Report on Cement Sector

23 August 2004

The Cement Hoopla!The Cement Hoopla!The Cement Hoopla!The Cement Hoopla! Cement Sector

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Underweight

Unless Pakistanis start eating cement, the potential cement supply demand gap is unlikely to vanish over the next 3-4 years. We believe that the current cement story needs to be analyzed from both demand and supply perspectives instead of only arguing on the demand side.

The demand side is positive, however, one should not base ones view only on the basis of the governments planned projects. Similarly, there is a big difference between the hype and the reality of demand from the private sector.

The cement manufacturers are forcing themselves into a situation that is similar to the one that existed in the early 90s. We foresee at least 15mn tones of additional cement capacity over the next three years.

The current retentions are healthy for the cement manufacturers however, these are unlikely to be sustainable in the long run owing to various reasons.

The FY05 budget carried a positive message for the cement sector; however, investors should not read too much between the lines.

The cement sector is a relatively risky sector compared to the market. Its high beta and poor quality of earnings deserves a below market PER.

The sector has been extremely cruel to small investors. The payouts have been ridiculously low and we expect this trend to continue in future.

Except for Maple Leaf Cement, we recommend a SELL on most of the cement stocks at current levels.

Analyst Shagufta Irshad [email protected] (9221) 2635501-10 ext 335

For Analyst Certification, see Page 12 Refer to important disclosures at the end of the report.

Investors should assume that KASB is seeking or will seek investment banking or other business relationships with companies mentioned in this report.

SEC

TOR

REPO

RT

Pakistan Pakistan

KASB Securities (Pvt.) Limited 6th Floor, Trade Center, I.I. Chundrigar Road Karachi.

Phone Number 111-222-000 [email protected]

www.kasb.com

Cement Sector 23 August 2004

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Executive Summary The Cement Hoopla! The general opinion of researchers regarding the outlook of the cement sector appears to be divided. However, a clear tilt is visible on the positive side since most analysts are only getting support from the demand side. On the other hand, APCMAs data releases are misleading and tend to impress punters with (I) inflated capacity utilization numbers, and (II) low priced stocks hysteria. Similarly, medium to long-term investors are not paying significant attention to the exceptionally higher valuation multiples of the sector, whereas this sector needs to be valued at a multiple lower than that of the market. The so-called futuristic earnings growth appears to be overriding all other valuation tools. At the same time, investors are also under the impression that the higher earnings will translate into higher dividends, even though history has a totally different message for investors.

Positive Outlook on Demand side, But The demand side is positive, however, one should not fully base ones view on the basis of the governments planned projects. Similarly, there is a big difference between the hype and the reality of demand from the private sector. We expect cement demand to witness 11.88% growth (5 years CAGR) over the next 5 years. Even though we believe that the momentum of cement growth will eventually slow down, we are assuming that the current growth rate in cement demand will continue in medium term. Supply side has its own and bigger issues! The cement manufacturers are forcing themselves into a situation that is similar to the one that existed in the early 90s. We foresee the existing production capacity of the industry increasing by 16% over the next 5 years, which will cause an excess supply of 15mn tones in 2007 under the best case scenario, while the actual supply demand gap is likely to be more than 17mn in 2007. The current retentions are Healthy The current retentions are healthy for the cement manufacturers, however these are unlikely to be sustainable in the long run owing to various reasons. The cartel is functioning very fairly and everyone, irrespective of efficiency, is

