Wednesday, September 21, 2016 4:50pm / Exotix Partners
· In this note, we revise our earnings estimates and target price for our universe of Nigerian cement companies. We maintain our neutral stance on the sector on the basis of: (1) a downward revision of our earnings outlook over the medium term owing to the weak macro backdrop and intense competitive pressures; and (2) weaker profit margins and RoE trajectories. Moreover, we think the market has now incorporated what we believe to be a fair premium over peers for the sector multiples.
· Setting new margin levels. Core operating margins have been on a downward trend, declining 3ppt pa on average since FY12. This, in our view, is a result of persistent and under-appreciated structural forces, namely: (1) excess production capacity as companies continues to amass capacity ahead of the consumption growth curve. For context, consumption has only grown at a meagre 6% average over the past five years (FY10-FY15), while capacity has grown at a compounded annual rate of 24% over the same period; (2) weak selling prices which reflects the tense competitive landscape; and (3) mounting cost-side headwinds on the back of erratic gas supply and naira weakness. We expect that, within the context of such structural changes, margins will remain around their currently depressed levels with little room for improvement well into the medium term.
· But some positives — Recovery in cement consumption. In spite of the challenging macroeconomic environment and fiscal position, cement consumption grew 15% yoy in H1 16 by our estimate, driven primarily by a rush to complete construction in fear of further hikes in building material prices, and the demand for inflation-protected assets such as real estate properties. We take the view that a gradual recovery in public sector spending and an improvement in retail presence could sustain the positive trend in consumption over the medium term.
· We update our key assumptions. We review our earnings estimates in light of the relatively weak sector fundamentals over the medium term. We cut sector earnings growth, estimating a 26% decline in FY16f net earnings (previously -11%) and our medium-term earnings growth estimate to 6% pa over FY15-FY18f (previously +10%). Similarly, we expect medium-term operating margins to trend lower at an average of 29.4% over FY15-FY18f, representing a sharp decline from the five-year historical average of 39.3%.
· We remain broadly neutral on cement stocks. Current sector multiples of 11.6x and 7.9x FY17f earnings and EBITDA respectively, are at a justifiable premium to SSA peers which trades on 8.6x and 6.9x FY17 earnings and EBITDA respectively. We reiterate our Sell recommendation on Lafarge Africa (NGN52.00/share TP) and maintain our Hold recommendations on Dangote Cement (NGN188.00/share TP), Ashaka Cement (NGN21.00/share TP) and Cement Company of Northern Nigeria (NGN7.00/share TP). If you must own a Nigerian cement stock, we recommend Dangote Cement, which we believe is the most resilient to current economic headwinds.
The Nigeria cement sector has historically outperformed the broader Nigerian equities market. Over the last five years the sector returned 67% vs +31% for the broader market based on the NSE 30 index. This in our view has been a reflection of fairly resilient sector earnings, and excitement around aggressive sector capacity expansion and M&A — which have recently reshaped the industry although not necessarily translated into value creation for investors.
With the exception of the noise around corporate actions, performance has been persistently weak, evident in the broad-based decline in core operating margins and RoEs, down 7ppt and 11ppt respectively between FY12-FY15. More recently, however, the sector has underperformed the broader Nigerian market and Frontier materials alike (see Figures 1 and 2 below), down 22% YTD, as fundamentals prevail and performance begins to mirror the general economic cycle and the weakness in construction activities.
Notably, the weaker margin trend has become even more pronounced recently,-12ppt yoy in H1 16. The key question facing investors today is whether this notable decline in profitability will persist into the medium to long term. In our view, the industry has now reached a new mean margin level, with little room for improvement within our forecast period.
In light of this we remain broadly neutral on the industry over the medium term. We believe the market has now incorporated a fair value for the sector, evident in current trading multiples of 10.6x FY16f EV/EBITDA which we believe is at a justifiable premium to SSA peers which trade on a FY16f multiple of 8.8x and to its five-year historical average EV/EBITDA of 8.1x.
Key themes shaping the industry in the medium term
The year has proved challenging for cement producers in Nigeria. Latest growth figures (-2.06% GDP growth in Q2 16) have indicated that the economy is indeed in a recession, presenting probably the toughest year for cement stocks in the medium term.
This reflects the slump in oil prices and production above all else, but also a fallout from delays in fiscal and monetary policy response. As a result, growth expectations for the economy have deteriorated, evident in the IMF’s recent downward revision of GDP growth estimates to -1.8% in FY16 (previously +2.3%) and +1.1% for FY17 (previously +3.5%).
We anticipate that even under a benign recovery scenario in H2 16, the Nigerian economy will struggle to realise growth higher than -0.8% in FY16.
We take the view that the economy will begin to recover in H2 16, and consequently expect an improvement in fiscal position which will provide support for cement consumption.
However, we consider the sector’s investment case over the medium term will be threatened by developments relating to:
(1) excess production capacity;
(2) weak selling prices;
(3) mounting cost-side headwinds; and
(4) possible amendments to tax incentive laws.
Recovery in cement consumption
We have observed an improved trend in cement consumption in recent quarters, up 15% yoy in 1H 16 (by our estimate), despite general economic weakness. In an effort to better understand the unexpected demand trend, we highlight two lines of demand for cement produced in Nigeria: (1) volumes consumed locally; and (2) re-exported volumes (volumes exported by distributors from neighbouring countries who are favoured by exchange rates and pricing in Nigeria).
