INDUSTRY RISK ANALYSIS CEMENT INDUSTRY

PERIOD OF ANALYSIS FY 2002-03 Abstract The paper attempts to analyse the historical trends observed in the cement industry and draw out inferences as to the dynamics that operate within the the industry. The study has touched upon the following :a) b) c) d) e) f) g) Key economic features of the industry Degree of competition & evolving market structure Competitive analysis of the industry. Financial performance of players Competition & Strategies at the firm level Emerging trends & outlook in industry Risk profile of the industry

Analyst : Krishnan Chari Dy Manager (Risk ) UTI Bank Ltd

Risk appraisal Cement Industry

EXECUTIVE SUMMARY 1. Indian cement industry has a long history and contributes significantly to the GDP of the economy. The industry comprises of 110 cement units of which 40 are large. The total aggregate capacity for cement production as on FY 2002-03 is 130 million tonnes . At present the industry operates at 83% capacity utilisation resulting in a total production of 107 million tonnes. Domestically, the cement industry is very competitive . Though 50% of aggregate capacity is controlled by major business groups such as ACC, Gujarat Ambuja ,L&T, Grasim, India Cement etc. the rest of the capacity is still fragmented among independent cement units. 2. Globally cement industry contributes very little to international trade and account for 6 to 7% of the total world trade. As cement is a bulk commodity , movement over long distances is uneconomical and requires special bulk material carriers. Due to this reason, international trade is concentrated mainly in cement clinker and countries which are poor in limestone reserves import clinker for processing it into cement. 3. The demand supply imbalance continues to exist resulting in excess capacity plaguing the industry. The demand for cement in the Western States during FY 2001-02 was sluggish on account of delayed implementation of public projects and lack of private investments. However, the demand in Eastern and Southern States has been buoyant on account of civil constructions, road projects, rural infrastructure and housing constructions by agricultural class. Following the regional patterns in demand variation in prices were maximum viz; 10.84%, in the Eastern Region and minimum viz; 5.63% in the Western Region. Though the overall macro economic situation has not dramatically changed during the FY 2002-03, towards the second half, construction activity is reported to have gone up by 7.2% as against 2.7% in the second half of FY2001-02. This is indicative of a slight recovery on account of improved Government off take of cement for rural and urban infrastructure projects. For the coming fiscal 2003-04 demand from Eastern and Southern States is expected to lead the overall aggregate demand for cement. Continued signs of recovery however will depend upon Budgetary policy for 2003-04.

Risk appraisal Cement Industry

4. Price realisations have been low due to excess capacity in industry, cost escalation by way of freight rates, power tariffs, due to inadequate bulk handling terminals/transport carriers and frequent revision in electricity tariffs by SEBs have resulted in increased pressure on net margins of cement units. A sample of 26 large cement units shows signs of financial distress across the spectrum of the industry. Companies especially the leaders such as ACC, Gujarat Ambuja, L&T, Madras Cement, Grasim Industries, etc. are working towards cost effective logistics, brand building and process improvement in order to manage costs and improve their bottom lines. 5. The industry was fragmented with large no of firms with capacities of 1 million tonnes and below. As mentioned above, the excess capacity situation led to increased pressure on net margins. The market structure began to evolve since 1996 through mergers and acquisitions. The ongoing consolidation though slow, is expected to result in few business houses controlling capacities across various regions. In the long run, the likely market structure will be oligopolistic in nature where firms/ business groups would compete by way of product differentiation and adopt differential pricing strategies. 6. The emerging market trends are, focus on blended cements, special cements such as Ready Mix Concrete, shift towards cement being positioned as a retail commodity and increased investment in material handling terminals. 7. In a nutshell, we may infer that players with deep pockets , who increasingly focus on enhancing operating efficiency, achieve higher economies of scale are not dependent on few regional markets but have more or less national presence , have good distribution network, possess strong brand recall will survive in the long run. On the risk rating framework, the cement industry scores 63 points and has been awarded a rating of UB-BBB indicating moderate safety with a higher impact of risks emanating out of business, earnings, market structure and government policy. 8. The present portfolio of the bank comprises of mid sized players in the industry concentrated in southern markets. The Bank must broad base its exposure in cement industry by exploring relationships with industry majors and also diversify its regional exposure in this industry.

Risk appraisal Cement Industry

TABLE OF CONTENTS Index A B C D E F G H I J 1 2 3 4 5 6 7 Sections Page Key Economic features of cement industry Competitive analysis of the industry Key success factors for players in the industry Financial performance of large cement units Strategies at the firm level Emerging market trends & future outlook Portfolio concentration risk ( at industry level) Risk profile of the industry Industry rating Risk of banks portfolio Annexures Cement Industry rating sheet Concentration risk in industry portfolio Banks credit exposure to cement industry as on 31 Dec 2002 Financial analysis on a sample of large cement units Cement market majors Degree of Concentration of market power in industry Econometric model for Cement demand estimate.

5 16 21 22 23 24 26 27 29 31

Risk appraisal Cement Industry

A ) KEY ECONOMIC FEATURES OF CEMENT INDUSTRY :

1. Economic Importance of Cement Industry : Percentage contribution to GDP The economic importance of cement industry emerges from its sectoral contribution to the GDP of the country and partly also because Cement has been the key ingredient for construction activities in a wide range of sectors. Infrastructure and commercial construction activity account for 75% of cement off-take while housing construction accounts for 25% of cement consumption. As construction activity on the whole contributes 5.51% to GDP, cement being a direct response to construction activity is also a major industry . 2. International Trade : Since cement is a basic commodity with virtually no substitute, it is used worldwide for construction purpose. Only countries that have adequate limestone reserves are producers of this commodity while others import cement or clinker . In FY 2000, the worlds largest cement producing country was China with a total production of 520 million tonnes. Cement is a low value bulk commodity and freight costs are significant factor in determining the landed cost of cement. Higher freight costs result in lower volumes of international trade in cement. The overall world trade in cement falls in a narrow range of 6 to 8% of the total world trade. Major importing countries happen to be developing nations where public sector investments in infrastructure projects are high. However, Middle East imports its entire cement requirements due to a non availability of lime stone reserves and also due to demand from oil well construction projects. Indias share in bulk movement of cement in international markets was around 1% in 1999 which is very low and leaves sufficient scope for improvement. USA is the major international market for cement and is supposed to be consuming around 20% of international production of cement. Major exporters to USA are Europe, Latin America, China and Canada. South East Asian countries also account for significant trade in cement. Cement trade between Japan and South East Asia is a significant part of international trade. Clearly international trade of cement is divided between the west and the east on account of lead distance and bulk transport cost. Note : Holderbank
(Switzerland), Lafarge(France), Heidelberger (Germany), Cemex(Mexico), Chichibu Onada (Japan), Italicementi Group (Italy) and Siam Cement (Indonesia)are major Risk appraisal Cement Industry

international cement companies. Internationally Lafarge owns many cement plants over different countries by way of acquisition. In India too over the last two years, Lafarge and Italicementi have already made inroads through acquisition and strategic alliances.

