Inter Market Perspective Research Entity Number –REP -085
Pak Elektron Ltd 10 July 2017 Demand drivers are well-entrenched; initiate with Buy
• We initiate coverage on Pak Elektron Ltd (PAEL) with a Buy rating and Dec’17 TP of Syed Waqas Imam [email protected] PkR120/sh (25% upside). PAEL offers a unique combination of exposure to rising consumer demand, and infrastructure growth in the power sector. We forecast 3yr +92-21-111-467-000 Ext: 102
earnings CAGR of 15% (CY16-19F). Our TP implies a target P/E of 11.2x on CY17F EPS.
• PAEL’s appliances division – with second largest market share is well positioned to capitalize on rapidly growing refrigerator sales in Pakistan, bolstered by close competitors being in transition and a protective backdrop. Importantly, with greater appliance sales, PAEL will sustain strong margins and improve cash-flows. Initiation of coverage
• Also, PAEL’s dominant position in the electrical equipment market will make it a significant contributor to rapid infrastructure development in the power sector amidst Pak Elektron Limited
an unprecedented investment boom. Burgeoning participation from ADB and WB in Price (PkR/sh) 96.00 this investment cycle will further improve risk profile of sales to power sector. TP (PkR/sh) 120.00 Stance Buy Well-aligned to turnaround in Energy sector & Consumer demand Upside 25.0% PAEL is a unique growth story with exposure to two high-growth markets in Pakistan – Fwd D/Y 3.1% appliances and electrical equipment, which are both enjoying conducive macro backdrop, Total Return 28.1% surging demand and weak competition. We initiate coverage with a Buy rating and Dec’17 Bloomberg / Reuters PAEL PA / PKEL.KA TP of PkR120/sh (25% potential upside). We forecast 3yr earnings CAGR of 15% which is Mkt Cap (US$mn) 455.8 backed by (i) double-digit sales growth in both appliances and sales divisions, (ii) increasing 52wk Hi-Low (PkR/sh) 123.73/65.02 share of appliances sales to overall revenue, which will not only lift margins but also improve 3m Avg. Daily Vol ('000 shrs) 4,490 cash-flows, and (iii) healthy EBITDA margins in tandem with sales growth which will fuel swift deleveraging. With more than half its business in the Consumer sector, we find PAEL’s 3m Avg. Traded Val (US$mn) 4.69
valuations undemanding at a CY17F P/E of 9.0x (PEG: 0.6x). Topline to be pushed by a more prominent appliances segment Favorable macros (low inflation and interest rates), turnaround in power supply, high GDP PAEL - Valuation Snapshot growth, and very low penetration (around 40% of total population) all support double-digit Key Ratios CY15A CY16A CY17F CY18F CY19F sales growth of appliances in Pakistan. Of greatest importance is the improved energy EPS (PkR) 5.79 7.35 10.72 10.60 11.17 availability in tandem with low power tariff, which have improved economics for cooling EPS Growth 28.5% 26.9% 45.9% -1.1% 5.4% appliances (refrigerators, deep freezers and A/C splits) for the masses at large. In addition to PER (x) 16.6 13.1 9.0 9.1 8.6 demand growth, local producers of white goods are protected from imports with a sticky PBV (X) 2.4 1.9 1.6 1.4 1.3 25% duty along with freight advantages in case of refrigerators. In this backdrop, PAEL enjoys 26% market share in the key Refrigerator market; we expect its appliances sales to DPS (PkR) 1.00 3.00 3.00 3.00 3.00 grow at a CAGR of 18% over CY16-19F. Additionally, we expect CY17 to be a very good year DY (%) 1.0% 3.1% 3.1% 3.1% 3.1% for PAEL where appliances sales are expected to jump 31% largely due to weak competition ROE (%) 23.4% 21.2% 23.4% 19.9% 18.2% – as per channel checks Dawlance’s restructuring post acquisition by Arcelik disrupted EV/EBITDA (x) 10.2 9.1 7.1 6.8 6.1 supplies at the beginning of year. That said, we expect growth to normalize CY18 onwards. Source: IMS Research
Reforms and investments to drive Power division’s revenues The power sector will see massive influx of investments – both in generation and PAEL - Price Performance transmission & distribution (T&D) – and PAEL, being a major supplier of electrical equipment 1M 3M 12M FYTD CYTD (esp. transformers), is set to significantly elevate sales. CPEC related power projects will Absolute % (18.5) 2.9 47.6 (13.0) 34.7 trigger investment in T&D network, because the existing one is often cited as inadequate to Rel. Index % (8.6) 8.5 28.5 (10.1) 40.1 support greater supply. GoP focus on energy sector reforms and curbing blackouts has been Abs. (PRs) (21.8) 2.7 31.0 (14.3) 24.7 crucial, underlying this turnaround. A revival of privatization of distribution companies, akin to K-Electric, will be the next big trigger (potentially post elections). Another key growth Index Abs. (%) (9.8) (5.6) 19.1 (2.9) (5.4) Source: IMS Research area will be EPC contracting where PAEL can see increased order flows amid growing housing and commercial projects. Valuation & Risks We have valued PAEL on a blend of DCF, relative P/E and relative EV/EBITDA valuations. We have used a WACC of 12.4% and terminal growth rate of 4%. Our target price offers a potential upside of 25%. Risks include (i) PKR depreciation, (ii) slowdown in execution of power sector projects, (iii) stronger competition, and (iv) working capital constraints. ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 17 & 18
To find our Research on Bloomberg, please type -IMKP
Perspective
Appliances division to grow on the back of macro uptick
Glass door a big success Air-conditioners growth due to lower base effect and overall industry growth
Source: Company website
Deep freezer sales to be pushed by energy availability Launching new products
Source: Company website Source: Company website
Source: Company website
Power division to fare well amid energy sector transformation T&D revamp to boost DT PT sales jump as generation increases Switchgears to replicate transformers sales
Source: Company website Source: Company website Source: Company website
AMR/AMI Products Energy Meter
Energy meter growth privy to implementation of Smart meters
Source: Company website Source: IMS Research 2 | P a g e
