Just like Don Quixote, Spanish novelist Miguel de Cervantes’ character who fought imaginary giants in windmills, the domestic cement industry too is living in a fantasy world. The rate at which capacity addition has happened over the past few years would mean that companies will have to keep running on the treadmill just to stay as they are, even conceding that the development boom may lend itself to consistent demand. Thankfully, they are financially healthy at the moment.

Though government spending has resulted in stable realisations, of late, there has been a divergence in cement prices across the country. Prices in the south have come off big time and this may spell bad times for players operating in the region. Prices in the north too have come down but not as much

Against this backdrop, investors would be better off switching loyalties to companies based in the north or even central India. The ideal strategy would be to bet between two mid-caps, say you buy a Birla Corporation and sell an India Cements. This is akin to pair trading followed by some sophisticated investors, but one could consider a simple switch.

Fast and furious

In the past five years, capacity addition grew at an average 9 per cent, with demand growth slightly above 8 per cent. Vineet Hematasaria of Pinc estimates that with an installed capacity of 230 million tonne per annum (MTPA), the Indian cement industry is the second largest in the world after China. Of the total capacity, 218 MTPA is from large plants and the balance comes from smaller plants.

In a bid to counter the effects of the global crisis last year, the government announced a slew of measures, centered on the easy availability of money and infrastructure development.

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Problem of plenty

Capacity expansion is concentrated in the southern belt

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More importantly, the low-cost housing plan is being seen as a big driver for companies in the days to come, as half of the cement demand comes from the housing sector. Also, First Global estimates that the Commonwealth Games, irrigation and other infrastructure projects will keep up demand in the north in the next year as well.

The ideal strategy would be to bet between two mid-caps, say you buy a Birla Corporation and sell an India Cements

But in the south, which constitutes about 35 per cent of industry capacity and accounts for 30 per cent of the consumption, the situation is dismal and prices have taken a beating. According to J Radhakrishnan of IIFL, today cement is the cheapest in Hyderabad, having fallen 45 per cent from its April 2009 peak, the sharpest drop in 15 years. Industry sources say volatile price movements could result in fluctuation of performance of south-based companies.

While reasons for oversupply are many, the principal cause has been the weakening demand in Andhra Pradesh. Rajan Kumar of Centrum expects prices to stay under pressure in the south and west, as supplies from new capacities increase. (See graphic: Problem of plenty)

North-south divide

Birla Corporation, the M P Birla group company that was a part of the feud between the Lodhas and the Birlas, is quietly gaining strength now. The company operates plants in Uttar Pradesh, Madhya Pradesh, Rajasthan and West Bengal with an aggregate capacity of 5.8 MTPA.

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Hyderabad blues

Source: Industry, IIFL Research Nov 93

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The company has diverse businesses, like jute and auto parts, but earns more than 90 per cent of revenues from cement. Jinesh Gandhi of Motilal Oswal feels the company’s Rs 2,000 crore capital expenditure plan to more than double its capacity to over 12 MTPA by FY13 is one of its most aggressive moves thus far. Gandhi expects the company to generate free cash-flows in excess of Rs 1,000 crore in the next couple of years. That should help the company fund its growth plan comfortably.

Between April and October, average capacity utilisation for India Cements was around 70 per cent against 90 per cent for Birla Corporation

Besides, an important reason why analysts are bullish on the stock is the amount of cash the company is sitting on. Mihir Jhaveri of Religare Hichens Harrison says that with more than Rs 1,100 crore parked in liquid investments, Birla Corporation is better placed to sustain any downturn.

Jhaveri expects the company to have about Rs 151 per share of cash by FY11 – that’s nearly 50 per cent its current market price of Rs 310. This is also one of the reasons why the company appears cheap on an enterprise value basis. (Enterprise value is arrived at by adding the debt to the market capitalisation and reducing cash on books.)

Compared with Birla Corporation, India Cements is a bigger player a capacity of 14 MTPA. Apart from the 1.1 MTPA unit at Parli in Maharashtra, India Cements’ capacity is concentrated in Tamil Nadu and Andhra Pradesh. Radhakrishnan of IIFL feels cement companies may incur losses at Ebitda level if prices dip below Rs 120 a bag, and this would prompt them to sell in the other regional markets.

From around Rs 260, prices in the south have dropped to less than Rs 200 per bag. In Andhra Pradesh, prices have fallen to around Rs 135-140 per bag. As far as the northern region is concerned, prices are still in the Rs 250-255 range.

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Concrete performance

Birla Corp has outperformed the Sensex by 75 per cent and India Cements by 143 per cent this year so far

Source: Bloomberg

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Jhaveri points out that India Cements has planned capital expenditure of Rs 2,100 crore for power plants and adding cement capacity. Analysts expect the stock to remain muted as the company is raising further debt and equity to fund the expansion.

Kumar of Centrum feels India Cements may post sluggish results because of weakening prices over the next few quarters, beginning October-December 2009. But, analysts say, forex gains in the current quarter and losses in the previous corresponding period may mask the actual deterioration in margins. Besides, volume growth and control on costs could further temper the degrowth.

Between April and October this year, average capacity utilisation for India Cements was around 70 per cent against 90 per cent for Birla Corporation.

North ahoy!

Some investors might ask, why adopt a risk mitigation strategy in a stressed out sector when there are enough opportunities available in other sectors? The idea behind the pair strategy is to have a near market-neutral position while trying to earn returns in volatile and uncertain market conditions. Since the current environment in cement is uncertain and there could be wild price fluctuation, one could consider a pair strategy in these two companies.

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Going cheap

Birla Corp's valuations look attractive

in Rs cr	FY09	FY10E	FY11E
Sales	1,791	2,191	2,306
Change (%)	3.8	22.3	5.2
Ebitda	458	732	660
Change (%)	-22.7	59.8	-9.8
Net profit	324	572	512
Change (%)	-17.7	76.6	-10.4
EPS (Rs)	42	74	66
Book value (Rs)	167	234	289
ROE (%)	28.1	34.3	23.9
P/E* (x)	7.5	4.2	4.7

Source: Bloomberg; *At Rs 317 a share

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India Cements trades at an EV/Ebidta (a valuation multiple like PE that is usually used for companies in an investment phase) of 5.5 times next fiscal numbers, compared with 4.1 times for Birla Corporation. Even on a price-to-earnings front, India Cements trades at 8.4 times next fiscal earnings compared with 4.7 times for Birla Corporation. On a replacement cost basis, too, Birla Corporation looks cheap.

Motilal Oswal’s Gandhi estimates that Birla Corporation trades at an EV per tonne of $31 for the next fiscal, whereas Radhakrishnan of IIFL estimates India Cements at $75 EV per tonne for the comparable period. Industry giants such as Grasim, ACC, and Ambuja are also trading close to their replacement costs of nearly $100 per tonne on an EV basis.

Both Gandhi of Motilal Oswal and Jhaveri of Religare are bullish on Birla Corporation with a target price of Rs 384 and Rs 365, respectively. Radhakrishnan of IIFL has a ‘sell’ on India Cements with a target price of Rs 87, while Kumar of Centrum has a ‘sell’ with a target of Rs 91.

Investors are advised a switch from India Cements into Birla Corporation. Those with no holdings in India Cements can initiate an exposure to Birla Corporation at current levels.