Lafarge Surma Cement Ltd. March 4, 2010

Transcription

1 Aminul Haque, CFA (880) ; Md. Ashfaque Alam (Research Associate) Lafarge Surma Cement Ltd. March 4, 2010 Rating: OUTPERFORM Target Price: BDT 575 Company Summary 52-week Price Range (BDT) Current Price month Target Price 575 Total Return 30% Number of Shares MM 58.1 Market Cap BDT MM 25,651.8 BDT MM 2008A 2009E 2010E Revenue 6, , ,391.7 Ops Income 2, , ,811.2 Net Income , ,458.3 Margins 2008A 2009E 2010E Gross Margin 40.2% 40.0% 40.0% Operating Margin 35.2% 33.5% 33.5% Net Margin 2.8% 14.9% 17.4% Growth 2008A 2009E 2010E Revenue Growth 159% 23% 10% Net Income Growth NM 542% 29% Per Share 2008A 2009E 2010E EPS DPS Book Value/Share Cashflow BDT MM 2008A 2009E 2010E Operating 1, ,409.5 Capex Dividend Valuation 2008A 2009E 2010E Forward P/E 145.3x 22.6x 17.6x Forward P/B 7.5x 5.6x 4.3x ROE 5% 25% 24% ROA 1% 6% 8% ROIC 4% 9% 10% Misc BDT MM 2008A 2009E 2010E Total Debt MM 12, , ,080.1 Cash Debt/Equity 373% 276% 167% Debt/Asset 72% 66% 55% Lafarge Surma Cement Ltd. (LSCL) is an integrated cement manufacturing company in Bangladesh. Lafarge Group of France, one of the world leaders in building materials is the majority shareholder of LSCL. Although LSCL competes with a large number of cement manufacturers in the country, it has a few unique advantages. While all other manufacturers import clinker, only LSCL has the capacity to manufacture clinker in-house using limestone from a owned quarry. This provides the company the benefit of significantly higher gross margins. Because of its affiliation with Lafarge worldwide, LSCL is considered a leading brand in a competitive market, and it enjoys price premium because of a perceived quality leadership. Lastly, Lafarge has one of the largest production plant in the industry (1.2MT, expandable to 1.5MT). In a fragmented industry where smaller producers are being gradually squeezed out of the market, LSCL has the advantage of scale. As and when consolidation starts in the market, LSCL stands prepared to benefit because of its staying power. LSCL recently experienced a setback in sourcing limestone from its quarry in the Indian state of Meghalaya. The Supreme Court of India ordered a suspension on mining at the quarry till a full hearing takes place on March 19, Till then LSCL has been operating with previously mined limestone, which would last for about two more months. Since the suspension was announced, LSCL shares prices fell significantly on the Dhaka Stock Exchange (DSE). Since early February when the suspension order was made public, stock prices retraced by over 30%. We do not have a view as to the outcome of the Indian Supreme Court hearing in March. However, we assessed the upside from a favorable verdict and the downside from a permanent ban on mining, and on balance we find LSCL is an attractive stock at this price. We initiate coverage of LSCL with an OUTPERFORM rating and a 12- month target price of BDT 575. Our rating considers the upside from a favorable verdict by the Indian Supreme Court. We also took into account the sustainable advantages enjoyed by LSCL such as a price premium enjoyed by the company, LSCL s potential for achieving top and bottom line growth and an overall positive outlook for the consumption of cement in the country, especially in the backdrop of infrastructure investment. Our recommendation is based on a P/E of 20x an estimated 2011 EPS of BDT and on a 4.5x estimated 2011 book value of BDT With no expectation for a dividend in the immediate future, this target price implies an estimated total return of 30%. Although on a balance we find Lafarge an attractive investment, we still draw attention to the considerable risk associated with this stock. In case of a permanent ban on mining, Lafarge would have to look for some costly alternatives, and it may take a number of years for the company to return to profitability. The company may be liable for restoration of forest land, and the cost for such reclamation may be higher than the company's estimate Volume Close