India exports cement as well as clinker to neighbouring countries. The major cement exporters are among the top five producers of cement namely L&T, ACC, Gujarat Ambuja , J .K Industries and India Cements. Exports of Indian cement and clinker are mainly to countries such as Nepal, Bangladesh, Srilanka, Mauritius, and South Africa . During the last four years , the growth rate in clinker and cement exports was at CAGR of 3.31% and 18.02% respectively. Bottlenecks in Indian exports of cement : Besides loss of price competitiveness, structural factors that hinder the growth of cement exports by Indian industry are : a) Low rate of ship loading. Cement is packaged in bags and is normally dispatched as break bulk cargo which is not cost effective. Given the lack of adequate bulk handling terminals, the industry is not able to reap the benefits of bulk transport of cement. b) Inadequate storage facilities at almost all Indian ports necessitates large quantities of cement to be moved at short notice through rail. As there is already delay in wagon availability, the transport of cement to ports is delayed from the hinterland thereby inflicting higher costs especially higher demurrage charges to be paid for waiting ships. However companies having production facilities near the coastline such as Gujarat Ambuja Ltd have managed these bottlenecks by owning captive ports and material handling facilities. This proves the point that unless sufficient investments are made in logistics to gain cost competitiveness, boosting exports is not possible by Indian cement units. 3. Product standardisation .. Cement is a low value , high bulk commodity and is the key building material in construction activity. Cement is a highly standardised product with virtually no substitute as of the present date despite research taking place in alternative construction materials for low cost options.

Risk appraisal Cement Industry

There are various types of cement further classified into different grades . However the major types of cement manufactured in India can be classified as to their generic uses and quality as under : Broad Categories of Cement Ordinary Portland Cement Uses As % of total cement production

Useful for all types of civil engineering 62.0% works. Sub categories of OPC have applications for urgent requirements (such as airport highway repairs), cementing of oil wells, construction works under marine environments which require strong corrosion resistant properties. Blended Cement Blended cement find applications in 37% marine construction. Speciality Speciality cement is used in places of 0.80% Cement severe chemical attack and also in underground activity where the sulphur is present. Ordinary Portland Cement is manufactured in different types which are put to specific uses due to certain properties . OPC is available as Moderate heat portland cement (MHPC), Rapid hardening cement ( RPC), Sulphate Resistant Cement (SRC) , Oil Well cement (OWC), White Cement . Blended cements are manufactured by use of man made compounds such as pozzolona, slag and sandstone.. Blended cements are of different types such as Portland Blast Furnace Slag Cement (PBFSC) and Portland Pozzolona Cement. These cement varieties are more sulphate resistant and are used in construction structures which face attack from sulphate elements. Among the speciality cements, Ready Mix Concrete(RMC) is a recent innovation in cement product which finds as the name suggests ready to use applications in infrastructure projects. Internationally, RMC accounts for 95%of the cement type used for infrastructure projects. However in India it accounts for only 0.5% of the speciality cement produced. Cement quality is measured in terms of its strength which is a function of the quality of clinker and the superiority of the grinding process. Higher grade cement varieties posses higher strength. The international quality of cement has been on the rise since 1950s and as of today is in the category of 55 (28 day comprehensive strength). Against this the quality of Indian cement is

Risk appraisal Cement Industry

around 33 (28 day comprehensive strength). Lower quality of Indian cement can be attributed to lower quality of coal and also that the present basic operating practice of construction business in India does not favour higher quality of cement . In India, depending upon the pace of construction activity the standard quality of cement used is of 33 grade. 4. Process technology : Cement manufacturing in India has a long history and process technology is well established. The Wet Process, Semi Dry Process and Dry Process are the three types of process technologies available in manufacturing of cement. Among these, Dry Process Technology is widely used by cement manufacturers as it is comparatively energy efficient and also is a less polluting technology. 5. Demand supply dynamics : The demand for cement is driven by the pace of construction activity in the private and public sector. The segments which influence aggregate demand for cement are infrastructure projects, commercial projects and housing sector. With virtually no threat of substitute the proportion of cement in construction activity is large. At the macro level it is generally observed that the demand for cement is strongly correlated with the growth in GDP. The correlation coefficient works out to be around 0.81 which indicates high degree of association. Approximately 40% of the construction activity is influenced by the government expenditure ( through expenditure on ports, railways and other civil structures such as roads and bridges) . As government and private expenditure vary from State to State , demand is regional in nature and is influenced by economic activity in each State. Regional trends in demand growth is as under : We trace the growth in cement demand over two phases of economic growth/business cycle the period 1991-92 to 1995-96 consisting of the growth phase and the period covering 1996-97 to 2000-2001 which depicted a recession phase. The regional growth in demand measured in compounded annual growth rates ,indicate a wide shift in demand across regions. Region ( states) Eastern States Northern States Southern States Western States CAGR of cement demand 1991-to-1995 0% 8.82% 16.98% 35.45% CAGR of cement demand 1996-to-2001 13.12% 9.73% 6.44% 4.54%

Risk appraisal Cement Industry

Observations are as under : There is a significant shift in demand for cement between States. The Eastern States which experienced virtually no growth in the better part of the business cycle have a CAGR of 13.12% in cement demand during the sluggish phase of the economy. The major shift can be attributed to the increased thrust by the central budgetary outlay on Eastern States as well as north Eastern States leading to increase in construction activity. The impact of economic slow down is much severe in the Western Region partly on account of reduced business investments , slow pace of infrastructure projects and also natural calamities during the year 2001-02.

