05-JAN-BMA

Pakistan Market Strategy

Macro improvements continue as a blend of political and economic developments lend credence to bullish momentum at the KSE where we foresee the KSE-100 racking up another 27% gain over CY15F. Our blended index target of 41,400 points for Dec15 incorporates an earnings growth of 8%YoY and dividend yield of 6%, while the market is likely to re-rate by 10%+ backed by continued monetary easing, ample local and foreign liquidity and narrowing discount between KSE-100 and the region. KSE-100 currently trades at a CY15F P/E of 8.9x compared to regional average of 13.7x and MSCI FM 100 at 9.7x. At the same time, Pakistan markets dividend yield at 6% is significantly above the regional average of 3% and MSCI FM 100 yield of 4%. Improved economic metrics particularly in light of declining global oil prices (inflation, CAD), continued privatization process (fx reserves) and economic reforms are likely to form key check points for price discovery in the market. Growth in FDI over a longer horizon particularly in light of recent agreements with China and Russia should also aid sentiment while increased political consensus as well as a decisive operation against militants constitute upside to our estimates. Preferred plays include Cements (MLCF, LUCK, FCCL) while we also like Fertilizers (ENGRO), Banks (UBL, BAHL) and Textiles (NML). With market having already priced in global oil price declines, we continue to like E&Ps (POL, OGDC) on developmental projects in CY15. Falling oil prices also lead to a bullish outlook on PSO as circular debt accretion slows.

Political consensus as attention shifts to the economy: With opposition protests a back page story, we believe the governments focus is likely to once again shift towards economic reforms. Lower inflation levels (FY15: 6.0%-6.5%) against a backdrop of declining global oil prices should allow the government to gradually lower energy subsidies. We believe FY15 will witness broad improvements with a sustained Balance of Payment (BoP) surplus at USD4.1bn, CAD at 0.9%-1.0%, GDP growth at 4.5% and fiscal deficit at 5.3%. At the same time, continued privatization will likely capture headlines with a key distinction in CY15 being the privatization of inefficient entities.

Eyeing 41,400 points by Dec15! Our Dec15 KSE-100 index target of 41,400 points implies an upside of 27%. We expect the market to re-rate by 10%+ backed by monetary easing as well as reversion to mean historical differential between PIB and earnings yields. At the same time, continued ample liquidity on the local and foreign investor front as well as a potential peace dividend from a successful Operation Zarb-e-Azb may result in market beating our target. Any deterioration in law & order (particularly a terrorist retaliation) forms a key downside risk.

Several economic indicators are comparable to CY06; a time of peak multiples: The KSE-100 peaked at a P/E of 13.8x in Apr06 while similarities between economic measures then (CPI: 8.9%; DR: 9.0%; SBP Reserves: USD10.6bn) and now (Average CPI: 6.1%; DR: 9.5%; SBP Reserves: USD10.3bn) are striking and support our view of an upward re-rating from CY15 P/E of 8.9x. Another key thesis for markets re-rating is the contracting P/E to regional economies where Pakistan currently trades at a discount of 35% to regional markets.

Conviction Calls: Declining energy costs despite anticipated tariff pass-through in Jan15 form the basis of our preference for Industrials. We continue to like Cements where our top picks include LUCK, MLCF and FCCL. We also like Textiles (NML) where declining energy costs will likely be complemented by lower raw material costs. Despite declining interest rates, we continue to like Banks (UBL, BAHL) owing to high PIB accretion and growth in non funded income. ENGRO makes our cut due to positive group developments while we also like Oil & Gas (OGDC, POL, PSO) as negatives from lower oil prices are already priced in.

Pakistan Equity Market Strategy 2015

Stage set for a strong re-rating!

BMA Universe Valuation Summary

5 Jan 2015

Priced on: 1-Jan-15

KSE100 Dec15 target: 41,400

KSE100 Index: 32,480

Upside: 27%

KSE Market Capitalization

PKR7.4tn (USD73.6bn)

KSE100 Market Capitalization

PKR6.4tn (USD63.4bn)

12M KSE100 ADT Value

PKR7.8bn (USD78.3mn)

BMA Research [email protected] +92 111 262 111 www.bmacapital.com

CY14 CY15F CY16F

EPS Chg (%) 18 8 7

P/E (x) 10.1 8.9 8.1

P/B (x) 2.1 1.9 1.7

D/Y (%) 5 6 7

E/Y (%) 10 11 12

ROE (%) 21 21 21

ROA (%) 4 4 4

*All metrics based on current prices

KSE100 Index & Volume Chart

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Timeline: Events Chart CY14 ..... 1

Key Charts . 2

Pakistan Market: Targeting 41,400 by Dec15! ................................................................ 4

BMA Conviction Portfolio...... 8

Pakistan Politics: A United Front! ... 10

Pakistan Economy . 12

Sectors... 17

Oil & Gas: Exploration and Production. 18

Oil Marketing Companies.......... 20

Banks......... 23

Cements ... 26

Textiles... 28

Chemicals (Fertilizer) ...... 30

Conviction Calls.. 32

OGDC: Developments meriting a second look! .... 33

POL: Negatives already priced in! ... 35

PSO: Gaining momentum on recovery in energy chain.... 37

UBL: Banking on diversified revenue base...... 39

BAHL: The Safe Banking Haven ...... 41

LUCK: The emerging conglomerate! 43

FCCL: Yielding higher returns 45

MLCF: De-risking with growth. 47

NML: Core operations turning the corner........... 49

ENGRO: Gaining traction!....... 51

Table of Contents

Pakistan

Market Strategy

Events Chart CY14

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Key Charts

Figure 1: Forward Regional P/E (x) Figure 2: Forward Regional Dividend Yield (%)

Source: Bloomberg, BMA Research

Figure 3: Average PIB and E/Y differential Figure 4: P/E vs. Reserves

Source: KSE, SBP, BMA Research

Figure 5: CPI vs DR Figure 6: BOP Composition (USDmn)

Source: SBP, BMA Research

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PakistanMarket

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Market Outlook: Targeting 41,400 by Dec15!

Pakistan Equities look geared for another year of stellar returns where our KSE-100 Index target of 41,400 points offers an upside of 27% from current levels. At the same time, the market continues to offer a dividend yield of 6%, the highest amongst the regional markets. KSE-100 P/E of 8.9x at CY15 earnings is at a considerable discount to historic peak of 13.8x in CY06 while similarities in macroeconomic indicators then and now are striking. Equities are supported in our view by five tailwinds of i) continued macroeconomic de-risking as economic indicators improve and privatization process remains on track, ii) reduction in policy rate by the SBP where BMA expects a cut of 150bps in CY15, iii) ample local and foreign liquidity, iv) political stability as all parties front a unified stand in the wake of recent terrorism and v) attractive relative valuations with the KSE continuing to be the cheapest market in the region.

