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House is in order; Small caps ripe for re-rating

Extending our earlier analysis - Smaller players get ready for the big league - we believe that smaller players in the cement space are ripe for re-rating, as they have sacrificed volume growth in FY16-21 to get their house in order. Key observations: i) Smaller players are invariably more cost efficient in operations, and reducing realisation gap vs. larger peers has helped them to significantly narrow their EBTIDA/t gap to INR 300-350 (vs. INR 450-550 in FY16); ii) Stronger expansion pipeline (27% of capacity vs. 14% for large peers) is expected to drive growth and market share gains in the medium term, while reducing regional concentration risk; iii) Buoyed by strong cash flow generation over FY20-21, their capital structure has witnessed material improvement. Net debt to EBITDA for mid-sized and small players has improved from 2.8x and 5.3x in FY16 to 1.2x and 0.7x respectively in FY21. Given the strong demand outlook (9% CAGR over FY22-24E) and limited supply growth (13% over FY22-24E), we believe utilisations will continue to rise. Against this backdrop, we believe the valuation discount of smaller companies to large players (on a TTM EV/EBITDA basis) at 55% (the 5-year average of c.31%) is unwarranted and bound to narrow.

We initiate coverage on Sagar Cements with BUY (Focus on growth with cost efficient operations, new capacities to drive diversification and beginning of deleveraging phase), Orient Cement with BUY (To embark on expansion soon, strong expansion capability with existing resources and one of the most efficient players in the industry) and HeidelbergCement India with HOLD (Focus on premiumisation helped growth, lack of capacity expansion despite strong balance sheet).

* Small players have yielded market share but outperformed in terms of profitability: Larger players have gained market share owing to strong capacity addition (mid-sized and large players have added 25% and 33% of existing capacity respectively over the last five years vis-à-vis 19% for smaller players). But smaller players have outperformed the sector in terms of EBITDA (25% CAGR vs. 16-17% CAGR for larger peers over FY16-21). The outperformance on profitability has been driven by exposure to favourable markets, focus on better pricing (aided by peaking clinker utilisations) and control over costs.

* Strong cash generation has strengthened balance sheets: The sector has seen strong cash generation over FY20-21 led by profitability improvement, partially aided by the release of working capital. Strong cash flows have helped drive both the deleveraging exercise and funding of expansion projects. Net debt for the sector has declined from its peak in FY19 and net debt-to-EBITDA for the players under analysis is comfortable at -2.4x to 2.6x.

* Smaller players to gain share: We note that smaller players are slated to gain capacity share from larger peers. Cumulatively, smaller players’ pipeline capacity forms 27% of their existing capacity whereas large players are constrained by lack of feasible opportunities with their existing pipeline c.14% of operational capacity. Dalmia Bharat is leading expansion in the mid-sized category with c.18MTPA of announced addition. We assign limited execution risk as the balance sheet across the sector is well capitalised.

* Valuation discount of small players to large peers to narrow: It currently stands at 55% vs. the 5-year average discount of 31% on a TTM EV/EBITDA basis, owing to market share loss. Going forward, we believe the valuation discount should narrow as i) the sector-wide up-cycle would continue to drive profitability; ii) the relatively higher proportion of pipeline capacity for smaller players would curb market share losses; and iii) strong cash flows and robust balance sheets provide comfort on capex execution.

* Initiate on Sagar (BUY), Orient (BUY) and HeidelbergCement (HOLD): We initiate coverage on Sagar Cements with BUY (Focus on growth with cost efficient operations, new capacities to drive diversification and beginning of deleveraging phase), Orient Cement with BUY (To embark on expansion soon, strong expansion capability with existing resources and one of the most efficient players in the industry) and HeidelbergCement India with HOLD (Focus on premiumisation helped growth, lack of capacity expansion despite strong balance sheet)

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