Demand supply dynamics in different regions for the period Aug 2001 to Aug 2002 can be tracked as under : Western Region Prices in the Western Region witnessed continued pressure as a result of weak demand and oversupply situation in both Gujarat and Maharashtra. This coupled with lack of investments in Maharashtra adversely affected the off take in the Western Region. While cement demand continued to be buoyant in Andhra Pradesh on account road projects undertaken in the State, demand in Tamilnadu remained subdued mainly due to lack of investment from the government and slow implementation of commercial projects . However, the supply situation outsripped the demand causing downward pressure on prices. Demand in the Northern States namely UP, Punjab, Haryana and Himachal Pradesh was driven by agricultural and housing segments. Demand for cement in Eastern States remained buoyant leading to very little change in cement prices.

Southern Region

Northern Region Eastern Region

Risk appraisal Cement Industry

The demand drivers for various regions for the coming fiscal FY 2003-04 is broadly mentioned as under : Region( states) Eastern Region Northern Region Western Region Demand Drivers General housing demand and civil constructions General housing demand arising from agricultural sector. Demand growth will depend upon the private investment growth implementation of general infrastructure projects and also incremental government off take. The quadrilateral projects in the south are expected to continue till 2003-04. The main demand drivers will continue to arise from these projects as it has been during 2002-03.

South Region

Demand-Supply imbalance : We expect the demand for the FY 2003-04 to be led by the Eastern & Southern Region. However we find some capacity additions taking place in regions where existing demand conditions are already sluggish. Capacity additions during the year was mainly in the States of Gujarat and Karnataka. The imbalance in demand is expected to continue and persist through the year end 2003-04 and follow through the coming fiscal 2003-04 unless general infrastructure projects and commercial investments take a big leap. Price elasticity of demand : As mentioned above, demand for cement is mainly driven by general construction activity. Retail sale of cement is very less, normally cement is sold in bulk quantity and mostly through tender mechanisms in case of government off-take for infrastructure projects. Prices of cement therefore vary regionally and are also strongly influenced by supply co-ordination by cement units. Post deregulation has also witnessed branding of cement which has its impact on price elasticity of cement. Statistical measures such as the Correlation Co-efficient conducted on regional demand and price movements in the North, West, Eastern and Southern States indicate very low degree of association.

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In view of the fact that there are no substitutes and that price elasticity of demand is low, the cement units have been building brands to maintain demand for cement in a sluggish market. 6. Demand Forecast : Based on the quarterly data available on cement demand and GDP estimates since 1996-97 to 2001-02, we regressed the cement demand ( as a dependent variable) on the GDP at factor cost( the independent variable). The regression model estimated for cement demand over the short run was as below

Ye = a + [Log (GDP)] + ei
Where Ye is estimated quarterly demand Regression constant (intercept) =a is the regression estimate GDP is the quarterly gross domestic product at factor cost. Ei is stochastic random disturbance
The semi log function has been chosen by transforming the explanatory variable GDP into a log scale in order to scale down the computation . However such a variable transform continues to maintain the linear relationship among the variables and satisfies the test of goodness fit. The R2 works out to 66.25%

The details of the regression calculation are shown in annexure - 7. The demand for the quarter Jan to March 2003 estimated through the above model was 27.02 million tonnes under 95% confidence interval with a significance level of 0.025% ( two tailed test). The interval estimates for quarterly demand was 31.50 million tonnes as the maximum possible and minimum demand estimate was 22.58 million tonnes. Aggregate cement capacity in the industry is 130 million tonnes. Present operating rate i.e FY2002-0-3 in the industry is 83% of installed capacity which works out to 107 million tonnes. Considering no increase in capacity and 4% growth in GDP during the quarter, cement demand may be aggregated at 108.08 million tonnes for the ensuing year FY 2003-04. Going by the above assumptions the demand supply imbalance is expected to get corrected by the end of FY 2003-04. Note : For purpose of demand estimates keeping in line with the historical data the GDP growth factors was assumed at 4% over the estimated quarter. 7. Size distribution of players & degree of competition : The overall market size comprises of around 40 large cement units which have capacity of more than 2 million tonnes. The aggregate growth in industry turnover over the last four years was at 7.50% CAGR. The sluggish growth in aggregate volumes of cement can be attributed to economic slow down over the last few years.

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While volumes have been laggard , the pressure on margins due to low price realisations and cost escalation has forced cement units to consolidate . Cement industry is highly skewed in favour of the large units owned by major groups such as L&T, Grasim, Gujarat Ambuja, India Cement , B.K Birla, K.K Birla group, Ramco ,Rajan Raheja , Bangur Group & Lafarge . The existence of mini cement plants are due to pre librealisation motives by the regulators to counter concentration of large units in the industry. However, mini cement plants contribute very little to the industry in terms of competition. The consolidation wave in the industry began since 1996 and continues unabated till date. The consolidation has been through mergers with exceptions of some strategic alliances and acquisitions into the market by foreign players such as Lafarge and Italcementi. The extent of competition is still significant and throws up vast opportunities for further consolidation. In this study we made use of Entropy Index( Er) to measure the degree of concentration in the industry. The index moves around a value of 1 to 0 measuring increased competition as (Er) tends to 1 and higher degree of monopoly/concentration of market power as it tends to 0. The Entropy Index for the Cement Industry using 2001-02 data for 40 large units measures to 0.79 indicating competitive situation in the industry. This is also justified by the fact that around 50% of the cement capacity in the industry is held by a few large groups. The remaining share of the market is still fragmented. The mathematical model for Entropy Index is given in the annexure -6 8. Cost, Pricing & Profitability : The factors that influence the cost structure of the industry are the proximity to basic feed stock i.e limestone, demand supply imbalance in availability of coal & power and revision in tariffs rates for logistics . Lack of bulk material handling & storage terminals lead to delay in dispatches and higher transport costs. In many a times the units end up paying higher demurrage charges for waiting ships in case of export consignments. Spatial features of cement plants also influence the cost structure. Cement units are normally clustered around limestone reserves and have an advantage in terms of limestone clinker availability while those located along the coast line have to transport clinker from long distances to processing units entailing a higher cost. Also the quality of limestone and clinker differ regionally which impact processing costs.

