JAZIRA SECURITIES BROKERAGE ARACEMCO

Tuesday, December 21, 2010

Equity Research

Another simple winning formula BUY

Here is another mid cap company we like; Aracemco. Aracemco has the for- Market Price (EGP/share) 28
mula that we favor in our mid cap picks, which includes: a significant capacity
expansion just completed (most of the capex is behind us), manage to operate Target (EGP/share) 41
close or at full capacity (will be able to push the expanded capacity swiftly to Upside 47%
the market), good position in its market, adequate profit margins with plans to
cut cost further, and no debt burden draining its profitability. Furthermore, Reuters Codes CERA
Aracemco has a relatively low price earning ratio and eventually will have a
high dividend yield that supports our target price upside. Full Name: Arab Ceramics Company -Aracemco

Aracemco captures around 4.5% and 10.0% of the Egyptian ceramic tiles Short Name Aracemco
and sanitary ware markets, respectively. Furthermore, it exports around Exchange Listing EGX
22% of its sales, mostly to Gulf states, and around 10% of its exports goes to
Index Inclusion n/a
Eastern European countries.
Aracemco is among the top 4 sanitary ware market players in Egypt. How- Number of Shares (mn) 25.00
ever, it sells its sanitary ware units at around 40% discount from the mar-
ket leader Lecico, which provides Aracemco with a better competitive edge in Market Cap (EGP mn) 700
the low and middle income broad market segments. EV 2010 (EGP mn) 686
In 2009, nearly 71% of Aracemco’s revenues were generated from ceramic 52 Week Low-High (EGP) 17-31
tiles sales and 30% were from sanitary ware sales. In 2010, the ceramic tiles
Average Daily Volume (52 weeks) 40,937
contribution to revenues will increase to the upper 70s% due to completion of
its expansion while by 2012, it will scale back to its historical levels, following Stock Performance Absolute / Relative to index (EGX70)
the sanitary ware new line completion in March 2011.
Three Month 25%/8%
Aracemco doubled its ceramic capacity in mid 2009 from 10.5 mn m2 per Six Month 47%/13%
annum to 21 mn m2 per annum (or 60k m2/day) with an investment cost worth
EGP75 mn. The new plant provided major cost cutting advantages, as it re- One Year 40%/25%
quired less than half the older plant’s workforce, or 250 worker instead of 600
worker. The new plant is also 30% more energy efficient. Shareholders Ownership stake

Aracemco as a whole has 2.9k employee and the company utilize in-house cali- Fathallah Al Saudi Sons Co. 42%
bers to operate the new lines it establish. Kuwaiti Real Estate Investment Group 24%
Furthermore, Aracemco will finalize in March 2011, the construction of a Musaad Al Saleh Group, Kuwait 7%
new sanitary ware line, worth EGP25 mn, which will produce 1.75 mn piece
per annum. Currently, the company has 4 operating sanitary lines, each with an Nasser Social Bank 3%
annual capacity of 350k piece or 1.4 mn piece in total. However, the new line Free Float & Others 24%
uses the same energy requirements as one of the old lines.
Analyst: Mohamed Fahmy
Ultimately, Aracemco will use the new sanitary ware production line as its first
production option, as using it alone while producing the same capacity as now Email : mfahmy@jaziracapital.com
will reduce energy cost by 75%, or bringing the total sanitary ware operating Mobile: +2012 2157312
cost down by 11%. Furthermore, if the company would find a growing de-
33
mand and use the older lines to up production to 2.45 mn piece. 31
Ara c e mc o S ha r e P r ic e (EGP )

29
Sanitary production can be further increased to 3.15 mn piece per annum, if the 27
company spends between EGP3-4 mn on a sanitary ware accessories production 25
23
facility bottle neck. However, the company will not spend this amount unless it 21
sees demand hiking from its current levels of 1.4 mn piece to cross the 2.45mn 19
17
capacity threshold. 15
D- 09 J - 10 F-10 M-10 A- 10 M- 10 J - 10 J -10 A-10 S -10 O-10 N-10 D- 10
A glazing production facility (the material used in creating the glazy resistant
surface on ceramic tiles) is expected to be completed in Q1 2011, at a cost of FY ending Dec. 2009a 2010e 2011f 2012f
EGP10 mn, Aracemco currently imports the glaze materials and its in-
Revenues (EGP mn) 273 345 388 443
house production is expected to reduce ceramic production cost by around
3-4%. EBITDA Margin 34.5% 37.0% 38.1% 42.1%

