The Hindu Business Line : After build-up could come the softening

A high pace of capacity additions, which could lead to excess supply over a two-year period, possible pressures from rising input and freight costs, and regulatory intervention on prices are key risk factors that investors may need to consider.

The demand for cement is likely to grow at 10 per cent in the coming three years.

C. Rajalakshmi

A spurt in government spending on road development from Rs 18,000 crore to Rs 44,000 crore, investment of Rs72,000 crore in rail and port infrastructure and GDP growth of over 8 per cent for two years in a row — all this paints a rosy outlook for the Indian cement sector.

The major players are also in the midst of huge capacity additions to cater to pent-up demand. But the outlook for the cement sector is not without its share of dark areas. A high pace of capacity additions, which could lead to excess supply over a two-year period, possible pressures from rising input and freight costs, and regulatory intervention on prices are key risk factors that investors may need to consider.

The cement industry is highly sensitive to business cycles as well as broader economic trends. It is a sector whose performance is closely tied to overall economic growth as well as developments in the core sectors such as housing and infrastructure. As with all other commodity-oriented businesses, trends in prices are a key determinant of profitability for players in the sector. Here is a look at the factors that could impact the delicate demand-supply balance for cement, based on historic trends.

Demand-supply dynamics

There has been a sustained and rapid growth in cement production in the last 16 years, keeping pace with the increasing demand. A supply deficit situation that existed in cement till 1989 turned into a surplus one after 1991. Since then, supply has been growing at a compounded annual growth rate of 8.3 per cent with consumption accelerating at 8.1 per cent.

However since April 2007 supply has not been able to keep pace with demand. While the demand in April was 139.7 lakh tonnes the total production for the month was only 133.8 lakh tonnes. The deficit situation persisted in August too. The spike in demand has been largely driven by increase in infrastructure spending by the government and growth in real-estate and construction activity. Empirical data of the last 10years, as well as industry forecasts, suggests that cement demand has a strong association with GDP growth. A regression analysis based on the observations made suggests that cement demand could grow at a CAGR of 10 per cent till FY10, if GDP growth stays at the projected level of 8-9 per cent.

Capacity additions, supply overhang

While demand may post fairly strong growth, cement companies have been aggressively adding capacities to cash in on this demand. Many cement majors have announced capacity additions in the coming years. Capacity additions announced so far would total up to the extent of 88 million tonnes by 2010.

There is considerable regional disparity in the demand-supply situation. Industry experts say the northern and southern regions of the country could garner over 80 per cent of the cumulative capacity additions. On the other hand, the southern region is expected to have a higher demand growth in FY 2008-10 driven by government projects, IT parks, Special Economic Zones and infrastructure projects. On the other hand, the Reliance multi-product SEZ in Haryana is expected to boost demand in the west.

With growth of 11.08 per cent in the financial year 2006 and 10.56 per cent in 2007 it appears highly likely that demand growth for cement will record a 10 per cent growth in the coming three years, given the optimistic expectations on GDP. However, even if this materialises, if the additional capacities are commissioned on schedule, there is still a possibility of the cement market moving into a surplus situation as early as 2009. This could trigger a cooling of cement prices.

Prices — bone of contention

In recent times, cement prices have been a bone of contention between the government and cement producers. Wholesale cement price in Mumbai market has moved up from Rs 224 in February 2007 to Rs 260 per bag currently. While cement prices in the markets have risen across regions, there has also been a corresponding spike in the realisation numbers of cement companies.

Grasim Industries’ average realisation per bag has increased from Rs 104 in FY2004 to Rs 169 in FY2007. Grasim’s peers in the sector, India Cements and Shree Cement, have also seen close to 30 per cent spike in their realisation numbers over this period.

An interesting sidelight here is the difference of around Rs 40-50 per bag between the quoted market prices of cement and the realisations actually recorded by manufacturers. This differential is accounted for by incidental costs such as loading and unloading, transportation, storage and dealer margins, and has shown a tendency to decline in recent years. From FY2004 to FY2007, the realisation per bag of Grasim Industries, India Cement, Shree Cements, Birla Corporation and Prism Cement, on average, has increased by around 50 per cent whereas retail prices have gone up by a comparatively low 30 per cent.

The past couple of years, particularly, have seen several attempts by the government to temper prices through taxes and regulatory intervention. The Government, in the 2007 Budget, introduced a differential excise duty structure. Excise duty was raised to Rs 600 per tonne on bags of cement priced above Rs 190 and reduced to Rs 350 per tonne from Rs 400 for MRP of Rs 190 or less. Imports were also liberalised to enable a bridging of the domestic deficit.

But despite these moves, there hasn’t been a significant correction in cement prices. The move of liberalising imports from Pakistan in August this year didn’t see much of an impact on prices because though import duty was reduced, the infrastructure bottlenecks at ports constrained bulk imports. With cement prices under check, the key growth avenue for manufacturers is volume increases, which can be delivered by ongoing capacity additions.

As the deficit persists, the near-term price outlook on cement however remains positive. In the southern region, demand may gain momentum after December, on progress of ongoing infrastructure projects in Tamil Nadu and Andhra Pradesh. In the North, cement prices in Delhi have showed a strong year-on-year growth due to airport and infrastructure projects. The demand for cement from construction activity related to the Commonwealth Games is expected to drive demand in Delhi in the months to come.

Rising Input cost

Cement producers, however, face other risks apart from cooling prices. These exist in the form of rising input costs. Increase in cost of coal, power tariff, royalty on limestone and freight costs have resulted in cost pressures. Coal prices in the international market have jumped from $46.6 per tonne in the last quarter of 2006 to $57.5 per tonne in the second quarter of 2007.

Domestic coal prices also surged following a 10 per cent hike in the prices of all grades of coal by Coal India Ltd in December 2007. The sharp surge in coal prices has been due to continued demand growth in the Asian region and the significant rise in international oil prices, which prompted a move towards coal-based power generation. Cement plants account for around 4.2 per cent of India’s coal demand.

Over the years, there has been an increase in the consumption of imported coal compared to the indigenous variety due to its better quality. A further spike in energy costs could have adverse margin implications for manufacturers, especially if pricing power is limited, in the coming years.

While there are few doubts about a strong demand scenario for cement, the pace of capacity build-up remains a cause for worry. An oversupply scenario could see a softening of prices as players compete with each other to protect eroding margins. All appears well for cement till mid-2009; but the scenario thereafter will depend on the market’s ability to absorb new capacities. Regulatory intervention to curb cement prices until now has not been too successful and prices have shown an upward bias. However, further attempts to cool rising prices cannot be ruled out, given the politically sensitive nature of the commodity.

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