We initiate our coverage of Kohat Cement (KOHC) with a Jun21 Target Price of PKR 189/sh, offering an upside 31%. Our preference for the stock is based on: 1) improving cement sector dynamics likely materializing in demand recovery, 2) timely expansion to capitalize on improving sector dynamics, 3) lower global energy prices to ease production costs, 4) sharp monetary easing to provide bottom-line and valuation support, 5) a clean balance sheet with a low Debt to Asset ratio of 23% & Debt to Equity Ratio of 38%, and 6) one of the cheapest valuations in the cement sector.

Cement demand anticipated to pick up from FY21 onwards

We anticipate cement demand to pick up in the coming months after easing of the pandemic-driven lockdown restrictions. The central government has classified the construction sector as an “essential industry” due to its scale within Pakistan’s economic landscape. Apart from easing the lockdown restrictions from the sector, the Prime Minister also announced a construction amnesty package to incentivize investments within the construction industry. On expectations of high levels of participation for the amnesty, we anticipate domestic demand to find support from the private sector from FY21 onwards. Moreover, the commencement of large-scale construction projects such as the Diamer Bhasha Dam may further support the demand prospects for the sector.

Another timely expansion within the industry

KOHC was also part of the industry’s 3rd expansion cycle, enhancing its production capacity by over 100% to 5.3mn MT (8% of capacity). The company’s expansion coinciding with improving fundamentals will likely allow its revenues to grow sharply from FY21 onwards, with an estimated CAGR of 29%.

Pricing harmony expected amidst recovering fundamentals

The industry’s pricing power is likely to improve in the coming months as favorable sector dynamics will likely alleviate the demand-supply imbalances within the industry. Note that from FY19 onwards, the 3rd expansionary cycle coincided with economic stabilization, resulting in the widening between demand and supply. Consequently, the industry witnessed a price-war in which prices fell by 30% to a low of PKR 450/bag in a bid to capture market share. KOHC’s pricing also took a significant hit with its retention levels falling by 32% to PKR 4,600/MT as of 3QFY20 compared with highs of PKR 6,600/MT seen back in FY19.

From FY21 onwards, we anticipate a significant recovery in pricing power as demand recovers. We have already witnessed a semblance of accord amongst cement manufactures back in Apr20 when they agreed to a synchronized PKR 50/bag hike in cement prices. While government intervention compelled the manufacturers to revert the hike, cement manufacturers remain optimistic over positive developments in the upcoming budget including a potential reduction in both FED and Sales Tax. Materialization of said reduction would allow cement manufacturers, including KOHC, to improve retention while keeping prices stable.

Lower energy prices to further augment margins

Lower coal prices are expected to bode well for KOHC’s margins as it incorporates a key component of the company’s cost structure. Coal prices have fallen from their peaks of USD 90/MT witnessed back in Jan20 to present levels of USD 60/MT. We estimate that for every USD 5/MT reduction in coal prices, KOHC’s production cost falls by PKR 9/bag.

Monetary easing coupled with healthy cash-flow generation to aid bottom-line growth

Interest rates have been cumulatively slashed by 525bps to 8.0% as the focus has shifted away from economic stabilization and towards recovery. For KOHC, we estimate the 525bps reduction in interest rates will likely enhance the company’s profits by PKR 375mn (EPS Impact: PKR 1.33) during FY21. Moreover, anticipation of healthy cash-flow generation will likely allow KOHC to completely de-lever its balance sheet.

One of the cheapest valuations in the industry

Kohat Cement offers one of the cheapest valuations in the cement industry, trading at an EV/MT of USD 40, implying a 20% discount to industry average and a 60% discount to its replacement value. Moreover, healthy cash-flows will enable KOHC to further improve its valuations in the coming years with an estimated EV/MT of USD 28 and an EV/EBITDA of 2.7x by FY25.

Sensitivity Analysis

Sensitivity to Pricing

Cement pricing is the key influencer in determining the industry’s profitability. As mentioned, we anticipate pricing power to recover amid improving cement dynamics. The table below highlights the earnings’ sensitivity to varying levels of cement prices.

Sensitivity to utilization                     

Industry utilization also factors towards a cement manufacturer’s profitability. As mentioned earlier, we expect cement off-take to recover amid improving dynamics. The following table provides earnings sensitivity to varying leveling of utilization rates.