Sector wise commentary by AKD Securities

Updated May 07, 2005



Technical problems, rising interest rates outlook and lack of sustained enthusiasm from investors have already led to a 31% correction (from its peak of 10,303 points made on March 15, 2005) in the KSE-100 index. In fact, the falling market has brought investors and analysts back to the drawing board, where they are trying to re-evaluate the true intrinsic value of stocks. We, at AKD Research after deep market analysis, see most of stocks close to their fair values, and a further 5% to 10% correction will make them attractive (moving from negative to positive territory) for value investments. So its time to get the shopping carts ready for bargain-hunting season.


Overall, we remain firm in our belief that Pakistan has become a more shock resistant economy and will comfortably manage through a decent 6%+ real GDP growth for FY06. However, we believe that the adverse monetary tightening in play will weaken the momentum of the real GDP growth for the coming years, where the rising domestic inflation has enforced the central bank to accelerate the monetary tightening paddle. Even if we ignore the rising international oil prices and assume that inflation will be curtailed, the rising Fed rates, and the consequent rise in global interest rates, will ensure that the domestic interest rates do not come back to the low levels that we witnessed in the last few years. This is likely to dampen the aggressive investments that we observed in the past few years. Nonetheless, we have built this into a model where we still deem that Pakistan will remain on a welfare-enhancing trajectory, thanks to greater macroeconomic stability and institutional reforms, even during a period of global unease.


We have updated our models with the latest sales volume data and oil price forecast. However, despite the strong fundamentals, we continue to recommend an Under-Weight stance on the sector. This is simply due to the fact that stock prices have more than incorporated the positives, further fueled by privatization rumors. Investors should always remember that value investing is done at the trough of the cycle, as opposed to the present situation when international oil prices and the industry are going through its peak. Adding to this, the two main E&P companies OGDC and PPL are primarily gas producers, and gas prices are tagged to oil prices that are capped at US$36 per barrel (Arab-light). Thus, further hikes in international oil prices do not make a significant impact on the bottomline of these companies. Thus, Pakistan Oilfields remains our top pick in the market, while we recommend a Reduce stance on OGDC and PPL. Having the largest weight on the KSE-100 Index, stock price movements in the sector have a greater influence on the market than any other sector. However, given the huge run-up in stock prices of this sector, we feel the sector is likely to under perform the market, in the short to medium-term.


While we remain Buyers in CTTL, we have a neutral stance on the telecom sector as we maintain our Reduce stance on the Index heavy weight, PTCL. Though, we would like to inform our readers about one significant change that we have made in our valuation methodology for PTCL. We feel that it is unfair to calculate PTCL's fair value on a stand alone basis, as Ufone is the company's major growth segment. However, since numbers for Ufone are not published, it is difficult to assign a value to Ufone to determine the consolidated fair value of PTCL. Nonetheless, we have incorporated Ufone's forecast into our consolidated numbers. Two major assumptions used are target Average Revenue Per User (ARPU) and net subscribers additions in the coming years. With recent cut in call rates, we believe that ARPUs will continue to fall as long as the difference between per minute fixedline and cellular rates is not reduced to a level, where average cellular rates are not more than 2x the per minute fixedline rate. In keeping with this assumption, we assume Ufone to report an ARPU of US$6.5 per month during FY05, which is likely to fall to US$ 4.9 by 2010. At the same time, we expect Ufone to close FY05 with a total subscriber base of 2.35 million, which is likely to grow to 4.36 million by 2010. After incorporating the Ufone numbers, our Fair Value before the 100bps increase in discount rate comes to Rs55. However, after a 100bps increase in our risk free rate, our new 'consolidated' Fair value for PTCL is Rs50.3.


Banking sector remains one of the brightest sectors on Karachi Stock Exchange. With the recent plunge in prices, the valuations have become much more attractive for the banking sector. Rising interest rates turning into higher spreads, record credit outflow in the past three quarters, strong corporate earnings and growing trade activity combined with falling tax rates for the banks ensure a very positive outlook for the industry. On the other hand, banks' operating expenses growth will lag the income growth, paving way for very attractive earnings growth. For the aforementioned reasons, we remain overweight on the sector with NBP and ACBL being our top picks, as both these banks are cheaper on valuations. NBP is trading at P/B (Tier 1) of 1.96x against the regional average of 2.0x, so we recommend an accumulate stance on NBP. However, we have excluded NBP's tier-2 capital in our valuation, which can boast NBP's value to substantial levels after realization. On the other hand ACBL is trading at P/B (Tier 1) of 1.83x so we recommend an accumulate call on ACBL as well. We recommend a reduce stance on MCB as it's trading at P/B of 2.18x, which is higher than the industry.