getting a share in the pie. Having said this, we feel that this could be the biggest potential weakness of the current arrangement. Budget 05- Dont read too much The overall budget carried a positive message for the cement sector with a mixed bag of incentives and disappointments; investors should not read too much between the lines. An allocation of PkR202bn for PSDP, out of which PkR87bn would be allocated for infrastructure development is likely to boost cement demand but largely in qualitative terms. While the government has not announced any further reduction in CED, a number of measures have been announced to boost housing activity. However, these measures are not sufficient enough to give a real boost to construction sector due to a drastic increase in input costs. No concept of Profit Sharing The sector has been extremely cruel to small investors. The payouts have been ridiculously low and we are of the view that the managements will continue their past practice and will retain most of their earnings to either repay their loans or to redeploy these monies into their groups. Deserve a Lower PER than Market In our view the cement sector is a relatively riskier sector compared to the market. Its high beta and poor quality of earnings deserve a below market PER. Owing to negative earnings in the past, it is difficult to prove this point through tracking historical relative PER of the sector. However, sectors price beta provides a useful insight of this factor. Last 5 years sector beta is 1.2x, which means that sector is 20% riskier to the market. Thus the sector should be trading at a proportionate discount to the market PER however, at present the sector is trading close to the market PER. Thus we are changing our Neutral stance on the sector to Underweight. The speculative newsflow generated by the APCMA may cause temporary price hikes in the sector, which will stay exposed to extreme volatility in any market downturns. We also expect long-term investing grade money to stay away from this sector. What about Cement stocks? We do not like most of the cement companies. In our view most of these companies are trading towards the higher end of their DCF based valuation ranges. Maple Leaf Cement can be a good bet if investors want to take exposure in cement. Our DCF based Fair value of PkR43.99/share for Maple indicates a potential upside of 14% from current levels.


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Contents

Section Page

Executive Summary 2

1. The Cement Hoopla! 4

2. Positive Outlook on Demand Side but 7

3. Supply Side has its own and Bigger issues!

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4. The Current Retentions are Healthy 10

5. Budget 05- Dont read too much between the line

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6. No Concept of Profit Sharing 12

7. Deserve a Lower PER than market! 13

8. What about Cement Stocks? 14

Buy Maple Leaf!


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The Cement Hoopla! The general opinion of researchers regarding the outlook of the cement sector appears to be divided. However, a clear tilt is visible on the positive side since most analysts are only getting support from the demand side. On the other hand, APCMAs data releases are misleading and tend to impress punters with (I) inflated capacity utilization numbers, and (II) low priced stocks hysteria. Similarly, medium to long-term investors are not paying significant attention to the exceptionally higher valuation multiples of the sector, whereas this sector needs to be valued at a multiple lower than that of the market. The so-called futuristic earnings growth appears to be overriding all other valuation tools. At the same time, investors are also under the impression that the higher earnings will translate into higher dividends, even though history has a totally different message for investors. The greedy punters, functioning of an illegal cement cartel, speculative APCMA reporting and sensational research journalism equally fueled the current cement sector hype. Agreed the sector has seen a massive re-rating over last two years, this adjustment was due and its over now. From here onward, any further re-rating is impossible given the recent expansions announced by the industry. Unfortunately retail investors are not willing to accept reality. They are still maintaining their faith in the sector and are dreaming about the continuation of the sectors past performance in the future. Though market has been hovering around the 5100-5600 range for quite some time, the cement sector investors have lost their shirts in the nearly 20% up and down rallies in the cement sector. Each one of the cement investors is still hoping to see the materialization of the two dams, Bhasha and Kalabagh without realizing the basic fact that the present government will never be able to develop a national consensus on these in the present atmosphere. Talking specifically about private sector demand, real growth cannot be seen till the land prices come to a level where everyone can afford a house. Nearly 400% increase in land prices simply means that only a few can afford houses. On the other hand, the manufacturers are about to exploit the cement investors passion by making cash calls. During our discussion with various cement companies, the managements revealed details of capital calls. We are crystal clear in our belief that these cash calls will be death traps for the smaller shareholders in the medium to long term. There will be significant earning dilutions along with negative incremental returns. We are not advocating that our investors dump the cement sector. Undoubtedly the sector has growth potential and is well poised for decent growth in line with its previous correlations with the economy. However, there is always a price attached to every investment opportunity. The market has overly priced the growth story in cement. And there is a need for an adjustment. How will this adjustment take place? We foresee a whole set of triggers for this de-rating in the future. Slowdown in cement demand growth (eventually), more capacities, non-materialization of large dams and poor payouts from the managements can be the triggers.