EPS (EGP) 2.69 3.60 3.94 5.10

There are also plans to purchase and install a colors production facility
over the next 12 months to serve both the ceramic and sanitary ware lines DPS (EGP) 2.00 2.00 3.00 4.27

at an estimated cost between EGP10-15 mn. PER 10.4x 7.8x 7.1x 5.5x

DY 7.1% 7.1% 10.7% 15.2%

Both the coloring and glazing in-house production will reduce import exposure
by EGP24 mn a year, or 14% of the production cost and both their respective EV/EBITDA 6.8x 4.8x 3.8x 2.7x
in-house production is expected to save between 5-6% of the total cost. Net Cash (EGP mn) 12 35 67 82

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 JAZIRA SECURITIES BROKERAGE
December 21, 2010
Changing ceramic milling
technology will bring ce-
ramic’s production cost further
downward by 11%
Dry milling plant will cost
EGP15mn and is pending
board approval
Has a 48% interest in a paper
packaging greenfield
During 2010, Aracemco man-
aged to sell around 50k m2 of
ceramic tiles per day after new
line becoming operational
versus less than 30k m2 before
the upgrade
Q4 sales came slower after a
good 9M in 2010
The cost efficient new ceramic
tiles plant and better econo-
mies of scale pulled margins
up
ARACEMCO
Equity Research
Aracemco Main Highlights, continued
Aracemco management intends to propose to its board to adopt the dry milling technology for its
ceramic production instead of its current wet method. The dry milling technology provides an
improved final product quality, up to 80% lower energy cost, more economical in its raw materi-
als use, no water consumption, eliminate pollution and increases kilns production.
The company received an offer from a specialized company in the field to install this line in
around one year with an estimated cost of EGP15 million and the offer promises that the new
technology will reduce ceramic tiles production cost by EGP1/m2 or around 11% of the total
cost.
Management hopes to get board approval soon, and have the dry milling line operating by Q1
2012.
The strengthening of the US Dollar against the Euro has been in favor of Aracemco since it im-
ports around 15% of its sanitary ware production inputs (3% of the total cost) from countries
like UK and Portugal using the Euro, while uses the US Dollar in pricing its exports.
The company is bank debt free and management have been able to finance 50% of its recent
expansions utilizing vendors finance with a tenor of around 1-2 years.
In a bid to control cost further, Aracemco has invested in a carton packaging green field, with an
investment worth of EGP24 mn or 48% stake in Egyptian Company for Paper Industries - EGY
Paper, enabling Aracemco to account for it using the equity method. EGY Paper started opera-
tion earlier this year and have managed to contribute around EGP823k of investment income to
Aracemco’s 9M 2010 income statement. However, Aracemco has still not benefited from the
possible synergies, through utilizing EGY Paper cartons in packaging its products.
Financial Assessment & Forecasts
During 9M 2010, we estimate that Aracemco managed to sell around 50k m2 of ceramic tiles a
day benefiting from the new founded capacity up from 37k m2 average in 2009, since the new
ceramic line was established in mid year 2009. While in 2008, prior to the new line establish-
ment, it had sold less than 30k m2 a day.
Interim Income Statement (EGP mn) 9M FY09 9M FY10 % Change
This surge in ceramic tile sale has re-
Revenues from Operation 185.1 266.6 44%
sulted in a 20% surge in ceramic reve- COGS (116.2) (153.1) 32%
nues and 16% in cumulative 2009
COGS/Revenues 63% 57% -9%
revenues. Furthermore, 9M FY10sales S, G & Adm. Expenses (5.0) (7.6) 51%
recorded a whopping 44% surge again
EBITDA 63.8 105.9 66%
supported by the larger ceramic sales
EBITDA margin 34% 40% 15%
volumes. Depreciation (7.9) (11.8) 49%
We project revenues to grow by a 30% Reported EBITA 55.9 94.2 69%
yoy in FY10, compared to the 44% Net Interest Income 0.5 2.3 325%
revenue growth reported in 9M FY10, Investment Income 0.0 0.8
as word has it, that the market activity Other Non-Operating Income, Net 1.2 1.0 -22%
was slow in the forth quarter. NPBT 57.7 98.3 70%
Source: Aracemco financials
Going forward, we expect revenues to
grow 11% in 2011, driven by a 25% increase in sanitary ware revenues, following the comple-
tion of the sanitary ware new line which will become fully operational by early 2011.
COGS/Revenue improved by over 600 basis points in 9M FY10 to reach 57% compared to 63%
in 9M FY09. This improvement was driven with the new ceramic tile plant coming online in
addition to the stronger US Dollar against both the Egyptian pound and Euro.
The company’s S,G&A remained relatively stable, as it recorded 2.8% of revenues in 9M FY10
vs. 2.7% in the comparable period last year. However, as a figure it grew 51% to EGP7.6 mn.
Aracemco has no bank debt, while have a remaining vendors’ facilities balance of EGP29.5 mil-
lion, as the company opted to finance its recent expansions with vendors financing leveraging