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On analysis of the cost structure of the industry, the following were the findings :
Analysis of the major elements of cost structure measures of volatility (Variance over 1992-2002) period Standard Co efficient CAGR Average Cost Deviation of variance (over 10yrs) Rs per Bag Rs per bag Volatility 9.97 0.93 9.29% 3.25% 6.39 0.93 14.62% 4.31% 17.35 4.43 25.55% 10.48% 2.34 0.50 21.47% 5.96% 6.55 1.25 19.08% -4.20% 25.94 8.04 4.38 1.61 16.90% 20.04% 6.16% 8.74%

Coal Freight-Coal Power Limestone Packaging FreightCement Wages

Source : CRISINFAC Reports Note : Coefficient of variation measures the dispersion around the average quantity in percentage terms. In the above context it indicates volatility in cost around average cost of cement per bag in percentage terms.

The above cost behaviour indicates that the cost of power, and freight have been the most volatile ( as measured by the coefficient of variation) than coal costs . Volatility in power costs can be attributed to the consistent rise in power grid tariffs. The industry has shown a major preference for captive power generation which can be seen in a decline of power consumed through grid power from a level of 80% in 93-94 to 60% in 2000-01. Logistics holds the key for cement industry as both its inputs and output are bulk commodities. Approximately the proportion of cement moved through rail and road are 39% and 61% respectively in the year 2001-02. Due to lack of adequate wagon availability and higher lead distance ( around 350 kms ) in case of road transport , freight costs continue to be on the higher side. Transport by sea route has been economical and some of the coastal based cement units such as Gujarat Ambuja Ltd have been using this route effectively. However, the cement units in the hinterland continue to carry the brunt of uneconomical logistics. The industry lacks adequate bulk handling & storage terminals which can reduce the cost of cement dispatches .

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9. Pricing : As discussed above price elasticity is low with respect to demand. Also the price movements are more influenced by supply co-ordination and therefore, differ regionally. Again an analysis of the variation in cement prices per bag over the last eight years in four regions show very low percentage change in prices. On comparing the variation in cement prices against that of manufacturing cost it becomes clear that the cement producers have not been able to pass on the escalation in cost to the consuming segments.
Region wise movement in cement prices: Measured over (1992-2002) period Average Price Rs per Bag Northern Region Southern Region Western Region 136.00 159.25 145.75 Standard Deviation Rs per bag 8.31 11.87 8.21 Co efficient of variation % volatility 6.11% 7.45% 5.63%

Reigions

Eastern Region 142.50 15.45 10.84% Source : CRISINFAC reports Note : Coefficient of variation measures the dispersion around the average quantity in percentage terms. In the above context it indicates volatility in cement price around average price of cement per bag in percentage terms.

From the above table we can observe that maximum price variation has been in the Eastern Region comprising of the Eastern States where demand for cement has been buoyant. The Eastern Region is expected to lead the overall demand for cement for the coming financial year FY 2003-04

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10. Financial Performance & Profitability :

Trends in profitability of the industry is assessed as under : Cement Industry Aggregates Year 1995-96 1996-97 1997-98 1998-99 1999-2000 2000-01 PBDIT 22.42% 18.46% 16.50% 17.05% 15.94% 10.91% Net Margins 9.25 4.4 -0.51 -2.24 -3.3 -22.85% ROCE 27.73 19.88 15.17 15.66 15.35 12.52 Raw material days 171 201 213 194 160 204 WIP days 13 13 17 18 17 27 Finished Goods Days 13 15 16 14 15 21 Debtors Days 25 26 29 30 30 46 Creditors Days 42 40 37 38 40 74 Source : CRISINFAC reports

The aggregate performance for the industry has been consistently falling with respect to operating margins and overall return on capital employed. The pressure on margins can be attributed to falling cement prices on account of excess capacity and sluggish demand conditions. The increase in power and freight costs have also been responsible for erosion in the bottom line of the industry players over the period FY 1995-96 to FY 2000-01. During the FY 2001-02, the performance of sample large companies ( 26 units ) were analysed which showed sharp decline in net margins though operating margins were better. However reduced holding levels of inventory and book debts during the year 2001-02 indicate better working capital management. Nevertheless, the overall bottom line of the industry will be under pressure unless excess capacity gets corrected. It is however estimated that the balance will be restored by 2004 considering that the demand for cement off take is expected to be buoyant in the current fiscal. 11. Value Chain in the Industry : Value chain in the cement industry comprises of raw material suppliers (mostly the few public sector coal units ), manufacturers, C&F agents, wholesale and retail dealers . The retail sales of cement accounts for only 30% of the total sales, the rest is accounted for sales to institutional buyers. The value chain therefore is dominated by institutional players .

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B)

COMPETITIVE ANALYSIS OF THE INDUSTRY

Using Porters model for industry analysis : We have used the porters model framework in order to assess the factors impacting the industry performance and to understand the structural changes taking place in the industry. The impact of the economic and structural factors on the cement industry is analysed on a scale defined as under : Low , Moderate, High. In case the impact is favourable it is mentioned Positive or else it is indicated Negative. PORTERS FRAMEWORK FOR INDUSTRY ANLAYSIS 1. Bargaining position of suppliers :
Factors that increase the bargaining power of suppliers.

1. Coal, Limestone, power and logistic services are the key determinants in terms of aggregate essential supplies to the cement industry. The supply of coal is dominated by few public sector units who allocate linkages to cement plants quarterly/annually. The limestone reserves are within the control of the State governments which seek royalty on mining of limestone. Railways is a major option for movement of cement apart from road transport and sea route. Power supply is mainly through the grid and still a large proportion of power consumed by the industry is from the grid. In all, key supplies/logistic services to a majority of cement units are controlled by very few players. 2. At present cement units domestically as well as world over have very few alternatives to coal as a burning fuel in the cement process. Other fuel types such as LNG or Naptha are costly propositions. As coal producers are PSUs their productivity is low and also their produce is being distributed to other State corporations such as SEB, etc. The demand on coal linkages by other sectors is also high. Further, as there are many cement units, competition for attaining coal linkages is intense and is subject to heavy lobbying by cement units. 3. The proportion of cement units that are located in the hinterland are the major consumers of coal. The cement units are large in number as compared to the no of units that supply coal through linkages.