Figure 7: Forward Regional P/E (x) Figure 8: Forward Regional Dividend Yield (%)


KSE-100's upward journey to continue in the wake of macro de-risking: In continuation with the economic theme in our strategy report released in Oct14, we believe Pakistans macro de-risking remains on track. The end of protests by the opposition parties marks a prominent moment for the incumbent PML(N) government where we believe focus will shift back to economic reforms. In its recent meeting with the IMF, the GoP has outlined continued privatization of State Owned Enterprises (SOEs) with a key distinction in CY15 being the privatization of inefficient entities. At the same time, reduction in global oil prices will help Pakistan sustain its Balance of Payment (BoP) surplus to USD4.1bn with CAD improving to 0.9%-1.0% of GDP in FY15 from 1.2% in FY14. GDP growth is expected at 4.5% (FY14: 4.1%) while fiscal deficit is expected at 5.3% (FY14: 5.5%) with slippages on account of non-collection of GIDC as well as lower than targeted tax collection.

Attention will also turn to the outcome of Operation Zarb-e-Azb where the recent terrorist attacks have brought politicians, public, religious scholars and the military on one page with regards to the future course of action. News flow regarding success of the operation may unlock further foreign flows in the form of peace dividend along the same lines as Operations Rah-e-Nijat and Rah-e-Rast in FY09-FY10.

Dec15 Index target of 41,400! Our Dec15 index target of 41,400 offers an upside of 27% from current levels. Target index calculation is premised on a combination of i) earnings growth at 8% and dividend yield of 6% and ii) coverage universe target price mapping accounting for 150bps easing. The resultant index target incorporates a re-rating by 10%+.

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BMAtargetstheKSE100toreach41,400byCY15end.CurrentmarketP/Eat8.9xisaconsiderablediscounttohistoricpeakof13.8xMacroderiskingtoremainontrackamidpoliticalstability.Decisiveactionagainstterroriststounlockpeacedividend

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Index target calculation & regional valuation

Re-rating the key theme for CY15: Monetary easing is likely to be one of the main driving forces behind market performance in CY15 where our economist estimates a 150bps cut in the discount rate during the year. Every 50bps cut in the discount rate increases valuations by an average of 5%. At the same time, current differential between earnings and PIB yields stands at a level of 0.1% against an average of 1.6% during the period CY07A-CY14A, indicating the need for earnings yields to decline. Assuming convergence to mean differential, the market should ideally trade at a CY15 P/E of 9.9x compared to current 8.9x, translating into a potential re-rating by ~11%.

Figure 9: Average PIB and E/Y differential

Source: SBP, Bloomberg

Historical Precedence Comparison with CY06: While current forward market P/E stands at an undemanding 8.9x, the KSE-100 peaked in Apr06 when market P/E went as high as 13.8x. Similarities in macroeconomic indicators during the two periods are striking and certainly merit a revisit on market multiples.

Comparison - Key Metrics

Dec'14 Apr'06

SBP Reserves (USD bn) 10.3 10.6

CPI (%) 4.3 8.9

Discount Rate (%) 9.5 9.0

Market P/E (x) 8.9 13.8

Source: SBP, KSE, Bloomberg

Current policy rate stands at 9.5% with further easing expected while SBP reserves have increased to USD10.3bn. At the same time, average CPI for FY15 is expected in the range of 6.0%-6.5% while Dec14 CPI stood at just 4.3%. In CY06, the economic situation was somewhat similar, with the policy rate then at 9.0% while SBP reserves stood at

MonetaryEasingthekeydrivingforcebehindKSE100reratinginCY15EconomicsimilaritiesbetweenCY06andCY15furtherstrengthensconfidenceonmarketrerating

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Current PIB yields have been artificially inflated given GoPs need for re-profiling of debt Transition towards normalized rates as well as monetary easing in CY15 will likely take PIB yields significantly lower than CY15 E/Y

Country P/E (x) D/Y (%) ROE (%) Pakistan 8.9 6.2 21.0 India 16.7 1.5 15.9 China 12.3 2.7 13.5 Malaysia 15.7 4.4 12.6 Vietnam 12.3 3.6 15.5 Sri Lanka 11.2 2.5 12.3 MSCI FM100 9.7 4.2 16.1


Index Target Dec'15

Current Index 32,480

Earnings Growth & D/Y 40,398

TP Mapping 42,413

Blended Index Target 41,400

Upside to Index Target 27%

Source: BMA Research

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5 Jan 2015


USD10.6bn. Inflation in Apr06 stood at 8.9%, significantly higher than the current level. Given comparable economic indicators as well as a 35% discount to peak market multiple, we believe there exists a strong case for market to re-rate in CY15 by 10%+.

Figure 10: P/E vs. DR Figure 11: P/E vs. Reserves

Source: Bloomberg, SBP, BMA Research

Liquidity to remain ample! Market liquidity remains ample where Pakistan equities have continued to attract significant inflows. Total CY14 inflows stood at USD457mn, up 15%YoY while foreign holding as a percentage of free float has increased to ~35% from 31% in Jun12. Moving into CY15, we believe foreign inflows are likely to continue given attractive valuations for the Pakistani market (P/E: 8.9x, P/B: 1.9x, Earnings growth: 8%, D/Y: 6%) as well as the initiation of quantitative tightening in the US, widely expected in 2HCY15 and coinciding with a period of easing in Pakistan.

Figure 12: FIPI and Market Performance

Source: KSE, Bloomberg

Outlook for local liquidity remains favorable given i) continued monetary easing resulting in a shift from fixed rate investments to equities and ii) spare cash with locals as costs of doing businesses decline given falling interest rates and input costs (fuel, raw material). A quick and easy guide to increasing local liquidity would be the current ratios of domestic businesses where the Textile sectors current ratio has improved by 38% in just 3 years,

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5 Jan 2015


while the same for Cement and Auto manufacturers has improved by 2.3x and 20%, respectively. CY14 market performance recap: Despite consolidation in the latter half of CY14 as political disruptions came to the fore, the KSE-100 performed admirably, returning 24% in PKR terms and 33% in USD terms during CY14. In the process, the KSE-100 became the third best performing market in the world, trailing only China and Venezuela. At the same time, the Pakistan market also outperformed the MSCI FM100 index which remained flat (+1.1% YoY).

Figure 13: Regional Market Performance in CY14 Figure 14: Regional Market Performance in 2HCY14


Market Strategy: Preferred plays include leveraged sectors with particular liking for Cements (FCCL, MLCF, and LUCK) as well as selective Fertilizers (ENGRO). The Cement sector is also expected to benefit from a growing local appetite as well as reducing costs as coal and FO prices come off. ENGRO will likely benefit from i) continuation of gas supply to both of its fertilizer plants, ii) potential initiation of chargeability of the concessionary gas, iii) improving margins of food subsidiary Engro Foods given recent increase in retail milk prices, iii) cash induction from a secondary offering of EFERT and iv) initiation of the LNG project by Feb14. Despite the fall in oil prices, we continue to like the Energy chain with top picks being POL, OGDC and PSO. Falling interest rates should somewhat benefit Banks this time given AFS gains on PIB portfolio with our top pick being UBL, which offers an exposure to a blend of Pakistan and Middle East. Lower cotton costs and interest rate benefits result in our liking for Textiles with NML being our top pick. Rising power and gas costs, as agreed with the IMF recently, however, could result in some volatility at the start of the year. Long term fundamentals, however, merit a bull stance on Pakistan Equities!

