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Structural profitability reset amid multi-year upcycle; long cement

We believe India’s cement industry is entering a new upcycle that has no parallel in recent decades. We expect the next few years to be characterized by moderate volume growth (c.7% CAGR over FY20-26E) and price increases (2.5%); however, a more robust and sustainable improvement in profitability (RoICs) to 20%+ levels is likely to play out, supported by better price-discipline, ongoing cost-optimization and derisking efforts, and more importantly restrained capacity additions (5% CAGR in cement capacity). Thus, we expect cement companies to exhibit reduced cyclicality over time- RoICs will fluctuate, but should sustain well above the cost of capital in our view. We are long cement-sector based on our expected robust earnings compounding and a structural RoIC reset, even as valuation rerating is largely over for most stocks

* Calibrated capacity additions - supply growth to lag demand: We forecast capacity additions to be more calibrated in this cycle, leading to a moderate 5% capacity CAGR over FY20-26E. This is based on: 1) current visibility on capacity addition pipeline for next 2-3 years; 2) fairly low utilization (72% all-India level) that may reach 79% by FY26E based on our forecasts; 3) capacity additions undertaken mostly by the leading cement producers, resulting in further concentration - 54% capacity share with Top-6 players in FY23E; and 4) unviability of greenfield capacity for the next 7-8 years, even in promising markets of North/Central/East, unless price growth turns out higher than expected.

* Significant demand tailwinds but no super cycle: We estimate a c.7% CAGR in cement demand/production over FY20-26E, driven by higher infrastructure spending, pick up in rural and semi-urban housing, and urban real-estate revival thanks to low interest rates. As demand is likely to grow faster than supply in the foreseeable future, we expect a gradual improvement in capacity utilization levels; nonetheless, utilization is unlikely to reach anywhere close to levels seen in the past super cycle (>90% utilization). We forecast cement price CAGR of ~2.5% over FY20-26E (vs. 4.5% CAGR over the past two decades) on a pan-India basis, thanks to: 1) improving clinker utilization and 2) reducing risk of irrational behavior given growing capacity concentration. Further, we estimate cement prices need to be 7-8% higher even in ‘high utilization markets’ to justify green field capex in the current scenario.

* Sustainable improvement in RoICs but valuation rerating mostly done: We forecast RoICs to increase significantly through this upcycle, and expect them to reset in a 20-30% range over the long term. Cement stocks have already rerated, driven by improving outlook on growth and return ratios; current multiples are at trailing 5-yr avg., which itself reflects a 30% premium to previous 5-year average. We see limited rerating potential, and thus share price performance will likely be driven by EBITDA growth and FCF generation.

* Top picks are Dalmia Bharat, Shree Cement and Ambuja: We initiate with Buy rating on Dalmia, Shree, Ambuja and Ultratech, and Hold rating on ACC, Ramco and JK Cement. Our target EV/EBITDA (EV/E) multiples are backed by DCF analysis based on assumptions of long-term incremental RoICs (20-30% range) and sustainable FCFF/NOPAT growth beyond FY26 (8% for the industry = 5.5% volume + 2.0% price). Our Jun’22E TPs increase by 5-19% with a 50bps increase in the terminal FCFF growth rate.

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