Company Report. Buy. Reaching new horizons. September 3, For important disclosure and analyst certification, kindly refer to end of the report

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1 Reaching new horizons Company Report September 3, 2012 Construction and Materials We are initiating our coverage on Kohat Cement Company Limited (KOHC) with DCF based December 2012 target price of PKR 103.6/share, offering a striking upside potential of 84.8% from closing price of PKR 56/share. The core of our investment case for the scrip revolves around strong cement pricing, cooling off coal prices and healthy demand outlook. In addition to these, KOHC has been aggressively prepaying its long term loans, which is not only decreasing its fixed cost but also creating room for healthy payouts for equity investors. The stock is currently trading at FY13F PER of 2.9 offering a 42% discount to the AHL Cement Universe Stocks PER of 5.1x. It s all about the cement price Strong pricing scenario in the domestic market has been the driving factor for the cement industry. Retail prices in the domestic jumped by 18.3% YoY, which has turned around the company with ~ 26x YoY earnings growth expected in FY12 to PKR 1.6bn (EPS: PKR 12.52) compared to PKR 64mn (EPS: PKR 0.49) in FY11. Buy Target Price Last Closing 56.0 Upside 84.8% KSE Code KOHC Bloomberg Code KOHC PA Shares Market Cap (US$ m) 75.9 Outstanding Shares (m) Free Float 30.0% 12M Avg. Daily Turnover (m) M High/Low (PKR) 56.12/5.25 Major Shareholders Sheikh Family While healthy demand supports volumetric growth KOHC has achieved a 12% YoY growth in sales volume during FY12, a massive outperformance compared to the industry, which grew by 3.5% YoY. The company achieved a 4 years high capacity utilization of 59% in FY12, highest since it started operations of its expansion project. We expect company s volumes to grow at 4 years CAGR of 4% to 1.9mn tons in FY16 from 1.7mn tons in FY12, with domestic demand and exports improving at CAGR 4.5% and 1.5% respectively. Aggressive deleveraging to reduce fixed cost The company has achieved a phenomenal turnaround in financial stability. A couple of years back KOHC was finding it difficult to service its loans and had to reschedule them. However strong pricing scenario helped the company not only to retire its scheduled debt obligations but also prepay PKR 1.1bn in 2HFY12. This will result in a 49% YoY reduction in financial charges to PKR 301mn in FY13. Strong cash generation creates a room for payout As per our estimates, KOHC is likely to generate FCFE of around PKR 4/share and PKR 8/share in FY12 and FY13, respectively. With no major capex in the pipeline, the board of the company might decide to opt for cash distribution. We are of the view that financials of the company do allow a cash dividend of PKR 2.5/share and PKR 4/share in FY12 and FY13, respectively. Financial Highlights PKR mn FY10A FY11A FY12E FY13F FY14F FY15F FY16F Revenues 3,692 6,085 9,300 10,539 10,809 11,224 11,656 Net Profit (328) 64 1,611 2,425 2,401 2,416 2,468 EPS (PKR) (2.55) DPS (PKR) P/E n.m P/B ROE 15.5% 3.1% 58.6% 55.8% 38.4% 29.7% 24.5% ROA 3.8% 0.7% 17.7% 26.1% 24.7% 22.7% 20.4% Source: Company Financials Stock Performance 1050% Banks & Financial institutio ns, 0.6% 850% 650% 450% 250% Source: Bloomberg Analyst Syed Abid Ali abid.ali@arifhabibltd.com General Public, 39.2% Shareholding Others, 2.9% For important disclosure and analyst certification, kindly refer to end of the report 50% Aug11 Sep11 Oct11 KOHC Nov11 Dec11 Jan12 Feb12 KSE100 Mar12 Apr12 Directors & Associat es, 57.4% May12 Jun12 Jul12 Aug12

