economic strategy report

PAKISTAN STRATEGY: PAKISTAN RISING PAKISTAN EQUITIES: INFORMATION ARBITRAGE LIKE NONE OTHER Averaging annual return of 40% for the last 8 years, Pakistan equities have been regarded as one of the best performing markets in the region. Maintaining a positive stance on the market, we believe that the Bull Run is to continue amidst economic progress, double digit corporate earnings growth, improvement in intl risk perception and deep undervaluation. Security situation in the country remains a threat, however a closer look reveals that most high impact incidents have remained concentrated in the tribal-border region while businesses have continued to expand and capitalize on the indigenous demand story.

Thus the influx of foreign investment should not be surprising where foreign holding is now estimated to be accounting for record 33% of free float weighted market capitalization of Pakistan equities. Further, given the deep undervaluation, we feel KSE is well positioned to catch up to its 2011 underperformance against its regional peers.

PAK ECONOMY: REFORM PROCESS CONTINUES After marking a challenging FY09, Pakistan economy recovered to a far more stable footing with inflation, external deficits and growth – all pointing in the right direction. The stability and continued growth will however remain contingent on successful implementation of ongoing reforms i.e. 1) Fiscal Discipline, 2) Tax Reforms and 3) Demand Consolidation. We believe that coupled with strong inward remittances and robust rural incomes, the ongoing economic framework should allow Pakistan economy to return to its historic GDP growth trajectory and IMF projection of 6%+ by 2015.

THE UNDERLYING THEME: GETTING THE RIGHT MIX Our top equity investment themes remain 1) companies with pricing power, 2) devaluation positive revenue stream and 3) value with growth. Mapping them with potential upside in respective fair values and triggers in pipeline leads to POL, FFBL, LUCK and APL as our High Conviction Investment Ideas. Since the formalization of this list in 2009, our picks have yielded outperformance of up to 77% against the broader index.

BMA SECTOR STANCE: OMC AND ELECTRICITY THE TOP BETS

PAKISTAN RESEARCH STRATEGY

BMA RESEARCH TEAM

Hamad Aslam, CFA [email protected]

Abdul Shakur

[email protected]

Nurali Barkatali [email protected]

Sana I. Bawani

[email protected]

Omar Rafiq [email protected]

Muhammad Ali Taufiq

[email protected]

Overweight Marketweight Underweight Oil Marketing Companies Construction & Materials Automobile & Parts

Electricity Oil and Gas Exploration Refineries

Commercial Banks Insurance

Telecom and Technology Fertilizer Textile

Source: BMA Research

TABLE OF CONTENTS

1 Pak Equities: Information Arbitrage Like None Other 1

2 Pak Economy: Reform Process Continues 9

3 Banks: Overcoming the Challenges 17

4 E&P: Proxy to Int’l Oil Prices and Pakistan’s Rich Hydrocarbon Reserves 21

5 Refineries: Regulatory Risks Remain a Major Concern 25

6 OMC: Value with Growth 29

7 Electricity: Guaranteed Returns 34

8 Fertilizer: Still Favored! 38

9 Construction & Materials: Looking For Value? Go No Further! 42

10 Fixed Line Telecommunication: Ta(L)king to New Heights!

46

11 Chemicals: Can Do a Lot Mor! 48

12 Non-Life insurance: Driven by Investment Income 50

13 Automobile & Parts: On a Downhill 54

14 Textiles: Economy’s Bread and Butter! 56

15 Company Snapshots 59

1

November 25, 2010

PAK EQUITIES: INFORMATION ARBITRAGE LIKE NONE OTHER Pakistan’s economic and social environment remains challenging, particularly on account of security issues faced by the country. Yet at the same time rising foreign investment, improving risk perception and strong capital market performance beg to argue that there should be something deeper and more profound that is grabbing the investor and business community interest at large.

Indeed, and that is the inherent growth story of Pakistan. The population is growing at 2% pa with urbanization taking place at 3.5% pa. Not only that, 54% of the population falls under 19 year age bracket which is estimated to add 3.5mn people to the labor force over the next 5 years. Coupled with a large middle class (30mn people earning USD10k pa), it is not surprising to see indigenous demand allowing businesses to prosper even in the current environment. Thus with Pakistan equity valuations reflecting deep discounts to their historical average and regional peers, we remain bullish on the growth story and project re-rating to continue in the domestic bourses.

Valuations lagging Fundamentals; Re-rating to continue… Trading at FY11E PER of under 8x, Pakistan equities reflect 20% discount to historical mean of 9.5x and over 50% discount to regional comparable markets. Conversely put, Pakistan equities currently reflect forward earning yield of 13% compared to 6% for the region and 5% for India and China!. Moreover, excluding the index heavy weight Oil and Gas Development Company (OGDC) which is currently trading at premium valuations, the rest of the market is actually as cheap as 5x forward PER and 20% in terms of forward earning yield.

Comparing Pakistan more specifically to the markets it shares a distinct demographic DNA with i.e. Sri Lanka, India and Bangladesh, not only reflects a higher discount but highlights the prospects of valuation convergence given Pakistan’s unprecedented 2011TD underperformance.

Valuation Multiples: Regional Snapshot

Source: Bloomberg, Morgan Stanley, BMA Research

STRATEGY

Hamad Aslam, CFA Head of Research

PER 2011E Earnings Growth 2011E

12.2x

12.7x

12.7x

14.4x

14.9x

15.9x

7.9x

15.4x

Pakistan

Thailand

Asia ex Japan

China

Indonesia

Malaysia

Philippines

India

11.6%

12.8%

14.8%

15.9%

17.0%

20.5%

21.0%

22.9%

Philippines

Asia ex Japan

China

Malaysia

Pakistan

Thailand

Indonesia

India

2

November 25, 2010

…underpinned by robust corporate earning growth Given the indigenous demand in the country, businesses have continued to do well despite the law and order situation. In fact, companies have shown robust growth over the years with average annual EPS growth for the market clocking in at 21% for the period FY03-10!

Revenue stream tells no different story. A look at the quarterly data shows that the listed companies have been able to post an average of 5% QoQ growth since Jun06 alone!

KSE Companies* Quarterly Revenue Stream

* Top 90 companies out of KSE100 index


Growth continues + Imbalances addressed = Risk Perception starts to correct 2008 proved to be a challenging year for Pakistan as global financial crisis led to a sharp deterioration in the country’s economic indicators. However later, entry into IMF regime, resultant fiscal discipline, int’l commodity price meltdown and robust inward remittances brought in much needed stability.

CPI inflation eased off from a high of 25% in Oct08 to an average of 11.7% in FY10 while Pak Rupee stabilized after depreciating by 19% in FY09 – lending support to manufacturing sector and eventually the overall macroeconomic landscape. Thus while there is still some space to cover before the economy can get back on the track of 6%+ growth trajectory (which averaged during 2001-2007), risk perception on the country has improved remarkably.

-100200300400500600700800900

1,000

Mar

06

Jun0

6

Sep0

6

Dec

06

Mar

07

Jun0

7

Sep0

7

Dec

07

Mar

08

Jun0

8

Sep0

8

Dec

08

Mar

09

Jun0

9

Sep0

9

Dec

09

Mar

10

Jun1

0

PKR

' bn

3

November 25, 2010

Pak Eurobond – Yield has come off to 8.6% from Dec08 high of 26%

Source: Bloomberg

CDS Spread on Pak Eurobonds – rationalize to 6% after breaching the 50% mark in Oct08

Source: Bloomberg

Equity markets have been no exception. After 14 months of continuous foreign portfolio outflows, foreign investors turned positive for the first time in Jun09 – right after Pakistan’s inclusion in MSCI Frontier Markets. Since then, Pakistan has to date witnessed net portfolio inflows of around USD750mn. Interestingly, foreign holding as a percentage of free float weighted market capitalization now stands at an all time high of 33%!

Monthly Net Foreign Portfolio Flows and KSE100 Index

(150)

(36)(12)

95128

3813 4 15 17

10980

26 30 42 4123 32 35

(53)(22)

6 12

-

2,000

4,000

6,000

8,000

10,000

12,000

Jan-

09Fe

b-09

Mar

-09

Apr

-09

May

-09

Jun-

09Ju

l-09

Aug

-09

Sep

-09

Oct

-09

Nov

-09

Dec

-09

Jan-

10Fe

b-10

Mar

-10

Apr

-10

May

-10

Jun-

10Ju

l-10

Aug

-10

Sep

-10

Oct

-10

Nov

-10

KS

E10

0

(200)

(150)

(100)

(50)

-

50

100

150

US

Dm

n

FIPI KSE100 Index

Source: NCCPL, BMA Research

4

November 25, 2010

As a result, KSE100 has more than doubled to 11,000+ after marking a bottom of 4,815 in Jan09. In fact in CY09 alone, the benchmark index posted a staggering performance of 60% earmarking itself as one of the best performing equity markets in the global sphere. However this should not be surprising for investors familiar with the growth story of Pakistan equities as KSE100 has posted average annual return of 40% for the last 8 years.

KSE100 Annual Performance


Security situation remains the key risk; but businesses remain relatively immune While Pakistan is currently facing numerous challenges on the security front, a closer look reveals that terror incidents have not been targeted towards the businesses.

Karachi, the business hub as well as the financial capital of the country contributes to the major chunk of GDP, tax revenues and trade; followed by Faisalabad and Lahore (textile, leather), Sialkot (sports and surgical goods) and Gujranwala (electrical appliances). Encouragingly, these five cities have accounted for only 14% of the total terror incidents in the country since January, 2007 while the bulk of unfortunate events have taken place in the tribal and Afghan-border regions of Baluchistan and Khyber-Pakhtunkhwa provinces.

Terror Incidents since Jan07

-80%-60%-40%-20%

0%20%40%60%80%

100%120%140%

2002 2003 2004 2005 2006 2007 2008 2009 2010YTD

KSE100 Index Annual Return KSE100 Index Average Annual Return

Karachi5%

Lahore6%

Sialkot1%

Capital Territory12%

Gujranwala1%

Tribal areas and others75%

Source: NCCPL, BMA Research

5

November 25, 2010

Political Landscape; Democratic maturity evident, Reforms continue Political setup of the country has not been free from controversies and concerns. Pakistan has faced numerous military coups and government changes in the past; however it should be noted that 2008 marked the first successful completion of 5 year democratic rule in the country. Following elections resulted in a coalition setup of government at the federal and provincial levels. Thus while the evolution to democracy may be termed as fragile by some, a wider picture shows that the current setup has shown remarkable signs of maturity.

Mass public and media support backing operations against the insurgents in the border region: The situation on Pak-Afghan border has remained tense since 9/11; however recent chain of victories by Pakistan army in its operations against the militants paints an improving outlook. More commendable was however the mass public and media support that the democratic setup has been enjoying throughout the operation.

NFC Award, the first in 19 years: One of the biggest achievements by far for the current setup is the recent agreement between the federal and provincial governments on the 7th National Finance Commission (NFC) Award. Only the fourth successfully concluded in Pakistan’s 63 years of history, and the first in the last nineteen years, the award lays the basis for resource distribution between the Center and the Provinces. With all relevant stakeholders on board, the development will not only result in targeted resource allocation but also speaks of the stability of the current setup.

Independence of Judiciary and Presidential powers: For the overall masses, the much needed sign of relief came when the ruling government reinstated the judiciary deposed by the previous regime in November, 2007. Moreover the long pending issue of superior presidential powers was addressed through the recently passed 18th Amendment whereby the president himself surrendered his powers to dissolve National Assembly – a much cheered move by the proponents of democracy.

Reform process: For the business and investor community in particular, the key takeaway out of the political discussion however remains the reform process and government strategy. Encouragingly, most of the economic policies have remained unchanged from previous setups while overall reform agenda has stayed consistent over the last 20 years. All relevant political parties support tax reforms, deregulation, transparency, liberalization and privatization while regulatory bodies such as State Bank (SBP), SECP and Competition Commission of Pakistan (CCP) have only strengthened over the years.

Info Arbitrage within; the need to be Selective Pakistan, as the above arguments point and as coined by some global analysts covering the country, thus represents the most unique information arbitrage opportunity. However the theme is not just limited to the broader market; in fact select plays within the universe have continued to deliver and outperform the market. Our High Conviction Investment Ideas list is an effort to identify exactly that.

6

November 25, 2010

BMA High Conviction Investment Ideas List

Performance of Our Current High Conviction Investment Ideas


Performance of Our Previous High Conviction Investment Ideas


(Re)Introduction of Leverage the key trigger; Domestic liquidity a blessing in disguise Amongst other measures taken by the regulatory authorities following the 2008 crisis was the elimination of leverage market (Continuous Funding System and futures market). However later as stability returned to the market, Cash Settled Future (CSF) contracts were introduced in 1HCY09 followed by Deliverable

Company Ticker Current Price

Fair Value

PotUpside EPS (PKR) PER(x) EPS Growth Dividend Yield

PKR/share PKR/share FY10E FY11E FY10E FY11E FY10E FY11E FY10E FY11E

Pakistan Oilfields. POL 265 274 3% 31.4 42.9 8.4x 6.2x 32% 36% 10% 11%

Attock Petroleum Ltd APL 320 426 33% 52.0 51.8 6.2x 6.2x 17% 0% 8% 8%

Lucky Cement LUCK 75 79 4% 9.7 12.5 7.8x 6.0x -32% 29% 5% 5%

Fauji Fert Bin Qasim FFBL 34 35 3% 4.8 5.4 7.0x 6.3x 19% 12% 14% 16%

BMA Universe Average 9.2x 7.9x 12% 17% 6% 7%

0%

5%

10%

15%

20%

25%

30%

35%

APL FFBL POL LUCK

Stock Performance during the Period KSE100 Performance during the Period

-20%-10%

0%10%20%30%40%50%60%70%80%90%

POL HUBC OGDC LUCK PSO DGKC ACPL MCB PPL FFBL

Stock Performance during the Period KSE100 Performance during the Period

7

November 25, 2010

Future contracts in Jul09. With these products failing to gain wide popularity amongst the investors, concept paper has been finalized and approved for Margin Trading System (MTS) – which is likely to be introduced during 1QCY11.

While this alone is likely to be a key trigger for the market, a key blessing in disguise for Pakistan equities has been the surplus cash position with the majority of domestic investor class (individuals, mutual funds, banks and institutions). Given that the ongoing rally has been largely fuelled by foreign investment, local investors are estimated to have sold USD750mn worth of equities since May09, with mutual funds sitting on 15-20% cash position. Thus, not only is an unexpected trigger likely to result in a strong rally, but a potential slowdown of foreign flows is to be cushioned by strong domestic liquidity.

BMA Sector Stance Sector BMA Recommendation

Oil Marketing Companies OVERWEIGHT

Electricity OVERWEIGHT

Construction & Materials MARKETWEIGHT

Oil and Gas Exploration MARKETWEIGHT

Commercial Banks MARKETWEIGHT

Telecom and Technology MARKETWEIGHT

Fertilizer MARKETWEIGHT

Textile MARKETWEIGHT

Automobile & Parts UNDERWEIGHT

Refineries UNDERWEIGHT

Insurance UNDERWEIGHT


8

November 25, 2010

Equity Investment Themes Theme Narration/Catalyst Sectors under focus Stocks to Play

Power HUBC

Fertilizers ENGRO, FFBL, FFC 1 Pricing Power

Ability to pass on inflationary impact to end consumer

Sustain margins on the back of regulatory framework and/or supply-demand gap Oil Marketing Companies PSO, APL

Power HUBC Companies deriving their revenues in USD E&P PPL, POL, OGDC

Cements ACPL, LUCK, DGKC 2 Devaluation Positive Export driven

Textile NML

Power HUBC Fertilizers ENGRO, FFBL, FFC

Industries catering to basic needs and hedged against any slowdown or turmoil E&P PPL, POL, OGDC

3 Potential Political Turbulence High beta stocks may suffer from

unprecedented volatility and present opportunity to accumulate at attractive levels

Select high beta stocks MCB, NBP, PSO, OGDC

Power HUBC

Oil Marketing Companies PSO

Cements ACPL, DGKC, LUCK

Refineries NRL, ATRL

4 Value with Growth

Cheap on multiples Sustainable Growth Predictable dividend payouts Upside to fair values

Chemicals ICI, LOTPTA Large cap stocks (Mkt Cap >

USD1bn) Highly liquid (avg daily traded

value > USD4mn)

MCB, NBP, OGDC, PPL

5 Global Liquidity

Domestic liquidity – to be further aided by (re)introduction of leverage products

Continued foreign investment amidst global liquidity and potential inclusion of Pakistan in MSCI EM

Sectors offering direct exposure to Pakistan theme and growth

MCB, NBP, ENGRO, FFBL, FFC, OGDC, PPL, PSO, APL PTC


9

November 25, 2010

PAK ECONOMY: REFORM PROCESS CONTINUES Pakistan economy has come cross two major setbacks in a short span of last three years – the commodity price boom of 2008 and flash floods of 2010. The former exogenous shock had a severe strain on external account, fuelled domestic inflation and eventually plummeted GDP growth to 40 year low of 1.2% in FY09 - against an average of 6.6% recorded in the preceding 5 years.

Post 2008 crisis however, Pakistan entered the IMF SBA program which brought with it fiscal discipline and economic reforms and eventually revived GDP growth to 4.1% in FY10. Unfortunately though, Flash Floods hit Pakistan before the country could return to a more sustained and stable growth trajectory. Nonetheless, prospects of a strong rebound amid ongoing reform process should outweigh short lived post flood concerns. In this perspective, progress achieved during FY10 is encouraging and provides a case for swift transition to the envisaged growth trajectory and achieve IMF’s projected GDP growth of 6% by FY15.

Economic Roundup 2010; strong rebound from 40 year low Pakistan economy posted strong rebound and achieved 4.1% real GDP growth in FY10 from its historical low growth of 1.2% recorded in the preceding year. This was primarily fuelled by a gradual recovery in the international markets, together with domestic growth stimulus i.e. downward revisions in inflation and interest rates, which allowed the turnaround in manufacturing sector and post a growth of 5.2% in FY10 against a sharp decline of 3.7% in FY09.

