With Q2 history against them, cement stocks' valuations looks stretched

Most analysts have a 'sell' or 'reduce' recommendation on the sector

Cement demand is always affected by seasonal considerations since construction is impeded when the weather is poor. In addition, cement production costs are linked to both, the price of raw material, and the cost of power, since it is a power-intensive process. Transport costs are also substantial. The 2022-23 financial year started on a poor note for the sector with soaring prices on the metals, coke & coal and high energy front, hitting cement margins.

However, the first quarter for the 2022-23 financial year (Q1FY23) looked good in comparison to the weak base of Q1FY22 -- since that was affected by the second wave of the Covid-19 pandemic -- with demand up 17 per cent year-on-year (YoY). In May and June, 2022, the was some margin recovery as metals and energy prices started to stabilise but both, volumes and margins, declined sequentially (QoQ). In aggregate, the profit after tax (PAT) and earnings before interest, tax, depreciation and ammortisation (ebitda) also declined, both YoY and QoQ, for a sample size of 11 cement stocks.   

Capacity utilisation was estimated to be about 67 per cent. Cement prices have since corrected in July and August, as there is usually poor demand in any Q2, caused by rains. The situation, with respect to excess capacity, could mean low realisations going forward, especially with the entry of the Adani Group after its takeover of ACC and Ambuja Cements. Will price discipline be maintained in this situation or will there be a price war in an attempt to win market share?

Cost pressures are likely to ease in second half (H2FY23) with energy and coke prices coming down further. But Q2FY23 could see a lagged effect with energy prices still ruling high in absolute terms, and low demand continuing to erode margins. Consensus ebitda estimates have moved down by 10 per cent in the last three months.

Meanwhile, all cement majors have long-term capacity addition plans. UltraTech is slated to increase its domestic capacity to 154 million tonnes per annum (mtpa) by FY2025-26 while Shree Cement is expected to increase it to 56 mtpa by FY2024-25 (current 46 mtpa). Another major, Dalmia Bharat, is could increase its capacity to 49 mtpa by 2023-24 (current 37 mtpa). This could mean a prolonged period of surplus capacity, unless there’s a big pickup in the construction sector.

The share price movements over the last 6-8 weeks have been positive for the sector with major stocks seeing 10-15 per cent rise, with investors betting on margin recovery alongside higher demand in H2.  The Q2FY23 results are likely to be disappointing but may have been largely discounted since seasonal weakness is expected.

The key factor in H2 will actually be moderation in costs. If energy prices continue to soften, margins are likely to pick up and there could be a positive surprise on this front. Given the uptrend, however, valuations could be stretched, unless there is an extraordinary jump in demand and margins in the H2. Most analysts have ‘sell” or ‘reduce’ recommendations on the sector.