2 Valuation Summary Our Free Cash Flow to Firm (FCFF) based December 2012 target price for KOHC works out to PKR 103.6/share, translating into a striking upside potential of 84.8% from closing price of PKR 56/share. Our valuation is based on the cost of equity 17.7% a weighted average cost of debt of 7.9% and a terminal growth rate of 3%. Due to considerable changes in the capital structure as the company is following aggressive loan retirement strategy, we have calculated separate WACC for ever year to incorporate the rapidly changing capital structure. Discounted Cash Flow Valuation PKR mn FY12 FY13 FY14 FY15 FY16 FY17 Terminal EBIT (1t) 2,066 2,622 2,452 2,383 2,346 2,224 Add: Depreciation Add: Changes in Working Capital 224 (24) (44) (335) (400) (61) Less: Capital Expenditure (139) (150) (150) (150) (150) (150) Free Cash Flow 2,432 2,727 2,544 2,188 2,090 2,311 16,145 WACC 12.3% 14.4% 16.3% 17.1% 17.7% 17.7% Present Value 2,578 2,551 2,028 1,475 1,183 1,108 7,743 WACC Parameters Risk Free Rate 10.5% Market Return 17.5% Beta Cost of Equity 17.7% Cost of Debt 12.1% After tax Cost of Debt 7.9% WACC (FY12) 12.3% AHL Research Terminal Growth Rate 3.00% NPV 10,925 NPV of Terminal Value 7,743 Enterprise Value 18,668 Less: Net Debt 5,333 Equity Value 13,335 No. of Shares (mn) 129 Target Price (PKR) Dec Risks to Valuation Cement Price Risk Our valuations are extremely sensitive to the cement price; every PKR 5/bag change in our assumption changes our earnings estimates by PKR 0.72/share or 4%. Coal Price Risk Cement manufacturing is an energy intensive process, with coal constituting around 50% of the total manufacturing cost. This makes our earnings and valuation extremely sensitive to the coal prices. Every USD 5/ton change in our coal price assumption has an EPS impact of PKR 0.8/share or 4%. Electricity Price Risk Electricity is the second largest cost component after coal for (20% of total cost). We have assumed a power tariff of PKR 9/kwh with a 3% annual growth, every PKR 1/kwh deviation in our estimates changes the bottom line with PKR 0.96/share or 5%. Electricity availability Risk Despite having a captive power plant of 22.6MW, KOHC relies completely on national grid due to expensive oil based power generation. Power disruptions can cause a production halt, as witnessed in July12, however we believe that the company can manage the risk as it has a low capacity utilization (~60% in FY12), which forms a blessing in disguise. 2

3 Strong pricing still driving the momentum Strong pricing scenario in the domestic market has been the driving factor for the cement industry. Retail prices in the domestic jumped by 18.3% YoY, averaging around PKR 419/bag in FY12 compared to PKR 354/bag in FY11. Despite hawkish stance of Competition Commission of Pakistan and an oversupply of around 13mn tons, cement prices in the domestic market have remained resilient around PKR 440/bag since April We believe that the pricing power of the industry to remain strong in medium term. Our confidence in the pricing power has emanated from our discussion with the managements of cement companies both in Northern and Southern regions, which forms a consensus of no price war scenario. Here we outline a brief thesis on cement price resilience in medium term. For detailed discussion please refer to 2 nd page of our last update on Lucky Cement Limited. Retail Cement Prices; Resilience to sustain PKR /bag Jun10 Aug10 Oct10 Dec10 Feb11 Apr11 Jun11 Aug11 Oct11 Dec11 Source: Pakistan Bureau of Statistics Feb12 Apr12 Jun12 Aug12 Pricing war or breaking up of status quo normally comes from a large cement manufacturer. However large cement manufacturers are either recovering from low profitability cycle of FY0911 (DGKC, BWCL, MLCF) or have huge investment plan in the pipeline (LUCK with ~PKR 13.5bn investment in FY13), which makes it highly unlikely for them to initiate a price war. Pricing consensus even prevailed during the period of dull demand; thus we find breaking up of consensus highly unlikely, when demand is picking up. Though coal prices have fallen by 15% since 4QFY12, however falling rupee has reduced its full benefit. In addition rising electricity and gas prices are still fueling the cost pressures, which may keep cement manufactures from reducing prices. We have assumed per bag ExFactory prices of PKR 375 and PKR 370 for FY13 and FY14, respectively, compared to PKR 385/bag prices during 4QFY12. Following table reflects the sensitivity of our ExFactory price assumption on earnings and target price. Sensitivity Analysis of ExFactory Prices FY13F FY14F FY15F Target Price Base Case Prices EPS PKR Scenario1: Increment by PKR 10/bag Scenario2: Increment by PKR 5/bag Scenario3: Base Case Scenario4: Reduction by PKR 5/bag Scenario5: Reduction by PKR 10/bag Healthy demand outlook to further support revenues KOHC has achieved a 26.5% YoY growth in domestic sales during FY12, a massive outperformance compared to the industry, which grew by an 8.8% YoY. Exports on other hand suffered a steep decline of 29.6% YoY to 273k tons; reducing total growth to 12%, still better than the industry s growth of 3.5%. The company achieved a 4 years high capacity utilization of 59% in FY12, highest since it started operations of its expansion project. We expect company s volumes to grow at 4 years CAGR of 4% to 1.9mn tons in FY16 from 1.7mn tons in FY12, with domestic demand and exports improving at CAGR 4.5% and 1.5% respectively. mn tons Healthy Volumetric Growth Exports Local Capacity Utilisation FY11A FY12E FY13F FY14F FY15F 70% 65% 60% 55% 50% 45% 40% Sources: Company Financial and AHL Research 3