Investment which is considered to be a critical factor for sustainable growth however remained weak. Gross capital formation during FY10 declined by 0.6% YoY, with private sector investment declining by 4% YoY. This may not be surprising given the prevailing economic environment (declining yet high inflation and interest rates). Resource gap, one of the serious concerns, continues to be disturbing given Pakistan’s position as a front line ally in the war against terror where higher fiscal outlays will remain a challenging part. This resultantly translated in a resurging budget deficit of 6.3% in FY10 against original target of 4.0%. Nonetheless, ongoing reforms have yielded results in terms of declining private consumption and external account deficit which have helped narrow down the investment saving gap.

Economy

Abdul Shakur Economist

Strong GDP Growth Rebound to 4.1% in FY10 Resource Gap Widens to 6.3%

Source: MoF, BMA Research Source: MoF, BMA Research

-5%

0%

5%

10%

15%

20%

FY00

A

FY01

A

FY02

A

FY03

A

FY04

A

FY05

A

FY06

A

FY07

A

FY08

A

FY09

A

FY10

A

0%1%2%3%4%5%6%7%8%9%10%

GDP (RHS) Agriculture Manufacturing Service Budget deficit

5%

4% 4%3.7%

2.3%3.3%

4.3% 4.4%

7.6%

5.3%6.3%

0%1%2%3%4%5%6%7%8%

FY00

A

FY01

A

FY02

A

FY03

A

FY04

A

FY05

A

FY06

A

FY07

A

FY08

A

FY09

A

FY10

A

10

November 25, 2010

Promising core Fx inflows supporting External Account On external front, core Fx inflows have improved current account position where the deficit has declined by 62% YoY on the basis of a) consolidating trade deficit (down by 10% YoY), and b) strong inward inflows through trade & remittances. In addition, parallel flows under financial account have taken Fx reserves to record high levels of USD16.8bn with import cover improving to 5x in FY10 compared to only 2.9x in FY08. While it may be argued that a substantial part of the inflows has come in the form of debt, the debt to GDP ratio still stands at a manageable level of under 62%. Moreover, based on projected retirement of IMF related loans from FY12, external debt to GDP is expected to peak out at the prevailing levels of 32% to GDP.

Pakistan Flash Floods; FY11 to take one-time hit before returning to the growth trajectory Starting in Jul10, floods ravaged approximately 20% of the country’s landmass with flow rates topping 1.1mn cusec. As much as 20mn people were affected making it one of the world’s worst natural disasters toping Tsunami 2004, Kashmir earthquake 2005 and Haiti earthquake 2010.

For a country like Pakistan, where economic recovery was still fragile, the devastation raised serious concerns on the agriculture productivity, rural demand and communication activity. Taking into account the above mentioned factors, economic indicators for FY11 are now projected to take a one-off blow before returning to their long term growth trajectory.

Strong Core Fx inflows have stabilized CAD Debt to GDP peaking out at 62%


-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

FY00

A

FY01

A

FY02

A

FY03

A

FY04

A

FY05

A

FY06

A

FY07

A

FY08

A

FY09

A

FY10

A

Trade deficit to GDP CA deficit to GDP

0%10%20%30%40%50%60%70%80%90%

FY00

A

FY01

A

FY02

A

FY03

A

FY04

A

FY05

A

FY06

A

FY07

A

FY08

A

FY09

A

FY10

A

Total debt External debt Internal debt

11

November 25, 2010

What did the Floods change; non recurring economic slowdown imminent in FY11

But does that deter the growth trajectory? GDP growth projected to be at 6% by FY15 It is important to highlight here that the Flash Floods, while catastrophic in all economic and social sense, should only result in one-time hit in FY11 while subsequent years should see the country progress to its growth trajectory. In fact, in the latest “World Economic Outlook (WEO)” report released by the IMF, it is projected that Pakistan’s rebound will take the country’s GDP growth to 6% by FY15.

Regional Economic Outlook by IMF – Pakistan GDP growth to rebound to 6% in 2015

FY11 – Pre Flood Outlook FY11 – Post Flood Outlook

GDP Growth Continued revival was expected in LSM while agriculture was projected to post a growth of 3-4%. GDP was projected to rebound to 4.5%

Agriculture sector is expected to post negative growth while overall GDP growth may settle at 2.1%

Inflation MoF and BMA Research CPI estimates stood at 9% and 12%, respectively for FY11

Crop/food shortage and higher govt borrowing poses upside risks of 300-400 bps from initial forecasts

Interest Rates

SBP’s unwarranted stringent stance through 50bps increase in discount rate had already paved way for expectations of further hikes

Higher expected fiscal deficit and inflation, together with SBP’s hawkish stance reflects the possibility of higher interest rates over FY11

Budget deficit

With broader tax reforms announced in budget 2011, tax revenues were projected to grow by 12% YoY. Budget deficit to GDP was targeted at 4%

Due to unavoidable flood related outlays, it seems unlikely to meet the deficit target. However, proposed flood tax and ongoing reforms (RGST) minimize the upside risk for budget deficit

External account

Current account deficit was projected at 2.2% of GDP primarily based on consolidating import demand improving Core Fx inflows

Downward revision in export projections amid cotton crop losses and higher imports may result in CAD to settle above 2.8% of GDP. Strong financial account ensures sustainable reserve position for short to mid term


5.1

2.86.0

7.0

5.04.0

6.3

3.2

4.9

4.1UAE

MENA

Pakistan

Bangladesh

Thailand

Developing Asia

Inida

2011F 2015F

Source: IMF, BMA Research

12

November 25, 2010

Further, Moody’s in its recent announcement in Nov10, has maintained country rating at B3 with stable outlook. While highlighting risks to sustainable economic recovery, the agency has commended strong external account support and government revenue and current account receipts and reiterated the possibility of upward revision in credit rating going forward

Driven by intrinsic demand in the country, the projection appears to be achievable to say the least. However key challenges need to be addressed which include:

low tax to GDP,

subsidized consumption,

circular debt,

overheated consumption and

high inflation.

Ongoing structural reforms thus remain the only means to tackle these impediments to growth and restore sustainable growth going forward.

Way forward to stability; Structural Reforms Since the real GDP growth of yesteryears was not accompanied by parallel uptick in tax revenues, bourgeoning government borrowing for budget financing has fueled prices and hindered growth prospects. On the positive side, monetary tightening since FY05 acted as a counter balancing element to rationalize demand. Besides appeasing inherent demand in the short term, timely measures for resource building are also the need of the hour.

These include strict adherence to 1) Tax Reforms, 2) Fiscal Discipline and 3) Demand Consolidation.

1) Tax Reforms: Key determinant for resource building Revenue generation and enhancing tax base was the key theme for budget FY11 – government announced indirect tax reforms to eliminate tax exemptions, imposed tax on capital markets and services sector and has shown commitment to improve tax machinery to minimize tax avoidance. Government also seems committed to implement Reformed General Sales Tax (RGST) which is also a crucial part of IMF based reform measures. In this regard the legislation has already been tabled in National Assembly and is envisaged to be imposed from Jan11.

This will result in reduction of tax exemptions to minimal levels and encourage documentation. Contingent on the implementation of these tax reforms, Tax to GDP is projected to cross 13% by 2015 which would help contain resource gap to only 1.6% of GDP from current 6.3%.

Excess demand

-500

0

500

1,000

1,500

2,000

2,500

FY03

FY04

FY05

FY06

FY07

FY08

FY09

FY10

E

PK

R b

n

PAKISTAN'S LONG TERM SOVEREIGN RATING

Effective S&P Moody's

November-10 B3

August-09 B-

December-08 CCC+ B3

November-08 CCC

October-08 CCC+ B3-

May-08 B B2

November-06 B1

November-06 B2+

November-04 B+

October-03 B2

December-02 B

February-02 B3

December-99 B-

0%

2%

4%

6%

8%

10%

12%

FY00

A

FY01

A

FY02

A

FY03

A

FY04

A

FY05

A

FY06

A

FY07

A

FY08

A

FY09

A

FY10

A

Real GDP growth Tax to GDP

6%+ real GDP growth needs to be reflected in tax revenues


13

November 25, 2010

2) Fiscal Discipline: Subsidy elimination to curtail Circular Debt Diminishing Hydel power generation together with gas curtailment has been gradually resulting in increased reliance on alternate and expensive furnace oil based thermal power generation. However despite the increase in generation cost, the government did not substantially increase the energy tariffs prior to FY07 – resulting in a significant cost tariff differential between production and distribution. Power subsidies resulted in lower cash flows from end consumers for power distributors and producers, eventually leading to a circular debt and financial constraint in the system.

Besides long term plans for low cost power generation, government is also working on war footing basis to end prevailing circular debt. Commitment from the government is evident and encouraging as shown by the recent measures taken since Jun09:

a) government assumed liability on account of past subsidies and payments are being arranged through issuance of govt. backed securities,

b) subsidy elimination remained the key agenda for budget FY11; power sector subsidies reduced by 52% YoY and

c) monthly tariff adjustments proportional to generation cost based on fuel prices and generation mix.

As a result, substantial impact of previous back log has already been curtailed through upward revision in tariff - approx 62% since FY08 while further tariff increase of approx 24% is to take place in FY11.

In this regard, the government recently announced 2% increase in electricity tariff on monthly basis for the next 8 months. Completion of tariff adjustments ensures resolution of circular debt which has currently held back the optimum capacity utilization of energy and industrial sectors.

3) Demand Consolidation and inflation resurgence; Addressed by adequate Monetary Policy Strong consumption demand and flourishing liquidity was the key contributor in recent economic boom of FY01-06. More specifically high growth was supported by excessive credit availability and monetary policy ease; which translated into higher consumption and inflation.

Fiscal Adjustments to Eliminate Subsidies Tariff increased by 62% since FY08


67

180

87

53 4939

-20406080

100120140160180200

Budget 2009-10 Revised 2009-10 Budget 2010-11

PK

R b

n

Power related subsidies Others Schedule of electricity tariffs

2.0

2.5

3.0

3.5

4.0

4.5

Feb-

07

May

-07

Aug

-07

Nov

-07

Feb-

08

May

-08

Aug

-08

Nov

-08

Feb-

09

May

-09

Aug

-09

Nov

-09

Feb-

10

May

-10

Aug

-10

PK

R/K

WH

14

November 25, 2010

To address these resultant challenges, recent persistent monetary tightening has however played a vital role in eliminating monetary overhang. Most important and profound impact of consolidating demand can be observed in FY10 as private consumption growth plunged to mere 3.9% compared to significantly higher growth of 11.3% in the preceding year. Taking into account the post flood challenges; Sate Bank of Pakistan (SBP) further increased policy discount rate cumulatively by 100bps to 13.5% in the last four months. Considering persistent inflation and fiscal deficit, SBP is expected to remain vigilant with a further 50-100bps increase in policy discount rate expected during FY11.

Monetary Overhang Addressed Through Vigilant Monetary Policy

Source: SBP, BMA Research

With regards to inflation, a look at the recent statistics indicates that resurgence is primarily caused by food and energy items only. On the contrary, Non Food Non Energy (NFNE) core inflation has continued to ease and consolidate under 11% in the last two years. Given that the former was fuelled by tariff adjustments and harmonization of domestic oil price with int’l markets in a lagged gradual manner; continuity of double digit phenomenon is not likely beyond FY11.

1

6

11

16

21

26

Aug-

09

Sep-

09

Oct

-09

Nov

-09

Dec

-09

Jan-

10

Feb-

10

Mar

-10

Apr-

10

May

-10

Jun-

10

Jul-1

0

Aug-

10

Sep-

10

%

Food Energy NFNE

5%7%9%

11%13%15%17%19%21%23%25%

FY02

A

FY03

A

FY04

A

FY05

A

FY06

A

FY07

A

FY08

A

FY09

A

FY10

A

Money supply grow th Nominal GDP grow th

0%

8%

16%

24%

32%

40%

Jun-

07

Sep-

07

Dec

-07

Mar

-08

Jun-

08

Sep-

08

Dec

-08

Mar

-09

Jun-

09

Sep-

09

Dec

-09

Mar

-10

Jun-

10

Sep-

10

CPI SPI NFNE WPI

Inflation Resurgence Caused by Price Adjustment and Flood Impact

Source: SBP, BMA Research Source: SBP, BMA Research

15

November 25, 2010

Furthermore, recent resurgence in food inflation has come on the back of Jul10 flash floods. Damage to standing minor crops, disruption in transportation network and lack of storage facilities led to a sharp increase in food prices when compared to the preceding quarter.

However the flood timing has been a blessing in disguise, as wheat crop remained immune from the catastrophe - historically, wheat shortage has usually paved the way for food inflation in Pakistan. In addition, better water availability for 2011 Rabi season, improved crop yields and increasing arable land (as water reaches Baluchistan) suggest upward revision in wheat availability and sugarcane crop next year. These factors together with effective administration and relatively higher domestic food prices compared to international markets suggest food price rationalization in the medium term.

Thus while we project inflation to remain downward sticky during FY11 and settle in the range of 16-17%; the double-digit trend is expected to be short lived.

16

November 25, 2010

Select Economic Indicators as projected by IMF

Pakistan: Medium-Term Macroeconomic Framework

FY08A FY09A FY10P FY11E FY12F FY13F FY14F FY15F

Output and prices (Annual changes in percent)

Real GDP at factor cost 3.7 1.2 4.1 2.8 4.0 5.0 5.5 6.0

Consumer prices (period average) 12.0 20.8 11.7 13.5 9.5 7.0 6.0 6.0 (In percent of GDP)

Gross national saving 13.6 13.2 14.6 16.6 17.6 18.7 19.7 20.9

Government -2.9 -2.1 -2.4 0.3 1.0 1.5 2.0 2.3

Non-government 16.5 15.3 17.0 16.3 16.7 17.2 17.7 18.6 Gross capital formation 22.1 19.0 16.6 19.7 21.3 22.6 23.8 25.1

Government 4.4 3.1 3.5 3.4 3.4 3.9 3.8 3.9

Non-government 17.6 15.8 13.0 16.2 17.8 18.8 20.0 21.2

Balance of payments (USDbn, unless otherwise indicated)

Current account balance -13.9 -9.3 -3.5 -5.9 -7.3 -8.3 -9.4 -10.3

Net capital flows 1.3 0.8 1.0 1.0 1.1 1.1 1.1 1.2

Of which: foreign direct investment 5.4 3.7 2.2 3.1 4.0 4.5 5.2 5.7

Gross official reserves 8.6 9.1 13.0 16.7 18.2 18.7 17.9 16.5

In months of imports 2.6 2.9 3.7 4.6 4.8 4.6 4.2 3.6

External debt (in percent of GDP) 27.1 32.1 31.6 31.8 32.6 32.5 31.3 29.1 Public finances (In percent of GDP)

Revenue and grants 14.9 14.7 14.5 15.7 15.9 16.3 16.6 16.6

Of which: tax revenue 10.6 10.4 10.2 11.2 11.6 12.2 12.5 12.9

Total expenditure 22.2 19.9 20.5 19.2 18.4 18.7 18.3 18.2

Current expenditures 18.1 16.4 16.9 15.8 14.9 14.8 14.5 14.3

Development exp. (incl. net lending) 4.1 3.2 3.8 3.5 3.4 3.9 3.8 3.9

Primary balance -2.4 0.1 -1.3 0.6 1.9 1.8 2.2 1.8

Overall fiscal balance -7.3 -5.2 -6.0 -3.6 -2.5 -2.4 -1.8 -1.6 Total public debt (including obligations to the IMF) 59.6 60.6 63.4 63.7 61.3 58.6 54.7 49.2

Memorandum item

Real per capita consumption (% YoY) 5.0 6.5 1.4 0.8 1.5 2.0 2.2 2.5

Sources: Govt. of Pakistan for historical data; and IMF staff estimates and projections.

17

November 25, 2010

BANKS: OVERCOMING THE CHALLENGES Aftermaths of flood 2010 does not paint a promising picture for the banking sector which is yet to come out of the economic shock triggered in CY08. As per SBP’s initial estimates, banks may face incremental NPL losses of up to PKR48bn. With this incremental 10% increase, banking infection ratio is projected to reach 15.4% from current level of 15.0%.

It should be noted that given the inter-linkages of agri economy with manufacturing sector, supply shortages and cost escalation can also potentially hurt the productive capacity of SME and corporate sectors - which in turn contribute to the highest share in banks’ loan book.

In this regard, SBP had recently allowed banks to defer flood related provisioning by 15 months which should keep banks’ profitability immune form flood impact up till CY11. It is important to note that major part of pre-flood economic downturn had already been incorporated in provision losses. Thus despite its low value impact, this development is widely positive for banking sector as provision losses are now projected to continue downward trajectory. Amongst our banking universe in specific, we flag Habib Bank (HBL) and National Bank of Pakistan (NBP) as major beneficiaries of this development due to their hefty textile and agri loan portfolio.

Improving liquidity: Changing Tides We believe budget financing will remain the key hindrance in private sector credit growth for FY11. Initial target was set at PKR499bn (USD5.8bn) for budgetary borrowing from domestic sources. To put things into perspective, budgetary borrowing from banks had surpassed the target by 111% in FY10.

Thus while the current economic environment may make private sector credit expansion a challenging proposition; seasonal demand for textile and commodity financing suggest uptick in banking loans specifically in 4QCY10. With improving money multiplier and increasing NFAs, liquidity situation is projected to improve henceforth. Therefore, we rule out substantial increase in deposit cost while upside potential in earning yields exist amid increasing interest rate scenario.

BANKS

MARKETWEIGHT

Abdul Shakur Banking Analyst

10%11%

10% 64%

5%

Corporate SMEAgriculture Commodity financingConsumer

0%

5%

10%

15%

20%

25%

NBP BAFL HBL MCB UBL

Textile Agri relatedcement Transport. & const.

Classification of loan book Sector wise infection ratio Loan book of BMA universe

Source: SBP, BMA Research Source: SBP, BMA Research Source: SBP, BMA Research

25%

1%

12%

14% 17%

0%

5%

10%

15%

20%

25%

30%

Cor

pora

te

SM

E

Agr

icul

ture

Com

mod

ityfin

anci

ng

Con

sum

er

18

November 25, 2010

On the other hand, upside revision in National Saving Scheme (NSS) rates should put pressure on deposit cost; overall banking spreads are likely to be come down to 7%.

Moody’s took it serious: Stability advocates for improved outlook and rating revision Taking into account the recent economic challenges, Moody’s had revised its outlook to negative from stable on domestic deposits and financial health of five major banks of Pakistan. However, ratings have remained unchanged as mentioned in the table on the left. Rationales for outlook revision are as follows:

Financial health is considered to be more vulnerable amidst weak loan growth and emerging NPL pressure which may consequently lower profitability

Rating agency linked higher exposure in government securities to event risk at the sovereign level (sovereign rating stands at B3 with stable outlook).