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Company Profile Pak Elektron Ltd is a leading producer of transformers, electric meters, and home appliances. PAEL is considered to be the pioneer of Electrical Capital goods in Pakistan. The company came into existence in 1956 through a technical collaboration with M/s AEG of Germany. AEG exited from the company in 1960s and it was subsequently acquired by the Saigol group which owns 50% stake in the company. The business is divided into Power and Appliances divisions, with appliances contribution exceeding power segment contribution in overall revenue. Wapda and K-Electric are major customers of its Power Division. In its Appliances Division, PAEL has a network of over 2,600 dealers and 21 service centers; offerings include refrigerators, freezers, AC splits and microwaves. Commencement of operations 1956 Geographic presence (Country wide) - Head Office Lahore, Pakistan Net Sales (PkRmn) - CY16 26,834 Assets (PkRmn) - CY16 40,327 Liabilities (PkRmn) - CY16 14,816 Market Capitalization (PkRmn) 47,777 Shareholding Pattern Sponsors, Directors, CEO and children 50.30% Key Ratios CY14 CY15 CY16 CY17F CY18F Bank, DFIs & NBFIs 3.40% Sales growth (YoY) 25% 22% 7% 38% 9% Insurance Companies 2.80% Gross Margin 34% 32% 34% 31% 29% Mutual Funds 7.50% EBITDA margin 25% 23% 24% 22% 21% General public 11.70% 11% 11% 14% 14% 13% Others 6.10% Net margin Foreign Companies 18.20% Leverage ratio (x) 2.95 2.65 1.94 1.84 1.66 Source: IMS Research Power Division Appliance Division
7% 3% 8% 9% Air Conditioners Energy Meters EPC Contracting 15% Refrigerators/Deep Switchgears freezers
69% Transformers Microwave ovens/Others
90%
Source: Company accounts Source: Company accounts Appliances division gaining momentum (Revenue Mix)
100%
80%
60% 40%
20%
0% 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017F 2018F 2019F Power Division Appliances Division
Source: Company accounts
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Topline to be pushed by a more prominent appliances segment Favorable macros (low inflation and interest rates), turnaround in power supply, high GDP growth, and very low penetration (40%) all support double-digit sales growth of appliances in Pakistan. Of greatest importance is the improved energy availability in tandem with low power tariff, which have improved economics for cooling appliances (refrigerators, deep freezers and A/C splits) for the masses at large. In addition to demand growth, local producers of white goods are protected from imports with a sticky 25% duty and freight advantages in case of refrigerators. In this backdrop, PAEL enjoys 26% market share in the key Refrigerator market; we expect its appliances sales to grow at a CAGR of 18% over CY16-19F. Additionally, we expect CY17 to be a very good year for PAEL where appliances sales are expected to jump 31 % largely due to weak competition – as per channel checks Dawlance’s restructuring post acquisition by Arcelik disrupted supplies at the beginning of year. That said, we expect growth to normalize CY18 onwards. PAEL is a major player in the Appliances market PAEL is well positioned to capture the growing demand of white goods in Pakistan. It is one of the leading manufacturers of home appliances in Pakistan, especially in refrigerators and deep freezers. Currently, PAEL boasts a decent market share of 26%/11% in refrigerators/deep freezers. It is also a producer of Air conditioners and Microwaves which constitute a small portion of sales but exhibit growing demand amid rising consumerism.
PAEL is the second largest producer of refrigerators in Pakistan… …but has lower prominence in the Deep freezers market Others, 3% Waves 2% Others PEL, 11% 7% Dawlance, 11% Dawlance Orient 32% 20% Haier, 21% Waves , 28%
Haier PEL 13% 26% Varioline, 26%
Source: Company accounts Source: Company accounts PAEL’s strength lies in its widespread distribution network. The company has a total 2,600 appliances dealers' spread across the country but majorly concentrated in Punjab with 71% of the total dealers in the province. An extensive retail network is imperative in order to penetrate the different segments especially in the case of consumer durables. Moreover, the company places immense importance on R&D; glass-door technology and energy saving inverter refrigerators are shining success examples of constant strive to innovate and retain the market share in the industry .
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PAEL - Distribution map
Source: PAEL
Energy sector woes had long delayed realizing of underlying demand Pakistan is a population of 180mn with penetration of refrigerators of about 40% compared to over 80% in major centers of the Asia Pacific region. The chronic power shortages of about 3000MW have delayed the true demand of appliances in rural areas as appliances were long perceived as luxury items rather than a necessity. The insufficient rural electrification has been a major hindrance in the penetration of white goods, especially refrigerators and Air conditioners. Furthermore, expensive electricity (35% on furnace oil and diesel) coupled with a period of low economic growth over the period 2007-14 hindered the demand for white goods. With the blackout-focused PML-N winning elections in 2013 and oil prices plunge dragging power tariff along, the energy situation has markedly improved. What has changed? Since the PML-N government has taken the reigns, the energy availability has improved in relative terms as generation was immediately ramped up by greater utilization of the generation capacity. This was abetted by (i) GoP settlement of circular debt in 2013, (ii) commencement of LNG imports, and (iii) low oil prices. Going forward, the energy deficit will likely be bridged by a wave of new power plants (up to 10,000MW is priority CPEC projects only), where increase in rural electrification should improve dramatically in the next 3-5years. Power availability will improve in the wake of heavy investments through CPEC projects, LNG supply from Qatar, and government’s focus on reducing power outages in the run-up to elections. 5 | P a g e
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Launch of Sahiwal (1320MW) and Bhikki (1180W) power plants are key checkpoints, which can fill up to 50% of the peak power deficit near full capacity. Moreover, the overhaul and expansion of current T&D network will prove to be more effective in improving household electrification and improve living standards of average Pakistani household. In addition, government’s support to farmer income and easy credit availability will fuel demand for refrigerators and deep freezers for livestock purposes.
