Troubled Cement Industry

ARTICLE PRESENTATION SUBMITTED TO: SIR. AFAQ ALI KHAN

BY:

Syed Owais Ali SP07-BB-0135

Topic: Problems of Cement Industry

THE TROUBLED CEMENT INDUSTRY Can a manufacturer’s cartel ensure capacity utilization? By SHABBIR H. KAZMI Nov 23 - 29, 1996 The cement industry in Pakistan has come a long way since independence when the country had less than half a million tones per annum production capacity. By now it has exceeded 10 million tones per annum as a result of establishment of new manufacturing facilities and expansion by the existing units. Privatization and effective price decontrol in 1991-92 heralded a new era in which the industry has reached a level where surplus production after meeting local demand is expected in 1997. The cement industry in Pakistan faces two serious threats: closure of units based on wet process, and poor cash flow rendering the units incapable of debt servicing due to increasing cost of electricity, furnace oil and imported craft paper used for cement packing. The cost of furnace oil alone has increased by nearly 100% in the last 15 months alone. With the increase in furnace oil the increase in electricity tariff has also become inevitable. Pakistan has remained a net importer of cement but due to the privatization of units operating under state control and subsequent expansion programmes by the new owners supported by financial has pushed the industry to a point where the country is bound to reach an oversupply situation. However, the recent increase in energy cost provides opportunity for the efficient units based on dry process to sustain the situation for a relatively longer period. It would also be possible because the expansion by the existing units and establishment of new units are being delayed. Pakistan's cement market is divided into two distinct regions, North and South. The northern region comprises the Punjab, NWFP, Azad Kashmir and upper parts of Balochistan, whereas the southern region comprises the entire province of Sindh and lower parts of Balochistan. Traditionally, the southern region has always been surplus in cement production but with the establishment of more plants in the northern parts of the country the region has become almost self-sufficient in supply of cement. Demand vs. supply The demand-supply gap which for the last decade was in favor of manufacturers is now set to switch the other way with supply outpacing demand by the end of 1997. Historically, demand has grown at an average rate of 7%, with the Northern region averaging 8% and Southern region lagging behind at 4%. There is much pessimism about the industry's future due to a tremendous increase in supply expected by the end of next year. The way new plants are being established and existing plants are undertaking expansion, the demand-supply equation is bound to create surpluses. However, it has been observed that actual progress is slower than planned to avoid a possible glut situation. This will effectively narrow down the gap between demand and supply and thereby ease the pressure on prices. Factors which can possibly change the surplus position into a near-equilibrium between demand and supply are:-

1. Formation of manufacturers' cartel to avoid price decline; 2. Delay in implementation of planned additions and expansions;

3. Efforts to export cement; and 4. Increase in demand if construction of some of the mega-sized infrastructure projects starts More competition As the cement market is moving from a virtual 'sellers' market' to an over-supply situation, it is expected that when prices stagnate and profitability becomes a function of volume and economies of scale, locational advantage and proximity to markets will become extremely important factors. At present the freight charges are a massive 20% of the retail prices. The plants located very close to each other and tapping the same market will have to expand their markets which will increase their freight expenses. Dandot, Pioneer, Maple Leaf and Garibwal are all located within a radius of 100 kilometers and are selling bulk of their production in the same areas and will thus face serious competition from each other. Positive side Pakistan has one of the highest population growth rates in the world, touching 3%. This has prompted a sizable demand for housing facilities in the country. According to estimates of construction industry, there is a huge backlog of about 6.25 million housing units in the country. Bulk of the current demand of 0.6 million units needed every year is for urban areas. With greater urbanization the demand for cement is expected to grow at an average of nearly 7% per annum. The demand for cement for infrastructure units is expected to grow with the commencement of work on motorways, power plants, Islamabad New City, Karachi Package and Ghazi Brotha dam. If all these projects are implemented as per schedule, the demand for cement is expected to grow at a higher rate. Tax structure Instead of providing any relief in the budget, the sector was further penalized with a 3% increase in sales tax to 18% and an increase in excise duty to 35%. So far, the manufacturers have been able to pass on the increase to consumers but the situation is unlikely to continue. However, the possibility of formation of a cartel cannot be ruled out. Since massive investment has been made in the sector, any reduction in price of cement can reduce profit margins of all the units. Formation of cartel and fixation of price at a level high enough to cover increasing costs of inputs and ensure reasonable profit margins may provide a short-term relief to the manufacturers. Such a cartel may be against the interests of consumers but can help the manufacturers to survive with some dignity. Formation and smooth operation of a cartel is generally difficult but in the case of cement industry it may not be so because the only restriction could be on the level of capacity utilization along with a modest uniform reduction in price of cement. However, the units are in diverse states of financial health, enjoy different levels of competitive advantage, and therefore need different prescriptions to maintain their profitability. Production process

