Railway freight to impact cement industry

The proposed 5.79 per cent increase in rail freight as per the recent Railway Budget may impact the margins of the cement industry. Around 50 to 60 per cent of the freight expense of a typical cement company is related to rail freight, writes Deep N Mukherjee and Amey Joshi.

Demand for cement is generally driven by real estate construction (about 35 to 40 per cent of total cement production) and infrastructure activity such as roads and urban infrastructure. A leading indicator of the level of activity in these sectors is credit disbursement to these sectors. While growth in real credit to fund infrastructure and road development affects cement demand with a lag of six to nine months, credit growth to the construction sector has a more immediate impact on cement demand.

Of the total infrastructure spending (public private) during 10th Plan (2002-2007), electricity comprises 33 per cent of the total investments followed by roads and bridges sector. It has been observed that the actual total investments in infrastructure sector during 10th Plan has exceeded by 5 per cent as compared to original projections while during 11th Plan, the actual projected investments outlay has been increased significantly as compared to the previous Plan (135 per cent rise as compared to the previous Five Year Plan).

Although government has increased its estimates by 167 per cent as compared to 11th Plan, the corresponding effect on growth in cement volume is highly dependent on actual investment by government and private sector.

Before 2008-2009, the cement demand in India was largely driven by infrastructure activity. However, from 2010, the demand is driven more by the activity in the housing and commercial real estate sector (CRE). Before April 2010, the cement demand growth showed a positive correlation (0.33-0.55) with credit growth to infrastructure, construction and roads sector, with a lag of three to six months. However, after April 2010, the demand growth has shown a positive correlation (0.3-0.5) with credit growth of housing and commercial real estate sector, with a lag of six to nine months.

Capacity and regional imbalance

Cement sector has been divided in five regions ie (South, North, Central, West and East). Due to huge capacity additions in past few years in the southern region, there is always demand-supply imba­lance. Southern region always witnessed pressure on reali­sation due to demand-supply mismatch. Although in past two years, it has been observed that companies have reduced capacity utilisation levels to maintain the realisation. Ind-Ra expects the pace of capacity addition to decline in 2013 since large capacity additions in anticipation of demand growth have already taken place during FY08-FY11. Growth in capacity additions is likely to be around 5-6 per cent in the next three years (FY12: around 5 per cent). In line with Ind-Ra 2012 Outlook, overall capacity utilisation was 71 per cent in FY12. Southern Indian companies’ capacity utilisation (FY12: 61 per cent, FY11: 65 per cent) is lower than that in other regions. The agency expects that capacity utilisation is unlikely to cross 70 per cent till FY15 due to the continued demand-supply mismatch in this region. However, all India capacity utilisation is likely to improve with slow growth in capacity additions.

Higher input cost and pricing pressure

Ind-Ra expects the sectorÂ’s realisation to decline by 5-10 per cent year-on-year in 2013 given the expected moderation in demand compared with the demand surge observed in 2012.

Freight cost (17-27 per cent of cost of production) has increased substantially compared with raw material, power and fuel costs from FY10 to FY12 due to a rise in diesel cost and high inflation. However, actual freight rate is likely to (refer 2013 Outlook: India Auto Sector, dated 8 January 2013) decline in 2013 in a scenario of persistent weak economic condition, providing temporary relief to cement companies.

Also, the proposed 5.79 per cent increase in rail freight as per the recent Railway Budget may impact the margins of the cement industry. Around 50 to 60 per cent of the freight expense of a typical cement company is related rail freight.

In the event the cement manufacturers are unable to pass on the rail freight cost hike, their operating margins may reduce by 75 bps to 100 bps. This will be particularly applicable for cement manufacturers in South India, who given the unfavourable demand-supply situation, may not be in a position to pass on the increased cost.

However, cement players based in the rest of India (with the exception of South India) would be able to pass on a significant portion of the cost. As such, the railway freight hike may potentially increase the cement price by Rs 2 to 4 per bag in such regions. Any increase in economic activity will however cause the freight rates to rise again. During FY12, increased realisation and total volume mitigated the rise in total costs. Median realisation for 18 companies increased to Rs 4,080 per tonne in FY12 (FY11: Rs 3,615 per tonne) while median sales volume increased to 5 million metric tonne (4.38 million metric tonne). However, median growth rate in realisation and total volume is slightly lower than the median growth rate in overall costs.

Power and fuel costs have also increased from FY08-FY12 but at a slower pace compared with freights. The agency expects mid-large size cement companies to reduce their power and fuel costs with the increased use of captive power while smaller cements are vulnerable to volatility in international coal prices and currency rates, as most of them depend on international coal of high calorific value.

Deep N Mukherjee is Director – Corporates, and Amey Joshi is Analyst – Corporates, India Ratings.