4 Strong pricing and volumes to drive Revenues With strong pricing scenario coupled with healthy volumetric growth we expect the net revenues of the company to jump at 17% CAGR (FY1115) to PKR 11.2bn. mn tons 2.0 Strong pricing and healthy volumetric growth may grow revenue at CAGR 17% in FY15 Total Volumes Net Revenues PKR bn 12 PKR bn 12 Net Revenues ExFactory Price Kohat Cement Company Limited PKR/bag FY10A FY11A FY12E FY13F FY14F FY15F 3 FY10AFY11AFY12EFY13FFY14F FY15F 200 Source: Company Financials and AHL Research Falling coal prices to widen the margins Coal prices in the international market have been tracing a downward trajectory since January 2011, which got steeper in June 2012, when it plunged to 20 month low of USD 81/ton. Besides following other energy commodities like oil, coal prices were also affected by the sluggish demand from China. Coal; Mapping a downwards trajectory USD/ton We have pegged our coal price assumption with international crude oil price because of its strong correlation (0.88) and an R 2 of After remaining under pressure (touching 8 months low of USD 78/bbl) due to increasing intensity of EU debt crisis and muted growth in US, crude has bounced back to USD 96/bbl. In our base case assumption we expect coal prices (RB fob) to cool off by 9% to USD 95/ton in FY13 from USD 105.5/ton averaging in FY12. Our long term coal price assumption stands at USD 100/ton Oct10 Dec10 Feb11 Apr11 Jun11 Aug11 Oct11 Dec11 Feb12 Apr12 Jun12 Aug12 Our earnings forecast and valuations are very sensitive to coal price assumption, as coal constitutes around 50% of the total production cost for KOHC. Following sensitivity analysis suggests that every USD 5/ton change in coal price assumption increases our earnings estimates and valuation by PKR 0.8/share and PKR 5.9/share, respectively. Sensitivity Analysis of International Coal Prices FY13F FY14F FY15F Target Price Base Case Prices (USD/ton) EPS PKR Scenario1: Increment by USD 10/ton Scenario2: Increment by USD 5/ton Scenario3: Base Case Scenario4: Reduction by USD 5/ton Scenario5: Reduction by USD 10/ton Gross profit is expected to grow at 58% CAGR Resilient cement prices, coupled with falling coal prices are likely to yield highest ever gross profit margin of 35.7% in FY13. We have kept an assumed a fall of PKR 5/bag in cement prices and an increase of USD 5/ton in coal prices which is likely to drop gross profit margins to 33% and 31% in FY14 and FY15, respectively. Gross profit is expected to post a 58% CAGR during FY1115 to PKR 3.5bn. 4

5 Strong pricing and healthy volumetric growth are likely to grow revenue at CAGR 17% in FY15 PKR mn 4,000 3,500 3,000 2,500 2,000 1,500 1, FY10A FY11A FY12E FY13F FY14F FY15F PKR mn Gross Profit Gross Margins 4,000 40% 3,500 35% 3,000 2,500 30% 2,000 25% 1,500 20% 1, % 10% FY10A FY11A FY12E FY13F FY14F FY15F Source: Company Financials and AHL Research Aggressive prepayment to reduce finance cost KOHC is amongst the few cement companies, which have paid attention to aggressively deleveraging its balance sheet using the opportunity provided from strong pricing scenario. Because of losses in FY10, the company had to reschedule its long term debt whereby it increased its grace period and deferred its mark up payments. However, strong pricing scenario created healthy cash flow generation for the company, which pouncing on the opportunity, prepaid its long term liabilities to the tune of PKR 1.1bn in FY12. This is likely to reduce Debt to Capital ratio to 55% in FY12 from 72% in FY11. Aggressive deleveraging is expected to reduce finance cost by 49% YoY to PKR 301mn in FY13, with a per ton fixed cost reduction of PKR 92. Aggressive loan retirement reducing finance cost PKR mn 5,000 4,000 3,000 2,000 1,000 Short Term Loans Long Term Loans Finance Cost (LHS) FY10 FY11 FY12 FY13 FY14 FY Interest coverage goes north Interest Coverage (LHS) Debt to Equity (RHS) FY10 FY11 FY12 FY13 FY14 FY Source: Company Financials and AHL Research Profitability to post a 148% CAGR in FY1115 Amid strong cement pricing, healthy demand outlook and falling finance cost is likely to yield a massive growth at 148% CAGR during FY1115 to PKR 2.4bn (EPS: PKR 18.76). During FY13 alone, we expect the company to achieve a 50% YoY earnings growth to PKR 18.84/share compared to PKR 12.52/share in FY12. Strong cash generation likely to result payouts The company is expected to generate strong Free Cash Flow to Equity of PKR 4/share and PKR 8/share in FY12 and FY13, respectively. This coupled with the fact that the company does not have aggressive capital expenditure plans going forward, we see a possibility of cash dividend of PKR 2.5/share and PKR 4/share in FY12 and FY13, respectively. 5

