Cement Article Jun14

Weak utilisation levels to propel consolidation

June 2014

CRISIL Opinion

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Last updated: May, 2013

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CRISIL Opinion

1

Weak utilisation levels to propel further consolidation in the cement industry Large cement players are well positioned to further consolidate their position in the cement industry, which is facing low, never-seen-before levels of capacity utilisation and beaten-down profitability. The financial position of several mid-sized and small players has been severely dented by two consecutive years of weak demand amid large-scale capacity addition and rising costs. The situation is especially bleak in the South, where average utilisation levels have plunged below the 55 per cent mark.

CRISIL Research expects demand to gradually pick up from H2 2014-15, but this will still not be sufficient to correct the oversupply situation in the market as capacity additions continue to take place. Consequently, utilisation levels are expected to remain range-bound in the near term. In addition, valuations of most small and mid-sized companies continue to remain well below replacement cost. We, therefore, expect the industry to witness further consolidation, as larger players with strong financial profile seek to strengthen their presence in specific geographies and secure access to raw materials. As per our estimates, acquiring a small company based in the South can yield project IRR of 13-15 per cent, even assuming moderate pricing growth of 4 per cent annually over a 20-year period.

Enough reasons to consolidate The momentum towards consolidation has been building up over the past couple of years in the cement sector. In 2013-14, there were 7 M&A deals (Refer Annexure 5), most of them in the South. Despite expectations of a gradual pick-up in demand following the election of a stable government at the Centre, we expect consolidation in the industry to continue. The key factors driving our view are:

Utilisation levels to remain flat following continuing capacity additions Slump in profitability from historical levels due to pressure on utilisation and increasing cost pressures Considerable weakening of financial position of small manufacturers

We discuss each of these factors in greater detail below.

Utilisation levels not expected to improve in next 3 years Slower execution of housing projects, delays in infrastructure projects such as roads and power, significantly lower government spending and sand availability issues in some regions pulled down cement demand growth in 2012-13 and 2013-14. CRISIL Research estimates that pan-India demand grew by a mere 1.3 per cent in 2013-14, a 13-year low, and utilisation levels hit their lowest level in the last 20 years due to weakdemand exacerbated by continued capacity additions.

2

CRISIL Opinion

Demand growth outlook: Recovery to be gradual

183202 211

225 232 235243 255

2718.5%

10.3%

4.2%

6.6%

3.0%1.3%

3.7%5.0%

6.1%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

0

50

100

150

200

250

300

FY09

FY10

FY11

FY12

FY13

FY14

E

FY15

P

FY16

P

FY17

P

Consumption (LHS) Demand growth (%)

(mn tonnes)

Source: CRISIL Research

The recovery in demand will also be gradual; in 2014-15, we expect demand growth to continue to be muted at 3.5-4.0 per cent with growth being stronger in the second half of the fiscal. Efforts by the government to push infrastructure spending and give impetus to real estate projects would have a positive rub-off on demand, but with a 6-8 months lag. Therefore, any meaningful recovery in cement demand is expected to take place only from 2015-16 onwards.

Notwithstanding the subdued demand, capacity additions continue to take place, as many projects are at a significantly advanced stage of progress. Consequently, average utilisation levels at an all-India level are expected to hover around the 70 per cent level over the next 3 years.

Utilisation levels have plummeted sharply in the South, which accounted for as much as 40 per cent of capacity additions between 2009-10 and 2013-14. This is despite the region supplying around 15 per cent of its production to other regions. Capacity additions are expected to slow in south from hereon, thus stabilising utilisation rates at close to 55 per cent. Considering high fragmentation in the southern markets, a lot of smaller plants are functioning at below 50 per cent utilisation too.

3

South operating rates expected to remain weak

88% 85%77%

74% 70% 69% 69% 68% 69%

89%

76%

67%59% 56% 54% 55% 55% 57%

87% 90% 84% 83%79% 77% 77% 75% 76%

2008

-09

2009

-10

2010

-11

2011

-12

2012

-13

2013

-14

E

2014

-15

P

2015

-16

P

2016

-17

P

Pan-India operating rates

South operating rates

Pan-India operating rates (Ex-South)

Note: Operating rates have been calculated based on the effective cement capacities. Effective cement capacity is calculated on a pro-rata basis, taking into account the month in which the capacity becomes operational.


Region-wise capacity additions indicate sharp rise in capacity in South

219

375435

2924

15 6423

2413 8 10 5

050

100150200250300350400450500

2009

-10

Nor

th

East

Wes

t

Sou

th

Cen

tral

2013

-14

E

Nor

th

East

Wes

t

Sou

th

Cen

tral

2018

-19

P

(MTPA)


Profitability erodes amid lower utilisation, higher cost The profitability of cement companies has declined sharply and fallen to 10-year lows during 2013-14 due to weak demand and rising cost pressures on account of freight and raw material costs. In fact, cement prices declined by 1-2 per cent y-o-y, the first such decline in the last 8 years, indicating the pressure being exerted by weak demand. Aggregate EBITDA margins for the industry are estimated to have declined by around 500 bps in 2013-14.