half of the expansions value and a two year tenor.
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 JAZIRA SECURITIES BROKERAGE
December 21, 2010
A tight credit policy resulted
in a high cash balance
Effective tax rate to move to
20% in 2011 up from 11% in
2009
We project FY10 bottom line
to grow by 34% yoy….
Major capital expenditure out-
lays may result in conservative
Aracemco management to
reduce payout ratio in 2010
A stock dividend may come as
a sweetener for shareholders
like in 2008
All tax exemptions will expire
by 2010 end
We expect improved economic
conditions to make Aracemco
operating close to its new ca-
pacities ceiling by 2012
The dry milling technology
will cause a surge in operating
margins in 2012
ARACEMCO
Equity Research
Financial Assessment & Forecasts, continued
Cash balance increased significantly over the past couple of years up from EGP33 mn in FY08
to EGP70 mn at the end of FY09 and again up to EGP91 mn by September 2010. This increase
in cash has resulted in outstanding surge in net interest income, which increased to EGP2.4 mn
in 9M FY10 vs EGP0.5 mn in 9M FY09.
Aracemco has a credit policy of less than one month, which is extended to 3 months in the case
of exports to Eastern European countries. With this healthy credit policy, growing sales and
most of the expansions being completed, by early 2012, we expect Aracemco cash balance will
expand further resulting in higher interest income and/or higher cash dividends.
In 2009, the company’s effective tax rate stood at around 11%. However, some exemptions re-
lated to new lines installed back in 2005 have expired at the end 2009 and the remaining exemp-
tions will expire in 2010, making us expecting the effective tax rate will increase to 20% starting
2011.
Net income grew 42% in FY09 to EGP76 mn vs. EGP54 mn in FY08, driven by higher ceramic
sales and its related improved margins. Again in 9M FY10, net profit before taxes grew by 69%
to EGP94.2 mn compared to EGP55.9 million in 9M FY09. However, we project that full year
FY10 net income will grow only by 34%, since we estimate the company’s effective tax rate to
rise from 11% in FY09 to 14% in FY10, in addition to our estimation of a slower forth quarter
sales.
On average, Aracemco had a payout ratio of 63% over the past 4 years and distributed around
74% of its net attributable income in FY09.
The company also distributed around 9.2% on employees and 2.0% on board in FY09.
We expect Aracemco may distribute EGP2/share in 2010, similar to its distributed figure in
2009, given the company may require a capital expenditure of around EGP30-35 mn in each of
2010 and 2011, this is combined with management's preference to keep adequate cash balances
close by. The new sanitary ware line and the glazing facility will be completed by March 2011.
Furthermore, at the same time the company will be initiating the establishment of the new dry
milling ceramic plant and the coloring facility, all of which will require capital expenditure out-
flows.
Similar to when Aracemco first was thinking of the ceramic tile expansion it distributed a 1:2
stock dividend in 2008, we think it may compensate the shareholders with a stock dividend with
a ratio between, 1:3 and 1:2 in exchange for a lower payout ratio given the current expansions.
We have not plugged in the stock dividend in our model since it provides no significant input in
our DCF value calculation and because it is just a guess.
In 2011, net income will grow by 9.2% compared to 2010 bottom line, although revenues and
EBITDA will grow by 12.5% and 15.9%, respectively, due to the company being taxed in FY11
with an effective tax rate of 20% versus our estimation of 14% effective tax rate in FY10.
We project that Aracemco would distribute in 2011 the same payout ratio as its 2009 dividend
payout ratio, which was 74%.
Our expectations of a better economic conditions by 2012, would enable Aracemco to be able to
sell its ceramic tiles close to full capacity along with being able to operate on a better utilization
rate with respect to the sanitary ware line. These factors combined with our conservative 2%
increase in the company’s products prices, are expected to bring revenues higher by 14.3% to
EGP443 million versus EGP388 million we expect in 2011.
More importantly, by 2012, the dry milling ceramic plant will come into operation which will
result in a sharp drop in cost, bringing EBITDA margin to 42.1% in FY12 compared to 38.1%
which we estimate to be achieved in 2011. This strong operational performance will result in a
surge in 2012 earnings by 29% to EGP127 million up from EGP98 million in 2011.
We assumed starting 2013 that cost factors will increase at rates higher than the increases we
project in per unit sales, thereby EBITDA margins will start to shrink starting 2013.
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 JAZIRA SECURITIES BROKERAGE ARACEMCO
December 21, 2010
Equity Research

