KEY RISKS ON THE HORIZON

Transcription

1 KEY RISKS ON THE HORIZON CEMENT SECTOR 11 th July 2017 Sohaib Subzwari Research Entity Notification No.: REP-116 See last page for analyst certification and other important disclosures

2 Cement Sector Table of Contents Investment summary Macroeconomic growth at risk Domestic cement demand trends Subdued exports Looming capacity surplus Rising input costs Squeezed profitability margins Expensive valuations

3 Investment Summary Key Risks On The Horizon Aggravating external account concerns in the shape of current account deficit widening by 132% Y/Y to USD 10.6 bn in 11MFY17 amid draining foreign exchange reserves raise question marks over sustainability of balance of payments position and thus stability of currency, which is widely considered to be overvalued in the range of 20-25%. PKR bears an understandable relationship with key macroeconomic variables. Sharp currency devaluation in the wake of deteriorating balance of payments position, as has been the case in the past, may create inflationary pressures besides forcing the government to knock on the doors of IMF for BOP support. In addition to an upward revision in interest rates, fiscal austerity measures, such as cut in PSDP spending, can also be expected under the IMF program thereby cooling down broader economic activity. With domestic cement demand bearing a strong relationship with Gross Fixed Capital Formation and GDP, we anticipate a slowdown in local dispatches as PKR adjusts to equilibrium similar to the case witnessed post debacle. On the other hand, exports have entered 8 th consecutive year of decline since their peak in owing to a combination of PKR overvaluation, imposition of anti-dumping duties by certain countries, and fierce competition from regional giants. In this backdrop, cement industry is set to install approx. 27 mn tons of additional capacity in anticipation of continuation of robust domestic demand, excluding FCCL, taking total industry capacity to 74 mn tons by FY20. Our estimates suggest that industry capacity utilization may drop significantly to 59% in FY20 from 85% in FY16. Nonetheless, historical evidence suggests that retention prices tend to come under pressure as soon as new capacities start coming online. The trend can be validated by recent commissioning of CHCC s 1.3 mn ton capacity, which already put final prices in Peshawar under severe stress. PKR depreciation may also bode negatively for the sector in the form of increased cost of inputs. The cost of imported coal, used as the main fuel for kiln, shall escalate whereas furnace oil used for captive power generation will also get expensive. Natural gas tariff shall also creep up due to costly LNG imports and large returns required to compensate for growing network of gas distribution utilities. Worsening circular debt on the back of higher fuel costs and large capacity payments for LNG and Coal power plants shall push electricity grid tariff higher. Lastly, the valuation argument isn t compelling either with our sample of 9 listed cement companies trading at an Enterprise Value of USD 114/Ton against avg. plant setup costs of USD 86/Ton. Also, we believe a sector P/E of 13.3x, 19% premium to KSE-100 index P/E with fundamentals nearing peak, is not justified.

4 MACROECONOMIC GROWTH AT RISK

5 10MFY MFY17 Current account deficit widens 132% Y/Y in 11MFY17 Non-oil non-machinery trade deficit reaches a record USD 6.4 bn External account concerns appear to be aggravating with current account deficit expanding by 132% Y/Y to USD 10.6 bn in 11MFY17, primarily on account of trade deficit of goods stretching by 38% Y/Y to USD 23.7 bn. Against widely held belief that machinery imports are driving the trade deficits, it is pertinent to mention here that non-oil non-machinery imports (both consumer and industrial) are the major culprits. Non-oil non-machinery trade balance, which averaged a surplus of USD 1.6 bn between FY04 and FY15, has turned into a massive deficit of USD 6.4 bn or 2.5% of GDP in 10MFY (2) (4) (6) (8) (10) (12) (14) (16) USD BN Current Account Balance Expansionary monetary and fiscal policies coupled with an overvalued exchange rate have stimulated aggregate demand and thus imports, pushing current account deficits into an unsustainable territory USD BN Non-oil non-machinery trade balance Workers remittances, which absorbed large trade deficits in the past, have also stagnated given severe financial crunch in the GCC. - (2) Ideally, growing domestic demand should be financed through FDI but the numbers have remained dismal thus far owing to a host of structural issues. (4) (6) (8) Source: SBP, Zakheera, Next Research