The recent economic recovery and improving liquidity rule out any potential risk to banking deposits and assets particularly the government securities. Since Jul10, banking deposits have increased by 2% QoQ while CY10TD growth stands at 7%. Provision losses for all major banks have reportedly declined in 3QCY10. Therefore, we expect positive outcome in terms of upward rating revision for top tier banks in next review by these agencies.

Strong Asset Quality and Low Cost is the Key: Buy MCB Considering higher inflation and interest rate environment, we reiterate our recommendation bias for banks with relatively stable NIMs and stronger asset quality. With these criteria in mind, MCB is expected to outperform the peers going forward.

Comparative Analysis of Asset Quality


Although BAFL carries lowest infection ratio amongst BMA banking universe, lowest loan loss coverage suggests incremental provision losses going forward. Similarly NBP outperforms peers on valuation matrix due to low PBV multiple of 0.7x, yet we maintain a Neutral stance on the scrip (target price: PKR69/share) due to looming asset quality concerns and escalating deposit cost. MCB, on the other hand, currently trades at PBV multiple of 1.8x, and offers upside potential of 13% to our Dec11 based Target price of 230/sh. – recommend Buy!

Moody's rating for Pakistani banks Banks BFS LTDD LTDF

NBP D Ba2 B3

HBL D- Ba3 B3

UBL D- Ba3 B3

MCB D Ba2 B3

ABL D- Ba3 B3

BFS: Banks Financial Strength

LTDD: Long Term Deposits - Domestic

LTDF: Long Term Deposits - Foreign


0%

3%

6%

9%

12%

15%

NBP BAFL HBL MCB UBL Industry Avg.0.0

0.2

0.4

0.6

0.8

1.0NPLs to loan Loan loss coverage (RHS)

19

November 25, 2010

Regional Valuations

Short Name Ticker Country ROA (%) ROE (%) PBV (x)

Ind & Comm Bk-A 601398 CH China 1.20 22.24 1.94

China Merch Bk-A 600036 CH China 1.00 21.17 4.28

Shang Pudong-A 600000 CH China 0.91 25.29 2.06

ICICI Bank Ltd ICICIBC IN India 0.96 9.52 2.07

HDFC Bank Ltd HDFCB IN India 1.48 16.36 4.09

Punjab NATL Bank PNB IN India 1.43 23.19 1.71

Bank Central Asi BBCA IJ Indonesia 2.68 26.32 5.03

Bank Mandiri BMRI IJ Indonesia 2.17 24.32 3.45

Bank Rakyat Indo BBRI IJ Indonesia 2.74 28.62 3.76

Halyk Savings Bk HSBK KZ Kazakhstan 1.25 10.63 1.40

Kazkommertsbank KKGB KZ Kazakhstan 0.75 5.21 0.75

Malayan Banking MAY MK Malaysia 1.18 14.47 2.29

CIMB Group Holdi CIMB MK Malaysia 1.36 16.72 4.32

Public Bank Bhd PBK MK Malaysia 1.34 25.62 4.29

MCB Bank Ltd MCB PA Pakistan 3.14 22.50 1.92

Habib Bank Ltd HBL PA Pakistan 1.66 18.02 1.19

NATL Bk Pakistan NBP PA Pakistan 2.05 17.23 0.74

United Bank Ltd UBL PA Pakistan 1.53 16.44 1.02

Bank Philippine BPI PM Philippines 1.18 13.19 2.21

Banco De Oro Uni BDO PM Philippines 0.92 11.05

Metro Bank & Tr MBT PM Philippines 0.78 8.55 1.73

Commercial Bk COMB SL Srilanka 1.39 15.26 1.56

Hatton Natl Bank HNB SL Srilanka 1.63 18.18 2.52

DFCC Bank DFCC SL Srilanka 2.91 12.90 1.16

Siam Comm Bk Pcl SCB TB Thailand 1.72 16.07 2.35

Bangkok Bank Pub BBL TB Thailand 1.41 12.13 1.34

Kasikornbank Pcl KBANK TB Thailand 1.32 14.17 2.38

JSC Bank For For VCB VN Vietnam 2.01 28.89 3.23

Vietin Bank CTG VN Vietnam 1.09 18.86 2.00

Asia Commercial ACB VN Vietnam 1.23 21.17 2.15 Source: BMA Research

20

November 25, 2010

Stock Statistics

Ticker MCB

3-month High/ Low 208.7 / 179.6

Mkt Cap USD mn 1,823

12M ADT mn 1.36

Beta 1.09

MCB: ALWAYS A SAFE BET! INVESTMENT SUMMARY

Strong on Fundamentals: Despite tough conditions faced by the banking sector during the year, MCB has been able to maintain the highest NIMs in the sector at ~8%. This is thanks to an extensive branch network (3rd largest) and highest CASA (~80%) compared to its peers. Going forward as well, the bank can leverage this advantage with an aim to mobilize low cost deposits and hence maintain its NIMs. In addition, higher CASA suggests lower risk to incremental cost pressure in case National Savings continue to intensify competition by offering higher rates.

Comfortable CAR & Roomy ADR: MCB has extremely comfortable CAR of 19.1% (Dec09) and roomy ADR of ~58% (Sep10) which bode well for balance sheet growth going forward. Although we maintain our take of a meager 2% loan growth, MCB is well positioned to leverage on reversal of credit cycle. This should also ensure better asset quality and profitability as credit risk subsides going forward.

Superior Asset Quality: MCB, amongst its top tier peers, has one of the best asset quality given relatively lower NPL to gross loans at ~9% compared to sector average of 15%. In fact, MCB has shown remarkable improvement by posting provision reversals in Sep10. Moreover, the bank has also witnessed considerable deceleration in its NPL accumulation on a quarterly basis. Further, with regards to flood related delinquencies, MCB is to remain an outlier due to its least exposures to agriculture and other affected sectors. Therefore, we envisage more stability on asset quality front in the periods to come which should ensure sizable bottom-line growth.

Pension Fund Reversals: MCB continues to benefit from pension fund reversals. The management forecasts a three year timeline for complete reversals to take place which will continue to provide relief through lower administrative expenses and ensure relatively better cost to income ratio.

Maintained ROE: MCB also carries one of the highest ROEs (24%) amongst the Pakistani banks. Given the management’s intent to maintain the same at current levels, continued dividend payout can be expected in the future.

Financials

ADD Target Price: PKR 230 Current Price: PKR 205

MCB profile: MCB is one of the leading banks of Pakistan. Incorporated in 1947, MCB was nationalized along with all other private sector banks in 1974. During the last fifteen years, the Bank has concentrated on growth through improving service quality, utilizing its extensive branch network & developing a large and stable deposit base

Price & Volume Graph

CY09A CY10E CY11E CY12E

EPS(PKR) 20.4 23.6 26.7 29.7

Price to book (x) 2.2 2.0 1.7 1.5

Dividend Yield (%) 5.4 5.9 7.3 7.8

EPS Growth (%) 0.8 15.6 13.5 11.1

Return on Equity (%) 24.2 24.0 24.1 23.7

Return on Assets (%) 3.3 3.3 3.4 3.3


Others6%FI's

7%

Directors , CEOs & Ass. Cos.

16%

Foreign Cos.37%

Public Sector Cos.19%

Local and Foreign Public15%

Shareholding Pattern

150160170180190200210220

Nov

-09

Dec

-09

Jan-

10Fe

b-10

Mar

-10

Apr

-10

May

-10

Jun-

10Ju

l-10

Aug

-10

Sep

-10

Oct

-10

Nov

-10

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Volume mn Price PKR(LHS)

21

November 25, 2010

E&P: PROXY TO INT’L OIL PRICES AND PAKISTAN’S RICH HYDROCARBON RESERVES Production Numbers: Slowdown in the industry but select companies to Outperform Despite significant number of discoveries over the last 5 years, the overall oil and gas production numbers have been unimpressive for FY10. Oil production which accounts for 20% of the country’s crude demand, has posted a decline of 1.2% in FY10 to 64kbbl/day after remaining flat in the preceding year. Gas production, on the other hand, has posted meager growth of 1% in FY10 to clock in at 4bcf/day.

The recent numbers are however in sharp contrast with the FY02-08 CAGR of 8% for gas and 2% for oil production – primarily owing to litigation delays in development of two key blocks i.e. Tando Allahyar and Sinjhoro. Given that it may take 2-3 years before production can come online from these blocks, overall production numbers for the industry and the E&P giant Oil and Gas Development Company (OGDC) may remain lackluster in the short term.

Driven by production from TAL Block, however, outlook and performance for the other two listed companies i.e. Pakistan Petroleum (PPL) and Pakistan Oilfields (POL) remain bright. The block (ownership stakes – OGDC: 28%, PPL: 28% and POL: 21%) has recorded four discoveries since 2001, out of which Manzalai and Makori fields are already under production while Maramzai and Mamikhel fields are to come online during 2HFY11. Accounting for over 60% of reserves and expected production stream for POL, the block alone is projected to allow the company to continue with double digit hydrocarbon production growth over the next 3 years. For PPL, the block is to compensate for natural declines from Sui field (ownership stake: 100%) and translate into 2-5% production growth for the company.

Oil Production Gas Production

Source: PPIS, BMA Research

-

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

FY08A FY09A FY10A FY11E FY12E

barr

els/

day

Industry OGDC POL PPL

-500

1,0001,5002,0002,5003,0003,5004,0004,500

FY08A FY09A FY10E FY11E FY12E

mm

cf/d

ay

Industry OGDC POL PPL

E & P

MARKETWEIGHT

Hamad Aslam, CFA E&P Analyst

22

November 25, 2010

Int’l Oil Prices: Hard to Call but Higher the Better With retention prices for Pakistan’s oil producers benchmarked against Arab-Light crude oil prices, international commodity prices continue to be a key determinant of profitability for domestic E&P companies. Fears of global recession and consequent financial meltdown had its adverse and exaggerated impact on international oil prices as Arab-Light crude oil fell from its high of USD143/bbl in Jul08 to USD33/bbl in Dec08. However since then we have seen a sharp recovery in international commodity markets with oil standing at over USD80//bbl at present.

Basing our models and assumptions on a conservative side, we have used oil prices assumption of USD75/bbl for FY11 and beyond. Thus while any unprecedented oil price hike in the international markets is likely to be negative for Pakistan’s economy, price performance of E&P companies is to remain strong owing to the sector’s resultant higher profitability projections.

Playing the Devaluation Theme: Oil Prices Faring even Stronger in PKR While retention prices for E&Ps are benchmarked against int’l crude oil, it is important to remember that eventual revenue is generated in Pak Rupees thereby allowing the exploration companies to benefit from PKR depreciation against the greenback. Annual PKR depreciation has averaged at 7% for the last 30 years while inflation and interest rate differential hints towards continued weakness against the green back. Projected surplus in BoP however leads to our projection of ~5% annual depreciation assumption in the medium term – thereby hinting towards a sustained (PKR based) revenue growth even if the production levels and int’l oil prices are to remain unchanged. Moreover, the sector should thus also continue to play the devaluation theme as a hedge against any unprecedented depreciation.

Outlook: Positive on the Sector; Albeit in the Right Companies The E&P sector continues to be an ideal avenue for equity market investment based on the devaluation hedge, higher int’l oil prices and production growth from select fields. At current prices we like POL based on its growing production stream and a resultant NAV based fair value of PKR274/share. We have a fair value of PKR196/share for PPL for which our liking for the company stems from its renewed strategy of an aggressive exploration program, steady production flows and higher wellhead gas prices.

23

November 25, 2010

Regional Valuations

Company Country EPS Growth PER ROE EV/EBITDA

Wintime Energy Co Ltd-A China 112.0 68.2 20.7

Sinopec Shandong Taishan-A China (94.2) 1,261.8 0.4

Shenzhen Guangju Energy Co-A China (16.0) 62.8 3.7

Gail India Ltd India 17.7 18.7 20.0 11.6

Bharat Petroleum Corp Ltd India 157.6 17.1 11.9 13.6

Reliance Natural Resources L India 27.8 69.7 4.1 661.6

Hindustan Oil Exploration Co India (19.2) 77.2 4.1 35.9

Selan Exploration Technology India (38.5) 17.9 23.6 13.6

Energi Mega Persada Tbk Pt Indonesia (4,842.0) (33.2) 22.2

Petronas Gas Bhd Malaysia 1.5 21.0 12.6

Petronas Dagangan Bhd Malaysia 30.2 14.7 16.4

Oil & Gas Development Co Ltd Pakistan 6.6 11.9 41.7 6.3

Pakistan Petroleum Ltd Pakistan (15.8) 10.3 36.2 4.3

Pakistan Oilfields Ltd Pakistan (33.7) 8.4 25.3 3.9

Pnoc Exploration Corp-B Shs Philippines (40.8) 20.6 18.1 14.1

Thai Oil PCL Thailand 5,272.7 17.0 10.1 12.1

Bangchak Petroleum PCL Thailand 8.2 11.1 10.0

Siamgas & Petrochemicals PCL Thailand 3.1 14.0 28.5 8.5

Regional Average 34.6 91.0 9.6 45.1 Source: BMA Research

24

November 25, 2010

Stock Statistics

Ticker POL

3-month PKR 268.4 / 199.7

Mkt Cap USD mn 734

12M ADT mn 1.61

Beta 1.13

POL: GROWTH FROM THE CORE INVESTMENT SUMMARY

Amidst materialization of production growth from TAL Block: POL’s performance over FY07-09 has stayed lackluster as it posted dismal production data over the period, primarily on account of concerns in one of its key fields, Pindori (POL ownership stake: 35%). As a result, oil production for the company declined from 6.0kbpd in FY07 to 3.7kbpd in FY09 while gas production declined from 47mmcfd to 38mmcfd during the same time period.

However with POL accounting for 21% stake in Tal Block, the ongoing production additions have turned around the company’s profile. Central Processing Facility came online during 2QFY10 at Manzalai field, enhancing its oil and gas production to 200+mmcfd (up 4x) and around 4,000bpd (up 7x), respectively. As a result, POL has already seen its oil and gas production double from Oct09 levels and has clocked in production of 4.1kbpd of oil and 62mmcfd for FY10 alone.

Further, with Mamikhel and Maramzai being relatively recent discoveries, they are projected to come online during 2HFY11 with cumulative oil and gas production of 85mmcfd of gas and 3,000bpd of oil. We thus project POL to deliver an impressive oil production growth of 25% and 12% for FY11 and FY12 while gas production is likely to see a growth of 37% and 17% for the next two years.

Relative immunity from circular debt to allow aggressive exploration activity: POL being the exploration arm of the Attock group’s portfolio derives part of the strength of its business model through an inherent shield against the system’s circular debt. Supplying a substantial portion of its production to the group’s refineries (Attock Refinery and National Refinery), the company has been able to sustain itself better than its peers (PPL and OGDC) in the current liquidity starved environment.

It should thus allow the company to deliever on its recently revived exploratory program for which at least 4 wells (including JVs) are already in the drilling phase.

Double-digit EPS growth; Prospective Dividend Yield of 8% for FY10E: Offering robust EPS growth of 36% and 14% for FY11E and FY12E respectively, the company not only stands to benefit from its core growth but also reflects the most compelling valuations amongst its peers – FY11E PER of 6.2x and dividend yield of 11%.

Financials

NEUTRAL Fair Value: PKR 274 Current Price: PKR 265

FY10A FY11E FY12E

EPS(PKR) 31.4 42.9 48.9

Price to Earnings (x) 8.4 6.2 5.4

Dividend Yield (%) 9.6 10.5 11.3

EPS Growth (%) 32.1 36.4 13.9

Return on Equity (%) 25.5 28.0 28.0

Return on Assets (%) 18.9 24.0 25.7


POL Profile: POL is engaged in oil and gas exploration in the country and has been investing independently and in joint venture with various other exploration and production companies. In addition it is also involved in manufacture of manufacture of LPG, solvent oil and sulphur. The company is part of The Attock Oil Company Limited (OCAC) and holds 25% ownership stake in National Refinery Limited.

Price and Volume Graph

Shareholding Pattern Others10%

Associated Cos.54%

NIT, MF and

Modarabas9%

Individuals11%

Banks, FI's,

Ins.Cos.16%

150170190210230250270290

Nov

-09

Dec

-09

Jan-

10Fe

b-10

Mar

-10

Apr

-10

May

-10

Jun-

10Ju

l-10

Aug

-10

Sep

-10

Oct

-10

Nov

-10

0

2

4

6

8

10


25

November 25, 2010

REFINERIES: REGULATORY RISKS REMAIN A MAJOR CONCERN Pakistan has annual oil refining capacity of 13.8 mn tons, whereas the annual demand currently stands at 20.6 mn tons; well above the support rendered by the refineries. Refineries are heavily dependent on imported crude oil, as a result imported crude constitute ~72% of total crude processed. Pakistan currently has 5 major refineries out of which 4 are listed on KSE.

Pak Arab Refinery (PARCO) is the largest and unlisted refinery in Pakistan with throughput of 100,000bpd, followed by National Refinery (NRL), Pakistan Refinery (PRL), Attock Refinery (ATRL) and BYCO Refinery (BYCO) with throughput of 65,000bpd, 50,000bpd, 40,000bpd and 33,000bpd respectively.

Despite recent sharp growth in POL product demand in the country, refining industry has experienced heavy losses on account of adverse regulatory changes and lower global Gross Refining Margins (GRMs).

Pricing Regime for Domestic Refineries The companies operate under the refineries Import Parity Pricing formula which was modified wef Jul02 whereby the minimum rate of return of 10% on paid-up capital was withdrawn for the listed companies.

Deemed Duty was granted to the refineries in order to incentivize them to establish desulphurization units and produce Euro–II grade diesel. Euro–II standard diesel contains 0.05 per cent sulphur, whereas refineries in Pakistan produce diesel with sulphur contents between 0.5pc and 0.8pc in a liter diesel.

Refineries on the other hand did not make any progress on up-gradation of plants, as a result of which deemed duty on HSD was cut from 10% to 7.5% and withdrawn from other products. These regulatory changes coupled with depressed international GRMs forced refineries to operate at low utilization levels amid losses.

Gross Refining Margins still too low… Refining Industry continues to face unfavorable GRMs, however for the past few quarters GRMs for the industry have improved sequentially from USD-1.59/bbl during 1QFY10 to USD2.47/bbl over 1QFY11. Refineries in Pakistan have a variety of product mix which eventually determines their profitability and utilization levels.