Oil and Gas Exploration & Production: The market already appears to have factored in the negative impact of declining oil prices in current valuations, thus providing for an attractive entry point. Our conviction on the sector is based on i) steady volumetric additions (3 year oil production CAGR of 10%), ii) more than 100% reserve replacement owing to drilling in high impact areas, iii) strong FCFE generation (up by 15%YoY to PKR51.7bn in FY15F) and iv) undemanding sectoral valuations of 7.7x (P/E) and 4.5x (EV/EBITDA), depicting a marked discount of 37% and 25% over regional peers, respectively. We flag POL (TP: PKR550/sh) and OGDC (TP: PKR261/sh) as our preferred plays.

Oil Marketing Companies: The OMC sector is expected to witness a better CY15 driven by i) strengthening petroleum sales, ii) increasing share of high margin and cash based

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TheKSE100yielded33%inUSDtermsinCY14,becomingthethirdbestmarketintheworldBMAConvictionideas:FCCL,MLCF,LUCK,ENGRO,NML,PSO,UBL,BAHL,OGDC,POLWebelievethemarkethasalreadypricedinthenegativeswithinE&Ps

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5 Jan 2015


products, iii) declining interest rates and iv) decreasing exposure to circular debt. The sector is currently trading at a marked discount of 18% over the KSE-100. We re-iterate PSO (TP: PKR463/sh) as our top pick in the OMC sector.

Banks: The banking sector will continue to remain in the limelight in CY15 due to robust yields locked in on the investment portfolio along with a gradual uptick in private sector credit off-take. As a consequence, BMA Banking Universe is expected to register earnings growth of 16% in CY15 with an impressive 5yr CAGR of 20%. Within the banking universe, we reiterate our preference for UBL with a TP of PKR225/sh, reflecting an upside of 29% from current levels. We also like BAHL with a TP of PKR60/sh, offering an upside of 24%.

Cements: The cement sector backed by 1) declining fuel and power costs, 2) monetary easing and 3) growing local cement demand is expected to continue its growth streak. FCCL, MLCF and LUCK remain our top picks with target prices of PKR34/sh, PKR62/sh and PKR596/sh, translating into upsides of 27%, 33% and 16%, respectively.

Textiles: The sector is all set to post healthy returns in CY15 due to i) 21%YoY decline in cost of raw material, ii) reduced fuel and power cost on account of 40% FYTD decline in prices of FO and iii) 17%-31%YoY growth in the exports of value added textile products. Our top pick from the textile sector is Nishat Mills Limited (NML) with a TP of PKR146/sh, offering an upside of 25% from current level.

Electricity: In the backdrop of falling yields on fixed income instruments, IPPs will continue to garner increased investor attention with an attractive dividend yield of 10% and US dollar based revenue stream. Our investment theme is premised on the sector being i) the highest yielding sector in the market, ii) hedge against macro volatilities (inflation and exchange rate depreciation) and iii) potential improvement in liquidity position amid slowdown in circular debt pile-up.

Chemicals: The fundamentals of the sector will remain critically dependent on stable gas supply and any imposition of levy by the government on feedstock rates. With falling oil prices taking its toll on international urea prices, thereby narrowing premium over local prices, we believe the outlook of the sector remains mixed. Though we advocate a cautious stance on the sector, we maintain our liking for ENGRO, backed by improving fundamentals, secondary market cash generation and new risk free business ventures (note: Engro Elengy).

BMA Conviction Calls:

Banksarelikelytodepicta5yearearningsCAGRof20%DecliningfuelandpowercosttoexpandmarginsofTextilesandCementsMultipletriggersstrengthenourconvictiononENGRO

Conviction Calls

Companies Price TP Upside DY Total

Return P/E P/B ROE

(1-Jan-15)

POL 382 550 44% 13% 57% 7.2 2.5 35%

OGDC 206 261 26% 6% 32% 8.0 1.9 24%

PSO 362 463 28% 3% 31% 6.2 1.1 17%

UBL 175 225 29% 7% 36% 8.2 1.8 22%

BAHL 48 60 24% 5% 29% 7.0 2.3 32%

LUCK 513 596 16% 2% 18% 12.2 2.8 23%

FCCL 27 34 27% 7% 35% 10.7 2.2 21%

MLCF 46 62 33% 0% 33% 7.3 1.4 19%

NML 124 146 17% 4% 21% 7.2 0.8 12%

ENGRO 232 272 17% 0% 17% 6.2 1.4 23%

Portfolio Return 31%

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5 Jan 2015


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5 Jan 2015


Politics takes a back-burner; focus likely to shift on economic policy: The end of the protests marked a triumphant moment for the incumbent PML-N where we believe attention will once again shift towards economic decision making. The Governments decision to sit with the opposition for forming a committee to look into the alleged rigging in CY13 elections is a big positive and will likely further strengthen the democratic set-up in the country. A key positive is also the continued non-interference of the military despite several hiccups.

Given the backdrop of improving political situation within the country, the government has started focusing on regional relationships and attracting investments. Recent successes in this regard include

i) the recently signed USD1.7bn energy deal with Russia for laying a liquefied natural gas (LNG) pipeline from Karachi to Lahore

ii) the USD3.0bn Gwadar LNG pipeline and terminal project with China

iii) the USD45.6bn China-Pak Economic Corridor project.

Withstableinternalpolitics,thefocuswillnowshifttoregionalstrategicrelationships,unlockingpotentialFDI

12


5 Jan 2015


PakistanEconomy

13


5 Jan 2015


Inflation - CPI to remain under 7.0% owing to lower commodity prices

We expect FY15 CPI inflation to average 6.0%-6.5% (FY14: 8.6%), lower than the IMF and SBP estimates of 8.0% and 6.5%-7.5%, respectively. We foresee a high likelihood of lower inflation to continue and expect FY16 CPI in the range of 7.0%-7.5% even if global oil prices rebound to USD70/bbl. We do not foresee a bull run in oil prices given surplus supplies and a weakening global demand. While oil has a weight of 3.03% in the CPI basket, spending on oil comprises 6.2% of Pakistan's GDP and 46% of Manufacturing Sector's GDP. As such, in the absence of any sharp rebound in oil price levels, price pressures within the economy would remain muted in the medium term. Lower oil prices are likely to more than offset the impact of increasing power (already up 4%) and gas tariffs (expected: 14%) as current spending on gas comprises 1.8% of GDP while spending on electricity comprises 3.5% of GDP.

Recent inflation figures are highly encouraging

Moderation in commodity prices coupled with freefall in global crude prices resulted in CPI declining to 4.3% in Dec14 (Nov14: 3.96%) from 9.2% in Dec13. This has dragged average inflation for 6MFY15 to 6.1% from 8.9% recorded during the same period last year. Further, NFNE (Non Food Non Energy inflation), a close proxy of core inflation, has also moderated to 6.7%YoY in Dec14 from 8.2% in Dec13. We expect headline inflation to remain on the lower side during 2HFY15 as well given i) benign food prices along with ii) the recent decline in fuel prices.

CY15 to be a year of monetary easing; expect another 150 bps cut in policy rate

We expect a cut of 150 bps during CY15, given expanding real interests. 2HFY15 expected CPI at 6.3% yields a positive real interest rate of 3.2% against previous 5 year average of 1.5%, underpinning our expectation of monetary easing.

