cement stocks: Costs on a leash, cement stocks set for faster recovery

ET Intelligence Group: Select cement stocks including UltraTech, Ambuja Cements, Dalmia Bharat and Heidelberg Cement have gained 10-23% since March 24, notwithstanding the possibility of lacklustre volume growth in the coming months.

Better cost control due to higher proportion of variable costs, price discipline, better cash generation compared to players in other manufacturing sectors and cheaper valuations are the major factors attracting investors to cement stocks.

Analysts expect a marginal decline in the cement volumes for FY21, which will be the second instance in the past two decades. The lockdown due to Covid-19 will hamper cement offtake in the June quarter, which is a seasonally strong quarter for the sector. In this backdrop, analysts are focusing on companies that will be able to recover fast once normalcy in business operations resumes.

Amid weak demand, one relief for the sector is the high proportion of variable costs in total operating costs. According to estimates by Crisil, the cost of manufacturing a tonne of cement in India is Rs 3,860. Of this, 75-85% cost is variable, which can be controlled depending upon the demandsupply balance.

In addition, costs of petcoke, a major input for cement and diesel, used for transportation of cement, will be lower given sharp fall in international crude oil prices. Lower raw material and freight costs may lower the cost of production by Rs 100-200 per tonne.

Higher cash generation and strong balance sheets are the other important factors that make the sector attractive. The ratio of debt and operating profit before tax, depreciation and amortisation (EBITDA) is below one for most of the large cement makers. Historically, after a lean phase due to external factors, cement volume picks up due to pent-up demand and price discipline by manufacturers.

Spark Capital, a domestic brokerage, estimates 8% growth in cement demand in FY22 after a modest expectation of 2% increase in the current fiscal. Realisations may improve by 2-5% in the next year assuming renewed infrastructure investments from the government and resuming of construction activities.

On the valuation front, cement companies trade at reasonable valuations after the recent fall in the stock market. Their enterprise value (EV) per tonne is at nearly 50% discount to the replacement value, a level not seen even during the financial crisis in 2008. Also, their EV/EBITDA is at 20-40% discount to the 10-year average.