2 Business Lafarge Surma Cement Ltd. (LSCL) is a majority owned subsidiary of Lafarge Group of France. The Lafarge Group is a global market leader in construction materials. With Euro 5.4 Billion in revenue, it is one of the largest manufacturers of cement by shipped volume. Lafarge is the largest producer of cement and among the top three producers of aggregates, concrete and gypsum in the world. Lafarge operates in 79 countries and employs 84,000 people. Lafarge is traded on the Paris Stock Exchange and has a market cap of Euro 13.7 Billion. Through a wholly owned subsidiary, Surma Holding, Lafarge owns majority (59%) shares of LSCL. The other institutional shareholders are IFC, ADB, Sinha Fashions and Islam Cement. LSCL was incorporated in Bangladesh in The production facilities are located in Chattak in the Sunamganj district in Northeast Bangladesh bordering the Indian state of Meghalaya. The production facilities consist of a dry process cement plant with a 1.5 million metric ton (MMT) capacity and a clinker production line of about 1.2MMT capacity. LSCL also operates two subsidiaries in the Indian state of Meghalaya. Among these two, partially owned (75%) Lum Mawshun (LMMPL) holds the mining rights with two local partners, and wholly-owned Lafarge Umiam Mining (LUMPL) carries out the mining operations. Limestone and shale are mined at the quarry and transported across the international border by a 17 kilometer long conveyor belt. The project has a 30 MW captive power plant that ensures uninterrupted energy supply. Figure 1: LSCL Plant in Sunamganj LSCL markets its cement under the brand name of Supercrete. It produces a general purpose cement that can be used with different kinds aggregates for various purposes. This product passes all local quality standards. The company markets its product in 50KG bags. Because of a perception of higher quality of Lafarge products, a 50KG bag of cement receives a BDT BDT premium on average over cement produced by local competitors. The company started its operations in 2005 while ago and could achieve capacity utilization of a satisfactory level only in 2008 (62%). The company faced some challenges in mining at its quarry and transporting the limestone to Bangladesh. Share Holding Structure Shareholding Number of shares Percentage Surma Holdings 34,184,935 59% IFC 5,387,400 9% ADB 5,797,000 10% Sinha Fashions Ltd. 1,755,000 3% Islam Cement Ltd. 1,595,710 3% Other shareholders 9,348,630 16% 58,068, %

3 Industry Lafarge Surma Cement Ltd. In terms of cement production, Bangladesh ranks about 40th in the world. Cement manufacturing is a highly fragmented business in Bangladesh. During the 1990s, many small cement companies entered the market as soon as the government started encouraging local production with favorable tariff differential. Currently 123 companies are listed as cement manufacturers in the country. Of them 63 have actual production capacity while about 30 do not have any production at all. The current installed capacity is 22.0 MMT. However, because of supply constraints for power and clinkers, the actual capacity is about 17.0 MMT. Bangladesh is one of the few sizable producers of cement that does not have its own supply of limestone and cannot produce clinkers domestically. Except for LSCL, all other cement manufacturers of Bangladesh are in essence grinders of clinkers. There is a strong tax-support for local cement manufacturers in Bangladesh. They receive a significant import tax advantage over finished cement (about 15% for raw-materials versus 100% for finished cement). This tariff differential helps most to operate profitably. A change in the tariff structure is not anticipated in the near future. Construction takes up an important role in the economy (about 10% of the GDP). Annual demand for cement in the country is about 10.0 MMT. Understandably the market has a capacity overhang. There is a small market for export of cement, mainly to the small northeastern states of India. However, the size of the export is quite small (about 200 KMT a year). There are four categories of cement consumers in the country. The largest with about 60% of the consumption are the individual homebuilders. This is also the most price sensitive segment. Real estate developers, especially in the country s urban area constitute about 8% of the market. Construction contractors constitute another 3% of the market. Lastly, various government projects take up about 30% of the total cement construction. Demand for cement was particularly weak in for several reasons. First, the anti-corruption drive of the military-backed caretaker government subdued expenditure of undeclared funds. Most of these funds usually go to the construction sector. Second, a rapid climb of raw materials and shipping costs in the global market escalated the price in the local market for cement and other construction materials, further squeezing consumers out of the market. Third, government spending in construction under the annual development programs (ADP), which constitutes a large part of the cement market, was particularly slow in these years. Consequently, many of the smaller and some major cement manufacturers operated at less that 50% capacity and incurred large losses during these years. Figure 2: Jamuna Bridge The industry realized about 20% sales growth in 2009, mostly because of the latent demand from last years. On a secular basis, ongoing demand growth is expected to be about 8%, The outlook for the cement industry seems positive for a number of reasons. First, the government seems to be on a war footing to increase both the amount and the efficiency of spending in social and physical infrastructure under the Annual Development Programs (ADP). Second, the private sector is also energized because of certain tax advantages for undeclared funds if they are invested in real estate. Third, a number of large infrastructure construction projects (such as the Padma Bridge) are on the horizon. Both the government and the private sector are soliciting funds for such projects. If implemented, these projects would significantly improve demand for construction materials. The largest 10 cement manufacturers hold about 70% of the market share. While Heidelberg, Holcim and Lafarge are the leaders among multinational cement manufacturers; Shah, Akij and MI are the leading domestic manufacturers. Shah cement is the market leader with close to 12% of the market share, closely followed by Heidelberg with about 10% of the market share.