GRMs for Pakistani refineries are linked with international GRMs; white oil being high margin product whereas Black Oil generates negative margins. Currently NRL has the best product mix with higher concentration on high margin products backed by its lube-refining operations. On the other hand, BYCO and PRL have the worst product mix and despite improvement in GRMs, were not able to report any profits during FY10.

REFINERIES

UNDERWEIGHT

Muhammad Ali Taufiq Refinery Analyst

26

November 25, 2010

Product Mix

Performance Indicators

Circular Debt; Immunity for Select Listed Refineries PARCO is the major sufferer of the ~PKR150bn net inter-corporate circular debt issue, which has brought lot of friction in the energy chain for the last 3 years. Among the listed refineries, PRL and BYCO are most exposed to this menace. As a result financial charges for PRL stood at PKR1.13bn for FY10, up 14x compared to FY07.

ATRL and NRL however remained relatively safe from circular debt due to their concentration of supplies to private entities. Liquidity for both the refineries is also enhanced by profitable lube refining operation as in case of NRL and non-refinery income as in case of ATRL.

While resolution of circular debt can improve liquidity and payout for the distressed refineries, we only foresee a gradual ease in the current environment.

Products Industry NRL ATRL PRL BYCO PARCO

Motor Spirit 12.4% 6.5% 17.9% 7.1% 6.1% 18.4%

Kerosene 1.7% 0.4% 3.2% 0.6% 0.0% 2.7%

HOBC 0.1% 0.0% 0.0% 0.0% 0.0% 0.3%

HSD 31.4% 32.4% 29.3% 26.2% 36.9% 33.3%

LDO 0.9% 3.2% 0.2% 0.0% 0.5% 0.4%

FO 29.7% 17.4% 23.0% 41.8% 47.1% 30.5%

Aviation Fuels 9.2% 7.6% 10.9% 11.8% 0.0% 10.5%

Naptha 7.3% 11.7% 11.4% 10.2% 7.4% 0.0%

LPG 2.1% 0.6% 0.4% 2.4% 0.4% 3.6%

Lubes and Other oils 2.6% 10.0% 0.5% 0.0% 1.7% 0.4%

Asphalt 2.5% 10.3% 3.1% 0.0% 0.0% 0.0% Source: OCAC, BMA Research

Util. rate

GRMs (USD/bbl)

Cash & equiv/

total assets

Quick ratio

ROE Ann

FY11 P/E

Mar. Price BVPS PVGO/

share

NRL 85% 2.5 34% 110% 17% 4.5x 262 246 16

ATRL 97% 0.8 7% 75% 1% 4.8x 124 82 42

BYCO 50% (2.7) 1% 37% NM NM 12 -13 25

PRL 90% (0.7) 0% 64% NM NM 82 67 15

PARCO 65% 0.1 NA NA NA NA NA NA NA


27

November 25, 2010

Valuation Summary

Regional Comparison: Cheap Valuations Justified Local refineries currently trade at average FY11E PER of 4.7x while the regional median FY11E PER is 14.6x, reflecting 68% discount to their peers. Local refineries are also trading at heavy discount of 88% and 41% on P/S and PBV basis compared to their regional peers. However, we are of the opinion that cheap valuations for the local refineries are justified on the basis of regulatory risks and poor product mix of local refineries compared to their regional peers.

Regional Valuations

Short Name Ticker Country 1 Year Beta P/E P/S P/B Div. Yld. % ROE % ROA % Return

YTD % Natl Ref Ltd NRL PA Pakistan 1.03 4.5 0.13 0.92 9.10 16.73 6.36 38.64

Attock Refinery ATRL PA Pakistan 1.37 4.8 0.08 0.76 5.00 0.96 0.24 (26.46)

Byco Petroleum P BYCO PA Pakistan 1.28 NA 0.06 NA - NA (32.45) 12.74

Pak Refinery PRL PA Pakistan 1.13 NA 0.03 1.17 - (131.41) (9.38) (36.21)

Median 1.21 4.7 0.07 0.95 5.80 0.96 (4.57) (6.86)

Short Name Ticker Country 1 year Beta P/E P/S P/B Div. Yld. % ROE % ROA % Return

YTD % Total Cote D'ivo TTLC BC BRVM NA 8.42 0.32 1.61 NA 20.69 10.62 7.91

Wintime Energy-A 600157 CH China 1.24 65.58 1.61 9.58 NA 20.70 4.24 41.92

Sinopec Shando-A 000554 CH China 1.06 1,228.51 1.19 4.24 NA 0.39 0.37 7.79

Alexandria Miner AMOC EY Egypt 0.60 5.60 0.60 1.53 NA NA NA 29.97

Reliance Inds RIL IN India 1.14 13.15 1.57 2.27 0.65 18.69 9.69 (0.14)

Indian Oil Corp IOCL IN India 0.50 9.54 0.31 1.37 4.40 21.87 7.36 41.93

Medco Energi Itl MEDC IJ Indonesia 1.01 63.35 1.29 1.34 NA 3.08 1.05 69.82

Energi Mega Pers ENRG IJ Indonesia 1.72 NA 1.88 0.85 NA (33.17) (13.45) (35.31)

Delek Group Ltd DLEKG IT Israel 1.31 14.82 0.20 4.80 NA 38.78 0.92 38.26

KMG Ep RDGZ KZ Kazakistan NA 7.24 2.03 1.11 NA 18.37 14.48 (27.33)

Ikarus Petroleum IKARUS KK Kuwait 0.94 NA 0.78 - (1.13) (0.76) 16.95

Petronas Gas Bhd PTG MK Malaysia 0.64 21.01 5.91 2.33 NA 12.63 10.40 17.87

Oando Plc OANDO NL Nigeria NA 7.52 0.25 1.58 3.23 21.65 3.48 3.13

Petron Corp PCOR PM Philippines 0.50 NA NA 1.55 NA 14.47 4.25 36.02

Rabigh Refining PETROR AB Saudia Arabia 1.26 NA 1.06 3.97 - (16.77) (2.86) (36.62)

Sasol Ltd SOL SJ South Africa 0.97 11.96 1.34 1.91 3.82 17.85 10.55 10.20

PTT Pcl PTT TB Thailand 1.23 11.89 0.38 1.53 NA 16.67 6.55 27.14

PTT Expl & Prod PTTEP TB Thailand 1.14 15.62 3.58 3.15 NA 24.14 11.73 19.40

Petrolimex Petro PLC VN Vietnam 1.39 5.89 0.31 2.62 - 51.69 17.43 102.56

Median 0.98 14.61 0.60 1.60 1.83 11.48 4.18 13.55


Listed Refineries under coverage and BMA Stance

Refineries Last Closing Price (PKR)

Fair Value (PKR) Pot. Upside BMA

Recommendation NRL 262 230 -12% REDUCE

ATRL 124 132 6% ADD

PRL 82 Nil NA SELL

28

November 25, 2010

Outlook: Regulatory risks will continue to result in uncertaininty We maintain UNDERWEIGHT stance on the sector, backed by regulatory risks, circular debt issue and unhealthy GRMs. However, given high demand for POL products and rising import bill for the economy, we may expect some regulatory relaxations by GoP which can bring back refineries to an operational level.

We thus have selective picks from the sector where we highlight ATRL on the basis of its cheap valuations and its non-refinery income. We currently have an ADD stance on the stock on the basis of our DCF-based fair value for the company stands at PKR132/share, offering an upside of 6% from last closing price.

29

November 25, 2010

OMC: VALUE WITH GROWTH The Oil Marketing industry has experienced average CAGR of 5.1% in total sales volume over last 5 year period with major contributor to growth being Furnace Oil (FO) and Motor Spirit (MS) segments.

Pakistan State Oil (PSO) is the major and most dominant player in the market. In terms of volume, the company accounts for 68% of total market share as of FY09, followed by Shell Pakistan (SHEL) 12%, Attock Petroleum (APL) 7% and Caltex 5%.

Market Share; Turning Fortunes Market share of PSO in Furnace Oil (FO) volumetric sales had increased significantly from 81% in FY07 to 89% in FY10. The reason behind this remarkable increase is the unwillingness of other OMCs (APL and SHEL) in supplying FO to the power producing companies, due to the rising circular debt in the value chain.

On the other hand, since FY07 SHEL has lost its share in HSD and MoGas to new OMCs (APL, Admore, Hascombe, Askar and Bosicor) by 405bps and 354bps respectively. 55% of SHEL's volumetric offtakes come from HSD and 19% from MoGas in which it holds the second largest market share. The company however has been reporting consistent declines in its market share across all segments which can also be attributed to a reduction in its number of retail outlets to 839 in Dec09 from 1088 in Jun07.

APL being relatively new OMC has been very aggressive and successful in increasing market share in HSD and MS by 434bps and 205bps over 3 year period to 5.06% and 6.64% in FY10 respectively.

Over the next 5 year period we expect the two largest OMCs (PSO and SHEL) to lose market share in HSD and MoGas (by 800bps and 500bps respectively) to new OMCs (APL, Admore, Hascombe, Askar and Bosicor), as the latter aggressively expand their retail networks. Moreover, resolution of circular debt issue will also encourage APL and SHEL to regain their market share in FO sales.

Turnover Tax Rate Issue Resolved; 2Q to Post a Turnaround As per recent media reports, Ministry of Finance has agreed to reduce turnover tax applicable on OMCs to 0.5%. Previously, FBR in Jul10 had announced increase in turnover tax to 1.0% in its FY11 Budget, which had a significant impact on the OMCs especially PSO and SHEL. To incorporate the change in tax regime applicable from July 01, 2010; PSO recorded tax expense of PKR9bn (49.6% effective tax rate) for FY10 and wrote off PKR2.8bn deferred assets on the company’s balance sheet. On the other hand SHEL also made provisions for tax expense at effective tax rate of ~50%. However, APL remained safe from this change due to its highly profitable business where its corporate tax remained higher than turnover tax.

To incorporate the recent reversal in turnover tax made by FBR, we anticipate one time respective reversal of PKR21.1/share and PKR12.2/share for PSO and SHEL to be booked in 2QFY11.

OMC

OVERWEIGHT

Muhammad Ali Taufiq OMC Analyst

30

November 25, 2010

Circular Debt PSO and PARCO are the major sufferers of ~PKR150bn net inter-corporate circular debt issue, which has brought a lot of friction in the energy chain in the last 3 years. Among the OMCs, PSO is most exposed to this menace; as a result it reported colossal finance costs of PKR9.9bn during FY10 compared to PKR6.2bn during FY09 and a mere PKR1.3bn in FY08. Resolution of the circular debt can improve liquidity and payout of the company. More importantly, it has a potential to reduce annual financial charges for the company by 85%. SHEL and APL on other hand are relatively safeguarded from this trap due to their intentional distance from FO sales and hence, report insignificant amount of financial charges.

At present, we only foresee a gradual resolution of the crisis as electricity tariff hikes start to ease the liquidity crunch in the system.

Power Deficit Calls for Further Demand in FO During FY10, PSO dominated a sizeable market share of 89% in FO sales. Consumption of Black Oil grew by 14% YoY owing to supply constraints for natural gas and reduced hydro-electric potential. PSO therefore continues to benefit most from increasing FO demand from the power sector. With the new IPPs and RPPs coming online, we expect industry FO demand surge to continue with total demand to grow by 10% over FY11.

We believe circular debt in the system should however continue to hold back APL and SHEL from regaining their market share; however any resolution of the issue would encourage these OMCs to re-enter the market. We have thus assumed a conservative market share of 87% for PSO by FY12E.

Rising Sales FO sales experienced staggering CAGR of 16.4% in sales volume over last 5year period, primarily due to increased reliance of power sector on thermal energy and growth in energy requirements of the country. We expect FO volumetric sales to experience CAGR of 3% over next 5 year period. HSD sales volume on average remained flat over the last 5 years, on the back of subsidy elimination on the product. We expect HSD sales volume to experience CAGR of 1% going forward on account of growth in transport sector and increased power outages encouraging HSD usage for private generators.

MS sales have experienced CAGR of 4.3% in sales volume over last 5year period, due to 1) growth in transport sector, 2) reduced price differential between MS and CNG and high convenience yield attached to MS and 3) increased power outages. We expect MS sales volume to experience CAGR of 3.0% going forward.

JP’s volumetric sales remained flat over the last 5 year period. Growth in exports have been offsetting fall in domestic sales. We expect JP sales volume to experience meager CAGR of 0.8% going forward.

Regional Comparison: Attractively Positioned Listed OMCs of Pakistan, trade at significant discount on PER basis compared to their regional peers. PSO, APL and SHEL currently trade at FY11E PER of 4.6x, 6.2x and 7.4x respectively, while the regional median is 17.3x. Further, PSO, APL and SHEL have 1year beta close to that of their regional peers, while

31

November 25, 2010

their ROE and ROA are significantly higher than regional average. Dividend yield for PSO, APL and SHEL also stand at 3%, 10% and 8% respectively compared to regional peers’ average of 3%.

The regional oil companies represent a useful benchmark for the local market, however it should be noted that most of these companies are integrated oil and gas companies having both refinery and marketing operations (midstream and downstream). Refineries globally are trading cheap due to concerns emanating from abysmal GRMs, therefore most of the regional peers (mentioned in the table below) already reflect substantial discount to their respective markets. PSO, APL and SHEL however are structurally different from their regional peers with their operations only limited to oil marketing; yet they are currently trading at substantial discount of 76%, 67% and 52% on FY11E PER basis respectively, which makes the sector even more attractive.

Regional Valuations

Short Name Ticker Country Beta:Y-1 P/E P/B P/S Dvd Yld % ROE % ROA % Return YTD %

Pak State Oil PSO PA Pakistan 1.12 4.57 1.30 0.06 3.00 36.05 5.09 (8.96)

Attock Petroleum APL PA Pakistan 1.03 6.19 2.02 0.20 10.35 44.05 18.10 11.86

Shell Pak -Pbs SHEL PA Pakistan 0.87 7.37 1.48 NA 8.20 17.40 4.17 (18.78) Shenzhen Guang-A 000096 CH China 1.14 64.07 1.92 2.41 NA 3.72 3.43 (3.73)

Oriental Energ-A 002221 CH China 1.17 68.29 3.98 1.22 NA 6.75 2.07 0.98

Gail India Ltd GAIL IN India 0.75 18.68 2.92 2.03 1.83 20.04 10.20 19.99

Bharat Petrol BPCL IN India 0.57 15.95 1.32 0.15 2.70 11.89 2.82 15.42

Essar Oil Ltd ESOIL IN India 1.17 523.85 3.53 0.45 - 0.77 0.14 0.68

Hindustan Petro HPCL IN India 0.60 11.18 0.88 0.10 3.77 12.60 2.78 27.72

Confidence Petro CONF IN India 0.86 19.91 0.77 0.38 NA NA NA 132.29

Elnusa ELSA IJ Indonesia 1.07 NA 1.47 0.56 NA 1.39 0.67 4.29

Petronas Daganga PETD MK Malaysia 0.85 14.57 1.96 0.44 NA 16.37 10.16 31.70

Petron Corp PCOR PM Philipines 0.50 NA 1.55 NA NA 14.47 4.25 36.02

An Pha Petroleum ASP VN Vietnam 1.12 27.11 1.27 0.16 - 2.68 0.75 (31.02)

Regional Median 0.95 17.31 1.68 0.41 2.85 12.60 3.43 8.07 Source: BMA Research

OVERWEIGHT stance maintained

We maintain OVERWEIGHT stance on the sector, backed by cheap valuations and growing offtakes for furnace oil and motor gasoline. However the sector is faced by various challenges such as the circular debt issue. Given our assumptions of gradual ease of the issue over the next 5 year period, we expect the sector to experience significant improvement over the next decade and hence maintain our bullish stance on the sector.

APL is attractively valued with FY11E PER and dividend yield of 6.2x and 8.4% respectively. Our fair value for the stock stands at PKR426/share reflecting an upside of 33%; we maintain the stock amongst our high conviction investment ideas.

According to our estimates, PSO is also attractively valued with FY11E PER of 4.6x. Moreover, with our fair value of PKR361/share reflecting 27%, we maintain our BUY stance on the stock.

32

November 25, 2010

On the other hand, we remain unimpressed by SHEL owing to its premium valuations (CY10E and CY11E PERs of 17.0x and 7.4x respectively) and limited growth story.

33

November 25, 2010

Stock Statistics

Ticker APL

3-month High/ Low 320.5/236.2

Mkt Cap USD mn 259

12M ADT mn shares 0.16

Beta 0.97

APL: SHINING STAR INVESTMENT SUMMARY

Expanding market share: Attock Petroleum Limited (APL) is the 4th largest Oil Marketing Company (OMC) in Pakistan. During the last 3 years APL has increased its number of retail outlets at a CAGR of ~15% and now operates 277 retail outlets. In terms of volumetric sales, APL accounts for 7.0% of total market share and has witnessed rapid volumetric growth in sales during FY10 of around 87% and 67% for Motor Spirit (MS) and High Speed Diesel (HSD) respectively, compared to industry average of 27% and -3% respectively.

Market leader in Asphalt: Currently APL is the only OMC which markets Asphalt and hence it holds significant monopoly in the market. Asphalt sales volume has experienced 5year CAGR of ~2.3% and contributes ~40% towards APL’s total gross profit. APL has significant synergies with the Asphalt producing refineries associated with Attock Group of Companies which places it in an even more attractive position.

Relative hedge from circular debt: Being a non-government entity, APL chose to keep itself away from circular debt menace. APL had to pay the cost for this choice by losing market share by 280bps (from 7.32% in FY07 to 4.52% during FY10) in furnace oil (FO) segment. However benefits obtained were prevention of rising financial charges and increased concentration on retail network expansion. Nonetheless, as circular debt issue eases off, APL can benefit by regaining its market share in the segment, thus providing upside risks to our future volumetric projections.

Outlook: On a broader level, we expect sales of energy products to rebound in post-flood scenario and additional growth in Asphalt sales on the back of increased infrastructure rebuilding activity. APL being the major stake holder in sale of non-energy products will significantly benefit for the rest of the year. There onward we expect modest CAGR of around 2% in volumetric offtakes of Asphalt to continue as domestic economy gets back on track. We expect sales volumes of MoGas for APL to cross 110,000 MT mark by FY11 due to 1) persistence in power outages, 2) continued growth in transport sector and 3) expansion in its retail network.

