DEVASTATIONS OF EXCESSIVE CAPACITY IN CEMENT AND SUGAR

The government is losing immense amount of revenue from the menace of tyre smuggling

Some 10-15 years ago, ownership of sugar and cement plants in Pakistan was envy of every top businessman because of the bright profit prospects. Now it is a different scenario. Cement and sugar units are operating with lackluster performance and the country appears to be stuck with excessive capacity, far beyond our local needs and much in excess of the competitive export prospects. Excessive capacity in sugar and cement has contributed most to the troubles of both these important sectors with adverse consequents for stakeholders particularly the creditors and the minority shareholders. The unenviable position will be clear if one looks at the share quotations of the listed companies as well as the respective Price/ Earnings ratios (Annex-One to this paper). Low market prices and very low or negative P/E ratios amply depict the prevailing troubled conditions. The shares of a large number of sugar companies are not listed on stock exchanges but their condition is not expected to be much different.

This paper is an attempt to discuss the reasons that led to the unhappy situation, to guess the amount of funds tied up, to know the relative sufferings of the stakeholders and to discuss if establishment of such excessive capacity can be controlled in a developing country like Pakistan that is moving towards market economy. This analysis may possibly also help in better allocation of scarce resources in future.

The arrive at the estimates of excessive capacity, the installed capacity for Portland cement and the white sugar respectively is compared with the existing demand for both these products in Table-A.

1. New capacity is based on modern technology and the plants are of bigger capacity. Sponsors of the new plants probably were of the opinion that with modern and more efficient plants, they will be able to force out the old plants and thus create enough space for the new capacity. However, in actual this did not happen. The old cement mills are based on wet-process or earlier versions of the dry-process. These plants are not as efficient as the modern plants. Some of the old capacity should have been retired long ago but it was not, in some cases due to good economic reasons. The owners of these plants perceive them viable, as there was not much of a depreciation charge and little debt servicing, so they got enough cash by continuing with the operations.

2. New cement capacity was also planned based on increased activity in construction and the start of many mega projects. However, it appears the mega projects were late in coming to initiation stage and also that the local housing and construction activity did not pick up as much as was expected.

3. Because of cheap labour and availability of all raw materials, big potential of export of cement is mentioned while justifying capacity gap and in determining the viability of new cement plants. After the plants are established, the exports might not materialize in volumes as originally envisaged due to a number of reasons and thus the excessive capacity.

1. Sugar plants are thought to be vehicles for development of agriculture and for the economic development of the rural areas. On local level this may be so but overall viability of the sugar plants need to be also judged from country perspective. If there are a number of sugar mills already operating in a particular sugarcane growing location, one must be weary of putting up new sugar mills there. Obviously, the concerned people ignored this reality and thus contributed towards the excessive capacity.

2. Sugar production depends, to a large extent, on the availability of sugarcane in a particular year. In case local production is less, the deficit is met through imports. Large quantities of sugar also used to be smuggled out to the neighbouring countries. This may have caused some confusion as to the total demand and supply requirements.

3. In the past Pakistan offered large subsidy (Rs 4500 per tonne) on sugar exports. This may also have been a contributing factor towards excessive capacity. The then pricing system for the sugarcane may also be one of the probable reasons.

1. Certain big business groups with a number of successful industries become over-confident and are able to set up industries for which there is marginal space for additional capacity. The creditors also prefer to go along and happily finance such business ventures, confident that the group will honour the commitments in any eventuality. In certain cases new plants may have been installed disregarding or misreading the projected demand / supply situation. This attitude might have contributed in the setting up of certain plants in sugar and cement sectors.

2. Lack of reliable statistics about production capacity, actual production, export prospects, government policies, etc. might also have contributed for the situation.

