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Updated on Sep 01, 2001

The KSE - Overview: Where's the volume?

KSE-100 Index declined by 10 points to close at 1258.44 during this week as market players were hesitant to enter the market due to the absence of much awaited institutional support fund of PkR5.0bn from public financial institutions. Average daily volume (ADV) fell by 60% to 30mn shares from 74.6mn during last week. Even though the drop in the KSE-100 Index was just 1% during this week, the sharp fall in the ADV indicates the fading investor interest in current market scenario.

The market, however, managed to hold its ground on Monday by finishing two points above its Friday's close. Market participants, on Tuesday, were expecting activity in major fertilizer shares as the new fertilizer policy was to be announced. But this euphoria did not last very long and as soon as the news of delay in the announcement of the fertilizer policy hit the street, the selling wiped the gains made during the day. The Index dropped 8 points with ADV touching the all week high of 35.4mn shares.

The ADV on Wednesday fell to 21.22mn shares, surpassing the low of 24mn shares reached on May 28, 2001. Shell saw a drop of PkR8.85/share just a day before announcement of its FY01 results. Shell Pakistan Limited reported a drop in NPAT of over 19% in FY01. Adamjee Insurance, on the other hand, reported its first ever loss of PkR212mn in lH01 since its inception 40 years ago. These announcements added fuel to the already bearish sentiments of the market, thus making investors ever more reluctant to step inside the trading ring. However, the market, on Thursday, did manage to see some trading activity in major stocks of the fertilizer sector as the delayed fertilizer policy was finally announced.

Adding to the uncertainty were the prospects for the release of the final tranche of 105mn SDR from the IMF under the SBA facility. Our economist believes that there should be no hindrances to the disbursement of the final tranche. He also feels that rumors regarding the IMF only extending another 1 year SBA are also unfounded, and believes that the medium term PRGF is likely to come through. The timing of the PRGF will depend on the time that the GoP needs to finalize the PRSP (currently doing the rounds of the provinces) and to lay down the framework for a transition to Islamic financing.

We believe that the bearish trend is not likely to continue for very long as, according to market sources, the support fund is in its final stage of completion and we believe that anyone's guess is as good as ours as far as the timing of its entering the stock market is considered. We believe however that the down side risk is limited to 1245 level and there is potential of correction in the short term.

The next two months will see an inflow of FY01 result announcements, which will set the tone of the market going forward. In our opinion, any positive news flows coupled with improved performances in FY01 from the financial, FMCG and Auto & Allied sectors could provide the needed fuel to lift investor confidence, going forward.

On the KSE administrative front, starting September 1, 2001, all the stocks will be successfully transferred to T+3 rolling settlement system from the existing T+5. The future trading in one month contract has already begun on Thursday 30, 2001 and we believe that trading activity on the future counter would increase, going forward, as local investors understanding of the trading system improves.

Sector Review

Lucky Cement

With the growing emphasis of the government on the construction and housing industry and development of new water reservoirs, a silver lining maybe discernable for the cement industry in the coming future, especially since 60-70% demand comes from the construction and housing industry. On the basis of the World Bank's recommended occupancy rates of 6 persons per house and Pakistan's population of 140 million, the total number of required housing units in the country are estimated at 23.4mn as of June 2001. Also, with the GoP allocating a fund of PkR100bn for various water reservoirs and storage projects overall demand of the cement sector is expected to rise.

With the availability of limestone and gypsum domestically, Pakistan can potentially become one of the major producers of cement in South Asia. Despite this, it has the lowest capacity utilization within the region at around 70%-75%. Furthermore, domestic per capita consumption is only about 71kg/head versus the average regional consumption of 242kg/head. According to industry sources, these projects are likely to improve the capacity utilization of the sector from 60% to 65% (excluding Pak-Sadi Cement).

The government has recently allowed the conversion of cement plants from furnace oil to coal. According to industry sources, the average cost per 50kg bag is around PkR260 versus an average price of PkR225/bag, with the main cash cost elements being fuel and power inputs, which come to about 65% of the production cost. According to industry sources, the cost of coal is around 55% of the furnace oil cost and the conversion is likely to reduce it by almost two-thirds. However, this process is likely to take more than two years and require an additional investment of around PkR300-400mn.

Potential Silver Lining

In an over supplied cement market like Pakistan where the manufacturers are forced to cut down their capacity utilization, the possibility of cement export is the proverbial silver lining for the recession-torn industry. Countries like Sri Lanka, Bangladesh and Vietnam are net importers of cement, importing 2-3 million tonnes each year. Pakistan can reduce its surplus capacity by exporting cement to these countries, while competing with Indian and Chinese suppliers.

The government, in order to boost exports, has recently allowed the exporters of cement to avail duty drawback facility (central excise duty) on trade with the Afghanistan and Central Asian States through the land route. Cement manufacturers have been pressing this issue for quite a long time. According to industry sources, this is due to the reason that domestic cement was becoming much more expensive than other regional exporter countries.

