Company Report. Buy. Capacity expansion to fuel earnings growth. March 2, 2012

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1 Company Report March 2, 2012 Fauji Cement Company Limited Construction and Materials Capacity expansion to fuel earnings growth We initiate coverage on Fauji Cement Company Limited (FCCL) with DCF based December 2012 target price of PKR 7.8/share, offering a striking upside potential of 74% from closing price of PKR 4.5/share. Our positive stance emanates primarily from strong volumetric growth after capacity expansion and resilient cement prices. We acknowledge that the company is highly leveraged (Debt to Equity of 1.2) but we believe that strong volumetric growth and striking price outlook will be sufficient enough to absorb the pressure of higher debt servicing of PKR 3bn. Capacity expansion to yield massive volumetric growth After commissioning its new 7,200 tpd clinker line, FCCL has now become the 4 th largest cement manufacturer in the country with installed capacity of 11,445 tpd. With this increase in capacity, FCCL is likely to fetch a 74% YoY volumetric growth in FY12 to 1.9mn tons, a modest capacity utilization of 55% (101% in FY11). Going forward we expect the company s volumetric sales to increase at 3 years CAGR of 36% at a long term capacity utilization of 80%. Strong pricing scenario is painting a rosy picture Unlike the fears of steep price decline after the capacity expansion by FCCL, cement prices have remained unbudged around PKR 400/bag. This suggests that the cement industry may not wage a price war despite the highest ever oversupply of ~13mn tons. However if prices do fall and a situation of cut throat competition arises, then large cement manufacturers will increase their capacity utilization to maintain their revenue and small cement manufacturers may find it difficult to survive. Nonetheless we have assumed Exfactory price of PKR 315/bag and PKR 305/bag for FY13 and FY14, a 13% and 16% drop from the prevailing Exfactory prices. Buy Target Price 7.8 Last Closing Upside KSE Code Bloomberg Code Market Cap (US$ m) Outstanding Shares (m) Free Float 12M Avg. Daily Turnover (m) 12M High/Low (PKR) Major Shareholders Banks 16.3% Shareholding General Public 21.7% Shares Fauji Fertilizer Co.Ltd Mutual Funds 0.4% 30.0% 1.27 mn 4.98/3.00 Fauji Foundation Others 12.1% % FCCL FCCL PA ,331 Strong earnings growth is sufficient to service debt Due to strong volumetric growth coupled with healthy cement price outlooks, we believe that meeting debt servicing of more than PKR 3bn for next 3 years may not be a challenging task for the company. Our calculations suggest that 53% and 48% capacity utilization would be sufficient to yield EBITDA to Debt Servicing and Interest coverage ratios of 1 during FY12. Earnings are expected to jump at 34% CAGR We expect the net earnings to grow at 3 years CAGR of 34% to PKR 1bn in FY14. Although FCCL is likely to achieve gross margins of around 2021%, however these margins may not translate into similar net margin growth due to high finance cost. 130% 110% 90% Stock Performance FCCL Fauji Group 49.5% KSE100 Financial Highlights (PKR mn) FY10A FY11A FY12E FY13F FY14E 70% Net Revenues 3,808 4,743 9,733 12,287 12,854 Net Profit ,022 Feb11 Mar11 Apr11 May11 Jun11 Jul11 Aug11 Sep11 Oct11 Nov11 Dec11 Jan12 Feb12 EPS (PKR) DPS (PKR) Price to Earnings Price to Book ROE 2.6% 4.1% 2.1% 5.8% 6.9% ROA 1.0% 1.4% 0.8% 2.7% 3.5% Source: Company Financials and AHL Research Source: Bloomberg Analyst Syed Abid Ali abid.ali@arifhabibltd.com For important disclosure and analyst certification, kindly refer to end of the report