Cement and sugar plants have a long history of profitable operations in Pakistan. In those early days capital cost was relatively less and the technology used was not so advanced. In the last decade the capital cost of new plants has been many times higher as compared to the cost incurred some twenty or thirty years ago. This is understandable particularly if one looks at the Dollar-Rupee rates over this period. New plants have been added while old plants in many cases have not been retired. Old plants generate sufficient cash for the owners, as there is little debt servicing required or depreciation to be accounted for. In such a situation one does not find clear demarcation as to when the installed capacity reached excessive limit and as to the cost of which particular plants to be used for estimating the money stuck up in the excessive capacity. Both for sugar and cement plants, the average capital cost during past 7-10 years have been used. As is evident from Table-A above, for Portland cement the excess capacity is around 40%, whereas for white sugar it is about 50%. Such capacity required huge capital outlay, the volume of which been guessed in Table -B, below:

Capital expenditure incurred for the excessive capacity is guessed at around Rs 43 billion. However, it may be noted that the situation created by the excessive capacity has jeopardized both the existing as well as the new investment. Existing plants as well as newly set up plants, all are facing difficult odds. Some are showing meager profits while others are in red. Therefore for the purpose of analysis, the total investment in both the cement and sugar sectors need to be taken in account. Such investment might be in the range of Rs100-125 billion. Assuming debt equity ratio of 60:40 for the lower figure, the debt portion is approx. Rs.60 billion and the equity portion is Rs. 40 billion. This is large money by any standards. If cement and sugar plants do not perform well, it will have devastating impact on different stakeholders particularly the creditors, investment banks, leasing and Modarabas as well as the minority shareholders from the general public. In fact, the suffering on individual and institution level has been high and painful. Perhaps, this might have precipitated the demise or merger of some of the DFIs or banks.

The following may help for better appreciation of the impact on different stakeholders:

1. Cement plants, or for that matter other large industrial plants, are financed through financial resources of the project sponsors, general public and the creditors, both local and international. In case the plant is not able to operate near full capacity, the cash generation and the profitability might not be enough to meet the expectations of stakeholders by way of taxes, profits, dividends or appreciation in the value of shares on the stock exchanges.

2. The cement plants can meet the demand operating at about 60% of the installed capacity. In fact every plant has been operating around this number and there were allegations of existence of some sort of cartel but the cement manufacturers denied it. The rest of the capacity is not being utilized. As such all the fixed charges are now to be covered through this relatively lower capacity. This way per tonnes of output, the fixed charges are relatively higher. There is some adverse impact on the overall cost due to lower capacity operations. This raises the cost of production per unit and the product competitiveness is reduced. The prospects of export of cement and sugar have brightened up due to the rehabilitation and reconstruction efforts in the neighbouring Afghanistan, but this will have limited impact on the use of excessive capacity.

The consumer generally benefit if there is excess capacity and the manufacturers are in a mood to fight it out through war. This, however, does not appear to be happening in Pakistan. The manufacturers of cement plants are operating around 60% capacity while maintaining prices at levels higher than the ones announced by the government. The impact on other stakeholders is briefly given below:

a. Higher debt in case of foreign currency loans and thus higher debt serving and drain on country's scares foreign exchange resources.

b. Lower activity so lower taxes to the government and lower opportunities to small and medium industries in any way related to these sectors. Also, lower employment opportunities (direct and indirect).

a. High possibility of default in debt servicing or actual default. This has direct threat to the very existence of the creditors.

b. Numerous requests for rescheduling or debt restructuring, with little hope of recovery even after that.

c. No or little return on investment in case of investment in shares. This also threatens solvency of the institution concerned.

a. The payment situation should not be that bad in case of cement plants. The main raw materials and spares constitute a small percentage of the cost of cement. Energy and power cost are the main elements that are recovered by the utilities each month.

b. The payment situation is very bad in case of sugar. Raw material is sugar cane and the mills are not famous for timely payment even in normal years or conditions. The farmers suffer badly as payment for the sugarcane is delayed for months, even for years in certain cases. The presence of middlemen often muddles the situation.

c. Providers of stores, supplies and services also experience delays in the clearance of bills, in some case total loss is also not ruled out.

5. Institutional investors and minority shareholders: The situation created by the excessive capacity can be visualized from a review of the Sectoral Indices, and Market Capitalization (summarized in Table-C below) and the Share Quotations, P/E ratios (given in Annex-One). A larger number of minority shareholders have lost a fortune and so have a number of financial institutions. The development overtime and how the fortunes experienced ups and downs can be briefly seen from Table-C, below:

Profitable industries contribute to the economic welfare of the populace. In the absence of viability there is loss of confidence in the investment process in the country and the rationale for savings is shattered to some extent. Loss of confidence is a serious cause and timely actions may be taken by the government to avoid repetition.