Using a DCF model, we at-
tained Aracemco’s sharehold-
ers value at EGP41.3/share
If Aracemco doesn’t build the
dry milling plant, our target
price would drop by 8%
Valuation
Aracemco’s stock have showed strong correlation with the EGX70 index, as its beta came at
0.86x against the index. Aracemco is not a constituent of the EGX70, as it was pulled out of it in
the latest rebalancing in August 2010, but we expect that with its growing trading volume and
market capitalization improvement it will be included again in the coming revision. Using this
beta on our risk free rate of 8.75% and a market risk premium of 9.00%, it yielded a cost of eq-
uity and consequently a WACC of 16.49%, since the company has no interest bearing debt.
We have valued Aracemco using discounted cash flow model, in which we discounted the oper-
ating free cash flow stream using the discounted factor of 16.49% and a perpetual growth rate of
3.0%. Ultimately, we attained an enterprise value of EGP947 mn and then we added the book
value of Egyptian Company for Paper Industries which amounts to EGP24 mn and an amount of
EGP61 mn as excess cash. Thereby Aracemco’s shareholders’ value came at EGP1,032 million,
or EGP41.3/share.
Alternative Scenario - No Dry Milling Ceramic Tiles plant-
We have made an alternative scenario, in which we didn’t assume that the company will estab-
lish the dry milling ceramic plant. We opted to do this scenario just to assess the downside in-
case the plant establishment doesn’t pass the board approval.
The shareholders DCF value under this scenario would go down to EGP961 million or
EGP38.4/share, which imply it would reduce our target price by 8%. However, even under this
scenario, Aracemco remains provide a hefty upside based on our target price compared to pre-
vailing market price.

Aracemco Key Assumptions

Annual ceramic tile capacity 2008a 2009a 2010e 2011f 2012f 2013f 2014f 2015f
increase to 14 mn m2 in 2009 Annual Capacity (based on 350 days/annum operation)
since we assumed the new
Ceramic tiles (mn m2) 10.5 14.0 21.0 21.0 21.0 21.0 21.0 21.0
capacity operated 1/2 of that Sanitary Ware (Pieces mn) 1.4 1.4 1.4 2.5 2.5 2.5 2.5 2.5
year
Productions (Annual)
Ceramic tiles (mn m2) 10.8 13.4 18.2 19.3 21.0 21.0 21.0 21.0
Sanitary Ware (Pieces mn) 1.2 1.4 1.4 1.8 2.1 2.3 2.5 2.5

Utilization
Ceramic tiles 102% 96% 87% 92% 100% 100% 100% 100%
Sanitary Ware 86% 98% 100% 71% 86% 93% 100% 100%

Unit Price (EGP)

Ceramic tiles/m2 15.12 13.61 14.29 14.57 14.86 15.16 15.46 15.77
Sanitary Ware/Piece 52.52 56.72 57.86 59.01 60.19 61.40 62.62 63.88

Revenues (EGP mn)

Ceramic tiles 159 190 260 280 312 318 325 331
Sanitary Ware 74 79 81 103 126 140 153 156
Total Revenues 232 270 341 384 439 458 478 488

