Investors who bought the stock of Ambuja Cements on our ‘buy' recommendation in August 2010 at Rs 121 can consider booking profits now with a 30 per cent return; the stock touched a high of Rs 165.50 in the previous week. At its current market price of 153, Ambuja Cements trades at a pricey PE multiple (trailing twelve month) of 20 times. UltraTech Cement, the largest cement producer in the country, trades at a price-earnings multiple of 16 times.

Ambuja Cements' operating profit margin, though still higher than many in the industry, fell to 20.9 per cent in the September quarter from 30 per cent in the June quarter. The stock may find it difficult to keep up its rich valuation for long. After two subsequent quarters of fall in net profits, the company registered increase in profit (up 13 per cent) only in the September quarter, thanks to a low base effect. In the September 2010 quarter, the company's net profit had dropped 52 per cent.

Unlike in the South, cement prices have been subject to wide fluctuations in the northern market from where Ambuja Cements derives the bulk of its income. From Rs 245/bag in March last year, the price fell to Rs 210 in January-2011, then rose to Rs 260 in July and was down to Rs 233 by September. Cement price didn't offset the increase in input prices entirely for players in northern India, including Ambuja Cements, and profit growth was hard to come by. The increase in cement price to Rs 250-255/bag in the last two months in the northern market may also not hold if the recent pick-up in demand doesn't last.

The rally in cement stocks, which started a year back, may lose strength if earnings weaken. Price of imported coal and freight charges have risen sharply and are eating into profit margins. Benefits of a low-base in cement prices will also wane after the coming March quarter (southern cement players though may enjoy the low-base effect for some more time). A valuation de-rating may cause significant price erosion in cement stocks, especially of players that trade at a premium.

Low-base effect to wane

Between March and December last year, sluggish demand saw cement prices fall steeply (barring in Chennai and few other southern markets); price corrected by around 15-20 per cent. But this year, in the same period, prices ruled 10-15 per cent higher, thanks to the concerted efforts of the manufacturers to keep supply tight. Ambuja Cements reported a 10 per cent growth in sales in the April-September period even as sales volume was up just two per cent.

Yet, compared to players such as ACC and UltraTech Cement, which have some southern market exposure, Ambuja Cements reported slower growth in sales. This was largely due to the comparatively lesser increase in realisations. The company's volumes grew at a rate slightly higher than the industry (at 7.6 per cent in the September quarter compared to industry average of 5-6 per cent). Ambuja Cements had recently commissioned a 1.1 mtpa cement plant in Chhattisgarh. Come January and the base effect benefit will start to diminish. From March 2012, there will be no cushion from low base. Sales growth from then on would have to largely come from volumes. In the April-September period of the current year, overall cement demand saw an increase of around 4-5 per cent from last year, not a significant rise.

There are many pre-conditions for cement demand to revive. First, the current gloomy economic situation should end and capex activities should pick up. Inflation should ease and interest rates should go down to encourage purchase by home buyers. If these things happen in the coming year, cement manufacturers will be able to better utilise cement capacities they had built up in the last two years and achieve good sales and profit growth. However, instead of speculating on demand now, investors may be better off paring exposures to cement companies, especially northern players, now and re-enter when demand revival signals emerge.

Increasing margin pressure

Cement manufacturers have been facing an increased pressure from input costs over the last few quarters. In the nine months ending September 2011, Ambuja Cements recorded only 0.6 per cent growth in operating profits even as sales grew 10 per cent.

Increase in freight expenses on higher cost of diesel and petrol, higher expenditure on power with increase in cost of imported coal, and the rising price of fly ash and gypsum have been weighing on profits. In the September quarter, raw material expenses were higher by 11 per cent and freight expenses up by 21 per cent for Ambuja Cements.

The rupee's sharp depreciation against dollar has also increased landed cost of coal for the company. Margins at the operating level for the company in the September quarter was 20.9 per cent, down by two percentage points over last year and lower by nine percentage points over June 2011 quarter. The year 2011 could end on a disappointing note for the company.

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