Portland's stock to rise as firm shrugs off currency risk

Daily Nation , Business Week
Story by NICK WACHIRA
Publication Date: 06/14/2005

East African Portland Cement (EAPC) is expected to shrug off the currency exposure risk that has affected its profitability in the second half of the firm’s financial year.

This expected to boost its share price, which analysts say has lagged Bamburi due to Portland's exposure to a big Japanese yen-denominated loan, and a poor dividend payment history.

"Strong operational performance and an improving Kenya shilling-Japanese yen exchange rate in the second half will see a substantial increase in earnings and dividends in the forthcoming results to be released in September," says a stock research report released by African Alliance Kenya that upgraded the outlook for cement sector.

The stock brokerage firm has given Portland a favourable "overweight" rating along with Athi River Mining. This research is usually sent to African Alliance Kenya brokerage clients to advise them on what is happening in the stock market urging them to either buy, hold or sell shares.
"EAPC has lagged behind Bamburi trading at a big discount on most valuation metrics. Portland now trading at a forecast price-to-earnings multiple of 9 compared with Bamburi at 16.7," says the report. "However the strong underlying operating performance, the expected boost to earnings from the exchange rate gain in the second half of 2005 and the possibility of a dividend payout does not justify this discount.

Even with the rosy recommendation, analysts says that Portland continues to hold significant risks to its balance sheet due to the firm’s currency exposure to the Japanese yen. African Alliances says that based on May 2005 closing rate for yen in Kenya, EAPC’s exchange gain could top Sh253 million. The firm’s financial closes in June.

While the yen is currently trading favourably to the Kenyan shilling, it is estimated that a 20 per cent depreciation of this exchange rate could force EAPC to report a loss in 2006 and worsen its debt to equity ratio to 276 per cent. Portland is also faced with significant risks that it cannot expand its capacity faster to meet growing demand for cement in the country and this could limit the firm’s ability to grow revenues. The firm last year paid a dividend of Sh1.75 per share, even after posting poor results with a net loss of Sh269 million.

With loss per share standing at Sh2.99, the management dug into reserves to pay Sh157 million dividend, which was increased from Sh33 million in the previous year. Since 2000, Portland has had a spotty profitability record, which was heavily influenced by currency exposure risks.
Portland acquired the Sh3.5 billion yen denominated loan in 1996. This loan had not been hedged and hence currency swings have heavily affected profitability and debt ratios.

"Yen sensitivity is a key concern among investors and in the last three sets of result releases it has negatively impacted earnings. Indeed in 2004, the exchange loss reduced earnings from Sh368 million to a net loss of Sh299 million," says African Alliance.

"This trend continued into the first half results for December 2004 with an exchange loss of Sh143 million."

The Japanese loan will only be repaid fully in 2020 and the yen exposure will always remain a big risk that the firm’s investors will continue to face.
In spite of this risk, Portland shares have been performing well on the Nairobi Stock Exchange (NSE), rising from an all time low Sh8 in October 2001 to the recent levels at Sh57. Since August 1997, EAPC shares have outperformed the NSE 20 Index.

The share has, however, earned a return of negative 3.2 per cent in the last three months and negative 20 per cent relative to the NSE 20 Share Index after it announced a big loss.

Portland is currently operating at full capacity in Kenya, and its management is said to be looking at plant expansion. If the capacity issue is not resolved and the demand for cement continues growing, Portland will miss major opportunities. "We believe however that if cement demand in Kenya were to spike," says the report, "EAPC would have to accept a substantially reduced market share from its current 35.2 per cent or embark on an expansion project." Portland got a new CEO, Zakayo Ole Mapelu, last year and is emerging from a long period of bad management.
The company has been pursuing an aggressive export strategy that has allowed it to fetch higher profit margins and ease pricing pressures in the local market.

Before the recovery of the cement sector, pricing pressures had started eating deeply into industry profit margins. The price war was mainly waged by Portland, which was making an aggressive push into the market. However, an increase in demand in the region has started reducing the effect of excessive price competition.

With the pricing pressures in Kenya falling, both Portland and Bamburi are enjoying good profit margins in the region. EAPC is said to been keenly interested in tapping the Sudan market, which is expected to benefit as the reconciled government starts rebuilding infrastructure.
Of the three cement companies in Kenya, Portland is the most indebted. The company is expected to generate slightly over Sh1 billion in cashflow from operations in 2005 and Sh426 million in free cashflows. To reduce the firm’s currency exposure risk, the company says that it has previously asked the Treasury to review the loan. However, the Japanese government, which guaranteed the loan, seems not to be interested pursuing such a strategy.

Getting out of this debt arrangement could involve an expensive prepayment penalty that could force the company to issue more issues on the NSE to fund the operation or seek the intervention from the government at a time when the Treasury does not wish to support quasi-parastatals.