6 Improving profitability and Distribution PKR EPS DPS FY11A FY12E FY13F FY14F FY15F PKR mn PAT Net Margins 3,000 25% 2,500 20% 2,000 15% 1,500 10% 1, % 0% FY11A FY12E FY13F FY14F FY15F Source: Company Financials and AHL Research About the Company Kohat Cement Company Limited (KOHC) was incorporated in 1980 and is listed on all three stock exchanges of the country. The Company operates a cement plant with a capacity of 2.8mn tons per annum of Gray and 0.15mn tons of White cement. KOHC has increased its gray cement capacity by ~5x from 0.5mn tons in FY08 to 2.8mn tons in FY10. The company since then had been in leverage problem as low profitability caused the company to reschedule its expansion related loan in February KOHC has recovered from that liquidity shock, evident from interest coverage ratio of 4.6x in FY12 compared to 0.4x in FY10. 6

7 Summary Financials and Forecasts Income Statement (PKR mn) FY09A FY10A FY11A FY12E FY13F FY14F FY15F FY16F Net Sales 3,396 3,692 6,085 9,300 10,539 10,809 11,224 11,656 Cost of Sales 2,591 3,342 5,158 6,436 6,773 7,270 7,757 8,240 Gross profit ,864 3,766 3,539 3,467 3,416 Selling expenses Selling expenses Operating Profit ,738 3,631 3,397 3,320 3,263 Other Operating Expenses Other Income EBIT ,671 3,623 3,421 3,387 3,429 Depreciation EBITDA ,107 2,952 3,903 3,708 3,677 3,724 Financial charges PBT 21 (382) 126 2,084 3,322 3,289 3,309 3,381 Taxation (6) (54) PAT 27 (328) 64 1,611 2,425 2,401 2,416 2,468 Earnings per Share (PKR) 0.21 (2.55) DPS Balance Sheet (PKR mn) FY09A FY10A FY11A FY12E FY13F FY14F FY15F FY16F Paid up ordinary Capital 1,288 1,288 1,288 1,288 1,288 1,288 1,288 1,288 Accumulated Profit ,975 3,886 5,771 7,672 9,625 Shareholders' Equity 2,272 1,961 2,103 3,392 5,302 7,188 9,089 11,042 Long Term Finances 2,989 3,049 3,537 1, Other Non Current Liabilities Non Current Liabilities 3,407 3,470 4,211 1,773 1, Trade and other payables 869 1,241 1,407 1,500 1,541 1,603 1,360 1,057 Current Portion Short Term Financing 1,398 1,407 1,364 1, Current Liabilities 2,946 3,242 2,811 3,887 3,076 1,843 1,600 1,114 Total Liabilities and Equity 8,625 8,673 9,124 9,052 9,532 9,945 11,363 12,830 Assets Fixed Assets 6,938 7,229 7,141 6,999 6,869 6,732 6,593 6,448 Non Current Assets Total Non Current Assets 6,979 7,266 7,171 7,024 6,890 6,748 6,604 6,454 Stores and Spares Stock in trade Trade debts Cash ,244 2,713 4,233 Current Assets 1,646 1,407 1,954 2,028 2,643 3,197 4,760 6,376 Total Assets 8,625 8,673 9,124 9,052 9,532 9,945 11,363 12,830 7

