Large cement companies are trading at valuations that are far higher than their historical average. Using one-year forward earnings estimates, it is around 17 times EV/Ebitda. If you thought brokerage firms will be hard-pressed to justify these valuations, think again. Some of them are even making a bullish case for cement stocks at current valuations.
EV stands for enterprise value and Ebitda is earnings before interest, tax, depreciation and amortization.
Morgan Stanley, for instance, foresees the longest ever upcycle for the cement sector. “Indian stocks now carry roughly a 40% premium to their long-term average—which is sustainable, given our view that the cycle will be higher for longer. We project a robust 31% EBITDA CAGR over FY16-19... The upcycle will be the longest relative to history (in the last two decades). In our view, it could last for at least five years versus the historical average upcycle duration of around two years,” it said in a recent note to clients. CAGR is compound annual growth rate.
The brokerage firm’s main hypothesis is that capacity addition will happen at a relatively sedate pace in the next few years, while demand will grow at around 7%, resulting in improving capacity utilization and hence increased pricing power for the industry. Based on the current capacity pipeline, it expects the rate of capacity addition to slow to around 3% between FY16 and FY19.
While it’s true that the rate of capacity addition is set to slow down, there are two important factors that are being missed out in the above analysis, according to a senior cement analyst at a domestic institutional brokerage firm. First, one needs to account for all the excess capacity that has come on stream in the past few years. And secondly, an excess supply scenario is expected to negatively impact the industry in the eastern and southern regions, where capacity utilization is either extremely low or new additions have outpaced demand by a high margin.
As such, a meaningful improvement in capacity utilization can be expected largely in only the northern and central regions. And, it goes without saying, that much can change over a five-year period. In this backdrop, investors would do well to exercise caution, especially since valuations are already at a substantial premium to the long-term average.
The expected fall in new capacity addition is mainly due to unfavourable demand-supply dynamics witnessed in the last two-three years, which has hurt the economic viability of new projects. Besides, according to some analysts, government clearances are taking longer compared to previous years, which is also resulting in a slowdown in the pace of capacity addition.
The writer does not hold positions in the companies discussed here.