Monday, 21 October 2013

Price Fixing and Power Price Shocks - All in a day for the Cement Industry of Pakistan!

Temporary value drainers like cartel-breaking rumors and electricity prices increases have created significant opportunity in the cement sector which continues to be the most lucrative in Pakistan.

High cement prices, supported by the evil of cartelization, persevering demand (September dispatches were highest in the country’s history) and low coal prices (Coal is the largest cost driver for the industry) are all a few factors that continue to support stellar margins and exceedingly high profits.

Now doubt, the Cement sector has been one of the best performing in the last two years as given by the following graph.

Swamped with cash, companies like Lucky Cement have gone for acquisitions, while others like Pioneer cement have swathes of cash on their balance sheet and no idea what to do with it.

Scares like cartel break-up have hurt investor returns in the last one month, but this only presents the shrewd investor with opportunity. Given investigations and revelations by KASB and other brokerage houses, the scare is unwarranted, and the camaraderie is here to stay. Cement prices are likely going to stay high in the intermediate term and continue to support the margins of these cash cows. In fact just recently there was news of price increases in the Northern region where players have already increased prices by around Rs. 20 per bag.

Given the evil of cartelization, it is thus with a confused and heavy heart that I must present the sector as a viable investment opportunity. While my heart tells me that I should be writing against this evil, let us just put being a Samaritan on the back burner for a while and concentrate on making money.

Owing to recent the cartel scare, along with the electricity price scare, both of which are explained later on cement stocks have been beaten to the point of whimpering. The following chart explains this rather beautifully (as made by me):

Big Scare 1.0

Cartelization is perhaps the most pertinent theme of the industry, perhaps seconded only by low coal prices which is like the sonay pe suhaga. You see the cement industry has vast overcapacity. Days of good development in the early part of 2010s resulted (we all remember financing our cars at 4% don’t we) resulted in increased demand of cement and the industry invested heavily in capacity expansion. However, later on Zardari came and destroyed everything end of story. So now there is significant capacity and not enough demand. Under normal (and fair) economics, the cement companies decrease prices and go into competition, in order to sell more and drive up capacity utilization. But obviously doing so can be disastrous for many as low prices eat into margins. In fact cartelization  was pretty much the case when CCP busted APCMA’s office sometime back ( In don’t know the exact time) and loads of companies such as Pioneer Cement, Gharibwal Cement, Bestway Cement and the world famous Maple  Leaf Cement restructured their debt obligations (effectively defaulted).

Later on, the companies got braver and the country got Zardarier, and ‘The Cartel’ (sounds like the Mafia or something) has been getting its way ever since. Perhaps we need ‘the Untouchables’ to save us. Even Ajay Devgan would do.

However, the scare was not as deadly as it sounds, the apparent damage was caused by a smaller player wanting to drop prices while the a bigger player threatened to walk away which was all amicably resolved later on. No action by the CCP or anything. Just an internal matter. However, the market was not as brave, and the cement index lost significant capitalization as a result. Later on news of a patch up duly appeared the stocks had their heyday again. However, their woes did not end there and then came big scare 2.0.

Big Scare 2.0

Just as stock prices came up at the surface gasping for air, the government dropped another bomb on them by announcing an increase in electricity tariffs by around 60%. The scare hasn’t been felt by the masses as it used to before the present government (political gimmickry?) but cement stocks took hit hard and hence the Big Scare 2.0 as illustrated in above graph.

An increase in electricity prices is especially harmful for those companies, that obviously, buy their electricity form the natural grid rather than produce it in-house. Companies like Fecto Cement take the brunt of such changes.

The price increase would indeed have spelled bad for the industry or specific companies, but the companies have taken a measure to circumvent this by increasing Cement prices by around Rs. 20 per bag - something that they have been doing since the last five years. Here I present a graph that details the quarterly retention prices (prices net of sales tax and other ancillary items) for a few companies during the last eight quarters:

The above chart only presents scanty prices. This is because I am only in the process of building financial models for all these companies. Nevertheless, prices for Pioneer Cement have been plotted back to almost 20 quarters. The graph aptly depicts cement price increase since last 5 years. But stretching back of Pioneer Cement Prices back to September 08 reveals a whole new page of history.

The Big Dip, as highlighted, was a time when CCP took action against alleged cartelization, raided APCMA offices and what not and what ensued was a dip in cement prices. Together with this, many cement companies defaulted since they could not sustain the debt they recently taken up for expansion. Maple leaf, the 16-bagger, is one of them.

Given the fact that the cement companies are getting out hands, would this happen again?

Well, we can only speculate at best. However we do know that the Big Scare 1.0 occurred because of an internal matter and not because of any regulatory action. Secondly, we also know that cartelization is most necessary in face of low capacity utilization. Given September quarter dispatches being the highest in history, I don’t think anyone would want to threaten prices for the sake of increasing utilization. So I believe the high prices are here to stay.

So what about the recent raise in electricity tariffs?

The tariffs will surely have an impact on margins for companies that produce their own electricity, like Fecto Cement. But that is a problem no more, as cement prices have recently been raised by Rs. 15-20 per kg, amounting to around Rs. 300-400 per ton. I have not run any calculations but something tells me they should be enough to cover any margin loss due to the power price hike.

On a side note, companies like DG Khan Cement (despite my detestation for large caps), and others, that produce their own electricity should benefit most from the price hike since for them there has been no price hike. They actually produce their own electricity from gas whose prices really haven’t risen much. Since cement prices move together, these companies will benefit most from the price increase.

Good times are here to stay for the Cement Industry. Inflated prices will keep margins inflated and ensuing earnings which will in fact continue to positively impact valuations. Given the beating the industry has taken over the past few weeks - the prices are at very attractive levels. And given the cement price increase as of late, stock prices are only going to go up and it is only a matter of time when the pre-cartel-breaking-rumors levels are going to be achieved. Perhaps the market already realizes all these factors and for this reason, many stocks in the sector closed at ‘upper-locks’ on the last trading day. Perhaps we are at the advent of another bull run. I see 25-30% returns from current levels in the next few weeks especially in the wake of the upcoming results reason and suggest taking positions as soon as possible for healthy returns, especially in the short term.

The market opens in about 1.5 hours. It is time to jump on the band wagon! 

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