Muneeb SalmanPakistan Cement Sector Credit SuisseSector OverviewThe cement sector is fairly fragmented with a large number of operators. A few large players dominate with 55% of market. 84% (37.2mn tones) is located in North provinces of Punjab and KPK. The remaining 7.1mn tones are located in Southern provinces. Lucky is the largest company with plants in both regions, thus benefitting from a competitive advantage in the export market (both land and sea routes.)Price hikes to sustain amid positive demand outlookThe cement sector in Pakistan currently benefits from a price arrangement (cartel) which regulates prices and supply to ensure viability of the sector. As a result, despite an oversupply situation, retention prices have managed to increase 25% over the past 12 months.Given the accelerated pace of urbanization in the country two million people shifting from rural to urban areas annually the demand for housing is likely to remain upbeat. Pakistan has a housing backlog of approximately 8.5mn units with an annual addition of 300k units to the outstanding backlog.Major chunk of Public Sector Development Program (35%) is being allocated to infrastructure, including highways, dams, and power projects.Cost pressures on the declineCoal remains the single most important cost component for cements, constituting approx. 40% of the total production cost. The recent down trend in international coal prices (-20% over 6M) therefore bodes well for cement manufacturers as the sharp decline has coincided with a gradual uptick in cement prices (retention prices up 25% in FY12). In addition to higher prices and downward trend in coal prices, cement majors such as Lucky and DGKC will also benefit from cost rationalization measures such as installation of Waste Heat Recover (WHR) and Tyre derived fuel (TDF)/ Rubber derived fuel (RDF) plants. WHR has already helped to reduce electricity generation cost of Lucky and DGKC by 20-25%, while TDF/RDF offers 30-35% cheaper fuel than coal and can be used to replace 20% of coal utilization.Exports provide a perfect hedge against PKR depreciation. Every 5% Rupee depreciation increases average production cost by approximately 2%, however it also boosts revenues by 1%. For Lucky cement, every 5% PKR depreciation improves Luckys earnings by 0.6%.Top Pick- Lucky CementWe initiate coverage on Lucky, the largest Pakistani cement manufacturer, with an OUTPERFORM rating and a target price of PRs185, implying 43% potential upside.Margin expansion to continue amid easing cost pressures. The cement prices-led margin expansion in FY12 is likely to continue with Lucky geared to benefit from a sharp fall in international coal prices as well as successful execution of cost control initiatives. Moreover, cost control initiatives such as Waste Heat Recovery and Tyre Derived Fuel should help margins to improve to 36.7% in FY13 (31.8% in FY12).Diversification plans outline robust long-term growth strategy: Lucky remains the most innovative cement manufacturer in Pakistan outlined by: (1) being the first mover towards expansion in the mid-2000s including timely expansion in the South; (2) identification of new export markets in Iraq, Africa, Sri Lanka; and (3) undertaking cost-control initiatives such as WHR and TRF.