Pakistan cement stills attractive at PSX index

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With the massive surge in local demand and recent increase in North cement prices, we reiterate our Overweight stance on the Pakistan Cement sector. The steep rise in gross margins towards c.31% by FY22f and a 3yr EPS CAGR of c.40% will push the rally further, in experts view.

Domestic cement demand growth will remain in double-digits during FY21/22f (up 16% yoy in 7MFY21) led by strong private demand amid government incentives for construction sector. The cement prices in North are expected to rise further to PKR610/bag by the end of FY21 – having already increased by c.PKR50/bag since November 2020.

Our top picks are (i) DGKC for higher earnings growth and a complementary investment portfolio, (ii) FCCL for lower fixed costs and sales exceeding capacity share, (iii) KOHC for high sensitivity to prices and (iv) LUCK for superior profitability and unmatched diversification.

Lift earnings estimates with better demand outlook

We now estimate cement sales growth of 16%/10% yoy for FY21/22f from 10%/8% earlier, in light of an enhanced outlook for demand growth, along with quicker-than-expected price increases during FY21f so far. As a result, the FY21/22f EPS estimates for our Cement Universe have risen by c.10%/9% on average. We reiterate our Overweight stance on the sector, despite the 113% rally since late March 2020. Our top picks are DG Khan Cement (DGKC, Buy, TP PKR180/sh), Kohat Cement Company (KOHC, Buy, TP PKR300/sh), Fauji Cement Company (FCCL, Buy, TP PKR35/sh) and Lucky Cement (LUCK, Buy, TP PKR975/sh). Fresh triggers for the sector will be further hike in cement prices in North and more expansion announcements during 2HFY21, where LUCK has already announced an expansion in North of 3.15mn tons pa (details inside).

Multiple factors will lead to optimal utilization

Recent rise in local dispatches was mainly propelled by private sector and pent-up demand after Covid-19 induced lockdown. This demand is expected to sustain for a couple of years mainly backed by multiple construction projects countrywide, stirred by government incentives (notably, amnesty for builders). We think demand will accelerate once the construction of dams and CPEC related projects commence work (will entail greater PSDP). In this backdrop, exports will continually be replaced by much higher-margin local sales (especially in case of South producers). Therefore, we expect industry utilization to nudge 95% by the end of FY23f – beyond which, it will be an opportune time for the industry to add new capacities, in our view.

Prices will rise further, coupled with declining variable costs

Retail cement prices in the North have increased by c.PKR49/bag since November following recent increase in international coal prices and robust demand illustrated above. We foresee that North based cement prices will potentially increase to PKR610/bag by June 2021 from c.PKR590/bag at present, given the demand outlook. Note that since November 2020, average coal prices have increased by only 4.4% to US$87.3/ton (while PKR was flat); whereas, cement prices have increased by 8.6% during the same period. We assume that coal prices will normalize at US$70/ton after February 2021, when global winter demand will normalize.

Hence, the increase in cement prices and decline in variable cost will lift gross margins for our Cement Universe by 22/7ppt to average c. 23/31% in FY21/22f. In the South, however, prices have remained flat around PKR660/bag since November 2020; but we expect them to recover to PKR700/bag as well by June, as producers replace exports with local sales, and North producers will be absent in the South market.

New expansion cycle won’t be a big threat for the medium term

As the industry is operating at c.82% utilization levels (by January 2021), new expansion cycle has already begun, where LUCK is the first company that announced a new expansion (of 3.15mn ton in North). We believe that most of the expansions will be in the North, except that of Attock Cement (ACPL) in the South. Also, majority of the players are expected to opt for green-field expansion (except for LUCK, KOHC, ACPL and DGKC). Average time for any brownfield expansion is at least 1.5-2.0 years, while green-field projects take 3-4 years. The stupendous increase in profitability during FY21-23 will also ensure optimal use of leverage for most cement companies, in our view. Therefore, we believe that expansions do not pose a material threat to our medium-term outlook for cement profitability.

We remain Overweight on the sector

While we have Buy rating for all the companies in our coverage, we prefer those companies which are selling more than their capacity share (such as DGKC and FCCL). Our top picks are (i) DGKC for the higher earnings growth potential and a complementary investment portfolio, (ii) FCCL for selling more than its capacity share and cost leadership amid lower fixed costs per ton, (iii) KOHC for a good blend of high sensitivity to prices and ample room for volume growth due to low utilization post new expansion, and (iv) LUCK for unmatched cost efficiencies and diversification.

Courtesy – Intermarket Securities Limited

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