By: Yousuf Rahman,
Global Securities Pakistan Ltd.
Sitara Chemical Industries Limited (SITC) posted earnings of PKR 831mn (EPS: PKR 38.80) during 1Q FY15, increasing by 191% YoY compared to PKR 286mn (EPS: PKR 13.35) recorded during 1Q FY14. The increase in earnings was primarily supported by a one-off gain on the sale of land, amounting to PKR 858mn. Revenues declined by 6% YoY to PKR 2,045mn during 1Q FY15 because of lower demand of caustic soda. Moreover, excess supply in the caustic soda industry led to producers being unable to pass through rising energy costs. In addition, lower gas supply caused SITC’s overall power costs to rise substantially as the company had to rely on the more expensive national grid for its electricity requirements. Consequently, core margins of the company shrank by 17pps to 12% during 1Q FY15.
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Source: Company Accounts
Short-term demand to remain suppressed
Pakistan’s textile industry consumes ~50% of all caustic soda produced inside the country. Recently, Pakistan’s textile sector faced a number of issues that led to the significant decline in the sector’s profitability and hence, production. Considerable electricity shortage in the country caused many textile manufactures to not be able to operate their production facilities at potential capacity. Moreover, despite being granted GSP plus status by the EU, Pakistan was unable to take full advantage of the benefit because of the prevalent Euro Zone crisis and the consequent depreciation of the Euro. Furthermore, with Indian Textile companies enjoying interest rate subsidies of up to 6%, cheaper cotton and lower electricity tariffs and with Bangladesh textile exporters benefitting from an ~25% cost advantage over Pakistan due to cheaper labor and gas prices, Pakistan will continue to face difficulties competing with these two countries in the international market. In view of these factors, we anticipate Pakistan’s textile production and hence, local caustic soda demand, will continue to remain subdued for the remainder of FY15. This potential supply glut is expected to keep caustic soda prices under pressure in the near term.
Exports likely to stay depressed
During FY14, SITC’s caustic soda exports plummeted to PKR 62mn from PKR 546mn during FY13 because of border tensions with India. This situation forced SITC to divert its potential exports to the local market, creating an excess supply scenario. Based on recent occurrences at the Pakistan-Indian Border, we anticipate tensions between the two countries to persist and for SITC’s exports to stay depressed during FY15. Lower exports will worsen the supply-side situation and will likely cause additional downside pressure to local caustic soda prices.
Electricity tariff reduced; benefits likely to be passed through
Based on news reports, NEPRA has reduced the industrial power tariffs by PKR 2.32/kWh. Since Caustic Soda is produced from an energy intensive process, this decline in industrial tariff significantly lowers the company’s cost of production. We, however, believe that in light of the recent supply side scenario and by additional confirmation from the company’s management, SITC will likely pass through the benefits of the tariff cut by lowering its prices; thus, nullifying any potential gains from the reduced cost.
Coal-fired power plant to provide necessary respite
SITC relies on the national grid to fulfill a significant portion of its electricity needs. Meanwhile, the company’s main competitor, Engro Polymer and Chemicals Limited (EPCL), relies solely on gas for its electricity needs. Cheaper production costs, coupled with lower transportation charges, allows EPCL to possess significant pricing power in the local caustic soda industry. The company, however, has raised PKR 2.0bn to invest in a 35MW coal-fired power plant. This power plant will likely reduce the company’s reliance on the national grid and will lower the company’s overall electricity production cost by ~20%. Installation of the coal-fired boilers will allow SITC to regain a portion of the pricing power due to the significant reduction in production costs.
Demand expected to grow; plant utilization levels to rise
During FY14, SITC’s caustic soda’s plant registered utilization levels of a bleak 48% due to lower industry demand. We anticipate caustic soda demand to remain depressed during FY15 because of unfavorable conditions for Pakistan’s textile sector. Textile operating rates, however, are expected to increase after FY15. Significant focus on mega coal-fired projects through lucrative tariffs will allow Pakistan’s electricity generation to increase substantially, going forward. Moreover, many textile producers are increasing focus towards value-added garment production to take full advantage of Pakistan’s GSP Plus status granted by the EU. In addition, since textile comprises over 50% of Pakistan’s total exports, we believe the GoP will continue increasing incentives for the sector, similar to the way the Indian Government provides incentives to its textile industry, to improve Pakistan’s trade gap. Furthermore, as EPCL operates its caustic soda plant at almost full capacity, a large portion of the anticipated increase in caustic soda demand will likely be fulfilled by SITC. Consequently, SITC’s utilization and profitability levels will rise substantially.
Valuation upgraded; BUY maintained
We have rolled forward our models and have incorporated the impact of the planned coal-fired power plant in our valuations with effect from 3Q FY16. Our Dec15 TP for the share stands at PKR 365/sh. The stock offers an upside of 17%, a dividend yield of 3% and trades at anFY15 PE of 6.4x. BUY!
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