4 Challenges Lafarge Surma Cement Ltd. On February 5, 2010, The Supreme Court of India ordered LSCL to stop mining operations at its quarry in Meghlaya. The order was the result of a lawsuit brought by Shella Action Committee, a civil rights group in Meghalaya. The lawsuit alleged that LSCL mortgaged the tribal land, on which the quarry is located, to foreign consortium lending to CSLM violating the country s law. The Supreme Court asked the company to stop mining, continue shipping the already mined limestone (about 2-month supply) and set March 19 as the date for next hearing. CSML contends that the company s use of the land followed legal processes and consultation with the rightful authorities at every stage, including the state government and the union government. They also contend that use of the land was cleared with the Khasia Darbar, the rightful representative of the tribal interests whereas Shella is an obscure non-local civic organization with no formal authority to represent the Khasia community. Before the next court appearance, the company is trying to gain support from various interested parties including the Khasia Darbar, the state government and the union government. According to the company, LSCL is a result of an agreement between the governments of India and Bangladesh, and both the governments have a moral obligation to support the company. In an earlier event in April 2007, the Indian Union Ministry of Environment and Forestry ordered a stop of mining on the ground that the company misrepresented the condition of the land and hid the fact that it was a forest land. A special bench of the Supreme Court allowed continuation of mining on an interim basis, in November 2007, till a full verdict is given on forest clearing. Because of the special status of the land (forest land) and the people inhabiting it (the tribal Khasias), the quarry is subject to the attention and interest of many different parties. It appears that LSCL s acquisition of this vital asset came with its share of headaches. LSCL management is optimistic that the law favors its position. They also point out that the state government and the governments of India and Bangladesh are supportive of the project for economic and employment reasons. The Meghalaya government is currently negotiating with Lafarge for the company to build another cement factory in the state, which would solely cater to the local demands and generate employment in a backward state. In other words, the state government has every incentive to keep Lafarge in business in the state. Options available to LSCL Even in the worst case that the Court puts a permanent ban on mining, LSCL is not without options. However, under any of these scenarios, the profitability of the company would suffer. There are other quarries in the region whose product are traded in the open market. Transport of limestone by boat and trucks is already an established practice for Chattak Cement Factory, a government owned manufacturer in the same area. Although it would need substantial capacity building, LSCL can meet part of its limestone requirement from importing locally traded limestone. Import of clinkers like other cement manufacturers is also an option, although very costly for LSCL. In such a case, the company would have to import cement via Chittagong, transport it to current plants in Sunamganj for grinding, and then send it back to Dhaka and other distribution centers. This may involve relocation of its grinding plant. Acquiring other grinders may also be an option for LSCL, although that would require additional capital outlay. As the cement sector consolidates, the larger companies such as LSCL gains market shares at the cost of smaller manufacturers. It is expected that in the end only the ten or so manufacturers, who currently hold about 70% of the market share would survive. In such a case, Lafarge can shift its manufacturing from Sunamganj to Dhaka by acquiring the facilities of the marginal producers.

5 Valuation Lafarge Surma Cement Ltd. Case 1: In the base case scenario, we have assumed that the company would be allowed by the Indian Supreme Court to resume mining of its quarry. We also made the following assumptions: 1. The company maintains a 40% D/E ratio by repaying current long-term debt and assuming new debt. 2. After paying off the debt from multilaterals, interest rates are slightly higher 3. Company s Interest expenses are significantly reduced as most of its debt are at floating rates, 4. With Rupee appreciating against Taka, there would be no translation loss or even may be a gain 5. Gross margin is maintained at the current 40% level 6. With an average of 8% growth each year, LSCL runs out of current capacity and goes for expansions in 2012 (to 1.5 MMT), in 2015 (to 1.8 MMT) and in in 2018 (to 2.0 MMT). Under these assumptions, we conducted a comparative as well as a discounted cash flow (DCF) valuation using free cash flow to equity method (FCFE). Lafarge valuation EPS BVPS 2011 estimates Multiple 20.0x 4.5x Target price Average Target price month target price Dividend yield 0 Total return 30% Discounted FCF, MM Operating Cash , , , , , , , , , , ,688.4 Capital Expenditure (359.1) (356.9) (354.8) (352.7) (876.4) (677.0) (458.1) (412.3) (411.0) (409.8) (408.6) (407.4) Change in Debt (217.6) (2,490.4) (1,501.1) (2,153.1) (972.7) (1,252.8) (422.9) (422.9) (437.8) , , , , , , , ,281.0 Net Terminal Value 96,906.9 Terminal Value 96,906.9 Terminal liabilities 2,485.0 FCFE (437.8) , , , , , , , ,187.9 Discount Rate 15% Terminal Growth Rate 8% NPV 28,162.1 NPV/Share Based on the valuation, our 12-month target price in BDT , which implies a price of 20x 2011 earning of BDT This target also implies a 4.5x 2011 BVPS of BDT This price target, if achieved, will provide a 12-month price-return of 30%.

