the outbreak and spread of the corona virus have hit the industry hard. Cement is a primary construction material and has experienced a considerable dip in holistic demand ever since the national lockdown. Yet, seeing an 86 per cent year-on-year fall in the world’s second-largest cement producer is significant. Cement production declined to 4.1 MT from 29.2 MT. Further data shows that as part of the Indian government’s eight core industries, steel and cement production suffered the most. Coal, crude oil, natural gas, petroleum refinery products, fertilisers and electricity generation all fell by far less.
In comparison, China’s monthly cement output only fell by around 30 per cent since the peak of the outbreak. This difference can be accounted for by the fact that there was a graduated lockdown implemented in China, with the toughest measures applied in Wuhan, the place the virus was first identified. The output fell by 80 per cent in this city. So India’s experience feels somewhat similar, except that it is on a national scale rather than on a city level. The last time the country had such a dramatic dip in cement production was in late 2016 when the government introduced its demonetization measures which dented cement production growth rate and national productivity in the process.
The month of March was a particularly bad time for the government to shut down industrial plants because it is normally in this month when annual construction work is at its peak, and cement production usually hits a high during this period too. Credit rating agency, Care Ratings, has slated cement production to drop by 25-30 per cent in FY21 as the pandemic sucked demand from the end-user industries. This would be the steepest fall for the industry in any year. Capacity utilisation in FY21 is seen at 40-45 per cent. This follows a figure of 65-70 per cent over the last six years with the exception of FY20 when it was dragged down to 61 per cent.
Most of the top Indian companies in this space like Ultratech Cement, Orient Cement, Ambuja Cement, India Cement, Dalmia Bharat, JK Lakshmi Cement, Shree Cement and others had suspended their operations by various levels in the first phase of the lockdown in March 2020. It was only during mid-April 2020 that operations of industrial plants in rural areas were cleared to reopen. Even this was impacted due to limited manpower availability and logistics constraints, forcing the plants to run at depleted capacity. All of this started to show in financial results towards the end of March 2020 as sales graphs took a deep dive downwards. The worst is yet to filter through to balance-sheets.
Performance of Cement Companies
To understand the financial impact on the Indian cement industry during the time of the virus pandemic, we have taken the financial performance of Indian cement companies for the quarter ended March 2020 and have compared that to the same period for the previous fiscal year. We find that there has been a stark decline in net sales and the net profit numbers reported by these companies in Q4FY20. On an average, there has been a 9.05 per cent decline in net sales’ figures reported in Q4FY20 as compared to that of Q4FY19 with India Cements, Gujarat Sidhee Cement and Jaiprakash Associates among those worst affected. Similarly, net profit saw a decline of 26.13 per cent on an average on a year-on-year basis with Jaiprakash Associates, Saurashtra Cement and India Cements among those being most negatively affected.
We can see that despite showing lacklustre returns over a one-year period, these stocks have provided impressive returns since the onset of the current financial year. On a three-month basis, these stocks have provided returns of around 48.58 per cent on an average and this surge in stock price from March-April lows is believed to be on account of the easing of the lockdown in many parts of the country, which has helped the demand recover. It should be noted that Indian cement manufacturers are trading at a premium to their global peers. As the chart alongside indicates, the one-year forward price-to-earnings (PE) multiple of Indian companies is much higher than that of global counterparts.
Even on an EV or EBITDA basis, which is another parameter for valuations, Indian companies are expensive. EV stands for enterprise value. EBITDA is short for earnings before interest, taxes, depreciation and amortization. These valuations remain on the back of bleak demand outlook, weak price recovery, and consequently, a poor outlook for earnings. The disruptions caused by the pandemic have resulted in many cement firms delaying their expansion plans for the current fiscal year. So, keeping this in mind, a question that needs to be answered is whether these valuations are warranted?
Global cement makers trade at relatively cheap valuations because of low capacity utilisation. Even though the problem of overcapacity exists in India, cement valuations don’t reflect it. The sector was expected to see a demand super-cycle in the fiscal year 2021. A demand super-cycle occurs when there is a massive spurt in demand. It was expected that cement demand would improve substantially, aided by the government’s affordable housing push. But this clearly seems unlikely now and so these valuations hardly justify the sector’s fundamentals. It may be another classic case of how the stock market remains disconnected from the economy.
According to Jefferies India (P) Ltd., the cement sector is a good proxy to play the long-term capex revival story, especially since the aggregate leverage across companies is near-zero. Although select players are currently leveraged owing to the recent consolidation, the focus remains high on deleveraging. Therefore, valuations continue to be at a slight premium to the historical average despite the correction in the stock prices due to the ongoing crisis.
Outlook
The cement industry is seeing some demand recovery now that the lockdown is being lifted in many states. Cement dealers’ channel check by various brokers shows that pent-up demand is aiding the sector’s utilisation levels. Further, improvement in demand is expected to be driven by rural segments. As supply constraints ease, cement prices have started to recede as well. Labour issues are expected to be a major hurdle to the sector returning to normalcy. The mass movement of workers back to their homes made news headlines as it began at the onset of the lockdown. Now they have to move back and this is unlikely to be completed until after the monsoon season, by September 2020. Hence, partial recovery is not likely at least until autumn or full recovery of the sector until January 2021 at the earliest.