Each tone of cement requires about 1.7 tones of limestone, gypsum and silica, etc. By volume limestone accounts for about 80% and clay 19% of the intermediate product — clinker. Gypsum is later on added to clinker in the ratio of 4:96 to obtain cement. Pakistan has all these raw materials in abundance and the country can feed this material to existing cement plants for more than 100 years. This ensures both cheap and smooth supply of raw materials but proximity to raw materials supply is not a major competitive advantage. Production of cement is a continuous process. Raw materials are dried, ground, proportioned and homogenized before being burnt in rotary kilns. The resulting material 'clinker' is pulverized with gypsum at the grinding stage to obtain cement. The cement industry in Pakistan uses two distinct production processes, the 'dry' and the 'wet' process. Both the processes use different types of kilns. In the wet process raw materials are fed into kiln in slushy form. As it consumes more energy to raise the temperature of the kiln to the required levels it is costly. In the dry process the ground raw materials are fed into the kiln in dry powder form therefore energy consumption is low to raise the temperature to the required level. Cement plants established in Pakistan up to the seventies were based on wet process whereas the plants established in the eighties and onward are based on dry process. These include the plants established by the SCCP and the private sector. As of June 1995, 60% of the production capacity was based on dry process which has further increased as the newer units are also based on dry process. Cost of production Since the industry faces a situation where sales price will be fixed by mutual consensus, the cost of production will be the most critical factor of profitability. Energy cost is a major component of total cost of production. It contributes at an average 40 to 45 percent towards total cost of cement production. Energy cost is even higher in case of those plants which use wet process. A cement plant based on wet process consumes 165 kg of furnace oil to produce one tone of clinker as compared to 85 kg of furnace oil used in dry process to produce the same quantity of clinker. Since cement plants use both furnace oil and electricity, any increase in the prices of these two products is detrimental to profitability of the industry. Ever since October 1995, however, there has been more than 60% increase in the price of furnace oil. Another significant cost component is packaging material. Cement is rarely sold in bulk in Pakistan — almost all cement sales are in four-ply papersacks. Cost of papersacks has gone up by almost 90% since December 1994. Only one unit, Cherat Cement, has the advantage of having an associate company producing such bags. Key players Until recently there were 24 cement manufacturing units in the country which were reduced to 23 with the closure of National Cement's Karachi unit. Out of these, 2 units produce white cement; one slag cement and the remaining produce ordinary Portland cement (OPC). Cherat Cement located in NWFP has an installed capacity of 0.72 million tones per annum. Cherat was the first cement plant in the private sector to commence commercial operations (1985) after the end of state monopoly. Its main markets are NWFP and upper Punjab. The company is owned by Ghulam Faruque group which also owns Cherat Papersacks. The company has recently doubled its capacity and expansion has come at an appropriate time. It is in a position of taking advantage of the 'cement hungry northern region' for capacity utilization. Expansion also provides potential of achieving economies of scale. Given Cheat’s

