Cost synergies seem to justify premium deal valuation

Whether players maintain discipline or turn aggressive on pricing as new capacities come on stream will be crucial

Adani Group’s deal to buy Ambuja Cements (ACEM) and by extension, ACEM’S stake in ACC has triggered open offers for additional stakes in both companies. The deal, including open offers, should be worth something more than $10 billion and given the approximate 73 million tonnes per annum (mtpa) capacity, the valuation will work out to around $170-180 per tonne. The deal is going through at around 8 per cent premium to market price. Given the deal ramifications and the open offers, it will take six to nine months to complete the formalities.

Adani Group becomes the second-largest player in the cement sector, with Ultratech (114 mtpa) remaining the market leader. The Ambuja-acc combine has a pan-indian footprint and around 12 per cent current market share.

Adani is believed to be considering either brownfield or greenfield capacity expansion, doubling capacity over the long term. Current capacity utilisation is around 80 per cent so, it cannot aggressively increase volumes without increasing capacity.

Obviously the deal changes the dynamics of the cement sector or rather it will change by the end of the current financial year (202223). Adani should be able to generate cost-cutting through merger synergies since the group has a big presence in power, coal, and logistics. Given that these are all big cost heads in cement manufacture and distribution, the group could improve margins by cutting costs. It is also conceivable that Adani Group could also look to move into construction-heavy infrastructure sectors, such as roads, to ensure offtake for this new cement capacity under its belt.

On calculation suggests Adani could gain ~125-150 per tonne synergy benefit from a formal merger of ACC-ACEM and it will generate ~50-60 per tonne savings since it would not need to pay existing royalty payment (1 per cent of sales) to Holcim. In addition, it could probably cut power and transport costs.

How Adani funds this deal — the cost of financing it — will presumably drive the strategy. The group doesn’t have a great deal of free cash-flow due to being in long-gestation, low-margin businesses.

Will it look for market share, or price realisation?

The valuation per tonne for ACEM and ACC is significantly higher than that paid in earlier deals. Back-of-the-envelope calculations suggest that earnings before interest, tax, depreciation, and amortisation (Ebitda) per tonne will need to improve significantly from the current levels of just over ~1,000 per tonne to justify the valuations Adani has offered to pay. Ultratech for example, has an Ebitda margin of around ~1,300, so this may be achievable.

While it could hope to claw back greater market share, it cannot do so by fighting a price war without damage to the profit and loss account. In the long term, capacity expansions could help Adani win market share, but a price war would not seem rational.

Other cement companies are also increasing capacity, so there could be a scenario where prices soften, unless there’s pick-up in cement offtake. Right now, the only serious driver is public infrastructure spending and given the budget deficit, that cannot be increased much. A pick-up in private consumption could help with demand, but that depends on improved macroeconomic variables.

Market response to the deal will be clearer in the next few days as we see the impact on the share prices of other cement companies. As of now, investors don’t see a price war threat.