Pakistan has been beset by energy deficit of ~3000MW… ...but as the situation improves, refrigerator production is on the rise
20,000 8.0% 1,600,000 16% 1,400,000 14% 6.0% 1,200,000 12% 15,000 4.0% 1,000,000 10% 10,000 2.0% 800,000 8% 0.0% 600,000 6% 5,000 -2.0% 400,000 4% 200,000 2% 0 -4.0% - 0% FY11 FY12 FY13 FY14 FY15 FY12 FY13 FY14 FY15 FY16 Avg. Generation MW Avg. Peak Demand MW
Avg. Generation % Change Avg. Peak Demand % Change Refrigerators YoY change - Rhs
Source: Energy year book, IMS research Source: LSM
Rising consumer incomes along with low interest rates and inflation rate The per capita income has increased from US$1,531 in FY16 to US$1,629 in FY17, growing Rising per capita income supports demand 6.4% YoY. The SBP policy rate has remained low while inflation rate is at a cyclical bottom. of white goods We expect oil prices to remain range bound between US$45-60/bbl in FY18-19 posing PkR 200,000 limited threat to inflation; however, inflation will likely still moderately pick up from next
160,000 quarter. Other possible triggers positively affecting the macro backdrop are improving crop yields complimented by rising commodity prices. Also, a strong and deeply penetrated 120,000 media has improved awareness of consumer goods among the low income strata. 80,000 Duty protection in the white goods segment offers great relief to local producers as the 40,000 threat of cheap imports is thwarted. A hefty duty of approximately 25% remains a hurdle - for imports to capture the Pakistani market. Moreover, the logistical fragility of transporting bigger appliances adds up to the barriers of entry for imported products. On 2010 2011 2012 2013 2014 2015 2016 2017E 2018E 2019E 2020E 2021E the other hand, smaller home appliances are easier to transport with the quantum of Gdp per capita damage much lower than in the case of bigger appliances. Therefore, smaller appliances Source: Ministry of Finance have found their way into the Pakistani markets; but PAEL currently does not majorly contribute to the segment. In our view, the threat of cheaper imported appliances in the refrigerator, air-conditioners and deep freezers markets is expected to remain at bay. However new Chinese entrants with assembling facilities could be a potential threat to the market share of current local producers. We have conservatively incorporated this in our model by keeping market share in check and trimming our margins going forward. Penetration in rural areas can increase PAEL boasts a decent market share of 26%/11% in refrigerators/deep freezers. Its widespread presence in Punjab, as reflected by approx. 70% of its dealers located in the region, provides a unique opportunity to capture the growth in rural areas. The FMCG sales uptick is also the reason behind rising deep freezer sales as PAEL’s clients include the largest FMCG companies operating in Pakistan. The sales of the top consumer companies (Nestle Pakistan, National Foods, Engro Foods, Unilever Foods Pakistan, Rafhan Maize, Mitchells and Shezan Foods) accelerated strongly during the 2006-2012 commodity super- cycle which pushed farmer incomes. After a slow period, these companies are once again appearing to embark on a stronger sales growth phase. With the energy situation in much better shape, this factor can push PAEL’s sales more than it has in the past.
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Refrigerators price ranges (PkR)
Waves
Changhong Ruba Kenwood Electrolux Samsung ORIENT HAIER PAEL Dawlance PkR/Unit - 20,000 40,000 60,000 80,000 100,000 120,000 140,000 160,000
Source: IMS Research
Competitors in transition PAEL’s sharp increase in sales and profitability is attributed to the temporary pruning of market share of its biggest competitor, Dawlance. As per industry sources, Dawlance’s market share will temporarily decline as it is recalibrating its supply chain in a post- acquisition scenario (Dawlance was recently acquired by Turkey’s Arcelik). PAEL as the second largest player in the refrigerator market will be in a sweet spot to capture the market share of Dawlance. However, once Dawlance regains its market share, PAEL market share will also normalize thereafter. PAEL tends to dominate in the smaller size refrigerators market (7cft, 8cft) while Dawlance remains a preferred choice of customers in the larger-size refrigerators. As a result, PAEL is able to charge higher prices than Dawlance Air conditioners market share and others in this category; whereas Dawlance's prices tend to be higher in larger-size 4.0% 2.0% 5.0% refrigerators. The market for Air-conditioners has revived 12.0% PEL Orient We foresee an upsurge in the overall market for air-conditioners, and PAEL will benefit in 20.0% Haier tandem. Overall segment production grew by 21% in FY16, the highest among the home Dawlance appliances according to LSM numbers. Much of the growth is attributed to generic factors Digital world 22.0% Changhong such as improving economic backdrop but the linchpin of growth in Air-conditioners has 20.0% R&I been the shift in lifestyle. Rural to Urban migration coupled with the growth of corporate Others Pakistan has led to greater usage of Air-conditioners. Moreover, rising consumer incomes 15.0% is causing greater AC adoption than ever before.
