Investment Kashmir and Gilgit-Baltistan while South Zone includes

Investment
Case

Lucky Cement
Limited (hereon referred to as LUCK as quoted on Pakistan Stock exchange) is a
leading player in Pakistan’s cement sector. The cement industry has seen a good
run in wake of rise in local construction activity over the past few years. The
company started its commercial operations in 1993 and in little over two
decades, it was at the top a near 20 percent market share. Starting off with a
capacity of 1.2 million tons per annum, it gradually increased its capacity to
1.5 million tons in 1999. In another expansion cycle which started in 2005
brought further new capacities into the industry, LUCK further increased its
capacity by adding new lines to with seven production lines, bringing its total
production capacity to 7.5mn tons, the highest in the industry at that time. The
cement 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 Sindh
and Balochistan. There are a total of 17 players with a total of 24 cement
units; 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 rated
capacity i.e. approximately 81%. Both North and

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South zones have
their separate demand-supply dynamics, as detailed below:

South Market: Players
operating in the South Market have the opportunity to tap a number of export
markets thus providing greater room for revenue diversification. However, with
a number of key export markets for South players undergoing local capacity
expansion, reliance on imports has reduced affecting dispatches. Export of
South players has already been impacted due to anti-dumping duty imposed by
South Africa in FY15-16.

North Market: Given the
stronger local demand in North Zone, reliance on exports is lower; export
potential for players in the North Zone is limited mainly to Afghanistan where
influx of cheaper Iranian cement and limited construction activity due to
withdrawal of allied forces has contributed to decline in exports.

LUCK has a
unique advantage over its competitors as it remains the only major player with
presence in both regions of the country through its plants in Pezu (KPK) and
Karachi (Sindh). Apart from local operations, LUCK is also a major player in
the key export markets such as South Africa, Sri Lanka, Afghanistan and other
African countries. As part of its global expansion plans, LUCK recently set up
a cement grinding unit in Iraq and a manufacturing plant in the Democratic
Republic of Congo.

Off late, local
sales have remained the key factor driving strong profitability for the company
due to strong construction boom in the country. Exports, on the other hand, have
continued to disappoint with deterioration in overall fundamentals of the key
export market such as South Africa where anti-dumping duty to the tune of
14-77% was imposed on Pakistani Cement manufacturers.

The share price
of LUCK cement shown astounding performance since 2013 due to a host of factors
such as (1) sharp drop in international coal prices, (2) increasing cement
prices in the local market and (3) rising local demand due to strong housing
and infrastructure related activity. LUCK being the largest and the most cost
efficient producer utilized favorable industry landscape to strengthen its
position further by investing in diversification. As part of its
diversification drive, the company acquired ICI Pakistan Limited (ICI) for
US$152.5mn in 2012. ICI Pakistan is a chemical manufacturer and a trading
company that has been operating for more than 70 years. ICI Pakistan has four
major divisions: polyester, life sciences, soda ash and general chemicals. It
also has a management stake in the infant milk formula business under the name
of NutriCo Pakistan Private Limited, which manages the import, marketing and
distribution of select Morinaga Milk Industry Co. Limited products in Pakistan.
Through its superior management, LUCK managed to turn around distressed ICI and
improve its profitability in the following years. This is evident from massive
increase of xx% in share price of ICI during this (xx-xx) period. LUCK’s own
stock 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 MW
coal 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 continuing
its diversification footprint. This is evident from company’s recent
announcement to setup a car assembling plant in Pakistan in collaboration with
Kia Motors. For this purpose, an associated company to undertake the
manufacturing, assembling, marketing, distribution, sales, after sales service,
import and export of all types of Kia Motor vehicles, with a proposed equity
investment of up to Rs 14 billion will be setup. LUCK’s 5 year beta is 1.15
which means it is 15% more risky as compared to the broader market. However,
historical beta does not account for company’s new investments and
diversification drive due to which it can be said that it is now somewhat less
risky as compared to its historical price movement. The company’s share price
is currently Rsxx and trades at a trailing FY17 P/E of xxx vis-à-vis industry
average of xxx. The P/E looks pricier as compared to overall industry but the
comparison here is with other manufacturers who are pure cement plays or
otherwise less diversified as compared to LUCK. The premium valuations
therefore, are justified for a strong business group like LUCK. Moreover, LUCK
is also one of the stocks which were recently included in the MSCI Emerging
Markets (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.

