Engro Polymer & Chemicals: Investment Case

Engro Polymer and Chemicals 

Company description 

Engro Polymer and Chemicals Limited (EPCL), a 56%-held subsidiary of Engro Corporation, is the sole producer of PVC Resins in Pakistan. The company also produces caustic soda, Sodium hypochlorite and Hydrochloric acid. EPCL’s total production capacity of PVC stands 295k tons after the addition of its PVC line III in CY21, having production capacity of 100k tons.

 Moreover, the company also has production capacity of caustic soda and flakes tallying to 126 k tons. Since EPCL is the sole producer of PVC, it holds ~85%-90% share of the domestic PVC market. Its caustic soda market share stands at 29% where it is the only producer present in the South. The current sales mix stands at 80/20 PVC/Caustic with exports to USA, Middle East, Europe, and Afghanistan contributing approximately 6%.

Target Price & Ratin

We reinstate coverage on Engro Polymer and Chemicals (EPCL), the sole producer of PVC in Pakistan, with a “BUY” stance and Dec-2024 Target Price of Rs 80, offering an upside of 73 %. With a downside of 2%, we believe negatives are priced in, while smooth road ahead. Our estimates suggest dividend payout of Rs 8/10 per share for CY24/CY25, respectively.

We expect the earnings to resume upward trajectory CY24 onwards on account of improved capacity utilization, stable margins, and lower finance cost as debt matures.

Efficiency Projects 

The company has initiated several projects that would improve efficiencies of various processes. High Temperatures Direct Chlorination (HTDC) project of EPCL is on track and expected to come online in CY24. The project will bring energy efficiencies and reduce carbon dioxide emission and consumption requirement of water.

 Hydrogen peroxide Project: 

Hydrogen is produced as by product in the production process of caustic soda. EPCL will divert this hydrogen to produce hydrogen peroxide once the project is complete. This will enable the company to enter a new product segment, achieving diversification. Hydrogen peroxide is mainly used as bleaching agent in textile industry which is currently served by Sitara Peroxide and Descon Oxychem. The project is expected to come online in CY24. 

Debottlenecking of VCM: 

The company’s VCM capacity currently stands at 254k tons per annum. To enhance its VCM capacity to 300 k tons, a capex of US$4mn has been approved for conducting basic engineering followed by a FEED study.

Overview of the Domestic Industry

Poly Vinyl Chloride (PVC): 

Pakistan’s total PVC market is around 250k tons per annum which translates into per capita consumption of ~1.2 kg compared to global average of 6 kg per capita. In the last 10-years, PVC demand in the country has grown at CAGR of 5.1%. Approx. 65%-70% of PVC demand stems from the construction sector in the form of raw material for pipes & fittings, cable compounds, ducts, and flexible hoses. Moreover, with the introduction of new applications, PVC has been widely deployed in manufacturing of PVC walls & floor panels, composite doors & windows, and decorations alongside woodwork. EPCL is the sole producer of PVC in Pakistan with annual capacity of 295 k tons and approximately 85-90% market share, while the rest is met via imports. The company has recently expanded its capacity to fully substitute imports and generate valuable FX for the country by exporting to USA, Middle East, Europe and Afghanistan. EPCL has been able to capture the import market since it takes 2-3 months to import while EPCL can deliver its product on immediate basis.

Margins: PVC-Ethylene margins peaked during the end of CY21 and stayed on the higher side during CY22, however ever since the margins are in a downtrend and are currently trading at nearly USD300 per ton. The global slack demand after rate hikes, recession looming around for major economies, and lower-than-expected growth of the Chinese economy after reopening borders are the major reasons for the downtrend of the margins.

According to our research, the average reversion to the mean which is around 380 per ton for the core delta takes about 97 days excluding exorbitant prices. We believe the trend will continue and margins that are trading thinly will recover to $380 per ton from the lows of $280 in Nov-2023. Interest rates have peaked around the globe and inflation tapering off, interest rate cuts are expected from next year which will help recover the demand side of the PVC market. Thus, our stance is that the margins will recover to USD380 per ton, and we have based our working on these margins.

Offtakes:

 Our local sole producer of PVC showed good recovery in PVC volumes with a 39% increase in QoQ in the 3QCY23. Volumes for the whole of CY23 are expected to decline by 5% YoY despite LC issues and economic slowdown the volumes remained higher than expected. We reckon that volumes will stage a good recovery in CY24 and reach an all-time high in CY25 as the interest rates will fall and construction activities will resume.

Caustic Soda: 

Pakistan’s total caustic soda market stands at approximately 400k tons with three main players namely, Sitara Chemicals and Ittehad chemicals in the North while Engro Polymer in the South. Caustic soda is used as a major input in various industries including textiles, soap, detergents, and water treatment. Production of caustic soda requires large amount of electricity thereby; it is significantly impacted by electricity tariff or production cost of electricity. Moreover, local caustic soda usually sells at a discount to international caustic soda prices. In recent years, caustic soda demand remained robust on account of increased industrial activity as well as focus on textile exports of Pakistan which are expected to cross the US$20bn mark this year. Due to economic slowdown in EU and America however, exports to these regions may take a hit, impacting the market of caustic soda as well. Moreover, due to significant increase in the local cost of production and inflationary pressures, the industrial activity in the country may slowdown.

The caustic soda volumes which despite economic challenges showed positive growth in CY23 and will continue to support the bottom-line of the company in case of adverse numbers of PVC volumes.

Gas Issues and Future outlook

Gas price has undergone a significant increase, rising from PKR1,087 to PKR2,440 for the company. Furthermore, due to depleting gas reserves and resulting supply chain changes company are being provided with RLNG which further inflates company costs. To mitigate this issue somewhat Engro have opted for an annual mix of local and RLNG at a ratio 50:50; however, it still causes the cost of gas to reach soaring heights amounting up-to 200%. Hope is on horizon as HTDC (High Temperature Direct Chlorination) project plans nearing completion; slated launch towards early CY24.The implementation will help reduce overall gas expenses between around 3-4%; undoubtedly great news during times where high-gas-costs seriously impact bottom line profits. Not stopping there, the H2O2 Project aims optimization & better utilization of hydrogen byproduct Ancillaries related investments previously put in place and planned deployment expected via Launch dates in Lofty-Towards early CY2024.

 

(Jahanzaib khan)