6 P 2018P MFY17 An uncanny resemblance with the year Current account deficit projected to reach USD 17 bn in FY18 Large current account deficits to push BOP into deeper red 10 USD BN 5 - (5) (10) (15) BOP & PKR hold a decent correlation of -0.7 with one period lag 6 USD BN (2) (4) 30% 25% 20% 15% 10% 5% 0% -5% (20) (6) -10% Current Account Balance Balance of Payments Balance of Payments PKR/USD (%Y/Y) Source: SBP, Zakheera, Next Research

7 Eyeing sharp FX drawdown unless FDI picks up PKR depreciation critical to addressing external woes Depleting FX reserves to create pressure on PKR 25 USD BN % 25% 20% 15% 10% 5% 0% Inflation shall creep up and reversal in interest rate cycle likely 30% 25% 20% 15% 10% 5% 0% -5% - -5% -10% FX Reserves PKR/USD (%Y/Y) Discount Rate Inflation PKR/USD (%Y/Y) Source: SBP, Zakheera, Next Research

8 Another round of IMF program likely Fiscal indiscipline reigning today, buckle up for austerity tomorrow The incumbent government has ramped up consolidated PSDP spending from PKR 695 bn in FY13 to revised estimate of PKR 1.5 tn in FY17, and proposed to further increase to PKR 2.1 tn in FY18 budget. The colossal spending aims to boost GDP growth rate by providing further impetus to aggregate demand besides serving the purpose of attaining popularity running into the election year. Large current account deficits have already put FX reserves under pressure, which have retreated to USD 21 bn from a high of USD 24 bn. Further acceleration in spending will only pull current account deficit and balance of payments into deeper red, thereby compelling the government to resort to IMF for BOP support. IMF reforms have always called for curtailing fiscal slippages in order to keep rising debt levels in check. A cut in PSDP spending and/or imposition of increased taxation measures can be anticipated. At the same time, rising inflation may also trigger a reversal in interest rate cycle, which in combination with public spending cut can be expected to ease broader economic activity and GDP growth. 1,400 1,200 1, PKR BN PSDP Spending Source: MoF, Zakheera, Next Research

9 Slowdown in broader economic activity likely GFCF growth bears a reasonable correlation of -0.7 with PKR/USD USD Nominal GDP Growth vs PKR/USD 30% 25% 20% 15% 10% 5% 0% -5% -10% Gross Fixed Capital Formation Growth vs PKR/USD 40% 35% 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% GDP Growth PKR/USD (%Y/Y) GFCF Growth PKR/USD (%Y/Y) Source: PBS, Zakheera, Next Research

10 DOMESTIC CEMENT DEMAND TRENDS

11 FY91-96 FY96-02 FY02-08 FY08-13 FY13-16 Domestic Cement Demand & Gross Fixed Capital Formation Slowdown in GFCF poses risk to cement demand growth A vibrant relationship is visible Comparing CAGRs for different periods 40% 35% 20.0% 18.0% 18.0% 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% 16.0% 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 6.7% 5.3% 0.7% 0.2% 14.9% 2.1% 0.6% 9.6% 8.0% Local Dispatches Growth GFCF Growth Local Dispatches GFCF Source: PBS, Zakheera, APCMA, Next Research

12 FY91-96 FY96-02 FY02-08 FY08-13 FY13-16 Domestic Cement Demand & GDP Growth and so does slowdown in GDP growth USD Nominal GDP Growth vs Local Dispatches Growth 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% Comparing CAGRs for different periods 18.0% 16.0% 14.9% 15.3% 14.0% 12.0% 10.0% 8.0% 6.8% 6.0% 5.3% 4.0% 2.3% 2.0% 0.7% 0.0% 2.1% 9.6% 6.4% 6.4% Local Dispatches Growth GDP Growth Local Dispatches Nominal GDP Source: PBS, Zakheera, APCMA, Next Research