Strong volume growth (up 18% YoY), rising domestic oil prices (up approximately 16% YoY) and privatization rumors of PSO have led to a joyride for the oil marketing sector. However, the outlook going forward is not that encouraging, especially considering the current stock prices. Firstly, sales volume growth is likely to taper down in the coming months, as better water availability will result in lower furnace oil (FO) demand, while commencement of white oil pipeline will negatively affect high-speed diesel (HSD) sales volume. Furthermore, GoP under pressure from inflationary concerns and opposition parties is finding hard to pass on the impact of rising international oil prices to the consumers. On the other hand, GoP is actively discussing the idea of reducing domestic oil prices, by revising the OMCs distribution margin formula. Currently, distribution margin for OMCs are a percentage of final selling price, which also includes the government taxes in it. The proposal under discussion is that distribution margin should not be on final selling price, and should exclude government taxes and levies. If this is implemented, it will have a negative impact on OMC's bottomline.




We are extremely bullish on the fertilizer sector purely on the back of a wide gap between urea demand and local urea supply, which is likely to keep urea prices at higher levels, particularly during CY05 and CY06. On the basis of potential urea short supply, we estimate average urea prices to increase by 6-7% during CY05 and CY06. Though, growth in fertilizer manufacturers' profitability will largely be a function of better urea prices as most local plants are already operating at 100%+ capacity utilization rates. In keeping with robust agricultural indicators, where farmers' purchasing power has improved significantly, we feel that urea manufacturers will have a much stronger case to raise urea prices. In the sector, we remain Buyers of FFC and FFBL, which are likely to report 17%YoY and 30%YoY NPAT growth in CY05. On the other hand, due to a 28-day long maintenance shutdown, Engro's urea production is likely to remain low, hence despite high urea prices; growth in the company's NPAT is estimated to grow only by 5.5%. At current prices FFC and FFBL trade at 15% and 28% discount to our target prices of Rs158 and Rs37.8 respectively, while Engro trades at a slight premium to our DDM base fair value of Rs110. While there may be a GoP package for the farming community in upcoming budget, we do not expect any particular incentives for the fertilizer manufacturers. It is possible that the GoP decides to make positive modifications in the fertilizer policy in order to attract investment in the sector.


We cover two main companies of the sector, which are Hubco and Kapco. Both these companies operate under almost fixed return formula and are pure dividend plays. Thus, in a rising interest rate scenario, investors should be cautious before investing in these scrips, as alternative investments become more attractive.


During the period, July to March 2005, the sector has seen a 19.5%YoY growth in volumes and 10%YoY increase in cement prices. We have updated our financial models by incorporating the growth in volumes and prices (the revised fair values mentioned below include updated price and volumetric growth). While we remain positive on the demand side of the sector and expect it to grow at a 4-year CAGR of 11%YoY, we have our reservations about the unprecedented growth in supply, which is set to increase to 34.5 million tonnes; resulting in 14.5 million tonnes of excess capacity by FY08. We believe that the increasing expansions are likely to pressurize cartel-governed prices, where the next meeting of APCMA in June FY05 might be a precursor to another jolt in the cartel over the issue of incorporating Lucky cement's capacity expansion of 2.6 million tonnes. With the interest rates moving northwards, we believe that this highly leveraged sector will receive a dent in the form of high financial charges. Furthermore, with no gain expected in form of dividends, at current prices we recommend investors to keep minimum exposure in the sector. However, at lower levels, Cherat looks attractive, where our fair value for the company is Rs63.6. In the upcoming budget, a reduction in CED from the current Rs750 per ton to Rs500 per ton may act as a positive trigger for the market sentiment.


With robust macro indicators, consumers purchasing power is bound to remain strong, which bodes well for the demand for consumer goods. We believe that with a 6%+ GDP growth over the next 3-4 years, the FMCG companies will continue to record improvement in their profitability going forward. In the sector, our top pick is now Unilever as it is trading at a discount to its DDM based fair value of Rs1408, though we favor Nestle on fundamental grounds and recommend investors to accumulate the stock below Rs470.


