Elixir Securities Limited – Elixir Insight

Karachi, October 10, 2018 (PPI-OT): Descon Oxychem Limited – Corporate Briefing Notes

Elixir Securities Pakistan held a Corporate Briefing on Descon Oxychem Limited (DOL) yesterday, where the company’s management discussed industry dynamics, company’s financial performance and provided details on the upcoming expansion.

Midst rising hydrogen per oxide prices (up 56% during 2018TD), stringent cost controls, decline in finance cost and increase in other income, the company’s financials improved during FY18 thus translating into higher Profit after Tax (up 57%YoY).

The Management also discussed the various options that they are evaluating to redeem Preference Shares, including the possibility to convert them into intra-company loan – which can significantly raise value for common shareholders.

After incorporating the Preference Shares conversion (110mn shares @ PKR10) into long term loans (PKR1.1bn), our back of the envelope calculation suggests annual cash flow savings of PKR55mn having per share impact of PKR0.54; in addition to avoiding the potential dilution of ~50% which the current structure entails.

The management disclosed that their upcoming expansion of ~7kMT will come online by Dec-19 at an envisaged Capex of PKR1.1bn – a bulk of which will be funded through debt.

Elixir Securities Pakistan held a Corporate Briefing on Descon Oxychem Limited (DOL) yesterday (October 9, 2018), where the company’s Chief Executive, Mr. Imran Qureshi, and CFO, Mr. Muhammad Saqib Abbas, discussed industry dynamics, company’s financial performance and provided details on the upcoming expansion.

DOL was incorporated in Pakistan as a private limited company in 2004 and was converted into a public limited company in 2008. The company is principally engaged in production, procurement and sale of hydrogen peroxide (H2O2) and allied products (Sanidol and CareOx35). H2O2 is an environment friendly chemical used as a bleaching agent in Textile industry, an oxidant in Mining and as an ingredient in Food and Beverages (F and B).

The Company currently has an annual H2O2 capacity of 28kMT, operating at utilization of around 120%. Given the shortage of the product in the country, DOL had recently announced to increase its capacity by 25% to 35kMT. The Management disclosed that the project will come online by Dec-19, with an envisaged Capex of PKR1.1bn (may overshoot due to recent PKR depreciation). While the optimal capital mix for the project is yet to be finalized, the Management believed that a bulk of the Capex will be funded through debt since the current Balance Sheet is almost leverage free.

Industry Dynamics Hinting towards Export Potential: Pakistan’s total demand for hydrogen peroxide stands at ~68kMT, 80% of which is met by local manufacturers while the rest of 20% is met through imports. Textile sector accounts for over 80% of the annual demand, followed by mining (~10%) and F and B (~5%). With a revival in Textile Industry on the cards, the Management expects demand for H2O2 to grow at 5-6% pa over the coming years. Incorporating this assumption, leads to an expected annual demand of 79.8kMT by FY21.

Currently, there are two leading players in the domestic market i.e. DOL and Sitara Peroxide (SPL) with name plate capacities of 28kMT and 30kMT, respectively. In terms of production, DOL constitutes a larger market share of 62% in domestic market with an annual production of 34kMT (i.e. 121% capacity utilization). SPL on the other hand has a market share of 38% with an annual production of 21kMT (i.e. 70% capacity utilization).

Recently, DOL and SPL have both announced to increase their existing capacities by 25% and 46% after which new capacities for both plants will stand at 35kMT and 43.8kMT, respectively. Considering the increasing demand and rising price trend, Engro Polymer and Chemicals (EPCL) has also decided to enter into Hydrogen Peroxide business through a Greenfield manufacturing facility with a CAPEX of USD23mn. Taking cues from CAPEX, we expect the company to set up a plant with 25kMT capacity. Incorporating all these expansions would take the total industry capacity to 103.8kMT in FY21 (1.8x of current capacity).

Typical of any commodity play, the supply in the industry is expected to rise due to the recent surge in international prices. While the next 2 years remain comfortable, we believe that there will be an excess supply of over 20k tons by FY21. The Management believes that they are well placed to address the rising competition as 1) they aim to be the lowest cost producer in the country, 2) the option to export will be viable given that they have done it in the past and 3) the company’s location in North is much closer to the demand hub when compared to the new player who is entering the southern market.

International Hydrogen Peroxide Prices have turned the Tide for Domestic Manufacturers: International Hydrogen Peroxide prices posted a surge of 43% during 2018TD mainly due to production constraints, hikes in international gas prices (a core ingredient for hydrogen extraction) and strong demand (spurred by Paper and Pulp industry). As per the management, the commodity is currently trading around USD700/ton (the closest publicly available spot benchmark shows much higher prices of USD970/ton when converted from INR72/kg).

The trickledown effect was witnessed in local markets as well where retail level prices had reportedly surged to as high as PKR200/kg before stabilizing between PKR100-120 – a surge of ~56% during 2018TD. Yesterday’s PKR depreciation of ~8% is likely to inflate prices for imported H2O2 further and may result in further hikes in domestically produced product.

The management shed light on global commodity cycles and expected them to last 3-5 years, before prices cool off once new expansions come online. While the management believed the global pricing trend to stay favourable, they also highlighted that H2O2 prices are likely to stabilize around USD500-600/ton over the next 3 years – still much higher than previous cycle average of ~USD400/ton.

The increasing selling prices have already allowed DOL to turn around its gross margins from 22% in FY16 to 30% in FY18 – resulting in a 6x surge in ROE to 18% in FY18 from 3% in FY16.

Preference Shares’ Potential Redemption Can Double the Existing Common Shareholder’s Value: During FY16, DOL offered 110mn preference shares of PKR10 each to existing members of the Company in equal proportion to their existing shareholding. The allotment of preference shares was done on December 29, 2015. Some of the key terms of the issue include;

1) The preference shares shall be cumulative, and shall carry entitlement of a fixed annual cumulative dividend of 12% to be paid out of the normal profits of the Company in each financial year. Any dividend not paid in a financial year shall accumulate towards entitlement of dividends in future years.

2) The preference shares shall be convertible into ordinary shares at the ratio of one preference share to one ordinary share at the option of either of the Company or the preference shareholder, any time and from time to time after expiry of five years from the date of allotment of the relevant preference shares.

However, in a recently conducted Extra Ordinary General Meeting (EOGM), the company had proposed some amendments to its initial issue terms. The amendment now gives the company a liberty to redeem its preference shares through a sinking fund created internally or through external funds (i.e. loans). The Board is still evaluating different options that would yield maximum return for the company; these options include conversion to intra-company loan, complete redemption, partial redemption and conversion to common shares.

We believe that the maximum return for the existing common shareholders would be achieved if the Preference Shares are either fully redeemed for cash or converted into debt. This can yield a number of advantages i.e. 1) avoid the inevitable dilution of around 50% that would otherwise take place in FY21, 2) increase recurring cash flows, 3) encourage the company to start paying dividends to common shareholders to avoid penal taxation, 4) lead to a tax efficient capital structure, and 5) remove current dilution in EPS (diluted EPS is currently almost half of basic EPS).

Assuming a conversion of Preference Shares (110mn shares @ PKR10) into long term loans (PKR1.1bn), our back of the envelope calculation suggests annual cash flow savings of PKR55mn having per share impact of PKR0.54 (due to a lower assumed rate on debt and tax deductibility on financial charges). While this will be hugely positive for the company (for reasons detailed above), it will nonetheless have an additional impact of financial charges (~PKR77mn) on financial statements (dividend on preference shares are not booked on Income Statement) – leading to a negative EPS impact of PKR0.75.