PAKISTAN CEMENT

10 November 2016

SOUTH ASIAN
INDUSTRIALS

Chinese ship at Gwadar port

Source: Chinas Deputy Chief of Mission

in Pakistan (via Twitter)

Contact:
Vahaj Ahmed
+971 4 447 9207
vahaj.ahmed@exotix.com
Alan Cameron
+44 (0) 20 7725 1027
alan.cameron@exotix.com

Chinese-driven disruption unlikely

A Chinese player with an eye on Pakistan. According to a stock exchange

notice, a Chinese potential strategic investor is carrying out due diligence on
Dewan Cement (DCL PA, Pakistans sixth-largest cement manufacturer)
which may eventually lead to an acquisition. Anhui Conch, one of the largest
cement manufacturers in China, is one of the names mentioned in the local
press. It is the same Chinese company which has been involved in disrupting
the Indonesian cement industry through undercutting prices, albeit more via
imports from its own factories in China. Many believe that Anhui Conch (if it
is the Chinese entrant) could try to disrupt Pakistans cement industry in the
same way. In this note, we make comparisons with the Indonesian cement
industry.

Chinese competition would raise fears of disruption similar to

Indonesia. Major capacity expansions by Anhui Conch (following its
acquisition) would cause concern only if Pakistans industry utilisation drops
below 75%. The last period of price indiscipline in Pakistan happened when
industry utilisation dropped to 74% in FY09 (from 89% in FY06) as a result of
the near-doubling of installed capacity to 45.3mt (compared to FY06) the
installed capacity today is 45.6mt. This might be similar to the situation in
Indonesia between 2013 and 2015, when 30% higher supply outstripped the
growth in cement demand (just over 2% per annum), with utilisation dropping
from 86% to 70%. The effect of capacity expansions in Indonesia was
probably compounded by the deceleration of the economy, which we do not
foresee in Pakistan.

Yet undercutting prices does not make commercial sense, in our view.
In FY16, DCLs EBITDA margin stood at 17% compared to the weighted
average of 42% for the five stocks in our coverage, while its average
domestic price (US$81.3/tonne) was c6% lower. Improving EBITDA margins
and/or commanding higher retail prices will require significant investment in
indigenous power generation to reduce costs as well as branding, in addition
to any acquisition premium paid, for example, by Anhui Conch. Therefore,
undercutting prices to gain market share will not benefit unless the acquirer
can afford to operate at a loss for a long time.

Chinese imports uncompetitive with import duties and inland freight.

Local cement prices in Pakistan average US$91/tonne (US$68/tonne
excluding local taxes/duties). This is compared to an all-in delivered Chinese
cement of US$110-120/tonne in Punjab where 82% of Pakistans cement is
consumed. However, if the government removes import duties, Chinese
cement would be 4-12% cheaper but only in the port cities such as Karachi
and Gwadar (ie US$60-65/tonne). In October 2016, 20kt of Chinese cement
was imported by COPHC (the developer and operator of Gwadar port).

We still like Pakistan Cements, top pick Maple Leaf. We reiterate our
positive stance on the sector on the back of pent-up domestic demand
fuelled by (1) an improving economy, (2) rising government expenditure, and
(3) CPEC. Maple Leaf (MLCF PA) remains our top pick (TP PKR143, ETR
50%). We see greatest valuation upside in MLCF, driven mainly by reduction
in energy costs. We forecast MLCF achieves the cheapest fuel-mix for inhouse power generation with the availability of its coal-fired captive plant
from FY18 (which should meet c70% of its existing power requirements).

Recommendations and opinions in this report, unless otherwise stated, are based on a combination of discounted cash flow analysis, ratio analysis, industry knowledge, logical extrapolations, peer group
analysis and company specific and market technical elements (events affecting both the financial and operational profile of the company). Forecasting of company sales and earnings are based on
segmented top-bottom models using subjective views of relevant future market developments. In addition, company guidance and financial guidance is taken into account where applicable. This report is
on a stock under active coverage. All prices provided within this research report are taken from the close of business on the day prior to the issue date unless explicitly stated.
Exotix Partners LLP is authorised and regulated by the Financial Conduct Authority. Please see disclosures on the last page of this document.
Required Disclosures: http://www.exotix.co.uk/uploads/exotixpartnersllpresearchdisclosuresib.pdf.

PAKISTAN CEMENT

A Chinese player with an eye on Pakistan

According to a stock exchange notice, a Chinese potential strategic investor is
carrying out due diligence of Dewan Cement (DCL PA) which may eventually lead to
an acquisition.
Anhui Conch, one of the largest cement manufacturers in China, is one of the names
mentioned in the local press. It is the same Chinese company which has been
involved in disrupting the Indonesian cement industry through undercutting prices,
albeit more through imports from its own factories in China. Many believe that Anhui
Conch (if it is the Chinese entrant) could try to disrupt Pakistans cement industry in
the same way.
DCL is the sixth-largest cement manufacturer in Pakistan with an installed capacity of
2.9mt. It has two production facilities: 1.8mt in the south (near Karachi) and 1.1mt in
the north. Below we provide some benchmarks to help compare Dewan Cement
(DCL) with Exotixs cement coverage in Pakistan.

