Tuesday, October 24, 2017 12:00PM /ARM Research
Over the last 10 months, Dangote Cement Plc. (DANGCEM) has steadily raised prices to support revenue at the expense of marked volume weakness with analysts, almost unanimously, making the call for substantial price pass-through to earnings in the current year. For us, this call has largely panned out and so focus must shift to 2018, a year for which we expect energy efficiency to upstage price as the critical driver of earnings’ growth. Even though our model adjustments translated to a downward revision to 2018E EPS, we believe the implied 19% YoY upside would still be enough to douse investors’ anxiety.
2017 assumptions were spot on. In line with expectation, DANGCEM further cemented its leading position in the sector with a cumulative 9M 17 EPS (N11.33) that is already 1.0x and 1.1x those of FY 16 and FY 15 respectively. Over Q3 17, the company’s EPS was also 63% higher YoY at N2.88 in spite of a shock effective tax rate of 24%. For context, we note that the company’s EPS would have printed at N3.51 going by the average effective tax rate of 7.4% recorded over H1 17.
Nigerian revenue attribution highlights depth of price gains. Going by breakdowns, the company’s result got the greatest boost from sizably higher prices in the Nigerian operation (+55% YoY to N44,943/ton in Q3 17) which made up for weaker volumes (-12% YoY to 2.8MT).
To buttress on the scale of price pass-through, we note that although the Nigerian business accounted for 55% of total Q3 17 volumes (vs. 59% in Q3 16), its revenue attribution rose 5pps YoY to 65%. Conversely, while non-Nigerian volumes were relatively stronger (+2% YoY to 2.3MT) following small contributions from Sierra Leone, rest of Africa still accounted for only 35% of revenue (vs. 40% in Q3 16). Consequent on the price-inspired momentum in Nigeria, and pass-through from currency translation1, group revenue printed 27% higher YoY at N190 billion—missing our estimate by only 4.6%.
Q3 provides first sparks from energy flexibility. Elsewhere, we observed signs of life from the business’ energy flexibility investments with input cost (-11% YoY to N82 billion) decelerating faster than volumes in Q3 17 (-6% YoY to 5.0MT). To this point, management reported a 27pps YoY decline in proportion of LPFO used in its Nigerian operations to 2% by end of 9M 17 with coal and gas now assuming greater importance amidst a relatively stable exchange rate and production environment. Gross profit was therefore 89% higher YoY at N109 billion with related margin at 56.9%—its highest level since Q2 15.
Thus, whilst there was renewed operating pressure (+14% YoY to N41 billion) following ramp up of market presence in Sierra Leone and Congo, the company’s operating profit was still over two-folds higher YoY at N70 billion (vs. N73 billion in our forecast) with related margin coming in 20.3pps higher YoY at 36.5%.
No doubt, although current operating margin represented a strong rebound from the troughs of 2016, it remained below pre-2016 mean levels (53.6%). This disparity mainly reflected heavy operating expenses and sustained energy challenges in climes outside Nigeria with Tanzania and Zambia more recent examples of the latter.
Although the overall positives from prices, currency translation, and improved energy mix translated to strong growth at the PBT level (actual: +171% YoY to N65 billion; forecast: N71 billion), an unexpected surge in effective tax rate to 24% in Q3 17 (vs. 6.1% in Q2 17, 8.7% in Q1 17, and tax credit in Q3 16) slightly tapered earnings momentum.
According to management, the surge in effective tax rate was meant to correct for tax under provisioning in the first two quarters of the year with tax concession on Obajana line 3 said to be expiring in the current year. On balance, DANGCEM’s Q3 17 was still robust and reflected gains from strong price and currency gains as well as better cost management.
Price momentum to see off volume worries. Going forward, we expect pass-through from price gains to gradually wane in Q4 17 (Q4 17E price: +22% YoY to N44,943) due to the high base implied by major Q4 16 price increase (+57% YoY to N36,805/ton) in Nigeria.
In addition, despite demand challenges for most part of 2017 (9M 17 sales volume: -19% YoY to 9.6MT), we have raised our FY 17 Nigerian volume estimate slightly higher to 12.7MT with weighted price at N43,634/ton. This implies Q4 17 production volume of 3.1MT (vs. 3.2MT in Q4 16) and Nigerian FY 17 revenue of N555 billion (vs. N548 billion in previous forecast and N439 billion in 2016).
Away from Nigeria, we leave our FY 2017 volume forecast unchanged at 10.2MT, which already reflects projected cement volumes of 510kt for new operations in Congo and Sierra Leone. On balance, group revenue for FY 17 should come in 29.5% higher YoY at N797 billion (Q4 17E: +12% YoY to N193 billion).
Despite the implied weaker top-line growth rate for Q4, we believe the momentum built over the first three quarters of the year, a normalisation of effective tax rate (~10% in FY 17E) and the now obvious energy flexibility gain should leave FY 17 earnings in good shape (FY 17E EPS: N15.07 (+33% YoY), DPS: N11.15).
Bet on DANGCEM to deliver in coming year. Going into 2018, three things are crucial to expectations. The first is the outlook on prices while the other two are closely related to currency and energy projections. On prices, we believe that with Nigerian gross margin having exceeded pre-crisis level of ~61.8%, the argument for leaving prices at currently elevated levels to compensate for cost pressures will gradually fall apart. But, we expect this price correction to be gradual as the market leader considers the sustainability of current gains.
In view of this, we now adopt average Nigerian cement price of N40,000/ton for 2018 (vs. N34,280/ton previously). Consequent upon the price drop, we expect consumers to be slightly stimulated and thus hold out for a 13% YoY growth in Nigerian volume to 14.3MT (vs. 18.8MT in prior forecast), with related revenue expected to print at N574 billion.
Elsewhere, even though the Sierra Leon and Congo operations are expected to gain some traction in the coming year, we project non-Nigerian volumes and mean price at 12.3MT (vs. 14.3MT previously) and N27,606/ton respectively, with weaker volume projection reflective of ongoing output slowdown in other climes. In all, we now look for implied FY 18 group revenue of N858 billion (vs. N921 billion previously).
For us, with currency and energy outlook looking stable over most of 2018 (please see “Q4 2017 Outlook: Pathway in turning tide”), we see scope for a 42% cost to sales ratio in the coming year (2017E: 43%). This should leave gross profit 10% higher YoY at N497 billion with related margin at 58%. In addition, with most of the maiden market penetration expense already committed in 2017, we expect current high base to lead to a moderation in operating expense pressure in the coming year (+2% YoY to N159 billion) and drive EBIT 13% higher YoY to N343 billion with operating margin of 40% (vs. 38% in FY 17E, 30% in FY 16).
Given the scale of deceleration in net finance expense in the current year, we also believe the company could end up in a net finance income position in 2018 with DANGCEM already gearing up to refinance some debt in the anticipated lower interest rate environment. In addition to this, effective tax rate is expected to play around 12% (vs. 10% in 2017E) in the coming year going by recent management guidance.
On balance, largely reflecting our more tapered volumes expectation across the group, we now look for 2018E PAT of N305 billion (+19% YoY) with most of the gains expected to come from greater cost efficiency (as opposed to the price-led gains of 2017).
The concussion of these changes, which includes adjustments for gradual price correction as well as changes to input cost assumptions over forecast horizon, translates to a 5% decline in our FVE to N203.32. DANGCEM trades at 2017E EV/EBITDA of 10.8x which is at premium to EMEA peers (~10.0x). We retain a SELL rating on the stock.