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Lotte Chemical Pakistan (LOTCHEM): Improving Global PTA Margins to Support Earnings (Rated Buy)

• Investment thesis: Recent turnaround in global commodities has turned our attention to Lotte Chemical Pakistan (LOTCHEM), Pakistan’s one and only producer of Purified Terephthalic Acid (PTA) whose margins move in tandem with international PTA-Paraxylene (PX) margins. PTA-PX margins are in their 4th up trend cycle since 1993 and are currently hovering near US$150/ton. We expect international margins to remain strong for next 2-3 years due to consolidation of global PTA Industry and higher Global & Local PTA demand in downstream sector.
• Global industry consolidation: China’s top PTA producers have informally cut down their production to match demand and supply of PTA in market as per our channel checks. While in 2017, various mergers and acquisitions also took place that led to shut down of idle capacity.
• PTA Margins at 7-year high: Global PTA margins have touched 7-year high of US$158/ton in April 2018 as 1) PTA industry is undergoing consolidation phase, 2) China’s ban on import of waste plastic (Polyethylene Terephthalate or PET) material, 3) Higher demand from downstream players, especially polyester and 4) planned turnaround of various international leading players. Based on the aforementioned reasons, we expect margins to average around US$130 and US$140/ton during 2018 and 2019 respectively. Various international research reports also suggests margins outlook at US$130-US$160/ton for 2018/2019 vs. average of US$88/ton in last 2 years (2016-2017).
• Currency devaluation to improve PKR margins: Dollar denominated prices and margins are likely to converge in higher absolute PKR margins going forward, as further PKR devaluation of 10% during 2018 is anticipated. We expect PKR devaluation of 7% and 3% during 2019 and 2020, respectively. To note, the company has USD denominated payables, that results into exchange loss. However, quantum of its dollar denominated margins is higher than exchange losses.
• Pakistan’s PTA demand to show steady growth: During 2017, PTA demand in Pakistan grew by 9% to ~735k tons over last year, mainly due to higher demand from downstream sector amidst Anti Dumping Duties (ADD) and Regulatory Duties (RD) on its major consumers, improved power availability, and better law and order situation. Going forward, we expect demand to grow at 5-year (2018-2022) CAGR of 5% as Pakistan is 6th largest populous country of the world with per capita PTA consumption of 3.5kg vs. 8kg of World and 5.3kg of India. Additionally, increasing urbanization in Pakistan is generating higher demand for FMCG goods, that indirectly generates demand for PTA in Pakistan. 
• Surplus power and GIDC accruals: The Company is pursuing National Electricity and Power Regulatory Authority (NEPRA) for sale of surplus power (around 20-22 MW) to K Electric (KEL). Post approval, we expect this power sales to contribute ~7% that is around Rs200-220mn (Rs0.12-0.15 per share) to the bottom-line of LOTCHEM. Additionally, the company’s annual GIDC amount is around Rs500mn, that has accumulated to Rs2.1bn. Any development (like 50% waive off or reduction in GIDC rate) related to GIDC accruals will have both incremental cash flows and earnings impact. We haven't incorporated both these events in our valuation/earnings forecast.
• Possibility of expansion, cannot be ruled out: Keeping in view the current demand of PTA in Pakistan, LOTCHEM might go into expansion (with capacity of 1mn tons at an estimated capex of US$400-500mn). This we believe is subject to more protection by the Govt vs. current import tariff of 5%.
• Attractive relative valuation: Currently, the company is trading at EV/EBITDA of 3x and 2018E P/E of 6.3x vs. 7x, and 11x, respectively of regional peers. Our DCF based target price of Rs15 per share offers potential upside of 45%. Historically, the company has traded at average EV/EBITDA of 7-8x in last 8 years.
• Key Risks: Key risks to our valuation/earnings assumption includes 1) decline in import tariff, 2) decline in international  PTA margins, 3) dumping of PTA from other countries, 4) less than anticipated devaluation, and 5) any unfavorable decision related to GIDC.