PAEL: Multipliers come in all shapes & forms

We initiate coverage on Pak Elektron Ltd (PAEL PA) with a Buy rating having a Dec’18 TP of PkR51.70/sh. Rising consumer durable spending propagated by rapid urbanization and favorable demographics are slated to amplify White Goods purchases while distribution focused commercial energy CAPEX push power equipment demand. Both undergo upswings from existing but undisciplined infrastructure and consumer durable consumption patterns maintaining a long-term demand sweet-spot for PAEL. That said, we also highlight medium-term competitive pressures in the appliance segment and public-sector governance risks as weighing on earnings. Grounded in these, sturdy demand is forecasted with a 5-yr gross sales forward CAGR of 19.5% (vs. ~16% during CY12-17A). However, passing-on the high cost of directly imported materials (66% of total COGS) remains challenging in an environment where the currency is under pressure, translating into CY18-22F average GM of 27.4% vs. 30.4% during CY14-17A. Resulting NPAT growth (5-yr forward CAGR of 12.7%) postures for re-rating as the stock currently trades at a CY18/19F P/E of 6.2/5.0x and PEG ratio of ~0.26x. At current price level, the stock provides an upside of 34.2%.

Balance sheet revival going steady: PAEL’s valuation set has firm grounds for re-rating as a conducive environment for demand endows balance sheet health, guarding against swings in profitability and working capital. Catalysts in consumer appliance are conducive to our growth outlook supported by high relative market shares. A follow-on, is the ability of PAEL to taper its debt burden. Facing a weakened PkR vs. US$ outlook, our sensitivity shows that every 1% increase in long term PkR depreciation, assuming only 50% of the cost is passed-on (our base case is 80%) reduces earnings by ~6% or PkR0.62/sh and softens gross margins by ~70bps from our base case. Additionally, swings in fair value and debt levels (using average net debt to EBITDA) indicate that just a 10 day increase in annual average DIO and DRO reduces fair value by PkR~6/sh (PkR3.04bn), while compensating for the same through leverage raises net debt by ~9% (additional borrowing of PkR1.77bn). Markedly, the working capital cycle is a crucial source of stress on valuations.

Multipliers come in all shapes and forms: Prominence of new entrants and incessant emphasis on improved features/functionality prompt a shift beyond price-based competition, propagating shorter replacement cycles in the appliance space. Developments germane for a legacy brand, such as PAEL to leverage for market share. Exploring the medium to long term outlook for demand, we highlight our moderate view on power segment sales, concentrating on tepid margins, reduced pricing power in the equipment’s business. In the EPC segment, we take a more bullish view, basing sales growth assumptions on planned CAPEX upcycle and public spending, only after CY19F. Consequently, we highlight immense room for capacity additions to distribution, estimating a potential ~30% increase in the system’s MVA between CY18-21F. Moreover, we map a series of events on the horizon, that could have a material impact, such as the approved (but yet to be executed) MYT CAPEX plans, where just the top-tier IESCO, FESCO and LESCO plan could raise meter/distribution transformer demand by 14.5/38.3% p.a through to FY20F.

Investment Perspective: Our bullish thesis accommodates accelerating EPC income, operating cash flows keeping debt burdens manageable while heavy relative market shares (largest player in product segments that account for more than ~77% of gross sales) sustain free-cash-flow growth. Looking at a range of regional power equipment and household appliance manufacturers, we limit the relative comparison to smaller peers where PAEL looks attractive in terms of valuation metrics and payouts. Emblematic of a manufacturing concern in high-growth segments, high net working capital drain (average PkR3.28bn p.a for CY18-20F vs. PkR2.75bn in CY17) and CAPEX outlays (PkR~1.76bn p.a CY18-20F average), necessitate leverage (D/E average ~63% over CY18-20F). Nevertheless, payout ratios are expected to sustain at ~41%, underpinning attractive dividend yield (CY18/19F D/Y of 6.3/7.9%). With a FCFF based TP of PkR51.70/sh, 5-YR forward earnings CAGR of 12.7%, the stock offers ~34% upside from current price level. Buy!

  AKD Research