Equity Analysis /
Pakistan

Pakistan Cement: Hard times to continue

    Intermarket Securities
    12 July 2019

    We resume coverage of the Pakistan Cement sector with an Underweight stance, as we believe the weak short-term outlook overrides favorable long-term prospects, at least for now. The compression in both demand and margins will continue this year, amidst a tough economic backdrop and risks to the government’s allocation towards infrastructure development. Demand should improve from FY21f, but only moderately.   

    We see sector profitability declining by a sharp 69% yoy in FY20f, led by the second consecutive year of declining local demand (-3% yoy), and lower margins. There are safeguards against a full-fledged price war, but intermittent price disruptions are inevitable, in our view, as some producers have relatively low breakeven price levels. 

    Our Cement Universe may look undervalued on EV/ton basis (cheaper than in times of price wars) but not particularly so on EV/EBITDA. We have Buys on LUCK (diversification + unlevered balance sheet) and KOHC (EV/ton of just US$21/ton). We are Neutral on MLCF and DGKC, and have Sells on CHCC and FCCL.  

    Downturn in demand to continue

    We expect local cement demand to decline by 3% yoy in FY20f, before growing at a 6% CAGR over the following 2-3 years. Near-term risks arise from potential cuts to the government’s allocation for infrastructure development, particularly if the government remains fiscally constrained, as well as from the general weak economic backdrop which is likely to affect private sector demand. Medium-term demand dynamics may be affected by the PTI’s relatively lower focus on infrastructure development, at least compared to the PML-N. The government’s low-cost housing scheme and construction of large dams serve as upside risks to our thesis, but we see implementation risks on both.  

    Margins have no respite  Gross margins for our coverage cluster have reduced by c. 8ppt to 23% (estimated) in FY19, and are expected to reduce further to 18% in FY20f. Other than the possibility of lower cement prices, cost pressures have already build up and are likely to escalate in FY20f because of: (i) the after-effects of c 35% PKR depreciation in the last 18 months, (ii) a 30-70% increase in gas & power tariffs, and (iii) higher duties. The net impact of the increase in these variables ranges between c. PKR60-75/bag for our Cement Universe, some of which will likely have to be absorbed given the weak demand backdrop.  

    Intermittent pricing disruptions are inevitable

    The possibility of a full-fledged price war is low given (i) leveraged producers may be discouraged by their high fixed costs, and (ii) industry leaders such as LUCK are undergoing expansions in other businesses that require significant capital outlay. That said, we believe intermittent disruptions in pricing discipline are likely to continue in FY20f, especially during 1HFY20f which will see the industry add 7.5mn tons (30% of new capacities). In certain months, utilization levels may drop below 70% (especially in the North), which can pave the way for price cuts. One such episode took place in Apr-May’19, when prices declined by 25% to c. PKR450/bag (breakeven level for the lowest cost producers), before recovering subsequently to c PKR600/bag at present. Our average cement retail price assumption for FY20f is PKR540/bag, at which level CHCC, MLCF and DGKC could depict losses in the year. 

    Valuations

    The sector trades at a FY20f EV/ton of US$31, which is lower than in times of prices wars. This is comforting but FY20F EV/EBITDA of 5.4x is still significantly higher compared to past troughs (2.4x during FY12-14). Moreover, while the hefty plant depreciations (post expansion) make the P/E metric less relevant, the market is likely to give due consideration to the prospects for losses this year (for selected companies).   

    Risks: (i) Further breakdown in cement prices, (ii) steep rise in international coal prices, (iii) cuts to PSDP allocation, and (iv) a sharp increase in interest rates.