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4. Switching costs from one supplier to another for any cement units is very high as coal linkages are attained through long term contracts and many a times cement units will have to lobby to get the best of these linkages.
Impact of bargaining power of suppliers on cement industry.Negative- High

1. Lower availability of quality coal thereby forcing units to import coal at higher costs. As many cement units are located around clusters transport cost of moving imported coal to the plants in hinterland is higher. Therefore, these units have few options available but to depend on PSUs for coal supplies. 2. Freight costs are on the higher side as railways have been consistently revising their freight rates upwards . Also the non availability of adequate wagons pose a problem for the dispatch of cement. 3. Coal linkages have to be lobbyed for which has its implied cost. 4. Frequent fluctuations in power supply and increase in grid tariffs have induced cement units especially the large ones to install captive power plants entailing additional capital expenditure.

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2. Bargaining power of consumers Factors that increase/decrease the bargaining power of consumers 1. Cement being bulk commodity is being largely consumed by the construction sector especially the government, civil contractors and builders including project divisions of infrastructure projects in public and private sector. A small percentage is also consumed by the retail housing segment. However this is confined to only certain states where residential accommodation is mostly in the form of independent houses. Overall the demand for cement emanates from institutional consumers who purchase cement in bulk quantity. One could approximate that around 70% of cement dispatch is in bulk quantity through the wholesaler, distributor network. 2. Cement units are large in number and the fragmentation of cement units regionally offers adequate scope for consumers to switch between suppliers of cement. The cost of switching between cement suppliers is comparatively very low. 3. Normally cement purchases are made through tenders floated by the government , PSUs or the infrastructure projects whether it be private or public. Also civil contractors purchase cement by either inviting bids or negotiation. As bulk of demand is generated by institutional consumers, the purchase methods adopted provide more flexibility to consumers than cement units.
Impact of the consumer bargaining power on industry Negative -Moderate

1. As Bulk sales of cement is through negotiation/tendering, the bargaining power of consumers is relatively higher. In a surplus capacity situation, the relatively better bargaining power of consumers has added to the downward pressure on cement prices.

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3. Competitive position of the Industry :

Factors that explain the structure of industry and competition among existing players :

There are around 110 cement units scattered around different States of which 40 are large units with a capacity over 1 million tonne. Of these 40 units, the top 8 units hold 50% of the installed capacity in the industry. The competition therefore is intense. Cement industry is very capital intensive process and therefore possess high exit barriers to individual players in the industry.

The market shares of cement majors for the last two years are as under :
Cement Market Majors Company Name ACC Larsen and Toubro Grasim (A.V Birla group) Gujarat Ambuja India Cements Century Textiles(B.K Birla group) Birla Corporation Ltd ( M.P Birla group) Jaiprakash Inds. Source : CRISINFAC Reports Graphical representation in annexure -5 % mkt share 2002 12.21 11.06 10.26 8.74 6.30 5.05 4.01 3.94

2001 11.41 11.47 10.89 8.36 7.61 5.48 4.08 3.90

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Impact of competition on industry Negative-High

1. Competition in the industry is intensive and there is substantial pressure on margins of the players impacting their bottom lines. The situation has aggravated due to ,current sluggish demand conditions ,excess capacity and increasing costs. 4. Threat of New Entrants

Factors that influence threat of new entrants.

1. The minimum economic size for a cement plant is 2 million tonnes. However, the industry being fragmented there are many units within a range of 1 million tone to 2 million tonnes. The capital cost involved in putting up a green field cement plant is Rs 3600 per tonne and therefore for a 1 million tonne plant it works out to Rs 360 crores which is high by any standards. 2. As cement capacities are scattered regionally, national presence can be attained by a corporate group only if it can control capacities across various regions and gain by differential pricing in each of these markets. Companies with multi regional presence will be able to command differential pricing in various markets due to region specific demand conditions. Though there are no major cost advantages to existing players, their proximity to clusters where feedstock is available and their ability lobby with coal producers and the government for obtaining extensive linkages are in favour of domestic players in the industry. 3. Inadequate availability of bulk material handling terminals hinder effective movement of cement to target markets. The industry requires sufficient investments in these segments as cement companies in the hinterland are the most affected on account of lack of bulk cement handling terminals. MNCs will be in position to infuse capital needed for such infrastructure. 4. Cement majors have been successful in penetrating rural and semi rural areas are through a well layered distribution network of wholesalers and retailers while new units will take time to set up such vast distribution network.

Threat new entrants- Moderate-Positive

1. Higher capital cost, additional investments in logistics & distribution network act as sufficient disincentive for new units to be set up. 2. Existing players are already concentrated around different clusters and therefore, the lead distance ( which is at present 350 kms) from the site of raw material and targets markets is expected to be high resulting in higher supply chain costs to the new units
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3. 4.

Extent of competition among existing players is high which has resulted in falling operating margins. Given the above factors, it can be seen that the only incentive for new entrants would be to gain ownership of large capacities in different markets and follow a differential pricing strategy in accordance with the regional demand supply dynamics. It is evident that the bargaining power of cement producers is very low and therefore, they can benefit only by controlling supply through co-ordination. Under these circumstances, new entrants especially the global cement majors have preferred the strategic acquisition route than setting up green field projects. While this happens, existing corporate groups have been extending their control over regional capacities by mergers and amalgamations. Based on the above factors threat of new entrants by way of green field projects is considered to be moderate. However the threat of average existing players emerging stronger after having taken over by MNCs exists.

5.

C) KEY SUCCESS FACTORS FOR PLAYERS IN THE INDUSTRY

Based on the above forces acting on the industry, the key success factors for any individual group/corporate for sustainability in this industry emerges as under. Sr Brief description of the KSF No 1 Ability to produce blended quality of cement suitable for various construction activities. 2. Adequate brand building of cement 3 Thrust on exports in order to balance against domestic fluctuations in demand 4 Lowering the supply chain costs by effective management of logistics and also identifying cheaper means of transport to reach target markets thereby reducing the lead distance to markets. 5 Adequate investments in bulk material handling terminals . 6 Low cost manufacturing efficiency by process consolidation. 7 Self reliance in power consumption by putting up captive power plant.

