Pakistan’s premier investment firm BMA Capital’s Economic Strategy Report for 2009 entitled “Slowing Down, U-Turn Ahead” encapsulates BMA’s economic review of 2008 and forecast for 2009, advising on specific opportunities for investors in the coming year. The report has been released in the context of the unusually challenging year that 2008 has been economically for Pakistan, the region, and the world. The global downturn and volatility has challenged the business models of financial services firms the world over, with many firms not surviving. Aided by a strong corporate culture, talented team, and excellent client relationships, BMA has endured with a clear determination to succeed and to continue to deliver value for our clients with integrity.
The report explains that 2008 witnessed a 58% decline in the Karachi Stock Exchange’s KSE-100 index which is currently at a five year low and trading at its historical bear market price to earnings (P/E) multiple of four and one half times (4.5x). The good news in this for investors is that stock valuations are now extremely cheap, potentially representing rare opportunities for astute investors. An upswing in business activity towards the end of the year on improved macroeconomic fundamentals could well see the index close higher on a Year-on-Year (YoY) basis by December 2009. Key factors which will determine whether a sustained upswing is imminent include monetary easing by the summer of 2009 and the subsequent return of liquidity, stronger earnings growth in Fiscal 2010, and stability in global markets.
Macroeconomic indicators are already improving on the domestic front. IMF support for Pakistan has boosted the foreign exchange reserve position to over US$10bn, while remittance inflows have reached new highs. BMA forecasts Pakistan’s trade deficit to shrink (YoY) by June 2009 as a result of lower commodity prices. Inflation has been registering a decline since November 2008 and BMA Research expects it to continue to do so rapidly over the next six months. BMA’s top trading ideas for 2009 include FFC, OGDC, PPL, HUBC, PTC and NBP which represent our preference for defensive plays. These stocks are expected to post positive earnings growth over FY09E, are cheap on both trailing and forward multiples, offer strong dividend yields and possess other strengths such as low gearing.
Highlights from this report are given in the following pages. The complete report can be retrieved from BMA’s website: www.bmacapital.com
2009: SLOWING DOWN, U-TURN AHEAD
Pakistan equities: weak start could make for a strong finish
The removal of the price floor precipitated a 35% decline in the KSE100 Index from the floor level. After touching our target low, the benchmark index is now trading at a forward PER of 5.0x at an unprecedented 48.1% discount to the region. The good news is that investor sentiment is dismal, valuations are ridiculously cheap and the dividend yield sits in excess of 20% for certain stocks. Given that the KSE100 Index opened the year at a four year low, an uptick in business activity towards the end of the year on improved macro fundamentals could well see it close up YoY by December 2009.
Factors that will turn the tide: bottom of the U?
Key factors will signal whether a sustained upswing is imminent. Monetary easing is one and will provide a boost to business and economic activity. Earnings have likely bottomed with FY09E expected to post a slight decline but FY10E will be decidedly better. The return of liquidity is also crucial to this cause. Domestic liquidity management is likely to remain tight with fiscal spending being reigned in for the next six months but monetary easing towards the latter half of the year will help in this regard. Stability in global markets is equally important as portfolio inflows for the domestic market are highly co-related to global equities performance.
Economic update: the silver lining begins to shine
Gradual improvements in macro indicators are coming through. IMF support has boosted the FX reserve position to over USD10bn, while remittance activity recorded yet another high for December 2008. The trade deficit will shrink on a YoY basis by Jun 2009 on the back of lower oil/commodity prices. Inflation remains well in the twenties, although the good news on this front is that it has been registering a month on month decline since November 2008 and we expect it to come off very rapidly over the next six months. This, combined with government efforts to limit CB borrowing, should see interest rates begin to ease as early as 2QCY09.
Top trading ideas for 2009: defense is the best offence
Our top picks for the year include FFC, OGDC, PPL, HUBC, PTC and NBP. These represent our preference for defensive stocks which are expected to post positive earnings growth in FY09E and are cheap on a trailing and forward PER (PBR for financials) basis. Strong dividend yield has also been highly favoured as this will help boost total return in a crawling equity market. Other factors include good cash position and low debt, to minimise earnings impact from higher financial charges. Other ideas to look out for include potential merger activity especially in the listed banking and brokerage space.