Cement Sector 06 Aug 23 August 2004

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Unless We Start Eating Cement! Unless Pakistanis start eating cement, the potential cement supply demand gap is unlikely to vanish over the next 4-5 years. We believe that the current cement story needs to be analyzed from both demand and supply perspectives instead of only arguing on the demand side. The following factors are responsible for the widening supply demand gap: ! Expansions The speculative bubble in the Cement sector is likely to explode by FY07 when overall cement supply will be increased to 35mtpa with the completion of the expansion plans announced by the cement manufacturers as opposed to expected demand of 18mtpa, thereby reducing the capacity utilization rate for the year to 56%. This situation is expected to get even worst by FY09. In our calculations, we are incorporating only the announced and duly approved expansions of the respective companies. ! Allocation for PSDP will eventually be diversified! The current upsurge in cement demand from the public sector is misleading from a longer-term perspective. The massive allocations for physical infrastructure development in the budget will eventually be diversified to other components of government spending. Also one needs to understand that PkR82bn physical infrastructure spending does not mean that the entire amount will be spent on buying cement. ! Increasing Cost of Construction Despite the incentives announced in the budget, sky-high real estate prices, higher cement, steel and paints prices and higher labor costs have slowed construction activity in the country. In our view, this will remain a limiting factor in the medium to long term unless the government improves regulations to curb such illegal trade practices. ! Best case scenario also shows a 44% supply surplus Our best-case scenario indicates that the Pakistani market will retain a demand surplus to the tune of 44% by FY07. We are assuming 12% growth (5 years CAGR) in local cement demand over the next 5 years, 10% annual increase in export sales and 0.75mtpa extra consumption for the Mangla expansion and the Bhasha Dam.


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Chart 1: Supply Demand Situation

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10152025303540

2004 2005 2006 2007 2008 2009 2010

mn to

nnes

0%10%20%30%40%50%60%70%80%

Utiliz

ation

Rate

Supply Demand Utilization Rate

Source: Industry Sources, KASB Estimates


Positive Outlook On Demand Side, But The demand side is positive, however, one should not fully base ones view on the basis of the governments planned projects. Similarly, there is a big difference between the hype and the reality of demand from the private sector. ! 12% is the growth target in best case scenario We expect cement demand to witness 11.88% growth (5 years CAGR) over the next 5 years. Even though we believe that the momentum of cement growth will eventually slow down, we are assuming that the current growth rate in cement demand will continue in the medium term. Having said this, we feel that the chances of a demand growth slow down are more than the chances of a further increase in momentum. ! Long-term growth trend will be in line with GDP Growth Cement demand is strongly correlated to GDP growth. Pakistans GDP grew by 6% in FY04. The main source of Pakistans GDP is agricultural output, which comprised around 23.3% of GDP in FY04. Pakistan has entered into an era of high economic growth, which leads us to expect 6.5-7.5% growth in GDP and 4-6% growth in the agricultural sector over the next 3 years depending upon the availability of water and the fertilizer consumption situation. Chart 2: GDP Growth and Cement Demand Growth Rate

-20%

-10%

0%

10%20%

30%

40%

50%

93 94 95 96 97 98 99 00 01 02 03 04

Grow

th Ra

te

Cement Demand grow th GDP grow th

Source: Economic Survey 2003-04 With the current upturn in the domestic economy, we expect cement demand to ultimately follow the GDP growth momentum eventually. The qualifications for our best-case scenario Even though for this note we are assuming that the best-case scenario will emerge in the future, we want to still highlight a few shortcomings of our best-case scenario: ! Public Sector The public sector appears to be dominating the demand side at this point in time. The governments current focus on building the


