The build-up to an up-cycle

The tide is turning; upgrading to Buy: We are upgrading our rating on cement majors, from either Underperform or Neutral, to Buy due to three key factors: (i) In FY14, for the first time in five years, cement capacity additions (16m tpa) will be lower than additional demand (+17m tonnes); (ii) Demand growth in the next 18 months is expected to overshoot the long-term GDP multiplier owing to a possible impact from the upcoming general elections; (iii) Stock valuations will likely climb to the upper end of their valuation range at about 10-12x (times) EV/Ebitda (enterprise value/earnings before interest, taxes, depreciation and amortisation) for majors. Despite YTD (year-to-date) outperformance, majors currently trade 15-30% below up-cycle multiples.

What has changed?

Industry's capacity utilisation is visibly bottoming in FY13e: The change in our views is driven by visible bottoming of the industry's capacity utilisation in FY13e and lower-than-expected capacity additions over FY14-15e. Updating for latest industry feedback, we estimate the industry's effective capacity utilisation at 71% in FY14e (flat y-o-y) but tightening sharply in FY15e to 76% helped by demand acceleration. Compared to our earlier expectations, overcapacity is a tad higher in FY13e but capacity pipeline for FY14e is sharply lower. Installed capacity growth in FY14e is now estimated at 4% y-o-y versus 8% growth expected earlier.

Earnings up 30-60% due to improved margin outlook: We have lifted our FY14-15 Ebitda estimates for cement majors by about 25-50%, led by higher cement prices and better margins. Net profit estimates for majors are up 30-60% versus earlier. Broadly, we now expect the industry's Ebitda/ton to improve 10% p.a. over the next two years versus our earlier expectation of flat-to-lower Ebitda/ton in FY14. The change in our margin outlook reflects a bottoming of the industry's capacity utilisation in FY13e.

Our concern that cement prices are vulnerable to the CCI's (Competition Commission of India) recent verdict on cartelisation has already played out with cement prices showing weakness over Jun-Nov 2012; pan-India cement prices are down 5% since the CCI order in Jun 2012 versus about 7% price rise in the same period last year (Jun-Nov 2011). Our FY13/CY12 Ebitda estimates stand trimmed by 3-6% to reflect the slightly higher-than-expected price drop in recent months. Despite possible price volatility in CY13/ FY14e, we expect an improving trendline for cement prices over the medium-term as industry supply-demand balance is set to tighten.

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