Industry Analysis: Cement – Part 1

As part of my initiative to help you enhance your “circle of competence”, I am starting on a new series on analyzing key industries that can offer you profitable, long-term investment opportunities. I start this series by analyzing the Cement industry.

1. About Cement
Wikipedia defines ‘cement’ as…

…a binder, a substance that sets and hardens as the cement dries and also reacts with carbon dioxide in the air dependently, and can bind other materials together. The word “cement” traces to the Romans, who used the term opus caementicium to describe masonry resembling modern concrete that was made from crushed rock with burnt lime as binder. The volcanic ash and pulverized brick additives that were added to the burnt lime to obtain a hydraulic binder were later referred to as cementum, cimentum, cäment, and cement.

At the basic level, cement is a binding substance that is intended for use in building or construction material and can withstand varying environmental conditions. The four elements necessary for its creation are iron, aluminum, silicon, and calcium.

These elements are burned together in a kiln and are finely pulverized to create the powder and used as an ingredient of mortar and concrete we then call cement. This powder hardens once it is mixed with water but water does not break the bond once it is formed.

The manufacturing process of cement consists of mixing, drying, and grinding or limestone, clay, and silica into a composite mass. The mixture is then heated and burnt in a pre-heater and kiln to be cooled in an air-cooling system to form clinker. This is the semi-finished form of cement. This clinker is cooled by air and subsequently ground with gypsum to form cement.

You can watch the entire cement manufacturing process in the video below…

There are various varieties of cement manufactured and sold in India. The basic difference lies in the percentage of clinker used. Here are a few common types –

• Portland Blast Furnace Slag Cement (PBFSC): This consists of 45% clinker, 50% blast furnace slag, and 5% gypsum. PBFSC accounts for around 10% of the total cement consumed in India. It is generally used in construction of dams and similar massive constructions.
• Ordinary Portland Cement (OPC): This is commonly known as “grey” cement, and is used in ordinary concrete construction. It has 95% clinker and 5% gypsum and other materials.
• Portland Pozolona Cement (PPC): PPC has 80% clinker, 15% Pozolona, and 5% gypsum. It accounts for around 18% of total cement consumption. As it prevents cracks, it is useful in the casting work of huge volumes of concrete. It can be availed at low cost in comparison to OPC.
• White Cement: It is a kind of OPC. The ingredients of this cement are inclusive of clinker, fuel oil and iron oxide. The content of iron oxide is maintained below 0.4% to secure whiteness. White cement is largely used to increase the aesthetic value of a construction. It is preferred for tiles and flooring works. This cement costs more than grey cement.

2. About Indian Cement Industry
The cement industry plays a significant role in the economic development of any nation, providing a vital raw material for the basic building blocks of a nation’s infrastructure and housing development.

India’s cement industry has historically grown faster than the overall economy — in fact, its remarkable progress has made India the world’s second-largest cement producer (after China) — and it has evolved to become one of the most effective industries in the world in terms of process efficiencies.

The evolution of the Indian cement industry has been in three distinct phases, characterized by the extent of government regulation –

1. Complete government control (1956–1982): Prices were regulated by the government. This period saw modest growth of 6.6% in overall demand on a very low starting base, with the prior decade facing a sharp slowdown in both demand and capacity creation. Entry of new players was limited because of suboptimal returns on investment.
2. Partial government control – Quota system (1982–1989): To trigger growth in the industry and support emerging Indian infrastructure, the government introduced a system of partial deregulation in 1982. The new law required at least two-thirds of all sales to be to government and small developers; the companies were free to sell all remaining product on the open market at a ceiling price. The industry responded through moderate growth in capacity. By 1988, both the quota and the ceiling price were increased substantially, resulting in a growth increase of 8.2%.
3. Free cement market (1989–present): In 1989, all price and distribution controls on the sale of cement were withdrawn, and the industry was deregulated by 1991. This resulted in a massive expansion of cement capacity, which has only accelerated as the country has developed.

As a country, India has one of the lowest per capita consumption of cement in the world, even when compared to other economies at similar prosperity levels (GDP per capita). Unlike developed markets and large developing markets such as China, India has some distance to go to create sufficient infrastructure, overcome a large housing deficit, and jump-start its slow pace of urbanization. The growth potential for the industry, thus, looks promising.

3. Production & Consumption

• Indian cement industry is the second largest producer in the world. Production has increased at a compounded annual growth rate (CAGR) of 9.7% during FY06 to FY13, and currently stands at around 300 million tonnes (MT). Production is expected to grow to 550 MT by FY20.
• As per a study by Global Construction Perspectives and Oxford Economics, India is expected to become the world’s third largest construction market by 2025, adding 11.5 million homes a year. Given this, the growth potential for the cement industry is huge. Domestic cement consumption is expected to rise from around 265 MT currently to 400 MT in the next three years. Around 65% of cement is consumed by the housing sector, while 17% goes into infrastructure.
• Per capita consumption of cement in India – at 185 kg per person per year – is amongst the lowest in the emerging world. Indonesia and Brazil, for instance, have per capita consumption of 225 kg and 345 kg respectively. India’s low consumption levels are due to three key reasons – a). Low infrastructure intensity, as we are largely a services-oriented economy, b). High level of housing deficit, and c). Low pace of urbanization as compared to other countries. Per capita consumption is however going to rise due to rising consumption from urban areas, rising nuclear family households, and upgrades from non-pucca to more permanent pucca houses.
• Cement capacity in India has always kept ahead of demand which, during times of slowdown, really hurts companies in the form of lower capacity utilisation and declining margins (as fixed costs remain high).