In 2014-15, with expectations of a modest price hike of around 4 per cent (April-May 2014 price increase has been to the tune of 2 per cent) amid continued cost push, we estimate a further dip of around 100 bps in

4

CRISIL Opinion

EBITDA margins. As a result, the financial performance of the industry is expected to deteriorate. The situation, though, is likely to turn better in 2015-16; we expect the decline in profitability to be arrested with improved pricing growth.

Industry profitability at an all-time low

26.2%28.2%

19.9% 20.6% 20.7%

15.8% 14.8%15.2% 15.1%

9.6% 10.3% 10.3%7.5%

0%

5%

10%

15%

20%

25%

30%

2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15P

Operating margins Net margins


Small cement manufacturers worst-hit; financial health deteriorates Large players continue to enjoy a healthy credit profile despite weakening profitability as their balance sheets are strong. But mid-sized and small players have been hurt badly, with several of them making single-digit EBITDA margins and losses at the net level in 2013-14. Within the CRISIL-rated portfolio, there were 8 downgrades and no upgrades in the last one year ended May 2014, while the median long-term rating moved to CRISIL BB from CRISIL BBB. Going forward also, in 2014-15, we expect the financial health of smaller players to deteriorate further with heightened pressure on industry profitability.

For small and mid-sized players, interest coverage ratio has also plummeted below comfortable levels. During 2013-14, aggregate interest coverage for small and mid-sized players has fallen to around 1 time, while for large players it continues to be healthy at around 4.3 times. In addition, most of the smaller cement companies had asset turnover ratios of less than 1 times in 2013-14 (Annexure 1), with a decline in capacity utilisation and muted realisations.

Company classification based on: Small players Mid-size players Large players

Total installed capacity Less than 2 MTPA Between 2 and 8 MTPA More than 8 MTPA

Refer to Annexure 4 for the list of companies considered in the aggregates below.

5

Trend in EBITDA margins across cement players

28%

24%

19%

29%27%

20%21%

18%

12%

23%

17%15%

22%

16%13%

17%

10%

7%

Large Mid Small

2008-09 2009-10 2010-11 2011-12 2012-13 2013-14


Trend in Net margins across cement players

16%

14%

7%

15%16%

8%10% 9%

0%

11%

7%5%

10%

7%

9%9%

3%

-1%Large Mid Small

2008-09 2009-10 2010-11 2011-12 2012-13 2013-14


6

CRISIL Opinion

Trend in interest coverage ratio across cement players

8.5 8.6

4.7

10.6 10.0

3.6

5.34.3

1.1

5.7

3.9

1.9

5.4

3.41.9

4.3

1.20.4

Large Mid Small

2008-09 2009-10 2010-11 2011-12 2012-13 2013-14


South may lead in consolidation CRISIL Researchs analysis of demand-supply dynamics in each region, asset turnover and profitability of small and mid-sized players suggests that consolidation may be higher in the South. While demand in the South is expected to gain traction, particularly after the formation of Telangana state, average utilisation levels are unlikely to cross the 60 per cent mark till 2016-17. In addition, the lower valuations of many of these companies, as compared to the typical replacement cost of $120 per tonne, makes them more vulnerable (Please refer to Annexure1).

CRISIL Research has analysed the returns that will accrue to a larger cement company if it acquires a smaller cement company operating in the South region. The analysis reveals project IRRs of around 13-15 per cent, assuming a valuation of $49 per tonne (15 per cent premium to average existing valuations) and a modest 4 per cent annual growth in pricing. If pricing increase is of a greater magnitude, the IRR would shoot up disproportionately. Synergy benefits in terms of better pricing power, ability to improve utilisation with better market reach and efficiency in raw material and power cost would further aid such returns. (Please refer Annexure 2 for detailed assumptions and Annexure 3 for sensitivity of IRR to pricing growth and average utilisation levels)

To sum up, we expect continuing weak capacity utilisation and the relatively weak balance sheets of small and mid-sized players to propel further consolidation in the cement industry, with the South being at the forefront.

7

Annexures: Annexure 1: Valuation and asset utilisation of cement companies

Region

Total installed capacity (MTPA)

Enterprise value per tonne ($)

Asset turnover

(times)Large companiesA C C Ltd. Pan-India 30.6 145 0.9Ambuja Cements Ltd. Pan-India 28 202 0.7Century Textiles & Inds. Ltd. East, West, Central 10 158 0.7India Cements Ltd. South, East 14.1 74 0.5J K Cement Ltd. North, South, West 7.5 88 0.6Ramco Cements Ltd. South, East 12.5 121 0.6Shree Cement Ltd. North 13.5 322 0.9Ultratech Cement Ltd. Pan-India 53.9 226 0.6Dalmia Bharat Ltd. South, East 9 31 0.4Mid-sized companiesPrism Cement Ltd. East, Central 5.6 132 1.2Sanghi Industries Ltd. West 2.6 69 0.6Orient Cement Ltd. South, West 5 58 1Heidelberg Cement India Ltd. Central, South 3.1 145 0.5Mangalam Cement Ltd. North 2 71 0.6O C L India Ltd. East 5.3 62 0.7Sagar Cements Ltd. South 2.4 43 0.7J K Lakshmi Cement Ltd. North, West, East 5.3 116 0.6Birla Corporation Ltd. North, East, Central 9.3 65 0.6Small companiesShree Digvijay Cement Co. Ltd. West 1.1 48 1Anjani Portland Cement Ltd. South 1.2 50 0.7Deccan Cements Ltd. South 1.4 27 0.8Gujarat Sidhee Cement Ltd. West 1.3 9 1.3

