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Pak Elektron (PAEL): Earnings revised downward 'Maintain Buy'

• We revise down our earnings of Pak Elektron (PAEL) after tweaking our assumptions post 2Q2018 result and incorporating new product estimates based on guidance from the company’s 1H2018 corporate briefing.
• We were previously anticipating the company to post EPS of Rs5.3/6.0/6.3 for 2018E/2019F/2020F. We now revise this down by average 31% to Rs3.1/4.1/5.0 for 2018E/2019F/2020F.
• However, we maintain our ‘Buy’ call on PAEL given the recent correction as the stock is down 32% in 2018YTD, underperforming the benchmark index by 34%.
• Though the company’s sales were broadly in-line with our estimates during 2Q2018, earnings were marred by lower gross margins which contracted by 7ppts YoY to 23%.
• Lower margins were on the back of 1) Chinese entrants affecting sales, 2) currency devaluation and 3) fluctuations in the international commodity prices. This trend in margins is expected to sustain in the near future, we believe.
• We have also incorporated PAEL’s upcoming new product line that is LED TV (32”, 40”, 50”), which is expected to be launched by the end of this month. The management expects to capture 15-20% market share in next few years in an industry of 1mn units with margins of 20-22%. We expect LED TVs to contribute 3% to PAEL’s 2018 earnings and 13% in 2019 earnings.
• The company has also announced to launch washing machines by mid 2019 with semi-automatic and fully automatic features. The washing machine market is estimated at 2.5mn units per annum with margins of around 25%. Though, we have not yet incorporated washing machines in our assumptions, it can potentially add EPS of Rs0.2-0.4 per annum to PAEL’s earnings.
• To increase access to customers, PAEL has recently launched its online store as consumer durables and electronic companies in Pakistan are increasing their penetration through e-commerce (e-commerce industry of Pakistan is estimated at US$0.7-1bn). Orient, one of PAEL’s competitors is already providing this service. Moreover, to further extend its reach, the management expects to collaborate with Daraz, a leading online retailer in Pakistan.
• In appliances division, we expect PAEL to post flat sales growth in refrigerator and air conditioners in 2018 with around 461k unit refrigerators and 87k unit air conditioners (refrigerator and air conditioners constitute around 80% of PAEL’s appliances sales). Appliances sales will be affected due to stiff competition in the segment owing to penetration of Chinese players in the market as well as row with one of its largest distributors.
• On the flip side, microwave oven and water dispenser (constitute around 5% of appliances sales) are cumulatively expected to register 39% YoY growth in 2018 thanks to larger penetration of PAEL owing to aggressive advertisement campaign.
• In Power division, sales of power transformer and energy meters (constitute 16% to power sales) are expected to fall 8% YoY in 2018 while we anticipate EPC contracting which is provided for underground electrification in housing projects and grid stations (constitute around 29% of power sales) to decline by 19% YoY.
• We expect sales of switch gears which is used for fluctuation control in buildings and towers (constitute around 20% to power sales) to fall by around 4% YoY in 2018. Decline in sales of power division is due to lower order intake from Govt. utilities and slowdown in housing projects.
• While competition has certainly intensified in both appliances and power division due to new entrants which has affected sales, rising input costs are putting pressure on margins. However, the management expects to raise appliance prices from January 2019 to pass on the hike in input costs, though to what extent is yet to been seen.
• We flag, 1) increase in raw material costs and the company’s inability to pass it on, 2) greater than expected PKR devaluation against US$, 3) higher financial charges to fund working capital and 4) greater competition due to new entrants key risks for PAEL. We highlight here that larger discounts and distribution expenses can significantly affect PAEL earnings outlook.