The efforts to optimize cost of production is yielding positive results

May 24 - 30, 2004

With the resurgence of demand, improvement at the retention level, coal conversion, and debt restructuring, cement industry has entered the era of improving profitability. With growth of the economy being linked to infrastructure development special emphasis is being paid to the construction sector. The prospects of economic growth and construction sector are intertwined.

According to a report prepared by Elixir Securities Pakistan, cement demand is expected to be the most significant earnings driver for the sector, going forward. Cement demand is expected to grow at 13% per annum for the next 5 years due to 1) expected increase in construction activities in the housing sector owing to introduction of new house finance schemes by the financial institutions, 2) increase in budgetary allocation for PSDP by the government for FY04 which is expected to boost infrastructure development within the country and 3) expected growth of 66% in exports to Afghanistan over the next five years with the exports expected to reach the 3 million tonnes by FY08.

Improvement in the retention price is the second component, which is likely to contribute towards around 62% growth in revenues of the industry over the next five years. This improvement is likely to flow from 1) a complete phase-out of CED by FY07 through an annual reduction of 25% and 2) stability of the cartel, which is primarily the reason for the 12% improvement in the retention price in FY04.

Coal conversion has reduced the cost of production for the cement manufacturers, which is likely to improve the gross margins of the industry by 97%. According to the estimates coal conversion is likely to save about Rs 300 per tonne in fuel cost for cement manufacturers.

Reduction in financial charges is another reason behind turn around story of the industry. The financial cost for the sector dropped by about 680bps during the year.

The numerous housing and construction incentives will translate into a housing boom in the near future. The housing sector alone has a potential to generate an additional 4.5 million tones/annum demand due to the shortfall in housing units. With the easy availability of funds to the housing sector where banks have announced new financing schemes cement demand is likely to improve substantially.

About 60% of the cement demand is derived from construction activities in the housing sector. The development of the housing sector in Pakistan has fared abysmally creating a backlog of 4.3 million houses. According to estimates annual requirement of the houses is 570,000 units as compared to the annual construction of approximately 300,000 units. This indicates towards an annual a shortfall of about 270,000 units. Based on this the housing sector has the potential to generate an additional demand which is expected to flow from 1) new housing policy, 2) financing schemes announced by different banks and 3) budgetary incentives.

Though, the challenge of reviving the housing industry is a daunting task a start has been made. The National Housing Policy 2001 was the first initiative for bridging the demand supply gap by building 500,000 housing units annually. The emphasis of this policy is on 1) land availability, 2) incentives for home ownership and 3) incentives for developers and constructors. A concerted effort to remove impediments to the construction industry will aid cement sales. In this respect the Housing Advisory Board recently convened a meeting to push ahead with the initiatives under the Housing Policy.

The financial institutions have taken a strong initiative as well. The State Bank of Pakistan is endeavoring to inject liquidity in the system to what it perceives to be a more stable investment opportunity of housing finance. In this regard, besides extending the per party lending limit by Rs 2.5 million to Rs 7.5 million for housing finance, the debt equity ratio in housing finance has also been improved to 80:20 from 70:30 and provincial governments are rationalizing stamp duties and registration fees on transfer and acquisition of housing property.

The SBP has also announced an impending launch of a 15-year Euro bond to match mortgage maturities. This will enable banks to price mortgage loans. By the time this bond is introduced we expect it to give a yield in the range of 7-8%. Pricing atop this yield in the range of 100-200bps will give returns of 9-10% which is currently the rate being used by banks for extending housing finance, the variance being due to the perceived risk of the customer.

Export of cement to Afghanistan is another reason for overall increase in exports. Due to this the proportion of exports in cement sales has now increased to 8% from the previous 4%. This proportion is expected to improve further to 17.5% by FY08 where we believe that cement exports will touch 3 million tones/annum. The reasons for the expectations are 1) increasing construction activity in Afghanistan and 2) lower competition from Iran.

Donors had pledged grants to Afghanistan in excess of US$ 3 billion. Early estimates had put the figure of annual investment in Afghanistan at US$1 billion with 15% (US$ 15 million) share committed for cement consumption. This represents very good prospects for construction activity in Afghanistan and the results are evident from the demand for exports materializing from Afghanistan.

Iran is the major competitor of Pakistani cement in Afghanistan. Due to the cheaper cement, the market share of Iranian cement was much higher than Pakistani cement. Previously, Iranian Cement prices were much lower at US$ 32/tonne as compared to Pakistani price of US$ 70/tonne. However, Pakistani exporters have now become more competitive and are exporting better quality cement at US$ 30/tonne. Furthermore, Iran was initially exporting 10% of its production to Afghanistan, however, with an increase in its domestic demand Iran is now concentrating on its domestic market. This is likely to improve the market share of Pakistani cement.

In addition to Afghanistan, Sri Lanka, Bangladesh and Vietnam are being explored as new destinations for cement exports. Industry sources indicate that there is a potential to export 2-3 million tones/annum of cement to these countries. However, this is too premature to be accounted for.

Coal conversion will improve the EBITDA margins of the cement manufacturers by 15% as the relatively cheaper coal replaces expensive furnace oil. A vast majority of the manufacturers have converted their plants at an average cost of Rs 325 million for a 900,000 tonnes/annum plant with a payback period of 2-3 years.

According to the estimates coal conversion is likely to save Rs 300/tonnes for the cement manufacturers and likely to result in a corresponding improvement in the margins as well as the bottom line.

The cement manufacturing process is highly energy intensive. Fuel and power cost constitutes as much as 60% of the cost of production depending on the furnace oil price. In addition to stagnant demand cement manufactures began to feel the brunt of incessantly increasing furnace oil prices, which put substantial pressure on margins. This provided the impetus to push conversion to coal as a major fuel source.