The budget has numerous incentive for the manufacturing sector, particularly in attracting private investment. Key measures include the broad reduction in duties on raw materials, a 10% reduction in industrial power tariff, customs duty and other tax exemptions on the import of machinery (which is not produced locally) and strong incentives for the SME sector.
This is further supported by an expansion in public investment by the government (PSDP PkR202bn) and by public sector enterprises (PkR50bn). On a negative note, the budgetary measures are likely to have a negative impact on the trade balance, inflation and ultimately will place further upward pressure on interest rates.
Given the host of revenue-negative measures and high world oil prices, we predict that CBR revenue targets and surcharge revenue targets respectively will be hard to attain, hence the PSDP expenditure has substantial downside risk.
The impact on the equity market is likely to be quite negative. The imposition of Capital Value Tax on the purchase of equities will raise trading costs substantially, and will have a negative impart on trading volumes. As noted above, the budget is quite simulative and will put further upward pressure on interest rates, that have a inverse relationship with PER multiples.
Furthermore, the 2 year exemption given to capital gains tax indicates to us that the government sees that as the cut-off date for exemption of the capital gains tax.
The budget also did not deliver on a further reduction in CED on cement - a key growth sector - and in the reduction in duties on CKD kits in the auto sector, while it cut tariffs further on CBUs.
BUDGET IMPACT ON THE MARKET
Capital Value Tax
-- The government has levied a 0.1 % capital value tax on the purchase of shares. This measure imposes a PkR4.8-5.3bn tax on the trading volumes on the KSE (on the basis of the average of the 1m, 3m, 6m and 12m average trading value).
-- This is quite negative for a trading oriented market such as the KSE as it raises substantially the transaction costs, and will result in a reduction in trading volumes. This is likely to particularly hit fundamentally weak stocks, where trading occurs in very tight bands.
Capital Gains Tax
The government has extended the capital gains tax exemption for a further two years, apparently abandoning its previous position of only allowing its exemption for one year. This two year extension could have been driven by one of two considerations, in our opinion:
-- To placate the market after the imposition of Capital Value Tax.
-- To send a signal to the market that the government will not consider a further exemption after two years. In our opinion, and the market is also likely to perceive it as such, the signal is that the exemption will go after two years. This will also impact market sentiment negatively.
We do however feel that these measures are positive for the market over the long run. It will act as a deterrent to speculative build-ups in the market, and furthermore is a step further in the direction of proper documentation and regulation of the equity market.
Negative for interest rates
-- The budget for FY05 in quantum terms will expand the fiscal budget, while as a percent of GDP the increase is nominal.
-- The inflationary impact of an expansion in the budget deficit quantum is already evident in FY04, in the presence of a substantial government multiplier.
-- The budget also includes several incentives to bolster investment, however these are also likely to exacerbate the trade balance further. This will have a negative impact on the net flow of foreign liquidity into the economy, and deliver a relative tightening in monetary conditions.
-- Continued high oil prices will exacerbate this trend further, though this will be mitigated somewhat by the supportive impact that high oil prices have on workers' remittances.
-- Higher interest rates normally result in the market trading at lower PER multiples. Unless the market posts positive earnings surprises. On the basis of our universe earnings, the impact on the market should be negative.
OVERWEIGHT
Textiles:
-- Heavy incentives for capex and lower working capital requirements.
Telecoms:
-- Government continues to be supportive of the sector with a reduction in taxes on new cell connections.
-- Zero-rated import of equipment not produced locally.
-- High growth will help telecom volumes.
Oil Marketing:
-- Greater economic activity has already had a very positive impact on sales volumes in FY04, will continue into FY05.
Fertilizer:
-- Strong agriculture orientation in the budget, which will further bolster the positive impact of high liquidity and high prices in the previous year.
Commercial Banks:
-- Short-term long yield movement will be negative.
-- Over the medium term, this will be mitigated by rising spreads and lending volumes.
UNDERWEIGHT
Cement:
-- Expected reduction in CED on cement has not materialised.
Auto Assemblers:
-- Unlike the rest of the manufacturing sector, the sector has not received any relief on import duties on CKD kits.
