Ezz Steel Update - December 2016

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PRIME INVESTMENT RESEARCH BUILDING MATERIALS| EGYPT EZZ STEEL – UPDATE

18TH DECEMBER, 2016

EZZ STEEL… NEW LEVELS POST FLOTATION, LEADING TO TREMENDOUS UPGRADE

We upgrade our fair value for Ezz Steel (ESRS.CA) to EGP 20.9/share from our previous fair value of EGP 9.2/share; with an upside potential of 55%, implying a Strong Buy recommendation. The considerable change in fair value and our new positive view for Ezz Steel comes on the back of what we stated pre flotation in our latest update issued in 29

th of September 2016, as we stated “Although the significant

upside potential, we advise short term traders to avoid the stock at the mean time… On the other hand, at this current price levels, we advise medium to long term investors to start build their position in Ezz Steel… as Egypt is going to solve the FX crunch, through securing external debts, as well as solving the problem of NG shortage within 2017, Ezz is expected to perform well.” Nevertheless, in terms of USD, our fair value upgrade by only 9%, at an exchange rate of EGP 18.5/USD compared to EGP 8.88/USD. Our valuation horizon starts at FY2017 and ends by FY2021. In our opinion, the catalyst is stemmed from the synchronized occurrence of four elements; 1- EGP floatation, liberalizing Steel pricing. 2- Improvement in NG supply, especially in 3Q2016, which can be noticed in EZDK’s 3Q2016 financial results. 3- Global Prices rebound during 2016. 4- The duplication of DRI model in ERM’s new DRI plant, since DRI based model bears a cost advantage of USD c100/ton. Post floatation, we believe we are about to see new price levels and unprecedented profitability levels in Ezz Steel, due to the expected dollarization of the company’s operations. Selling prices are now a function of USD/EGP exchange rate and global steel prices. This relation can be noticed when tracing back the changes in selling prices and the USD/EGP exchange rate. We did not expect floatation to have a negative effect on Ezz Steel, as we believed the company will link its selling price to the USD/EGP exchange rate, which what really happened. This means that floatation will affect positively 100% of the revenues side. On the other hand, EGP floatation will result in a negative effect on production costs, by increasing its value. However, only 60-65% of the company’s production costs to be affected by the floatation. This means that, the positive effect is to exceed the negative one. Additionally, with the increasing cost of imported steel, coupled with government trend to control imports with local substitutes, we believe Ezz is now able to pass the full increase in production costs to the end consumer, more than ever. Moreover, post floatation, the revaluation of ESRS’s debt is expected to result in an interest bearing debt of EGP 20bn by 2016, compared to EGP 17bn in 2015. Despite the fact that the number might be alerting, we do not consider debt as a major risk, since we expect the company to generate enough operating profits to cover its debt servicing costs. Furthermore, when translating total debt to USD, we will notice that the number is lower post floatation, in addition, Ezz controls assets valued in USD, such as the recent DRI plant, with a cost of USD 600mn, which on its own represents half of total debt post floatation. In sum, if we looked at both sides of Ezz steel balance sheet in dollar terms, Ezz is a net beneficiary of floatation. EZDK’s turns to profitability in 3Q2016 indicates faster than expected improvement in NG supply. EZDK

recorded a positive bottom line, surprisingly, of EGP 273mn during 3Q2016. This is mainly attributed to the

higher than expected NG supply during the quarter, as all expectations were that the company’s DRI

production will be at its lowest level during 3Q2016, summer season, when electricity consumption reaches

its peak. Looking at DRI production levels during 3Q2016, we found that DRI plants produced the highest DRI

volume during 2016, even higher than 1Q2016, which indicates that DRI plant’s NG supply was, unexpectedly,

stable during the quarter. This came to support our positive outlook concerning NG supply starting 2017,

urging us to maintain NG supply expectations during 2017 at 65%, increasing gradually until it covers all the

company’s needs of NG starting 2019. Subsequently, we expect a parallel improvement in ERM’s new DRI

plant NG supply to record 50% in 2017, compared to less than c25% in 2016. Our positive expectations are

also backed by the massive NG explorations in the past two years that are expected to come online by the

end of 2017 and 2018. This coupled with Egypt’s agreement to import c60 LNG shipments during 2017, in

addition to paying part of the oil companies dues post floatation.. It is worth mentioning that, government

allowed four companies to import LNG shipments, which provides a good alternative for Ezz to buy NG, in

case the government was not able to supply its NG needs.

