Wednesday, November 16, 2016 4:01 PM /Vetiva Research
Weak earnings, debt restructuring weigh on WAPCO
WAPCO has declined 50% ytd, much steeper than the Industrial Goods sector (-24%) and the broader market (NSE ASI: -9%). The sell pressure started after the release of H1’16 earnings with a negative PAT exacerbated by N28 billion FX loss.
By October, WAPCO came under renewed pressure amidst talks of a debt-equity conversion deal for its foreign currency denominated shareholder loans – same liabilities that yielded the FX loss.
Shareholder loans emerged from the acquisition of UNICEM
For starters, the shareholder loans were debts originally taken by UNICEM (WAPCO’s subsidiary), largely for the financing of its plant expansion (UNICEM Mfamosing Line 2), but later transferred to the books of WAPCO at FY’15 following increase of its equity stake in UNICEM to 50%, and subsequent merger of Lafarge SA (WAPCO’s parent company) and Holcim Limited (holder of the remaining shares in UNICEM) to form LafargeHolcim.
The shareholder loans stood at $310 million as at FY’15. Following the 100% acquisition of UNICEM by WAPCO in H1’16, additional shareholder loans of $200 million were consolidated from HoldCo level, taking the outstanding balance of the loans to $510 million.
Equity instrument – no preference over ordinary shares
From our discussion with management, we understand that $493 million of the shareholders’ loan ($510 million) has been converted to an “equity instrument” (as at July 1) which is repayable at borrower’s (WAPCO) discretion.
The debt conversion did not result in a change in WAPCO’s shareholding structure. The instrument will bear an average annual interest rate of 6% which management said is also payable at borrower’s discretion.
Whilst the interest payment would be recognized like “dividend” to the equity instrument holder (WAPCO’s parent) as it would be distributed from the net earnings just like dividends to ordinary shareholders (in line with provisions of IAS 32 - Financial Instruments: Presentation), the equity instrument holder would not have any form of preference over the ordinary shareholders.
As such, in the event WAPCO decides not to pay the annual interest charge in any year (given borrower’s discretion right), WAPCO can still go ahead to declare dividends to ordinary shareholders. The shareholder loan balance ($17 million) represents the current interest portion on the loan, and will be converted the same way as the principal when due.
Whilst the restructuring does not relieve WAPCO of the obligation to repay principal and interest, it will free-up the income statement from the volatility that may arise from revaluation of the loans amidst currency movement.
In other words, in the event of further currency depreciation, the consequent FX losses would be recognized and adjusted for in WAPCO’s Other Comprehensive Income (in line with provisions of IAS 32), rather than as a finance charge in the income statement.
With full discretion on repayment of the principal, we imagine that the repayment would not be made anytime soon until WAPCO operations and financials have fully normalized, and the FX market becomes liquid. On WAPCO’s external USD bank loans, management said it has started engaging the lenders as regards restructuring; we continue to watch that space.
Restructuring move, a better shield to overall earnings
Although timing of payment of the 6% annual interest charge on the equity instrument is at borrower’s discretion, management said WAPCO’s intention is to pay annually. Using our FY’17 end exchange rate forecast (NGN350/USD), and assuming no further currency depreciation, we estimate the 6% annual interest payment at c.N10.7 billion (charged to retained earnings).
Although the restructuring might not have relieved WAPCO of the obligation to repay the shareholders loan, it however provides some underlying upside to earnings. The liquidity pressure, particularly in light of the tight supply in FX market, to meet principal and annual interest payment obligation (assuming the loans were not converted to equity) would ease now that the principal and interests on the “equity instrument” are payable at management discretion.
This flexibility feature will be especially key in the near term as WAPCO gradually recovers from the FY’16 earnings slump. It would also be much more appreciated in challenging years when WAPCO comes under unforeseen profitability or liquidity pressure.
Underlying investment to deliver stronger value from FY’17
On a much brighter note, UNICEM’s new plant (Line 2) which is the asset partly financed by the shareholder loans has begun operation. Total installed capacity at the subsidiary has now been effectively doubled to 5 million MT.
According to management, the line produced its first clinker on August 28, and would be ready for normal cement production in November. By FY’17, we expect UNICEM to deliver 2.5 million MT (FY’16E: 1.6 million) to be buoyed by Line 2. Given the new age of the plant, coupled with ongoing works of energy diversification, we expect UNICEM to deliver improving EBITDA margin in the coming years.
9M’16 earnings disappoint on another tough quarter
Q3 EBITDA turns negative amidst persistent challenges
WAPCO reported a disappointing loss after tax of N37.4 billion amidst further losses in third quarter. Q3 standalone yielded loss after tax of N8.5 billion as challenges in previous quarters persisted in the three-month period.