established marketing base it could be the immediate beneficiary if export of cement to Afghanistan is allowed — the country needing massive reconstruction after devastation of a long war. However, commencement of commercial production by Lucky and Army Welfare plants may create over-supply even in the Northern region. Cherat will have to spend more on transportation cost as it will have to tap distant markets to sell production from expanded capacity. Constant increase in fuel prices will add to total transportation expenses of the company in a substantial way — currently the freight cost comes to more than 20% of retail prices of cement. D.G. Khan Cement was the most prized unit out of the cement units privatized by the Nawaz Sharif government. Of all the plants owned by the SCCP it was the most modern plant with bulk of depreciation amortized and interest charges paid for. The company enjoys a virtual monopoly in its sales territory. There is no other cement plant within a radius of 400 kilometers. The current capacity of 720,000 tones per annum (TPA) is being enhanced to 1.809 million tones at a cost of Rs. 6 billion. The IFC is also participating in the project with a loan component of US$ 65 million and equity worth US$ 5 million. The expansion will come on line at a time when there will be supply overhang in the industry. With margins coming under pressure it will have to bear the added brunt of higher financial charges and increased depreciation cost in the years to come. Analysis of the latest half-yearly results of the company shows that although sales of the company have gone up by 3.5%, the increase in cost of sales has reduced gross margin from 61% to 48%. With rising inputs cost not being matched by similar increase in price of cement, margins are expected to shrink further. The company, after the expansion is expected to face fiercer competition from Zeal Pak, Pioneer, Dandot and Wah. To wrest market share from the competitors, it is likely that D.G. Khan will have to reduce its cement prices. Dandot Cement, privatized in 1992, was able to wipe off its accumulated losses by the end of its first financial year after privatization. Dandot has increased the plant capacity from 1000 tones to 1600 tones per day, through an optimization programmed completed in July1995. The Chakwal Group, which acquired management control of Dandot Cement, is setting up another cement plant, Chakwal Cement — the largest cement plant in the country. This will give the Group control over 2.3 tones per annum production. The decision to set up another plant in the same vicinity could go both ways. On the positive side it could provide leverage to out-price competitors especially as the industry moves towards a possible over-supply situation. Chakwal Cement is located close by a motorway to be constructed which provides it an opportunity to market its cement in large quantities to the project. On the negative side, Dandot is a highly unionized concern and suffers from a strained labormanagement relationship which has led to plant closure in the past. In addition, the investors are losing confidence in the Group mainly due to delayed commencement of its much-talked about Dhan Fibers project. Cement export The federal government's decision to allow export of clinker and cement by the private sector has been eclipsed due to absence of necessary rules and regulations. The export consignment of clinker by a unit was delayed as the customs authorities refused to allow export. The federal government on August 13 issued a notification which stated "Export of cement and clinker will be allowed by sea on such terms and conditions as may be notified by the ministry of commerce.

Since consumption of cement in southern region has gone down and northern region has attained self-sufficiency, units located in southern region are forced to cut down their capacity utilization. The possibility of cement export is the proverbial silver lining for the recession-torn industry according to analysts at AKD Securities While there are cement deficient countries like Bangladesh and Sri Lanka importing approximately 2 million tones per annum each, there is tough competition from India and Chinese suppliers. In fact, apart from the prices offered by Pakistani manufacturers, lack of facilities for handling bulk export of cement has become a major impediment — bulk handling is cheaper than handling bagged cement. Export of cement is necessary for the existence and survival of the industry rather than a source of profit. The announcement of policy on cement export has created positive sentiments. Future outlook At the current point cement manufacturers and the government have to take concrete steps even to keep units in production. On the inputs side, necessary steps are required to contain the increasing energy cost. The government must also look into the case of providing subsidy on freight to the exporters of clinker and cement. The prescription is to optimize capacity utilization. According to analysts the future of cement exports depends on two factors: surge in cement prices in the export markets and the government of Pakistan subsidizing freight charges. While the quantity of exportable cement in the region would gradually decline and prices are expected to increase, it will take time to get a favorable decision from the government to provide subsidy even on freight cost. But absence of bulk cement handling facilities will remain a major deterrent. Lucky cement which completed its construction at a fantastic speed to qualify for duty exemptions has met the fate apprehended by the industry experts. Due to various technical problems including sinking of some foundations, the management was forced to close down the production soon after starting commercial production. It is feared that it would not be able to resume production till the first quarter of the next calendar year. But prospects of recovery of cement industry have been further reduced due to another recent increase POL prices. Electricity tariff is also expected to be revised upward shortly. The advantage of devaluation has been eroded almost completely due to increase in energy cost. Historical perspective The history of cement industry in Pakistan dates back to 1921 when the first plant was established at Wah. At the time of independence in 1947 there were four cement factories with an installed capacity of 470,000 tones per annum. These units were located at Karachi, Rohri, Dandot and Wah. In 1956 Pakistan Industrial Development Corporation (PIDC) established two plants at Daudkel and Hyderabad and subsequently more plants were established in the private sector. The industry was nationalized in 1972 and the State Cement Corporation of Pakistan (SCCP) was established following the Economic Reforms Order, 1972. As a result of nationalization, a total of 10 cement units with an installed capacity of 2.8 million tones per annum were transferred to the SCCP. Effective price control was also vested with the SCCP and for a long time the industry operated under a regime of strict regulation and price control. While the cement industry was working under state control, the SCCP established five new units with an installed capacity of 1.8 million tones per annum.

