Thursday 20 December 2012

Building Materials - Lacklustre demand to continue


We are keeping our NEUTRAL recommendation on the sector (steel & cement) at this juncture given the vulnerability in, and volatility of, the raw material prices, which could further compress margins for the building material players, especially steel millers. Generally, steel millers are still hit by the slower-than-expected recovery in steel prices and high inventory costs due to 1) the recent economic uncertainties arising from the debt crisis in the Euro zone, 2) the economic slowdown in China and 3) the extensive dumping of construction steels by Chinese mills globally. However, we could still see a better prospect for the overall industry in 1Q13 underpinned by the execution of major construction projects under the Economic Transformation Project (“ETP”) i.e. MRT, LRT, Tun Razak Exchange, Iskandar region development and etc. As such, we prefer cement players than the steel millers, with LMCEMNT (Not Rated) being the likely immediate beneficiary. We are not positive on the steel millers like ANNJOO (UP; TP: RM1.17) and MASTEEL (MP; TP: RM0.90) as their performances are likely to be subdued in the near term. We are looking to initiate coverage on LMCEMNT (Not Rated) in the near term. 

Steel:
Slower sales volume to continue. Thus far, the steel players’ earnings have been bogged down by a lower sales volume and expensive inventory prices due to the impact of slower demand for steel globally coupled with the slowdown in China’s economy. Due to the high inventory level and weak demand, China steel mills are holding back their productions, which could be prolonged in the next 6 to 12 months before a gradual growth in demand take place. Steel prices are expected to be subdued due to the  current on going rampant dumping activities. To recap, China's supply represents c.47% of the world’s crude steel supply in 2012.  Steel trading opportunities. Despite the slower recovery in steel prices, local demand has continued to support the demand for steel players like  ANNJOO (UP; TP: RM1.17) and MASTEEL (MP; TP: RM0.90). The local demand will somewhat partially cushion the impact of the slower exports, underpinned by the execution of major construction projects domestically under the Economic Transformation Project (“ETP”) i.e. MRT, LRT, Tun Razak Exchange, Iskandar region development, etc. With the busier construction activities in 1H13, we expect this will help pare down steel millers’ high inventory level, but their bottom line growth will still be limited due to their current high holding costs.

Cement:
Valuations already rich. Cement stocks namely LMCEMNT (Not Rated) and TASEK (Not Rated) on average are already trading at their up-cycle valuation at a 1-year forward PER of 19x (+0.5SD above the mean of their 5-year forward PER of 15x). TASEK is currently trading at 16x 1-year forward PER, which is more than a +2SD above its 3-year historical forward PER mean of 10x. Due to the rich valuations but stable  earnings growth, we have assigned a Neutral rating on the sector. We expect cement demand to grow by 5% annually through 2017.

Flattish margin ahead as capacity increases. Going forward, we are turning cautious on the cement companies’ ability to sustain their high/lucrative margins as more and more supply are gradually coming into the market. New entrant,  Hume Cement has already started production in 4QFY13. Upon completion of its plant in 1QFY13, it will add about 1.5m MT p.a. in clinker capacity, making up about 8% of the current industry capacity. CIMA and YTL Cement are also expanding with c.1.5m MT p.a. of additional clinker capacity each. However, we believe that the price competition will be a tricky one due to increase in demand of about 5% annually up till 2017 underpinned by the various mega projects, e.g. KVMRT, Tun Razak Exchange, RRIM land, Menara Warisan, etc. Note that Budget 2013 expects the construction sector to grow by 11.2% in 2013. While the volume growth will be sustained, the net selling price may face some pressure arising from the higher rebates offered due to the increased competition.

OTHER POINTS
Higher ASP but offset by higher rebates.  Despite LMCEMNT increasing its ASP by 6% from RM320/mt to RM340/mt in August, the accretion to its earnings was offset by the higher rebates given due to the increased competition. Based on our channel checks, rebates have increased to more than RM70/mt from RM40-50 in October. This was attributed to the entry of Hume Cement and the rainy weather in 4QFY12, which slowed down cement consumption. If rebates stay at current high levels, smaller players like Hume Cement will be the main losers. Based on our sensitivity analysis, the rebate level of RM120/mt will be close to the break-even point for cement producers.

Low coal prices provide the cushion.  On a positive note, we would like to point out that there has been a dip in the coal price, which makes up about 30% of the production cost. The benchmark Newcastle coal price has fallen by c.20% YTD from USD111/MT to USD90/MT. We expect coal prices to gradually recover as key economic indicators are showing an improving Chinese economy and from efforts by coal producers in China and Australia to cut production to control prices.

Saving grace is dividends.  While cement stocks offer limited upside in terms of capital appreciation, they do offer decent dividend yields, which provide a cushion considering the uncertain market environment. LMCEMNT offers a 4.4% dividend yield based on the consensus’ FY13 DPS estimates of 42 sen while TASEK offers a 3.9% dividend yield of based on the consensus’ FY13 DPS estimates of 50 sen. Cement companies namely LMCEMNT and TASEK have ample capacity to sustain their dividends as they are in net cash positions.

Valuation and recommendation.  We are maintaining our Neutral outlook on the building material sector for 1Q13. On the cement sector, our Neutral recommendation is due to the rich valuations of cement players, which currently trading at their upcycle valuations. However, decent dividend yields will provide the support to their valuations considering the current uncertain capital market environment. We favour LMCEMNT (Not Rated) as it offers a decent dividend yield of 4.4% coupled with the fact that it may announce a potential dividend hike or a capital repayment exercise. We are looking to initiate coverage on LMCEMNT in the near term. As for the steel sector, we do not expect steel players’ earnings to recover in the near term despite the increase in the local demands. This is due to their high operating costs as a result of their excess capacity and higher inventory costs.

Source: Kenanga

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