Focusing on local consumption, we observed that the key driver of growth in H1 16 was from demand for the completion of private construction projects hastened by inflationary pressures; we link this directly to inflationary pressures for two reasons: (i) we believe there was a rush by home-builders to complete construction in fear of further hikes in building material prices, and (ii) we suspect that there was an increase in demand for inflation-protected assets such as real estate properties.
Other supporting factors are: (1) low base effect from weakness recorded in previous years; and (2) we suspect increased retail penetration could also be a driver, as cement players deepen route to market in an effort to counter competitive pressures in key markets, although we do not have enough evidence to support that view currently.
Whereas most of these factors have begun to tail off given recent hikes in prices, our view is that the impact of an improvement in retail presence could be sustained in the coming periods. In addition to this, we expect a gradual recovery in public sector demand.
Improving retail penetration
Local cement producers have become more proactive in deepening their RTM in a bid to counter aggressive competition and have adopted unique approaches in doing so. Lafarge’s approach has been to diversify its regional capacity to under-penetrated markets in the south-south through Unicem, and the north-east through Ashaka Cement.
Dangote Cement, on the other hand, has recently revamped its distribution channels by initiating key distributor schemes and increasing its retail outlets. This is a strong positive for the company, in our view, given that there wasn’t much of a relationship with its distributors in the past, which became evident when the company incentives such as price cuts never reached the end-users as intended.
Even so, we believe Dangote’s approach of transporting cement over hundreds of kilometres to depots or directly to end-users in other regions from the south, where it has amassed capacity, may not be sustainable into the long term due to high transport costs. We believe that regional players will increase capacity, thereby enabling them to dispatch cement to such markets at lower cost.
Recovery in public sector demand
We expect the government to increase its spending on construction in H2 16 in a bid to remedy waning economic growth. While we expect the implementation of capital projects to be low at just 50% as a result of the government’s poor fiscal position, we are of the view that this level will still result in an improvement from the last 12-18 months which saw a near stand-still in construction activities.
Our estimate for total public sector consumption in FY16f is 2.5mt, significantly higher (+109% yoy) than public sector consumption in FY15, although FY15 was a low base.
Our estimate is based on the following conservative assumptions: (1) 50% (NGN794bn) of capital expenditure allocations is released and spent; given that NGN400bn has been released so far; (2) cement accounts for c9% of the total project costs in Nigeria according to the National Bureau of Statistics; and (3) cement prices will average NGN28,400/tonne in FY16f.
However, we note that the public sector accounts for c15% of total demand, and highlight that we expect growth from the private sector to slow due to increased constraints on consumer spending and higher cement prices.
Cement volume outlook - we estimate 10% pa over the medium term
Accordingly, we estimate that cement volumes will begin to recover at 10% pa on average over the medium term (FY15-FY18f) to 28.0mt by FY18f, slightly higher than our previous medium-term average of 8% pa due to better than expected growth in FY16f.
Although we note that this contributes marginally to cement per capita consumption (PCC), which grows marginally to 144kg by FY18f vs similar middle income countries where consumption is expected to average 265kg per capita.
Excess cement production capacity
At an effective size of 41.3mt, production capacity for the Nigerian cement industry widely outpaces consumption (see Figure 5 below). The gap between capacity and demand has been widening since 2011 as cement producers continued to amass capacity ahead of the growth curve.
To put this into perspective, we highlight that while capacity has grown at a compounded annual rate of 24% over the past five years (FY10-FY15), consumption has grown at a meagre 6% average over the same period. Based on our conservative capacity assumption of 44.1mt by 2018, cement consumption will have to grow 19% pa in the medium term, ahead of our 10% forecast in the same period, for local production capacity to achieve 80% utilisation.
This is unachievable, in our opinion, given the challenges the industry faces which are discussed in a later section of this note. We narrow the core drivers of excess capacity to (1) latent demand, which remains untapped due to lack of commitment on the part of government to infrastructure development, and to a lesser extent higher price of building materials; (2) government protectionism and incentives in form of import bans and tax holidays; (3) cheap Chinese funding for plant construction in an effort to divert capital from its local over-invested industries; and (4) poor delivery by the cement companies on their export strategies.
The fallout of such excesses has manifested in increasing competition, the resultant volatility in cement prices and higher marketing costs to grow market share.
Consequently, profitability measured by return on assets (RoA) has shown a downward trend. In the period between 2011 and 2015 RoA dropped 6ppt on average annually to 8.7% in 2015.
We see little room for improvement in efficiency over the medium term; as such we forecast an average RoA of 7.4% over FY15-FY18f, a notable drop from the five-year historical average of 13%.
Our estimate of 44.1mtpa capacity by FY18 includes existing infrastructure as well as expected capacity which we believe has been reasonably funded. Local cement producers, on the other hand, are more optimistic on bringing more capacity to the market by 2018, which worsens the investment case for the industry.
The only cement companies we realistically see bringing on additional capacity before the end of 2018 are UNICEM, which is at quite an advanced stage of its 2.5mtpa expansion, and Ashaka Cement, via a debottlenecking programme on existing plant.
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