In 1985-86 the cement industry was deregulated and private sector was allowed to establish cement plants. But bulk of the capacity was controlled by the SCCP which had effective control in the fixation of prices. Severe shortage of cement and price deregulation prompted the private sector to establish more plants. Seven units were established in the private sector before commencement of the process of privatization in 1991. During the regime of Nawaz Sharif the industry went through major transformation. The government embarked upon an ambitious privatization programmed and eight units have been privatized so far. The SCCP at present controls less than 25% of the total installed capacity in the country which is shrinking with the establishment of more plants in the private sector and expansion in the privatized units. The units working under the SCCP control are old and inefficient using 'wet process' whereas the units established in the private sector are new, efficient and use 'dry process'. Cement manufacturing is a high capital- and energy-intensive industry. The capital cost of a 2000 tones per day (TPD) plant ranges between Rs. 3.5 billion to Rs. 4 billion whereas the capital cost of a 3000 TPD plant is estimated at more than Rs. 5.5 billion. Energy consumption by cement manufacturing units based on 'wet process' is higher than 'dry process'. The 'dry process' is estimated to be economical by 40% to 50% compared to 'wet process'.

Installed capacity Cement Plants in Northern Region 1) Associated (Wah) 2) D.G. Khan 3) Cherat 4) Pioneer 5) Mustehkam 6) Fecto 7) Kohat 8) Gharibwal 9) Maple Leaf 10) Dundot 11) Lucky Cement Sub-Total Cement Plants in Southern Region 12) Zeal Pak 13) Attock 14) Javedan 15) Pakland 16) Dadabhoy 17) Thatta 18) Associated (Rohri) 19) Essa Sub Total Cement Plants under Construction 20) Saadi 21) Lucky 22) Army welfare 23) Fauji 24) Chakwal Sub-Total Grand Total

(000 tones) per annum 900 1,710 720 660 660 600 330 540 1,460 480 1,200 7,580 880 660 500 540 450 280 230 150 3,690 960 1200 660 900 1,650 5,370 16,640

Lucky Cement Lucky Cement is a 1.2 million TPA Greenfield project based on dry process. Plant and machinery has been supplied by China — the biggest Chinese plant outside China. It is located near Pezu village in NWFP and enjoys sales tax exemption until year 2001 — a unique competitive edge apart from having the lowest project cost among upcoming cement plants. Lucky Cement also holds 100% equity of Lucky Powertech which would supply power to the cement plant upon completion. While Lucky's advantages include sales tax exemption, nominal financial charges — it is almost totally equity-based — the possible risks are: location in a remote area which would result in higher transportation cost of cement, spread over a huge equity-based EPS would always be low and reservations about Chinese technology. Lucky completed its construction at a frantic speed to qualify for duty exemptions but the apprehensions expressed about the structure came true. The unit was closed down soon after commencement of commercial production due to technical reasons including sinking of some strategic foundations. It is feared that it would not be able to resume production for another three months.