Air-Conditioners prices range (PkR) Source: Company Accounts Kenwood
Orient
Haier Mitsubishi Gree LG Dawlance Pael
PkR/Unit 25,000 50,000 75,000 100,000 125,000 150,000
Source: IMS Research Historically, PAEL used to be the market leader in the window AC category but the transition from window AC to split AC diluted its advantage in that market due to influx of imports. Since the transition, PAEL’s market share has considerably fallen while the market
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Perspective remains highly oligopolistic as the big-four producers capture 77% of the market. PAEL has lagged behind mainly due to less variety in its product line while the competitors flourished on the back of sleek designs and adoption of inverter technology much before it was mainstream. Air-conditioners account for just 8% of PAEL’s appliances division revenues which suggests that the company’s R&D force has been greatly applied to refrigerators. Nevertheless, the increase in the overall pie suggests that the company will be able to record an impressive growth even at the same level of market share. But the slowdown at Dawlance’s end means that PAEL will be able to push its market share in the near term. In addition, the launch of inverter series is met with high ratings of approval and the lower base in CY16 suggest that the category can double sales, in our view. Others appliances to post growth via introduction of newer products Other appliances account for just 2% of PAEL’s revenues particularly given greater degree of competition from local and international brands. Imports in this category are rife as shipping these is more cost-effective way of transportation than in case of refrigerators. PAEL management, however, remains upbeat in capturing a bigger market share in the category by launching a new range of products in the home appliances category and leveraging on its existing strong brand recognition. The company plans to launch washing machines and water dispensers as part of its new product strategy by the end of 2017. Expanding the product line in the small home appliances category is not very rewarding as margins tend to be low due to high level of competition with a variety of brands competing in the segment. The small home appliances category is extremely useful in pushing bigger appliances by bundling the two as a retail strategy to attract a wide reception of customers. We have conservatively increased utilization of other appliances by 1% every year (much slower than GDP).
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Reforms and investments to drive Power division’s revenues The power sector will see massive influx of investments in next 3years – both on generation and the transmission & distribution (T&D) fronts. PAEL, being a major supplier of electrical equipment (esp. transformers), is set to significantly elevate sales in this backdrop. CPEC related power projects will trigger investment in T&D network, because the existing one is often cited as inadequate to support greater supply. GoP focus on energy sector reforms and curbing blackouts has been crucial, underlying this turnaround. A revival of privatization of distribution companies, akin to K-Electric, will be the next big trigger (potentially post elections). A key growth area will be EPC contracting (growing at 27% 5-yr CAGR) where PAEL can see increased order flows amid growing housing and commercial projects. PAEL well placed to play improvement in power sector For the best part of the previous decade, the power sector was heavily underinvested (esp. Transformer production is strong (LSM) on the T&D side) with the demand-supply deficit peaking at 3,000MW (1/4th of overall Units demand). The period between 2009 and 2016 was mired with chronic blackouts, which 35,000 30,000 were more acute in the North of the country. The energy sector until recent years was 25,000 plagued by circular debt, expensive electricity based on import Fuel, and poor 20,000 management at the state owned distribution companies (DISCOs) with high line losses and 15,000 non-recoveries. 10,000 5,000 The PML-N government’s efforts in overhauling the energy sector has improved the - scenario where low oil prices and an IMF program also enabled better management of
Mar cashflows. Build-up of circular debt has decelerated to an extent by directly managing the - FY12 FY13 FY14 FY15 FY16 payment discipline between fuel suppliers, power producers and distributors. The DISCOs
FY17TD have thus been able to reduce line losses and improve recovery rates to a great extent.
Source: Ministry of finance The Ministry of Power & Water has hinted at adding up to 10,000MW of electricity to the national grid by 2020 as per the notified list of upcoming IPPs, along with up-gradation of existing transmission lines. The Matiari-Lahore 660 kV HVDC transmission line project is Demand for transformers will rise given the underway with expected commissioning date by end of 2019. As a result, large investment GoP's focus; PAEL is the market leader in the is going into the sector for up gradation and expansion of existing transmission lines. segment Normally, demand for power transformers is realized immediately then demand for distribution transformers follows. By international standards (also applicable in Pakistan) for every 1MW of electricity added, about 3MW of transformers is required for transmission. Applying this to planned power addition in FY18-21, we estimate crude demand for 30,000 MVA of transformers due to new power plants. If PAEL maintains its market share of 81% in power transformers, then estimated demand would be 24,300MVA over the next four years, which is 3.5x the full capacity of producing transformers. In our view, another impetus could be the revival of the privatization program, from which the overhauling of DISCOs can be expected. K-Electric is a shining example of this. However, we believe that a fresh privatization campaign will only be restarted post elections. Nonetheless, we project transformer sales to jump in 2018 as the correlation between transformer sales and election years is very high. It is imperative for the government to spend more in order to curb power outages in a bid to be reelected. PAEL is dominant in transformers market In the power transformer market, the market share is divided among only two players with PAEL capturing as much as 80% of the demand. PAEL is the leading producer in the distribution transformers category as well with a 40% market share. We project the utilization of the transformers capacity to be above 80% given the anticipated demand. Sales to WAPDA exhibit low credit worthiness which could aggravate working capital problems but increasing sales to projects undertaken by ADB and World Bank serve as a mitigating factor. We project sales CAGR of 10.5% for the next 3 years. Considering the demand for transformers, PAEL will likely need to incur a Capex to expand its capacity in order to maintain its healthy market share.