“STRONG BUY” FAIR VALUE EGP 20.9 MARKET PRICE EGP 13.5 POTENTIAL 55% UPSIDE

INVESTMENT GRADE “VALUE”

Stock Data Outstanding Shares [in mn] 543 Mkt. Cap [in mn] 7,926 Bloomberg – Reuters ESRS EY / ESRS.CA 52-WEEKS LOW/HIGH EGP 6.11/EGP14.7 DAILY AVERAGE TURNOVER EGP 24.8MN

Ownership Ezz Industries 65% Free Float 35%

All prices are as of 15 December 2016

Source: Bloomberg

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ESRS EGX30 - Rebased

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18TH DECEMBER, 2016

EZZ STEEL’S SELLING PRICE STEEL, IRON ORE & SCRAP GLOBAL PRICES

SOURCE: EZZ STEEL, BLOOMBERG & PRIME CALCULATIONS

Although the government backed away from its decision to reduce NG prices supplied to steel

manufacturers, DRI integration model still carries a cost advantage of USD c100/ton over scrap based

method, so a stable NG supply will be much more beneficial than a reduction in NG price.

Since Ezz Steel imports 80%-85% of its raw materials, the company increased its selling price by 100%

ytd, in order to pass the declining value of the Egyptian Pound to the end consumer. Ezz Steel is

currently selling at an ex factory price of EGP c8700/ton, which reflects an exchange rate of EGP

18.5/USD. Hence, we tied local selling price with our exchange rate expectations and global steel selling

prices expectations. Apparently, imported steel risk has been partially eliminated as a result of the

rebound in global steel prices and the drop in the local currency value, however, another drop in global

steel prices represents a risk for ESRS’s ability to increase selling prices and bears the risk of repeating

what happened in 2015, where local steel producers were not able to increase their selling prices

pressured by imported cheap steel.

Global steel industry witnessed a slight rebound during 2016; however, it came faster than our

expectations. This increase mainly comes on the back of higher Chinese, largest consumer and producer,

demand, as the country ramped up infrastructure investments in order to meet the announced GDP

growth rates by the government. As a result, we believe the industry still faces shaky circumstances

leading to slower prices growth rates. Global steel price is selling at USD 575/ton, which represents a 46%

ytd increase, nevertheless, this still way below the historical levels of above USD 700/ton. In addition,

iron ore prices surged by 113% during 2016. The jump in iron ore price in the recent months is attributed

to oil prices surge and partially to Trump’s winning of US Presidential elections, as he promised massive

infrastructure investments. We believe the main risk for iron ore prices relies on the entrance of a new

huge Brazilian ore mine by 2018.

4,704

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18TH DECEMBER, 2016

Ezz Steel’s bottom line improved in 3Q2016, Supported by EZDK’s

Improvement

The company reported a consolidated net loss before minority of EGP 744mn in 9M2016, compared to a net loss of EGP 740mn in 9M2015. On quarterly basis, the company reported a net loss of EGP 128mn in 3Q2016, compared to a net loss of EGP 381mn in 2Q2016. This improvement is attributed to positive bottom line recorded by EZDK, as the company recorded a net profit of EGP 273mn in 3Q2016, supported by higher NG supply coupled with higher sales volume by 36% y-o-y and by 11% q-o-q, in addition to the increase of EFS’s production by 49%, q-o-q. Subsequently, and on consolidated levels, Ezz Steel’s 3Q2016 sales value increased by 69% y-o-y and by 47% q-o-q. Gross profit margin came in at 14% in 3Q2016, compared to 10% in 3Q2015 and 13% in 2Q2016. EBITDA jumped by 76% in 3Q2016, q-o-q, while EBIT soared by 199%, q-o-q. EBITDA and EBIT margins came in at 10% and 6%, respectively, in 3Q2016, compared to 8% and 3%, respectively, in 2Q2016. Although the improvement in operational margins, net profit margin came at -2%, crunched under interest expenses and FX losses.

