Slightly over a year ago,the Indian corporate world never tired of touting the India growth story. This story rested on two themes: domestic consumption and infrastructure growth. Together these two themes,it was said,would keep the Indian economy on a growth path for decades. Alas,the global economic slowdown has swept all in its wake,and the India growth story has lost much of its sheen. One sector that has been caught on the wrong foot by the adverse economic developments of the last one year is cement. An overdose of optimism during the good times led to excess capacity being created. And now as demand slows down,achieving profitability will be hard.
The good times
Between 1998 and 2008,the cement sectors income grew at a compounded annual growth rate (CAGR) of 13.4 per cent and profit after tax (PAT) at 36 per cent. During the last four years of the boom (2004-2007) the price of cement increased by as much as 75 per cent.
Total cement capacity in India stood at 175.7 million tonnes per annum (mtpa) at the end of FY08. So high was demand that capacity utilisation (Q1FY08) rose to almost 100 per cent.
Demand for cement comes primarily from housing which accounts for 60-65 per cent of total demand; infrastructure (20-25 per cent); and commercial construction (10-15 per cent). On an average,cement demand grew at the rate of 8.8 per cent during FY03-08,mainly due to strong GDP growth and huge investments in real estate. From 2006 to 2007,when cement price increased almost 50 per cent,net profit margin and operating profit margin grew by 700 basis points and 930 basis points respectively for the sector. Thereafter,major input costs such as that of coal,freight and other raw materials rose sharply leading to cost pressures.
The first half of FY09 saw double-digit inflation,which was chiefly the result of rising commodity prices worldwide. To quell inflation,the government imposed a ban on export of cement on April 11,2008. This ban was subsequently relaxed in December.
Prices. Over the last one year,the pricing scenario has remained bleak mainly on account of increased government intervention to curb inflation. All-India average cement prices increased by 4.5 per cent year-on-year (y-o-y) in Q3FY09. But prices were marginally lower when compared to Q2FY09. This decline was the result of lower demand and a 4 per cent reduction in excise duty on cement,which the government announced in its stimulus package of December 7,2008,and which was passed on to customers.
Income and profits. In Q2FY09,y-on-y growth in income stood at 13.1 per cent. But reflecting the ongoing economic slowdown,y-o-y topline growth fell to 5.8 per cent in Q3FY09.
While topline growth still remains in positive territory,net profit has taken a worse hit. In Q2FY09 y-o-y growth in net profit was -19.3 per cent. In Q3FY09 this plunged even further to -23.5 per cent. According to Pawan Burde,analyst at Angel Broking,Profits were down due to pressure on margins.
Margins. The cement sectors margins have been under pressure in all the three quarters of FY09. Between the September and the December quarter,operating profit margin fell from 26.38 per cent to 24.34 per cent,a decline of 205 basis points. Similarly,net profit margin fell from 13.81 per cent to 11.99 per cent,a decline of 183 basis points.
Explaining the decline in margins,Amit Srivastava,research analyst at Karvy Stockbroking says: During the first nine months of FY09 cement prices were firm,but major input costs,such as that of coal,freight,and other raw materials witnessed a sharp increase. This led to the squeezing of margins.
Expenses. Next,let us next turn to the actual elements that caused the damage to margins. From the September quarter to the December quarter of FY09,the cement sectors total expense as a percentage of income rose by 260 basis points. Power and fuel expenses (they account for nearly 20-25 per cent of total cost of production) as a percentage of income surged 230 basis points over this period. However,relief came in the form of raw material costs which,as a percentage of income,declined nearly 220 basis points over this period.
Says Burde: The cost of coal increased significantly during FY08 and kept rising till July-August FY09,peaking at around $170-180 per tonne. Prices doubled during this period (from March 08 to July-August FY09). But after peaking in July 2008 coal prices have fallen by around 60 per cent.
The cement industry is in the midst of a downturn. In FY09 slowdown in housing demand has led to a slowdown in demand for cement. What has exacerbated the sectors woes is the significant capacity addition that has already been made,and more that is expected to be added in future.
According to Srivastava,The cement industry has completed incremental capacity addition of around 23.4 million tonnes in FY08. Another 90 million tonnes of incremental capacity will become operational in the next three years. We believe that incremental capacity coupled with lower demand will lead to lower capacity utilisation and subsequent pressure on cement prices. A sharp decline in the price of coal and in freight cost is expected to provide some cushion against the expected fall in cement price. But most companies will report a decline in profitability. Currently total cement capacity in India stands at 208 million tonnes. The industry is expected to add another 32.1 mtpa capacity by FY10.
Demand and supply. According to Srivastava,The countrys GDP growth reflects the growth in housing,infrastructure and industrial investment. Hence,estimated GDP growth rate has a strong correlation with the demand for cement. In the last 10 years,the cement industry has had a correlation factor of 1.18X with GDP growth rate,so if the latter is expected to grow by 7.1 per cent in FY09,cement demand is expected to grow by 8.3 per cent. According to Yashika Singh,headeconomic analysis,Dun & Bradstreet India,Cement production and consumption are expected to grow by 9.2 per cent and 8.7 per cent respectively in FY10.
Prices. Overcapacity within the cement industry means that prices will remain under pressure for at least a couple of years until the economy revives and demand catches up with supply. Cement prices are expected to remain stable in the coming months,but could fall in the second half of FY10,as fresh capacities come on-stream leading to a drop in utilisation rates. Earlier this week the government announced a reduction in excise duty on bulk cement of 8 per cent or
Rs 230 per tonne,whichever is higher. This is expected to have a marginal positive impact on overall demand for cement, says Singh.
Financials. Cement companies are expected to witness a slowdown in income,profit and margins on account of low demand growth and excess capacity,which is expected to lead to fall in prices. Going forward,Srivastava expects cost pressures to cool down due to a sharp decline in coal prices. However,due to a decline in realisations,total expenses as a percentage of sales are expected to go up.
A turnaround in the cement sector is some time away. Investors should keep an eye on prices and capacity utilisation in order to get an idea of whether demand is beginning to catch up with supply.