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Power transformers market share Distributor transformer market share Pan power, 7%
Elmetec, 10% HEC 19% JF PEL, 40% industries, 8%
PEL 81% Transfo Power, 24%
Source: Company accounts Source: Company accounts
Switchgears to follow the transformer trajectory The switchgears demand replicates the growth pattern for transformer sales. As more housing and industrial projects keep emerging, the demand for switchgears will move in tandem. The last 5-yr average utilization in switchgear segment was a meagre 24%. Therefore, a surge in the demand of switchgears could easil y be fulfilled by PAEL considering it has the leading market share (25%) in the switchgear segment. We have incorporated a modest growth of 3% in the utilization rate of switchgear capacity. Energy meters market share Switchgear market share
Pem Pak, 11% Others, 15% PEL, 18% PEL, 25% Siemens, 10% Escorts, 8%
Schneider, 16 Accurate, 9% Creative, 19% % Siddiqsons, 20% KBK, 15% Micor FICO, 18% Tech, 16%
Source: Company accounts Source: Company accounts
Meters The smart-metering project pushed by ADB will be the biggest impetus for PAEL’s energy meter sales. The ADB has earmarked US$1.5bn investment over 10 years for the smart meters and billing system projects. In the first phase, the ADB has offered US$400mn for installing smart meters in Lahore and Islamabad electricity distribution companies. However, the project has seen many delays. We have remained conservative in our approach as the smart metering project could be subject to further delays given its recent trend. Currently, PAEL holds 18% market share in the keenly contested market for meters. PAEL’s utilization rate in the category has hovered around 74%. We project a CAGR of approx. 9% for the next 3 years. Engineering Procurement and Construction (EPC) The outlook for EPC segment of the power division remains optimistic due to a greater number of housing schemes and mega construction projects like malls and new industrial units being set-up in the country. All the above mentioned projects involve setting up of customized grid stations and electrification. The revenue materialization of the segment is based on the number of orders in hand. The dynamics of the project vary as the requirements are customized and specific in nature to the client. Currently, the management expects a healthy rise in the revenues from the sector as they have been working on projects worth PkR 4-5 bn.
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Margins to normalize in the medium term Over 2013-16, PAEL’S gross margins jumped 5ppt to 34%(ex-depreciation and amortization) due to plunge in global commodity prices which the company did not pass onto customers because of high pricing power amid strong demand for both power equipment and appliances. This was also supported by weak competition in the Power division (as Siemens decided to exit the market) and product development in the Appliances division (glass-door refrigerators and inverter ACs). Also, equally importantly, the PKR was mostly stable or depreciated only slightly after adjusting steeply in 2013. 2HCY16 rally reversed in 1HCY17 Commodity prices remain a key determinant of PAEL’s margins. Broadly speaking, PAEL’s 750 margins are affected mostly by – Steel, Copper, ABS Plastics (petrochemical, derivative of crude oil) and such inputs as compressors and transformer oil. 650 For oil, Bloomberg consensus estimates suggest oil prices are likely to remain low. This is 550 due to OPEC and Russia’s production cuts not proving completely fruitful due to rebound 450 in shale production. That leaves the demand side with a lot of weight to lift. Further, steel 350 prices staged a rebound in 2HCY16 but then followed a descending trajectory owing to a surge in iron ore production. In addition China, the biggest producer of steel, has been 16 16 17 16 17 17 17 ------reluctant to cut steel production amid depressed demand worldwide. Steel prices will Jul Jul Jan Sep Nov Mar May likely remain range bound in the short term until demand recovers. Overall growth in steel HRC (US$/m.t) CRC (US$/m.t) demand will remain modest because of slowdown in China, consumer of 45% of global Source: IMS Research, Bloomberg steel. Since appliances segment is characterized by high competition, we assume that some margin attrition will be inevitable in this segment, going forward. This puts PAEL’s margins at risk, mostly from PkR depreciation. However, the only scenario which will avert margin attrition would be that the local producers simultaneously increase prices across- the- board on all appliances. In our view, power division gross margins will continue to sustain at current levels but the growing contribution from the appliances division revenues lowers the resultant impact from the division. Conventionally, margins in the appliances division tend to be higher than margins in the power division. Rupee depreciation is a risk Lastly, currency movement is another important determinant of the margins as 70% of the USD/PkR 120 Raw materials are imported. Steel and Compressor fittings (mostly power division) are 110 imported from Europe whereas ABS is imported from China. If PAEL is able to pass-on the
100 effect of the rupee depreciation, they will be able to maintain the current level of margins.
90 In our view, power division allows the company to pass-on the effect, though with lagged
80 effect; whereas, the pass-on in the appliance division is checked by competition. However, due to low localization of most players in the appliances industry, they will likely increase 70 prices together. This is supported by the fact that while PAEL did not materially reduce 60 prices amid commodity down cycle, its competitors did not either. High demand period 13 16 14 08 10 08 09 12 13 11 15 17 ------Jul Jan Jun Oct will also keep price competition limited. Nonetheless, in our estimates gross margins may Sep Feb Dec Aug Nov Mar May May
USD/PkR normalize tow ards 25% in the long run, which is well below current margins of over 31% and close to 15-years’ average. Source: IMS Research, Bloomberg
Gross margins to normalize
40%
35% 30% 25% 20% 15% 10% 5% 0% 2012 2013 2014 2015 2016 2017F 2018F 2019F
Source: IMS Research, Company accounts
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Further Rights issue seem unlikely in near term PAEL is a consumer proxy as the appliances division constitutes a major portion of the revenues. The stock, however, has mostly trailed at a discount to the consumer sector average P/E. Although the company’s appliances division is directly exposed to the consumer, the sales concentrate in the 2nd Quarter and the 4th Quarter every year. The uneven distribution of revenues derails working capital management leading to liquidity crunch. PAEL has consecutively issued 3 rights in the last three years in order to control the growing illiquidity and working capital problems. The rights issue were fully subscribed at all times but raises concerns regarding the cash conversion cycle.
