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HC: Ex-factory price hike is key for rerating Eastern Company

In its recent report, HC Brokerage presented their updated evaluation of Eastern Company assuring that: “Ex-factory price hike is key for rerating Eastern Company and maintaining our Overweight rating”.

  • Despite resilient product nature, further pricing power limitation lowers our FY20/21–FY23/24e top line estimates by c11%, on average

  • High margins are unlikely to be sustained without outright price increases, in our view

  • We cut our TP c27% to EGP16.2/share on lower estimates, but maintain our Overweight rating on further share price weakness

Noha Baraka, the Head of Consumers at HC commented that: “Limited pricing power, along with a lower USD denominated toll fee, suggest an c11% downward revision to our FY20/21FY23/24e top line estimates: We are becoming more skeptical about Eastern Company’s margin expansion given its limited pricing power over its products. This was clearly evident following last February’s sales tax hike which was not accompanied with any price benefits for the company. While the new tax brackets mean the cigarettes price could go up by as much as EGP7.50/pack without being subject to a higher lump‐sum tax, we opt to exclude any direct price increases based on the company’s recent pricing strategy. We only account for sales-mix improvement and conservatively assume an annual c1% increase in blended local ex-factory price over our forecast period. This translates to a c13% downward revision to our FY20/21e–FY23/24e blended local ex-factory price estimates. Also, we expect the 2021e renewal of the company’s toll manufacturing agreement with Philip Morris International (PMI), and British American Tobacco (BAT) to kick in at a lower FX rate in light of the EGP appreciation compared to the time of the contract. Our estimates point out to an average rate of EGP16.8/USD down from EGP18.0/USD previously. While several industries got hit during the pandemic, we still assume demand for cigarettes to continue to be fairly resilient thanks to the product’s nature, as the lock-up period, and the working from home environment during the pandemic could cause a further spike in demand. However, we still estimate Eastern Company’s top line growth to be largely muted, growing at a 5-year CAGR c6% over our forecast period, however c11% lower than our previous estimates. We see higher blended ex-factory price as a key catalyst for rerating.”

“High margins are unlikely to be sustained over our forecast period: Over the past couple of quarters, Eastern Company’s gross profit margins have proved quite resilient despite the lack of price increases, mainly on the retailers’ margin cut along with a stronger EGP/USD rate. Despite the limited likelihood of price increases during the next year, and its cost-cutting initiative not kicking in yet, along with the EGP1.5/kg newly imposed development fee on raw tobacco, we still expect high margins to be largely sustained in FY20/21 given that the company is carrying 15 months of inventory procured at a lower EGP/USD rate. We expect Eastern Company’s gross profit margin to stand at 39.4% in FY20/21e, only 0.6 pp lower than our expected FY19/20e estimate and some 2.4 pp lower than our previous estimate. Post FY20/21e, we see margins to contract by some 3.6 pp over our forecast period to 35.8% in FY23/24e. Our SG&A expenses are now c10% lower over our forecast period, but still representing c6% of sales, in line with what management is guiding. This filters through to a c22% downward revision to our FY21/22–FY23/24e EBITDA estimates, leaving our terminal margin at 34.3%. Our new estimates filter through to a c24% downward revision to our EPS estimates on c2% lower net interest income, assuming the company maintains its current raw tobacco inventory level, with any potential interest rate cuts by the Central Bank of Egypt posing a downside risk to our numbers.” Added Noha Baraka.

Noha Baraka concluded that: “Maintain Overweight on share price weakness: In light of our lower estimates, we cut our TP c27% to EGP16.2/share. Our new target price puts the company at a FY20/21e P/E multiple of 8.1x (trading at 6.8x) and EV/EBITDA multiple of 4.5x (trading at 3.6x), and implies a potential return of c28% over the 26 August closing price of EGP12.6/share. We therefore maintain our Overweight rating for the stock. In our view, valuation is compelling, with the stock underperforming the market by c7% since the coronavirus outbreak. Also, dividend yields are becoming more attractive on recent share price drop and we also expect a higher DPO ratio starting FY19/20e on limited CAPEX needs and improved profitability compared to its historical level. In our numbers, we expect the FY19/20e and FY20/21e DPS to stand at EGP1.25/share, implying a dividend yield, net of tax, of 9.4%, and, which is 2.5 pp higher than its 2-year historical average of 6.9%. Based on our FY20/21e DPS estimate and average dividend yield, we arrive to a valuation of EGP17.2/share, which is only c6% higher than our DCF-based valuation, and c36% higher than the current market price, further solidifying our Overweight rating.”