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D ) FINANCIAL PERFORMANCE OF LARGE CEMENT UNITS

We have analysed 22 cement companies were major segment of business is cement . The analysis has been done on the basis of financial ratios such as 1. Net Working Capital to Total Assets 2. Retained Earnings to Total Assets 3. Earnings Before Interest & Tax to Total Assets 4. Net Worth/Total Outside Liabilities 5. Net Sales to Total Assets. On the basis of the above financial variables, the Altman Z score for the years FY 2001 and FY2002 were arrived at. The analysis reveals that most of the units excepting the diversified groups have strained financials which has only worsened during the year 2002. Cement happens to be a capital intensive industry and the asset turnover is low. Also due to higher operating costs and competition , the return on assets is very low resulting in less internal resources of these sample companies. The sample adequately explains the industry situation of declining margins , higher cost conditions and lower turnover of working capital. For simplicity, in using the Altman Credit Scoring model , we assume that the co-efficients apply to Indian context and do not differ significantly.
Details of financial indicators of major players are provided in the annexure-4 :

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E)

STRATEGIES AT THE FIRM LEVEL

A brief review of strategies (to counter the forces acting on the industry) adopted by some of the leading firms in the industry is as under : The table below indicates the segmental focus of dominant players in the industry.
Company Technology & process mgt Debottlenecking & increased throughput Process optimization Energy mgt Captive power Working Capital mgt Receivable mgt Supply chain mgt Review overall logistics of Business Product strategy Divest in non core business areas Marketing strategies Review of distribution network Effective distribution network Shift from institutional to retail sales Result impact Cost reduction

ACC Ltd

Grasim Industrie s Ltd Gujarat Ambuja Ltd

Alternat ive fuels

Improve supply chain

Process and productivity improvement

Split location plant Innovation through transporting to inland markets by sea route.

Reduction in logistic & mfg costs Improve sales volume & realisation s

Madras cement Ltd

Setting up world class units with lowest cost of production pet coke substitu te for coal. Receivable / credit mgt Reducing lead time in road transport Brand building Penetrate Rural markets Undertake distance realisation study to identify new target markets Focus RMC on

Shree Cement Ltd

Achieving competitiv eness in manufactu ring To focus trade sales of cement than institution selling.

L& T

Process improvement

Source : CRISINFAC Reports

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1.Observations on strategies of dominant players : a) Strategies of dominant players focus around process improvement, energy management , improved logistics, brand building and improving the product mix. Though cement is a commodity , the value chain has been dominated by institutional buyers, some of the players as indicated above have been trying to reposition cement as a trade product and have started penetrating rural and semi urban markets by retail selling. Brand building initiatives of the companies support this strategy. As against coal, some of the players have started using pet coke as a substitute.

F)
1.

EMERGING MARKET TRENDS & FUTURE OUTLOOK

There is increased focus on Blended & RMC special type cements by dominant players in the market such as Madras Cement, ACC, Chettinad Cement Ltd , India Cement Ltd , Grasim Ltd and L&T. Recently, RMC has been made as a mandatory use for infrastructure projects in Mumbai( especially the flyover projects). Such policy support is also expected to be in place in Chennai and other metros. This product therefore holds a good promise for the industry in the near future. There are two specific problems in cement logistics, a) Around 80% of cement is sold through the dealer network and therefore cement transport is normally as break bulk cargo whether in the hinterland or through sea. b) Bulk cement handling terminals are inadequate and sufficient scope for improvement is present. Players are likely to adopt the following strategies in the long run :a) Focus on retail sale of cement through dealer network and put up specialised bulk cement handling terminals for supporting project sales/ exports. At present cement sales for both wholesale buyers as well as small purchases are made through the dealer network resulting in a supply chain mismatch. Higher value can be added by reducing distribution costs if the industry splits the supply chain to focus on wholesale and retail distribution where in bulk transport of cement will be the key cost effective mechanism. b) Split location plants have been experimented with where clinker plants are set up near coal /limestone availability and later clinker produced is sent to grinding units in target markets for cement manufacture. Split location plants economises logistic

2.

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capacities and has found favour with units such as Gujarat Ambuja. 3. Process of consolidation : Only a handful of players are likely to remain in the market and hence will enjoy superior pricing power. The domestic industry witnessed intense consolidation wave during the last couple of years and the same is expected to continue over the medium term. The larger and stronger players in the industry have adopted a focused approach for growing in future. They are consolidating their positions by focusing on internal controls and adding capacities through acquisition route rather than by setting up Greenfield projects. The weaker / smaller players on the other hand are finding it difficult to survive given the recent recession and have become prime acquisition targets for larger and stronger companies. Only players with deep pockets , who increasingly focus on enhancing operating efficiency, achieve higher economies of scale, are not dependent on few regional markets but have more or less national presence, have good distribution logistics and possess a brand recall are likely to survive in the long run.

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G)

PORTFOLIO CONCENTRATION RISK

( AT THE INDUSTRY LEVEL)

In order to measure portfolio credit risk the industry has been viewed as a portfolio of assets with an objective to measure the co-variance as between returns of various units within the industry . The hypothesis being that if the portfolio correlation co efficient works out to be negative, then we infer that the industry players have weak co-variance between themselves and do not behave alike in terms of returns. This would mean less concentration risk as the asset portfolio in terms of the industry as a whole is well diversified. Contrary to this if the correlation coefficient were to be positive, we infer that the industry as a portfolio of assets is not well diversified and fortunes of the players in the industry have strong co-variance leading to higher concentration risk. The magnitude of the co relation coefficient also indicates the degree of co-variance between the asset returns. The sample comprised of 26 large cement units and were then divided into three asset classes depending upon the market share which were used as weights. It is to be noted that the analysis was under static conditions based on data for 8 years FY 1992-93 to FY 2001-02. Use of measures of dispersion especially the Mean-Variance-Co-variance frame work was made in order to assess the concentration of credit risk in the industry. The objective was to assess the credit risk in terms of the co-variance of asset returns viz Return on Capital Employed as between each of these asset classes. The variance co-variance model used is shown in the annexure no-2 The resulting correlation co efficient for the industry sample comprising of 26 companies was positive and had a measure at 0.24. The positive portfolio correlation co- efficient indicates that the returns of the sample companies i.e 26 large units moved closely with each other. A positive correlation also indicates that all players experienced similar fortunes and therefore there is concentration of credit risk. However as consolidation in the industry continues, it is expected that few large players may emerge who would be competitive. It is possible therefore that the industry correlation coefficient may move towards a negative sign indicating diversification of credit risk i.e the possibility of some units outperforming others in the industry. Such a phenomenon will indicate that the industry portfolio is well diversified . Details of the framework have been provided in the annexure-2.