Figure 16: Inflation vs. DR Figure 17: CPI, Food and Non Food


External Account; Strong financial flows to strengthen BoP position

We expect the external account to remain in surplus in FY15, owing to an expected decline in CA deficit and accretion in financial account. A successful conclusion of discussions (fourth and fifth reviews) with the IMF has already augmented the forex reserves by USD1.05bn. This will likely pave the way for additional inflows from other lending agencies including World Bank, ADB etc. In addition, the GoP witnessed an overwhelming investor interest in its recent sovereign global Sukuk offering, raising USD1.0bn against an oversubscription of USD2.3bn. Timely realization of these flows has strengthened the external position of the country while increasing total fx reserves to USD14.9bn (SBP Reserves: USD10.3bn).

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CPI Food Index NFNE

0.0%

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4

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CPI DR

CPIisexpectedtoremainintherangeof6.5%7.5%duringFY15&FY16Weexpectcumulativeeasingof150bpsgivenlowerCPIandwideningrealinterestsDisbursementofIMFtranchetounlockfurtherflowsfromothermultilateralagencies

14


5 Jan 2015


With a likely policy shift towards economic reforms, we believe FDI may also witness an improvement in FY15F to USD2.0bn, up 23%YoY particularly within the Energy & Telecom sectors. Incorporating lower import bill along with robust remittances (up 10%), we expect CA deficit in FY15 to clock in at USD2.7bn (1.0% of GDP). Consequent to our expected financial flows as well as a reducing CAD, we expect overall BoP to post surplus of USD4.1bn in FY15F, taking SBP reserves likely above USD13.3bn. Continued strength in SBP reserves also makes a case for a stable PKR vis a vis the greenback.

Are we ready for the next FDI spurt?

As stated above, FDI in 5MFY15 stood at USD423mn while full year FY15 FDI is expected at USD2.0bn, up 23%YoY contingent on investment flow within the Telecom and Energy sectors. Despite the improvement, expected FDI in FY15 is significantly lower than average FDI of USD4.0bn recorded during the period FY07A-FY10A but in-line with the insipid USD1.4bn averaged during the past 4 years (FY11-FY14).

We believe Pakistan is primed for a spurt in FDI over the next few years where the next leg is likely to be led by investment in the Energy sector (primarily Power) while the previous leg (FY07-FY10) was led by the Telecom sector. In this regard, as already mentioned earlier, the GoP has put ink to paper on deals with Russia (USD1.7bn energy deal) and China (USD3.0bn Gwadar LNG Pipeline; USD45.6bn China-Pak Economic Corridor).

Figure 18: BoP Composition (Units USDmn) Figure 19: Mix trend FDI and FIPI (USDbn)


On-track reform process to bear fruits:

Renewed commitment towards reforms and resultant conclusion of fourth and fifth IMF reviews has unlocked cumulative USD1.05bn tranche, pushing FX reserves near the psychological barrier of USD15bn. Moreover, the economy has shown significant signs of recovery as evident from 4.1% increase in GDP where GoP expects it to further augment to 5.1% and 6.0% in FY15 and FY16. In addition, fiscal deficit was restricted to 5.5% of GDP in FY14 where expenditure rationalization together with expansion in revenue base will further improve fiscal deficit to 4.9% and 4.0% in FY15 and FY16, respectively. The comprehensive energy sector reforms are planned for resolving administrative constraints in energy companies and price distortion where GoP will reportedly increase gas tariffs by 10% to 63%.

The government has successfully launched its privatization initiative and divested its stakes in UBL, PPL (partially) and ABL and raised a total of USD680mn out of which 71% was subscribed by foreign investors. GoP failed to conduct a 10% stake sale in OGDCL due to

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FDI FIPI

(20,000)

(15,000)

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(5,000)

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Current Account Bal Capital AccountFinancial Account

CADeficittoGDPinFY15tonarrowdownto0.9%1.0%TheGoPhasalreadysigneddealswithRussia(USD1.7bnenergydeal)andChina(USD3.0bnGwadarLNGPipeline;USD45.6bnChinaPakEconomicCorridor)FY15andFY16GDPgrowthisestimatedat5.1%and6.0%

15


5 Jan 2015


a sudden plunge in oil prices around the time of OGDCL offering. GoP is planning to offload 42% stake in HBL in 3QFY15 which will likely raise USD1.2bn. Besides capital market offerings, GoP has successfully raised USD2.0bn through Euro Bonds and USD1.0bn through International Sukuks in CY14. Unlike CY14 where the divestment plan was focused on shoring up reserves, we believe CY15 will mark the strategic sale of governments stake in inefficient entities (see table).

Privitazation of Public Sector Entities in CY15

Public Sector Entities Transaction Type GoP Stake Timeline

National Power Construction Corporation Strategic and Asset Sale 100.0% End Mar 2015

Habib Bank Limited Capital Market Transaction 42.0% End April 2015

Faisalabad Electric Supply Company (FESCO) Strategic Sale 100.0% End Aug 2015

Northern Power Generation Company (NPGCL Strategic Sale 100.0% End Aug 2015

Islamabad Electricity Company (IESCO) Strategic Sale 100.0% End Oct 2015

Lahore Electric Supply Company (LESCO) Strategic and Asset Sale 100.0% End Oct 2015

Source : IMF

Fiscal Account: Fiscal consolidation to continue

Fiscal consolidation measures opted by the government are in the right direction, in our view. That said, further stringent measures are required on both the revenue and expenditure side for attaining an envisaged fiscal deficit target of 4.9% and 4.0% in FY15 and FY16, respectively. The fiscal position improved remarkably in FY14 where fiscal deficit reduced to 5.5%, lower than 8.2% in FY13. The improvement in FY14 fiscal deficit was driven by 22% growth in total revenue along with a controlled expansion in expenditure by 9.2%.

FY15 will be a challenging year as revenue collection is likely to fall below GoPs target of 24% growth in tax collection to PKR2.8tn, primarily on account of oil related sales tax collection. To note, oil comprises 40% of overall sales tax collection. However, growth in 1HFY15 tax collection was below target at 12% (GoP target: 24%), indicating subpar performance on overall revenue enhancing efforts. The applicability of Gas Infrastructure Development Cess (GIDC) is in doldrums where GoP expects PKR145bn (0.5% of GDP) collection under GIDC. GoP is aiming to boost tax to GDP ratio to 11.5% in FY15 and 12.1% in FY16 from 10.6% in FY14. While on the expenditure side, the government ought to take stringent measures for achieving expenditure to GDP target of 19.4% in FY15 however bourgeoning expenditures in the wake of defense spending (considering on-going military operation) and additional funding for rehabilitation of IDPs and flood victims may swell expenditures.