-- Substantial reduction in the import tariffs of CBUs, which compete with domestically assembled vehicles.
FERTILIZER SECTOR
-- Though, the budget 2004-05 does not entail any direct incentives for the fertiliser sector, except the ones pre-announced, we feel that the various incentives announced for the farmers' community will have a positive impact on this sector.
-- The Finance Minister reiterated in his speech that modifications in the fertiliser policy 2001 are underway, which are expected to be completed by June 30, 2004. As the current fertiliser policy does not provide any major incentives to the potential investors, it is expected that the GoP would modify the policy to encourage fresh investment in the sector so as to meet the potential shortfall in urea supply over the next 2/3 years.
-- Moreover, the PkR100 reduction in DAP price per bag via adjustment in taxes is likely to arrest the decline in demand for this fertiliser. At present, DAP is selling for PkR999 per bag.
FMCG
-- Budget 2004-05 finally answered tea marketers plea and custom duty was reduced to 10% on tea from existing 20%. This will arrest the increasing trend in smuggling of tea, which bodes well for Unilever. (tea accounts for 38% of Unilever's topline).
-- On the other hand, the Minister made no specific announcement for duty cut in soaps, which is negative for Unilever as smuggling of this product is the a biggest challenge for manufacturers of personal care products.
-- Furthermore, the elimination of 10% excise duty on juices is encouraging for Nestle and we feel that the company's margins as result of this would improve by 20-30bps.
TELECOM
-- As expected, the GoP has announced a 100% reduction in activation charges, which now stand at PkR 1000.
-- Following this announcement, we feel that deferred demand for cellular connections would pick up pace and companies like Ufone and Insta, who have recently rolled out capacity, would be the beneficiaries.
-- The elimination of import duty on machinery is encouraging for the deregulated telecom sector, as following the issuance of LL and LDI license, the new entrants would start importing the equipment.
AUTO ASSEMBLING
-- The news is broadly negative for the sector as the GoP has announced substantial cut in import duties for CBU across different categories in the range of 25%-50%, while no incentive was announced with regard to CKD imports.
-- The import duty for CBU is fixed at 50% for cars upto 1300cc, 70% for cars upto 1600cc, 80% for cars upto 1800cc and a 100% import duty for cars beyond 1800cc. Against industry expectations, no relief has been provided on the import of CKD as the GoP feels that auto manufacturers are already running on economies of scale.
-- The withholding tax on import of CBU tractors has been reduced from 6% to 2%, while import duty of 10% has been fixed for import of tractors below 35hp and above 100hp. Since, local manufacturers produce tractors between 50-75HP, we feel that this decision is unlikely to impact sales of locally produced tractors.
COMMERCIAL BANKING
The impact of the budget is positive on three fronts:
-- The 'crowding-in' of private investments should help lending activity.
-- The budgetary borrowing requirement is likely to put upward pressure on yields. Greater inflation pressure is negative in the short-term due to impact on long yields, but eventually short-yields will rise which should improve sector spreads as deposit rates have tended to be sticky upwards.
-- Commercial banks tax rate cut by a further 300bps, which is a pre-announced measure.
OIL MARKETING (OMC)
-- As expected the budget did not bring any new incentives for the sector. Petroleum levy and surcharges for the FY04E was estimated at PkR46. 1bn, we expect FY05F levy and surcharges to remain in the same vicinity (PkR61.1bn was estimated from oil & gas sector for FY04E, the target for FY05F is PkR63bn).
-- Greater public investment (PkR202bn PSDP) is likely to make a positive impact on oil volumes. We foresee a 4% YoY growth in volumes for FY05, against a constant decline in preceding years.
-- Although, the budget did not bring anything new, we continue to believe that with high oil prices and growth in volumes, the sector is likely to maintain current strong bottomline performance in the coming years.
EXPLORATION AND PRODUCTION (E&P)
-- GoP has hinted towards fiscal incentives for the sector; however, details have not been circulated. Thus, the true impact is hard to determine.
