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Cement: Q2FY20 preview - Weak quarter; gradual uptick likely

Several government and private infrastructure projects faced execution delays during Q2FY20. Our channel checks cited reasons such as lack of funds, clearance delays, labour unavailability, heavy monsoons across regions, etc. for the execution slowdown. Accordingly, most regions saw muted demand as reflected in All India cement production growth of 1.5% for Jul-Aug 2019. Moreover, the weak demand scenario led to fall in prices across regions by Rs15-40/bag, varying across regions, from the peak of Q1FY20. As such, all-India average cement price decreased by ~4% qoq. However, we expect cost pressures to ease, supported by lower power & fuel (P&F) and freight costs (petcoke prices fell 27% yoy and 11% qoq; diesel prices fell 6% yoy, flat qoq). For Q2FY20E, we expect qoq profitability to deteriorate for all companies under our coverage, led by lower realisations and negative operating leverage due to weak volumes, partially offset by lower P&F and freight costs. Nevertheless, we reiterate our positive view on the sector and expect demand to gradually improve in H2FY20E (sustained government impetus on infra, good monsoons to boost rural demand) and utilisation to improve. Accordingly, pricing power would augment, providing a boost to earnings. Ultratech Cement (UTCEM) is our top pick in the sector.

Weakness in demand momentum continues in Q2FY20: The quarter saw continued weakness in demand across regions, largely led by slowdown in execution of infrastructure projects due to extended monsoons, floods in certain areas, festive season and lack of funds. Demand picked up in July-19 (+8% yoy in production) but was impacted in Aug-19 (-5% yoy) across regions on heavy rainfall and slow uptick in government projects. Overall, cement production was muted at 1.5% yoy during Jul-Aug 2019. As per our channel checks, demand was extremely weak in South due to cancellation of orders in AP/Telangana, floods in Kerala, unstable government in Karnataka and heavy rainfall across these states. Demand in the East decelerated across states due to heavy monsoons and floods in certain states, labour scarcity and slow movement in government projects. We expect most companies within our coverage universe to report muted to negative volume growth on weak demand trends.

Prices decline in Q2FY20 on qoq basis: Cement prices dropped across regions during Jul-Aug 2019 vs 1QFY20 due to weak demand and high competitive intensity. Price drop in South and East India were the sharpest at ~Rs35-45/bag from peak of Q1FY20, while West saw a drop of Rs15-20/bag (largely driven by Maharashtra). However, price drop was relatively moderate in North at Rs12-15/bag (largely towards the end of the quarter). Overall, All India cement prices are up 7% yoy due to the price hikes taken in 1QFY20 and a decline of ~4% on qoq basis.

Cost pressures easing: Domestic petcoke prices fell sharply by 27% yoy and 11% qoq in Q2FY20, with international petcoke prices too easing to US$75-80/t from US$95-100/t over last few months. We expect the price drop to provide relief in P&F costs on both yoy and qoq basis. However, lower petcoke costs would entirely reflect in Q3FY20E, as companies typically carry 2-4 months of inventory. Similarly, a 6% yoy fall in diesel price in Q2FY20 (flat qoq) should result in lower freights costs. We expect cost pressures to ease for all companies under our coverage.

EBITDA/t to improve: Sluggish demand would result in companies reporting muted volumes in Q2FY20, in our view. Moreover, price correction across regions and thereby a drop in realisations are likely to cause EBITDA/t to decline on qoq basis, albeit reporting growth on yoy basis. However, easing cost pressures would in turn partially offset the muted volumes and weak prices.