Table 1: Selected benchmarks - Dewan Cement vs Exotix universe

DCL

Exotix
universe

Utilisation

63%

91%

Local retail price (US$/tonne)

81.3

86.2

Energy cost (US$/tonne)

31.8

19.6

EBITDA margin

17%

42%

EV/tonne (US$)

78

146

Source: APCMA, Company reports, Exotix estimates

The threat of capacity expansions

The prospect of a large new entrant from China will legitimately raise concerns over
excessive capacity expansion, followed by a drop in prices. In the Pakistani context,
the last period of price indiscipline was when industry utilisation dropped to 74% in
FY09 (from 89% in FY06) as a result of the near-doubling of installed capacity to
45.3mt (compared to FY06) the installed capacity today is 45.6mt. The fear is that
Anhui Conchs entry will cause a repeat of this scenario.
Such fears are likely to have been informed by the experience of Indonesia the
other major market where Anhui Conchs expansion has become synonymous with
disruption. Between 2013 and 2015, total capacity was expanded by 30% to which
Anhui Conch itself contributed 8% outstripping growth in cement demand, which
was just over 2% per annum. The result was a decline in cement demand growth from
an average of 9.9% in 2011-13 to just 2.1% per annum in 2014-15. Softening demand
dynamics pushed utilisation rates from 86% to 70%, resulting in downward pressure
on net prices which fell from US$89/tonne to US$71/tonne.
Anhui Conchs 1.6mtpa plant (c2% of Indonesias installed capacity) became
1
operational in late 2014. According to one report , the company has been
undercutting prices in Kalimantan (one of the six regions in Indonesia representing
c6% of the population and c7% of 2015 domestic consumption). In addition to its
2
domestic production, Anhui Conch was reported to have been importing cement from
its own factories in China. With a landed cost estimated at US$60-65/tonne c8-15%
lower than local prices of US$71/tonne, net of taxes and negligible inland freight
costs, this would still have been a profitable strategy for the company. Could the
Pakistani market succumb to a similar fate?

Arrival of new players causes pressure on Indonesia's cement prices

What about Indonesias cement industry in 2016

PAKISTAN CEMENT

Why Pakistan is no Indonesia geography

We see at least three important distinctions worth making. First, Indonesias
geography and market structure are simply not comparable. Shipping costs from
China to Indonesia (US$5/tonne) are much cheaper than to Pakistan (US$15/tonne).
This is partly because Indonesian islands can be accessed through a total of 37 sea
ports (of which at least 10 are active) compared to only two active ports in Pakistan,
both in the southern city of Karachi. Therefore, cement imported into Pakistan would
need to travel 1,000-1,200km inland to reach central Punjab (where 82% of the
countrys cement is consumed); inland freight makes it uncompetitive.
We provide below our estimate for all-in delivered cost of imported Chinese cement
(on a per-tonne basis, excluding 17% sales tax and US$10/tonne excise duty which is
levied on locally-produced cement):

US$45-50 freight-on-board (FOB) price

US$15 shipping costs

US$9-10 import duty (at 20% of FOB price)

US$35-40 domestic transport costs (to Punjab customers)

US$5 distributor margin

This brings the total cost of delivering Chinese cement to US$110-120/tonne with
current prices in Pakistan at US$91/tonne, this means that Chinese companies would
necessarily be operating at a loss. The only way to mitigate these losses would be for
the government to remove import duties, in which case the Chinese cement could
theoretically be 4-12% cheaper, but then again this would only be in the port cities
such as Karachi and Gwadar, where the existing markets are small. The maps
appended to this note show the important differences in geography and market
infrastructure.
In October 2016, 20kt of Chinese cement was imported by China Overseas Ports
Holding Company (COPHC) the developer and operator of the deep sea port in
Gwadar (Pakistan).

Why Pakistan is no Indonesia economic cycle

The second differentiating factor relates to their stage in the economic cycle. In
Indonesia, the large capacity expansion of 2013-2015 coincided with a period of
slowing headline growth, characterised by a slowdown in public expenditure in
particular. Real public sector expenditure growth dropped from an average of 6.4%
yoy in 2011-2013 to 3.1% in 2014-15 (the trough being in 2014). And more
specifically, there was a sudden drop in levels of public sector capital expenditure,
which contracted by 19% (nominal terms) in 2014 alone.
This contrasts with the situation in Pakistan, where the (announced) capacity
expansion is being delivered into a period of accelerating headline growth and rising
government capex. Real GDP growth has been increasing steadily from 2.5% yoy to
nearly 5.0% (expected) in 2016, while public sector capex is now running at 60-70%
above its average level over the past five years, despite the fact we are in a period of
overall budget consolidation. Additional demand is being fuelled both by large-scale
infrastructure projects and consumer demand, which remains robust.