Revenue Breakdown
Although there are many fac- Ceramic tiles 68% 71% 76% 73% 71% 70% 68% 68%
Sanitary Ware 32% 29% 24% 27% 29% 30% 32% 32%
tors that would reduce cost
further, we assumed that the COGS/Revenues 67.0% 63.6% 60.2% 59.1% 55.1% 56.3% 57.6% 58.8%
normal growth in energy
prices and raw materials will Capex (EGP mn) 40 55 35 30 10 5 5 5

factor part of the improvement Source: Aracemco historical, Jazira Capital calculations, estimates and projections

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 JAZIRA SECURITIES BROKERAGE ARACEMCO
December 21, 2010
Equity Research

Historical & forecasted financials

Figures are in EGP mn
Income Statement 2008a 2009a 2010e 2011f 2012f 2013f 2014f 2015f
Revenues 235 273 345 388 443 463 483 493
Growth 27.4% 15.9% 26.3% 12.5% 14.3% 4.5% 4.4% 2.0%
EBITDA 73 94 128 148 187 189 191 189
Growth 52.3% 28.4% 35.4% 15.9% 26.2% 1.4% 1.2% -1.0%
EBITDA Margin 31.2% 34.5% 37.0% 38.1% 42.1% 40.9% 39.6% 38.4%
Depreciation & Amortization (20) (12) (16) (18) (19) (18) (16) (15)
Reported EBIT 54 82 111 130 167 171 175 175
Non-Operating Items 2 2 4 4 5 5 6 6
Net Interest 1 1 3 4 7 9 11 12
Net Profit Before Tax 57 85 118 139 180 186 192 193
Income Tax (5) (9) (17) (28) (36) (37) (38) (39)
Net Profit After Tax 51 76 102 111 144 149 153 154
Extraordinary Items 2 0 - - - - - -
Minority Interest - - - - - - - -
Net Income 54 76 102 111 144 149 153 154
Non-Appropriation Items (6) (9) (11) (12) (16) (17) (17) (17)
Net Attributable Income 48 67 90 98 128 132 136 137
EPS 1.9 2.7 3.6 3.9 5.1 5.3 5.4 5.5
Growth 22.8% 41.5% 33.8% 9.2% 29.6% 3.5% 3.0% 0.6%

Balance Sheet 2008a 2009a 2010e 2011f 2012f 2013f 2014f 2015f
Cash & Marketable Securities 33 70 96 154 205 237 266 291
Trade Receivables-Net 5 8 10 12 13 14 14 15
Inventory 56 48 62 71 83 87 92 95
Other Current Assets 6 8 10 11 12 13 14 14
Total Current Assets 100 133 178 248 313 352 387 414
Net Fixed Assets 74 117 136 148 139 126 114 105
Other LT Assets 31 26 24 24 24 24 24 24
Non-Current Assets 105 143 160 172 163 150 138 129
Total Assets 205 276 337 420 476 501 525 543

Short Term Bank Debt & CPLTD - - - - - - - -

Account Payable 6 11 13 15 17 18 19 19
Dividends Payable 25 59 61 87 123 127 131 132
Other Current Liabilities 18 31 38 40 37 24 8 (10)
Total Current Liabilities 49 100 113 143 177 169 158 141
Long-Term Debt & Bonds - - - - - - - -
Other LT Liabilities 19 23 32 46 64 83 103 123
Non-Current Liabilities 19 23 32 46 64 83 103 123
Paid in Capital 75 100 100 100 100 100 100 100
Total Shareholders' Equity 137 153 193 216 237 259 281 303

Net Cash (adjusted with Div. Payable & debt) 8 12 35 67 82 110 135 159
Working Capital 52 33 65 105 137 183 229 273

Free Cash Flow 2008a 2009a 2010e 2011f 2012f 2013f 2014f 2015f
NOPLAT 47 78 104 117 151 155 158 158
Depreciation 20 12 16 18 19 18 16 15
Gross Cash Flow 66 90 120 135 171 173 174 172
Gross Investments (58) (39) (49) (40) (29) (24) (27) (26)
Operating Free Cash Flow 8 51 71 95 142 148 148 146
Source: Aracemco financials & Jazira Capital estimates and forecasts

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 JAZIRA SECURITIES BROKERAGE ARACEMCO
December 21, 2010
Equity Research

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