Equity Analysis /
Pakistan

Pakistan Cement: Lower margins to dent profitability in 4Q

    Intermarket Securities
    1 August 2019

    We expect the IMS Cement Universe (including LUCK) to post combined profitability of PKR2.6bn in 4QFY19, declining sharply by 75% yoy. The expected decline is led primarily by pricing indiscipline amongst North based producers that led to a steep fall in cement prices. Moreover, increase in borrowing cost amid depressed cashflows will also drag earnings.

    The key developments during the quarter included: (i) CoD of MLCF (2.3mn tons) and Power Cement’s new line (2.5mn tons), and (ii) short episode of pricing indiscipline amongst North based producers amid weak dispatches, leading to a significant fall in cement retention prices. 

    Gross margins of our cement universe are likely to fall by an average of 6ppt yoy to 17% in 4Q, despite lower coal prices (down 30%yoy). Increase in energy tariffs (gas and electricity tariff up by 10-30%) and elevated depreciation expenses of new plants have already pushed down margins. This remains a difficult period for cement manufacturers. We selectively maintain our liking for LUCK owing to its exposure to diversified segments.

    Lower prices to weigh down on profitability

    We expect the IMS Cement Universe (including LUCK which has already released results) to post combined profitability of PKR2.6bn in 4QFY19, declining sharply by 75% yoy. The decline is expected primarily on account of infighting amongst North based producers that led to a steep fall in cement prices in the region. Specifically, the sector faced a short episode where prices plunged to as low as PKR450/bag, following lower domestic sales amid Ramadan and halt in cement exports to India. Non expansionary manufacturers, in order to maintain their existing share, exacerbated the situation by giving hefty discounts. Prices, however, normalized post imposition of budgetary measures. On a sequential basis, earnings are likely to follow a similar pattern, posting a decline of 65%qoq, primarily led by weak cement prices more than offsetting the fall in coal prices. 

    Key development during the quarter included (i) CoD of MLCF (2.3mn tons) and Power Cement’s new line (2.5mn tons), (ii) levy of additional FED of PKR25/bag in Budget FY20, and (ii) short episode of pricing indiscipline amongst North based producers amid weak dispatches. Notably, with the commissioning of the new line for MLCF, profitability of the company is likely to fall in the near term from escalating finance cost and higher fixed costs. Hence, pre-tax earnings are expected to drop to PKR0.5/sh. However, some respite may arise from potential realization of tax credit. However, in light of the recent revision in tax credit rates on plant and machinery, CHCC may book a reversal (potential impact of PKR2.5/sh). We have not factored these in our 4Q estimates.

    Margins to squeeze further

    Gross margins of our cement universe are likely to fall by an average of 6ppt yoy in 4QFY19 to 17% mainly due to lower retention prices, offsetting the benefit of decline in coal prices. The increase in energy tariffs (gas and electricity tariff up by 10-30%) has already surged the production cost. Elevated depreciation expense of new plants coupled with higher contribution of exports in the sales mix will also compress margins, in our view. We expect LUCK to post the highest gross margins of c. 26%. However, margins of MLCF post commissioning of new plant are likely to fall to 17% (from 23% in 3QFY19) owing to higher fixed costs. 

    Weak prices and higher production cost will more than offset improved volumes 

    As per provisional data, overall cement sales increased by 5%yoy to 11.7mn tons in 4QFY19. The increase in dispatches was observed on both local and export front which increased by 4% and 7% yoy respectively. Utilization levels stood at 75% during the quarter (assuming industry capacity of c. 62mn tpa). Company wise, MLCF, DGKC and CHCC witnessed volumetric growth of 46%, 41%, and 42%yoy respectively, while LUCK observed a steep decline of 14%yoy in local dispatches. Going forward, we expect pressure on pricing will likely continue to persist amid a slowdown in demand and addition of new capacities by PIOC, KOHC and LUCK. To highlight, cement prices have already come off below PKR550/bag in the North after increasing to c. PKR600/bag post Budget FY20. That said, further increase in gas and power tariff and failure to build pricing consensus are likely to keep a check on profitability in FY20.

    Risks: (i) Breakdown in pricing consensus, (ii) further rise in coal prices, and (iii) levy of additional taxes.