Another issue, which has yet to be solved, is the lack of facilities for handling bulk export of cement. At present, Pakistan has the capability to export 5.9mtpa cement, after fulfilling the domestic demand through which approximately US$415 million could potentially be earned, assuming an average price of US$70.3/tonne. The main hindrance for cement export is the lack of facilities for handling bulk unpackaged cement, which is much cheaper than handling bagged cement. According to 1998 figures, Pakistan's port-handling capacity is less than 0.5mtpa. Therefore in the coming years, should Pakistan wish to export cement, limited bulk cement handling facilities will remain a major deterrent.

The Company

Lucky Cement is a 1.32mtpa green field project based on the dry process. The plant and machinery has been supplied by China, making it the biggest Chinese plant outside China. This project has been sponsored by Younus Brothers, one of the leading textile-based business houses. The group is operating in diverse industries. Other listed concerns include Gadoon, Saif, Fazal Textiles and Security Investment Bank.

Enjoying lower costs:

As the market has moved from a virtual sellers market to an over supplied situation, where the prices are stagnant, profitability has became a function of volume, location advantage and proximity to markets. Being located at Pezu, in Lakki district of NWFP, 1 km away from the main highway connecting Bannu and Kohat, Lucky is catering to the markets of Southern Punjab and NWFP like Peshawar, Kohat and DI Khan, and fulfilling 11% of the demand of this region. Lucky is earning superior profits on account of lower transportation costs as compared to some other plants located in the northern zone. Easy access to the raw materials and furnace also helps to suppress costs. However, in order to reduce cost, from current levels, the company is planning to switch over to the coal in place of furnace oil, as soon as possible.

Its 47.25MW wholly owned subsidiary Lucky Powertech, provides electricity to the plant at the rate of PKR3.62/kwh against the average market rate of PKR4.61/kwh to industrial users.

Financial layout:

Lucky is a fairly new player in the cement industry. With China-made crushing lines, company's project cost at PKR 2,800/ tonne is lower than others. Its low gearing and the strong financial position of its sponsors further reduce its risk of default. The company's interest coverage for HY 01 of 3.2x is also higher than that for DG Khan (0.26x) and Fauji (0.42x), for the corresponding period.

If we look at the Dupont ROE decomposition of Lucky we can see that the ROE ratio of the company has increased substantially to 6.3% in FYOO.

Dupont analysis indicates that the improved ROE can be explained largely by the increase in the operating margin. Since starting operation, the company has grappled with technical difficulties with one of the production lines of its Chinese-origin plant, which explains lower operating margins in the first two years. Now, with the increasing operating margins Lucky's ROE is also improving.

Our Expectations for FY01

Lucky cement is expected to post a 40% reduction in its estimated net earnings during FYO 1 to PkR126mn, compared with PkR226mn in FYOO.

We expect only mediocre growth in sales due to marginal volume growth, since demand conditions have remained poor for the cement sector. In lHO1 capacity utilization was only 58.6% for Lucky and we do not expect to be higher than 60% for the full year.

Further, an all out price war during lHOl hurt all cement producers. Although the "cartel" was slightly better organized in 2HO1, we believe that average cement prices were at least 15% lower for the full year FY01 versus FY00. At the same time, furnace oil prices moved significantly higher during FY01 as compared to FY00.

As a result of the above, we forecast that the gross margin for Lucky is likely to come out at only 12.8% in FY01 to PkR270mn versus PkR545mn in FY01. With financial charges continuing to fall significantly for Lucky (in the first half of 2000) the reduction in net margin of 6% for FY01. Thus, we feel that NPAT for FYO1 will come out at PkR270mn.

Risk factors

Proposed GoP projects not implemented or being delayed
Lucky located on a riverbank, and hence faces problems associated with its foundations, which limit Lucky's ability to operate above 80% of capacity utilization
Lucky has a Chinese plant, with 40% European components, which may have lower operating efficiency than competitors.

Valuations & Fundamentals

With the new horizon opening to the cement sector especially on the export front the cement companies located in the northern area of the country, near Afghan and Central Asian countries' borders are likely to benefit more. This includes Lucky, DGK, Cherat, Fauji, and Maple Leaf etc.

Lucky is trading at a high premium to market valuations with FYO1 (forecast) PER of 11.9x and thus we do not expect it to significantly outperform the market over the next twelve months. At the same time, we believe that with a Book Value per share of PkR15 FY01F, the downside from current levels is also limited. From a trading strategy perspective, we feel that reasonable liquidity in the stock means that it can jump up in the short term on announcement of infrastructure development news. So, for investors betting on the overall market improving in the short term, Lucky is a Trading Buy at PkR6.00 levels.

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