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countrys physical infrastructure and the largest ever increase in the PSDP allocation will have positive impacts on demand. However, this demand is difficult to quantify at this juncture. Moreover, this demand factor is largely dependent upon the governments performance on achieving national consensus on the mega projects. Thus, the large PSDP allocation should not be taken as a very sound bullish argument for the cement sector. ! Private Sector Thanks to easy liquidity and improving economic conditions private sector construction is another positively contributing factor on the demand side. However, soaring land prices, sky rocketing steel prices and the reluctance of bankers to go beyond first tier clients in the case of house financing has slowed the upward growth momentum in demand. ! Exports Though the recent surge in UAE cement prices and the exceptional growth in neighboring countries have created a small window of opportunity for Pakistani cement in Afghanistan and the UAE, we feel that investors need to focus on the quantum of exports rather than MoM or YoY growth in exports. Furthermore, the UAE can not be considered a potential export market for Pakistani cement in the long term owing to: (I) Saudi Arabia, Iran and Qatar are planning to double their production capacities by FY07; and (II) Pakistan does not produce high quality cement that can be used in mega housing and infrastructure projects in the UAE. We are of the opinion that the said opportunity will only improve the profit margins on the exported products to the level that has been achieved in the case of local products otherwise there will be no significant impact on the sector as a whole. ! Bhasha Dam Turning Controversial! Under the best-case scenario, we have assumed the timely implementation of Mangla Dams raising and the construction of the Bhasha Dam. Bhasha Dam is turning out to be controversial, owing to: (I) The project is not ideally located for power supply arrangements as opposed to Kalabagh, (II) Punjabs position that Bhasha should not be considered a substitute for Kalabagh, which will not be beneficial for irrigation purposes, and (III) Sindh also has certain reservations regarding the Dam and strongly supports the Skardu and Katzarah dams instead. These controversies could delay the process of launching a detailed design for the dam that would require at least 24months to complete, which will eventually result in a loss of potential demand for cement leading to an ever increasing supply demand gap.


Supply side has its own and bigger issues! The cement manufacturers are forcing themselves into a situation that is similar to the one that existed in the early 90s. We foresee at least 15mn tones of additional cement capacity over the next three years. Two courses of action have been planned by most of the cement manufacturers. One, most of the companies are opting for the de-bottlenecking of their existing plants to gain further capacities; Two, all the major cement plants are also going for capacity expansions. Two thoughts are prevalent in the cement players minds: (I) additional capacities would mean a higher quota allocation in the cartel driven supply management structure; (II) the current operating environment is conducive for taking new investment initiatives owing to lower interest rates and higher repayment capacities. Chart 3: Cement Supply Side

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25

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35

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2003 2004 2005 2006 2007 2008 2009 2010

mn to

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Source: Industry Sources If one looks at the future capacity numbers released by APCMA and the cement companies, the total additions will be to the tune of 15mtpa, which will take local cement capacity from 20mtpa to 35mtpa in 2007. In terms of the timing of these expansions, these are well spread and will crop up every year. One cannot rule out the possible slippage in a few capacities on account of late thoughts, nevertheless the final tally of the capacities will be over 37mtpa by 2009. We foresee the existing production capacity of the industry increasing by 16% (5 year CAGR) over the next 5 years, which will cause an excess supply of 15mn tones in 2007 under the best case scenario, while the actual supply demand gap is likely to be more than 17mn in 2007.


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The Current Retentions are Healthy The current retentions are healthy for the cement manufacturers, however these are unlikely to sustain in the long run owing to various reasons. ! The Cartel is itself the biggest threat to the present scenario! Undoubtedly the effective functioning of the cartel has improved manufacturers retentions significantly. The cartel is functioning very fairly and everyone, irrespective of efficiency, is getting a share in the pie. Having said this, we feel that this could be the biggest potential weakness of the current arrangement. Efficient players will want a larger share and this urge will force them to break the cartel. This is a natural phenomenon and will happen eventually, affecting retentions negatively. While the efficient players will gain from increased volumes, the second and third tiers will suffer due to their relative inefficiencies. ! Government interventions to curb illegal practices Though the government has yet to come up with any measures against the working of the cartel, various stakeholders have been raising their voice against this practice. In fact, even government agencies have raised their concerns over this issue. We are of the view that the government will also address this issue eventually. Our argument gets support from the governments action against the auto assemblers, who have been involved in similar tactics. ! 100% increase in Coal Prices The 100% rise in coal prices will have a negative impact on retention levels. Coal prices have surged to almost double in a few months. Local coal prices have increased from PkR1400/ton to PkR3000/ton while imported coal prices have increased from US$33/ton to US$68/ton. Thus the net advantage from converting to coal is gradually vanishing. While there is a general cry that the cement makers should increase retail prices to mitigate the impact of higher coal prices, the cement producers cannot transfer such a burden to the end consumers due to the fact that they have not passed on the benefit earned from a substantial reduction in production costs from the conversion to coal to the consumers in the first place. ! No further reduction in CED The government has not announced any further reduction in Excise Duty on cement in the budget, which will have a negative impact on the sector in terms of lost potential retention level. While we do believe that the retentions of these cement companies will come down from current levels, we are not assuming any such reductions in our earning forecasts. We just want to highlight the basic fact that the cement companies are not worth their existing prices even in the best-case scenario.


