With demand growing far slower than production, cement manufacturers will find it difficult to pass on increasing costs to customers, which is likely to result in a steep reduction in profit margins by 2012-13

Moneylife Digital Team

Crisil Research has forecast that the profitability of the cement sector will decline to its lowest in a decade by the next financial year, mainly due to a huge glut in supply.

The independent research house said in a statement, describing the highlights of a study it has completed recently, that the supply glut will slacken cement manufacturers operating rates, consequently restricting their ability to pass on a sharp rise in power and fuel costs to consumers.

"The magnitude of the demand-supply imbalance and cost escalation will halve the cement industry's EBITDA margins from the current 20% to around 10% in 2012-13-the lowest level in the past 10 years," said Prasad Koparkar, head of industry and customised research at CRISIL Research.

Crisil estimates that over the next two years cement capacities will rise by 60 million tonnes per annum (mtpa), while demand will increase by much less, about 30 mtpa. Operating rates of cement manufacturers would, therefore, plunge to around 72% in 2012-13 from an already subdued 78% in the last fiscal.

In fact, the cement sector has been under pressure for some months now due to rising input costs and lower demand, particularly due to the slowing pace of housing construction that has historically been the largest contributor to cement demand. This, together with the seasonal drop in demand, has resulted in a decline in cement prices by about Rs35-40 a bag over the past couple of months.

According to Emkay Securities, demand growth has also been impacted by a slowdown in government infrastructure projects, and project clearances that have affected private spend. Interestingly, the country was importing cement a couple of years ago for construction work related to the Commonwealth Games.

Even as demand has turned sluggish, cement manufacturers are increasing capacity since the past couple of years. Ultratech Cement is spending over Rs2,000 crore on a unit, with installed capacity of three million tonnes, in Rajasthan's Jhunjhunu district. Birla Corporation has invested Rs4,000 crore to increase its cement production capacity. Shree Cement has commissioned its 1.80mtpa clinker grinding unit at Udaipur Udasar, in Sri Ganganagar district of Rajasthan.

Cement stocks have been mixed this year, The Moneylife Cement Index is down by 9% since 1st January 2011, against a 21% drop by the benchmark Sensex. The cement index comprises 29 companies. The only gainer since January has been NCL Industries (up 16%). Ultratech (down 2%), Ambuja Cement (down 5%) and ACC (down 6%) are down. Tow others Barak Valley Cements (down 51%) and Dalmia Bharat Sugar and Industries (down 55%) have lost heavily.

Crisil expects costs of power and fuel, a major input for cement, to increase by as much as 18% in the current financial year, in view of the steep increase in coal prices by Coal India, the leading supplier. An increase in effective excise duty rates will also lower cement manufacturers' net price realisations by 2%-4%.

Looking ahead, the research firm believes that small-sized cement manufacturers (with capacities of less than two million tonnes per annum) will likely post losses of about 2% at the EBITDA level in 2012-13. However, large cement manufacturers (with capacities of 10 mtpa or higher) would fare better than the industry average, with EBITDA margins of about 12%.

Key reasons for the better performance of large cement manufacturers is their greater use of captive power and inherent economies of scale. These companies meet three-fourth of their power requirements through captive generation. Small cement companies, in contrast, get a mere 5% of their power requirements through the captive route, and source the remainder from the more expensive grid power.

"Captive power can make a critical difference to cement profitability," said Ajay D'souza, head, Crisil Research. "Every 10 percentage point increase in captive power consumption can improve cement companies' EBITDA margins by 50 basis points."