There are four distinct stakeholders namely, minority share holders, project sponsors, foreign creditors and the local creditors. Because of little or no dividends the minority shareholders suffers the most. Local creditors are the next to lose a fortune. The foreign creditors such as IFC, CDC have bigger clout and in most cases will get paid or the loans will be rescheduled on their terms. The project sponsors also do not get any dividends. However, as they are running the management of the plants as Chief Executive or Executive Directors, they are partly compensated for their efforts. They do not have to worry for their day-to-day expenses. Most of them probably would not avail the opportunities of making extra money due to their being in control of the operations and all other activities of the mills / companies concerned. However, one never knows when greed overcomes the moral and legal restraints.

Capacity forecasting is a difficult area. If one is more careful about expansion in capacity, there might develop a situations when local or export demand is not fulfilled and there is threat of losing established market. Moreover, Pakistan is moving towards market economy and as such the government might not like to put undue restrictions on the setting up of new plants or capacity in the country. However, the minority shareholders / general public might protected through provided more detailed and accurate information as to the existing capacity vis-a-vis existing demand for cement or white sugar or for other products. The Prospects for floating of shares or for the placement of TFCs may better be made more informative so that they are in a better position to assess the risks. The sponsors, their financial advisors and other concerned parties may be held accountable for misinformation or for misleading or untrue statements. The creditors, both local and foreign, together with the institutional investors are also expected to play a bigger role in thorough assessment of the risks involved in the credit operations particularly all relevant factors including demand supply situation vis-a-vis plant capacity. They have to identify and manage the risks well for themselves as well as to help the minority shareholders with much better information. They owe it to their country and its people.

TABLE- C Sectoral Indices of Share Prices (1990-91=100) and Market Capitalization
	CEMENT			SUGAR
Years	Share Price Indices	Market Capitaliz.	% of Total capitaliz.	Share Price Indices	Market Capitaliz.	% of Total capitaliz.	Total Capitaliz Ord. Shares.
		(Billion Rs)			(Billion Rs)		(Billion Rs)

1991 -92	305.86	6.69	3.06%	123.43	6.84	3.13%	218.36
1992-93	382.35	11.45	5.34%	121.39	7.59	3.54%	214.43
1993-94	986.48	31.38	7.76%	153.50	9.63	2.38%	404.58
1994-95	496.82	22.20	7.57%	98.73	6.12	2.09%	293.33
1995-96	220.17	.18.23	4.99%	86.06	5.21	1.43%	365.24
1996-97	144.71	14.45	3.08%	80.27	4.77	1.02%	469.15
1997-98	65.60	6.40	2.47%	70.60	4.30	1.66%	259.30
1998-99	69.42	6.02	2.08%	70.97	4.17	1.44%	289.20
1999-00	106.22	10.21	2.61 %	69.50	3.83	0.98%	391.86
2000-01 *	76.57	7.54	2.30%	78.30	4.08	1.24%	328.24
2002(April)		15.54	3.64%		4.45	1.04%	427.35
*( end March)**