Compelling Valuations: APL currently offers an upside potential of 33% to our DCF-based fair value of PKR426/share; and is attractively valued with FY11E PER of 6.2x. We maintain the stock amongst our High Conviction Ideas.

Financials

FY10A FY11E FY12E

EPS(PKR) 52.0 51.8 51.9



EPS Growth (%) 16.6 -0.4 0.2




BUY Fair Value: PKR 426 Current Price: PKR 320


APL Profile: Attock Petroleum Limited (APL) is the 4th largest Oil Marketing Company (OMC) in Pakistan. During the last 3 years APL has increased its number of retail outlets with CAGR of ~15% and now operates 277 retail outlets. APL deals in various POL products and is the sole OMC to deal in Asphalt. In terms of volumetric sales, APL accounts for 7.0% of total market share. The rapid growth in its volumetric off-takes and retail network speaks its success story.


Others10%

Asso. Cos.66%

Local & Foreign Public, Cos. 4%

Directors and CEOs

7%

FI's13%

200

230

260

290

320

350

Nov

-09

Dec

-09

Jan-

10Fe

b-10

Mar

-10

Apr

-10

May

-10

Jun-

10Ju

l-10

Aug

-10

Sep

-10

Oct

-10

Nov

-10

0.00.20.40.60.81.01.21.4


34

November 25, 2010

ELECTRICITY: GUARANTEED RETURNS

Supply Demand Situation to Remain Under Stress: Opportunities Galore! Energy (electricity) plays a vital role in the growth of an economy which however remained ignored during the previous economic boom. The deterioration of infrastructure and increase in electricity demand consequently resulted in an average gap of over 3,000MW in FY10. Pakistan’s current installed capacity is estimated to be at 21,000MW with majority contributed by thermal sources (67%), followed by Hydel at 31% and Nuclear at 2%. However, after accounting for forced outages, lower available capacities and inefficiencies arising from circular debt issue, the total generation capability is estimated to be at 16,000MW. Moreover, seasonal availability of hydel sources of generation reduces the overall capacity to 13,000MW during winter months.

Electricity Supply by Installed Capacity

Source: PPIB, Energy Yearbook, BMA Research

With economy projected to grow at an average of 4.0% in the next three years, electricity demand is expected to follow its historic average of 6.0%. Thus the electricity supply deficit looming at an average of 3,000MW in the peak season is not only a cause of concern but it also highlights an area of opportunity for investments. The government has already started taking measures and has enhanced incentives for the Independent Power Producers (IPPs) operating in the private sector. These include emphasis on low cost thermal alternatives i.e. generation on coal within the thermal chain and exploiting sources of hydel generation at the same time.

Electricity Demand-Supply Situation

ELECTRICITY

OVERWEIGHT

Nurali Barkatali Power Analyst

Source: PPIB, Energy Year Book, BMA Research

-

5,000

10,000

15,000

20,000

25,000

30,000

FY04

A

FY05

A

FY06

A

FY07

A

FY08

A

FY09

A

FY10

A

FY11

E

FY12

E

FY13

E

FY14

E

FY15

E

Hydel Thermal (WAPDA) Thermal (KESC) Thermal (IPPs) Nuclear

-

5,000

10,000

15,000

20,000

25,000

30,000

FY04

A

FY05

A

FY06

A

FY07

A

FY08

A

FY09

A

FY10

E

FY11

E

FY12

E

FY13

E

FY14

E

FY15

E

(MW

)

Available Supply Demand

35

November 25, 2010

The Flood Aftermath: Blessing in Disguise Recent floods in the country adversely affected the electricity T&D infrastructure and power plants; but a swift response by PEPCO resulted in a complete restoration of the electrical network as well as the power plants with the only exception being AES PakGen with a capacity of 327MW.

On the flip side, abundance of water has resulted in increased capacity utilization of hydel electricity generation. At present, utilization of hydel resources stands at approximately 89% i.e. 5,700MW from an estimated 4,350MW in Jun10 which has also brought down the average electricity cost of power generation.

Guaranteed Rate of Return: 15% for Thermal, 17.5% for Hydel and 21% for Coal Supply deficiency in the country and promising upside in the sector are ideal conditions for investment into the sector; government guarantees 15% USD IRR to the thermal IPPs along with pass-through of all major expenses including fuel costs. The investment acts as a perfect hedge against PKR depreciation with indexation factor based in USD and scalable with US CPI.

Moreover, with increasing reliance on thermal based power generation and resultant pressure on foreign currency, the government has laid out an even higher indicative USD IRR for hydel generation at 17%; Hub Power Company (HUBC) has taken the lead and through its subsidiary, Laraib Energy, is setting up an 84MW hydel plant. Furthermore, for the exploitation of vast coal reserves of ‘Thar desert’ in Sindh province and power generation from them, government is offering a 20.5% IRR to the companies achieving financial close before December 31, 2015 (with additional 0.5% IRR for firms achieving financial close by or before December 31, 2014).

Outlook: Attractive Dividend Yields, Inter-Corporate Debt a Concern though Rising oil prices and inability of the previous government to pass on the impact to end consumers led to a serious buildup of inter-corporate debt (ICD) in the system by the end of 2008. Additionally, line losses, inefficient distribution networks and inability of WAPDA to collect dues from their customers have continued to balloon the outstanding amount. Hence despite commitments with the IMF and disbursement of over PKR300bn by the government, the outstanding net amount is still estimated to be in the north of PKR150bn (USD1.7bn).

As a consequence, IPPs continue to face liquidity crunch (as WAPDA curtails its payments) while furnace oil supply shortage (PSO facing similar liquidity problems) lead to lower load factor. While returns are guaranteed for IPP investors, cash flow constraints remain a concern – raising flags on the ability of IPPs to continue to distribute generous dividends.

We believe the problem may persist in the sector for the time being, however the gravity of the situation will be reduced following the recent and upcoming hikes in power tariffs. Accounting for all the aforementioned arguments, we are still bullish on the power sector specifically in companies where we see sustained growth and continued ability to pay out dividends i.e. HUBC.

36

November 25, 2010

Regional Valuations

Short Name Ticker Country ROE % ROA % P/E P/B Dvd Yld %

Hub Power Co. HUBC PA Pakistan 19.5% 4.4% 7.3 1.4 13.6%

Kot Adudu Power Co. KAPCO PA Pakistan 24.6% 7.0% 5.6 1.5 14.5%

Reliance Power Ltd RPWR IN India 3.9% 3.7% 62.3 2.7 N/A

Torrent Power Ltd TPW IN India 26.0% 10.8% 12.2 2.9 1.1%

Reliance Infrastructure Ltd. RELI IN India 7.8% 3.3% 14.2 1.06 1.1%

GD Power Development Co. 600795 CH China 9.1% 2.0% 23.7 2.1 1.3%

Shenergy Co Ltd 600642 CH China 9.0% 6.0% 17.1 1.5 2.5%

BEIJING JINGNENG 600578 CH China 16.3% 4.3% 20.3 3.1 1.5% Source: BMA Research

37

November 25, 2010

Stock Statistics

Ticker HUBC

3-month High/ Low 36.7/ 32.9

Mkt Cap USD mn 497


Beta 0.80

HUBC: FOR EVER AND A DAY INVESTMENT SUMMARY

Expansion, from strength to strength: Domestic electricity demand currently outstrips supply, as the gap is estimated at over 3,000MW. The situation raises grave concerns for economic growth but highlights potential opportunities for select players. HUBC is all set to capitalize on this opportunity with two additional power projects i) 225MW Narowal Power project and ii) 84MW Laraib Power Project in the pipeline.

While Narowal Power Project got delayed by ten months, it is expected to be commissioned by 3QFY11. The company has negotiated financial settlements with the EPC Contractor which are expected to be high enough to cover Liquidated Damages payable to WAPDA and other costs. Hence, unless there is a wavier extended by the GoP/WAPDA, the company will be required to abide by the contractual liability of paying Liquidated Damages (LD) at the rate of USD17,800/day.

The company is also the first in the private sector to venture into hydel power generation via its 75% recent acquisition of Laraib Energy Limited, located in Azad Kashmir. Based on envisaged 70:30 debt to equity ratio, the management plans to employ internally generated cash for equity investment and is well positioned to capitalize on 17% USD IRR guaranteed by the government. The plant is expected to come online in FY13 and will start adding to shareholder value from then onwards.

Tariff and indexation factors; hedged bets: Given the U-shaped tariff structure of Power Purchase Agreement (PPA) governing HUBC, Dec06 marked the trough for Project Company Equity (PCE) laid out for the company. Since then, the rise in PCE has been and is projected to result in increasing tariff and payout for HUBC. Additionally, with the tariff indexed in USD, any depreciation in PKR is projected to translate into proportional increase in bottom-line, cash payouts and fair value for the company.

Moreover, with debt repayment schedule being front-loaded for IPPs, HUBC has already retired the principal portion of its long-term debt for its original plant of 1,292MW. The remaining portion will be completely retired by FY16 – allowing the company to take additional debt for its upcoming expansions as well as sustain its dividend stream going forward.

Dividend payout, as fit as a fiddle: We have already priced in Narowal project’s delay implications, based on which our DPS projections stand at PKR5.0 and PKR5.5 for FY11E and FY12E, respectively. Current prices thus still reflect attractive prospective dividend yields of 14% and 15% respectively. In addition, the stock offers USD based IRR of 16% and reflects 8% upside to our DDM based fair value of PKR40/share.

Financials

HUBC Profile: HUB Power Company is an Independent Power Producer. Its principal business activity is to own, operate and maintain furnace oil based power generation. With current installed capacity of 1,292MW, the company is the second largest IPP of Pakistan.

HUBC is in the process of setting up an additional 225MW thermal power plant at Narowal along with a 75% controlling stake in Laraib which is to set up an 84MW Hydel power project by FY13.

FY10A FY11E FY12E

EPS(PKR) 4.8 5.1 6.4


Dividend Yield (%) 13.6 13.6 14.6

EPS Growth (%) 46.9 5.3 27.2


Current Ratio 1.0 1.0 1.0


ADD Fair Value: PKR 40 Current Price: PKR 37


20

25

30

35

40

Nov

-09

Dec

-09

Jan-

10Fe

b-10

Mar

-10

Apr

-10

May

-10

Jun-

10Ju

l-10

Aug

-10

Sep

-10

Oct

-10

Nov

-10

024681012



FI's23%

Joint Stock Cos.43%

Inv. Cos, Ins. Cos., Mod., MF, Leas. Cos.

12%

Individuals14%

Others8%

38

November 25, 2010

FERTILIZER: STILL FAVORED! Classifying Pakistan as an agrarian economy is justified considering that agriculture and livestock accounts for over 22% of the country’s GDP, while it provides employment to over 55% of the country’s labor. With a population of over 170mn people (and a growth rate of over 2.2% p.a.) Pakistan has approximately 3.5mn additional people every year which require a balanced nutritional diet. In such a situation fertilizer sector becomes integral to the economy in the short, medium and long term.

Listed Capacities of Fertilzier in the Country by CY11 (mn tons)

Floods; Wash Away of Demand only Temporary Pakistan’s nutrient consumption has shown a CAGR of nearly 9% for the last 5 years, with particularly more rapid growth during the last 2 to 3 years on account of high support prices for crops and an unabated demand from consumers.

Long Term Trend in Nutrient Demand Remains Intact


Although fertilizer demand is likely to be hurt during CY10E where we expect Urea and DAP to witness a contraction of around ~10% and ~30% for the year. However at the same time Urea and DAP have shown a consistent rise in prices off late. Further, we expect any shortfall in demand to be transient where the sector is likely to resume its long term trajectory from CY11E onwards.

FERTILIZER

MARKETWEIGHT

Omar Rafiq Fertilizer Analyst

mtpa Urea CAN NP/NPK DAP SSP Total (N:P:K)

FFC 2.40 2.40

ENGRO 2.28 0.13 2.41

FFBL 0.55 0.67 1.22

PFL 0.11 0.45 0.30 0.86

Fatima 0.50 0.42 0.66 1.58

Agritech 0.49 0.18 0.67

DAWH 0.48 0.48

Total 6.81 0.87 1.09 0.67 0.18 9.62


-

0.5

1.0

1.5

2.0

2.5

3.0

3.5

FY73

FY75

FY77

FY79

FY81

FY83

FY85

FY87

FY89

FY91

FY93

FY95

FY97

FY99

FY01

FY03

FY05

FY07

FY09

Nitrogen Phosphate

Previous floods in Pakistan

39

November 25, 2010

Pricing Power Remains the Play While the government subsidizes urea producers through cheap allocation of feed stock gas price, fertilizer prices in Pakistan remain at a discount over and above the value of the subsidy provided. Annual appreciation of prices has mirrored and some times exceeded cut in subsidy allocation to the fertilizer companies which has allowed the companies to remain economically attractive for investors.

Subsidy Allocation and Discount to Regional Prices (USD/ton)


Outlook: Mirroring International Prices - DAP Remains our Favoured Play Although Urea remains a favoured fertilizer of farmers in the country, we believe that contracting pricing differential between DAP and Urea is likely to result in a much more balanced fertilizer usage over the coming years. As a result we expect DAP sales to remain strong given that wheat’s (primary crop of importance related to DAP offtake) indigenous demand is likely to grow going forward.

Fauji Fertilizer Bin Qasim (FFBL) continues to remain the sole DAP producer in the country with a name plate capacity of 0.67mn tons for DAP. Current and future demand of DAP is likely to be significantly above the domestic production

200

6

8

Local price Subsidy Excess discount over Subsidy

Demand and Supply Outlook: Urea (mn tons) Demand and Supply Outlook: DAP (mn tons)

Source: BMA Research Source: BMA Research

0.01.02.03.04.05.06.07.08.0

CY0

6A

CY0

7A

CY0

8A

CY0

9A

CY1

0E

CY1

1E

CY1

2E

CY1

3E

Urea demand Urea Production

-0.20.40.60.81.01.21.41.61.82.0

CY0

6A

CY0

7A

CY0

8A

CY0

9A

CY1

0E

CY1

1E

CY1

2E

CY1

3E

DAP demand DAP Production

40

November 25, 2010

capacity which is contrary to medium term outlook of urea. FFBL is thus our top pick from the sector with a fair value of PKR35/share and is currently trading at CY10E and CY11E dividend yield of 14% and 16% respectively.

Regional Valuation

.

Company Name Country ROA ROE PBV PER Dividend Yield

Petrovietnam Fer Vietnam 22.5 26.8 2.1 8.7 -

Sinochem Intl-A China 4.3 14.9 2.3 19.8 -

Natl Fertilizers India 6.1 11.2 3.1 35.1 1.1

Rashtriya Chems India 4.7 13.4 2.4 23.2 1.4

Chambal Fertiliz India 3.9 15.9 2.3 15.8 3.1

Gujarat State F India 9.2 22.3 0.9 9.4 2.6

Nagarjuna Fert India 1.3 3.5 0.7 21.8 1.6

Aditya Birla Che India 17.7 25.7 0.6 4.5 1.9

Bharat Fert India 19.7 86.4 2.6 8.6 -

Fauji Fertilizer Pakistan 22.9 67.4 5.7 8.5 11.8

Fauji Fert Bin Qasim Pakistan 11.9 35.4 2.96 8.4 11.8

Engro Corp Pakistan 3.5 13.8 2.2 16.1 3.0

Maximum 22.9 86.4 5.7 35.1 11.8

Minimum 1.3 3.5 0.6 4.5 -

Average 10.6 28.1 2.3 15.0 3.2

Source: Bloomberg, BMA Universe

41

November 25, 2010

Stock Statistics

Ticker FFBL


Mkt Cap USD mn 371


Beta 1.05

FFBL: PHOSPHATE ADVANTAGE INVESTMENT SUMMARY

DAP Advantage: Compared to other fertilizer manufacturers, Fauji Fertilizer Bin Qasim is the sole DAP producer of Pakistan. The company currently has a productive capacity of 0.67mn tons of DAP p.a. which is less than 50% of the annual demand. DAP is primarily used in winter season (especially for wheat). With a growing population (170mn people; growth rate of 2%p.a.) and wheat being the main staple diet across the country, DAP demand is only expected to increase going forward which bodes well for the company as it mitigates urea capacity overhang risk.

Mirroring International Prices: Contrary to local prices of Urea, DAP prices for FFBL mirror international prices as the government does not allocate any subsidy on the main input of DAP (phos-acid). As a result, DAP margins are well above those gained through production of urea by its competitors. Currently, DAP core margins stand at USD234/ton in the domestic market compared to urea’s core margins of only USD140/ton. With a relatively inelastic demand from the local agrarian economy (as a result of high farming margins), price increase is likely to have a positive impact on earnings of the company as fixed costs remain stable.

Wheat Support Price: Government of Pakistan has been very generous with regards to setting a support price for wheat in the domestic arena. Wheat support price currently stand at PKR950/mound which is approximately 22% premium to internationally traded wheat prices. High support prices together with no agrarian tax system allow for farmer margin improvement and have resulted in robust growth of fertilizer demand.

Dividend Yield King: Fauji Foundation’s indirect holding of FFBL has been a boon for other investors. The foundation’s cash requirements are met with dividends from its undertakings, with FFBL being no different. Currently FFBL is the highest dividend yielding stock in the BMA Universe with CY11E expected dividend yield of ~16%. FFBL has maintained a payout ratio in excess of 95% for the last 5 years.

Financials



EPS(PKR) 4.1 4.8 5.4 5.4

Price to Earnings (x) 8.4 7.0 6.3 6.3

Dividend Yield (%) 11.8 14.0 15.8 15.6

EPS Growth (%) 30.5 19.2 11.9 -0.6

Return on Equity (%) 35.4 47.5 51.4 50.7

Return on Assets (%) 10.4 14.2 15.7 15.0



FFBL Profile: Fauji Fertilizer Bin Qasim (FFBL) is the sole DAP and granular urea producer of Pakistan. The company is located in the south with a total fertilizer capacity of nearly 1.2mtpa. The company is part of the Fauji group of Pakistan. FFBL has also managed to improve its supply chain by entering into a JV with the Moroccan government for the production and marketing of Phos-acid. Currently the company is one of the best dividend yielding stock in the sector.