Continued

8

CRISIL Opinion

continued

Region

Total installed capacity (MTPA)

Enterprise value per tonne ($)

Asset turnover

(times)K C P Ltd. South 2.2 67 0.7Kakatiya Cement Sugar & Inds. Ltd. South 0.3 23 0.9Keerthi Industries Ltd. South 0.6 25 0.6Saurashtra Cement Ltd. West 1.5 26 1.2Barak Valley Cements Ltd. East 0.2 114 0.5Bheema Cements Ltd. South, West, East 0.9 51 0.3Burnpur Cement Ltd. East 0.3 35 0.3Kalyanpur Cements Ltd. East 1 26 1.9N C L Industries Ltd. South 0.3 22 0.7

Note: Enterprise Value (EV) has been calculated as (Total debt + Market Capitalisation Cash & Cash equivalents. Balance sheet parameters are as of the latest available date. Net sales is based on trailing twelve months. Market cap numbers are as on May 30, 2014.


Annexure 2: Base case assumptions for returns analysis

Parameter Unit Value Comments

Cost of acquisition Rs mn 5,895 The cost accounts for a premium of 15 per cent over the typical enterprise value for a 2 MTPA capacity south-based cement company

Capacity of the acquired company MT 2 - Average capacity utilisation of the acquired company over 20 years

per cent 75 Assumed an improvement of around 2-3% each year starting

from 55% in 2013-14

Growth in realisations every year per cent 4 Long-term growth rate assumed for South region prices

Time period for calculation of returns years 20 -

Annexure 3: Sensitivity of project returns to price and volumes

Annual Price growth (over 20 year period)

Average Capacity utilisation (20 year average)

3% 4% 5% 6%

55% -1.0% 11.1% 17.1% 21.7%

65% -0.1% 12.5% 18.9% 23.8%

75% 0.8% 13.8% 20.5% 25.7%

85% 1.6% 15.0% 22.1% 27.6%

9

Annexure 4: List of companies considered for profitability analysis Large companies A C C Ltd. Ambuja Cements Ltd. Century Textiles & Inds. Ltd. India Cements Ltd. J K Cement Ltd. Ramco Cements Ltd. Shree Cement Ltd. Ultratech Cement Ltd. Mid-size companies Birla Corporation Ltd. Heidelberg Cement India Ltd. J K Lakshmi Cement Ltd. Mangalam Cement Ltd. O C L India Ltd. Sagar Cements Ltd. Small companies Anjani Portland Cement Ltd. Deccan Cements Ltd. Gujarat Sidhee Cement Ltd. K C P Ltd. Kakatiya Cement Sugar & Inds. Ltd. Keerthi Industries Ltd.

Saurashtra Cement Ltd. Shiva Cement Ltd. Shree Digvijay Cement Co. Ltd. Note: The above companies have been considered based on availability of profitability data for the last 5 years. The above companies account for 60 per cent of the industry revenues.

10

CRISIL Opinion

Annexure 5: Recent deals in the cement industry

Month of the deal

Acquirer Deal party Nature of deal Plant Location Region

Acquired capacity (MTPA)

Deal value

(Rs mn) May-13 Barings PE Lafarge 14% stake in

Lafarge - North, East - - 14,270

Aug-13 My Home Industries

Shriram EPC

Sale of Sree Jayajothi Cements

- Andhra Pradesh

South 3.2 14,000

Sep-13 Ultratech Jaiprakash Associates

Sale of cement plants

Integrated cement plant (Kutch), grinding unit (Wanakbori)

Gujarat West 4.8 38,000

Sep-13 AvH Resources India Pvt Ltd

Sagar Cements

Increasing stake from 15.7% to 18.5%

- Andhra Pradesh

South - n.a

Oct-13 JSW Ispat Steel

Heidelberg Cement

Sale of grinding unit

Raigad grinding unit

Maharashtra West 0.6 n.a

Mar-14 Chettinaad Anjani Portland

Acquisition of Anjani Portland

- Andhra Pradesh

South 1.2 n.a

Mar-14 Dalmia Cement

Jaiprakash Associates

Stake sale in cement plant

Bokaro Cement plant

Jharkhand East 2.1 11,500

Note: Valuations for some of the above deals as reported by the company are:

1. Ultratech-Jaypee deal at $124 per tonne.

2. Barings-Lafarge deal at $260 per tonne.

n.a stands for not available.


Analytical Contacts:

Ajay Srinivasan Hetal Gandhi Nimisha Agarwal Director, CRISIL Research Associate Director, CRISIL Research Analyst, CRISIL Research

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