2 Valuation Summary Our Free Cash Flow to Firm (FCFF) based December 2012 target price works out to PKR 7.8/share, translating into a striking upside potential of 74% from closing price of PKR 4.5/share. Our valuation is based on the cost of equity 18.7% and a weighted average cost of debt of 9.2%. This lower cost of debt is primarily because of a low cost (6M USD LIBOR plus a premium of 0.8%) USD based debt, which constitutes 55% of the whole loan portfolio. We have included a 4% PKR devaluation in the cost of this foreign loan to adequately incorporate PKR devaluation in the cost of debt. Discounted Cash Flow Valuation PKR mn FY12 FY13 FY14 FY15 FY16 Terminal EBIT (1t) 1,102 1,531 1,626 1,614 1,625 Add: Depreciation 1,462 1,447 1,420 1,424 1,383 Add: Changes in Working Capital 762 (452) (100) (45) (29) Less: Capital Expenditure (210) (80) (84) (101) (111) Free Cash Flow 3,116 2,446 2,862 2,893 2,868 20,705 WACC 12.4% 13.1% 14.0% 15.0% 16.1% Present Value 3,116 2,162 2,203 1,904 1,576 11,380 Terminal Growth Rate 2.00% NPV 10,962 NPV of Terminal Value 11,380 Enterprise Value 22,341 Less: Net Debt 13,070 Equity Value Jun12 9,272 No. of Shares (mn) 1,331 Target Price (PKR) Dec WACC Parameters Risk Free Rate 12% Market Return 18% Beta 1.12 Cost of Equity 18.7% Wt. Avg. Cost of Debt 9.2% After tax Cost of Debt 6.0% WACC (FY12) 13.0% AHL Research Risks to Valuation Cement Price Risk Our valuation is very sensitive to the cement price, evident from the fact that every PKR 5/bag change in our ExFactory price assumption changes our earnings forecast by PKR 0.8/share or 11.6%. International Coal Price Risk Coal is the biggest cost component of the cement manufacturing process constituting around 41% of the total manufacturing cost. We have pegged our coal price forecast with international crude oil price and we are expecting coal prices to cool off by 12% in FY13 to USD 126/ton. However every USD 5/ton change in coal price forecast will change our FY13 EPS by PKR 0.7 or 10.5%. Electricity Price Risk Power cost constitutes around 21% of the total manufacturing cost. FCCL has to rely on the national grid as its captive power capacity (22MW) can only meet 47% of its demand based on total utilization. Our forecast can be distorted if company faces steeper rise in power and gas tariff. Exchange Rate Risk The company is exposed to fluctuation in the exchange rate as it has to import coal from the international markets and has a foreign exchange loan of USD 88mn. We have assumed a 3% PKR devaluation against USD, a greater devaluation will cause higher than expected exchange loss. 2

3 Capacity expansion is yielding volumetric growth After commissioning of its new 7,200 tpd clinker line, FCCL has now become the 4 th largest cement manufacturer in the country with installed capacity of 11,445 tpd or 3.4mn tpa. With this increase the company is likely to fetch a 74% YoY volumetric growth in FY12 to 1.9mn tons, which translates into a modest capacity utilization of 55% (101% in FY11). Going forward we expect the company s volumetric sales to increase at 3 years CAGR of 36% at a long term capacity utilization of 80%. Market share has improved by 3 ppt in 1HFY12 Despite subdued demand growth (4.2% YoY increase in 1HFY12) in the industry, FCCL has managed to bag a 74% YoY growth in dispatches to 915k tons due to its capacity expansion. This has improved market share to 7.8% in the Northern domestic dispatches in 1HFY12 as compared to 3.6% in FY11. Exports market share on the other hand has dropped to 6.5% (7.1% in FY11) taking total market share to 7.5% (4.5% in FY11). As illustrated in the pie charts below, FCCL has successfully captured market share from the likes of DGKC, Bestway and Maple Leaf. This solidifies our confidence in the company s ability to achieve volumetric growth going forward. Volumetric growth at 36% CAGR (FY1114) mn tons Exports Local Capacity Utilisation 120% 100% 80% 60% 40% 20% 0% Source: Company Financials and AHL Research Market Share (1HFY12) LUCK, 10.5% Market Share (FY11) LUCK, 10.2% Others, 43.5% DGKC, 15.8% Others, 43.7% DGKC, 17.4% Bestway, 12.7% Bestway, 13.0% MLCF, 11.1% FCCL, 7.5% MLCF, 10.0% FCCL, 4.5% Still attractive at 70% terminal capacity utilization Being conservative in our approach, we have assumed 63% and 75% capacity utilization in FY12 and FY13, respectively and have kept it constant at 80% beyond FY13. We believe that our assumptions is highly conservative if we consider the track record of FCCL, which has the history of operating close to 100% capacity utilization; comprehensively outperforming its peers operating in the northern part of the country. Following table summarizes the fact that every 5% increase in long term capacity utilization inches up our target price by 3%. Sensitivity of long term capacity utilization level on target price Utilization Level Volumes (tons) Target Price (PKR) 70% % Capacity utilization; a history of outperforming the industry 105% 95% 85% 75% 65% FCCL Industry North FY07 FY08 FY09 FY10 FY11 80% % % % % Source : AHL Research 3