8 Disclaimer and related information Analyst certification The analyst for this report certify that all of the views expressed in this report accurately reflect his personal views about the subject companies and their securities, and no part of the analysts compensation was, is or will be, directly or indirectly related to specific recommendations or views expressed in this report. Disclosures and disclaimer This document has been prepared by investment analyst at Arif Habib Limited (AHL). AHL investment analysts occasionally provide research input to the company s Corporate Finance and Advisory Department. This document does not constitute an offer or solicitation for the purchase or sale of any security. This publication is intended only for distribution to current and potential clients of the Company who are assumed to be reasonably sophisticated investors that understand the risks involved in investing in equity securities. The information contained herein is based upon publicly available data and sources believed to be reliable. While every care was taken to ensure accuracy and objectivity, AHL does not represent that it is accurate or complete and it should not be relied on as such. In particular, the report takes no account of the investment objectives, financial situation and particular needs of investors. The information given in this document is as of the date of this report and there can be no assurance that future results or events will be consistent with this information. This information is subject to change without any prior notice. AHL reserves the right to make modifications and alterations to this statement as may be required from time to time. However, AHL is under no obligation to update or keep the information current. AHL is committed to providing independent and transparent recommendation to its client and would be happy to provide any information in response to specific client queries. Past performance is not necessarily a guide to future performance. This document is provided for assistance only and is not intended to be and must not alone be taken as the basis for any investment decision. The user assumes the entire risk of any use made of this information. Each recipient of this document should make such investigation as it deems necessary to arrive at an independent evaluation of an investment in the securities of companies referred to in this document (including the merits and risks involved), and should consult his or her own advisors to determine the merits and risks of such investment. AHL or any of its affiliates shall not be in any way responsible for any loss or damage that may be arise to any person from any inadvertent error in the information contained in this report. We and our affiliates, officers, directors, and employees may: (a) from time to time, have long or short positions in, and buy or sell the securities thereof, company (is) mentioned herein or (b) be engaged in any other transaction involving such securities and earn brokerage or other compensation or act as advisor to such company (is) or have other potential conflict or interest with respect to any recommendation and related information and opinions. The disclosures of interest statements incorporated in this document are provided solely to enhance the transparency and should not be treated as endorsement of the views expressed in the report. AHL generally prohibits it analysis, persons reporting to analysts and their family members from maintaining a financial interest in the securities that the analyst covers Arif Habib Limited, Corporate Member of the Karachi, Lahore and Islamabad Stock Exchanges and Pakistan Merchentile Exchange. No part of this publication may be copied, reproduced, stored or disseminated in any form or by any means without the prior written consent of Arif Habib Limited. 8

9 Contact Information Equities Research Designation Telephone Faisal Khan Deputy Head of Research Syed Abid Ali Assistant Vice President Ext : 211 Sana Tawfik Economist sana.tawfik@arifhabibltd.com Ext : 248 Tahir Abbas Junior Analyst tahir.abbas@arifhabibltd.com Ext : 248 Ovais Shakir Database Officer ovais.shakir@arifhabibltd.com Ext : 211 Domestic sales Designation Telephone Mohammed Imran, CFA, ACCA Head of Equity Sales m.imran@arifhabibltd.com M. Yousuf Ahmed Senior Vice President yousuf.ahmed@arifhabibltd.com Farhan Mansoori Vice President farhan.mansoori@arifhabibltd.com Syed Farhan Karim Vice President farhan.karim@arifhabibltd.com Afshan Aamir Vice President afshan.aamir@arifhabibltd.com Faraz Naqvi Assistant Vice President faraz.naqvi@arifhabibltd.com Furqan Aslam Assistant Vice President furqan.aslam@arifhabibltd.com Azhar Javaid Manager Corporate Sale azhar.javaid@arifhabibltd.com International Sales Designation Telephone Adnan Katchi Head of International Sales adnan.katchi@arifhabibltd.com Money Market & FX Designation Telephone Ziley Askari Head of Treasury askari@arifhabibltd.com Corporate finance and advisory Designation Telephone M. Rafique Bhundi Head of Corporate Finance rafique.bhundi@arifhabibltd.com Usman Saeed Assistant Vice President usman.saeed@arifhabibltd.com Muhammad Zeeshan, CFA Assistant Vice President muhammad.zeeshan@arifhabibltd.com Ahmad Zeeshan Senior Analyst ahmad.zeeshan@arifhabibltd.com Management Designation Telephone Bilal Amanullah Moti CEO bilalmoti@arifhabibltd.com