Figure 20: Tax Revenue Budget vs. Revised Figure 21: Improving Fiscal Deficit to GDP Ratio


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9.0%

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11

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12

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13

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14

FY

15F

Fiscal Deficit to GDP

8.0%

8.5%

9.0%

9.5%

10.0%

10.5%

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05

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07

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13

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14E

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Budget Revised

PrivatizationprocesstoremainontrackwithfocusshiftingtowardsdivestmentofGoPstakeinlossmakingentitiesFiscalDeficitwillimproveto5.3%inFY15comparedtolast5yearaverageof7.1%

16


5 Jan 2015


Schedule of Performance Reviews & EFF Tranches

Date SDRsmn USDmn Percent of Quota

Conditions

September 4, 2013* 360 522 35 Approval of arrangement

December 2, 2013* 360 522 35 First review and end-September 2013 performance/continuous criteria

March 2, 2014* 360 522 35 Second review and end-December 2013 performance /continuous criteria

June 2, 2014* 360 522 35 Third review and end-March 2014 performance /continuous criteria

September 2, 2014* 360 522 35 Fourth review and end-June 2014 performance /continuous criteria

December 2, 2014* 360 522 35 Fifth review and end-June and end-September 2014 performance /continuous criteria

March 2, 2015 360 522 35 Sixth review and end-December 2014 performance /continuous criteria

June 2, 2015 360 522 35 Seventh review and end-March 2015 performance /continuous criteria

September 2, 2015 360 522 35 Eighth review and end-June 2015 performance /continuous criteria

December 2, 2015 360 522 35 Ninth review and end-September 2015 performance/continuous criteria

March 2, 2016 360 522 35 Tenth review and end-December 2015 performance /continuous criteria

June 2, 2016 360 522 35 Eleventh review and end-March 2016 performance /continuous criteria

August 1, 2016 73 106 7 Twelfth review and end-June 2016 performance /continuous criteria

Total 4,393 6,366 425 *( Amount Received)

Source: IMF

Benchmarks S.No Structural Benchmarks Time Frame (by End of Period)

Fiscal sector

1 Enact amendments to the relevant tax laws (as defined in the TMU) and submit amendments to the Anti-Money Laundering Act (AMLA) to Parliament.

December 2014

2 Approve an administrative order to consolidate the responsibilities of public debt management in the debt management office.

Partially met

Monetary sector

3 Enact the amendments to the SBP law to give SBP autonomy in its pursuit of price stability as its primary objective, while strengthening its governance and internal control framework, in line with Fund staff advice.

June 2015

Financial sector 4 Enact the Securities Bill, in line with Fund staff advice. June 2015

5 Enact the Deposit Protection Fund Act, in line with Fund staff advice. June 2015

Structural Policies

6 Privatize 26 percent of PIA's shares to strategic investors. December 2015

New Structural Benchmarks 7 Draft legislation that will permanently prohibit the practice of issuing SROs that grants exemptions and loopholes. March 2015

8 Announce a time-bound plan to improve the SBP's interest rate corridor by setting the policy rate between the floor and ceiling rates of the corridor.

February 2015

9 Improve the internal operations of the SBP by the following measures: (i) the Investment Committee of the SBP Board will begin regular (at least four times per year) oversight and approval of the reserves management strategy and risk practices; and (ii) the authorities will provide confirmation that in line with standard IMF safeguard procedures, the Internal Audit Department will conduct reviews of the program monetary data reported to the IMF, within two months after each test date, for accuracy and compliance with the TMU and share the findings with IMF staff.

February 2015

10 Reorganize the Debt Policy Coordination Office as a middle office responsible for updating the MTDS and monitoring its implementation, coordinating the credit risk management functions.

March 2015

11 Conduct a review to reduce the number of existing processes and forms for paying sales and income taxes. March 2015 Source: IMF

17


5 Jan 2015


Sectors

18


5 Jan 2015


Oil and Gas: Exploration & Production

The sharp decline in oil prices has already taken its toll on the Exploration and Production (E&P) sector leading to 28% underperformance by the sector against KSE-100. E&P sector is currently trading at an undemanding P/E of 7.7x against 8.9x for KSE-100, an unusual discount of 13% as opposed to an average premium of 7% in last 5 years. We believe the sector has absorbed the impact of reduced oil prices. As per our estimates, closing prices have priced in oil at between USD50-55/bbl. Pakistan E&Ps have an aggressive development program with 3-year CAGR of 10% for oil and 3% for gas during FY15-17. Given huge exposure to largely untapped high potential blocks, the sector offers a high exploration upside. E&Ps remains unleveraged with strong cash generation. We believe the ramp-up of exploration activity in high priced new concessions offer further upside to valuations in the form of discoveries and reserve upgrades. Pakistan E&Ps trade at a discount of 37% and 25% over regional peers on P/E and EV/EBITDA respectively. We flag OGDC and POL as our preferred picks in the sector with TPs of PKR261/sh and PKR550/sh, translating into total returns of 32% and 57%, respectively. PPL follows with a TP of PKR228/sh.

Upbeat on rising production: The healthy trend in volumetric growth of E&P companies is expected to continue as we foresee a 3-year production CAGR of 10% in oil and 3% in gas during FY15-17. While expected growth in gas production is low due to declines in production in large maturing fields, 2.0x-3.0x higher prices offered on new discoveries will continue to keep gas sales on the uptrend. Consequently, we expect the sector to post decent FY15F-FY18F earnings CAGR of 5% despite falling oil prices. Robust volumetric growth coupled with i) an expanding reserve base on accelerated exploration efforts, ii) lower lifting costs and iii) hedge against PKR depreciation under pins our investment case for the sector.

Figure 22: Oil and Gas Production Trend Figure 23: TAL and Nashpa to lead the growth (bpd)

Source: PPIS, Company Reports, BMA Research

Reserve accretion to continue on aggressive exploration: The E&P companies managed to drill an impressive 50 exploratory wells in FY14, up 53%YoY, despite reemergence of circular debt. We believe the momentum in exploration is set to continue going forward, given an aggressive drilling target of 50 exploratory wells in FY15F compared to last 5 year average of 30 wells. Moreover, the pickup in exploration efforts and pilot projects in new concessions and shale formations will further bolster reserve accretion. The drilling will remain concentrated in hydrocarbon rich Sindh and Baluchistan regions.

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Oil Production (bpd) Gas Production (mmcfd)

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5 Jan 2015


Figure 24: Drilling Trend (wells) Figure 25: Smooth CAPEX on strong cash flows

Source: PPIS, BMA Research

Dollar hedged revenue streams: Given the USD denominated revenues, E&Ps provide a perfect hedge against PKR depreciation. As per our estimate, 1% depreciation in PKR against the greenback translates into annualized earnings impact of 1%-2% on the E&P sector.

Attractive yields on robust cash generation: The cash flows of the sector continue to remain strong as evident from 37% growth in operating cash flows of the sector in 1QFY15 to ~PKR50bn despite the resurgence of circular debt. Robust earnings and reduced intensity of circular debt will continue to keep cash flows strong in FY15 as well. We expect FCFE generation of the sector to improve by 15%YoY to PKR51.7bn in FY15F. POL will continue to offer highest yield of 13% in the E&P space followed by OGDC and PPL with 5% and 7%, respectively. The cash rich and unleveraged balance sheets of the exploration companies further strengthens our conviction on the sector.

Figure 26: Dividend Yield Figure 27: Robust FCFE on Steady Profitability (PKRbn)

Source: Company Accounts, BMA Research

Declining oil prices negatives overplayed: 51% decline in oil prices since Jun-14 has led Exploration and Production (E&P) sector to shed 19% of its value as the sector underperformed KSE-100 by 28%. E&P sector is currently trading at an undemanding P/E of 7.7x against 8.9x for KSE-100, an unusual discount of 13% as opposed to an average

16 2135

50 50 53 5634

36

6250 54

57 60

FY11 FY12 FY13 FY14 FY15F FY16F FY17F

Exploratory Development

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Operating Cash (PKRbn) CAPEX (PKRbn)

6%7%

13%

OGDC PPL POL

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5 Jan 2015


premium of 7% in last 5 years. We believe the sector has absorbed the impact of tumbling oil prices and is pricing in an oil price of USD50-55/bbl. Any further dip in stock prices on account of weak 2QFY15 results shall provide an attractive entry point for the investors. We have kept our long term oil price assumption at USD75/bbl. Even in a bear case scenario (USD65/bbl long term oil price assumption) the sector still offers a total return of ~22% against current market prices.

