CLSA cement supremacy, Gresik upgrades

Nick Cashmore upgrades his earnings forecast and TP for Semen Gresik (SMGR IJ). Our new fair value of Rp8,000 (previously Rp5,000) offers 19% further upside. Maintain Outperform.

Indonesia cement companies are making a fortune. The top 3 cement companies control over 90% of the market means enormous pricing power. Operating margins are the highest in Asia.

The key question to ask will be how sustainable is these margins? Looking at the industry dynamics where incremental (small) capacity addition is still from the top 3 players and demand steady as a base case scenario, cement companies will be able to enjoy an extended period of high profitability.

It is important to note the biggest chunk of cement consumption is still from housing (where we think we are at the infancy of a structural bull market - record low interest rates, the absence of leverage, rapid urbanization, young population), blue-sky will be from the pick up from infrastructure investments as prioritized from President SBY's second term administration.

While we are positive on overall cement in Indonesia, we prefer Holcim (SMCB IJ) and Indocement (INTP IJ) over SMGR. The table below shows more clearly why SMGR will lag peers even with this volume growth. Exports have been cut 50% this year to fund domestic demand and that is helping to boost margins; that will continue for the next few years in our view. But even with modest 5-6% increase in domestic volume growth this will absorb all of the marginal increase in supply for the next five years. CapU will dip the most in 2013 when everything is on stream but still not below 90%.

The bottom line here is SMGR is not going to be destroying cement prices when this capacity comes on stream and the industry still faces bottlenecks, particularly in 2011.

Key points from the report:
SMGR’s9M09 gross margins rose to a record high of 48%, driving margin improvements across the board. However, further margin gains are likely to be modest from here.

SMGR is moving ahead with expansion plans, will add 22% to capacity by 2012. This’ll be matched by growth in domestic demand.

Capex burden is manageable. SMGR to spend US$1.3bn over the next 3 years, largely to be funded internally.

SMGR is generating US$400m in annual operating CF with US$300mn in cash as of 9M09.

Tight capacity utilization = SMGR will lose market share but the benign (oligopolistic) competitive landscape = returns on capital will remain high

Valuations: not demanding. Stock trades at 12.3x 2010 PER, and our new TP of Rp8,800 is based on a blended average of 2010/2011 earnings and a PER multiple of 14x.