Based on promising macro-economic indicators and growth in car financing schemes, we remain overweight on the sector. We estimate the car sales to grow at a CAGR of 15% over the next our years. With the lowest car penetration ratios in the world (5.5 cars per 1000 people), we expect a potential break out in the car sales in Pakistan. In view of potential rise in car demand, we believe that local automobile assemblers will be the biggest beneficiaries. While we maintain our liking for Pak Suzuki and Honda Atlas, our top pick in the sector remains Indus Motors, which has presence in both high and low end segment, relatively better margins and offers an 8% dividend yield. Its recent aggressive entry into the imported cars market also bodes well for the company's future profitability through expansion of its product base. Over the next four years, we expect the company's topline to grow at an annualized rate of 16%. The government is likely to reduce the duty on the imported cars in FY06 budget by 20%. However, this may be accompanied with a reduction on CKD as we believe that the government is likely to take benign measures in order to protect the local automobile industry.


We remain underweight on the Airline sector particularly with oil prices at such high levels. PIA, the only listed airline company, is unlikely to report any real improvement in its profitability as long as oil price remain high. Furthermore, recent concerns expressed by the company's external auditors in the annual report for CY04 have further shaken our confidence in the company's management. While the recent replacement at the top management level may increase our confidence in the management, the high international oil prices will continue to put pressure on company's profitability. Therefore, we maintain our negative stance on the stock.


Gas companies are going through a transition period, where the new capex is still being incorporated by oil and gas regulatory authority (OGRA). Under the guidelines of OGRA, only those projects, which start commercial operations, are considered as capex (included in the fixed return formula). Hence, the projects of FY04 will be included in the formula in FY05, improving the bottomline for FY05 and FY06. The lag effect will continue to bolster the bottomlines in the coming years, as both the entities are going for huge capex plans, worth Rs60 billion for 2004-08, compared to the last capex cycle of Rs20 billion. Thus, in long-term view we remain over-weight on the sector. However, there are two negative news in the pipeline, the rising interest rates that will hurt the highly leveraged sector, while there is also talk of changing the fixed return on asset formula to fixed return on equity formula, where the ongoing capex plan will not have an impact. Nonetheless, SSGC remains our top pick in the sector.


Strong agriculture indicators imply improved demand for all agricultural inputs. However, tractor is a regulated industry, which restricts the tractor manufacturers from passing the increasing in raw material costs to the farmers. As a result despite high tractor sales, tractor manufacturers are experiencing pressure on margins. We feel that the GoP is likely to deregulate the tractor industry possibly in the upcoming budget, as with enhanced purchasing power, farmers are in a much better position to absorb the increase in raw material costs. If this follows through, the tractor manufacturers are likely to see improvement in margins as a result of growth in sales volume. However, at current prices Millat Tractor trades at a premium to our target price of Rs216 and we maintain our Reduce stance on the stock.


We remain overweight on the sector due to its strategic backward linkage with the textile sector. While in the short-run the sector has remained under pressure due to the rise in the feedstock prices and a record cotton (rival fiber) crop in Pakistan. The GoP has enhanced the duty drawback rates to maintain the competitiveness of these products in the international markets. We expect the GoP to continue doing so as feedstock prices continue to rise thus ensuring the demand for the sector. While there is no major expansion coming online in the next few years and capacity utilization of most firms will be above 90% by year-end and may lead to a shortage in FY06. Our top pick in the sector is ICI Pakistan, which has the most diversified source of earnings and has declining long-term debt, thus protecting it from the rising interest rate scenario. While we also like DSFL, due to its falling long-term liability and the potential gains that it can make from its share in an oil exploration license.


We are overweight on the sector, as Pakistan possesses one of the highest comparative cost advantages in the world in a number of textile varieties. While the restricted market access (tariffs) and the enormous competition from Chinese textiles has not yielded the growth anticipated by domestic industry participants. We believe that sooner or later, the developed economies will have to invoke their safeguard measures to protect their growing trade imbalances. As a result, we expect some of the trade flow from China to divert towards Pakistan, along with the planned reduction in the GSP by 3% since April-05 will further enhance the growth potential of the sector. Therefore we envision a 10% growth in the sector for the next five years.