4 Strong pricing scenario is painting a rosy picture Domestic cement prices have been tracing a rising trajectory since Jan11, prices since then have jumped by 26%. It is pertinent to mention that the cement prices have remained resilient despite the supply addition of 7,200 tpd plant of FCCL, which has increased surplus capacity to historic high of above 13mn tons. This has expanded the gross margin of the industry by 8 ppt as to 23.3% in 1QFY12 as compared to 15.4% in the same quarter last year. Large cement manufacturers benefited the most out of this scenario as economies of scale enabled them to widen their margins compared to their smaller peers. However after expansion FCCL has moved up in the food chain, which will strengthen its margins going forward. Prices may suffer a 10% drop in FY13 Unlike the fears of steep price decline after the capacity expansion by FCCL, cement prices have remained unbudged around PKR 400/bag. This explains that cement industry may not wage a price war despite the oversupply situation. However if prices do fall and a situation of cut throat competition arises, then large cement manufacturers will increase their capacity utilization to maintain their revenue and small cement manufacturers may find it difficult to survive. Nonetheless we have assumed Exfactory price of PKR 315/bag and PKR 305/bag for FY13 and FY14, a 13% and 16% drop from the prevailing Exfactory prices. Following table summarizes the sensitivity of our earnings estimates for Fauji Cement. Cement price; Mapping a rising trajectory PKR /bag Aug10 Oct10 Dec10 Feb11 Apr11 Jun11 Aug11 Oct11 Dec11 Feb12 Source: Federal Bureau of Statistics Earnings' Sensitivity to the ExFactory Price FY12 FY13 FY14 Base Case EPS EXFactory Price (PKR per bag) EPS (PKR) 290 (0.77) (0.60) (0.43) (0.26) (0.09) Revenues are expected to jump at 39% CAGR Strong pricing scenario coupled with healthy volumetric growth we expect the net revenues of the company to jump at 39% CAGR (FY1114) to PKR 12.8bn. Although we are expecting a declining trend in the cement prices however healthy volumetric growth is likely to keep revenues on the rising course. mn tons Source: Company Financials and AHL Research Strong Volumetric growth is fueling the top line Total Volumes YoY Growth 80% 70% 60% 50% 40% 30% 20% 10% 0% 10% mn tons Total Volumes Net Revenues PKR bn