Going forward: in need of real reform
Since the start of the century, Pakistan has made massive strides in transforming its economy and leaving behind the lost decade of the 90s. Between 2001-2007, growth averaged over 7% while GDP almost tripled in size from USD60bn to USD170bn. A previously insulated economy went through major reforms to open itself to the world; as a result the volume of international trade increased from USD20bn to USD60bn, all while retaining relative price stability.
However despite the creation of 5mn jobs, reduction in poverty and inflow of foreign direct investment totaling billions of dollars, the last year has shown how vulnerable the economy remains to external shocks. A boom in commodity prices shook the foundations of the entire structure and brought the country to the brink of default on its debt obligations. Consequently we were forced back to the ignominy of being bailed out by the IMF and being subject to the whims and criticisms of the international community.
The policy response to the threat of inflation necessitated in the minds of the SBP, a repeated tightening on the monetary front. The persistent power shortage plagued large scale manufacturing’s production capacity and the government’s decision to withdraw special rates on utilities for industrial use raised costs in an already inflationary environment.
As corporate profitability shrunk, the circular debt issue remained unsolved and the financial sector suffered one of the most tumultuous years in recent memory, projections for GDP were accordingly slashed. Growth is expected to slow from 5.8% in FY08 to 3.4% in FY09 and recover to 5% in FY10. This recovery should start to become apparent by the end of the calendar year as the SBP and Ministry of Finance move aggressively to stimulate the economy.
Despite the resilience displayed by the economy, a return to US$100 oil or an increase in the prices for palm oil and steel could derail the recovery in macroeconomic indicators very quickly. The financing from the IMF unfortunately remains little more than sticky tape over a gaping wound, which will be unable to provide long term relief unless a sustained policy to overcome the inherent infrastructural weaknesses in the economy is thoroughly implemented. To this end, Pakistan must learn to play to her strengths – investment in the workforce to raise productivity and skill levels as well as investment in agriculture, power and natural resource to expand the overall production capacity of the economic base will be crucial to avoiding such hard landings in the future.
Sector themes and outlook
Banks: forced consolidation
Over CY09E, asset quality and strong capitalisation will remain key issues for the sector to grapple with. Domestic consolidation will also be an important theme as smaller banks look to meet their MCR requirements through M&A activity. The country remains largely under penetrated with a credit to GDP ratio of 28% well below regional averages. Growth will be driven by an enhanced branch network with agri, consumer, SME and corporate sectors all pushing loan growth. Profit growth will be driven by volume and higher penetration of non-banked markets.
Cement: outlook negative but value picks emerge
Given the weak sector dynamics we advise investors to view the sector with caution and maintain an UNDERWEIGHT stance till industry dynamics strengthen. However we believe that select companies are emerging as long term value buys after witnessing steep corrections over the last 6 to 9 months. Our favored picks in the sector include LUCK and ACPL. LUCK and ACPL are trading on a FY09E P/E of 2.9x and 3.3x respectively. Potential triggers could include the takeover of an existing plant by a larger or international player. An acquisition by a player in the north of a smaller player in the south could be the start of a consolidation phase in the sector and is likely to spur interest. Subject to coal prices continuing their downward trek and inflation easing in 2HFY09E, interest in cement scrips could pick up as manufacturer margins show improvement and demand for the commodity picks up.
Chemicals: diversification is key
The diversified business portfolio of the company should help it remain stable in the current economic downturn. We expect earnings growth to occur at a 4yr CAGR of 15.6% moving forward. The scrip is currently trading at a CY09E PER of 3.8x of 10x and at current levels offers an upside potential of 107.6% to our fair value of PKR138.