Figure 28: Production driven Sales growth Figure 29: Profitability Trend (PKR bn)

Source: PPIS, BMA Research

Attractive valuations: The recent bearish trend in the E&P sector on account of dwindling oil prices has led to considerable undervaluation of E&P stocks, trading at an 37% discount to regional peers. We are upbeat on long term prospects on account of significant volumetric additions and upside in reserves due to aggresive exploration. Current preferred plays include OGDC and POL with TPs of PKR261/sh and PKR550/sh, which translates into total returns of 32% and 57%, respectively. PPL follows with a TP of PKR228/sh.

Oil Marketing Companies

CY15 will mark a period of recovery in the Oil Marketing Sector (OMC) owing to growing petroleum sales and easing liquidity position on the back of 51% reduction in oil prices during 2HCY14. The sector witnessed a dull CY14 on account of i) heavy inventory losses, ii) resurfacing of circular debt and iii) weakening FO margins. Though aforementioned variables may keep the sector in pressure in the near term, we believe long term fundamentals remain strong. Our bull case on OMCs is based on likely robust sales of high margin motor fuels on the back of considerable reduction in differential over CNG alternative amid declining MOGAS and HSD prices. Improved liquidity of IPPs would help steady FO sales. Falling interest rates would help reduce finance cost while lower oil prices will also reduce the pace of accumulation in circular debt. Long awaited restructuring and privatization of DISCOs in 2HCY15 will remain the key to the resolution of circular debt. OMCs are trading at an attractive P/E of 7.3x (18% discount over KSE100) thus providing an attractive entry opportunity at current levels. PSO, the main beneficiary of easing liquidity position in energy chain, is our top pick and currently trades at an attractive P/E of 6.2x with an upside of 28%. We also like APL which offers an upside of 23% along with a dividend yield of 10%.

Attractive entry opportunity as the worst is almost behind us: OMC sector remained under pressure in CY14 as earnings will likely fall 21% YoY in FY15 on account of inventory losses caused by a 51% plunge in oil prices and lower recovery of interest income on receivables during 1HFY15. That said, we believe the sector has priced in the negatives given the recent underperformance of 15% wrt to KSE-100 FYTD. With oil prices having stabilized around USD55/bbl, we believe the focus shall soon shift to the resulting stronger outlook on increased motor fuels volumes and improvement in circular debt. Long

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5 Jan 2015


awaited restructuring and privatization of DISCOs in 2HCY15 would be a key sign post to watch. OMCs are trading at an attractive P/E of 7.3x (18% discount over KSE100) thus providing an attractive entry opportunity. We continue to flag PSO as our preferred play in the OMC sector currently trading at an attractive P/E of 6.2x, a discount of 31% over local peers. We also like APL due to its strong cash generation and highest yield in the sector.

Figure 30: Sales Trend Figure 31: Profitability Trend (PKR bn)

Source: Company Reports, BMA Research

Increasing share of cash based and high margin products: We expect OMC volumes to grow at a 3 year CAGR of 7% during FY15-FY17 while core earnings will likely grow at a CAGR of 10% during the same period. The growth in volumetric sales will continue to be driven by MOGAS and HSD fuels further supported by growth in non-fuel segment (particularly Lubricants and Asphalt). The increase in sales of MOGAS (3 year CAGR of 14%) will be primarily driven i) narrowing premium over CNG (down to 6% from 45% three months back) and ii) continued expansion in outlets by OMCs. Moreover, expected growth in the sales of Asphalt and Lubricants coupled with increase in margins on HSD and MOGAS by 5% and 26% respectively, will increase the share of high margin and cash based products in the profitability.

Figure 32: Volume mix to skew in favor of cash based products

Figure 33: Share in Gross Profit

Source: OCAC, BMA Research

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EBITDA NPAT

44% 43% 44% 44% 43% 42%

56% 57% 56% 56% 57% 58%


FO Others

35% 37% 38% 44% 43% 42%

41% 42% 40%39% 37% 38%

23% 21% 21% 17% 19% 20%


HSD+MOGAS FO others

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5 Jan 2015


Figure 34: APL Sales Trend (mn tons) Figure 35: PSO Sales Trend (mn tons)

Source: OCAC, BMA Research

Improved GDP growth to help lift volumes; lower interest rates to curb finance cost: Recent cut in interest rates by 50bps along with a likelihood of further decline in 1HCY15 will help reduce borrowing cost for OMCs especially PSO. Pakistan's GDP growth is on the uptrend and likely to improve to 6% in FY16 (FY13: 3.5%) which will provide additional impetus to the sales of HSD and FO.

Figure 36: Break up of volume growth story (mn tons) Figure 37: OMC wise sales trend (mn tons)


Continuation of reforms to alleviate pressure on liquidity: In order to curtail the burden of energy sector subsidy, the government plans to improve the recoveries and collections in the power distribution sector through privatization/restructuring of DISCOs in 2HCY15. The elimination of inefficiencies post restructuring in the downstream sector will eventually assist the government in resolving the menace of circular debt. Falling oil prices will also reduce circular debt through i) reduction in absolute value of the lost electricity units and ii) bridging the gap between cost of generation and consumer tariffs. Furthermore, another cash injection by the government aimed at full settlement of circular debt is also possible amid overall improvement in fiscal position which can potentially turn the tides in favor of OMCs where key beneficiary shall be PSO.

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Total HSD MOGAS FO

12.312.6

13.113.4

14.2

14.8

1.8 1.82.1 2.3

2.42.6


PSO APL

23


5 Jan 2015


Figure 38: Dividend Yield Figure 39: PSO mounting receivables kept payout

under pressure


Banks

Pakistan Banks' earnings are likely to grow by 20% in CY14 and the momentum shall continue with an expected CY15 earnings growth 16% despite an expected decline in interest rates. We expect another 150bps cut in interest rates in CY15 following a 50bps cut in Nov-14. Though this may potentially dent investor sentiment in the short term, the massive PIB accumulation in CY14 has helped banks lock in higher yields which will continue to support NIMs in the near term. The sector may also book gains on partial liquidation on PIB portfolios as yields have already come down markedly. PIB gains will likely buoy the sector's equity by 5%. The asset quality of the banking industry remains impressive with NPL ratio expected to remain ~9% and coverage ratio around 90%, driven by cautious lending policies and inclination towards risk-free government treasuries. Also, the non-funded income of the banking industry will also witness a healthy growth of ~12% in CY15F which is expected to further support the sector's profitability. Within Banking space, we recommend a BUY call on UBL and BAHL with TPs of PKR225/sh and PKR60/sh offering total returns of 36% and 29%, respectively. Higher investment yields to support profitability: The yields on investments are likely to stay on the higher side during CY15 despite monetary easing as banks have piled up massive stocks in PIBs at an average yield of 12.6%. Banks have expanded PIB portfolios by PKR1.8tn, up 3.4x CYTD, to PKR2.5tn in Nov14. Furthermore, non-funded income is likely to grow by 12%, which, along with lower provisioning and operating cost, is likely to expand sector profitability by 16% in CY15F. Further, we expect 5 year earnings CAGR to clock in at 20%.