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H)
Sr no 1.

RISK PROFILE OF THE INDUSTRY

Risk Factor Business Risk Rationale Volumes in cement industry is dependent on the level of general construction activity which in turn is a function of general economic activity. Volumes in cement industry over the last two years have been affected by lower GDP growth which declined from 6.1% in the 1st quarter of 2000-01 to a level of 4.4% in 1st quarter 2001-02. Like wise construction activity is a major contributor to GDP slipped from 8.4% in 1st quarter of 2000-01 to 2.5% in 1st quarter of 200102. However current estimates by CSO for the second quarter of 2002-03 indicate that despite a bad performance by agricultural sector, the industrial growth , especially , in the construction sector was recorded to be 7.2% in 2002-03 as against 2.7% in 2001-02. This rise in construction activity is supposed to have pepped up the demand for cement and steel. The recovery is on account of government expenditure on road projects. Continued signs of recovery for the coming year depends upon incremental demand arising out of increased budgetary outlay by the government on public infrastructure projects in both rural and semi urban centres as well as private investment. With respect to international trade, the compounded annual growth rate in clinker exports for the over the last four years was 3.31% in quantity terms. As against this the compounded annual growth rate of cement exports over last four years was 18%. However we are of the opinion that medium term growth in exports will be possible only if substantial investments are made by industry players in bulk material handling terminals at the ports and hinterlands to ensure cost effective logistics.

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Earnings Risk

While volume growth for the industry as a whole is not yet buoyant, existing imbalance between demand and supply and intense competition among players will continue to keep prices and margins under pressure in the near term. Financial Risk The financial aggregates for the industry indicate lower turnover, low margins, cost escalation and resultant lower cash flow generation. The average Altman Z score of 26 large cement companies indicate financial distress. A detailed working of the credit score as per Altman Z score model is presented in the annexure-4 Foreign exchange Cement industry is not a major foreign exchange risk earner. However import of coal is evident in the industry due to its better quality as domestic coal linkages do not ensure better quality which is very essential for attaining efficiency in cement manufacturing. Though international coal prices have been stable over the recent past, rise in import prices on account of price fluctuations or devaluation of domestic currency could affect the bottom line of the industry. Market Structure There is still enough competition in the industry despite consolidation in the previous years. The market structure will continue to evolve and possibly emerge with five or more business groups operating multiple cement units all over the country. Continuation of this competition in the market will affect industry profitability. Government Future demand for cement depends to a great Policy extent on the budgetary outlay for infrastructure projects and also the incentives for inducing housing demand. The expectations on 2003-04 budget and central plan outlay will be the key driver for demand in this industry. Also higher incidence of indirect taxes and royalties levied by the state governments/central governments continue to distort price formation in the industry thereby lowering the price elasticity.

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Environment Risk

Globally cement industry has been addressing itself to sustainable development initiatives. The industry has environmental effects by way of particulate emissions. The present state of technology especially in large cement plants have curbed particulate emissions to a great extent. However mini cement plants continue to be a major concern in terms of environmental pollution. Incidence of pollution also increases if units produce cement based asbestos.

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I)

INDUSTRY RATING

Consequent upon the analysis, the industry has been rated on the basis of the following parameters : Parameters Business Risk Earnings & Financial Risk Foreign Exchange Risk Market Structure Competition Entry barriers Government Policy Environmental Risk Total Score assigned Total score assigned Score Maximum Assigned Score 20 30 2 5 3 5 & 9 15 10 15 4 63 15 25 5 100 63

Rating awarded UB-BBB Moderate Safety Industry performance is marked by low profitability on account of increased competition, excess capacity and economic recession resulting in a clear demarcation between the strong and weak players .The market structure is evolving and will result in few players dominating national presence. The resultant structure is expected to be oligopolistic in nature. Since the industry has a strong correlation with macroeconomic development, the performance of the industry is susceptible to general economic cycles . Any improvement in macroeconomic aggregates in the short run will push industry volumes. Detailed working of the industry rating is provided as an annexure-1

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J) RISK PROFILE OF BANKS PORTFOLIO

Risk profile of the banks portfolio is assessed by arriving at the credit score by applying the E.D Altmans model for financial distress .
Obligor Z Score FY2001 1.43 0.83 1.55 0.75 n.a 1.77 n.a 1.16 n.a Z Score FY2002 1.59 0.62 1.15 0.74 n.a 1.72 n.a 1.00 n.a Int Rating UBBBB Not rated UB-AA UB-D UB-A UB-A UBBBB Not Rated D Ext Rating LAAn.a n.a D n.a n.a n.a AA n.a Total Exposure 80.19 32.27 52.38 2.83 38.48 23.87 31.25 34.55 21.00 Exposure as % of capital Funds 8.87% 3.57% 5.79% 0.31% 4.26% 2.64% 3.46% 3.82% 2.32%

Dalmia Cement (Bharat) Ltd Chettinad Cement Ltd Shree Cement Ltd India Cement Ltd Kesoram Industries Ltd OCL Jaypee Cement Ltd Madras Cement Ltd Sanghi Industries Ltd

Note : As per the Altman model, the company will be classified as a distressed company if the Z score lies below 1.80 and non-distressed if it lies above 1.80. However we are working to arrive at corresponding value of Z score in Indian scenario by working on sample of good companies and default companies. 1. The banks regulatory capital fund is taken as Tier I +Tier II aggregating to Rs 904 crores as on 31.03.2002. 2. Credit score for Kesoram Industries Ltd has not been computed as it is a diversified entity. 3. Z score for Jaypee Cement Ltd has not been computed as the units has been recently hived off as a separate entity during 2001-02. An individual performance can therefore be judged once the FY 2002-03 results are out. 4. Z score of Sanghi Industries has not been computed die to lack of financials.