Date Announced Right Premium (Rs) Ex-Date Total rights issue PKR 15-Aug-13 120% 2.5 29-Aug-13 1.828bn 22-Sep-14 35% 10 9-Oct-14 2.064bn 4-Jan-16 25% 30 22-Jan-16 3.981bn
Gradual deleveraging but STB on the rise Sales registered a steep growth following the rights issue as the company was able to ramp up its production by effectively managing inventory with the additional cash flow. Sales (PkRmn) growth coupled with higher gross margins drove profitability in the years when rights were 8,000 50% issued. The working capital financing from rights issue enabled the company to cut its short term borrowings which led to lower than usual finance costs. 6,000 40% 4,000 30% However, amid sharp sales growth, we project short-term borrowing to also jump considerably as a result. Moreover, the company has followed a deleveraging regime since 2,000 20% the internal cash generation has relatively improved post-2013. The company has repaid 0 10% 57% of the long term debt outstanding in 2013 over the course of last 3yrs, bringing Debt- to-Capital down to 37% from 69% in 2012. Therefore, short-term borrowing can easily 2013 2014 2015 2016
2017F 2018F mitigate the growing working capital issue, undermining the need for a capital call, in our Short term borrowing (Lhs) view. Debt to Asset ratio Source: IMS Research , Company Accounts Working capital issues to persist but remain under-control Cash flows have inherently remained under pressure due to PAEL’s exposure to certain factors. The company imports majority of its Raw material which increases exposure to currency risk, which has worsened over time. Moreover, company’s biggest client in the power division is WAPDA which is effectively a risky credit client given the problem of circular debt prevalent in the sector. The cash blocked in the receivables results in the working capital drain but we project a rise in the operational cash flows as the appliances segment constitutes a higher percentage of the total revenues than before. Appliances segment exhibits a relatively smaller cash cycle as bulk of the sales through PAEL’s own outlets are cash-based. Working capital is still a problem (PkRmn) 40,000 4,000 35,000 2,000 30,000 25,000 0 20,000 15,000 -2,000 10,000 -4,000 5,000 0 -6,000 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017F Working Capital Revenue Cash flow - Rhs
Source: IMS Research, Company accounts
On balance, we think that the cash flow issues are likely to persist as we do not suspect any material changes in the cash conversion cycle in the near term. In addition, ex-WAPDA discos will still be the biggest buyer of power transformers and hence, we believe that the customer base would not witness a material change. On the other hand, we foresee that growing contribution from exporting income could improve the working capital issue in the future. The word from the management is that the exports are likely to follow a similar trend but the company will be seeking to increase their exports.
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Valuation Our blended TP (Dec’17) of PkR120/sh for PAEL offers 25% upside. The terminal year growth rate is assumed at 4% with a risk-free rate of 8%. PAEL currently trades at CY17F P/E of 9.0x vs. emerging market average P/E of 19.0x. We believe valuations can catch up after the country discount has been applied as Pakistan embarks on a growth trajectory led by a promising power sector and buoyant consumerism. We have used (i) discounted cash-flows method, (ii) comparable valuation using the regional P/E and (iii) comparable valuation using the regional EV/EBITDA. Assigned weights to these three are 50%, 20% and 30%, respectively.
DCF Valuation (A) WACC 12.4% WACC 12% Risk free rate 8.0% Terminal Growth 4% Terminal Value 87,820 Beta 1.10 PV of CF 31,809 Market risk premium 6.0% PV of Terminal Value 30,539 Cost of Equity 14.6% Enterprise Value 62,348 Debt 25.0% Net Debt (10,752) Kibor- 6.0% Equity Value (PkRmn) 51,595 Fair Value (PkR/sh) 104 Cost of Debt 8.5%
PkRmn 2017F 2018F 2019F 2020F 2021F 2022F 2023F 2024F 2025F 2026F Terminal EBITDA 8,265 8,293 8,863 9,815 10,636 11,434 11,755 12,474 13,010 13,891 Taxation (1,171) (1,319) (1,661) (2,234) (2,463) (2,700) (2,788) (2,993) (3,135) (3,359) Working Capital (4,071) (1,825) (2,071) (2,220) (2,923) (2,065) (2,304) (245) (1,725) (2,810) Capex (478) (489) (499) (509) (519) (1,587) (561) (572) (584) (595) FCFF 2,545 4,660 4,632 4,852 4,731 5,081 6,101 8,664 7,566 7,128 87,820 PV 8,265 8,293 8,863 9,815 10,636 11,434 11,755 12,474 13,010 13,891
EV/EBITDA (x) (C) Relative Valuation (B) Appliances 12.15 P/E (x) Power Equipment 14.13
Appliances 17.2 Average 12.97 Power Equipment 23.4 Discount to region 30% Target EV/EBITDA (x) 9.08 Average 19.8 CY17F EBITDA (PkRmn) 8,265 Discount to region 30% Enterprise value (PkRmn) 75,020 Target P/E multiple 13.8 Net debt (PkRmn) (10,657) CY17F EPS (PkR) 10.7 Equity value (PkRmn) 64,363 Fair value (PkR/sh) 129.0 Fair value (PkR/sh) 148.0 Source: IMS Research Source: IMS Research
Blended Value PkR/sh Weightage DCF method (A) 104.0 50% P/E valuation (B) 148.0 20% EV/EBITDA (x) (C) 129.0 30% Target Price 120.0 Current Price 96.0 Upside 25% Dividend yield 3% Total return 28% Source: IMS Research