Q3 EBITDA turned negative N0.3 billion (H1’16: N10.6 billion) amidst a number of factors; 1) Gas shortages and consequent use of more expensive fuel in South West and Mfamosing operations (UNICEM), 2) Industrial and logistics challenges in UNICEM leading to 27-day plant shut down, 3) Impact of currency devaluation on FX-exposed costs (average interbank exchange rate up 46% q/q to NGN308/USD), 4) Higher power costs at ASHAKACEM and, 5) Flood impact on Atlas and ReadyMix operations.
On a 9M basis, EBITDA crashed 84% y/y to N10.3 billion, significantly below our estimate of N28.5 billion. Meanwhile, the dampener of Q2 earnings – net FX losses on revaluation of dollar denominated loans - rose at a much slower pace to N30.7 billion at 9M’16 (H1’16: N28.5 billion) amidst milder currency depreciation at period end (Q3: NGN312/USD, Q2: NGN281/USD) and the restructuring of the dollar denominated shareholder loans at the start of Q3.
Management moves to calm the energy storm, targets FY’17
We understand that gas supply improved in September (following shortages in July and August) but has again worsened. As a result, the use of more expensive fuel - coal (more of imported) and LFPO - has relatively increased.
Meanwhile, management explained that it had moved to diversify energy mix at the South West and UNICEM operations through the use of coal that would be sourced from coal mines (which will be owned by WAPCO).
Management said that exploration/feasibility studies are already ongoing for the coal mine– first drilling phase completed, second and final drilling phase expected to be done before year end.
Although management expects the coal mine to be ready in FY’17, we believe WAPCO may have to wait till FY’18 before realizing meaningful impact from the project noting that it took DANGCEM almost over a year to ready its coal mine.
Also, in a bid to address the recent pressure from energy cost (for non-kiln operations) on ASHAKACEM’s profitability, management said it plans to extend the current coal logistics (for kiln firing) to generating electricity for other parts of the plant with a captive power plant currently under construction.
The project is also not expected to reach a meaningful threshold until FY’18. In the meantime, we expect WAPCO’s cost of sales to most likely remain on the high side as the effect of currency weakness and use of the more expensive fuels continue to weigh on production costs.
FY’16 Volumes estimates revised lower following disappointing Q3
In terms of volume roll out, WAPCO’s Q3 was disappointing – 1) South West down 11% q/q to 699,000 MT on gas shortages, 2) UNICEM down 55% q/q to 214,000 MT on gas shortages and logistics disruption amidst connection of Mfamosing Line 1 and the new Line 2 (27 production days lost), ASHAKACEM down 30% q/q amidst security concerns in the North-East region and resistance to price increases.
Together with the disappointing earlier quarters, Nigeria 9M’16 volume was down 16% y/y to 4.1 million MT (Vetiva: 4.7 million MT). Save for the logistics disruption at UNICEM which we see as a one-off, we think WAPCO is not fully out of the woods on other challenges.
As such, we struggle to see how WAPCO will meet management’s volume growth guidance of 7% y/y, as well as our erstwhile forecast even as South Africa operation is headed to a flat performance by FY’16.
In light of this, we revise our FY’16 Nigeria volume forecast to 5.5 million MT (Previous: 6.3 million MT) to reflect the disappointing Q3 volume and reduced optimism over Q4. We expect the group FY’16 volume to decline 14% y/y to 8.3 million MT. We anticipate a pick-up in FY’17 to 9.5 million MT, buoyed by production from UNICEM Line 2.
WAPCO still a BUY despite cut to valuation
Whilst we expect modest profitability in Q4 on the back of higher cement prices and cautious optimism on ongoing quick-fixes on energy front (biomass logistics in South West and adoption of coal in UNICEM), we still expect WAPCO to report a loss for FY’16 amidst FX losses recorded in previous quarters.
We believe WAPCO will return to profit by FY’17 as we expect some improvement on energy logistics, coupled with cement volume roll out from UNICEM Line 2. We are much more optimistic on WAPCO from FY’18 as we believe the ongoing own-coal project would have reached meaningful threshold that would significantly reduce reliance on gas.
After updating our model to reflect all relevant updates, we revise our target price to N68.42 (Previous: N80.85). Notwithstanding the cut in our valuation, WAPCO still presents upside to current market price of N48.00. We maintain a BUY rating on WAPCO.
1. Lafarge Africa Plc Gross Margin Contracts in Q3'16 Results; Shares Rated Outperform