Engro Polymer & Chemicals Limited: Time to offload!

We initiate with Sell stance on EPCL: At current levels the scrip is trading at a premium of 19% to our June-11 DCF based PT of PKR11/share. We understand that positives from backward integration will be overshadowed by burgeoning financial charges, emanating from PKR13.5bn debt acquired for expansion/backward integration. The scrip is trading at an expensive CY11E P/E multiple of 26x and CY11EV/EBITDA of 6.8x.

High finance cost to keep earnings growth subdued: Despite likelihood of threefold increase in gross margins to 22% in CY11 (integrated primary margin including NaOH estimated at USD664/ton) and healthy PVC demand, we believe earnings growth will remain subdued post COD of VCM plant, on the back of high finance cost. Interest coverage ratio will likely drop to 2.2x/2.6x in CY11/CY12 as against 20.2x in CY08.

Key risks to our valuation: Possible disruption in VCM plant operation and resulting need for spot purchases could further weigh down margins and earnings, whereas high financial leverage breeds high earnings sensitivity to margins. With debt/equity at 1.98x, 1% increase in interest rate would trim CY11 EPS by 16%.

Healthy demand of PVC & firm prices to strengthen top-line…

Post flood scenario favors Engro Polymer & Chemicals Limited (EPCL) with likelihood of robust PVC demand as reconstruction activities start in the country. Assuming 100% capacity utilization and 135k tons of PVC demand, the company will need to export a surplus of 15k tons during CY11, falling to 1k tons in CY13 owing to robust local PVC demand growth, assuming no further capacity enhancement. While export markets (like Middle-East, Sri-Lanka and India) exist for EPCL’s surplus PVC, exports would likely fetch a lower price than domestic sales leading to thinner margins. We foresee export price for PVC at USD983/ton for CY11, 12% lower than expected domestic price, leading to 21% lower primary margins on exports as compared to domestic sales.

Gross margins to jump post VCM’s COD

Gross margins plunged to 6% in 9MCY10 down 4pps YoY, as EPCL had to consume expensive imported VCM due to delays in commencement of the backward integration project. While 9MCY10 international PVC -VCM margins at USD133/ton were already 38% lower than last year’s level of USD213/ton, expensive spot VCM purchases (the company had abolished its long term VCM procurement contract in CY09 in anticipation of timely commencement of VCM plant) also contributed to input costs, leading to further attrition in margins. However, with the COD of VCM plant achieved on 30th September’10, primary margins shall increase by 3x YoY in CY11 (2.3x YoY after adjusting for higher fuel and power cost) from backward integration alone. This shall yield CY11 gross margins at 22% (PVC-Ethylene integrated margins assumed at USD664/ton), thus spearheading return to profitability in CY11.

Finance cost to restrict earnings growth

9MCY10 finance cost rising by 197% YoY to PKR1bn, ate the major chunk of the operating profit, as the company expensed out borrowing cost related to the VCM project in the second and third quarter. With PKR13.5bn in debt acquired for expansion/backward integration project, we estimate CY11 financial charges at PKR1.4bn. We anticipate interest coverage ratio to drop to 2.2x/2.6x in CY11/CY12 as against 20.2x in CY08. However, post CY11; decline in finance cost emanating from loan repayment will be the major contributor to earnings growth as we have assumed a muted increase (CY11-13 primary margin CAGR at 1.4%) in PVC-Ethylene margins.

Investment Perspective

We expect the company to post LAT of PKR58mn (LPS: PKR0.09) in 4QCY10, taking its full year CY10 loss to PKR849mn (LPS: PKR1.28). 4Q loss is mainly attributable to 1) Planned maintenance of the VCM plant limiting integration benefits and 2) High finance cost. Possible disruption in VCM plant tops the “key risks” list as resulting need for spot VCM purchases could further weigh down margins and earnings. Variance in PVC-Ethylene margins can steer earnings on either side as high financial leverage breeds high earnings sensitivity to margins. With debt/equity at 1.98x, change in interest rates remain a sizeable risk as 1% increase in interest rate would trim CY11 EPS by 16%.  At yesterday’s closing price of PKR13.8/share, the scrip trades at a premium of 19% to our DCF based June-11 PT of PKR11/share and an expensive CY11E P/E multiple of 26x. We recommend Sell!

Economic & Political News

SBP raises PKR52bn from Ijara Sukuk: 65% target achieved

The federal government has achieved 65% target of PKR80bn borrowing through new 3-year Government of Pakistan Ijara Sukuk in its first auction held on Monday.  The State Bank accepted only PKR51.837bn bids. The federal government had planned to raise PKR80bn, in the second quarter of current 2010-11 fiscal year, through the Islamic bond.  First auction has conducted on November 8, 2010 and the second auction will be held on December 13, 2010. Target for both auctions is PKR40bn each.