Others6%

Joint Stock Cos. 53%

Fin. Ins. & MF 9%

Charitable Trusts18%

Individuals

14%

20

25

30

35

Nov

-09

Dec

-09

Jan-

10Fe

b-10

Mar

-10

Apr

-10

May

-10

Jun-

10Ju

l-10

Aug

-10

Sep

-10

Oct

-10

Nov

-10

0

10

20

30

40

50


42

November 25, 2010

CONSTRUCTION & MATERIALS: LOOKING FOR VALUE? GO NO FURTHER! Cement sector of Pakistan has gone from a radical increase in demand to a situation of an over capacity conundrum of late. Domestic demand has remained stifled by fledging real estate prices as well as astronomical mortgage charges due to a high interest rate environment. From a broader prospect however, the country continues to have one of the lowest cement per capita consumption in the world standing at merely 130kg/capita compared to world average of over 300kg/capita and much less than China’s boisterous 1,100kg/capital consumption.

Capacity Overhang Remains a Concern Pakistan’s cement production capacity has shown remarkable growth over the last 7 years; demonstrating a CAGR of 14% over the period. However, offtake growth remains stifled by high construction costs and low infrastructure development impetus.

Cement Demand and Capacity – (mn tons)


Pakistan Remains the Cheapest whilst Maintaining International Standards Pakistani cement continues to remain one of the lowest priced cement in the region, despite meeting international standards (ASTM, BS etc.). Cost advantage stems from the fuel mix utilized (primarily coal) and introduction of Waste Heat Recovery power generators in the production process. Some manufacturers are also contemplating on induction of RDF (Refuse Derived Fuel) power plants on premises so as to reduce reliance on ever expensive power.

Pakistan cement currently trades at USD50-55/ton net of shipping charges compared to regional pricing of around the USD65/ton mark. As a result Pakistan has hovered between the 5th and 6th largest cement exporter (with sales of over 10.5mn tons) of the world despite prevailing cement over capacity in KSA and UAE.

CONSTRUCTION & MATERIALS

MARKETWEIGHT

Omar Rafiq Cement Analyst

-5

101520253035404550

FY04A FY05A FY06A FY07A FY08A FY09A FY10A FY11E FY12E FY13E FY14E

Local demand Export demand Capacity

43

November 25, 2010

Export Demand Pakistan’s location, next to deep sea, warm water ports, proximity to growth oriented economies (India, China, Sri-Lanka and MENA) and countries under reconstruction and development (Afghanistan and Iraq) allows it to tap these economies with its product. Further initiatives from the private and public sector companies to develop coal and clinker terminals at Karachi port, bodes well for local cement manufacturers as developments along these lines are likely o reduce shipping, storage and handling costs.

Moreover, consistent depreciation of PKR against USD further strengthens retentions for cement companies back home. A prime example of which is Lucky Cement (LUCK) which is the largest cement exporter of Pakistan accounting for nearly 35% of cement exports from the country.

Infrastructure Development: Opportunities and Risks go Hand in Hand While a growing population and consistent growth in trade warrants undivided and progressive outlook, the same has not been provided. Lack of infrastructure development has constantly stifled economic growth trends, whether it originates from lack of water reservoirs, dams, canal upgrade to bridge, road network and port developments. Pakistan’s geographical advantage remains untapped.

Agrarian Demand It goes without saying that Pakistan’s burgeoning population (growth rate in excess of 2% p.a.) leads many more mouths to feed on an annual basis. Consistent increase in food demand requires attention to be paid to building of reservoirs and dams. Current list of economically viable Dams include Daimer-Bhasha, Munda, Gomal-Zam, Satpara dams, however work on the same remains perpetually delayed due to lack of available funds. Moreover, the recent floods are likely to further constrain the government’s ability to fund any major development in the short to medium term.

Trade and Commerce Demand Pakistan’s geographical importance in relation to trade and commerce continues to be highlighted regularly; however major development along the same lines has been very slow. Pakistan’s territory provides a viable conduit for transport of energy from Central Asian countries to industrially booming India and China. Further, the Gawadar port can offer alternative route to tap the markets located in Central Asia for foreign products. However port development in Gawadar continues to remain extremely slow paced.

Demand has to be Catered to in the Coming Years Domestic cement demand continues to be flogged to stand still at around 20-22mn tons as development plans continue to be slowed down. Demand which exists however can not be swept under the carpet for too long and is likely to resurface in the medium to long term as housing demand from a growing population stems in along with an ever increasing demand for food and other infrastructure.

44

November 25, 2010

Thus despite capacity over hang issues, high debt levels and corresponding financial charges, our pick from the sector remains Lucky Cement (LUCK) which is currently one of the lowest cost producer of cement.

Regional Valuations

Outlook: Sector Remains Vulnerable but Select Companies still Attractive Much of the capacity expansion in the early part of the last decade has resulted in cement companies suffering from excess leverage. With high interest rate environment, much of the profitability has been eroded by increasing financial charges. However Pakistan’s cement manufacturers currently trade at an EV/ton of ~USD45/ton compared to regional average of USD70/ton and hence we believe that the risk has been priced in.

While D.G. Khan Cement (DGKC) provides significant upside potential to our fair value - PKR40/share for the stock, we need to highlight that nearly 52% of the fair value is derived from its equity portfolio (taken at 50% discount to market value as in the case of closed ended mutual funds). Further DGKC’s leverage has resulted in significant financial charges which are to erode profitability in the medium term.

However companies such as Lucky Cement (LUCK: Fair value: PKR79/share) remains our pick from the sector, as it has managed to successfully and significantly deleverage itself of late. Further, the company’s revenues are highly denominated in USD as it remains the single largest exporter of cement with a market share of nearly 35% in exports.

Company Name Country PER (x) PBV (x) Div Yield (%)

Indocement Tungg Indonesia 20.7 5.5 -

Holcim Indonesia Indonesia 18.7 4.7 -

Hatien 1 Cement Vietnam 6.6 1.2 -

But Son Cement J Vietnam 7.4 1.1 -

Hoang Mai Cement Vietnam 4.6 1.2 8.8

Ultratech Cement India 12.5 3.1 0.5

Ambuja Cements India 17.5 2.5 2.3

ACC Ltd India 11.8 2.8 2.6

Siam City Cement Thailand 17.7 2.9 -

Republic Cement Philippines 9.8 1.1 6.6

Lafarge Malayan Malaysia 18.9 1.9 -

D G Khan Cement Pakistan 44.8 0.2 -

Lucky Cement Pakistan 7.8 1.0 5.3

Maximum 44.8 5.5 8.8

Minimum 4.6 0.2 -

Average 15.3 2.2 2.0

Source: Bloomberg, BMA Research

45

November 25, 2010

Stock Statistics

Ticker LUCK


Mkt Cap USD mn 296


Beta 1.09

LUCK: SIZE DOES MATTER INVESTMENT SUMMARY

Location Advantage: Lucky Cement (LUCK) is the only cement manufacturer in the country with plants located both in the north and the south region of the country. The company’s unique location proposition allows for easy tapping of localized demand as well as managing logistical advantage on large scale projects. With rising transportation charges, logistical advantage is integral to retaining margin levels.

Low Leverage: LUCK has promptly and considerably reduced its leverage of late due to high interest rate environment. The company currently is one of the lowest leveraged companies in the sector. Lower degree of financial leverage bodes well for the company given that interest rate environment is unlikely to ease in the short to medium term. Further most (~74%) of the company’s outstanding debt is composed of ‘Export Refinance’ which is charged currently at 9.5% p.a. at a discount of 400bps from the prevailing discount rate.

Cost Reduction a case of Introspection: Nearly all cement companies in Pakistan currently utilize imported coal (anthracite) to fulfill energy requirements. As a result of a weakened PKR against the green back, as well as an overall general rising trend in energy products, energy costs for cement sector has increased significantly over the years. (From PKR1,267/ton during FY06 to PKR2,249/ton currently). LUCK is currently in the process of installing its WHR (Waste Heat Recovery) power plants which are expected to reduce dependence on purchased electricity by 20-22% on a YoY basis. Further the company is in the process of supplementing imported coal with domestically produced coal which is likely to improve margins as the company will likely benefit from lower cost of freight and lower prices of local coal.

Exports: LUCK is the largest cement exporter of the country, with a market share of nearly 35%. Here too the company’s unique location proposition comes to play. The proximity of the Karachi plant to the sea port allows the company lower inland freight charges on exports which significantly improve margins compared to its peers, while its Pezu plant in the north allows for exports to Afghanistan. Further, LUCK is the only company in the cement sector with access to a 25kton silo on Karachi port which increases efficiency and reduced costs; a fact which is displayed by the company’s market share of nearly 100% in bulk cement exports.

Financials


LUCK Profile: LUCK is the largest cement producer of Pakistan with a name plate capacity of nearly 7.5mtpa. The company has plants located both in the north and south of the country (Karachi and Pezu) and is therefore able to cater to geographically desperate demand in a cost efficient manner. The company is conducting efforts to reduce its reliance on ever increasing energy costs by instituting Waste Heat Recovery plants

FY10A FY11E FY12E

EPS(PKR) 9.7 12.5 17.6



EPS Growth (%) -31.7 29.2 40.5






Others17%

Directors & CEOs

30%

Local and Foreign Public31%

Asso. Cos.10%

Fin. & Non Fin.

Ins12%

50

60

70

80

90

Nov

-09

Dec

-09

Jan-

10Fe

b-10

Mar

-10

Apr

-10

May

-10

Jun-

10Ju

l-10

Aug

-10

Sep

-10

Oct

-10

Nov

-10

0

2

4

6

8

10

12


46

November 25, 2010

FIXED LINE TELECOMMUNICATION: TA(L)KING TO NEW HEIGHTS! Pakistan witnessed phenomenal growth in telecommunciation penetration in the last 5 years. Increasing per capita income and declining charges have resulted in cellular penetration of nearly 62.5% (~100mn subscribers) by the end of FY10. Despite growth in basic telephony slowing down, value added services at the moment continue to drive growth for the companies.

Cellular Subscribers Trend

Source: PTA, BMA Research

Broad Band Subscribers Trend

Source: PTA, BMA Research

USF: Reaching Out Growth in telecom has been further aided by a joint initiative of the government and the private sector by the set up of the Universal Service Fund (USF). USF is designed to improve, upgrade and expand infrastructure required to increase coverage. Nearly all telecommunication companies have taken advantage from the USF program. The returns on investment are likely to kick off by FY11-12E.

Rooting Out the Grey: Efforts to Reduce Grey Telephony Concerns While telecommunication growth has been rampant in Pakistan, concerns of grey traffic in the Long Distance International (LDI) business line have repeatedly hurt profitability. Pakistan Telecommunication Authority (PTA) has recently initiated drive to locate and remove illegal gateways. The initiative has been successful with over seven illegal exchanges being eliminated. However

FIXED LINE TELECOMMUNICATION

MARKETWEIGHT

Omar Rafiq Telecom Analyst

0

20

40

60

80

100

120

FY04

A

FY05

A

FY06

A

FY07

A

FY08

A

FY09

A

FY10

A

FY11

E

FY12

E

FY13

E

FY14

E

FY15

E

mn

0.000.200.400.600.801.001.201.401.601.80

Total Growth rate

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

FY06A FY07A FY08A FY09A FY10A FY11E FY12E FY13E FY14E FY15E

mn

0%

50%

100%

150%

200%

250%

300%Total Growth rate

47

November 25, 2010

concerns still remain as nearly 20% of the inflows of LDI minutes go unaccounted.

Regional Valuations

Outlook: The Future Still Looks Bright despite Slight Saturation Although on an initial front, the telecom sector seems to be saturated with growth on a decline, Pakistan’s telecom numbers do not depict the true potential of latent value added services. The government is already considering issuance of 3G licences, which bodes especially well for the cellular segment which can tap into the market with newer products catering to high ARPU (Average Revenue Per User) segment. As yet, Pak Telecom (PTC) remains our pick from the sector due to its first mover advantage in various geographic regions, strong balance sheet and being the market leader in nearly all segments it operates in.

.

Company Name Country PER (x) PBV (x) Dividend Yield (%)

Telekomunikasi Indonesia 16.4 3.8 0.3

Fpt Corp Vietnam 11.4 3.6 -

Time Dotcom BHD Bangladesh 1.4 1.0 -

Telekom Malaysia Malaysia 16.7 1.6 -

Digital Telecom Philippines 9.6 6.4 -

Pakistan Telecom Limited Pakistan 10.8 1.0 8.9

Maximum 16.7 6.4 8.9

Minimum 1.4 1.0 -

Average 11.1 2.9 1.5

Source: Bloomberg, BMA Research

48

November 25, 2010

CHEMICALS: CAN DO A LOT MOR’! Chemicals generally act as inputs for the production of a number of commodities of daily use. The industry is highly scientific in its approach and facilitates the provision of many of the important chemicals to various industries including paper and board, leather, paint, textile, sugar, cement and others. Therefore, the chemical sector stands as the keystone of an economy’s agrarian and industrial development which provides support for other industries. Furthermore, the advancement in chemical technology and industry, has converted it into a basic industry of primary importance. In Pakistan, there are 27 listed companies in the chemical sector out of which only 14 or 15 are actively traded on the KSE. We highlight here some of the key companies in the country and the products they manufacture:

Key players in the industry


Industry Dynamics: Small and Protected Pakistan’s import of agri and other chemicals amounted to USD5.3bn in FY10 which represents 17% of country’s total imports. It has grown by 52% compared to imports in FY05 (USD3.5bn) and by 6% YoY from USD5bn in FY09. We believe it clearly signals to the potential for the domestic industry to grow. However, it is imperative for the chemical sector to have a sustainable demand from the downstream industry to register sizeable growth.

It has also been observed that locally manufactured chemicals are costlier compared to imported ones where the latter remain cheaper even after adding import duties. This has been true for imports from China and other Far Eastern countries for products such as hydrogen peroxide (HP) and polyester staple fibre (PSF). To counter this and protect the local industry at the same time, the government has taken a number of protectionist measures for the industry. For instance, import duty has been increased by 5% to 10% w.e.f July 01, 2010 for HP imports; additionally, anti-dumping duties have also lately been imposed on the same originating from China (71%) and Korea and Taiwan (25%). Similarly, import duty on PSF imports has been increased to 6% from 4.5% earlier to encourage local production of the product.

CHEMICALS

MARKETWEIGHT

Sana I. Bawani Chemicals Analyst

No. Ticker Company Products

1 BOC BOC Pakistan Liquid Gases, Compressed Gases and other gases

2 DOL Descon Oxychem Hydrogen Peroxide

3 DSFL Dewan Salman Polyester Staple Fibre, Acrylic

4 EPCL Engro Polymer PVC, Allied Chemicals, Caustic Soda

5 ICI ICI Pakistan Polyester, Soda Ash, Paints, Chemicals, Sodium Bicarbonate

6 ICL Ittehad Chem Caustic Soda, Liquad Chlorine, Sodium Hypochlorite, and others

7 LOTPTA Lotte Pakistan PTA Purified Terephthalic Acid (PTA)

8 NICL Nimir Ind.Chemical Caustic Soda, Hydrochloric Acid, Soap Noodles and other chemicals

10 SITC Sitara Chemical Caustic Soda, Ammonium Chlorida, Bleeching Powder and various other chemicals

11 SPL Sitara Peroxide Hydrogen Peroxide

49

November 25, 2010

Profitability: Largely a Function of International Prices Majority of the chemicals produced locally have their prices pegged with prevailing rates in the international market. Therefore, profitability of such companies highly depends on their production cycles, procurement policies, and FX movements. At present, most of the chemical manufacturing companies in the country are profitable at the gross level however, some like Descon Oxychem (DOL) and Sitara Peroxide (SPL) which are still in their inception phase are highly leveraged resulting in finance costs eating up their profits. Similarly, profitability of LOTPTA (sole manufacturer of PTA in Pakistan) is largely a function of international PTA and PX prices and the demand/supply situation in the country; the company posted gross margin of 15% during 9MCY10 backed by an uptrend in PTA prices and a robust demand from the PSF and PET producers. Lastly, a look at ICI Pakistan (ICI) which manufactures PSF, Soda Ash, Paints, and other chemical products reveals that the company has consistently yielded margins in the vicinity of 20% and enjoys a loyal client following.

Outlook: Room for Growth Pakistan is a net importer of PTA (~120K tpa) and PSF (~100K tpa) while its raw materials, PX and MEG are not produced in the country and therefore, the entire requirement is imported. Additionally, the country also imports about 25ktpa of hydrogen peroxide each year to fulfill its requirements. This signals to the ever increasing demand for such products and room available for more efficient producers to enter the market.

Furthermore, the government offers incentives such as duty monetization on production of PTA (to LOTPTA) and import duties on PSF which should attract foreign investment into the industry. Last but not the least, the availability of port makes it cheaper for the country to source its chemical requirements from the Middle East, one of the largest producer of petrochemicals.

Valuations: Remain Marketweight The domestic chemical industry is characterized by companies with diverse dynamics. However, one needs to be more cognizant of the relevant company’s management capability, its ability to pass through inflationary pressures, and maintain strong profit margins. We continue to like ICI as a growth story given the aforementioned criteria; however given its recent price rally we now have a NEUTRAL stance on the stock.

Regional Valuations

Company Country Market Cap P/E EV/EBITDA (x)

USD mn FY11E FY12E FY11E FY12E China Pharmaceutical Group Ltd China 871 9.6 15.0 3.9 4.2

WuXi Pharmatech China 948 16.0 13.0 12.3 10.1

AkzoNobel Netherlands 18,781 12.8 11.1 6.5 5.6

ICI Pakistan Limited (ICI) Pakistan 218 7.9 7.4 4.5 4.3

50

November 25, 2010

NON-LIFE INSURANCE: DRIVEN BY INVESTMENT INCOME Non-Life Insurance industry has experienced average CAGR of 14.7% in net premiums over last 5year period fuelled by industrial growth, consumer lending by the banks and penetration into the market. However, Pakistan still has one of the lowest insurance penetration of 0.7(Gross Premium as % of GDP) and insurance density 2.2x (Gross Premium as % of Population) in the region.

Net Premiums- Industry

Source: Company Reports, BMA Research

Non-Life insurance industry in Pakistan is broadly classified into Fire, Marine, Motor and Treaty & Miscellaneous Insurance. Treaty & Miscellaneous classification is relatively new in the region and has experienced highest average CAGR of 34.5% over 5 year period. Fire and Motor Insurance also experienced exceptional average CAGR of 15.4% and 14.4% respectively over 5 year period.