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ELECTRICAL CAPITAL GOODS - REGIONAL PEERS symbol Company MkT Cap PE (x) PB (x) EV/EBITDA (x) ROE (US$) MN 2017F 2018F 2017F 2018F 2017F 2018F 2017F 2018F PKEL.KA Pakistan Elektron Limited 456.0 9.0 9.1 1.6 1.4 7.1 6.8 23% 20% 002202.SZ Xinjiang Goldwind Science & Technology - H 5,761 11.6 10.6 1.8 1.6 10.4 9.1 15% 15% BHEL.NS Bharat Heavy Electricals (BHEL) 5,130 26.9 18.7 0.9 0.9 14.5 9.9 3% 5% 601727.SS Shanghai Electric Group Company Limited - H 13,326 40.0 41.7 1.8 1.8 13.9 13.2 4% 4% 600875.SS Dongfang Electric Corporation Limited - H 3,164 n.m n.m 0.9 0.9 1.9 1.6 0% 1% 0658.HK China High Speed Transmission 1,811 11.0 10.4 1.0 0.9 7.1 7.0 9% 9% JKS JinkoSolar Holding Co., Ltd. 634 10.2 8.8 0.6 0.6 11.3 6.8 6% 6% 3898.HK Zhuzhou CSR Times Electric Co., Ltd. 5,870 12.4 11.2 2.2 1.9 9.8 8.8 18% 17% RLIN.NS Reliance Infrastructure Ltd 2,064 8.6 8.0 0.6 0.5 9.1 7.4 6% 6% 000400.SZ XJ Electric 2,684 15.3 13.6 2.2 1.9 11.5 10.5 14% 14% 002475.SZ Luxshare Precision Industry 9,121 30.0 24.8 4.9 4.2 22.0 16.6 15% 17% 600089.SS TBEA Co Ltd 5,551 15.1 12.8 1.5 1.3 11.9 10.6 10% 10% 600312.SS Pinggao Electric 2,834 13.7 12.0 2.0 1.8 10.9 9.9 14% 15% 600406.SS Nari Technology 6,481 26.2 22.5 4.4 2.9 22.8 19.6 17% 13% 600835.SS Shanghai Mechanical & Electrical Industry 2,926 12.8 11.8 1.8 1.6 3.6 3.3 14% 14% 601179.SS China XD 4,177 22.1 19.3 1.4 1.4 11.5 10.2 6% 7% 601222.SS Jiangsu Linyang Energy 2,000 18.8 15.2 1.6 1.4 11.0 8.7 8% 9% HVEL.BO Havells India Ltd 4,591 43.9 36.2 8.8 7.6 27.6 22.7 20% 21% Weighted Average 23.4 21.1 2.6 2.3 14.1 12.0 11% 11% Source: Thomson Reuters, IMS Research
APPLIANCES - REGIONAL PEERS symbol Company MkT Cap PE (x) PB (x) EV/EBITDA (x) ROE (US$) MN 2017F 2018F 2017F 2018F 2017F 2018F 2017F 2018F PKEL.KA Pakistan Elektron Limited 456.0 9.0 9.1 1.6 1.4 7.1 6.8 23% 20% 051900.KS LG Household & Health Care Ltd 13,118 23.9 21.1 4.9 4.1 15.5 14.0 21% 19% 6752.T Panasonic (6752) 30,176 18.0 15.5 1.9 1.8 5.6 5.0 10% 11% 6753.T Sharp (6753) 17,835 56.0 37.3 5.2 4.5 16.2 14.1 8% 12% 6758.T Sony (6758) 47,360 19.7 16.6 1.8 1.6 6.0 5.4 8% 10% GE General Electric Co. 228,475 14.5 14.9 3.2 3.1 14.3 13.8 19% 21% ELUXb.ST Electrolux 9,419 15.6 14.3 3.9 4.4 7.9 7.5 25% 30% 000333.SZ Midea Group 39,736 15.0 13.8 3.7 3.1 13.2 11.4 23% 23% 000651.SZ Gree Electric Appliance 33,985 12.1 11.7 3.7 3.3 7.7 6.9 29% 28% 600690.SS Qingdao Haier Co., Ltd. 12,717 13.7 12.2 2.6 2.1 10.1 9.1 19% 18% 600690.SS Hisense Electric Co., 12,717 13.7 12.2 2.6 2.1 10.1 9.1 19% 18% 000100.SZ TCL Corporation 6,305 14.2 12.8 1.6 1.4 10.0 8.8 11% 11% 000921.SZ Hisense Kelon Electrical Holdings 2,818 10.9 11.6 3.3 2.7 9.5 9.3 31% 24% 1169.HK Haier Electronics Group Co., Ltd. 7,152 15.3 13.7 2.3 2.0 9.0 8.0 15% 15% 0751.HK Skyworth Digital 1,776 7.9 6.8 0.8 0.7 5.6 4.7 10% 11% HVEL.BO Havells India Ltd 4,591 43.9 36.2 8.8 7.6 27.6 22.7 20% 21% VOLT.BO Voltas 2,404 29.3 24.9 4.8 4.2 24.1 20.3 16% 17% Weighted Average 17.2 15.8 3.2 2.9 12.1 11.2 18% 19% Source: Thomson Reuters, IMS Research
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Risks Rupee Depreciation PAEL imports 70% of its raw materials from abroad which creates a concern whenever the PkR comes under pressure. The concerns circling around the external account increases the probability of the currency depreciation going forward, which means an increase in costs may be on the cards. Margins in appliances division will be subject to minor attrition as the effect cannot be readily passed-on due to intense price competition. Since appliances segment will constitute a major proportion of the total revenues, margin attrition in the segment company will be more visible than in the past. . A mitigating factor could be low location among all appliances companies in Pakistan due to which all will increase prices simultaneously. Competition (Arcelik and new) The competition in appliances industry is stiff owing to many players. With the entry of Arcelik (leading appliances brand in Turkey with a market share of 50% in refrigerators) via Dawlance (already a leader), enhancement of the product line and advanced technology appliances are very likely in our view. We foresee a greater challenge for the local companies as a leading European Brand has entered the market with greater product variation and technology. Newer brands like Singer could potentially also hurt the PAEL’s share in the refrigerator and deep freezer segment. Slowdown of investment in power sector PAEL’s growth story in the power division is reliant on heavy investment in the power sector currently underway. Our thesis banks upon the massive investment planned for the sector in the upcoming years. However, delays in materialization of power sector projects could hinder the growth trajectory of this segment and could result in a potential slowdown. PAEL’s significant chunk of transformer sales are driven by state-owned power distribution companies. Working Capital constraints Working capital constraints remain a major concern given which has led to the company issuing frequent rights in recent past. The working capital will grow considering the sales growth projections but if the cash conversion replicates the historical trend, its implications can potentially be slower sales (losing share to competitors), heavy leverage subverting potential for inorganic and even a capital call. Moreover, persistent illiquidity will also dent the sales growth assumed in our model as inventory management will be disrupted, causing bottle-necks in the supply of goods.
