Karachi, November 03, 2022 (PPI-OT): Cement – How are money managers positioning?
An underperformance of 22% by cement sector vs KSE100 in 7MCY22 has been followed by 8% outperformance in last 3 months. We spoke with various money managers and present key takeaways regarding any shift in views. Average allocation of domestic mutual funds in cements now stands at 14%, up from 12% in Jul-2022 (KSE-100 weight: 8%).
With consistently declining coal prices and attractive multiples, the sector is being seen as a potential alpha play. Coal has declined by 29% since Jul-2022, after a sharp rise of 2.4x during 7MCY22.
While our sample of investors agrees on fundamental positives of the sector, it does not rule out concerns on macros. Moreover, unfavourable repercussions of upcoming capacity additions by cement manufacturers are also among key concerns.
Change in investor sentiments emerge in cement sector
Russia Ukraine tussle resulting in higher coal prices and a harsh monetary stance by the State Bank of Pakistan (SBP) coupled with dull cement demand led to cement sector underperforming KSE-100 by 22% in 7MCY22 (KSE-100: -10%).
The sector was at its lowest in late July from where it has shown an 8% rise on back of retreating commodity prices. The change in sector sentiments also reflects in asset allocation of some investors. To note, average allocation of domestic mutual funds in same now stands at 14%, up from 12% in Jul-2022.
Nonetheless we have observed that allocation has been higher than index weight as cement sector’s weight in KSE-100 stands at ~8%. We take a straight average of allocations to ensure that average is not swayed by differing assets sizes of funds. We spoke with various money managers regarding their current views on the sector and present key takeaways from our discussions.
Key takeaways
Unanimous view that the sector is trading at cheap valuations
Our sample of money managers was almost unanimous regarding the structural attraction of the sector. Investors are on board with the notion that valuations are at unprecedented levels, alongside better expected volumes during the next year over low base effect and rehabilitation demand due to damages caused by floods.
Moreover, the broader investor base also expects a reduction in interest rates during CY23. They are nonetheless concerned over political pressures impacting stock performance in the coming months.
View on the upcoming expansions in the cement sector
A key concern and a talking point across the industry has been the upcoming expansion in the cement sector and its implications. Majority of the participants were of the view that price instability cannot be ruled out as a result of the new capacities coming online but it will not be as intense and prolonged this time. So far, the cement sector has faced dull volumes with the Sep-2022 quarter showing a 25% YoY decline. Investors do have concerns regarding demand pick up in the coming months and this would be key in determining the pricing power of cement manufacturers and in turn investors’ comfort on the sector.
How do cement expansions differ from previous cycles?
Price movements have historically occurred in the Pakistan cement industry in phases. In times of excess supply, cement prices tend to move unfavourably, resulting in low profit margins for the entire industry. In the ongoing expansion cycle, since capacity additions will be spread out, our estimates incorporate relatively stable cement prices, as compared to earlier expansion cycles. Having said that, cement prices face risk of pressure owing to pro-longed lackluster demand situation.
Macros – An extended drag on capital markets
The participants’ main obstacle or worry is the difficult macroeconomic and political environment. Some investors believe the market might receive some traction post winter if the issues settle. Meanwhile, they were of the view that this can be an opportunity for the market to build positions in the cement sector during the on-going quarter.
High Debt levels increase sensitivity on profitability
We take a deeper dive to ascertain how the upcoming cement expansions differ from previous cycles. The upcoming cycle will likely see 7 cement expansions (22% of currently installed capacity). One key aspect in the context of a possible price decline (owing to lower demand) is the interest coverage of companies and whether it would allow for such interventions.
We observe that interest coverage is expected to drop for cement companies under our coverage as a whole but would still be better than previous cycles. One reason could be that profitability in the previous expansion cycles also had other factors impacting it. Expansion cycle in FY09 coincided with aftermaths of the global financial market crisis whereas FY20 saw a dull year which toward the end also saw low construction demand owing to COVID-19.
Attractive valuations: MLCF, LUCK and KOHC among top picks
We concur with money managers that fundamental positives of the sector cannot be ignored but the political instability and macro-economic woes are equally concerning. If we look at the EV/EBITDA for the sector taking JS cement universe companies as proxy (representing c. 80% of the listed space) we notice that it has gotten at attractive levels and is close to FY09 levels. It is clear that price disruptions due to the capacities coming online cannot be ruled out and does stand as a key risk likely to reflect in the first half of FY24.
We however believe that with coal prices declining consistently and hopes of an uptick in demand coupled with the incremental broad-based reconstruction demand due to flood rehabilitation, sector would likely stay in lime light in coming months. Margins for cement players on the other hand, which were expected to deteriorate earlier, have also been strong in recent quarters. Quicker than expected reversion in coal prices is an upside risk while the long-term fundamentals of the sector stay solid.
We have an overweight stance on the sector, our top picks include MLCF and
LUCK which are going for timely expansions before peers which will help them avail