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Observations : The average credit score of the industry sample comprising of 22 large cement companies excluding mini cement plants deteriorated from 1.12 in FY 2000-01 to a level of 1.04 FY 2001-02 . As stated earlier we are working to arrive at a value for Z score denoting distress in the Indian context. We need to take cognisance of the low score of 1.04 for the cement industry , as it has come out of the study and we need to have a closer look at the exposure. The dispersion around the average for the industry sample was 67.02% ( as measured by the co-efficient of variation) for the FY 2001-02 indicating higher volatility among financial parameters within the sample. Considering the fact that the average Z score of the industry sample is itself low, the deviations from the average have been much worse indicating higher credit risk. The Banks credit exposure to the cement industry totals to Rs 316.82 crores which is 35.04% of the total capital funds of the bank. The credit scores when mapped along the Banks internal ratings show significant differences. These difference arise on account of subjective ratings included in the obligor rating model that our Bank adopts. However we are of the opinion that the differences need to be narrowed especially on the business parameters by re-rating the exposures after the 3rd quarter of FY 2002-03 and 1st quarter of the coming fiscal FY 2003-04 as by then the budgetary policy and the review of Economic survey would indicate the expected buoyancy in demand for cement. A brief about specific cases of delinquency in the Banks our cement industry portfolio: 1. India Cements Ltd : India Cements followed a strategy of acquisitions to add capacities which were predominantly debt financed. The leveraged acquisitions were made during the sluggish phase in order to acquire more market concentration. However higher debt proportion coupled with declining realisations in Southern States resulted in reduced cash flows. The higher debt servicing burden finally resulted in delinquency. 2. Sanghi Industries Ltd : Sanghi industries is a cement plant which is lignite based which is reported to be advantageous to the unit. However due to cost escalations, the project finances have been restructured frequently and therefore has not yet been commercialised.

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PORTFOLIO VARIANCE CO-VARIANCE MODEL FOR ASSESSING INDUSTRY CONCENTRATION RISK Annexure-2 The statistical model used to measure the portfolio correlation coefficient for a portfolio comprising of three asset class is as under. The model can be extended to include as many assets as required. This model has been applied to the industry as a whole as a portfolio. The statistical model is as under:

P(cov ar ) = (Wi^ 2)(var i) + (Wj ^ 2)(var j ) + (Wz^ 2)(var z ) + 2(WiWj)(cov ar )ij + 2(WjWz)(cov ar ) jz + 2(WiWz)(cov ar )iz
P (Covar) indicates the portfolio covariance comprising of three assets W indicates weights of the asset class (i.e the ith class in the portfolio) (Covar)ij indicate the co-variance as between the returns of the asset classes (i& j). The portfolio correlation coefficient then is given by the following equation

Pr =

P(covar) (SDi)(SDj)(SDz)

SD indicates the standard deviations of the returns on the asset class (i) ,(j) and (z). The portfolio correlation coefficient is given by Pr which lies between 1 and +1. If the portfolio correlation co efficient moves towards +1 then it indicates that there is a positive & strong ( indicated by the magnitude) correlation between the returns of the assets in the portfolio. That they are not mutually exclusive. If the correlation coefficient moves towards 1 , then there is strong negative correlation between the returns of the assets in the portfolio indicating that there is enough diversification in the portfolio. When this is used against the industry as a portfolio, we infer that a positive co relation indicates that all players behave like wise under given point in time. In case of a negative correlation co efficient, the players behave differently and which is why there are some players who perform better than the industry. In certain cases the external environment and competition as in the instant case of cement industry will be more overwhelming and may force distress among all players. A negative correlation must induce us to search for those better assets (companies) in the industry who have certain core competencies which make them perform better.

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MATHEMATICAL MODEL OF ENTROPY INDEX

The entropy index was first used by an P.E Hart , in his work Entropy and other measures of concentration , Journal of Royal Statistical Society , Series A, 134,1971. The index was suggested by Hart to measure the degree of concentration in the cement industry. The entropy co efficient is a useful measure of market concentration in the sense that the population of firms for which the entropy coefficient is being computed can be decomposed or disaggregated into several groups, say on the basis of size, region ,product and the classification of industry , etc. to compute separate entropy coefficients for them, a weighted sum of such coefficients would then give the overall entropy coefficient. The mathematical definition of Entropy index is as under :

E = [ pi.Log (1 / pi )]
n i

The notation is defined as :1. E represents absolute measure of entropy index measured only on the basis of market share. 2. N is no of firms in the industry 2. A specific firm is represented by (i) which takes values 1,2,3 ..n 3. Pi represents the market share. 4. Log (1/Pi) is the weight attached to the market share of the ith firm in the industry. Interpretation : The value of absolute measure of entropy index always lies between the interval

0 E Log (n) .

If a firm is a monopoly then it holds 100% share of the market. In such a case the above relation will result in absolute measure of E being equal to 0. Therefore if market power is not concentrated and is perfectly competitive or monopolistic in nature then the entropy index ( in absolute terms i.e based on only market shares will take values towards a limit of Log (n). So more the entropy index the better the competition and lesser the concentration of market power.
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The above index is later modified for including the effect of no of firms in the industry . The index then becomes the relative measure of market power/ concentration and is represented as under :

Er =
The value of

E log(n)

0 Er 1

The notation Er measures the concentration of market power in relative terms i.e with respect to also the no of firms. Again if the market is perfectly competitive it will be 1. Therefore market power will realistically lie between the two extremes. Therefore from the above, there lies an inverse relationship between the value of Entropy index and the market concentration. If the value is higher and tending towards 1, the more the competition and if tends towards 0 the higher the concentration.

We have used this measure in analysing the concentration in Cement industry and found the measure to indicate adequate competition at all India level despite some degree of concentration at regional levels.

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