In EGP Mn 1Q2016 2Q2016 3Q2016 q-o-q 9M2015 9M2016 y-o-y

Production

EZDK 573 607 677 12% 1,791 1,857 4%

EFS 143 108 161 49% 196 412 110%

ESR/ERM 284 284 313 10% 937 881 -6%

Utilization Rate 69% 69% 79%

67% 72%

Sales Revenue 4,967 4,036 5,917 47% 12,759 14,920 17%

Gross Profit 676 529 835 58% 1,127 2,039 81%

GPM 14% 13% 14%

9% 14%

EBITDA 500 330 582 76% 536 1,412 163%

EBITDA Margin 10% 8% 10%

4% 9%

EBIT 305 127 380 199% (22) 812 NA

EBIT Margin 6% 3% 6%

0% 5%

Net Income (Loss) (137) (381) (128) -66% (740) (744) 1%

NPM -3% -9% -2%

-6% -5%

EZDK Turns to Profitability in 3Q2016, Supported by Healthier NG Supply and

Surging Prices

As noted in our previous commentary over the company’s unaudited financial results, EZDK recorded an unexpected positive bottom line in 3Q2016, recording EGP 273mn, compared to a net loss of EGP 160mn in 3Q2015. We attributed the surprising turn in bottom line to; 1- Higher selling prices. 2- Higher than expected NG supply to DRI plants. This turned out to be right as sales surged by 62% in 3Q2016, y-o-y, and by 47%, q-o-q, as sales volume jumped by 36% y-o-y, and by 11% q-o-q, in addition to the jump in selling prices, as average selling prices increased by EGP 300/ton. Meanwhile, COGS, ex depreciation, increased by 40% y-o-y, and by 33% q-o-q. Although the jump in COGS, gross profit margin surged to 22% in 3Q2016, compared to 9% in 3Q2015, and 14% in 2Q2016. The higher gross margin is ascribed to higher selling price and higher NG supply to EZDK’s DRI plant, which soared DRI production to record 464 thousand ton during 3Q2016, compared to 432 thousand ton and 411 thousand ton in 2Q2016 and 1Q2016, respectively. We remind our readers that EZDK operates through DRI method, which is the most efficient method and provides a cost advantage of more than USD 100/ton relative to the scrap method. Inputs include iron ore, scrap and NG as a feed stock.

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18TH DECEMBER, 2016

Subsequently, EBITDA improved to record EGP 632mn in 3Q2016, compared to EGP 83mn in 3Q2015 and EGP 219mn in 2Q2016. In addition, EBIT surged to EGP 518mn in 3Q2016, compared to a negative EBIT of EGP 27mn in 3Q2015 and EGP 102mn in 2Q2016. EBITDA and EBIT margins came at 18% and 15%, respectively, in 3Q2016, compared to 4% and -1%, respectively, in 3Q2015, 9% and 4% respectively, in 2Q2016. Net profit margin came at 8% in 3Q2016, compared to a net loss in 3Q2015 and 2Q2016.

EZDK’s Standalone 1Q2016 2Q2016 3Q2016 q-o-q 9M2015 9M2016 y-o-y

Rebar Utilization Rate 83% 84% 94%

84% 87%

Flat Steel Utilization Rate 62% 73% 82%

70% 72%

DRI Utilization Rate 51% 54% 58%

41% 54%

Sales Revenue 2,731 2,337 3,433 47% 8,303 8,501 2%

Gross Profit 336 321 744 132% 833 1,400 68%

GPM 12% 14% 22%

10% 16%

EBITDA 253 219 632 188% 503 1,104 120%

EBITDA Margin 9% 9% 18%

6% 13%

EBIT 139 102 518 407% 176 760 333%

EBIT Margin 5% 4% 15%

2% 9%

Net Profit (297) (193) 273 NA (319) (218) -32%

NPM -11% -8% 8%

-4% -3%

Although we expect Ezz Steel to report healthier operational margins during 2016, due to NG supply

improvement and higher selling price, bottom line is expected to be heavily crunched under large FX

losses recorded in 4Q2016. We expect Ezz Steel to report non cash FX losses of EGP 4.1bn during 2016,

at USD/EGP of 18, mainly derived from EZDK EGP 3.8bn fx loss. However, as the USD/EGP exchange

rate declines, we expect to see a capsize verse as the company will start recording FX gains.

Noteworthy, this huge FX loss will be non cash losses, as it arises from revolving credit facilities and ST

debt. Apparently, the huge FX loss recorded in EZDK during 2016 is expected to result in a huge

retained losses that exceeds capital, driving management to call for an EGM, due to regulatory

requirement, to decide whether the company should continue business or inject capital. The company

expects shareholders to vote for business continuation.

Upside Risks;

1- Higher than expected NG supply, leading to higher DRI utilization rate.

2- Higher than expected drop in cost of equity, as a result of lower risk free rate.

Downside Risks;

1- Slower than expected improvement in NG supply.

2- The inability of the company to cover its working capital needs, as the company is operating

currently at new levels, post floatation, as previously mentioned.

3- A drop in global steel selling prices, paving the way for local importers to dump local market with

cheap imported steel.

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18TH DECEMBER, 2016

SOURCE: BLOOMBERG & PRIME CALCULATIONS

In our peer analysis, we select peers with production capacity as close as possible to that of ESRS. Our analysis

implied that Ezz Steel’s EV/Ton is at USD 231/ton, which is at a discount of 39% to peer’s average at USD 377/ton.

This is justified by both company’s and Egypt’s specific risks that are not considered in EV/Ton calculation. We can

see that P/B and financial leverage are inflated during 2016, which is attributed to the expected excessive retained

losses that will squeeze shareholders equity, neverthless, as the company starts to generate net profits in the

coming years, retained earnings are expected to boost shareholders equity again.

