Rally in cement shares seems premature

Rally in cement shares seems premature

Cement prices have weakened due to oversupply in most regions. Cement prices, up nearly 20% from April until August, fell sharply thereafter. In November, they dipped by an average of Rs15-20/bag over August across the country, barring the eastern region.

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As if defying industry fundamentals, share prices of most cement firms have appreciated in the past three months.

Output, too, has declined. November despatches of some pan-India players such as Ambuja Cements Ltd and UltraTech Cement Ltd are not very encouraging. They declined by 9-10% over the year-ago period. However, despatches from ACC Ltd and Jaiprakash Associates Ltd rose 5% and 13%, respectively, due to capacity addition. Demand growth, too, has been weak, partly due to the high base effect of fiscal 2010 and partly due to poor offtake from real estate and slower infrastructure growth.

The moot question is whether cement prices will recover to hold up manufacturers’ profitability? A report by Citigroup Global Markets explains, “India has been prolific in cement capacity addition with 107 mtpa (million tonnes per annum), an increase of 65% since FY07, almost double the cumulative demand growth of 33% since then. Another 60 mtpa (+22%) is expected during FY11-13E." Analysts estimate weak demand growth for cement in fiscal 2011, at an estimated 7%, reportedly the lowest in seven years. Besides, surplus capacity in the south is forcing producers to sell cement in neighbouring states, despite higher freight costs, and hence subduing prices in those regions, too.

According to a report by Motilal Oswal Securities Ltd, the aggregate realization in September for six cement firms it covers dropped year-on-year by Rs539/tonne and quarter-on-quarter by Rs379/tonne, to Rs3,156/tonne. Higher costs of raw materials like fly ash and fuel also compressed operating profit margins. With more capacities coming on stream, cost pressure may increase for the industry. Motilal Oswal estimates a 16% contraction in the average operating profit and 22% dip in average net profit during fiscal 2011 compared with the previous year.

A contrarian investment approach perhaps best explains the rally in cement stocks. Investors perceived price hikes announced in August to be the bottom of the cement cycle, which triggered buying in these stocks. But media reports suggest an artificial scarcity in the market because of production cutbacks. Since July, shares of ACC, Ambuja and UltraTech have risen by 12%, 23% and 30%, respectively, while the southern giants—India Cements Ltd and Madras Cements Ltd—have remained flat despite their dismal performance.

Most broking houses have downgraded the sector’s earnings estimates until fiscal 2012, given that signs of improved profitability would be visible only from the second half of fiscal 2012. Hence, the current investor enthusiasm may be a case of jumping early on to the cement bandwagon.

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