Sector
Outlook

The uptrend in
private construction activity, fast track work on China Pakistan Economic Corridor
(CPEC), improving macroeconomic situation, stable law and order situation, increasing
development spending has led to the increase in local cement demand (up
17%/9.54% in FY16/FY17). Strong demand trend is likely to continue and grow at
a 3-yr CAGR of 10% with local sales constituting ~89% of the industry sales mix
as per leading industry analysts.

CPEC is a boon for the country

CPEC is expected
to be the main stimulator of cement demand going forward. Although the total
allocation of ~US$16bn for infrastructure spending out of the total ~US$65bn
investment in CPEC, remains a small amount, the optimism following the steady
progress on the projects along with expected economic development post
resolution of energy crisis will be the key driver of economic and construction
activity in the country leading to higher cement demand. The infrastructure
projects under CPEC’s flag include construction of roads and rail network on
all three routes including East, West and Central route, to facilitate smooth
trade activities thus creating a strategic nexus between Pakistan, China and
Central Asia. The incremental cement demand from CPEC related infrastructure
projects is expected to be in the range of 0.52-1.57mn tons per annum over a
span of 10-15years.

Fundamental
Analysis

LUCK maintains
impressive financial position with Rs33.7bn (20% of Market Capitalization or
Rs104/sh) in cash and cash equivalents as of 1QFY18 along with an EBITDA margin
of 45%. We expect the company to generate EBITDA of ~Rs73bn over the next three
years (average EBITDA margin of 40%). A strong EBITDA generation should allow
the company to comfortably meet the funding requirement for future growth
projects and add to existing cash pile of the company.

Profitability forecasts

LUCK is not only
the market leader with 18% market share in local cement industry but is also
the lowest cost producer (LUCK’s average cost of US$29/ton is well below
industry average of US$34/ton) with presence in both regions. In order to
better capture the stellar industry growth opportunities and to maintain its
leadership, LUCK has been constantly evolving into a bigger, better and more
efficient player thus leading its peers in the market. The company is currently
in the process of expanding its operations in both North and South regions with
2.3/1.25mn tons capacity addition respectively. Moreover, the company is in the
process of installing a 10MW Waste Heat Recovery (WHR) on its Pezu plant,
taking its total power generation capacity to 185MW and providing cost savings
to the company, where LUCK already enjoys industry leading margins of 46%. Analysts
expect LUCK’s standalone earnings to grow at a 3-yr of CAGR of 4%.

Risk
Analysis

Volatility
in international coal prices: International coal
prices have rebounded from their low of near US$50/MT mainly due to changes in
Chinese production levels. Currently, coal prices are trading at their high of
US$90/MT. Although prices are expected to sustain these levels, further
increases serve as risk to company’s profitability. Analysts estimate that for
every 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 other
international 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 by
International crude oil prices) serve as a risk to the company.

Greater than expected currency devaluation: Currency devaluation leaves local cement companies vulnerable to
higher coal import prices in local currency terms. Although this is somewhat
offset by dollar denominated exports by the company, overall quantum (coal
import 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% change
in our FY18 estimate for the company.

Delay in completion of growth projects executed by ICI:
The Company after its acquisition of ICI Pakistan
Ltd (ICI) has turned it around and continues to explore new investments by
utilizing its strong cash flow generation. Delay in implementation of these
projects may put pressure on stock price of ICI which can ultimately affect
value of LUCK.

Changes in operational environment: Breakdown in pricing arrangement between cement manufacturers in the
country may result in price war. This risk is especially gaining grounds as the
industry is undergoing an expansion cycle and is expected to see approximately
26mn 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 may
result in turbulence in cement prices in the local market.

Conclusion

LUCK therefore
is in a strong position to capitalize on its strong balance sheet strength to
explore further growth opportunities and face industry headwinds. With strong
profitability outlook, the prospects of LUCK remain strong going forward.
Therefore, an investment into the stock is recommended. LUCK is suitably
positioned to leverage its cost and market leadership to benefit from stellar
industry growth backdrop where it is not only constantly investing in improving
its operational efficiency but is also undergoing dual expansions, which
reflects management’s commitment towards future growth. The company is in the
process of turning into an international conglomerate with its value-additive
investments 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 joining
hands with Kia Motors in order to build a car manufacturing and assembly
facility in Pakistan. Moreover, LUCK has marked its footprints in Iraq and DR
Congo with cement grinding and cement manufacturing plants respectively, in the
wake of exploring new opportunities and markets to expand its core operations.
The stock remains one of the cheapest cement operators in both MSCI emerging
Asia and frontier markets, trading at a compelling valuation.

References

https://www.dawn.com/news/738596

http://epaper.brecorder.com/2016/11/16/8-page/817311-news.html

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

 

 

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