-- Nonetheless, if we go into details on the fiscal side, the current tax rate for the sector varies from 40% to 52.5% (inclusive of 12.5% royalty, netted out in the final tax calculations). However, the effective tax rate applied by the sector (in the last two to three years) has been in the range of 25% to 32%. Thus with already low tax provisioning, we do not foresee any change in the effective tax rate and believe it will have negligible impact on the bottomline for the sector.
-- The sector is getting aggressive on the exploration side with OGDC and PPL leading the way. Thus, the thing to watch out for is the success ratio in coming years, which will make a fundamental impact on the bottomline of the sector.
GAS T&D
-- Public sector entities are expected to invest PkR50bn in FY05 on infrastructure and we believe around PkR12.3bn will be done through this sector. we have already incorporated this in our model and thus remain Overweight on the sector.
-- Since, the sector has a guaranteed return at the EBIT level linked to net operating assets, the increased expenditure will result in growing bottomline for the sector.
-- SSGC is likely to post a NPACT CAGR of 16% for the period FY04-08, while SNGP will experience at 13% CAGR in the same period. Thus, we prefer SSGC to SNGP in the sector.
POWER (IPPs)
-- Electricity tariffs have been reduced in the rage of PkR0.10 to PkR0.58, which is positive for the overall economy and will help in reducing power cost for consumer. However, it will have no impact on independent power producers (IPPs), as they operate on a fixed return basis.
-- Other than IPPs, it will have a negative impact on KESC (KESC-PkR8.45), as its revenue will get a hit while cost base will remain intact. Finance Minister has said that government has provided a PkR2bn subsidy to WAPDA and KESC on this account. However, the overall subsidy for FY05F has been reduced to PkR45bn (inclusive of the above subsidy) against PkR51.9bn in FY04E. The GoP expects that these public sector entitles will reduce losses going forward anticipating better operating efficiencies.
-- For us, the power sector continues to be a pure dividend play and with rising interest rates we recommend investors to go underweight in the sector.
CEMENT
-- Finally, government has made a move that will send a strong message to domestic cement manufacturers; the much anticipated reduction of PkR250 pet MT in CED (PkR12.50 per bag) has not been announced. This will have a negative impact on the sector in two ways:
-- It was anticipated that the reduction in cement prices (passing on the incentive to consumers) will provide further impetus to the growing demand of cement. Although, we still foresee cement demand (volume) to grow, the rate is likely to taper off. We expected a 13% CAGR for the period FY04-08, which is likely to come into single digits.
-- Furthermore, domestic manufacturers were hopping that they would retain a portion of the incentive mitigating the high cost of coal for next year (up 100% YoY, US$70 per ton from US$35 per ton). Thus, with higher coal prices either manufacturers absorb the hit; negative for YoY bottomline growth, or they raise cement prices; further dampening growth (volume) prospects.
CHEMICALS
-- CED on paints (10%) has been abolished. Paints has been the growing segment for ICI and the decision will provide further impetus to demand. The increase in PSDP allocation and growing car demand also bodes well for the company.
-- On the other hand, there is no mention of Soda Ash duty being reduced. Thus, ICI is likely to maintain its gross margin (28%) for the unit (share in topline 16% share in gross profit 38% for FY03A).
-- On the PSF side, the reduction in GST will help PSF consumers to reduce working capital requirements, positive for ICI.
-- All in all, the budget will have a positive impact on ICI and we recommend a Buy on the company.
POLYESTER STAPLE FIBRE
-- GST rate for PSF, PTA and MEG has been reduced to 15% from 20%. The reduction in GST on PSF is likely to have a positive impact on PSF demand, as it lowers working capital requirements for consumers (textile). While the reduction on raw material import duties will lower working capital requirements of PSF manufacturers (sight decline in financial charges).
-- There has been no announcement of a reduction in custom duty on PTA and MEG (raw materials) and PSF. Thus, the sector fundamentals remain intact on this front.
-- The biggest problem for the sector has been the excess supply, as demand catches up with supply, we expect the sector to post growth in the bottomline in the coming years. Thus, we maintain our Overweight recommendation for the sector for the long-term investors.
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