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Nigerian Cement Sector - At the end of the tunnel?

• Volumes ebb and flow on fluid cement pricing in 2016: After a strong first half of 2016, when lower prices stimulated robust volume growth, sustained energy pressures forced sector players to abandon their low-price strategy in mid-August 2016. Accordingly, the sector-wide price hikes cascaded to tamer volumes in Q3 16. Over Q4 16, subdued private construction activity and deadbeat fiscal picture suggest an extension of output slowdown, in our view. For 2017, cutback in private sector demand should be tapered by gradual claw-back in government spending in the second half of the year. In addition, we expect pass-through from higher prices to more than offset impact of volume declines on sector top-line.

• Disruptions to gas supply compound margin woes: Over 9M 16, energy challenges exacerbated gross margin pressures across the cement sector following an extended gas shortage that drove increased usage of more expensive back-ups. Farther out however, with gas production gradually ticking up—a fall-out of FG’s conciliatory efforts—and a greater impetus towards energy flexibility which has seen coal mill projects reach advanced stages across our coverage, we see legroom for gross margin recovery over 2017.

• Naira depreciation drives diverse impact for coverage names: Our base case scenario for the naira is for the CBN to shift the current peg to N400/$ sometime in H2 17—a move we expect to drive mixed impact, as in 2016, across our cement universe. Specifically, despite its debt for quasi-equity swap in Q3 16 which shrank FCY loans by 82%, Lafarge remains the most exposed to currency fluctuations in our coverage universe. At the other extreme, DANGCEM’s net positive dollar position stands it out as a safer bet under a volatile naira environment.

• Tough operating environment to drive weaker FY 16E financial performance: Ahead of 2016 results release, we expect sector earnings to contract 35% YoY largely driven by Lafarge Africa, which faced significant FX related losses in prior quarters. For DANGCEM, which announces results tomorrow, we are looking for a 3% YoY contraction in earnings mainly reflecting pressures on the energy front in the earlier months of 2016.

• Cement sector remains relatively cheap: Overlaying our thesis about a recovery in earnings for 2017 with current market pricing after 2016 sell-offs, we find that our coverage cement companies are trading cheaper at respective 2017E PE and EV/EBITDA of 9.0x and 7.2x relative to Bloomberg averages of 18.0x and 10.0x for Middle East and African peers. This is in addition to boasting superior operating return metrics relative to peers. Across our coverage companies, we prefer DANGCEM, given its superior upside potential of 16% which is partly reflective of strong investments in energy efficiency and subdued charges from the tax man.

• Key risks: Broadly, a wider than anticipated NGN depreciation in 2017 could sizably impact input prices (i.e. gas, gypsum) as well as re-ignite FX losses in the books of Lafarge owing to its $108 million debt. While this risk could partially be offset by another price response, we highlight the potential for a boomerang effect on price sensitive cement demand. Importantly, with peace talks in the Niger Delta creeks still very fragile, we remain cautious on the broader macro front with potential knock-on effect capable of extending ongoing deterioration in construction activity in 2017