Is there no sector of the economy that the Covid-19 pandemic has not affected? Look no further: the chemicals sector, which has a current market capitalisation of Rs302 billion, was severely affected by the lockdown imposed in March. The two months of lockdown, followed by a gradual reopening in Ramazan, significantly curtailed demand.
That is why Ahmed Rauf, research analyst at Sherman Securities, a securities brokerage firm, has revised the expected earnings of Lotte Chemical and Engro Polymer & Chemicals – two of Pakistan’s largest chemical manufacturers – in a note issued to clients on June 10. The companies are both facing lower sales volumes in the second quarter of 2020, a trend that is expected to continue in the second half of the current calendar year, and affect profit.
So first, Lotte Chemical. Lotte is the Pakistan subsidiary of a South Korean conglomerate that bought majority shares in the local company, Pakistan PTA Ltd, in 2009. The PTA in the original name stands for purified terephthalic acid, which is an essential ingredient in the manufacturing of textiles, polyethylene terephthalate plastics (PET, used to manufacture plastic bottles and containers), and a whole host of polyesters, like staple fibre and filament yarn.
Lotte Chemical’s plant is at Port Qasim in Karachi which was built in 1996, and started operating in 1998. Since 2002, the plant has a capacity of up to 500,000 tons per annum.
It is a testament to the Covid-19 shock, that its massive plant is currently sitting shut in Karachi, due to a lack of demand for PTA. Sluggish demand, lower sales volume, along with lower interest rates dampening returns from other incomes, means that the earnings outlook for Lotte does not look great.
Rauf revised the 2020 earnings estimate down from Rs1.5 per share to Rs1.1 per share. He also lowered the volumetric sales assumption for 2020 by 24%, to around 375,000 tonnes. In other words, the company was on track to produce nearly 493,000 tonnes (or about 99% of its capacity), but instead will be producing closer to 75% of its annual capacity.
That is the equivalent of losing a full three months of production, which is more or less what has actually happened to Lotte Chemical, in the absence of any major industrial activity in the country, not just within the chemical sector, but in the industries that Lotte serves: textiles, plastics, etc.
And the reason for the collapse in industrial production in those sectors is that the end markets that they serve – the clothing industry and the consumer packaged goods sector – have seen demand collapse as people continue to stay at home and not go outside their homes due to the effects of the coronavirus pandemic.
The average international PTA-PX (PX stands for petrochemical paraxylene, which is used to manufacture PTA) gross margin is currently at $106 per ton. This is 4% lower than Sherman Securities’ assumption of $110 per ton.
Gross margin refers to the revenues generated by a product minus the cost of actually producing it, leaving aside the effects of things like overhead costs, etc. In other words, Lotte is able to buy PTA-PX at a cost of $110 lower than it is able to sell the PTA itself for after it is done manufacturing the PTA. The cost of the PTA-PX is the single biggest cost in the manufacturing of PTA.
“Hence, we are keeping our margin assumption intact for 2020 and beyond at $110 per tonne, at a discount of 15% from 10-year average margin of $130 per tonne,” said Rauf.
On a slightly more optimistic note, Raif expects demand for PTA to pick up, once economies reopen and demand for the textile sector, which exports, finally kicks in. Plant operations may still be subdued, but may recover by the fourth quarter of this calendar year. That is why the earnings per share for 2021 remain unchanged at Rs2.2.
Now, moving on to Engro Polymer. The company was founded in 1997, makes polyvinyl chloride (PVC) products (used in the manufacture of pipes and cables), and also caustic soda, which is used in the textile industry, for water treatment, and to make soap. As of 2018, the company commanded a market share greater than 70% of Pakistan’s market.
This time, it was the severely affected construction and textile industries which under lockdown were simply not demanding enough PVC.
Rauf revised the 2020 earnings estimate down from Rs3.3 per share to Rs1.4 per share. He also lowered the volumetric sales assumption for PVC this year by 23%, to around 137,000 tonnes, and caustic sales assumption by 25% to around 54,000 tonnes. Note the declines: they are similar to those of Lotte, in that they also represent effectively a three-month shut-down in operations.
The average international PVC-ethylene margin is currently at $360 per ton, which is 10% lower than Sherman Securities’ expectations of $400 per ton. Once again, this represents the gross margin at which Engro can import PVC-ethylene and manufacture the PVC for its customers.
“Hence, we are revising down our margin assumption for the second half of 2020 by 8% to around $370 per tonne, which is similar to the 10-year average margin,” said Rauf.
And just as in the Lotte case, Rauf expects the textile sector to recover later this year, and for plant operations to also recover by the fourth quarter of this year. However, Rauf revised the earnings estimates for 2021 from Rs4.6 to Rs3.1 per share.
