Response to My Open Letter: An Insight Into Nigeria’s Cement ‘Market’

A friend read my open letter to the Finance and Trade Ministers and sent me an email.

I have nothing personal against Dangote (not like it matters) so it’s important to share whatever (superior) information I have especially as cement seems to be the economic topic du jour.  I’ve posted his email, with permission, below, unedited.

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I think that’s a brilliant attempt at driving change in the cement industry. However, I think rather than comparing Dangote to these global guys, look much closer to home to see why the local market is distorted. Dangote, if you ask me is a brilliant capitalist in the mould of Rockefeller & J.P Morgan etc. The Nigerian cement market is your classic oligopoly featuring Dangote, Lafarge WAPCO, Ashaka (which is owned by Lafarge) CCNN, BUA and Unicem (Again partly held by Lafarge and Holcim, whose merger means they could potentially own three cement coys) and other puny players like Ibeto who import.

The table below showcases the gross margins of cement producers in Nigeria that are listed on the NSE over the last five years:

Screen Shot 2014-04-16 at 23.11.38

 

Notice Dangote has consistently high gross margins which is an insight into direct costs. Now local cement prices are the same for all players or broadly in range. Indeed Dangote’s prices were for some time slightly lower than peers until perhaps recently. 

Still he’s always had higher gross margins. Why?

The key driver of costs for local cement players at gross margin level is energy costs. Other players predominantly use LPFO which for a reason I can’t fathom is expensive to source locally. However, Dangote uses gas to fire his kiln at his cement plants thus he’s already at an advantage across all his shiny new plants except BCC, Gboko (which is why he rarely uses it).

Gas prices in Nigeria as you know are fixed and remain well below international prices (depending on who you speak to <$2). Which explains why not much investments in gas infrastructure until recently thanks to the gradual MYTO thingie. Anyway you can see why Dangote is much more efficient. Add to the mix that his plants are all more recent vs. ageing plants at CCNN and Ashaka. 

WAPCO seems to be catching up with their new plant which is gas powered. WAPCO was recently in the news about selling power to the grid but their older plants still use LPFO due to poor gas pipeline infrastructure issues. Most manufacturers now produce electricity using gas – Nestle, FlourMills, Dangote etc

Broadly speaking, you can clearly see why other players have no incentive to slash their prices as they stand to lose more than Dangote. Logically, he should slash it and force loss making firms to exit the industry.

My theory – what we have is implicit collusion which causes all cement producers to leave prices at current levels and enjoy high profits. Entry barriers to the industry are high enough so we can all stay comfortable as long as no one slashes. This means whoever drives the most volumes ends up market leader which is why Dangote always goes BIG! His efficient plants means profits are bulkier.

Screen Shot 2014-04-16 at 23.17.25

Next table is EBIT margins which gives a sense of operating efficiency. Again who’s the monster here, Dangote. Why? 

Again part of this reflects the feed through from gross margin levels but whatever Dangote is doing he’s ruthlessly efficient. OPEX includes stuff like distribution. Now I’m talking margins which mean he’s good at getting things out per unit of sales than other guys. Some of this reflects geography (my theory) – he’s centrally located vs. WAPCO; who are concentrated in the South West , CCNN; North West, Ashaka; North East and Unicem; South South.

Screen Shot 2014-04-16 at 23.24.51

Screen Shot 2014-04-16 at 23.25.33

Lastly is the PBT and PAT margin.

Look closely now – before taxes his margins are already 45%. Now the tax credits push him above 50%. Nigeria has a policy which I remembered being taught from undergrad days called Greenfield Tax Holidays. It’s real. You build a new factory and any incomes earned on that new factory is tax free for five years. It’s not Dangote alone who enjoys this. Several other companies enjoy it but it’s only on new factories. So if 50% of your sales come from your new plant, only 50% of incomes earned there are taxable. Dangote’s plants are all largely brand new. Voila! His tax holidays.  WAPCO last year also got a huge jump in earnings as it began benefitting from tax holidays on its new Latabaku plant.

But now to the economics. Dangote enjoys those high prices because he knows other players have no incentive to slash theirs or they would be on zero margins. All he has to do is work on efficiency and expand volumes to get fat profits. This is where my thesis of implicit collusion comes in. His getting fat implies other less efficient firms are allowed to survive on those high prices.

Rather than your Keynesian sounding idea which requires the firm hand of government – which runs contrary to the free market doctrine I associate with you – I would clamour for a competition commission as this is Nigeria, that process of having a website and doing lotteries still sounds arbitrary to me. I don’t think markets are bad, I think markets fail every now and then and thus we need visible regulation or system of rules to fix them. What would happen in other climes is that a competition commission steps in and decides ‘hey guys you’re colluding. We think prices should be down here’. After that hefty fines are handed out and prices adjust downwards which will force smaller loss making firms to either get bought up or liquidate. Currently we have equilibrium at an undesirable level, we need to invent that wheel to force everybody down.