5 Softening coal prices may keep the margins in tact Coal prices in the international market are mapping a downward trajectory since the start of CY11, when it was trading around USD 130/ton (Richards Bay fob). We have pegged our coal price assumption with international crude oil price because of its strong correlation (0.88) and an R 2 of Currently crude oil prices are trading at 26 months high due to political unrest in the Middle East and US sanctions on Iran. We believe that crude oil prices are bound to come down going forward as the tension in the Middle East cools off. In our base case assumption we expect coal prices to cool off by 12% and 7% in FY13 and FY14, respectively. Earnings' Sensitivity to Coal price FY12 FY13 FY14 Coal; tracing a down sloping trajectory USD/ton Jan11 Feb11 Mar11 Apr11 May11 Jun11 Jul11 Aug11 Sep11 Oct11 Nov11 Dec11 Jan12 Feb12 Base Case EPS Coal Price (USD/ton) EPS (PKR) (0.05) Gross profit is expected to increase 50% CAGR We expect the gross profit of the company to jump at 3 years CAGR (FY1114) of 50% to PKR 2.8bn. Softening coal prices may allow the cement prices to fall at PKR 305/bag in FY14, keeping gross margins around 2021% for FCCL as compared to 17% witnessed in FY11. Rising Gross profit and Margins PKR mn Gross Profit Gross Margins 3,000 24% Strong YoY growth in Gross profit PKR mn Gross Profit YoY Growth 3, % 2,500 2,000 1, % 20% 18% 16% 14% 12% 2,500 2,000 1, % 30% 20% 10% 70% FY10AFY11AFY12EFY13FFY14F Source: Company Financials and AHL Research 5

6 High leveraging to keep earnings subdued FCCL leveraging position has gown down from 1.7% in FY11 to 1.2% in 1QFY12 due to a 92% right issue and retirement of subordinated debt amounting PKR 3.2bn. The company had the luxury to capitalize the hefty finance cost, however after achieving commercial operation P&L statement is to feel the full brunt, evident from a massive 12x YoY jump expected in financial charges in FY12. On the positive front, FCCL has a low cost (6M LIBOR+0.8%) foreign loan, which constitutes around 55% of the total loan portfolio. Although this exposes the company to higher exchange losses, however even a 4% PKR devaluation would keep interest on this loan much lower than the prevailing KIBOR rates. Thus this low cost loan is likely to keep the overall borrowing cost under check. Finance Cost and Debt/Equity ratio PKR mn 1,400 1, FY12E FY13F Interest Expense Debt to Equity FY14F FY15F FY16F 90% 70% 50% 30% 10% 10% Strong earnings growth is sufficient to service debt Due to strong volumetric growth coupled with healthy cement price outlooks, we believe that meeting debt servicing of more than PKR 3bn for next 3 years may not be a challenging task for the company. As depicted in the chart on the right, both interest coverage and EBITDA to Debt Servicing ratios remain in the comfortable zone of above 1. Our calculations suggest that the company needs at least 53% and 48% capacity utilization to keep its EBITDA to Debt Servicing and Interest coverage ratios above 1 during FY12. Following table summarizes the minimum capacity utilization levels for break even and coverage ratio at the given Exfactory prices. Minimum required capacity utilization levels are far below our base case utilization assumptions. Capacity Utilization Sensitivity FY12 FY13 FY14 ExFactory Price (PKR/bag) Base Case Capacity Utilization 55% 75% 80% Minimum Utilization Levels For Breakeven 49% 54% 52% For Interest Coverage = 1 48% 52% 51% For EBITDA to Debt Servicing = 1 53% 68% 69% Earnings are expected to jump by 34% CAGR We expect the net earnings to grow at 3 years CAGR of 34% to PKR 1bn in FY14. Although FCCL is likely to achieve gross margins of around 2021%, however these margins may not translate into similar net margin growth due to high finance cost, which is evident from the margins outlook chart at the right Coverage ratios; Staying above 1 PKR mn 4,000 3,500 3,000 2,500 2,000 1, Interest Coverage EBITDA to Debt Servicing FY12E FY13F FY14F FY15F FY16F Debt Servicing Interest Expense Principle payment FY12E FY13F FY14F FY15F FY16F PKR mn 1, Profitability and Net Margins PAT Net Margins 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Source: Company Financials and AHL Research Strong YoY growth in profitability PKR mn PAT YoY Growth 1, % 175% % % % % 75% FY10AFY11AFY12EFY13FFY14F Margins outlook 25% Gross Operating Net 20% 15% 10% 5% 0% 6

