AKD Equity Research about Construction and Material Sector

Karachi: Coming off a below par price performance in FY11 (-ye 25% versus the KSE), AKD Securities expects his cement coverage cluster to pare price gains in FY12 versus the broader market.

According to AKD Securities, moving past the trough in the seasonal demand cycle, AKD Securities expects local cement off take to improve with a low base set last year. Higher volume coupled with likely margin expansion underpinned by the recent hike in bag prices as well as retention of benefits through budgetary measures should buoy earnings for our coverage cement cluster.

To recall, the FY12 Budget announced a host of positives with cuts in GST and FED with zero rating of SED impacting per bag prices in the range of PkR2I/bag-PkR23/bag. Post the budget announcement cement manufacturers reduced prices by only PkR6/bag- PkR10/bag and subsequently increased prices in mid July 2011 by PkR10/bag- PkR12/bag. This, buttressed by declining coal prices (currently lower by 8% from the latest peak of US$129.75/ton), should support margin expansion.

While dispatches in FY12 should move on a gradual clip through the lower end of the demand cycle, there should be incremental improvement going forward. AKD Securities expects total volumetric growth of 5%YoY in FY12 (local – low base due to FY11 floods and export – greater demand from Afghanistan). This gels in well with expectations of higher margins through FY12. That said, the recent sell-off in the KSE-100 index led to an absolute decline of 3.6% in the cement sector.

Considering this an opportunity, AKD Securities remains optimistic on the local cement sector, with LUCK (FYI2F PER: 5.64x) our preferred play, offering an upside of 20.3% to our target price of PkR87.6/share. Investors looking for more than just a cement play may also consider DGKC (FY12 PER: 9.78x) which offers an upside of 37.5% to our target price of PkR28.7/share.

FY11 Dispatches Recap: Total industry dispatches declined by 8%YoY to 31.4mn tons in FY11. Local dispatches declined by 7%YoY to 22.Omn tons with the contraction primarily due to the Aug10 floods and slowdown in construction activities in their immediate aftermath. At the same time, export dispatches registered a decline of 12%YoY to stand at 9.4mn tons in FY11 with a shrinkage in sea exports on the back of an improved international supply position (increased capacity in East Africa and Saudi Arabia).

In our view, FY12F dispatches should depict improved performance coming off a low base on the domestic front and likely improved demand from Afghanistan. Further impetus may arise if 1) PSDP allocation is not slashed wholesale, 2) continuing focus on dams (see table on the next page) and 3) new export markets in Africa/Far East are explored.

Good Budget for Cements: In order to boost domestic reconstruction activities in the aftermath of the devastating Aug’10 floods, GoP announced a host of incentives for the Cement sector in the FY12 Budget. Specifically, GST was reduced by 1 ppt to 16%, FED was reduced by PkR1O/bag (to PkR25/bag) and 2.5% SED was eliminated.

All in all, these measures were expected to reduce cement prices by PkR21/bag- PkR23/bag. In contrast, cement manufacturers reduced prices by PkRG/bag-PkR1 0/bag, clearly retaining the bulk of the FY12 incentives through an increase in margins. Following on, cement prices were increased by PkR1O/bag-PkR12/bag in mid-Jul’11 With manufacturing citing demand.

Margins on the Up: Local cement prices presently stand at PkR387/bag in the North and PkR416/bag in the South where prices have in general depicted a rising trend post the Aug 10 floods. In this regard, FY11 average prices mark a growth of-41%YoY. While the initial spurt in cement prices came in response to higher coal prices, the subsequent price increases are reflective of margin expansion for cement manufacturers. In this regard, after peaking at US$129.75/ton in mid FY11 (on the back of Australian floods), coal prices have now started to settle down.

Current coal prices stand at -US$118/ton, marking a decline of 8% from the recent peak. Going forward, while higher domestic demand should lead to higher cement prices across FY12, leading to sustained high margins for cement manufacturers. In this regard, while coal price trend represents a key swing factor, AKD Securities notes that cement manufacturers are increasingly looking towards alternative fuels to substitute coal. Specifically, the lire Derived Fuel (TDF) fuel for LUCK is expected to commission by Oct11.

FY12 Outlook: With Cements getting off to a good start in the new Fiscal Year, AKD Securities remains optimistic over the prospects for dispatches in FY12F. On the domestic front, volumetric growth should come from long awaited post-flood reconstruction (delayed due to Rabi harvest followed by anticipation of incentives for Cements in FY12 Budget).

AKD Securities conservatively expects local dispatches to revert back to normalized FY10 levels depict moderate improvement as cement companies move towards smaller African countries (e.g. Congo) and expand into the Far East markets. That said, the bulk of export demand is expected to arise from Afghanistan (where we export -50% of our total exports). Over the medium-term, if the US plan to pull troops out of Afghanistan is on track, post-war reconstruction in Afghanistan may lead to heightened demand over the longer term.

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