Construction materials: Falling coal prices to boost cement sector’s profits

After a stellar year, analysts expect further improvement in margins.

KARACHI:

Pakistan’s cement manufacturers have been complaining of lacklustre demand over the past few months, but at long last, it appears that they may have some good news: global coal prices are falling, which means that their input costs will likely fall, causing their profit margins to rise.

According to a report compiled by BMA Capital, an investment bank, the benchmark Richards Bay coal prices are down by almost 20% from their average from the previous fiscal year, to about $85 per ton. Muhammad Affan Ismail, a cement sector analyst at BMA, says that he does not anticipate the medium-term average price of cement to rise, since demand for the commodity appears to be falling.

“Subdued demand from four major coal importers namely China, India, Japan and South Korea will continue to keep the coal prices upward sticky,” said Ismail, in a report issued to clients on Wednesday.

But it is not just the subdued demand from the major importers that is keeping coal prices down: as the United States begins to produce more shale gas at very low costs, power plants in the US are increasingly shifting from using coal to using natural gas, which leaves the world’s largest coal producer with massive excess production capacity that it is increasingly offloading onto the global market, driving down global prices.

The decline in coal prices is likely to tremendously help the cement manufacturers, who use coal as one of their key inputs in their process. BMA Capital estimates that gross margins for cement manufacturers increased by between 5% and 9% due to falling coal prices, which translated into an average profitability increase of over 152% for 2012. For the coming year, the investment bank estimates an improvement in the gross margins by up to 3%.

Another key factor helping the industry is the decline in interest rates. Cement manufacturers are among the most highly leveraged sectors in the economy, and with interest rates dropping by at least 200 basis points over the last quarter, the finance costs for the sector are expected to come down sharply.

At a statement released to the press on Thursday, the All Pakistan Cement Manufacturers Association – the industry lobby – complained of low demand for the sector, citing slugging sales growth over the first quarter of the fiscal year ending June 30, 2013. He went on to demand that the government offer some sort of interest rate subsidy to the sector to offset their high borrowing costs.

Yet over the past year, the cement sector has been attracting considerable positive attention from investors. Cement stocks are up by an average of 114% over the past year, compared to the 33% rise in the benchmark KSE-100 index. This is also the same year that saw the industry’s profits rise by 152%, even as the cement lobby tries to portray an inaccurate picture of an industry in pain and begs for government handouts.

It is true that cement volumes are down from their fiscal 2010 peak of 34 million tons per year, but prices have also substantially increased over the past year as well, by as much as 20%. The cement industry appears to retain its pricing power, an ability that has – in the past – been attributed to a loose cartel that seeks to keep prices artificially inflated.

The industry has the installed capacity to produce about 44.8 million tons of cement ever year. Domestic demand rarely ever accounts for more than half of the utilisation of that capacity, and so the industry is dependent on exports, especially since many of these companies financed their capacity expansions by issuing bonds.

In the middle of the 2000s, Pakistani cement manufacturers benefited from the real estate boom in the Middle East that saw a massive increase in the number of construction projects. That boom came to an end just as Pakistani cement manufacturers had finished a major phase of installing additional production capacity, causing many cement companies to go into financial distress.

A revival in local demand – boosted by rising middle class incomes and a need for more affordable housing – as well as reconstruction activity in Afghanistan has helped keep the industry afloat.

Published in The Express Tribune, October 14^th, 2012.