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Figure 40: Earnings (PKRbn) Figure 41: ROE


Upbeat organic growth in the offing: The banking sector assets have been on the rising trajectory as total assets registered a CAGR of 13% in past four years. The robust growth in assets is a function of robust CAGR of 15% in industry deposits due to growing monetary base (average M2 growth of 14.2% in past four years). Going forward, we have assumed industry deposits to grow by 14%-15% CY15F-CY18. While we have continued to assume an equal allocation to advances and treasury investments (stable ADR & IDR) till CY15, we expect ADR to start rising from CY16 onwards due to revival in credit demand owing to resolution of energy and security concerns.

Figure 42: Deposits (PKR bn) Figure 43: Deposit Share


Economic recovery to revitalize credit cycle: Macro-economic indicators are consistently showing signs of recovery as evident from i) softening inflation, ii) improving energy supply and iii) exchange rate stability. This has resulted in improvement in private sector credit appetite as advances registered a growth of 12%YoY as of Sep'14. On the backdrop of economic recovery and expected lower DR, we expect a gradual uptick in private sector credit demand in CY15 and onwards where we have assumed gross advances to grow by 16% in CY15F-CY18F.

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Figure 44: Growing Advances (PKR bn) Figure 45: ADR & IDR


Risk aversion to continue propping up asset quality: Despite credit expansion, we expect asset quality of the banking sector (particularly top tier banks) will remain strong owing to stringent risk management policies which is further validated by 130bps decline in NPL ratio to 13.0% in Sep14 from 14.3% in Sep13. We belive bulk of the credit expansion in the early stage of economic recovery shall be of high quality and thus the next NPL cycle is atleast five years away. Going forward, we expect BMA banking space to post NPL ratio 9.4% and 8.7% in CY14F and CY15F, respectively. Also, we expect NPL coverage will remain elevated at ~89%.

Figure 46: Infection Ratio & Coverage Figure 47: Bank wise Asset Quality (CY14E)


Diversified income base to support non interest income: Consistent growth in branchless banking and expected increase in trade and remittances (foreign and domestic) will likely expand fee income where we have incorporated fee income growth of 14% and 15% in CY14 and CY15, respectively. Furthermore, banks are sitting on large stocks of unrealized capital gains on stock market investments which is likely to support earnings going forward. Thus we expect non-interest income of BMA's Banking Universe to register a growth of 12% and 11% in CY14 and CY15, respectively.

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Figure 48: Consistent growth in NFI (PKRbn) Figure 49: Bank wise share in NFI CY14E (PKRbn)


Revaluation surpluses on PIBs to augment equity: The banking sector is all set to register massive revaluation surplus on long duration govt. securities as yields on PIBs have come down by 1.7% to 12.6% after banks expanded their PIB books by 3.4x from Dec-13 levels. Cursory calculation reveals that banks should book revaluation surplus of PKR46bn on PIB portfolio on the back of decline in PIB yields. Consequently, the banking sector CAR is likely to jump to 18% from ~15% registered in Sep14.

Valuation: The banking sector is trading at Dec15 P/B and P/E multiple of 1.7x and 8.1x, respectively. Within the banking space we reiterate our conviction on UBL and BAHL with TPs of PKR225 and PKR60, respectively offering total returns of 36% and 29%, respectively. Cements

Cement sector will likely witness a blend of volume growth and margin expansion in CY15, while falling interest should also help reduce finance cost in selected leveraged cement companies. Strengthening in private and public sector demand will help local dispatches to grow at a 3yr CAGR of 6%. Furthermore, reduction in coal and FO prices along with a decline in power tariffs (due to fuel price adjustments) are expected to significantly expand the industry margins, going forward. We expect another 150bps decline in interest rates in 1HCY15 which will help lower finance cost for leveraged cement plays. As such, the sector will witness 3yr earnings CAGR of 12.5% in FY14A-FY17F. We highlight LUCK, FCCL and MLCF as our preferred plays in the cement sector with total stock returns of 18%, 35% and 33% respectively.

Margins to expand owing to falling fuel and power costs: We expect the margins of the industry to expand by 400bpsYoY in FY16, owing to declining in coal prices, drop in power cost on account of downward adjustments in fuel adjustment factor and commissioning of WHR. Coal prices are currently hovering at USD67/ton, down 13% from FY14 average of USD77/ton. We have assumed current and long term coal prices at USD70/ton, which will likely lead to a 6% decline in per unit coal cost in FY15. Furthermore, decline in power cost on account of downward revision in fuel adjustment surcharge will lower the cost of purchased electricity while in-house generation cost will also come down due to lower furnace oil prices. Furthermore, growing local dispatches amid declining exports would prop up average margin of cement companies as margins on domestic sales is 41% higher than exports.

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Figure 50: COGS per ton vs Coal prices (USD/Ton) Figure 51: Growing EBITDA (PKR/ton)

Source: Company Reports, BMA Research, Bloomberg

Volume growth driven by domestic sales: The country is experiencing a revival in cement demand growth as evident from 9.4% growth in domestic dispatches during 5MFY15. While PSDP expenditure has increased only modestly, domestic demand growth is driven primarily by private sector construction activities. Further improvement in GDP growth, decline in inflation and interest rates and political stability will further augment growth in cement demand. We have conservatively assumed growth in domestic dispatches at 6%. Exports, on the other hand will fall by 2% per annum during FY15-17 and limit overall dispatches CAGR to 4% during the period.

Figure 52: Dispatch growth vs GDP Growth Figure 53: Utilization (%) vs Dispatches (mn tons)

Source: APCMA, BMA Research

Cement industry is becoming cash rich: The cement industry has been able to significantly reduce its debt levels on the back sizable margins and improving profitability. Consequently, major operators like LUCK, PIOC and KOHC have managed to buildup considerable cash reserves. The strong cash generation has enabled the small players to undertake cost efficiency projects leading to valuable cost savings while the big players are diversifying into different industries and beyond local borders. Some companies have also announced expansion plans to benefit from the next up cycle in domestic demand growth.

Falling interest rates to help lower finance cost: The recent reduction in discount rate by 50bps along with expectation of another 100bps cut in CY15 will bode well for the sector. This will significantly decrease financial cost burden on leveraged payers such as

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MLCF and FCCL. We expect FCCL's finance cost to fall by 22% in FY15 and 42% in FY16 while that of MLCF will likely fall by 22% in FY15 and 21% in FY16.