Budget 05 Dont read too much between the lines! The overall budget carried a positive message for the cement sector with a mixed bag of incentives and disappointments; investors should not read too much between the lines. ! Higher Allocation to PSDP but An allocation of PkR202bn for PSDP, out of which PkR87bn would be allocated for infrastructure development is likely to boost cement demand but largely in qualitative terms. The demand factor is largely dependent upon actual government spending (as 30% remained unutilized from last years PkR161bn PSDP) on the mega projects, the implementation of which will remain politically controversial. ! No More CED Reduction The government has not announced any further reduction in CED. The government is also giving indications that the sector will no more be given more incentives unless the benefits are passed on to end consumers. The cement makers raised prices by PkR5-15/bag ahead of the budget on the hope that subsequent price reductions in line with CED adjustments would not cause any damage to their price retentions. ! Boost to Housing Sector not likely! The government in the budget announced a number of measures to boost housing activity, but these measures are not sufficient enough to give a real boost to the sector due to the drastic increase in major input costs including real estate, cement and steel. The reduction in customs duty on steel and construction equipment will have a positive impact on the housing sector, while the abolition of CED on paints and varnishes will not largely influence the housing sector as it represents only a small fraction in total construction costs. ! Duty Reduction on Import of Cement Plant The reduction in customs duty from 10% to 5% on cement plants up to 4000tpd per unit, not manufactured locally, would not benefit the industry due to the controversy that a cement plant can be locally manufactured. While the major expansion plans crossing the 4000tpd limit, including that of DGK and Bestway, would benefit from the given incentive, this would make these huge expansion plans more feasible thus worsening the supply demand gap in the long term.


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No Concept of Profit Sharing! The sector has been extremely cruel to small investors. The payouts have been ridiculously low, which is evident from their dividend payout history, and we expect this trend to continue in future. Table 1: Dividend Payout History (PkR)

Year DGK Maple Lucky Cherat

EPS DPS EPS DPS EPS DPS EPS DPS 1994 5.86 1.50 15.59 - - - 1.73 -

1995 3.91 - 2.62 - - - 3.31 -

1996 2.28 - 1.51 - - - 3.46 0.30

1997 0.55 - 0.21 - (0.11) - 2.25 0.15

1998 (0.44) - (2.07) - (0.48) - 0.10 -

1999 (4.38) - (3.27) - 0.22 - 1.20 0.20

2000 (0.66) - 0.01 - 0.92 - 3.36 0.25

2001 (2.91) - (1.58) - 1.05 0.75 1.56 0.20

2002 1.67 - 0.87 - 1.21 0.75 2.35 2.50

2003 2.84 1.00 0.83 - 0.93 0.75 0.18 1.25 Source: Company Accounts

The above table clearly indicates the payout policies of the top cement companies in the past. Even if one wants to challenge us on the bonus issues made by these companies, the irony of the situation is that none of these companies has been able to avoid the dilution in their earnings after opting for bonus issues. Furthermore, we do not want to give any benefit of doubt to the managements of these companies, on the basis of poor industry conditions in the past, as these managements have not shown exemplary visions while making decisions regarding their aggressive expansions. We are of the view that the managements will continue their past practice and will retain most of their earnings to either repay their loans or to redeploy these monies into their groups. Thus, small investors will continue suffering and good quality money will not be attracted to the sector.


