Fauji Cement finally decides to expand

At first glance, the notice seems almost routine. On February 19, Fauji Cement Company issued a notice to the Pakistan Stock Exchange (PSX), that it had approved the setting up of Greenfield Cement Manufacturing Plant of 2.05 million tons per year at Dera Ghazi Khan. The construction work on the project is expected to start this financial year, and is expected to have a construction period of two and half years. 

The total project cost will be announced after negotiations with suppliers and contractors, while the equity portion of the expansion will be funded through internal cash generation. 

According to the notice, the board decided to take this decision as construction activity has picked up, and significant spend on infrastructure is expected to continue. 

So far, makes sense. But what makes this interesting is: is this a case of too little, too late for Fauji Cement? Let us explain. 

First, Fauji Cement is part of the umbrella of the Fauji Foundation.  In 1954, the Pakistan Army set up the Fauji Foundation, as a charitable trust initially designed to help provide welfare for the army’s retired soldiers as well as their dependents. In 2020, it has sprawled into a massive conglomerate, that runs 21 associated companies, and three fully owned companies, in industries as varied as fertilisers, cement, power, oil, gas, food, grain, and even banking (Askari Bank). By its own estimates, its welfare programs serve 9 million beneficiaries.

And where is the money for this welfare program coming from? The two most important, and most lucrative, of those companies are Fauji Fertilizer Bin Qasim Ltd (FFBL), and Fauji Fertilizer Company (FFC). Fauji Foundation owns 39.4% of Fauji Cement, while FFC owns 6.79%. 

And this is the most crucial point: part of the issue for Fauji Cement relative to its peers in the cement industry may be the dividend bias that the company’s holding group – the Fauji Foundation – has from some of its larger businesses such as Fauji Cement and Fauji Fertilizers.

Given the mandate of the Fauji Foundation to generate cash to be distributed to orphans and widows of fallen soldiers, the foundation often ends up requiring its portfolio companies to pay out significantly larger sums of money in dividends than other investors might. As a result, comparatively little is left for capacity expansion, unlike its competitors, which are freer to reinvest their profits without necessarily having a strong mandate to deliver cash dividends.

And one can see this in the company’s own history: essentially, Fauji Cement ends to post better results than its peers because it has historically refused to expand. This lack of operational expansion is actually quite a big problem. Take, for example, the fact that Fauji underinvested in cost-efficient projects like captive and waste-heat power plants, which means that Fauji is over-dependent on the grid. Its a small fact, but something its rivals have actively worked on. 

Now, whenever the cyclical recovery kicks in, Fauji’s competitors will have a greater capacity to cater to demand because they expanded much earlier (most expanded in the years between 2006 and 2009). Not only will the plant be more expensive now, but the construction time of the plant itself, of around 30 to 36 months, would eat into the recovery cycle period – which means any expected benefit will bypass Fauji completely.

But once in a while, when the cement sector picks up, the conditions are such that it is almost impossible to not want to expand, and reap any benefits. And that is exactly what happened in the latter half of 2020. 

First, the interest rate was cut significantly by 625 basis points to 7%, helping with loan repricing, and new loans for large projects. 

Second, the federal government announced a construction package in April 2020, upon which investors will also be granted a waiver of up to 90% on tax, if they are investing in construction projects under the Naya Pakistan Housing Scheme. The industry will also have a fixed tax regime, instead of taxes on profits. The government also followed up with more incentives for the industry in the new budget for fiscal year 2021. Around Rs69 billion was allocated for dams, and Rs30 billion was allocated for the Naya Pakistan Housing Scheme. 

Third, the central bank asked commercial banks to allocate 5% of their total lending to the construction sector, which will be provided at a low rate of 5% and 7% for five and 10-marla houses (one marla is around 272 square feet). This will hopefully improve lending in general: as is, banks’ current exposure to the sector is only at 1% of overall advances.

All of these incentives means that the cement industry can finally start making some serious revenue. It is especially true for those companies that had already invested in expanding their capacity to meet rising demand from their existing customers. Fauji Cement has finally, belatedly, realized the importance of a new plant.