HC maintains Overweight for Arabian Cement on a still compelling valuation

No alternative for government intervention, HC maintains Overweight for Arabian Cement on a still compelling valuation

In its latest report, HC Brokerage shed the light on the cement industry in Egypt, specifically on Arabian Cement Company (ACC) asserting that: “prices unlikely to find a bottom without direct government intervention, which is now in the cards”

  • Capacity shutdowns outpaced by demand destruction; prices unlikely to find a bottom without direct government intervention, which is now in the cards

  • Lower coal/petcoke/electricity prices, a stronger EGP and lower SG&A expenses offset weak selling prices, giving a breather to Arabian Cement Company’s operating margins, but earnings remain in the red until the end of the year, on our estimates

  • We cut our 2020–23e EBITDA estimates c11% and TP c21% to EGP5.50/share, and maintain Overweight for Arabian Cement on a still compelling valuation

Mariam Ramadan, Head of Industrials at HC commented that: “Demand recovery to take longer than current players can sustain, all else constant: A series of setbacks (from the hit to export markets, to the crackdown on informal housing, to the coronavirus situation, to halting building permits in capitals) has left the industry in dire shape, with 2020 likely marking the fourth year of consecutive decline in sales. The bad news is that we have not bottomed out yet. Prices are still falling today when it is supposedly the good season, before 4Q comes with severe price competition and end-of-year discounts to achieve sales targets and clear inventory. Prospects of a pent-up demand materializing post the lift of the construction ban have been downplayed by sector players, and mega projects, whose contribution had helped keep sales afloat, have peaked. Long-term estimates have also become significantly worse as purchasing power suffers, private investments falter and government investments shift further away from cement-intensive structures. On the supply side, permanent exits have been slow to happen, but at least 10 players have idled production lines, and that was still insufficient to balance the market. Adjusting for idled capacity, utilization rates are effectively c20 pp tighter at least, suggesting prices (1) are far from reasonable, and (2) can no longer be rectified by demand recovery alone, no matter how fast that comes by. Sector economics have reached a level where prices need to rise enough to do away with the current operating losses, bring back idle production lines (we calculate some 25m tpa of “dormant” capacity), generate enough cash to recoup losses incurred over the past years, and pay down debts/shareholder loans.

“Small government support won’t cut it; direct intervention is the only way out: Government efforts have so far been fixated on fuel prices (which are no longer relevant), and the more generic interest rate cuts, electricity price cuts, or market-specific export support incentives. However, the government is now said to be in talks, more seriously than usual, over local sales quotas to try and match supply and demand forces, which in our view will be accompanied by a price floor. At the last reported annual utilization rate of 65%, we calculate a minimum price of EGP820/ton ex-factory, excluding VAT. This is based on the highest production cash cost among current players, not counting for SG&A, interest or depreciation. While Arabian Cement’s volumes would be affected by this arrangement, given its market share is significantly above capacity share (operating at 88% in 1H20, compared to sector average of 57%), such price floor would still be a game changer for the company, taking it back to pre-devaluation profitability, and does not take away its edge as the most cost efficient player (EGP25/ton lower than the second best) and having the biggest export share (unaffected by the quota). The assumption here is that the government will push only as high as to prevent exits (in order to preserve foreign investor sentiment and assuage investors who had yet to recoup capital outlays ahead of the establishment of the new Beni Suef plant, avert layoffs, credit defaults, etc.) and low enough not to entice public dissent. We do not account for this in our numbers, until we have more clarity, likely in September.” Mariam Ramadan added.

“Cut EBITDA estimates c11% but maintain Overweight on compelling valuation: Our new estimates filter through to a downward revision of c11% to each of our 2020–23e EBITDA and 2021–23e EPS forecasts, which leaves our TP c21% lower at EGP5.50/share, implying a c57% potential return on the 12 August closing price of EGP3.51/share. We therefore maintain our Overweight rating for Arabian Cement. With the share price holding its ground over the past year against bad EGX performance, paying out a dividend, and recording losses for the first time in its history, it seems the market is finally starting to see past the current point in the cycle and into long-term value, which remains strong, in our view, despite the worsened short-term fundamentals.” Mariam Ramadan concluded.

HC finds the IMF external account estimates for FY20/21 conservative

HC: We believe the IMF external account estimates for FY20/21 are more on the conservative side as they reflect c73% y-o-y decline in tourism receipts to USD2.7bn as well as foreign portfolio inflows of USD3.5bn.”