7 About the Company Fauji Cement Company Limited (FCCL) has an installed capacity of 11,445tpd (3.4mn tpa), after capacity expansion of new line of 7,200 tpd. With this expansion, FCCL emerges as the 4 th largest cement manufacturer in Pakistan. Plant is located in the district of Attock in Panjab. FCCL has a history of operating its plant at 100% capacity utilization, comprehensively above the utilization of its peers operating in the northern part of the country. FCCL is a part of Fauji Foundation, a trust set up for the welfare of Exservicemen. The Group has significant presence in Fertilizer, Cement, Power Generation, Oil, Financial Services and Food sectors. Fauji Foundation and its associated companies hold ~50% shares in the company. 7

8 Summary Financials and Forecasts PKR mn Income Statement FY09A Net Sales 5,315 3,808 4,743 9,733 12,287 12,854 Cost of Sales 3,627 3,293 3,920 7,840 9,675 10,075 Gross profit 1, ,893 2,612 2,779 Admin expenses Selling expenses Operating Profit 1, ,686 2,375 2,522 Other income Other expenses Earnings before Interest and Tax 1, ,696 2,355 2,501 Depreciation ,462 1,447 1,420 EBITDA 1, ,158 3,803 3,921 Financial charges ,304 1, Profit before tax 1, ,853 2,698 2,993 Taxation PAT 1, ,716 2,260 2,442 Earnings per Share Adjusted (PKR) DPS Balance Sheet FY09A Total Shareholders' Equity 9,691 9,611 11,014 13,596 14,409 15,431 Non Current Liabilities Long Term Loan 6,224 11,909 11,805 9,344 7,164 4,907 Subordinate Loan 400 3,189 Total Non Current Liabilities 9,128 13,184 15,812 10,162 7,981 5,724 Current Liabilities Trade and Other Payables 1,537 2,048 1,291 2,148 2,651 2,760 Total Current Liabilities 2,628 3,985 5,385 6,884 7,418 7,654 Total Liabilities and Equity 21,447 26,780 32,211 30,641 29,809 28,809 Assets Non Current Assets 19,792 24,709 27,419 26,167 24,800 23,464 Current Assets 1,654 2,071 4,792 4,474 5,009 5,346 Total Assets 21,447 26,780 32,211 30,641 29,809 28,809 Cash Flow Statement FY09A Cash flow from operating activities 1, (736) 3,783 2,913 3,271 Cash used in investing activities (4,893) (2,989) (1,388) (210) (80) (84) Cash flow from financing activities (433) 2,906 2,483 (3,985) (3,253) (3,060) Net increase/(decrease in cash & equivalents (3,330) (413) (420) 127 Cash

9 Disclaimer and related information Analyst certification The analysts for this report certify that all of the views expressed in this report accurately reflect their 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. 9

10 Contact infor Contact information mation Equities Research Telephone Faisal Khan Deputy Head of Research Syed Abid Ali Research Analyst Ext : 211 Usman Saeed Research Analyst usman.saeed@arifhabibltd.com Ext : 211 Saad Khan Economist saad.khan@arifhabibltd.com Ext : 248 Umar Hafiz Research Analyst umar.hafiz@arifhabibltd.com Ext:248 Ovais Shakir Database Officer ovais.shakir@arifhabibltd.com Ext : 211 Domestic sales 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 AVP faraz.naqvi@arifhabibltd.com Furqan Aslam AVP furqan.aslam@arifhabibltd.com Money Market & FX Telephone Ziley Askari Head of Treasury askari@arifhabibltd.com Corporate finance and advisory Telephone M. Rafique Bhundi Vice President rafique.bhundi@arifhabibltd.com Kashif Suhail Vice President kashif.suhail@arifhabib.com.pk Muhammad Zeeshan, CFA Assistant Vice President muhammad.zeeshan@arifhabibltd.com Ahmad Zeeshan Senior Analyst ahmad.zeeshan@arifhabib.com Ext : 229 Management Telephone Bilal A Moti CEO bilalmoti@arifhabibltd.com