SAUDI ARABIAN CEMENT. Revival in December 29, 2016

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1 December 29, 2016 SAUDI ARABIAN CEMENT Revival in 2017 Cement sector in Saudi Arabia ends the year with a dismay, as overall construction slowdown has affected the sector largely. However, sector price performance has been robust after markets rallied by +29% in 4Q and factors that drove such bullishness are i) government regaining sector s confidence after it settled contractor s payments ii) bond issuances boosting the country s fiscal situation iii) lifting the export ban on cement sector through an export fee. However, such news flows drove sentiments on prices but companies are yet to see the reflection in earnings performance. Overall cement prices remains subdued as large inventories continues to affect the pricing power after demand toned down in We expect 2017 to be better as budget for the next year has brought in some cheer for an otherwise ailing sector. We believe spending patterns are likely to increase as deficit pressure eases in 2017 with deficit expected to be lower by 33% from Double-digit decline in production levels With the end of 4Q and almost 11 month of industry numbers available, we conclude 2016 to be a year of slowdown, with cement production over the quarter to be weak. A combination of weaker demand and excess inventory in the system has led to many producers constrain their production levels despite the element of high fixed costs. As a result, cement production is expected to reach 12.9 MT in 4Q2016, an increase of +17% Q/Q and a decline of -20% Y/Y. Though an increase on Q/Q is just a base adjustment of lower economic activity in 3Q, the Y/Y decline implies the exact nature of underlying situation. According to sector monthly data, 8.6 MT of cement is already produced in the first two months of this quarter and we expect another 4.3 MT of cement in December. Historical trends also suggest that 4Q demand levels were high in last two years with an average of 15.4 MT; but unlikely this year. Overall, cement production is expected to end the year with 55.9 MT, recording a drop of -9% Y/Y. Inventory balances continues to pinch Industry inventories of 27.7 MT (table-1) have increased by +21% since the beginning of 2016 and recorded a new level over the years. This accounts for 50% of production levels over the last 12 months and 45% of current rated capacity. Though lifting the ban on exports is good news for the industry, but government imposing a heavy export fees to adjust the benefit of subsidy, turns to be a dampener. The export fees per ton of cement ranges from SAR 85 to SAR 133, which makes limited economic viability for producers, as prices in the neighboring markets also remains subdued. Additionally, cement transportation costs are high for markets in MENA region, which implies low margins. We believe exports beyond MENA markets makes limited cost benefits for producers and plans to enter European markets is not feasible due to heavy anti-dumping duty imposed by respective markets apart from high shipping costs. Overall, inventory glut is a net negative but expected to be minimal for certain producers operating out of western and central region which are high demand centers, however few producers in northern and southern region faces the brunt of excess inventory. Page 1 of 5

2 Sales volumes to decline by -20% Y/Y Industry sales volumes are expected to touch 12.8 MT in 4Q2016, with increase of +20% Q/Q as economic activity picks up after a slow 3Q, however it is likely to register a drop of -20% Y/Y. Volumes for the first two months are currently at 8.5 MT and expected to add another 4.3 MT in December. With lower cement demand due to weak construction activity, we expect sales volumes of 4.3 MT in December, which is in sharp contrast to 5.3 MT in same month last year. Overall, we expect sales volumes for the year to touch 55.0 MT for 2016 versus 60.4 MT in 2015, a decline of -9%. Sales volume expected to touch 7.3 MT For companies under our coverage, we forecast 7.3MT of sales volume in 4Q2016, a decline of - 15% Y/Y. Data over the months, the first two months show that only Yanbu cement registered a growth of +3.5 Y/Y while most producers witnessed a decline on a Y/Y basis. The most prominent was Southern which witnessed a drop of -24% Y/Y followed by Yamama with -17% and Saudi with -14%. Qassim also witnessed similar range of decline with -15%. We expect sales volume to drop in December also for our coverage group. Page 2 of 5

3 Weak realization leads revenue to decline of -17% Y/Y Revenues are expected to witness a decline in 4Q2016 as realization over 9M2016 has dropped significantly by -8% to SAR 221/ton and by -5% to SAR 224/ton for our coverage group amid low sales volumes. The revenue numbers from 9M2016 declined by -12% to SAR 9.3 billion from SAR 10.6 billion in 9M2015. Overall, we expect a drop of -10% in revenue for the sector in Revenue for the coverage stocks is at SAR 1.7 billion in 4Q2016E, a decline of -17% Y/Y from SAR 2.1 billion in 4Q2015. Earnings to decline by -25% Y/Y We expect operating income (refer table-3) for the companies under our coverage to fall by -21% Y/Y to SAR 834 million as impact of price discounts, higher energy costs to affect profitability. A large shift in demand from northern and southern provinces has put those seasoned producers under the dock, leading to high transportation costs in order to access and compete in new markets at low prices and margins. The impact of fuel hikes has affected producers since 1Q2016 wherein margins dropped by nearly bps which we opined in our report during 1Q2016. On the earnings front, we expect a -25% Y/Y decline in earnings for 4Q2016 to SAR 759million as margins weakened. We expect non-operating income to improve for companies with trading portfolio s, as sharp rally of +29% in TASl since the start of 4Q could propel investment income. Margins squeeze, a scenario since 2015 Amongst our coverage, Yamama is expected to witness a drop in margins because of changes in its depreciation cycle, while Southern cement also is likely to witness similar depreciation impact (already in 3Q) due to introduction of Tihama production line. We expect the overall impact of energy and transportation costs is likely to squeeze margins across producers, which we already discussed in our earlier previews. The extended impact of low utilization with some producers could be more visible in the coming quarters. Overall, we could see operating margins fall to 48% for 4Q2016 from 52% in 4Q2015 while net margins to fall to 44% from 49% in 4Q2015. Sector valuations look valued For now, we maintain our target prices but adjust our ratings as per our rating criteria mentioned in page 5. We revise the ratings from Buy to Neutral for all stocks as our 12-month target price has breached over the short term following the recent rally. We might revisit our outlook post earnings cycle in 4Q2016. We refer this adjustment as TASI re-rates to new valuation territory following government s announcements on delayed contractor payments and positive sentiments from budget announcement recently. Over the quarter, sector rallied by 24% but still lower than TASI s 29%. Valuation for the sector now stands at 12.3x for 2017E (consensus) though at a 22% discount to TASI s 2017E P/E of 15.6x. Page 3 of 5

4 Amongst the group, Southern Cement was the best outperformer during the quarter with a +30% return followed by Saudi Cement with a +28% increase in stock prices. Currently Yanbu Cement, offers best valuation profile with 2017E P/E of 11.2x and yields of 7.4%, while Qassim trades at expensive levels with a P/E of 14.7x and lower yields of 5.9%. Page 4 of 5

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