13 FY91-96 FY96-02 FY02-08 FY08-13 FY13-16 Reasonable relationship with PSDP spending too A PSDP cut may also have negative implications for local demand The two variables carry a correlation of % Comparing CAGRs for different periods 30.0% 60% 50% 40% 25.0% 20.0% 24.1% 19.5% 30% 20% 15.0% 14.9% 10% 0% -10% -20% -30% 10.0% 5.0% 0.0% 5.3% 7.6% 0.7% 4.6% 2.1% 9.0% 9.6% Local Dispatches Growth PSDP Growth Local Dispatches PSDP Source: PBS, Zakheera, APCMA, Next Research

14 SUBDUED EXPORTS

15 8 th consecutive year of decline with a CAGR of -8.3% Outlook remains depressed in the wake of fierce regional competition Multiple factors can be blamed for the incessant decline in exports including lack of competitiveness due to PKR overvaluation, imposition of anti-dumping duties by certain countries, and stiff competition from regional players. We believe robust local demand amid rising capacity utilization levels had also lowered the motivation of industry participants for exports in the wake of higher margins available on local sales. Domestic sales entail substantially higher margins than exports sales thanks to availability of 20% regulatory duty protection, besides freight cost savings MN TONS The risk of economic slowdown in China has forced its cement producers to resort to international markets to export surplus. With large economies of scale, we believe it is near to impossible for Pakistani manufacturers to compete with Chinese producers. 4 2 Lifting of sanctions has also opened up room for Iran to return to cement exports market, with ample surplus capacity available. Pakistani players have already lost a material chunk of market share to Iranian producers in the traditional export market of Afghanistan. - Exports Dispatches Source: APCMA, Next Research

16 LOOMING CAPACITY SURPLUS

17 Adding capacities to meet growing domestic demand 27 million tons of incremental capacities (57% of existing) in pipeline Expansions Location COD Assumed Capacity Attock Cement Lasbela Mar-18 1,260,000 Bestway Cement Farooqia Jul-18 1,890,000 Cherat Cement Nowshera Jul-19 2,236,500 D.G. Khan North Dera Ghazi Khan Oct-18 2,205,000 D.G. Khan South Lasbela Apr-18 2,835,000 Flying Cement Lilla Jul ,000 Gharibwal Cement Jehlum Jul-19 2,520,000 Kohat Cement Kohat Jul-19 2,340,000 Lucky Cement - North NA Jul-19 2,299,500 Lucky Cement - South Karachi Mar-18 1,260,000 Maple Leaf Cement Daudkhel Oct-18 2,299,500 Pioneer Cement Kushab Jan-19 2,520,000 Power Cement Dadu Apr-19 2,472,750 Source: Annual Reports, Corporate Annoucements, Next Research

18 P 2019P 1999 Capacity utilization may drop below 60% Retention prices tend to come under pressure as soon as new capacities come online 100% 90% 80% 70% 60% 50% 40% 30% 20% PKR/Bag 90% 80% 70% 60% 50% 40% 30% 20% 10% 50 10% 0% - 0% Utilization (Total Sales) Utilization (Local Sales) Retention Price Industry Utilization Source: APCMA, Next Research, Annual Reports

19 P 2018P 2019P 2020P Profitability margins bear cyclical relationship with utilization levels South region runs higher risks Gross profit margins running close to previous high Utilization levels based only on local dispatches 90% 100% 80% 70% 60% 50% 40% 90% 80% 70% 60% 50% 40% 73% 69% 78% 76% 85% 84% 81% 54% 57% 48% 30% 30% 20% 20% 10% 10% 0% 0% Gross Profit Margin Industry Utilization North Utilization (Local Sales) South Utilization (Local Sales) Source: APCMA, Next Research, Annual Reports

20 Jun-16 Jun-16 Jul-16 Aug-16 Aug-16 Sep-16 Oct-16 Oct-16 Nov-16 Dec-16 Dec-16 Jan-17 Feb-17 Mar-17 Mar-17 Apr-17 May-17 May-17 Jun-16 Jun-16 Jul-16 Aug-16 Aug-16 Sep-16 Oct-16 Oct-16 Nov-16 Dec-16 Dec-16 Jan-17 Feb-17 Mar-17 Mar-17 Apr-17 May-17 May-17 Price war seems possible Prices in north already showed signs of weakness post CHCC s expansion Average cement prices in the north declined significantly 600 PKR/Bag CHCC s new capacity put cement prices in the north under pressure 580 PKR/Bag North South Peshawar Rawalpindi Islamabad Lahore Multan Source: PBS, Next Research

