The Indian Cement sector – End of the road for mega transactions?

2016 was an interesting year for the Indian cement industry. The sector witnessed three billion dollar transactions in 2016- Ultratech’s acquisition of Jaypee Group’s cement assets, merger of Dalmia Bharat- OCL India and Nirma Group acquiring Lafarge India’s cement assets in East India. These transactions involved 57 MTPA of installed capacity under consideration, which is roughly 14% of India’s total installed capacity. Is this trend of mega transactions likely to continue in 2017 and 2018? The answer to this question lies in understanding the complex interlinkages between the Indian cement industry, regional play and the prevailing competitive landscape.

The Cement Industry

India is the second largest producer of cement in the world after China, with an estimated capacity of 400 million tonnes. Historically, cement demand growth closely mirrors GDP growth and typically follows a 5-6 year cycle. But, demand growth in the last 3-4 years has been considerably lower than the last 15-year growth. Overall utilization levels in the Indian industry are currently at ~70% levels i.e. demand of ~280 million tonnes. Rural incomes have been severely impacted due to poor monsoons in the last two years. Demonetization also had a negative impact on the sector in the second half of FY17 with North and East India taking the maximum hit due to large proportion of cash business.
Cement demand recovery is expected only from FY18/19 driven by increased allowance under government housing schemes and infrastructure spending driven by roads. With slow capacity addition plans of incumbent players over next few years, utilization rates are expected to improve in next 2-3 years. Price realizations have already started improving across India in FY17.

Regional Play

Given its high weight-to-value ratio, the cement industry in India is fairly local in nature. Each region has its own set of dynamics and behaves as a separate market.
South India has significant overcapacity currently. However, cement prices in South India have remained elevated, higher than pan-India average, due to strong pricing discipline. This market is highly fragmented with several small and mid-sized players (1MT- 5MT) having presence.
North has witnessed good capacity addition in last 5 years, leading to weak pricing. But price realizations are improving from FY17 onwards, due to increasing consolidation of capacities and no major capacity expansions. UltraTech and Shree Cement are the two main players in this market.
East India is seeing maximum capacity additions, due to strong demand expectations particularly in the housing segment. But with entry of many players, pricing in this market will be under pressure.
Central India has the best utilization rates in the country currently (~85%) but weak pricing. Pricing improvement in Central India is likely with UltraTech’s acquisition of Jaypee cement assets and no significant capacity addition plans.
West India continues to be the lowest pricing region due to weak monsoon in rural Maharashtra and decline in residential construction over last 2 years. Though a consolidated market with UltraTech, ACC and Ambuja controlling two-thirds of the market, West India receives cement from nearby states like AP, Karnataka and MP.

Competitive Landscape and Cost Structure

Indian cement industry is fairly organized with top 10 players accounting for ~70% of the total capacity in India. In 2016, both Jaypee Cement and Lafarge India have exited the Top 10, and in place Birla Corp and Nirma Group are the new entrants in the list.

For most of the top cement players, cost structure is skewed towards variable cost (Raw material, Power & Fuel, Freight, Stores & Packaging Expenses) with only 20% of the cost being fixed. Power and fuel along with freight comprise 55% of the cost. Hence cost efficiencies in energy consumption and freight optimization is very important to curb costs. Integrated cement plants (with captive limestone reserves and captive power plant) near the end markets are much more profitable than standalone cement units.

Reasons behind Mega Transactions in 2016

All the three billion dollar transactions last year were triggered by external factors. Nirma- Lafarge deal was driven by regulatory requirements (Competition Commission of India) due to Holcim-Lafarge merger globally. Jaypee’s sale of cement assets to Ultratech for INR 162 bn was triggered due to huge debt on Jaypee Group’s balance sheet. On the other hand, Dalmia Bharat- OCL merger is group reorganization exercise since Dalmia Bharat already owned 75% stake in OCL.

Mega Transactions in near future- Unlikely

Mega M&A transactions in the cement sector are unlikely in short term. Average EV/Tonne for recent transactions in India was USD ~114/tonne (table below). For a billion dollar transaction, at least 9 MTPA of target capacity is required. But there will be hardly any takers for such large capacity in the current scenario.

UltraTech’s acquisition of Jaypee’s 21 million tonne capacity limits its ability to invest in another large deal. ACC, Ambuja and Shree Cement are already undertaking greenfield/brownfield capacity expansions. Other medium-sized players will likely wait and watch before committing large sums of money for acquisitions. Also, garnering CCI approval to participate in a large ticket transaction will be a big hurdle for the incumbent cement players.

However, there are a number of reasons to believe that we will continue to see steady M&A activity and consolidation in the Indian cement space over the course of 2017 and 2018, even if not perhaps on the scale of the likes of Ultratech-Jaypee or Nirma- Lafarge deal.

> Greenfield expansion on average takes 4-5 years due to challenges in land acquisition and is typically more expensive (USD~140/tonne vs USD~114/tonne for acquisitions)
> Stressed balance sheet of smaller players (especially in South India) due to low price realizations and high competitive intensity
> Recent amendment to the MMDR Act allow companies to transfer captive mines– even those not acquired through auction- to the acquirer
> Right time to acquire assets at comparatively cheaper valuations since cement market recovery expected in couple of years