I think long term what will happen is that there will be fewer players maybe just 2. Most countries have just few players. Lafarge has been mulling merging Ashaka and WAPCO for sometime. But you know our people, they keep resisting fearing Lafarge will close down the factory in Gombe. I wonder what will happen now that Lafarge and Holcim have merged. Dangote knows this well which is why he’s aggressively expanding capacity to meet demand for the whole country so that when that time comes to slash prices it will be on his terms. This is your classic price leadership in Oligopoly outcome – standard in economic texts. I watch the sugar industry and I’m seeing the same thing playing out there as well. But the cement industry is some years ahead of this.

Dangote enjoys his high margins from gross levels largely not from taxes. Over the next 2-3 years this will lapse. His sugar business pays statutory 32%, no holidays there. I think Dangote is what happens when regulation is lax not that he’s some serial cheat. He’s the natural result of market failure. He’s exploiting the fact that others won’t slash prices.

NB: on the tax issue which a lot of people are getting worked up about – do you know how much taxes Nigerian banks pay? Hint: Sanusi was railing against the current banking model of getting cheap deposits at zero to 3-4% and investing in govt securities of over 10%. Why? Govt securities are tax free. Nigerian banks tax rates are nowhere near 32%.You can check it.

If you look closely at the Nigerian economy, everything is rigged: gas prices, petrol prices, school fees, exchange rate – the biggest subsidy of all and implicitly cement prices. We abhor competition because it creates price volatility. Yet, to unleash our economy we must break out from this mindset and move to a market based system. That change however is something we are not prepared for as you remember from the fuel subsidy protests. So it has to be gradual. 

I’m sorry I had to write this long thesis I hope it helps shape your solutions. Ironically today I was watching CNBC and the South African Competition Commissioner was saying cement is one of the most collusive industries globally. It does not need the players to do any cloak and dagger stuff all they need is some equilibrium that suits everyone which is guaranteed by high entry barriers.

Imports can work but I believe Nigeria is not at the time now. We still peg our currency implying everyone gets an implicit subsidy on imports and our size as well means imports have a negative effect on reserves.

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First off, thanks to the person who sent this to me [He wants to remain anonymous]

Let’s try to unpack some of that.

1. If the above theory is true (and I think it’s very sound), then the problem is rather different from what I thought it was.

‘Entry’ and ‘exit’ are compulsory features of any functioning market. Some people will always die and leave the market. But if profits rise for the survivors, that will attract new players into the market again. And so on. To enter the market, you have to do something better than those who are already there.

Does the fact that Kodak went bankrupt mean that people are taking less photos? No. In fact, human beings are taking more photos than ever before but Kodak has exited the photo market and new people – like Sony – have entered. This is how capitalism in a market system is supposed to work and improve lives.

2. What has happened in the Nigerian market is a really annoying situation. Rather than kill off his competitors by pricing them out of the market, Dangote lets them stay alive to help him make as much profits as he can.

Looking at those numbers above, if Dangote drops prices by say 15%, CCNN will die in about 10 minutes and Dangote will make up the drop in revenues by selling more cement. In such a situation, will Nigerians have less cement to buy? No. In fact they will buy more cement due to the lower prices. And life will go on.

3. But if Dangote uses price and efficiency to kill off the inefficient players in the market what happens? Well, we know that technology is improving all the time and we also know that Dangote’s plants are between 1 and 5 years old. Meaning that if you build a new plant today, you have a chance to beat him at efficiency and thus price. Again, this will be to the benefit of consumers, which is the whole point of production.

Instead, prices are kept high enough to sustain people who should either invest in new plants or exit the market. In short we have one kind of fake competition going on. If those weaklings die, it cannot be long before new players (or new plants) enter the market which will put the incumbents (esp Dangote) on the defensive.

In China, the government uses force to improve efficiency in the market – it simply shuts down small inefficient players or forces them to merge with others. As at 2012, there were around 3,000 (yes, 3,000) cement manufacturers in China and the top 10 producers combined, controlled less than 25% of the market. Some regions have now started to ban any new cement plants to reduce overcapacity and pollution.

In that kind of market, you can imagine that fixing prices will be very difficult.

In Nigeria, Dangote controls close to 70% of the market and as stated above, we have only 3 players really.

4. This theory explains the ongoing war over cement grades I think. Rather than eliminate competition by bringing down prices, I reckon Dangote wants to drive them from the market while keeping prices high (and maybe higher). Why?

He’s currently in the middle of his African expansion so he will extract as much profits from the Nigerian market as he can before the referee blows the whistle on this game.

