Basic Materials - Electric Shock

The 18.8% electricity tariff hike from Jan 2014 is an unpleasant surprise to power-hungry steel and cement producers in Peninsular Malaysia. As local  steel  players  are  struggling  to  survive,  the  tariff  hike   is  painful despite only translating into 1.8% of production cost vs 2.9% for cement players.  We  downgrade  most  of  our  basic  materials  stocks,  and DOWNGRADE the sector to NEUTRAL (from Overweight).

• Tariff  hike.  The  Energy,  Green  Technology  and  Water  Minister announced  an  electricity  tariff  hike  in  Peninsular  Malaysia  from  1  Jan 2014.  Meanwhile,  steel  and  cement  producers  in West  Malaysia  enjoy the discounted Special Industrial Tariff (SIT) of  10% as  electricity costs exceed  5%  of  their  total  operating  costs.  As  the  provision  of  SIT  is contradictory  to  the  energy-efficiency  policy,  the  Government  has decided  to  gradually  phase  out  and  increase  the  SIT  rate  by  18.8%, which is 2% higher than the normal increase in industrial tariffs.
• Double whammy to local steel mills.  Malaysian  steel mills  are barely surviving  judging  from  their  recent  quarterly  results.  Local  mills  are mostly  operating  electrical  arch  furnaces  (EAF)  which  consume  ~600 kWhr  of  electricity  to  produce  a  tonne  of  billets  and  120-150  kWhr  to manufacture a tonne of bars or wire rods from billets.  The new electricity tariff  will  translate  into  ~USD11  (about  MYR35)/tonne  (refer  Figure  1) extra steel-making conversion costs, thus putting further pressure  on the already paltry margin. That said, the impact on Ann Joo Resources (AJR MK,  NEUTRAL,  FV:  MYR1.04)  is  less  severe  as  its  recentlycommissioned  mini  blast  furnace  saves  the  company  ~300  kWhr  per tonne of billet production.
• Negative to West Malaysia cement boys.  While cement production is less  power-hungry,  with  around  100-130  kWhr  of  electricity  used  per tonne  of  cement,  it  accounted  for  17-20%  of  production  cost  given cement’s  relatively  lower value compared  to steel.  As such, we trim our FY14 estimates on  Lafarge Malayan Cement (LMC MK,  NEUTRAL, FV: MYR9.61) – the only West Malaysia’s cement producer in our universe –by 9.5%, assuming no changes to our cement selling price assumption.
• Sarawak  players  escape  the  hike.  While  cement  manufacturing  is  a key business of Cahya Mata Sarawak (CMS MK, BUY, FV: MYR7.55),  it escapes  the latest tariff hike as power generation and distribution in the state  of  Sarawak is  operated  by  Sarawak  Energy  Bhd  (SEB),  which  is excluded from  the  latest revision.  Meanwhile, Press Metal (PRESS MK, BUY, FV: MYR3.82),  which  consumes  680MW of power at  its aluminium smelting operation in Sarawak,  is  also not  affected. PRESS’  power tariff is based on  the  pre-agreed escalation clause at 1.5% p.a. under its 25-year power purchase agreement signed with SEB. 

 

Domino Impact From Electricity Tariff Hike
Downward earnings revision
Local steel mills are more vulnerable to earnings cut. Local steel mills have been under  tremendous  financial  pressure  in  the  last  couple  of  years,  with  no  sign  of significant  improvement.  The  18.8%  hike  in  electricity  tariff  is  no  doubt  a  double whammy on top of its existing industry challenges. Our quick back-of-the-envelope assessment  shows  that  all  steel  mills  suffer  earnings  slash  from  FY14  onwards.Although AJR is less impacted as its mini blast furnace (BF) helps  save ~300 kWhr per  tonne  of  billet  production,  it  will  still  be  affected  by  the  higher  tariff  as  the company consumes ~300 kWhr of electricity to produce a tonne of billets at its newlyupgraded plant and  120-150 kWhr to manufacture a  tonne of  bars or wire rods from billets. This prompted us to cut its FY14 earnings estimates by 22%.

Lower  earnings  for  LMC.  While  power  is  expected  to  make  up  some  17-20%  of LMC’s  production costs, the 18.8% increase in electricity tariff  shaves  only 9% of its FY14  earnings  to  MYR409m,  thanks  to  its  decent  profit  margin.  While  some  may argue that  the tariff  hike  may partially be passed  on to cement users, we think it may not be easy especially that  YTL Cement,  Cement Industries of Malaysia (CIMA)  and LMC plan to expand capacity on a  staggered basis over the next two years,  which should lead to more supply going forward.

Sarawak boys escape the hike.  Power generation and distribution in the state of Sarawak  is  operated  by  Sarawak  Energy  Bhd  (SEB),  which  is  excluded  from  the latest revision. Therefore, while cement manufacturing is a key business of CMS, the group  escapes  the latest tariff hike.  Meanwhile, Press Metal (PRESS MK, BUY, FV: MYR3.82)  which  consumes  680MW of power  at  its aluminium smelting operation in Sarawak  is  also  not  affected.  PRESS’  power  tariff  is  based  on  the  pre-agreed escalation clause at 1.5% p.a. under its 25-year power purchase agreement signed with SEB.

Downgrade basic materials sector to NEUTRAL
Largely  NEUTRAL  on  local  steel  mills.  Although  local  steel  mills  are  more vulnerable in terms  of earnings, we already  priced this in and value most of the steel companies at -1 to -1.5 SD of their respective P/BVs’ 5-year trading range. Therefore, we prefer to keep the stocks  at NEUTRAL,  with some of the counters’ FVs  tweaked slightly lower following their respective marginal earnings downgrades. The exception is Malaysia Steel Works (MSW MK, NEUTRAL, FV: MYR1.07)), which we downgrade to NEUTRAL (from Trading Buy). We initially recommended investors to take position in MSW as we believe the company is  in  the steel industry’s  sweet spot. However, we decided to downgrade the stock as  we reckon  the latest tariff revision  may deter investors from the sector, which recently saw two steel counters being designated the PN17 status.

Downgrade LMC to NEUTRAL.  While we continue to like LMC  for its  oligopolistic position  in  the  cement  market,  we  decided  to  downgrade  the  stock  to  NEUTRAL (from Buy),  as the latest tariff hike may dampen sentiment  as the counter’s valuation is already far more expensive than that of its regional peers. Our new MYR9.61 FV is derived from a 20x FY14 P/E,  or +0.5SD (from +2 SD) of its 5-year historical trading range.

Downgrade  basic  materials  sector  to  NEUTRAL.  With  most  basic  materials counters under our coverage having been downgraded to Neutral recently, along with likely  negative  investor  sentiment  on  heavy  industry  players  like  steel  and  cement following the electricity tariff hike, we downgrade our  sector rating to NEUTRAL (from Overweight).  Meanwhile,  we  continue  to  like  basic  materials  counters  involve d  in niche  products  or  are  operating  in  Sarawak.  The  latest  development  once  again substantiate  our  earlier  view  that  the  Sarawak  Corridor  of  Renewable  Energy (SCORE)  benefits from cheap energy, with  the state’s  vast  hydro energy offering  a competitive business environment to heavy industries like aluminium smelter, cement and  others.  Therefore,  we  are  keeping  our  BUY  recommendations  on  CMS (MYR7.55 FV) and PRESS (MYR3.82 FV).