Source: CII’s Cement Vision 2025 Report

4. Industry Structure

• Over the years, the industry has become more organized and structured, and average size of players has increased. Growing scale, coupled with improvement in manufacturing technology, has led to significant cost efficiencies as well. Energy use per kg of clinker production has dropped from 880 kcal per kg in 1991 to 690 kcal per kg now. Apart from this, power consumption has declined from 120 units per tonne to 65 units during the same period. What is more, average turnover per employee increased by more than 90% between 2006 and 2012.
• Supply side bottlenecks have also intensified. For instance, the share of linkage coal in the overall energy mix of the industry has declined from 65% in FY06 to around 35% now. Companies are thus more dependent on alternative sources.
• Setting up additional capacity has also gotten difficult (serves as an entry barrier) due to declining levels of linkage coal, inadequate logistics infrastructure (railways), shortage of skilled labour, and delays in getting land and environmental approvals.
• Linkages of raw materials like limestone also serve as an entry barrier. Most cement companies have backward integration to limestone by way of owning captive mines. Most limestone deposits in India are located in Madhya Pradesh, Rajasthan, Andhra Pradesh, Maharashtra, and Gujarat, thus leading to concentration of cement units in these states. As far as gyspum is concerned, its domestic reserves are limited, which has led some cement companies to explore the option of acquiring overseas gypsum mines. In addition to gypsum, the domestic coal supply has also become a major bottleneck (around 160 kg of coal is consumed per tonne of cement production). As a result, cement companies are looking to secure access to coal, either through joint ventures with overseas players or through the acquisition of overseas coal mines.
• Cost of manufacturing cement has risen over the years, thanks to higher costs of fuel and financing, and high taxes. While the companies have been able to pass on a part of cost hike to consumers, costs are still rising faster than cement prices.
  
  Source: CII’s Cement Vision 2025 Report

• Fixed costs in the cement industry are particularly high and significant relative to variable costs. Fixed costs generally account for more than 50% of the overall production costs. The fixed costs are usually sunk costs. Once built, a cement plant can serve no other purpose. As fixed costs are high with respect to the variable costs, the break-even point is high. With automation, labour costs have decreased, but energy consumption is a more significant variable cost. Thus, profits in the industry are sensitive to the level of utilisation of the production capacity. Significant cash flows are generated only when product increases beyond the break-even point, which depends on the efficiency of the plant.
• Cement is largely a regional product – manufactured and sold in a region – as transporting it over long distances is not possible (due to the nature of the product). Transportation is a major cost element for cement companies (around 20-25% of sales), often a bigger line item than net profits.
  
  Source: Ramco’s and Ambuja’s Annual Reports

• Thanks to the inability to pass on the entire cost increase to consumers, the IRR or internal rate of return for new cement plants has fallen to just around 9-10% (Source: CII).
• Cement prices have not increased as much as production and capital costs in the past four to five years, which has taken a toll on industry profitability. The rate of technological improvements in the industry has been slowing down, with a large share of the industry already employing the best available technology in terms of material and energy efficiency.
• While the widening gaps in operating costs and sales realization have been reducing the average EBITDA or operating profit per tonne for the industry, capital costs have been steadily rising (from an average of Rs 4,200 per tonne in 2009 to Rs 7,200 per tonne in 2013). As a result, the internal rate of return or IRR on a new green-field cement plant in India has seen a steady decline from 17% in 2008 to 9% in 2013.

5. Competition

• Competition in the cement industry initially occurs at the local level due to high transportation costs. Competition cannot be based on price, as price cuts are easily spotted because of the nature of the product, which is undifferentiated. Competition is hence based on head-to-head market confrontation focused on price rebates and sales volume, in order to expand market share. Any substantial price cut by a competitor results in a price war. Rivalry also occurs when firms want to enhance their respective competitive advantages on the basis of improved product quality or reduced production costs.
• High transportation costs make location an important factor in a cement company’s pricing policy. The best location combines three advantages – a) the plant is set up in a quarry with large quantities of high-quality and easily-workable limestone; b) the plant is close to large urban areas; and c) the plant is near a railway line or a road network allowing cement to be delivered to faraway places. A cement plant located inland rarely sells outside a 300 km radius and would normally sell the bulk of its production within 150-300 km.

6. Porter’s Five Forces Analysis
Porter’s Five Forces Analysis provides a “competitive forces” framework that allows us to better understand the different dimensions that govern competition within an industry. Porter’s five forces are –

1. Competitive rivalry;
2. Threat of substitutes;
3. Bargaining power of buyers;
4. Bargaining power of suppliers; and
5. Barriers to entry and exit.

Let us use Porter’s framework to analyse the Indian cement industry…

The above figure depicts the five competitive forces that shape the Indian cement industry. As you can see…

• Competitive rivalry in the industry is moderate;
• Effect of substitutes is weak;
• Buyer power is minimal;
• Supplier power is high; and
• Entry/exit barriers are high.

In essence, the horizontal supply chain has pricing power over final consumers, whereas the vertical dimension of competition (threat of new entry and threat of substitution) is lacking due to lack of the possibility of differentiated advantages in production.

Click here to read Part 2