5. But all these shenanigans can go on partly because importation of cement is banned. I still think that my recommendation on allowing imports will work precisely because I am almost certain it won’t happen. Dangote has so much capacity to cut prices [I understand that even at N500/50kg bag he will make profits on his cement] that if the Nigerian government were to allow imports, there’s no way he would sit around and watch. He’d simply drop prices low enough to make importation pointless. Job done.

6. Just to clarify – I think Dangote’s zero taxes are a symptom not a cause of the problem. It is merely rubbing salt into an open wound. Certainly, no law has been broken in not paying taxes and the tax holidays have a place in encouraging people to invest in the economy.

7. Here in the UK, in January 2012, the Office of Fair Trading referred the cement industry to the Competition Commission for investigation. After a 2 year investigation, the CC concluded that the market was not competitive enough and there was some sort of collusion/co-ordination going on.

It has now decided to increase competition in the market by creating a 5th player through forcing Lafarge and Hanson to sell some of their plants to a new entrant. You can find the 103 page report released in January here. What’s amusing is that all drama is happening in a market where the manufacturers operate at around the 7% PAT margin with a 25 year time frame to make a return on investments in new plants.

When people hear ‘free markets’ they tend to think of something with no rules. But a free market actually means that the rules are clear and apply to everyone equally to ensure competition and consumer protection.

So you have the OFT constantly watching markets to ensure nothing funny is going on (sometimes its very hard for consumers to see what’s going on) and if it finds anything, it asks the Competition Commission to investigate and apply sanctions as appropriate.

There is also a Competition Appeal Tribunal to which Lafarge and Hanson have applied to challenge the ruling of the Competition Commission [I think I support the cement manufacturers here because they have been under watch and investigated 3 times in the last 10 years or so and Lafarge has already been forced to sell some plants a few years ago. They barely make profits and demand for cement crashed after the recession and has not recovered since. Perhaps the UK is an example of ‘extreme’ regulation, but you get the point]

This is broadly the kind of structure you will find in more advanced economies.

We are nowhere near that level yet but a couple of days ago, someone sent me this link. The government is currently taking submissions on a competition policy. I will send in a contribution and if you can, you should too. I don’t know how long it will take to draft the policy and then get it through the NASS (elections are coming and people will lobby against it).

In short, it looks like these high cement prices will be here for a while. Change is hard. Change in Nigeria is even harder.

It really is in the government’s hands to remedy the situation if it wants to. But I think there is now enough information in the public domain for consumers to keep the pressure on those who matter.

I hope you haven’t been depressed by this long post? The problem is more serious than I even imagined it to be.

FF

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7 thoughts on “Response to My Open Letter: An Insight Into Nigeria’s Cement ‘Market’

  1. Well done FF, you have really put in a lot of time and energy into this matter. You have earned my admiration. Please keep it up.
    A few comments on your response:
    1. You assume that if profits are high enough, new players will enter the market to replace dead players that exited. Appears you didn’t consider entry barriers including very high fixed costs of entry and the very high sunk costs which make entry and exit difficult for players attracted by the profit. This is not a market for recharge card retail. I would say Dangote’s reputation however makes it easier for him to source the funds for the kind of investments he is making. Banks want to be associated with his businesses and want to claw part of the profit.
    2. You also assumed that Dangote should be content with whatever profit he can by selling at 15% less to kill competition. Economic theory says he can make more profit in the market if he allows his competitors to stay in the market. He just needs to sell slightly lower than them to make higher profits while they also make profits. In fact if he kills competition, he becomes a monopolist and may accordingly respond only to the incentive to restrict quantity and hike prices to the greater detriment of consumers. Dangote does love high prices as alluded to in your fourth bullet point and the Greenfield Tax holiday remains a huge incentive not to produce at Gboko.
    3. The firms appear to be in a Bertrand competition where the firms produce homogenous (assumed) goods but have varying marginal costs with Dangote’s being the lowest. If Dangote prices at his marginal cost (and makes no profit), he sells all he produces while the other firms produce zero to prevent losses. However, Dangote can make a profit by selling slightly below the other firms’ prices if the other firms sell at a profit.
    4. Now I know your kind of free-market adherent wants some government intervention unlike most US variants. I wrote my notes as I read your blog before I got to the point on the proposed policy but I will still tell you what I wrote. I had noted the lack of (or maybe folks don’t just know about such) an anti-trust agency in Nigeria. Are there anti-trust laws? Have there been cases to test these laws? Anti-trust cases aren’t as popular on the news either so I can’t really comment. If a public body is set up to uphold anti-competition laws will they truly protect consumers and producers in markets? Wrote this with the SON expert committee in your initial write-up on this matter at the back of my mind. Can a group of individuals just set up a body and implement the government policy?

    Keep up the good fight.

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  4. Wow! I have learnt a lot from this analysis and those of the anonymous contributor. Amazing how much insight into the cement industry is available here. Safe to say there’s hope for Nigeria if we decide to do the right thing. Thank you for this post FF!

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