Investment Kashmir and Gilgit-Baltistan while South Zone includes

InvestmentCaseLucky CementLimited (hereon referred to as LUCK as quoted on Pakistan Stock exchange) is aleading player in Pakistan’s cement sector. The cement industry has seen a goodrun in wake of rise in local construction activity over the past few years. Thecompany started its commercial operations in 1993 and in little over twodecades, it was at the top a near 20 percent market share. Starting off with acapacity of 1.

2 million tons per annum, it gradually increased its capacity to1.5 million tons in 1999. In another expansion cycle which started in 2005brought further new capacities into the industry, LUCK further increased itscapacity by adding new lines to with seven production lines, bringing its totalproduction capacity to 7.

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5mn tons, the highest in the industry at that time. Thecement industry in Pakistan can be divided into two separate regions; North& South Zone. North Zone includes provinces of Punjab, Khyber Pakhtunkhwa,Azad Kashmir and Gilgit-Baltistan while South Zone includes provinces of Sindhand Balochistan. There are a total of 17 players with a total of 24 cementunits; 19 cement units in the North region and 5 cement units in the South.Players in the North Zone represent around four fifth of the total ratedcapacity i.

e. approximately 81%. Both North andSouth zones havetheir separate demand-supply dynamics, as detailed below:South Market: Playersoperating in the South Market have the opportunity to tap a number of exportmarkets thus providing greater room for revenue diversification. However, witha number of key export markets for South players undergoing local capacityexpansion, reliance on imports has reduced affecting dispatches.

Export ofSouth players has already been impacted due to anti-dumping duty imposed bySouth Africa in FY15-16.North Market: Given thestronger local demand in North Zone, reliance on exports is lower; exportpotential for players in the North Zone is limited mainly to Afghanistan whereinflux of cheaper Iranian cement and limited construction activity due towithdrawal of allied forces has contributed to decline in exports.LUCK has aunique advantage over its competitors as it remains the only major player withpresence in both regions of the country through its plants in Pezu (KPK) andKarachi (Sindh). Apart from local operations, LUCK is also a major player inthe key export markets such as South Africa, Sri Lanka, Afghanistan and otherAfrican countries. As part of its global expansion plans, LUCK recently set upa cement grinding unit in Iraq and a manufacturing plant in the DemocraticRepublic of Congo.

Off late, localsales have remained the key factor driving strong profitability for the companydue to strong construction boom in the country. Exports, on the other hand, havecontinued to disappoint with deterioration in overall fundamentals of the keyexport market such as South Africa where anti-dumping duty to the tune of14-77% was imposed on Pakistani Cement manufacturers.The share priceof LUCK cement shown astounding performance since 2013 due to a host of factorssuch as (1) sharp drop in international coal prices, (2) increasing cementprices in the local market and (3) rising local demand due to strong housingand infrastructure related activity. LUCK being the largest and the most costefficient producer utilized favorable industry landscape to strengthen itsposition further by investing in diversification.

As part of itsdiversification drive, the company acquired ICI Pakistan Limited (ICI) forUS$152.5mn in 2012. ICI Pakistan is a chemical manufacturer and a tradingcompany that has been operating for more than 70 years. ICI Pakistan has fourmajor divisions: polyester, life sciences, soda ash and general chemicals.

Italso has a management stake in the infant milk formula business under the nameof NutriCo Pakistan Private Limited, which manages the import, marketing anddistribution of select Morinaga Milk Industry Co. Limited products in Pakistan.Through its superior management, LUCK managed to turn around distressed ICI andimprove its profitability in the following years.

This is evident from massiveincrease of xx% in share price of ICI during this (xx-xx) period. LUCK’s ownstock also provided strong return of xx% to its shareholders during the same period.Apart from overseas cement plant and ICI, the company is also investing 660 MWcoal based power plant at Port Qasim to sell electricity to the national grid. In a nutshell,LUCK is fast emerging as a leading conglomerate in Pakistan’s corporate landscape.With mighty debt-free balance sheet, company has massive room and is continuingits diversification footprint. This is evident from company’s recentannouncement to setup a car assembling plant in Pakistan in collaboration withKia Motors.

For this purpose, an associated company to undertake themanufacturing, assembling, marketing, distribution, sales, after sales service,import and export of all types of Kia Motor vehicles, with a proposed equityinvestment of up to Rs 14 billion will be setup. LUCK’s 5 year beta is 1.15which means it is 15% more risky as compared to the broader market. However,historical beta does not account for company’s new investments anddiversification drive due to which it can be said that it is now somewhat lessrisky as compared to its historical price movement. The company’s share priceis currently Rsxx and trades at a trailing FY17 P/E of xxx vis-à-vis industryaverage of xxx. The P/E looks pricier as compared to overall industry but thecomparison here is with other manufacturers who are pure cement plays orotherwise less diversified as compared to LUCK. The premium valuationstherefore, are justified for a strong business group like LUCK.

Moreover, LUCKis also one of the stocks which were recently included in the MSCI EmergingMarkets (EM) index post reclassification of Pakistan from Frontier Markets (FM)to EM. When compared to average P/E multiple of 16x of the EM cement companies,LUCK still remains cheaper, implying further room for price appreciation. Thus,the company remains an ideal bet for both value and growth investors.