Major Players in the Market Adamjee Insurance (AICL), EFU General Insurance (EFUG) and New Jubilee Insurance (NJLIC) are the major and most dominant player in the market occupying 73% market share collectively and 34%, 28% and 12% individually respectively.

Over the next 5 year period we expect insurance industry to remain concentrated among top three players as has been the case in last 5 year period; when other players showed a meager or no growth. Insurance industry, however, is expected to grow with CAGR of 6% for next 5 years as insurance penetration in the market and insurance density in Pakistan increases. This growth however will continue to benefit the larger players. Nonetheless overall profitability of insurance companies will continue to be determined by investment income which is entirely dependent on KSE performance.

Core Performance Insurance industry’s core operations have been sound, net premiums have grown at average CAGR of 15%, and combined ratio has clocked an average of 91%. Industry has experienced some changes in portfolio mix over last 5 years. Motor Insurance remains the dominant part of the portfolio with 51% share in total net premium for the industry. Share of Treaty & Miscellaneous insurance in

0

5,000

10,000

15,000

20,000

25,000

2005 2006 2007 2008 2009

Years

PK

R m

n

Fire Marine Motor Treaty & Misc.

NON-LIFE INSURANCE

UNDERWEIGHT

Muhammad Ali Taufiq Insurance Analyst

51

November 25, 2010

the portfolio has been rising over past 5 years from 8.4% in CY05 to 15.6% during CY09. On the other hand, share of Marine in the portfolio has been on a declining trend, from 20.3% in CY05 to 14.6% during CY09.

Investment Income: Determines Fate of Insurance Industry Investment income for the industry is derived from investments in available-for-sale marketable securities which are valued at lower of cost or market value. Hence, investment income is generated through 1) dividend income, 2) return on fixed income securities, 3) Gain/Loss on sales of AFS Investments and 4) Reversal/Provision for impairment in value of AFS investments. Dividend Income is seasonal in nature as much of the dividends are announced on CY end or FY end and therefore recorded by the company during 1QCY and 3QCY.

Investment Income has been volatile for the industry which faced massive dip during CY08 on the back of KSE market crash. It is very interesting to note that investment income for the industry is highly correlated with performance of KSE index; this indicates that most of the investment portfolio is dedicated to Held for trading and Available for sale securities and little into held to maturity securities. Going forward we expect investment income to continue to depend on KSE performance. With rising trend observed in KSE over the last 2 years we feel there is still room for many reversals to come, as market is still far from its historic peak.

Comparison of Insurance Co.s’ Investment Income & KSE performance

Portfolio Position - Industry Combined Ratio - Industry

Source: Company Reports, BMA Research Source: Company Reports, BMA Research

0%

10%

20%

30%

40%

50%

60%

2005 2006 2007 2008 2009

Fire Marine Motor Treaty & Misc.

40%50%60%70%80%90%

100%110%120%130%

2005 2006 2007 2008 2009

Fire Marine Motor Treaty & Misc. Total

(10,000)

(5,000)

-

5,000

10,000

15,000

20,000

25,000

30,000

2004 2005 2006 2007 2008 2009

PK

R m

n

-

2,000

4,000

6,000

8,000

10,000

12,000

Inde

x

Investment Income - Industry KSE All Share Index


52

November 25, 2010

Regional Comparison: Fairly valued Listed Insurance companies of Pakistan are currently trading on average PBV of 0.9x, at 20% discount compared to their regional average PBV of 1.13x.On CY10 PER basis, listed insurance companies of Pakistan currently trade at 14.9x, 37% premium to their regional peers. Average dividend yield for listed insurance companies of Pakistan is at par 2.6% compared to 2.8% for their regional peers. However, the discount on the basis of book multiple is justified when ROE and ROA are taken into consideration and also given the fact that KSE overall trades at ~50% discount to its regional exchanges.

Regional Valuations

Company Name Ticker Country 1 year Beta P/E P/S P/B Div Yld (%) ROE (%) ROA (%)

New Jubilee Life NJLIC Pakistan 0.7 22.2 0.7 5.3 2.3 27.0 1.9

EFU Life Assuran EFUL Pakistan 1.2 NA 1.0 0.6 NA (1.2) (0.5)

Atlas Insurance ATIL Pakistan 0.8 6.7 2.1 1.7 NA 27.5 11.7

New Jublee Insur. NJICL Pakistan 0.6 NA NA 1.7 NA NA NA

Shaheen Insur SHNI Pakistan 0.5 14.9 0.4 1.2 NA 8.1 2.4

Habib Insurance HICL Pakistan 0.7 4.7 1.7 1.2 10.9 27.5 13.3

East West Life A EWLA Pakistan 1.2 NA NA 0.9 - NA NA

Askari Gen Ins AGIC Pakistan 0.4 NA 0.3 0.9 - (9.8) (2.3)

Adamjee Insur AICL Pakistan 1.4 30.8 1.3 1.0 NA 3.1 1.4

Pakistan Reinsur PAKRI Pakistan 1.6 18.9 2.5 0.8 11.5 3.8 2.2

EFU Gen Insur EFUG Pakistan 1.2 NA 1.0 0.6 NA (1.2) (0.5)

IGI Insurance IGIIL Pakistan 0.8 23.0 27.5 0.6 2.8 2.4 2.1

PICIC Insurance PIL Pakistan 1.6 NA 0.9 1.2 NA (33.2) (7.9)

Central Insur CICL Pakistan 0.8 NA NA 0.5 1.4 (22.9) (21.9)

United Insur Pak UNIC Pakistan 1.0 3.7 0.6 0.4 NA NA NA

Premier Ins. Ltd PINL Pakistan 0.7 11.4 1.4 0.3 8.0 3.0 1.9

Median 0.8 14.9 1.0 0.9 2.6 3.0 1.9

Company Name Ticker Country 1 year Beta P/E P/S P/B Div Yld (%) ROE (%) ROA (%)

China Pacific-A 601601 China 1.20 27.5 1.9 3.0 1.1 11.9 2.1

Reliance Capital RCAPT India 1.18 46.4 3.3 2.6 0.8 5.7 1.7

Max India Ltd MAX India 0.83 NA 0.7 2.5 - (6.0) (0.8)

Panin Financial PNLF Indonesia 0.98 7.3 2.8 0.9 - 13.1 9.3

Panin Insurance PNIN Indonesia 0.86 4.4 1.2 0.6 - 15.2 6.2

Lpi Capital Bhd LPI Malaysia 0.56 17.9 9.3 2.6 2.9 15.8 8.1

National Reinsur NRCP Phillipines 0.64 41.6 2.0 0.7 2.3 1.7 0.9

Aviva Ndb Insura CTCE Srilanka 0.77 25.3 0.7 4.1 3.0 16.0 1.5

Ceylinco Insuran CINS Srilanka 0.80 15.4 0.5 1.5 1.3 10.4 1.6

Siam Commercial SCNYL Thailand 0.38 19.3 3.2 7.0 1.1 42.4 3.8

Bangkok Life Ass BLA Thailand 0.91 25.2 1.3 4.7 1.2 23.1 2.0

Baoviet Holdings BVH Vietnam 0.98 39.1 5.2 4.1 1.6 11.0 3.0

Petrovietnam Ins PVI Vietnam 1.28 8.3 1.2 0.6 11.7 8.6 3.9

Median 0.65 10.84 1.18 1.13 2.77 10.42 3.62 Source: Bloomberg, BMA Research

53

November 25, 2010

Outlook: Underweight on the Sector Given the economic and political uncertainty prevailing in the country coupled with natural calamities, insurance industry does not present a healthy picture. Insurance industry over the last year has experienced a decline of 6% in net premium and has shown no improvement in combined ratio. Hence we believe that the sector as a whole does not present any significant upside potential, thus calling for our Underweight stance.

For AICL in specific, the valuations do not appear to be too attractive at PBV of 1.0x, despite the erosion of ~40% in stock price since CY10 beginning.

54

November 25, 2010

AUTOMOBILE AND PARTS: ON A DOWNHILL The auto assembly sector witnessed a dramatic improvement of 43% YoY in its sales to 140K units in FY10 followed by 2 years of negative growth. The key factors behind this growth included 1) growth in remittances by 14% YoY to USD8.9bn compared to USD7.8bn in FY09, 2) a low base set last year of 98,161 units (-47% YoY compared to FY08) and 3) increasing rural incomes due to high support prices and subsidized farm inputs. It is also pertinent to mention here that auto loans sanctioned actually decreased by 23% to PKR67.4bn as of Mar10 against PKR87.6bn as of Mar09 and yet the sector witnessed growth.

Going forward, we expect FY11 to post a 20% YoY decline in automobile sales due to 1) lower agricultural incomes and depressed demand from the flood-affected regions, 2) higher interest rates and 3) poor law and order situation in the country.

Furthermore, new model launches do not seem a possibility during the current year as both INDU and HCAR introduced new models of Toyota Corolla and Honda City during FY09 while PSMC launched Swift during FY10 (Jan10).

Industry Dynamics: A Year of Low Demand Comparison of Auto Sales Growth (LHS) and Average Lending Rates (RHS)

Source: SBP, BMA Research

Rising Interest Rates Our research indicates that car sales are strongly correlated with the interest rates prevailing in the country. SBP increased the discount rate by 50bps in Sep10 which brought the discount rate to 13.50% and going forward, we expect it to increase further to 14-14.50% by Jun11. Subsequently, bank lending rates also follow suit which have already gone up following the decision and hence, are expected to have a negative impact on automobile sales in FY11.

Profitability: Margins Reflect PKR Movements Exchange rate movements in USD and JPY directly impact costs and hence, margins of auto assemblers which import steel and their CKD requirements from their parent companies either in Japan or elsewhere. PKR has depreciated by 13% and 4% YoY against JPY and PKR in 1QFY11 respectively, and is expected to depreciate further in FY11E. At the same time, prices of cold rolled steel witnessed an increase of 16% YoY during the quarter to USD705/ton in

-50%-40%-30%-20%-10%

0%10%20%30%40%50%

FY06 FY07 FY08 FY09 FY10 FY11E9%

10%

11%

12%

13%

14%

15%Sales growth (LHS) Avg Lending Rates (RHS)

AUTOMOBILE & PARTS

UNDERWEIGHT

Sana I. Bawani Auto Analyst

55

November 25, 2010

1QFY11 compared to USD605/ton in the same period last year. The same factors have led auto assemblers to increase the prices of automobiles a number of times during the year. However, given the present situation a drop in margins cannot be ruled out.

Outlook: A Dismal FY11 1QFY11 automobile sales show a 10% YoY increase to 33,496 units from 30,519 units in the same period last year. We however have an UNDERWEIGHT stance on the sector given the current industry dynamics and an expected drop in demand. For FY11 our EPS expectation for INDU stands at PKR32.5 with a DCF based fair value of PKR197/share calling for a SELL on the stock.

Regional Valuations

Country Market Cap P/E EV/EBITDA (x)

USD mn FY11E FY12E FY11E FY12E

Tata Motors India 13,395 32.4 26.1 16.2 13.5

Mahindra and Mahindra India 8,152 12.9 11.5 9.0 7.6

Dong Feng Motors China 12,837 9.6 8.8 4.2 3.4

Indus Motors (INDU) Pakistan 247 8.3 8.0 3.7 3.3

Pak Suzuki Motor Company (PSMC) Pakistan 72 9.2 6.4 2.3 1.8

56

November 25, 2010

TEXTILES: ECONOMY’S BREAD AND BUTTER! Pakistan ranks 4th amongst the cotton producing nations in the world after China, India, and the US. It is also the 3rd largest consumer of the commodity after China and India. Furthermore, it ranks 11th in global cotton exports and 5th in its imports. The country produced 12.7mn bales of the commodity in 2009-10 and estimates 11.5-12mn bales in 2010-11 (revised down from a bumper crop of 14mn bales, post flash floods).

A closer look at the trade numbers of the industry reveal that textile exports account for 52% of total export receipts of the country which have grown at a 5yr CAGR of 3% up till FY10 while imports have grown at 10% during the same period. The country’s textile exports amounted to USD10.2bn in FY10, up by 3.5% YoY from USD9.8bn last year. Additionally, knitwear, fabric, and bedwear exports contributed about 54% to total textile exports in FY10.

Industry Dynamics: Ready Source of Raw Material The entire value chain represents production of cotton, ginning, spinning, weaving, dyeing, printing and finally garments manufacturing. Being one of the largest cotton producers the domestic textile industry enjoys a cost advantage over its peers. Exports become all the more viable given the country’s advantage in availability of cheap labor (wage of USD0.55/ hour), tax incentives including zero-rating on exports, low fabric cost, shorter delivery time, and availability of financing on favorable terms. For instance, the local government encourages the industry through provision of low cost finance in terms of Export Refinance Facilities for short-term requirements (EFS currently at 10%) and Long term Financing Facilities (LTFF, maximum at 11.2% plus spread) in addition to duty drawbacks on achievement of set targets.

However, there are also certain limitations and constraints faced by the industry, first and the foremost being the soaring power costs which have lately forced textile companies to resort to self-generation with additional costs. It is important to mention here that the GoP has offered a number of incentives to companies who are interested in power generation activities therefore several companies have now set up their own captive power plants which has led to non-stop production activities. High transaction costs and lack of availability of modern technology in the textile sector are other impediments which have left

TEXTILE

MARKETWEIGHT

Sana I. Bawani Textile Analyst

Textile Exports Growth Trend Product-wise share in exports - FY10

Source: SBP, BMA Research Source: SBP, BMA Research

7.5

8.0

8.5

9.0

9.5

10.0

10.5

FY05 FY06 FY07 FY08 FY09 FY10

US

Dbn

-6%-4%-2%0%2%4%6%8%10%12%14% Raw

Cotton2% Cotton

Cloth18%

Knitwear20%

Bed Wear16%

Garments9%

Yarn13%

Others22%

57

November 25, 2010

the country behind giants like India and China. An upgradation of the same and greater research and development (R&D) activities is expected to lead to better productivity.

It would be useful to note that Pakistan has emerged as one of the most competitive textile nations in the world with some notable names like Nishat Group, Younus Brothers, Gul Ahmed Textiles and Chenab Group. Additionally a number of Pakistani companies also offer their products under their own brand names and have liaison offices established in the international market. However, the major drawback faced by Pakistan’s exportable textile products is assumed to be its fragmented textile sector. We believe if the industry is more organized and operations synchronized from cotton ginning to the finished product it would add immense value to the sector’s competitiveness.

Profitability: Product Prices on the Rise in the International Market Since Pakistan is one of the major exporters of textile products to the world, an uptrend in product prices with cost efficiencies bodes well for the national exchequer. Yarn prices skyrocketed during the 3QFY10 and continued to move upwards during 4QFY10 while exporters including Nishat Chunian (NCL) and Nishat Mills (NML) had low-cost inventories available till Sep10 which resulted in inventory gains and subsequently, exorbitant profits for FY10 and 1QFY11F. A robust demand for textile products including yarn, ready-made garments, and home textile products from the international market continue to ensure profitability for the domestic exporters in the years ahead.

Cotton is the key raw material for the industry and hence, its prices are the key determinant of the profitability of the entire value chain. It is pertinent to note that the price of the commodity witnessed a rapid increase of 35% over FY10 averaging at PKR4,683/maund compared to PKR3,461/maund in FY09. However, a tight world supply situation due to floods in Pakistan and a similar crop slowdown in China has led the rate to go as high as PKR8,300/maund at present! Similarly, cotton prices in the international market are also at an all-time high of USD1.34cents/lb compared to an average of USD70cents/lb in FY10. We believe that the rising cotton prices would have varied implications on companies’ profitability on different stages of the textile chain. For instance, it would be relatively easier for garment manufacturers and other exporters involved in value-addition to pass on the higher costs and maintain profitability whereas it depends as to what extent companies in the initial stage of the chain (yarn, grey cloth etc) can pass on the same in the end products.

Valuations: A Good BUY

Pakistan has recently been granted trade concessions by the EU on 65 textile products (out of a total of 75) and been favored for inclusion in the GSP plus scheme in 2014. We believe this would make the country’s products more competitive in the EU against India, Bangladesh and China and enhance exports to the region. Cotton fabric and denim products are included in the list which is expected to bode well for companies including NML, NCL, Azgard Nine (ANL), Artitic Denim Mills (ADMM) and other manufacturers going forward.

Our DCF based fair value for NML stands at PKR64/share, upside of 11% from current levels. BUY!

58

November 25, 2010

Regional Valuations

Company Country Market Cap P/E P/B EV/EBITDA (x) Dividend Yield

USD mn T12M

Jay Bharat Textile India 2,185 500.9 58.4 185.5 2.7%

Century Textile India 1,060 13.9 2.7 8.0 1.1%

Gitanjali Gems India 574 12.7 0.5 7.0 1.7%

Luolai Home Te-A China 1,458 52.2 4.3 23.9 1.7%

Dipped Products Sri Lanka 64 14.7 1.9 8.1 3.6%

Nishat Mills Limited Pakistan 235 7.1 0.7 6.6 4.3%

Nishat Chunian Limited Pakistan 47 4.7 0.8 5.0 6.2%

59

November 25, 2010

Company Snapshots

60

November 25, 2010

Stock Statistics

Ticker OGDC




Beta 1.11

OGDC: UNJUSTIFIED PREMIUM INVESTMENT SUMMARY

Production flows to be flat at best: OGDC’s production performance has been dismal off late. Oil production has come off by 4% and 8% during FY09 and FY10 to 36.6kbpd – result of natural decline from Bobi, Chunda, Kunar, Sono and Buzdar fields. Similarly, gas production has declined by 3% YoY to clock in at 971mmcfd for FY10. While production additions from Tal block have been heartening, natural declines from Qadirpur field have been the major reason behind dismal performance on gas front.

Going forward, we expect compression facilities at Qadirpur to come online during 2QFY11 and thus, coupled with further additions from Tal block and Nashpa, should alleviate some of the concerns. However natural declines in most other fields make it imperative that litigation issues are settled at their earliest. Current assumptions thus hint towards flat production profile for the company up till FY13 – and a likely underperformance against its peers POL and PPL.

Legal disputes and delays: Ongoing litigations at Sinjhoro, Kunnar Pasakhi (KP) and Tando Allah Yat (TAY) blocks remain unresolved as yet. The three blocks currently present potential production addition of over 4,000bpd of oil and 40mmcfd of gas. However the same will have to wait for 2 years, starting the settlement of legal dispute. These delays are the primary reason for failure of the company to translate the recent discoveries into production numbers.

