DG Khan Cement Limited (DGKC) Expanding Footprint To Amplify Earnings

Alfalah Securities Limited.

We initiate coverage on DG Khan Cement Limited (DGKC) with a BUY call and June’16 Target Price of PKR192/share, offering an upside of 39%. In the wake of strong private sector demand amidst increased spending on construction activities accompanied by sizeable demand outlook under CPEC and developments in Gwadar, the company has initiated work on setting up a 2.7mn tpa manufacturing facility in the area of Hub, Baluchistan set to come online in 2HFY18. While earnings growth will remain tepid in the medium term (limited by capacity constraint), post expansion earnings are set to rise by a 3 year CAGR of 13% despite our conservative stance on margins.
DGKC posted strong earnings of PKR 3.93/share in 1QFY16 in relation to PKR 2.64/share in the corresponding period last year, showing a massive uptick of ~49%. The topline increased by a healthy 7.4% YoY to reach PKR6.2bn in 1QFY16 from PKR5.8bn in 1QFY15. The company outperformed the industry with total dispatches of the company rising by 6% YoY as against 1.4% YoY increase in dispatches of the industry. The company experienced rising demand from the local market with dispatches going up by an impressive 12.3% YoY to reach 759k tons from 676k tons in the corresponding period last year. Exports continued to raise eyebrows declining by a massive 17% YoY versus a drop in industry exports by 27%.

• Expansion in sight. DGKC has initiated work on a brownfield manufacturing facility in Hub, Balochistan having a production capacity of 9,000tpd. The project is expected to come online in 2HFY18 with total production capacity of 2.7mn tons. The project is estimated to cost ~USD300mn and agreements are already in place with FLSmidth of Denmark and Loesche GMBH of Germany for supply of plant and machinery. The fact that the project will entitle the company to a tax holiday for 5 years will generate sizeable savings and open up avenues for sea-route exports besides giving it a strong presence in the South market as well as providing an ideal positioning to cater to planned development in Gwadar in the long run.
• Financing of the project is likely to come mainly from internal cash generation with some reliance on debt. As per our calculations, the company will have strong operating cash flows of PKR9.3/9.9/10.0bn in FY16/17/18 respectively, after posting CFO of PKR8.7/10bn during FY14/FY15. In 1QFY16, the company sold equity investments of PKR4.6bn, taking cash balance at the end of 1QFY16 to PKR6.7bn while net debt stood at negative PKR1.9bn. Thus in our view, the need for right issue is minimal under the current capex plans and industry scenario. While earnings growth will remain tepid in the medium term (limited by capacity constraint), post expansion earnings are set to rise by a 3 year CAGR of 13% despite our conservative stance on margins.
• Earnings surge by 49% YoY in 1q. The topline increased by a healthy 7.4% YoY to reach PKR6.2bn in 1QFY16 which can be credited to increased dispatches, climbing up by 6% YoY to 920k tons in 1QFY16. As a result of reduced exports, the company increased its reliance on local demand thereby increasing the local sales to exports mix from 78:22 in 1QFY15 to 83:17 in 1QFY16. This improvement in the sales mix translated into higher retention prices resulting in higher revenue. Government spending on infrastructure and development of various power projects along with soaring demand from the private sector as a result of increased construction activities continued to be the main demand drivers in local sales. Dip in exports continues to be a major area of concern for the cement industry. A combination of 1) up to 70% anti-dumping duties imposed by the South African government, 2) reduced exports to Afghanistan as a resultant of pricing competition with cheaper Iranian cement, and 3) fierce pricing competition in the African market added to the increasing woes of the already ailing exports division.
• Profitability margins improve. The GP margin of the company improved to 38.1% in 1QFY16 from 31.4% in the corresponding period last year. Despite increasing revenues, COGS went down by 3% YoY. This is attributed to falling prices of coal and furnace oil. In FY15, world coal prices dipped by about 19% to reach $60/ton, however, latest data shows that it has further gone down to around $50/ton. Furnace

oil at the same time has also continued to dip. NP margins followed the lead of GP margins and surpassed 27% in 1QFY16 in comparison to 20% in the respective period last year. Increase in NP margins was mainly due to 1) improved income from other business ventures, 2) reduced financial charges and 3) lower effective tax rate (24%) in comparison to 30% in 1QFY15.

Recommendation

The stock is currently trading at PKR138.2/share, offering an upside of 39% to our Jun’16 target price of PKR192/share. Going forward, we have remained conservative in our estimates and valuations but firmly believe that the company will report higher earnings in the medium term owning to the new expansion project. We have incorporated the Hub expansion project in our valuations.

Key valuation methodology & triggers

• Jun-16 price target: PKR192 based on discounted cash-flow methodology.
• Key upside triggers: 1) Strong local demand, 2) Low prices of coal and furnace oil and 3) CPEC projects.
• Downside triggers: 1) Rise in coal prices, 2) hike in FO prices, 3) further decline in exports, and 4) smuggled Iranian cement.