SectorOutlookThe uptrend inprivate construction activity, fast track work on China Pakistan Economic Corridor(CPEC), improving macroeconomic situation, stable law and order situation, increasingdevelopment spending has led to the increase in local cement demand (up17%/9.54% in FY16/FY17). Strong demand trend is likely to continue and grow ata 3-yr CAGR of 10% with local sales constituting ~89% of the industry sales mixas per leading industry analysts. CPEC is a boon for the countryCPEC is expectedto be the main stimulator of cement demand going forward. Although the totalallocation of ~US$16bn for infrastructure spending out of the total ~US$65bninvestment in CPEC, remains a small amount, the optimism following the steadyprogress on the projects along with expected economic development postresolution of energy crisis will be the key driver of economic and constructionactivity in the country leading to higher cement demand.

The infrastructureprojects under CPEC’s flag include construction of roads and rail network onall three routes including East, West and Central route, to facilitate smoothtrade activities thus creating a strategic nexus between Pakistan, China andCentral Asia. The incremental cement demand from CPEC related infrastructureprojects is expected to be in the range of 0.52-1.57mn tons per annum over aspan of 10-15years.FundamentalAnalysisLUCK maintainsimpressive financial position with Rs33.7bn (20% of Market Capitalization orRs104/sh) in cash and cash equivalents as of 1QFY18 along with an EBITDA marginof 45%. We expect the company to generate EBITDA of ~Rs73bn over the next threeyears (average EBITDA margin of 40%). A strong EBITDA generation should allowthe company to comfortably meet the funding requirement for future growthprojects and add to existing cash pile of the company.

Profitability forecastsLUCK is not onlythe market leader with 18% market share in local cement industry but is alsothe lowest cost producer (LUCK’s average cost of US$29/ton is well belowindustry average of US$34/ton) with presence in both regions. In order tobetter capture the stellar industry growth opportunities and to maintain itsleadership, LUCK has been constantly evolving into a bigger, better and moreefficient player thus leading its peers in the market. The company is currentlyin the process of expanding its operations in both North and South regions with2.

3/1.25mn tons capacity addition respectively. Moreover, the company is in theprocess of installing a 10MW Waste Heat Recovery (WHR) on its Pezu plant,taking its total power generation capacity to 185MW and providing cost savingsto the company, where LUCK already enjoys industry leading margins of 46%. Analystsexpect LUCK’s standalone earnings to grow at a 3-yr of CAGR of 4%.RiskAnalysisVolatilityin international coal prices: International coalprices have rebounded from their low of near US$50/MT mainly due to changes inChinese production levels. Currently, coal prices are trading at their high ofUS$90/MT. Although prices are expected to sustain these levels, furtherincreases serve as risk to company’s profitability.

Analysts estimate that forevery 1% change FOB coal price assumption, FY18E EPS for LUCK changes by 0.4%.Delay in commissioning of expansion projects: Delays in operations of company’s capacity enhancements and otherinternational projects is a key risk to company’s future profitability outlook.Gas supply cut / FO price increases: LUCK is mainly reliant on gas for its captive power generation.Although the plant is dual-fuel i.e.

it can run on both gas and Furnace Oil(FO), cut in supply of gas or increase in prices of FO (mainly driven byInternational crude oil prices) serve as a risk to the company.Greater than expected currency devaluation: Currency devaluation leaves local cement companies vulnerable tohigher coal import prices in local currency terms. Although this is somewhatoffset by dollar denominated exports by the company, overall quantum (coalimport costs vis-à-vis export revenues) results in net loss for the company.Analysts estimate that every 1% change in PKR/US$ parity results in 0.2% changein our FY18 estimate for the company.Delay in completion of growth projects executed by ICI:The Company after its acquisition of ICI PakistanLtd (ICI) has turned it around and continues to explore new investments byutilizing its strong cash flow generation. Delay in implementation of theseprojects may put pressure on stock price of ICI which can ultimately affectvalue of LUCK.Changes in operational environment: Breakdown in pricing arrangement between cement manufacturers in thecountry may result in price war.

This risk is especially gaining grounds as theindustry is undergoing an expansion cycle and is expected to see approximately26mn tons of new capacity coming online by the end of FY20. Quota allocation,as new capacities come online, will be a key problem going forward and mayresult in turbulence in cement prices in the local market.ConclusionLUCK thereforeis in a strong position to capitalize on its strong balance sheet strength toexplore further growth opportunities and face industry headwinds. With strongprofitability outlook, the prospects of LUCK remain strong going forward.Therefore, an investment into the stock is recommended. LUCK is suitablypositioned to leverage its cost and market leadership to benefit from stellarindustry growth backdrop where it is not only constantly investing in improvingits operational efficiency but is also undergoing dual expansions, whichreflects management’s commitment towards future growth.

The company is in theprocess of turning into an international conglomerate with its value-additiveinvestments within and outside Pakistan borders. In terms of local projects,apart from cements, the company has successfully invested in chemicals, pharma,power along with a recent announcement of entry in auto sector through joininghands with Kia Motors in order to build a car manufacturing and assemblyfacility in Pakistan. Moreover, LUCK has marked its footprints in Iraq and DRCongo with cement grinding and cement manufacturing plants respectively, in thewake of exploring new opportunities and markets to expand its core operations.The stock remains one of the cheapest cement operators in both MSCI emergingAsia and frontier markets, trading at a compelling valuation.


htmlCement Sector report: Pak Cements: Walkingthe talk; further upside remains. JS Global Capital (February 09, 2017)  


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