The International Monetary Fund (IMF) expects Egypt’s external funding gap FY20/21 will widen by about a third to USD12.2bn, compared with USD9.2bn a year earlier, as the disruptions caused by the coronavirus pandemic cut into its main sources of foreign currency, it said in its Egypt 12-month Stand-By Arrangement (SBA) report. It anticipates Egypt will cover its funding needs through several sources including the IMF expected to provide USD3.2bn under the SBA and other international financial institutions expected to provide USD2.5bn, in addition to Eurobond sales of USD6.5bn. The IMF said the financing gap has grown on “expectation of weaker FX inflows driven by lower remittances, portfolio flows, and FDI” with the global economic recovery weaker than previously expected. (Bloomberg)

HC’s comment:

We find the IMF external account estimates for FY20/21 more on the conservative side as they reflect c73% y-o-y decline in tourism receipts to USD2.7bn as well as foreign portfolio inflows of USD3.5bn. Given that direct outbound flights from Eastern Europe and Britain to Egypt’s Red Sea resorts are resuming soon, we believe that FY20/21 tourism receipts could exceed the IMF estimates. Likewise, there is circulating news that foreign portfolio inflows into Egyptian treasuries during the first 2 weeks of July amounted to USD3bn, a trend that we expect to continue during the year given the attractive Egyptian T-bills yields coupled with a stable currency. However, as mentioned in the report, the global economic scene remains uncertain which explains the IMF resorting to conservative assumptions, in our view. The IMF praises Egypt’s commitment to the economic reform that started in 2016 which it believes helped the country acquire the trust of different funding institutions and hence expects the government to successfully secure its funding needs in the international market.”

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Despite subdued inflation rates, HC expects the CBE to keep interest rates unchanged

Despite subdued inflation rates, HC expects the CBE to keep interest rates unchanged

  • In its latest report about their expectations on the likely outcome of the MPC meeting scheduled on 13 August and based on Egypt’s current situation, HC Securities & Investment expects the CBE to maintain rates unchanged despite subdued inflation rates. 

Head of macro and financials at HC, Monette Doss commented: “Inflation levels remains subdued coming in well below the CBE target of 9% (+/- 3%) for 4Q20 and also less than expected 4.6% y-o-y for July, which we attribute to low consumer demand arising from increasing unemployment and plunging consumer confidence. This together with a delay in expected tourism recovery prompt us to downward revise our 2H20e average inflation expectation to c6% y-o-y from c8% y-o-y, previously. In our new estimates, we remain cautious accounting for possible supply shocks. We hence, expect monthly inflation to average 0.8% m-o-m in 2H20e up from an average of 0.4% in 1H20. As of June, real interest rate on deposits and loans came in at 3.4% and 5.6%, respectively, significantly higher than their 12-year average of -3.5% and 0.7%. The high real interest rate environment, however, is justified by the low interbank liquidity, global economic uncertainty and the domestic funding gap, in our view. We take the CBE open market operations as a proxy for interbank liquidity. The figure came in at EGP420bn in June representing 13% of total banking sector local-currency deposits, below its 2008-2020 average of 22% (excluding 2011-2014 which witnessed post-revolution liquidity dry-up).

Moreover, following the outbreak of COVID-19 in Egypt in March, foreign portfolio outflows from Egyptian treasuries amounted to USD17bn increasing Egypt’s FY19/20e domestic funding gap to USD21bn, representing c6% of GDP, and taking Egypt’s foreign debt to an estimate of USD125bn in June from USD109bn last year. Using the Sharpe ratio for yields on Egyptian treasuries as well as other emerging markets, we believe that at current levels Egypt provides the highest risk-adjusted return coupled with low currency volatility, second only to Argentina whose currency display significantly high volatility. We believe this permits the government to remain on current interest rate levels, despite the increase in funding gap. We believe that this is behind the recent rebound in foreign portfolio inflows into Egyptian treasuries said to amount to USD3bn during the first 2 weeks of July, according to unnamed banking sources. That said and despite subdued inflation rates, we expect the MPC to maintain rates unchanged in its upcoming meeting maintaining the attractiveness of treasury yields to foreign investors and also reflecting relatively tighter liquidity in the Egyptian banking sector. Monette Doss added

It is worth mentioning that, in its last meeting on 25 June, the Central Bank of Egypt’s (CBE) Monetary Policy Committee (MPC) decided to keep rates unchanged for the third time after undertaking a 300bps rate cut on 16 March in an unscheduled meeting.  Egypt’s annual headline inflation accelerated to 5.7% in June from 4.7% in the previous month, with monthly inflation remaining subdued at 0.1% m-o-m up from showing no increase in May, according to data published by the Central Agency for Public Mobilization and Statistics (CAPMAS).