Figure 54: Sector FC % of PBT Figure 55: Cash reserves vs Debt (PKR bn)


Textiles

Textile segment is well positioned to witness a better FY15 as several factors are likely to improve the core textile operations. Cotton has shed 26% FY15TD on account of abundant supplies in the region, while fuel and power cost which constitute 1/4th of total COGS will likely fall due to 46% drop in FO prices FY15TD and reduction in electricity tariffs. Lower interest rates will help reduce finance cost as BMA's textile universe has an average debt to assets of 48%. A 50bps cut in DR will result in a positive annualized earnings impact of 3.5% to 7.5% on BMA Textile Universe. We believe concerns over Pakistan potentially losing GSP Plus status due to resumption of death penalties are overplayed and expect the GSP plus status to continue. Finally, as per IMFs directives, GoP might increase the gas tariffs, the impact of which will depend on the energy mix of individual companies where companies with higher dependence on gas will be the biggest losers. As per our calculations, for every 10% increase in gas tariffs, the EPS of NML, NCL and GATM will have a negative impact of PKR0.33/sh, PKR0.3/sh and PKR1.2/sh. Our TPs for NML, NCL and GATM currently stand at PKR146/sh, PKR52/sh and PKR76/sh, offering total returns of 19%-21% on the last closings. Strong earnings growth on easing cost pressures: We expect gross margins of the sector to improve by 250bps in FY15F primarily driven by easing raw material and fuel/power cost. Cotton, the sectors primary raw material, contributing ~25% to the total cost base has already shed 26%YoY. This is likely to result in the improvement of core margins, which we expect to clock in around 18%-20% in FY15 as against 9%-14% in FY14. Moreover, reduction in FO prices as well as cut in electricity rates will help increase BMA textile universe earnings by 2% to 8% on annualized basis.

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Figure 56: Strong margins on PKR depreciation and declining cotton prices

Figure 57: Fuel Mix of Textiles

Source: PPIS, Company Accounts, BMA Research

GSP+ starting to yield benefits: After posting dull exports numbers in the opening months of FY15, the benefits of GSP+ have started becoming visible, particularly within the value added segments. Pakistans value added textile exports depicted a growth of 10%-17%YoY in 5MFY15 which is an impressive performance given FY12A-14A CAGR of 8%-9%. With strengthening exports of value added products, we believe GATM and NML, with 70% and 75% of their total sales coming from value added segments, are likely to be the key beneficiaries. NCL, with 45% of its sales comprising of value added segment, will continue to remain the laggard.

Figure 58: Textile exports and growth Figure 59: Sales composition of BMA Textile Universe


Healthy investment portfolio: BMA Universe companies (NML, NCL) hold a diversified portfolio of subsidiary companies. The investments not only hedge the textile companies against textile sector's volatility through healthy dividend income (3 year CAGR of 12%) but also provide investors an indirect exposure to their respective portfolio companies (NML: MCB, DGKC, NPL, NCL and NCPL). Improvement in the dividend income (constituting 43%-45% of profitability) will continue to add to the bottom-line growth.

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Value added segments to outperform; Prefer NML and GATM: Given low cotton prices and substantially higher growth in value added segment's exports, we prefer the value-added textile sector over spinning units. NML is our top pick in the sector as it receives 75% of its sales from the value added segments. Our Dec-15 TP for NML stands at PKR146/sh, which translates into an upside of 17% along with a dividend yield of 4%. GATM's TP stands at PKR76/sh, which translates into total return of 19%. Our TP for NCL stands at PKR52/sh, translating into a total return of 17%.

Chemicals (Fertilizer)

The Fertilizer sector has returned an impressive 23% on average over the past 5 years, however, performance in CY14 remained tepid as the sector returned 17%YoY, underperforming the market by 10%. Concerns over gas supply and chargeability of GIDC were the prime reasons for the muted performance. Moving ahead, we portend earnings growth of 44% in CY15F, primarily led by the growth within the Engro group companies (ENGRO & EFERT). That said, declining trend in global oil price and its potential fallout on petrochems, coupled with rising costs in the local market (gas) may lead to pressure on urea price. While sector dynamics are likely to remain fickle, we flag ENGRO as an outperformer given group developments.

With Agriculture being the backbone of the country, the Fertilizer sector has historically been one of the best performing sectors at the Karachi Stock Exchange (KSE). Going forward, we expect sector profitability to rise by 44%YoY, however, growth remains contingent on i) continued supply of feed gas to the industry and ii) initiation of concessionary gas rate for Engro Fertilizer (EFERT).

Figure 60: Relative Performance Figure 61: Earnings Trend

Source: BMA Research, Company reports, KSE, Bloomberg

Local urea players have steadily increased their market share against imported urea as they offloaded 4.6mn tons urea during 11MCY14 compared to just 394k tons imported urea (down 55%YoY). The increase came amid increased production owing to improved gas supply situation to the industry.

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Figure 62: Local production vs Imports (000tons) Figure 63: Sales and EBITDA (PKR mn)

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ENGRO stands out as our top pick within the sector with a TP of PKR272/sh. At current levels, the scrip offers an upside of 17% and trades at undemanding CY15F and CY16F P/E of 6.2x and 6.0x, respectively. For risk averse investors, we also flag FFC given continued high dividend with the scrip currently offering a D/Y of 12%. Dividend yield looks particularly impressive given our view of decreasing interest rates.

Figure 64: Dividend Yields Figure 65: Steady Margins

Source: BMA Research, Company reports

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Oil and Gas Development Company (OGDC) is one of our preferred plays in the E&P space owing to i) least earnings sensitivity to oil prices on diversified revenue base, ii) vast exposure to exploration assets in Pakistan and iii) low risk production profile amid geographically diversified producing assets. Though near term prospects may remain dim on account of sharp decline in oil prices (down 51%FYTD) leading to 9%YoY decline FY15F earnings; however, long term prospects of the stock remain upbeat owing to an expected 3-year production CAGR of 7% and potential upside in reserves on an aggressive exploration program. Thus, we maintain our liking for the stock with a Dec15 TP of PKR261/sh, translating into a total return of 32% (capital gain: 27% + dividend yield: 5%). Our conviction on the stock is based on i) an aggressive development program likely yielding results in 2HFY15, ii) exploration drilling in high prospect areas, iii) strong cash generation and iv) potential upside from addition of shale and tight gas. With current market price implying an oil price of USD55/bbl, we believe OGDC has absorbed the negative impact of oil prices. Expected 14% growth in oil production and 16% growth in gas production in CY15F will likely be the key triggers for the stock. Concerns pertaining to oversupply have now settled due to indefinite postponement in GDR offering. At current levels, the scrip trades at FY15F and FY16F PER of 8.0x and 8.1x, respectively. BUY

Momentum in production growth to continue: The relentless decline in oil prices appears to have overshadowed the potential upside in earnings and valuations owing to materialization of a spree of development projects expected in CY15. The company targets to lift its production base through i) completion of Phase-II of KPD TAY (by Jan15) and Sinjhoro, ii) ramp-up of production from Uch-II and iii) Jhal Magsi and Nashpa development projects (expected in 1HFY16). These projects are estimated to add ~5,600bpd of oil and ~203mmcfd of gas to the production base of the company, depicting an impressive increase of 14% and 16% over the existing oil and gas production, respectively.

Strong exploration potential: With highest number of exploration concessions (62 licenses) located across the country, OGDC will continue to remain the main beneficiary of ongoing aggressive exploration activity in the country. The company has highlighted an aggressive exploration program aimed at drilling 11 new exploratory wells in FY15 compared to 5 wells drilled last year. The company also plans to initiate seismic activity in new blocks during CY15 with wellhead gas price of USD6.0/mmbtu, 2.0x higher than current realized gas price of OGDC. Moreover, OGDCs exposure to hydrocarbon rich and relatively unexplored Baluchistan and Kohat Basin will keep success ratio above 50% and help achieve +100% reserve replacement, going forward.

Product and fields diversification

05-JAN-BMA

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