Mention the concept of investing in a China cement company and the naysayers dismissively begin explaining why it is a bad idea. Topping their list of reasons is the mainland's macro-economic austerity measures, which target specifically the cement industry and its redundant, ill-equipped cement plants. Such stereotypical reasoning often leads investors to turn down very competitive, entrenched companies which will actually benefit as competitors are wiped out by the credit tightening. Last year China consumed 862 million tonnes of cement, up 19 per cent from the previous year. During the first half this year, consumption has increased 18 per cent to 425 million tonnes owing to robust demand from property and infrastructure projects. Despite slowing demand in recent months, consumption may increase 16 per cent to one billion tonnes, as demand is seasonally the highest in the fourth quarter. Anhui Conch Cement, the mainland's largest cement manufacturer, sold 20 million tonnes last year, an increase of 48 per cent over the previous year. Clearly, Anhui Conch outperformed market growth to capture, probably at the expense of smaller competitors, a larger market share of 2.8 per cent, which implies substantial room for growth. Cement is made by excavating limestone, crushing it into aggregates, blending them with clay and sand, heating the mixture to some 1,400 degrees Celsius inside a dry rotary kiln, and cooling it down to become clinker. This material is then blended with different additives such as gypsum to form different grades of cement. Note that clinker is much more demanding in energy and technology to manufacture than cement. Last year the company produced 5.6 million tonnes of clinker, an increase of 375 per cent over the previous year. Anhui Conch has its clinker plants located mostly in Anhui where there is an abundant supply of limestone. The nearby Yangtze River provides easy transport to the booming eastern Chinese provinces of Jiangsu and Zhejiang. The company's self-sufficient clinker production gives it a long-term advantage. In 1999 clinker fetched an average of 145 yuan per tonne; five years later the price rocketed to 216 yuan per tonne. During the same time frame, the price of high grade cement rose 24 per cent to 289 yuan per tonne. The results show clinker prices widely outperformed cement. The surge could be due to rising coal price and electricity tariffs, as clinker manufacturing is very energy consuming. Another reason could be a supposed deficit in clinker capacity in China, as it is less demanding to invest in a cement plant than a clinker plant. This is good news for Anhui Conch as many of its competitors have no clinker capacity and must procure it from other producers. That Anhui Conch earned a gross margin of 47.7 per cent, much higher than its listed peers, supports my hypothesis that its competitors are paying a premium for the base component. Another long-term competitive advantage is the company's unparalleled economy of scale: other listed cement companies have smaller production capacities. Anhui Conch can mitigate costs by flexing its king-sized muscle, although rising coal prices may erode gross margin moderately. The company also sells lower grade cement - a product that can be equally profitable if gross margins are maintained. This year, Anhui Conch is on track to rack up sales of 7.8 billion yuan, up 38 per cent year on year. Net profit is forecast at 450 million yuan, an increase of 83 per cent, or 1.16 yuan per share. At this rate, the company is currently selling at 9.8 times forward earnings. Given the long-term demand for cement in China, a higher valuation is justified. Even a conservative no-growth valuation would justify around 12 times earnings. Investors should be aware cement demand could grind to halt if the Chinese economy were to decelerate suddenly - an event which I believe is unlikely. Disclosure: the author owned shares of Anhui Conch when this article was published.