21 Price consensus restored for now DGKC s expansion in South likely to resume pressure Sharp spike in cement prices during the first week of Jun-2017 hints at restoration of pricing consensus. The manufacturers may increase prices further soon to pass on the impact of increased FED, announced in FY18 budget, to final consumers. However, we believe the pricing arrangement is unlikely to last for long with DGKC adding a large capacity in South at a time when demand growth runs the risk of a slowdown Mn Tons 8.2 It should be noted that DGKC s expansion makes up approximately 35% of FY17E total dispatches including exports. Moreover, European origin of new South Plant is likely to result in higher fixed costs for the company, which demand higher utilization levels for improved economies of scale. Growth in domestic dispatches in South can already be seen slowing down post completion of Gwadar Port. Domestic dispatches growth has eased to 12% in 11MFY17 from 25% in FY16. Hence, we believe substantial drop in region s utilization level post commissioning of DGKC s new capacity is likely to bring cement prices under pressure, with North region experiencing spillover effect as well South Dispatches (FY17E) 2.8 DGKC's South Expansion Source: APCMA, Next Research

22 RISING INPUT COSTS

23 PKR depreciation may also bloat the cost of inputs Coal is imported whereas furnace oil is priced on import parity basis USD/Ton 80,000 70,000 PKR/Ton 60, , , ,000 20, , Coal Furnace Oil Price (Excluding GST) Source: Zakheera, Next Research

24 Gas tariff may rise owing to costly LNG imports and expanding network Large capacity payments amid worsening circular debt shall push grid tariff further USD/MMBTU LNG Source: Zakheera, Next Research

25 SQUEEZED PROFITABILITY MARGINS

26 1999 Lower Retention Prices + Higher Input Costs = Squeezed Margins Gross profit margins have reached close to previous high Being a commodity business, profitability margins of the cement industry are cyclical in nature, bearing strong correlation with economic activity. A combination of healthy pricing power amid robust domestic demand and lofty utilization level coupled with decelerating input costs allowed the industry to enjoy vibrant gross profit margins, reaching close to previous high of 50%. We have used BWCL s historical financial data as a proxy for industry estimates, due to limited availability of data. The cement industry should be credited for attaining cost efficiencies in the form of conversion to coal, installation of WHR plants, RDF, and TDF facilities, which have also contributed to margins accretion over the years. Moreover, it should be noted that the industry s balance sheet are in a much better position today than it was a decade ago, owing to lower levels of financial leverage. Nonetheless, margins are bound to correct with fundamental tides turning against the sector in the shape of new capacities coming online. 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Gross Profit Margin Industry Utilization Source: Annual Reports, APCMA, Next Research

27 20% duty protection to an exporting industry can be questioned An average of 37% of FY16 earnings can be attributed to regulatory duty protection Company FY16 Local Dispatches C&F Price Duty Protection Exchange Rate O/S Shares EPS Impact FY16 EPS Contribution Million Tons USD / Ton USD / Ton PKR / USD Million PKR / Share PKR / Share % LUCK % DGKC % ACPL % FCCL , % MLCF % BWCL % CHCC % KOHC % PIOC % FECTC % Source: Annual Reports, Next Research

28 EXPENSIVE VALUATIONS

29 Plant setup costs look cheaper 19% premium to KSE-100 P/E (trailing) with peak margins is questionable Comparing Industry EV/Ton with Plant Setup Costs Comparing P/E Ratio (trailing) with KSE-100 Index USD Based on existing capacity Based on projected capacity Avg. Plant Setup Cost Cement Sector KSE-100 Our sample includes LUCK, DGKC, ACPL, BWCL, FCCL, MLCF, PIOC, CHCC, KOHC Stock prices as of 6 th July 2017 Source: Zakheera, Financial Reports, Next Research

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