Peer Analaysis EV/EBITDA P/B Financial Leverage EV/Ton

Nanjing Iron 165.2 2.0 5.1 417.9

Xinyu Iron 14.7 1.0 3.6 293.7

Anyang Iron NA 1.6 5.4 270.8

Liuzhou Iron 72.6 2.4 4.7 256.5

JSW Steel 11.7 1.5 3.9 649.9

Ezz Steel 13.1 95.4 27.2 231.7

Average 66.1 1.7 4.5 377.8

Median 43.7 1.6 4.7 293.7 All figures are as of 2016

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18TH DECEMBER, 2016

Financial Statements … Historical & Forecast Income Statement Brief Hist. Forecast

In EGP Mn 2015 2016F 2017F 2018F

Revenues 16,641 22,029 37,378 40,279

Change -14% 32% 70% 8%

COGS 14,804 19,275 31,601 34,044

Change -18% 30% 64% 8%

Gross Profit 1,837 2,754 5,776 6,236

Depreciation & Amortization 752 821 914 990

EBITDA 1,096 1,971 4,419 4,813

Interest Expense 1,211 1,752 1,865 1,647

FX Gains (Losses) -90 -4,063 284 375

Net Income After MI -418 -2,526 1,203 1,537

Balance Sheet Brief Hist. Forecast

In EGP Mn 2015 2016F 2017F 2018F

Cash 4,784 2,462 2,009 3,483

Net Receivables 15 119 195 173

Net Inventory 4,265 3,448 5,654 4,617

Other Current Assets 2,562 1,701 2,824 2,254

Total Current Assets 11,626 7,730 10,681 10,527

Net PPE 11,211 15,362 14,978 14,528

Other LT-Assets 490 637 591 593

Total Long Term Assets 16,609 15,999 15,569 15,121

Total Assets 28,236 23,729 26,250 25,648

Liabilities

STD - incl CPLTD 10,450 10,105 12,364 10,467

Accounts Payable 3,650 2,112 3,463 3,917

Total Current Liabilities 15,222 12,893 16,916 15,772

LTD 6,971 9,384 6,011 5,050

Other Long Term liabilities 1,260 1,374 1,454 1,431

Total Long Term Liabilities 8,232 10,759 7,465 6,481

Total Liabilities 23,454 23,652 24,380 22,253

Equity

Paid-in-Capital 2,644 2,644 2,644 2,644

Minority interest 1,484 (166) 425 1,112

Total Equity 4,782 77 1,870 3,395

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18TH DECEMBER, 2016

Financial Ratios Hist. Forecast

GPM 11% 13% 15% 15%

EBITDA Margin 7% 9% 12% 12%

NPM -3% -11% 3% 4%

EPS -0.77 -4.65 2.21 2.83

DPS 0 0 1.11 1.41

P/Ex NA NA 6.10 4.77

EV/EBITDA 22.07 13.08 5.81 4.74

ROA -1.62% -9.72% 4.43% 5.44%

ROE -7.07% -78.10% 63.28% 41.77%

Debt/Equity 3.64 253.39 9.83 4.57

Total Assets Turnover 0.64 0.85 1.50 1.55

BV/Share 8.8 0.1 3.4 6.2

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18TH DECEMBER, 2016

Stock Recommendation Guidelines

Recommendation Target-to-Market Price (x)

Buy x > 15%

Accumulate 5%< x <15%

Hold -5% < x < 5%

Reduce -15% < x < -5%

Sell x < -15%

Strong Buy x > 40%

Investment Grade Explanation

Growth 3 Yr. Earnings CAGR > 20%

Value Equity Positioned Within Maturity Stage of Cycle

Speculative Quality Earnings Reflect Above Normal Risk Factor

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18TH DECEMBER, 2016

PRIME SECURITIES

Hassan Samir Managing Director +202 3300 5611 [email protected]

RESEARCH TEAM

Aboubakr Emam, CFA Head of Research +202 3300 5724 [email protected]

Eman Negm, MSc Economist +202 3300 5716 [email protected]

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Ali Afifi Equity Analyst +202 3300 5723 [email protected]

Omneya El Hammamy Equity Analyst +202 3300 5718 [email protected]

Ingy Fahmy Equity Analyst +202 3300 5722 [email protected]

Taher Seif Equity Analyst +202 3300 5719 [email protected]

Mohamed Magdi Junior Equity Analyst +202 3300 5720 [email protected]

SALES TEAM

Mohamed Ezzat Head of Sales & Branches +202 3300 5784 [email protected]

Shawkat Raslan Heliopolis Branch Manager +202 3300 5110 [email protected]

Amr Saber Team Head – Institutions Desk +202 3300 5659 [email protected]

Amr Alaa, CFTe Manager +202 3300 5609 [email protected]

Mohamed Elmetwaly Manager +202 3300 5610 [email protected]

Emad Elsafoury Manager +202 3300 5624 [email protected]

HEAD OFFICE

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Ezz Steel Update - December 2016