Communication: down but not out
While faster-than-expected subscriber attrition remains a key concern, recent revision in rates/pulse timing for local loop calls should help bolster revenue from that head which we believe comprises almost 30% of total revenue. Furthermore, NWD which accounts for 11% of the top line has and will continue to benefit from the introduction of the Pakistan and Basic Plus packages. Additionally, recent significant PKR depreciation will also boost the effective average settlement rate for the LDI incoming segment which has an 8% share. These changes combined will help keep revenue and consequently earnings stable, moving forward which we forecast will rise at a 4yr CAGR of 1.5% and 10.3% through FY13E.
E&P: solid fundamentals
We maintain our OVERWEIGHT stance on the E&P sector backed by expectations of steady demand, handsome production growth and protection from PKR depreciation due to dollar denominated revenues. The current deteriorating economic environment globally is the main reason behind such a sharp drop in oil prices. Major concern and worries for the US economy, which is still by far the largest consumer of oil, have brought down demand for the commodity and expectations are that demand will further
slide if the US continues to post worsening economic numbers. Therefore, we believe that oil prices will remain on the lower side and recovery will be observed only when the major economies enter the recovery phase of the business cycle; this is not expected to take place in the near term.
Fertiliser: urea is king
Although heavy selling pressure was witnessed across the board upon removal of the price floor. The decline in fertilisers scrip prices have ranged from 41.2% to 29.2%. Going forward we believe the fertiliser sector remains in growth mode and is relatively insulated against the economic upheaval.
FMCG: the ‘white’ revolution
We have a neutral stance on the sector. In our opinion the steep rise in inflation resulting in reduced disposable income may place pressure on Unilever’s and Nestle’s topline and profitability. Even though inflation is expected to ease in 2HFY09 it is likely that consumers will continue to exercise caution when purchasing. The target market for FMCG products is the growing middle class and demand for its products is somewhat elastic. FMCG scrips are generally illiquid and low beta and we do not expect significant price action in them going forward.
Power: development in abundance
Electricity demand in the country has been extremely robust during the last few years, growing by 10% on average. This is attributable to increased consumption from electricity supplied areas as well as new demand coming from newly laid out power lines. The situation is expected to remain status quo until 2012. Current estimates put the power shortfall at 6,000MW.
In order to bridge the shortfall, the GoP is encouraging new investment and expansions from existing IPPs. PPIB plans to add 10,453MW to total domestic capacity by 2012. Some progress has been made on this front. Implementation agreements for 2,673MW
capacity have been signed while financial closure of 2,119MW capacity power plants has been achieved.
Refinery: when the going gets tough
Refinery margins and profitability are heavily dependent on global petroleum product prices. Refined product prices and GRM’s generally lag behind rising oil prices. We believe that refining margins will remain low as demand has been faltering in light of the global financial crisis. The local refinery sector’s fundamentals are deteriorating as the government has cut customs duty on HSD from 10.0% to 7.5%. Furthermore, it has also changed the price mechanism for Mogas which applies to refinerines, effectively reducing their selling price. Apart from these factors, PKR depreciation has also hurt refineries in the form of exchange losses on crude imports as reflected in recent 1QFY09 results. Even though last year was a bumper year for refineries, we do not expect the sector to show similar earnings growth over FY09E.
Technology: software softening
According to the SBP figures, Pakistan’s IT exports have grown at a 5yr CAGR of 46.3%. Exports though, still constitute a small chunk of the total industry size which is estimated to be USD2.8bn. This includes over 1,161 registered IT companies (including 60 foreign IT and telecommunication companies). Two companies (including NETSOL) have achieved CMMI Level 5 accreditation while 3 have reached level 3 and 15 have reached level 2. Pakistan’s demographic dividend also comes into play here with an IT workforce which is 110,000 strong and growing at a phenomenal rate of 20,000 IT graduates annually.
NETSOL is the only listed IT play on the KSE100. The company derives majority of its revenue (80.7% in FY08) from license sales, services and maintenance related to its flagship LeaseSoft product, a leasing solution whose scope has now been expanded to encompass lending in general. Given the prevailing global credit crunch, license sales are expected be depressed in FY09E YoY. While, the decline in license sales should be at least partially offset by rising services and maintenance revenue, given our expectation of negative earnings growth and lack of visibility of any positive triggers to price appreciation we remain UNDERWEIGHT on the sector.