Why Pakistan is no Indonesia industry dynamics

Analysing the financial statements of the top three cement producers in Indonesia
(collectively 86% of domestic market share in 2015), we observe that their EBITDA
margins are lower than Pakistani peers in spite of higher average revenues (in US$terms). In Pakistan, 15% of total volumes are exports which have a much lower
EBITDA margin than domestic sales (due to lower prices and expensive inland
freight). If we assume export volumes were only 2% of the total (like Indonesia),
estimated EBITDA margins for Pakistani peers would stand at 46-47% (compared to
28% in Indonesia). We present selected benchmarks in the table below.

PAKISTAN CEMENT

Table 2: Selected benchmarks - Indonesia vs Pakistan

Population (mn)

Indonesia

Pakistan

255

193

Per capita consumption (kg)

237

171

Capacity (mtpa)

88.2

45.6

Utilisation

70%

85%

Local volumes (% of total)

98%

85%

Export volumes (% of total)

2%

15%

Average revenue (US$/tonne) *

70.7

66.4

EBITDA (US$/tonne) *

20.0

27.8

EBITDA margin *

28%

42%

Source: Company reports, Exotix calculations, IMF, Indonesia Cement Association

(ASI), *cement business only

Pakistans cement industry seems to be in a better position. However, in the unlikely

event of major capacity expansions from Anhui Conch (or other Chinese cement
manufacturers), the subsequent decline in prices would still be negative.
Looking at DCL in particular, in FY16 its EBITDA margin stood at 17% compared to
the weighted average of 42% for the five stocks in our coverage, while its average
domestic price was c6% lower. DCL utilisation was well below the industry average of
85%. We believe this was due to a lower production quota allocated to the company
by APCMA (Pakistans cement association) as result of its inherent efficiencies,
possibly through its reliance on expensive national grid power and higher-thanaverage coal consumption.
Improving EBITDA margins and/or commanding higher retail prices will require
significant investment in indigenous power generation to reduce costs as well as
branding, in addition to any acquisition premium paid, for example, by Anhui Conch.
Therefore, undercutting prices to gain market share will not benefit unless the acquirer
can afford to operate at a loss for a long time.

Figure 1: Indonesia - capacity (mt), utilisation, market share

Figure 2: Indonesia - average revenue (US$/tonne), EBITDA

100%

100

100

50%

80%

80

80

40%

60%

60

60

30%

40%

40

40

20%

20%

20

20

10%

0%

2013

2014

Capacity (RHS)

Utilsation

Source: Indonesia Cement Association (ASI)

2015
Market share (Top 3)

0%
2013
Average revenue

2014

2015
EBITDA margin (RHS)

Source: Company reports, Exotix calculations

PAKISTAN CEMENT

We continue to like Pakistan Cements

We reiterate our positive stance on the sector on the back of pent-up domestic
demand fuelled by (1) an improving economy, (2) rising government expenditure, and
(3) CPEC. Maple Leaf (MLCF PA) remains our top pick (TP PKR143, ETR 50%). We
see greatest valuation upside in MLCF driven mainly by reduction in energy costs. We
forecast MLCF to achieve the cheapest fuel-mix for in-house power generation with
the availability of its coal-fired captive plant from FY18 (which should meet c70% of its
existing power requirements).

Table 3: Pakistan Cement - summary of rating, target price and FY17f EPS
Rating

TP
(PKR)

ETR
(%)

FY17f EPS
(PKR)

Capacity
(mt)

Utilisation
(%)

EV/tonne
(US$)

DGKC *

BUY

247

38%

19.5

4.2

105%

169

FCCL

BUY

42

15%

4.0

3.4

82%

151

Company

KOHC
LUCK *
MLCF

BUY

338

35%

29.3

2.7

78%

134

HOLD

713

5%

71.0

7.4

89%

143

BUY

143

50%

11.4

3.4

95%

141

Source: Exotix estimates, Share prices 9 November 2016, * EV estimate excludes

listed/unlisted investments

Valuation methodology
Our target prices are based on a DCF (and sum-of-the-parts for DGKC and LUCK)
and net cash. The main parameters in our DCF are:

(1) a risk-free rate of 11.0%

(2) an equity risk premium of 5.0%

(3) a cost of debt of 8.4%

(4) a terminal growth rate of 4.0%.

Risks to our valuation

Key risks to our forecasts, valuation and recommendation include:

An increase in the competitive intensity on pricing among local cement producers.

A deterioration in macroeconomic and political conditions in Pakistan, which

impedes the growth of cement demand from residential consumers and from
government infrastructure budgets.

An increase in fuel costs (rising international coal prices) or power costs (local
gas tariffs, national electricity grid tariffs) which cannot be passed on to
consumers without impacting demand.

An increase in the occurrence of gas supply interruptions for in-house power

generation which inhibits the growth of capacity utilisation.

Unplanned outages of cement operating capacity as existing assets age and run
closer to 100% utilisation.

The main upside risk is that local cement demand growth occurs at a higher multiple
of nominal GDP growth than we have assumed.

PAKISTAN CEMENT

Figure 3: Ports in Indonesia

Source: SeaRates.com

PAKISTAN CEMENT

Figure 4: Ports in Pakistan

Source: SeaRates.com

PAKISTAN CEMENT

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