Following the government’s review and axeing/deferral of some mega infrastructure projects, the domestic recovery in cement and steel demand would be much more gradual than originally anticipated. Hence, cement ASP should remain depressed even after factoring in modest improvement in 2H18. Steel ASP should ease gradually, given rising supply and limited incremental upside from the industry consolidation in China. Maintain MARKET WEIGHT. Top pick – Ann Joo.

WHAT’S NEW

Slower-than-expected demand recovery. With slower construction activities, we believe that the pick-up in cement and steel demand in 2H18 will be slower than our earlier expectation. Mega projects such as the East Coast Rail Way (ECRL), Kuala LumpurSingapore High Speed Rail (HSR) and Tun Razak Exhange will still continue despite facing some deferment while Mass Rapid Transit Line 3 (MRT 3) will be scrapped.

ESSENTIALS

Subdued outlook post GE-14 election. The historic GE-14 saw a sudden change in direction for construction companies and building material players were not spared. Part of the new government’s manifesto is to review mega and infrastructure projects that are not beneficial to the country. A decision has been made to postpone the Kuala Lumpur-Singapore HSR and scrap MRT 3. Apart from that, the government is reviewing other projects such as the ECRL and Pan Borneo Highway (PBH). The move by the PH government will certainly cause a major hiccup in steel and cement demand for which we had earlier anticipated would pick up by 2H18.

Local steel prices started to ease from the peak. According to the Ministry of International Trade and Industry (MITI), local steel bars prices dropped markedly by 11.1% to RM2,445/MT in Jun 18 after hitting a record high of RM2,750/MT in Jan 18. Local billet prices also declined to RM2,256/MT in Jun 18 vs the peak of RM2,399/MT in Jan 18. We think the steel bar prices will remain under pressure moving into 2H18 as demand recovery is expected to be slower than expected as the new government continues to review mega and infrastructure projects. Apart from that, rising steel supply also creates uncertainty over the direction of local steel bar prices where massive incoming new supply might outstrip weak steel demand.

Expect falling industry utilisation for steel. Collectively, the entry of Alliance Industries and Lion Industries (Johor and Banting plants) represent a 30% addition to the total industry’s active capacity. Assuming 5% growth in steel consumption this year, we forecast industry utilisation rate to fall from 88% in 2017 to 75% in 2018 - based on the base-case scenario where Alliance comes on stream with 1.5m tonnes in capacity and Lion Industries ramps up the utilisation rate at its Johor plant (currently 20% utilisation rate). In the worstcase scenario, industry utilisation rate may fall further to 68% if Lion Industries reactivates its Banting plant which has 500,000 tonnes of steel making capacity. However, should Lion Industries opt to delay commissioning, industry utilisation rate will still be at a healthy rate of 81% in 2018.

Limited upside from structural changes in China. We are of the view that China’s steel prices are capped, given the five-year plan for steel capacity cuts coming to its tail end. In 2016, the Chinese government set a target to cut 100m-150m tonnes of steel production capacity. As at 2017, Chinese officials had already slashed 115m tonnes of steel production capacity and are targeting another 30m tonnes in 2018. Assuming the capacity cut of 30m tonnes is achieved in 2018, the Chinese government would be left with capacity cuts of only 5m tonnes in 2019, and would have achieved the five-year target way ahead of time.

Replacement of defunct mills starting 2018. We also gathered that the Ministry of Industry and Information Technology (MIIT) in China approved new electric arc furnaces (EAF) with capacity of 48.4m tonnes in 2017 to replace capacity that had been shut. The new approved capacity, which is set to come on stream between 2018 and 2023, is said to be more environmentally friendly as it uses electricity rather than coal. Most of the plants for new approved capacity are located in southern China, where induction furnaces (IF) were previously most prevalent.

Cement demand fell for two consecutive years. Cement demand is still sluggish, having fallen by 6-7% yoy in 2017. This is the second consecutive year where demand has fallen. To recap, cement demand also declined by a similar quantum (6-7% yoy) in 2016. With the subdued outlook, we think cement demand will continue to fall in 2018, marking negative growth for three consecutive years.

Gross margins will likely contract in 2Q18 and beyond. Gross margin may contract to RM674/tonne in 2Q18 from RM711/tonne in 1Q18 based on available ytd spot data. Prices of steel bars and billets are down by 6.8% and 5.7% qoq in 2Q18 to RM2,523/tonne and RM2,225/tonne respectively. In addition, Ann Joo also guided that 2Q18 would be seasonally weak due to the Ramadhan and Hari Raya holidays. Separately, we also think that earnings for cement companies would remain under pressure given no immediate recovery in the cement demand.

Further delay in cement recovery. We opine the recovery in the cement segment will take more time, given uncertainties surrounding mega and infrastructure projects. Initially, industry players were expecting a significant recovery in cement demand this year on the back of the commencement of mega projects, resulting in a significant pick-up in the industry’s utilisation rate from 65-70% in 2017 (a multi-year low) to about 74% in 2018. However, with the deferment of various mega and infrastructure projects, we think industry utilisation may only improve from 2019 onwards. The delays in the construction of mega and infrastructure projects may also have a spillover impact on the property market which is expected to take a longer time to recover.

ACTION

Reiterate MARKET WEIGHT on the sector as we think demand for steel and cement will remain subdued in 2H18. Unlike cement, the steel segment is expected to be hit by rising supply from Alliance Steel and Lion Industries Corporation. Furthermore, we think upside from the consolidation of the steel industry in China is limited with the planned capacity cuts coming to a tail-end coupled with the replacement of defunct mills taking place between 2018 and 2023.

Maintain BUY for Ann Joo Resources (AJR MK/Target: RM3.05) following a 52% ytd drop in share price. Our target price is based on 7.0x 2019F PE. Our conservative assumption of a 45% dividend payout ratio represents an attractive dividend yield of 11% for 2018. Our trough valuation for Ann Joo is RM1.90 based on historical mean PE of 5x.

Maintain HOLD on Hume Industries (HUME MK/Target: RM1.50). Our target price of RM1.50 is based on 19x 2018F PE, derived from the five-year average PE of Lafarge Malaysia and Tasek Corporation. Entry price: RM1.00. Our trough valuation for Hume Industries is RM0.95 based on -1SD of 1.0x 2019F BV.

Source: UOB Kay Hian Research - 6 Jul 2018