ANNEX-ONE K S E: Share Quotations and P/E Ratios of Cement and Sugar Sectors (as reported in the Business Recorder in its issue of 25th April, 2002).
Cement Sector Companies	P/E Ratio	Prev. Rs Rate	Last Rate Rs	High Rs.	Low Rs.	Turnover(Nos.)
1 Bestway Cement	-	18.45	18.45	-	-	-
2 Chakwal Cement	-	1.80	1.80	1.80	1.65	144,500
3 Cherat Cement	3.36	24.00	25.00	25.00	24.00	25,500
4 D.G. Cement	-0.66	10.50	11.05	11.45	10.50	6,640,000
5 Dadabhoy Cement	0.04	5.65	5.70	5.70	5.70	1,000
6 Dandot Cement	-7.12	4.45	4.50	4.50	4.50	-
7 Essa Cement	1.41	10.00	10.15	10.15	10.05	5,500
8 Fauje Cement	-1.65	3.95	4.10	4.10	3.85	79,500
9 Fecto Cement	-1.75	8.05	8.00	8.00	8.00	7,000
10 Gharibwal	2.63	4.90	4.85	4.85	4.85	-
11 Javedan Cement	-10.54	4.55	5.00	5.00	5.00	4,000
12 Kohat Cement	1.03	27.00	27.00	-	-	-
13 Kucky Cement	0.23	9.60	9.90	10.00	9.65	338 000
14 Maple Leaf	-4.53	8.20	8.30	8.40	8.20	200000
15 Mustehkam	-17.97	13.00	13.00	-	-	-
16 Pakistan Slag	-0.94	1.90	1.95	2.00	1.95	1,500
17 Pakland C eme nt	-	5.10	5.10	-	-	-
18 Pioneer Cement	-2.42	3.60	3.60	3.65	3.60	11,000
19 Saadi Cement	-	2.00	2.00	-	-	-
20 Zeal Pak	-	13.90	13.90	-	-	-
Sugar Sector Companies	P/E Ratio	Prev. Rate Rs.	Last Rate Rs.	High Rs.	Low Rs.	Turnover(Nos.)
1 Adam sugar	-2.41	4.25	4.25	-	-	-
2 Al- Abbas Sugar	1.05	16.00	16.10	16.10	16.10	1,000
3 Al-Asif sugar (D)	-1.67	1.05	1.05	-	-	-
4 Al-Noor Sugar	-0.86	9.45	9.45	-	-	-
5 Ansari Sugar	1.30	1.60	1.60	-	-	-
6 Baba Farid	0.80	6.10	6.10	-	-	-
7 Bawany Sugar	-8.92	5.45	5.45	-	-	-
8 Chashma sugar	0.07	13.75	14.35	14.50	13.50	58,500
9 Crescent Sugar-XB	-	7.50	7.50	-	-	-
10 Dewan sugar	2.45	12.50	13.00	13.00	13.00	1,000
11 Faran sugar	4.14	7.10	7.10	-	-	-
12 Fecto sugar	0.66	8.00	8.00	-	-	-
13 Frontier (P)	-	37.30	37.30	-	-	-
14 Frontier (O)	13.64	26.00	26.00	-	-	-
15 Habib Sugar	1.60	11.25	11.25	-	-	-
16 Hamza Sugar Mills	-	24.50	24.50	-	-	-
17 Haseeb waqas	-0.83	2.70	3.00	3.00	2.60	65,000
18 Hussain Sugar	0.19	11.00	11.00	11.00	11.00	500
19 J.D.W.Sugar	-2.03	5.50	5.50	-	-	-
20 Khairpur Sugar	-2.23	10.00	10.00	-	-	-
21 Kohinoor Sugar	0.35	5.90	5.90	-	-	-
22 Mehran Sugar	3.20	16.25	16.25	-	-	-
23 Mian Mohammad (D)	-	0.20	0.20	-	-	-
24 Mirpurkhas Sugar	-1.42	6.55	6.55	-	-	-
25 Mirza Sugar	-	1.50	1.50	1.50	1.50	500
26 Noon Sugar-XD	5.18	30.50	30.50	-	-	-
2i Pangrio Sugar (D)	-	2.00	1.95	1.95	1.95	-
28 Premier Sugar	46.91	58.00	58.50	58.50	58.50	-
29 Sakrand Sugar	-0.68	1.50	1.50	-	-	-
30 Salim (O) (D)	-	6.00	6.00	-	-	-
31 Salim (P) 6% (D)	-	55.90	55.90	-	-	-
32 Salim (PP) (D)	-	4.00	4.00	-	-	-
33 Sanghar Sugar	-1.50	4.25	4.25	-	-	-
34 Shahmurad	0.85	5.90	5.90	-	-	-
35 Shahtaj Sugar	1.67	14.40	15.05	15.05	15.05	-
36 Shakerganj	0.15	10.00	10.00	10.00	10.00	10,000
37 Sind Abadgars	1.45	5.50	5.50	-	-	-
38 Tandialianwala	0.58	3.60	3.60	3.65	3.40	12,000
39 Thal Industries	2.40	13.00	13.00	-	-	-
40 United Sugar	0.53	10.00	10.00	-	-	-