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It is widely known that India’s cement sector is grappling with cost inflation. Even industry leader UltraTech Cement Ltd is feeling the heat. In the September quarter, UltraTech’s operating margin fell 340 basis points (bps) year-on-year (y-o-y) to 22.6% due to energy cost inflation.

In a post-earnings conference call, the management said raw material costs rose due to higher slag and gypsum prices. Given the continuous rise in thermal coal prices, the firm has increased its dependence on petroleum coke (petcoke). The composition of petcoke in its fuel mix has risen from 17% in Q1FY22 to 19% in Q2FY22. Yet, the management expects a cost headwind of 200/tonne in Q3FY22 from higher fuel prices.

The management expects another 500/tonne jump in fuel cost in the coming quarters due to higher spot coal prices; however, they see the current surge as transient. Freight costs are also expected to rise due to increased diesel prices.

Debt cut spree
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Debt cut spree

Not just fuel expenses, higher employee and maintenance costs also weighed on operating margins. Employee costs rose due to payment of incentives and wage hikes. The same is expected to be rationalized over the next few quarters, the management said. The management expects fixed costs to stay in the range of 5,000-5,500 crore in FY22.

Simply put, there is a near-term threat to operating margins from elevated raw material and fuel costs. However, investors can seek comfort from the management’s plan to pass on the impact of rising fuel costs through higher cement prices in the coming months. UltraTech took a price hike of 10-15 per bag in October, thus returning to pre-monsoon price levels, the management said, adding that the current round of price increases has sustained in most markets.

Analysts say that UltraTech would need an additional price increase of 35-40/bag to maintain margin growth of the previous quarters. Also, the near-term trajectory of the stock’s performance depends on the pricing outlook. That said, analysts note that the strong demand outlook gives UltraTech scope to increase prices.

The company faced weak volume growth in Q2FY22 on the back of stringent regional curbs and severe monsoons across India. Cement volumes rose 6% y-o-y to 20.4 million tonnes, while staying flat sequentially.

The management said volumes have shown a marginal improvement since October in line with receding monsoons. While the management refrained from giving any guidance, it expects demand to rebound sharply post monsoons. In the second half of the fiscal, it expects volumes to grow 6-8% y-o-y. The management expects to recoup lost volumes from a strong recovery in demand, primarily led by a pick-up in commercial real estate and higher government spending on railways, road and irrigation projects.

Amid the cost inflation battle, the firm’s efforts to further strengthen its balance sheet are being overshadowed, analysts said. Investors would reckon that UltraTech has been on a debt reduction spree in the past few quarters and aims to turn net-debt free by FY23. It should be noted that debt reduction is seen as one of the factors that could bridge the valuation gap between UltraTech and rival Shree Cement Ltd. On an EV/Ebitda basis, the former trades at multiple of 16 times, while the latter is the most expensive listed domestic cement stock with a valuation multiple of 22 times. It should be noted that Shree Cement is net cash positive.

EV stands for enterprise value. Ebitda stands for earnings before interest, taxes, depreciation and amortization.

UltraTech’s net debt rose 6% sequentially, but fell 47% y-o-y to 6,300 crore as of September. Net debt rose despite strong operational cash flow due to seasonal rise in the value of working capital and higher capital expenditure during the quarter. Net debt/Ebitda remained stable at 0.5 times as of Q2FY22 from 1.3 times in Q2FY21.

“With strong operational cash flows, we estimate 4-6% free cash flow yield in FY2021-24E despite growth capex and to help UltraTech become net cash positive in FY2022E," said analysts at Kotak Institutional Equities.

The analysts also said that UltraTech had in the past added leverage for inorganic growth. However, given no major cement asset being on the block, there is no likely risk from any merger and acquisition.

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