Deserve a Lower PER than Market! In our view the cement sector is a relatively riskier sector compared to the market. Its high beta and poor quality of earnings deserve a below market PER. Owing to negative earnings in the past, it is difficult to prove this point through tracking historical relative PER of the sector. However, sectors price beta provides a useful insight of this factor. Last 5 years sector beta is 1.2x, which means that sector is 20% riskier to the market. Thus the sector should be trading at a proportionate discount to the market PER however, at present the sector is trading close to the market PER. Thus we are changing our Neutral stance on the sector to Underweight. The speculative newsflow generated by the APCMA may cause temporary price hikes in the sector, which will stay exposed to extreme volatility in any market downturns. We also expect the long-term investing grade money to stay away from this sector. Table 4: Cement Sector PER

0.00

5.00

10.00

15.00

20.00

25.00

30.00

1/2/1999 1/2/2000 1/2/2001 1/2/2002 1/2/2003 1/2/2004

Cement Sector PE

Source: KSE The negative sector earnings have made it difficult to prove that sector has been trading at a discount to the market PER. However, sectors price beta provides a useful insight of this factor. Last 5 years sector beta is 1.2x, which means that sector is 20% riskier to the market. Thus the sector should be trading at a proportionate discount to the market PER however, at present the sector is trading close to the market PER. Thus we are changing our Neutral stance on the sector to Underweight. The speculative newsflow generated by the APCMA may cause temporary price hikes in the sector, which will stay exposed to extreme volatility in any market downturns. We also expect the long-term investing grade money to stay away from this sector.


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[email protected] [email protected]

What about Cement Stocks? We do not like most of the cement companies. In our view most of these companies are trading towards the higher end of their DCF based valuations. Though futuristic earnings growths are overriding all the investment arguments in these stocks, we feel that these high beta stocks will become exceptionally volatile when cement demand starts normalizing. The recent consumption pattern is already indicating this. Maple Leaf Cement can be a good bet if investors want to take exposure in cement. Table 2: Cement Stocks Valuation SECTOR PE 11.83x 20-Aug-04 COMPANY PRICE FAIRVALUE PE CAGR (3yrs) PE/ CAGR EPS(YTD) EPS(FY04E) RATING DG KHAN 56.00 47.35 11.77x -1.75% -671.19 3.37 4.76 SELL MAPLE 38.60 43.99 10.92x 38.14% 28.64 2.48 2.70* BUY CHERAT 78.75 86.08 11.33x -9.54% -118.73 5.36 6.99 HOLD LUCKY 38.15 41.61 6.43x 35.99% 17.85 1.80 2.54 HOLD PAKLAND 26.55 16.52 -11.82x -18.56% 63.65 2.28 2.84 SELL BESTWAY 38.00 39.24 10.39x 0.63% 1640.50 2.43 3.66 HOLD ATTOCK 47.00 37.20 13.67x -47.84% -28.57 2.59 3.44 SELL PIONEER 20.35 10.34 7.13x 15.95% 44.72 1.74 2.85 SELL Source: KASB Estimates * Actual EPS FY04 BUY MAPLE LEAF! We have a BUY rating for Maple Leaf owing to: (I) Improved gross margins to 34% as a result of the conversion

to dry process from wet and to coal from oil firing system; (II) The company has recently re-profiled its expensive foreign

currency debt, which has resulted in a reduction of 27% in financial charges or a pre-tax saving of PkR117mn in FY04

(III) The Governments decision to build Kalabagh or Bhasha Dam and raise Mangla Dam will bring a major boost to Maples cement sales.

(IV) Our DCF based Fair value of PkR43.99/share indicates a potential upside of 14% from current levels. The PER relative model assigns a fair value of PkR44.30/share. Buy Maple Leaf!


Analyst Certification I, Shagufta Irshad, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report.


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Report on Cement Sector