Cement Cos: Who is Best Poised to Benefit from Rate Cuts?

Cyclicals on the PSX have been on a serious bull run this year. Certain sectors such as the auto and fertilizer sectors have been on fire. Why? Well, expectations of an interest rate cut are leading to the belief that demand in the economy will pick up. Cyclicals would be a natural beneficiary.

The cement sector is another cyclical sector which has been at the forefront of this rally. With capacity utilization expected to be at 57% for FY24 and more capacity coming online over the next year, cement companies could see significant growth if demand does rebound.

But which cement companies would be best suited to exploit this opportunity? Or which ones could outperform the pack?

The important thing to note about cement is that the product is quite identical in quality, regardless of the producer. Moreover, the price of cement varies only based on the location of each producer (transaction cost). So, the differentiation in cement producers comes down to the production cost of each producer and their capital structure (debt-equity mix).

As a consequence, the key determinant of a cement company’s market value should be their production capacity.

If the market is valuing the production capacity of one producer more than another, it may be due to certain idiosyncratic characteristics. For instance, Bestway Cement has better governance practices than its competitors, so it naturally trades at a premium. But on average, companies with a lower market cap per ton of production capacity should be seen as cheaper on a fundamental basis.

Similarly, those with a lower PEG than the average should be seen as attractive as an investor is able to purchase growth at a lower per unit price. For the same reasons, a lower-than-average price-to-book value and EV per EBITDA would be attractive. However, a lower EV per EBITDA is special for another reason too.

Enterprise value is simply the total value of the firm’s debt and equity. Once interest rates fall, value would be transferred from debtholders to equity owners as finance costs for a company would fall. Or in other words, income flow to debtholders would fall.

Thus, a lower EV per EBITDA implies that the market is pricing each rupee of enterprise value for each rupee of earnings at a low rate. When interest rates fall, that enterprise value would become more valuable for shareholders.

On the flip side, a better-than-average return on equity and assets would be preferred as it implies more efficient capital allocation.

These metrics have been calculated here for the cement sector. Based on these metrics, Maple Leaf Cement looks the cheapest. Other seemingly cheap companies appear to be Fauji, Attock, Cherat and Kohat Cement.

Lucky Cement also seems to look cheap, however one cannot treat it as a true cement company due to its diversified (conglomerate) nature.

Based on these calculations, personally I prefer Maple Leaf, Attock and Fauji Cement among these fundamentally cheap companies, as they have a lower-than-average market cap per ton of production capacity.

An alternative viewpoint could also be to consider debt-to-equity ratios and pick those companies with the highest debt-to-equity ratios. Why? Well, when interest rates fall, finance costs (interest expenses) for such companies would plummet allowing them to enhance their earnings.

However, I personally do not subscribe to this view as it seems to take on unnecessary risk. One must note that the cement companies with the highest debt-to-equity ratios are those who are loss-making. What does this say about the management of these firms? Plus, why take on needless interest rate risk?

Furthermore, EV per EBITDA as a metric already captures the element of falling interest rates buttressing the financial viability of a firm.

So, based on this, when can one expect some of these cement shares to catapult themselves to new heights? Well, that’s the catch; one needs to be patient. It was only last week that Gharibal Cement (GWLC) was looking most cheap on these metrics.

Yet, within a week the share price of the company has gone up 37%. Now suddenly, the company looks realistically priced on a relative basis. That’s the thing about markets. They ignore value for some time. And when they do notice value on the table, they do so with aggression.