6 Valuation Case 2: In case that the Indian Supreme Court puts a permanent ban on mining from its quarries, LSCL would look for alternatives. We have made the following assumptions regarding this scenario: 1. The company gross margin reduces by about 10% 2. LSCL slows down payment of debt; the company maintains a slightly higher debt levels (50% D/E ratio) 3. Company initiates cost cutting measures, reducing SGA costs from 5% of sales to 4.5% 4. The company will take at least two years and some capital outlay to adjust to the changed business model. We use 2012 results for our basis for valuation 5. With a change in the company s profitability, valuation multiples are contracted. We use a P/E ratio of 18.0x, instead of the 20.0x in the base case scenario. Also, as a potential relocation may render many of the capital assets useless, we use a lower P/B ratio of 3.0x. Based on the valuation based on these assumptions, our 12-month target price in BDT , which implies a price of 18.0x 2012 earning of BDT This target also implies a 3.0x 2012 BVPS of BDT This price target, if achieved, will provide a 12-month negative return of 21%. Lafarge valuation EPS BVPS 2012 estimates Multiple 18.0x 3.0x Target price Average Target price month target price Dividend yield 0 Total return -21%

7 Income Statement MM BDT E 2010E 2011E Revenue , , , , ,263.9 COGS (111.3) (2,532.4) (3,712.6) (4,571.3) (5,035.0) (5,512.0) Gross profit/loss 41.9 (132.6) 2, , , ,751.9 General and admin (164.7) (263.9) (362.0) (380.9) (419.6) (463.2) Selling and distribution (36.6) (108.5) (131.6) (114.3) (125.9) (139.0) Total expenses (201.4) (372.4) (493.6) (495.2) (545.5) (602.2) Other operating income Operating profit/loss (159.5) (344.4) 2, , , ,149.7 Exchange gain/loss (363.1) (331.8) Finance expenses (163.7) (1,138.3) (1,224.5) (852.3) (622.9) (513.1) Interest income Other expenses/ (income).3 (6.2) (94.5) Worker's welfare fund.0.0 (49.5) (85.3) (109.6) (132.0) Net profit/loss before tax (685.4) (1,377.8) , , ,507.9 Income tax (123.0) (307.3) (486.0) (625.0) (752.4) PAT (808.4) (1,096.5) , , ,755.5 Number of shares MM EPS Cash Flow Statement MM BDT E 2010E 2011E Operating Cash Flow Net Income 1, , ,755.5 Add Back Non-cash Expense Change in Working Capital (637.5) (43.6) Cash Flow from Operations (945.6) (1,157.9) 1, , ,165.2 Investing Cash Flow Disposal of assets Capital Expenditure (359.1) (356.9) (354.8) Cash Flow from Investing (2,268.4) (629.6) (272.5) (359.1) (356.9) (354.8) Financing Cash Flow Change in Debt (217.6) (2,490.4) (1,501.1) Dividend Paid Cash Flow from Financing (2,268.4) (629.6) (272.5) (359.1) (356.9) (354.8) Effect of foreign currency translation.0.8 (2.4) Net Cash (1,064.1) (437.8) Beginning Balance 1, Closing Balance Operating cash per share (16.28) (19.94)

