Time to turn bullish on cement sector
The cement sector could be the first to turn around among the many sectors in the Philippine stock market today.
Recall that the cement sector was battered ahead of other sectors in the stock market as profits of cement firms started showing signs of weakness in the second half of 2016. During the said period, pro-forma operating profits of Cemex (CHP) increased by only 5.7 percent after rising by 18.2 percent in the first half of the year. Profits of Holcim (HLCM) fell by 37.9 percent in the second half of 2016. Profits of both firms disappointed as sales volume and selling price dropped. This trend continued in 2017 resulting in the 71-percent and 60.7-percent drop in the profits of CHP and HLCM, respectively. Due to their weak earnings, the price of the two cement companies fell by an average of 45.4 percent in 2017 despite the 25.1-percent increase in the PSEi index. Even Eagle Cement (EAGLE) which had its initial public offering in 2017 ended the year slightly lower than its IPO price of P15. This was despite the 6.4-percent rise in EAGLE’s 2017 profit as it was able to offset the drop in selling price by raising sales volume.
One of the main reasons for the cement companies’ disappointing earnings recently was the influx of cheap imported cement which resulted in lower cement prices and sales volume. Because the price of cement in the Philippines was much higher than those of other Asian countries such as Vietnam (which was suffering from a glut), traders capitalized on the huge price differential by raising their sales of cheap imported cement.
However, there are indications that the cement sector has seen the worst.
In the last two weeks, CHP and EAGLE disclosed their first quarter earnings results. Although the two companies’ earnings performance could be better, both CHP and EAGLE disclosed a 2-percent increase in their average selling prices relative to the fourth quarter of 2017. This is the first time the selling price of cement companies increased on a quarter-on-quarter basis. Sales volume in the first quarter was higher for CHP and EAGLE, both on a quarter-on-quarter and on a year-on-year basis. Consequently, the first quarter revenues of the two firms were higher quarter-on-quarter and year-on-year.
According to CHP, the volume of imported cement continued to increase by some 50 percent in the first quarter which is worrisome. However, the fact that both CHP and EAGLE were able to increase their selling price and sales volume despite the higher volume of imports could be an indicator that the growth of domestic demand is strong enough to absorb all the additional supply.
The said scenario is highly possible given that government spending on infrastructure increased by 33.7 percent to P157.1 billion in the first quarter of 2018. Demand will most likely stay strong going forward as the government is targeting to grow infrastructure spending from 5.4 percent of GDP in 2017 to 7.3 percent of GDP by 2022.
Because of the significant drop in share prices since 2017, valuations of cement companies have also become attractive giving us another reason to be bullish on the sector. While cement companies in Asia are currently trading at an average EV/Ebitda ratio (enterprise value/earnings before interest, tax, depreciation & amortization) of 10.8X, local cement companies are trading at an average EV/Ebitda ratio of only 9.1X due to uncertainties on where profits will bottom.
However, since there are indications that we have seen the worst, cement companies could possibly rerate and trade closer to the regional average EV/Ebitda multiple. Moreover, capital appreciation potential based on the fair value estimates of the cement companies that we cover—CHP (P4.20) and EAGLE (P18.60)—remains significant. This is despite the conservative assumptions we used in deriving our fair value estimates. For both CHP and EAGLE, we did not assume any increase in their selling price this year. For CHP, we assumed that sales volume would go up by only 8 percent, lower than the 16 percent increase in the first quarter. On the other hand, we assumed that EAGLE would enjoy significantly higher sales volume this year as its new production line commences operations.
The only way to be completely sure that the local cement sector has already seen the worst is to see all cement companies consistently reporting improving profits. Once that happens, share prices of cement companies will most likely be significantly higher. As such, it might be wise to consider adding some cement stocks in your portfolio now and just manage your risk by limiting your exposure to a small portion of your portfolio.