One-off cushions sustaining performance for the time being: On the positive side, the long pending wellhead gas pricing dispute for Qadirpur field (OGDC ownership stake: 75%) was resolved in Feb10. Accounting for around 38% of the company’s gas production, the field saw an upward revision of ~30% in its retention prices and translated into 7% recurring upward revision inthe bottomline for the company.

The announcement also resulted in one-off retrospective gains of PKR5.5bn (EPS impact: PKR0.76) booked in FY10. Moreover, one-off gains of PKR3bn (EPS impact: PKR0.42) were also booked in 1QFY11 post announcement of wellhead gas prices for Bobi field. Resultantly, the reported profitability does not fully reflect the deteriorating production profile of the company.

Substantial premium to peers; profit-taking advised: Backed by sustained foreign inflows, the stock has posted a remarkable performance of over 50% since Jan10. Resultantly, the stock not only reflects downside potential to our NAV based fair value but is now also trading at over 75% premium to its peers i.e. PPL and POL.

Financials

SELL Fair Value: PKR 125 Current Price: PKR 163

FY10A FY11E FY12E

EPS(PKR) 13.8 13.5 13.6



EPS Growth (%) 6.5 -2.0 0.5





OGDC Profile: OGDC is Pakistan’s largest oil and gas company dominating 30% of the country’s hydrocarbon reserves. The company has a presence in and knowledge of all four provinces.

The company’s exploration and drilling strategies include maintaining balanced portfolio of exploration blocks, accelerating exploration activities in offshore and extending exploratory efforts to unexplored and frontier areas.


Individuals1%

GOP75%

Others2%

Employees &

Empowerment Trust

10%

Foreign Investors

12%

80

100

120

140

160

180

Nov

-09

Dec

-09

Jan-

10Fe

b-10

Mar

-10

Apr

-10

May

-10

Jun-

10Ju

l-10

Aug

-10

Sep

-10

Oct

-10

Nov

-10

0369121518


61

November 25, 2010

Stock Statistics

Ticker PPL




Beta 1.1

PPL: SLOW AND STEADY WINS THE RACE INVESTMENT SUMMARY

Unrivalled exposure to Gas - Wellhead Prices lead to higher retentions: Wellhead gas prices continue to be one of the most important determinants of profitability for E&P companies. Announced semi-annually and based on trailing average Arab-light int’l prices, outgoing FY10 witnessed a 16% decline in bottomline for PPL despite its robust operational performance.

80% of the revenues for the company are driven by gas production out of which most the fields enjoy uncapped pricing regime. Hence the recent wellhead gas price announcement applicable for 1HFY11 has resulted in 8% higher retention prices for the company, compared to the preceding half year. We project another hike of 2-3% for the 2H which, coupled with production growth, promises a bottomline growth of 44% for the company!

Declining Sui production profile – but more than compensated!: Sui field (PPL ownership stake: 100%), the country’s largest gas producing field, has been posting natural annual production decline of 3-5%. Contributing to around 50% of PPL’s revenues, the field has been a major concern for the company’s ongoing production and revenue stream, However, recent and upcoming oil and gas production additions from Tal Block (discussed earlier) have more than compensated these fears.

Oil production stream tells no different story. Nashpa (PPL ownership: 26%) came online towards the latter part of FY10 with its full year production expected at 5.5kbpd for FY11 and beyond. Moreover, incremental additions from Tal Block (PPL ownership stake: 28%) and expected initiation of production from Hala field (PPL ownership stake: 65%) are likely to further balloon up the profile for the company. We thus expect FY10-14 CAGR of 19% for revenue stream from oil production alone – which is likely to increase the head’s contribution to overall topline to 23% by FY14, compared to just 11% in FY09.

Turning aggressive, finally!: After staying relatively muted on its exploration front for the last 3 years, the company has finally unraveled its plans to explore untapped reserves in Pakistan; we expect PPL to spend over PKR10bn on exploration activities during FY11-12 alone. Plans to assess deeper prospects at Sui are underway to offset depleting reserves and enhance production efficiencies while an aggressive international exploration program (with JV partners) in Iraq, Iran, Yemen and other countries can add further to the growth story.

Financials


FY10A FY11E FY12E

EPS(PKR) 19.5 28.2 29.6



EPS Growth (%) -15.8 44.5 5.0




PPL Profile: PPL is amongst the olderd E&P companies of Pakistan. Besides being the largest gas producer of the country, it also produces crude oil, Natural Gas Liquid (NGL) and Liquifies Petroleum Gas (LPG).

Government of Pakistan (GoP) owns 78.4% of the company while the remaining is divided between International Finance Corportation and private investors.



Others2%

General Public

3%

GOP70%

Public Sector

Cos, Mod. & MF7%

Emplo. & Enpowerment Trust

9%

Non Resident

FI's9%

120

140

160

180

200

220

Nov

-09

Dec

-09

Jan-

10Fe

b-10

Mar

-10

Apr

-10

May

-10

Jun-

10Ju

l-10

Aug

-10

Sep

-10

Oct

-10

Nov

-10

0123456


62

November 25, 2010

Stock Statistics

Ticker NBP




Beta 1.23

NBP: ENTICINGLY CHEAP INVESTMENT SUMMARY

The largest bank in Pakistan

National bank is the leading bank of Pakistan with highest market share of over 15% in banking deposits and advances. NBP also acts as trustee of public funds and an agent to the State Bank of Pakistan. The bank currently operates with 1,287 branches (2nd largest in Pakistan) together with its 22 operational branches in US, Europe, UAE and central Asia.

Loan book poised to grow

Being the largest public sector bank, NBP accounts for a substantial portion of loan requriements for public sector entities i.e. power sector, commodity financing and project financing. This factor has allowed the bank’s loan book to consistently outperform its peers since CY08. With heavily capitalized balance sheet and highest per party limit, NBP is well positioned to benefit from financing credit for potential investment and development as soon as the credit cycle reverses.

Comfortable CAR & roomy ADR: Similar to MCB, NBP also reflects a strong position to extend credit as the bank has low ADR and comfortable CAR. As of Sept10, NBP’s ADR stood at 60% relative to sector average of `64%. The CAR for the bank is also high at 18.7% which is well above minimum CAR requirement of 9% and industry average of 14%.

Asset quality a weaker link

NBP has diversified business portfolio with focus on corporate, commercial, consumer and SME banking in Pakistan. Given the challenging macro environment, NBP has thus faced serious deterioration in asset quality – NPL to loan has stayed high at 14.9%. However, Forced sale value (FSV) benefit is to provide support in containing provision losses going forward.

STA a potential threat to deposit growth and margins

As part of IMF led economic reforms, implementation of Single Treasurey Account (STA) is a key risk for NBP deposits. Since, Govt. depsoits account for 37% of NBP’s depsoits, STA would result in deposit contraction and resultantly put pressure on interest margins and liquidity.

Valuations – maintaining Neutral stance: NBP currently trades at 2010 PBR and PER of 0.7x and 5.9x, respectively. However, given the potential risk of STA and deteriorating asset quality, ROE is projected to stall for upcomming 2 years. With target price of PKR66/share, we maintain Neutral stance on the scrip.

Financials

NUTERAL Target Price: PKR 68 Current Price: PKR 66



EPS(PKR) 13.5 11.1 11.5 13.4

Price to book (x) 0.7 0.7 0.7 0.6

Dividend Yield (%) 11.3 9.1 9.1 10.6

EPS Growth (%) 17.8 -17.6 3.6 12.0

Return on Equity (%) 20.7 15.3 14.7 15.7

Return on Assets (%) 2.1 1.5 1.5 1.5


NBP Profile: NBP is engaged in providing commercial banking and related services in Pakistan and overseas. The bank also handles treasury transactions for the GoP as an agent to the SBP. The bank operates 1287 branches in Pakistan and 22 overseas branches.

404550556065707580

Nov

-09

Dec

-09

Jan-

10Fe

b-10

Mar

-10

Apr

-10

May

-10

Jun-

10Ju

l-10

Aug

-10

Sep

-10

Oct

-10

Nov

-10

0

5

10

15

20

25

30


Public Sec.

Cos, 2% Others, 4%

Fis, 8%

Foreign Cos &

Individual, 5%

G. Public - Local,

6%

SBP, 75%

63

November 25, 2010

Stock Statistics

Ticker ENGRO


Mkt Cap USD mn 699


Beta 1.08

ENGRO: DIVERSIFICATION AT ITS BEST INVESTMENT SUMMARY

Diversification: ENGRO’s main advantage stems from its diversified and well entrenched business lines. The company operates in fertilizer, foods, energy, chemical, chemical handling and automation business. The company has recently gone through a demerger of its fertilizer operations thereby becoming a holding company to better manage debt/cash flows for its ventures and further expansionary needs.

Largest Indeed: The company’s current expansionary plans to set-up a 1.3mtpa urea plant at Qadirpur is expected to make the company the largest urea producer of the country. Further the company is to receive feed stock gas subsidy in excess of its counterparts up till 2020 (under the Fertilizer Policy of 2001) at USD0.7/mmbtu compared to USD1.2/mmbtu prevailing for its peers. Core margin differential for urea production is expected to be in the tune of 7% which is to boost the company’s profitability. This increase in core margin bodes well for the company’s ongoing growth orientation as it has more access to internally generated funds in a high interest rate environment.

Synergies: ENGRO benefits directly and indirectly from synergies existing between its business units. Chemical handling and polymer generate supply chain links, Engro Foods benefits indirectly through market penetration and brand recognition of the fertilizer operations while Engro EXIMP acts as a trading arm for the fertilizer operations and potentially for other subsidiaries. By CY11 it is expected that some of ENGRO’s subsidiaries will reach the maturity phase and start paying out dividends. This should help boost internal liquidity for the company and reduce reliance on external sources of financing for the company.

Cash constraints/leverage: Aggressive expansionary plans have however raised concerns with regards to the company’s leverage. The company currently entertains a debt to equity of 68:32 which is significantly higher than that of its competitors such as FFC and FFBL. The market currently awaits COD of the new urea plant of the company which constitutes the single largest investment of the company. A timely operational success is likely to allay concerns; however, as of now investor concerns are likely to play a significant role in the company’s stock price.

Financials

ADD Fair Value: PKR 201 Current Price: PKR 182


ENGRO Profile: ENGRO Corporation (ENGRO) is soon to become the largest Urea producer in Pakistan with a name plate capacity of 2.3mtpa. The company has followed an aggressive growth strategy and now operates in various business lines such as FMCG, chemical handling, polymer production and automation.


EPS(PKR) 12.1 16.9 34.9 46.1

Price to Earnings (x) 15.1 10.8 5.2 4.0

Dividend Yield (%) 3.0 2.2 3.0 5.5

EPS Growth (%) -6.7 40.1 106.3 32.0

Return on Equity (%) 14.7 18.0 34.2 39.3

Return on Assets (%) 4.2 5.3 10.4 13.8



Fin. Inst.11%

Joint Stock Cos.47%

Ins. Cos. & Mod.

12%

Individuals

25%

Others5%

140150160170180190200210220

Nov

-09

Dec

-09

Jan-

10Fe

b-10

Mar

-10

Apr

-10

May

-10

Jun-

10Ju

l-10

Aug

-10

Sep

-10

Oct

-10

Nov

-10

024681012


64

November 25, 2010

Stock Statistics

Ticker PSO


Mkt Cap USD mn 570


Beta 1.04

PSO: REMAINS ATTRACTIVE INVESTMENT SUMMARY

Attractive valuations despite its leadership position: PSO is currently trading at an enticing FY11E PER of 4.6x and offers a potential upside of 27% to our DCF based fair value of PKR361/share.

It is the prime OMC in Pakistan with largest distribution network comprising 3,626 outlets and 80% of the country’s total storage capacity. PSO has overall market share of 71% and dominates in almost all product segments particularly in High Speed Diesel (HSD) and Furnace Oil (FO) with market shares of 56.8% and 88.3% respectively. PSO is also the major importer of POL products and dominates ~90% market share in imports

Strong FO demand from the power sector: During FY10, PSO denominated a sizeable market share of 89% in FO sales with contribution from the product accounting for 44% towards gross sales of the company. Consumption of Black Oil grew by 14% YoY owing to supply constraints for natural gas and reduced hydro-electric potential. PSO therefore continues to benefit most from increasing FO demand from the power sector. With the new IPPs and RPPs coming online, we expect industry FO demand surge to continue with total demand to grow by 10% over FY11.

We believe circular debt in the system should continue to hold back APL and SHEL from regaining their market share; however any resolution in the issue would encourage these OMCs to re-enter the market. We have thus assumed a conservative market share of 87% for PSO by FY12E.

The trigger to look for - PSO stands to benefit most from circular debt resolution: Owing to the working capital issues arising from the circular debt hazard, PSO reported colossal finance costs of PKR9.9bn during FY10, YoY rise of 60%. Company accounts for penal interest expense to refineries on accrual basis while penal interest income is treated on cash basis. As a result net penal interest (markup - expense) not presented on books currently stand at ~PKR3.5bn; thus resolution of circular debt will not only result in better cash flows but will also allow for materialization of the amount on income statements.

Resolution of Turnover Tax issue: As per recent media reports, Ministry of Finance has agreed to reduce turnover tax applicable on OMCs to 0.5% from 1.0% as previously announced in FY11 Budget. We anticipate that this recent reversal in turnover tax made by FBR, will result in one time reversal of PKR21.1/share for PSO to be reflected in 2QFY11 earnings.

Financials

PSO Profile: Pakistan State Oil (PSO) is the market leader in Pakistan’s energy sector. The company has the largest network of retail outlets to serve the automotive sector and is the major fuel supplier to aviation, railways, power projects, armed forces and agriculture sector. PSO also provides Jet Fuel to Refueling Facilities at 9 airports in Pakistan and ship fuel at 3 ports. The company is currently engaged in storage, distribution and marketing of various POL products. The company’s current market share of 83% in the black oil market and 58% share in the white oil market, alone speak volumes about its success.

FY10A FY11E FY12E

EPS(PKR) 52.8 62.2 67.3



EPS Growth (%) NM 17.9 8.2





Shareholding Pattern Others10%

Assoc. Cos.66%

Local & Foreign Public, Cos. 4%

Directors and CEOs

7%

FI,13%


200

230

260

290

320

350

Nov

-09

Dec

-09

Jan-

10Fe

b-10

Mar

-10

Apr

-10

May

-10

Jun-

10Ju

l-10

Aug

-10

Sep

-10

Oct

-10

Nov

-10

0

1

2

3

4

5


65

November 25, 2010

Stock Statistics

Ticker PTC




Beta 1.08

PTC: STILL THE LARGEST INVESTMENT SUMMARY

Catering to All: Pakistan Telecommunication Company Limited (PTC) currently has the largest OFC and copper network in Pakistan, spanning over 13,500Km. The company entertains the largest market share in nearly all markets it operates with a 96% market share in FLL, 46% market share in WLL, and 60% market share in Broadband internet.

Strategy Revision: PTC has repositioned itself lately to cater to a thriving broadband segment with being the only company in the sector to offer wireless broadband internet with a connection speed of 9.3Mbps and being the first company to offer a 10Mbps connection on its DSL service. Further, its first mover advantage in many parts of the country have had the advantage to tap in the market swiftly and at much lower cost compared to its competitors. The company is also concentrating on providing bundled products such as its Triple Play (Cable TV, Broadband Internet and Telephony) as well as Quad Play (Cable TV, Broadband Internet, Telephony and Surveillance).

Cellular Play: PTC’s wholly owned subsidiary Pakistan Telecommunication and Mobile Limited (PTML) is currently 3rd largest mobile operator in Pakistan operating with a rand name of Ufone. The company has displayed significant growth in subscriber, with a 5yr CAGR of 45%.

Taking Advantage: The Company has taken significant advantage of the Universal Service Fund (USF) set up in collaboration of the telecom sector and the Ministry of Information Technology. The company has won 50% of all contracts under the program which amounts to subsidy in excess of PKR7bn. USF program is designed to help aide the sector further telecom penetration to previously unchartered pockets in the country. With activity still in completion stage, true results are likely to be expected during the second half of FY11 onwards.

Zero Leverage: Testament to the Company’s financial strength is resounded by its balance sheet - PTC is the only company in the sector that carries no debt what so ever. As a result, the company’s profitability remains immune to higher financial charges due to the prevailing high interest rate environment.

Financials



PTC Profile: Privatized in 2006, Pakistan Telecommunication Company Limited (PTC) is currently the largest telecom service provider in Pakistan. PTC caters to nearly all markets, whether it is fixed line, wireless local loop, and broadband. PTC has the largest back haul support in the telecommunication sector. The company further owns

FY10A FY11E FY12E

EPS(PKR) 1.8 1.7 1.9



EPS Growth (%) 1.7 -4.5 8.4





Others4%

GOP62%

Foreign Cos.4%

Etisalat Internation

al26%

FI's4%

15161718192021

Nov

-09

Dec

-09

Jan-

10Fe

b-10

Mar

-10

Apr

-10

May

-10

Jun-

10Ju

l-10

Aug

-10

Sep

-10

Oct

-10

Nov

-10

0

10

20

30

40


66

November 25, 2010

DISCLAIMER This memorandum is produced by BMA Capital Management Limited and is only for the use of their clients. While the information contained herein is from sources believed reliable, we do not represent that it is accurate or complete and should not be relied upon as such. Opinions expressed may be revised at any time. This memorandum is for information only and is not an offer to buy or sell, or solicitation of any offer to buy or sell the securities mentioned. ANALYST CERTIFICATION

We, Hamad Aslam, Abdul Shakur, Nurali Barkatali, Sana I. Bawani, Omar Rafiq and Ali Taufiq, hereby certify that this report represents our personal opinions and analysis of information. All views are accurately expressed to the best of our knowledge. We certify that no part of our remuneration is linked either directly or indirectly to recommendations or analysis covered in this report.

KEY CONTACTS

Equity Sales

Ahsan Javed Chishty +9221 32465437 [email protected]

Sarah Gilani +9221 32417794 [email protected]

Omair B. Chaghtai +9221 32464496 [email protected]

Gohar Rasool +9221 32464358 [email protected]

Research

Hamad Aslam, CFA +9221 32464693 [email protected]

Abdul Shakur +9221 111 262 111 Ext. 2062 [email protected]

economic strategy report

Documents