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PAEL - Financials
Profit & Loss Account
(PkRmn) CY16A CY17F CY18F CY19F CY20F Key Ratios CY16A CY17F CY18F CY19F CY20F Net Revenue 34,124 43,612 47,518 51,713 56,498 EPS (PkR) 7.35 10.72 10.60 11.17 12.13 Cost of sales 17,755 25,564 28,589 31,328 34,095 EPS Growth (%) 27% 46% -1% 5% 9% PER (x) 13.07 8.96 9.06 8.59 7.91 Gross profit 9,079 11,506 11,802 12,628 13,928 Admin & Selling Exp. 2,457 3,023 3,294 3,584 3,916 BVPS (PkR) 51.26 58.98 66.57 74.75 82.88 EBITDA 6,465 8,265 8,293 8,863 9,815 PBV (X) 1.87 1.63 1.44 1.28 1.16 Dep & Amortization 850 839 855 873 890 DPS (PkR) 3.00 3.00 3.00 3.00 4.00 EBIT 5,616 7,427 7,437 7,990 8,925 DY (%) 3% 3% 3% 3% 4% Financial Charges 1,497 923 844 768 652 ROE (%) 21% 23% 20% 18% 17% Other income 37 28 37 46 100 ROA (%) 10% 12% 11% 12% 12% Debt to Equity (x) 0.46 0.39 0.30 0.20 0.14 Other charges 194 245 252 227 297 Profit before Tax 4,106 6,504 6,594 7,222 8,273 EV/EBITDA (x) 9.05 7.07 6.77 6.07 5.26 Taxation 450 1,171 1,319 1,661 2,234 EBITDA Margin 24% 22% 21% 20% 20% Net Profit after Tax. 3,656 5,333 5,275 5,561 6,039 Gross Margin 34% 31% 29% 29% 29%
Balance Sheet PAEL - Debt to Equity trend (PkRmn) CY16A CY17F CY18F CY19F CY20F 100% Non-Current Assets 18,068 17,741 17,407 17,067 16,719 Total Current Assets 22,259 27,628 29,808 32,280 35,343 80%
Total Assets 40,327 45,368 47,215 49,347 52,062 60% Share capital 5,426 5,426 5,426 5,426 5,426 40% Reserves 15,414 19,254 23,036 27,103 31,152 20% Surplus on revaluation 4,671 4,671 4,671 4,671 4,671 Total Equity 40,327 45,368 47,215 49,347 52,062 0% CY15A CY16A CY17F CY18F CY19F CY20F Long Term Debt 4,558 4,212 2,447 1,524 675 Debt to Equity (x) Tot . Non-curr. Liabilities 6,971 6,625 4,860 3,937 3,088 Short term Debt 6,770 7,199 6,873 5,699 5,039 Source: IMS Research Total Current Liabilities 7,845 9,392 9,222 8,209 7,725 PAEL - ROA and ROE Total Liabilities 14,816 16,017 14,082 12,147 10,813 25%
Cash Flow Statement 20%
(PkRmn) CY16A CY17F CY18F CY19F CY20F 15% CF from Oper. Activities 1,540 2,067 4,272 4,328 4,676 10% CF from Inves. Activities (2,088) (478) (489) (499) (509) 5% CF from Fin. Activities 523 (1,410) (3,585) (3,589) (3,500) Net dec./increase. in cash (25) 178 198 241 667 0% CY15A CY16A CY17F CY18F CY19F CY20F cash at beginning 578 552 731 929 1,170
Cash at end of year 552 731 929 1,170 1,837 ROE (%) ROA (%) Source: IMS Research Source: IMS Research
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I, Syed Waqas Imam, certify that the views expressed in the report reflect my personal views about the subject securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations made in this report. I further certify that I do not have any beneficial holding of the specific securities that I have recommendations on in this report.
Ratings Guide* Total Return Buy More than 15% Neutral Between 0% - 15% Sell Below 0% *Based on 12 month horizon unless stated otherwise in the report. Total Return is sum of any Upside/Downside (percentage difference between the Target Price and Market Price) and Dividend Yield.
Valuation Methodology: We use multiple valuation methodologies in arriving at a Target Price including, but not limited to, Discounted Cash Flow (DCF), Dividend Discount Model (DDM) and relative multiples based valuations. Risks: Please refer to page 15.
Disclaimer: Intermarket Securities Limited has produced this report for private circulation only. The information, opinions and estimates herein are not direct at, or intended for distribution to or use by, any person or entity in any jurisdiction where doing so would be contrary to law or regulation or which would subject Intermarket Securities Limited to any additional registration or licensing requirement within such jurisdiction. The information and statistical data herein have been obtained from sources we believe to be reliable where such information has not been independently verified and we make no representation or warranty as to its accuracy, completeness and correctness. This report makes use of forward looking statements that are based on assumptions made and information currently available to us and those are subject to certain risks and uncertainties that could cause the actual results to differ materially. No part of the compensation of the author(s) of this report is related to the specific recommendations or views contained in this report. This report is not a solicitation or any offer to buy or sell any of the securities mentioned herein. It is meant for information purposes only and does not take into account the particular investment objectives, financial situation or needs of individual recipients. Before acting on any information in this report, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. Neither Intermarket Securities Limited nor any of its affiliates or any other person associated with the company directly or indirectly accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. Subject to any applicable law and regulations, Intermarket Securities Limited, its affiliates or group companies or individuals connected with Intermarket Securities Limited directly or indirectly may have used the information contained herein before publication and may have positions in, or may from time to time purchase or sell or have a material interest in any of the securities mentioned or may currently or in future have or have had a relationship with, or may provide investment banking, capital markets and/or other services to, the entities mentioned herein, their advisors and/or any other connected parties.
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