8 Balance Sheet MM BDT E 2010E 2011E Current assets Inventories , , , ,852.8 Trade receivables Advances, deposits & prepayments Derivative instruments-assets Cash and cash equivalents Total current assets 1, , , , , ,789.3 Fixed assets Property plant and equipment 15, , , , , ,694.1 Intangible assets Deferred income tax assets Total fixed assets 15, , , , , ,962.2 Total assets 17, , , , , ,751.4 Current liabilities Trade payables , , ,389.6 Other payables Derivative instruments-liabilities Current portion of long term debt , , , ,117.5 Bank overdrafts , , , Short-term debt 1, , , , , ,452.1 Income tax payable Total current liabilities 3, , , , , ,374.9 Long term liabilities Long term debt 9, , , , , ,602.5 Lease obligation Deferred tax Total long term liabilities 9, , , , , ,602.5 Equity Share capital 5, , , , , ,806.9 Accumulated loss (1,839.9) (2,708.4) (2,531.9) (1,398.0) ,815.9 Foreign currency translation Share holder's equity; parent company 4, , , , , ,773.7 Share money deposits Total equity 4, , , , , ,774.1 Total liabilities and equity 17, , , , , ,751.4

9 Indicators Indicators E 2010E 2011E 2012E Grey cement Capacity '000 MT 1,500 1,200 1,200 1,200 1,200 1,200 Sales '000 MT ,089 1,198 Capacity utilization 22% 62% 75% 83% 91% 100% Clinker Capacity '000 MT 1,150 1,150 1,150 1,150 1,150 1,150 Sales '000 MT Capacity utilization 81% 57% 90% 98% 98% 98% Sales growth NM 159% 23% 10% 10% 11% Earning growth NM NM 542% 29% 20% 17% Gross profit margin NM 40% 40% 40% 41% 41% Operating margin NM 35% 34% 34% 34% 34% Net margin NM 3% 15% 17% 19% 20% Total debt Tk. MM 13, , , , , ,426.0 Debt/Total equity 421% 373% 276% 167% 110% 65% Effective tax rate 20% 64% 30% 30% 30% 30% Per share figures Number of shares (MM) Earning per share (EPS) x 3.04x 19.53x 25.11x 30.23x 35.27x Dividend per share 0.00x 0.00x 0.00x 0.00x 0.00x 0.00x Payout ratio 0% 0% 0% 0% 0% 0% Return on equity -34% 5% 25% 24% 23% 21% Return on assets -6% 1% 6% 8% 9% 11% Book value per share

10 IMPORTANT DISCLOSURES Analyst Certification: Each research analyst and research associate who authored this document and whose name appears herein certifies that the recommendations and opinions expressed in the research report accurately reflect their personal views about any and all of the securities or issuers discussed therein that are within the coverage universe. Disclaimer: Estimates and projections herein are our own and are based on assumptions that we believe to be reasonable. Information presented herein, while obtained from sources we believe to be reliable, is not guaranteed either as to accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation of the purchase or sale of any security. As it acts for public companies from time to time, BRAC-EPL may have a relationship with the above mentioned company(s). This report is intended for distribution in only those jurisdictions in which BRAC-EPL is registered and any distribution outside those jurisdictions is strictly prohibited. Compensation of Analysts: The compensation of research analysts is intended to reflect the value of the services they provide to the clients of BRAC-EPL. As with most other employees, the compensation of research analysts is impacted by the overall profitability of the firm, which may include revenues from corporate finance activities of the firm's Corporate Finance department. However, Research analysts' compensation is not directly related to specific corporate finance transaction. General Risk Factors: BRAC-EPL will conduct a comprehensive risk assessment for each company under coverage at the time of initiating research coverage and also revisit this assessment when subsequent update reports are published or material company events occur. Following are some general risks that can impact future operational and financial performance: (1) Industry fundamentals with respect to customer demand or product / service pricing could change expected revenues and earnings; (2) Issues relating to major competitors or market shares or new product expectations could change investor attitudes; (3) Unforeseen developments with respect to the management, financial condition or accounting policies alter the prospective valuation; or (4) Interest rates, currency or major segments of the economy could alter investor confidence and investment prospects. BRAC EPL Investments Capital Markets Group Aminul Haque Head of Capital Markets amin@bracepl.com Md. Monirul Islam Research Analyst monirul@bracepl.com Parvez Morshed Chowdhury Research Analyst parvez@bracepl.com Ali Imam Investment Analyst imam@bracepl.com Asif Khan Investment Analyst asif@bracepl.com Md. Ashfaque Alam Research Associate ashfaque@bracepl.com Khandakar Safwan Saad Research Associate safwan@bracepl.com BRAC EPL Research WW Tower (8 th Floor) 68 Motijheel C/A, Dhaka-1000 Tel: Fax: research@bracepl.com