Post 3QFY18 briefing, we expect earnings to be sustainable in the coming quarters. Management brushed away concerns of trade war (US and China) impact into its business in China, given 95% of the sales (Caterpillar equipment and BMW car) has already been localized and not impacted by import limitation or tariff. Industrial equipment sales will remain strong, driven by strong orders from Australia, but the margin is relatively low for equipment delivery as opposed to spare parts, service and maintenance. The commencement of BMW engine plant will improve BMW localisation rate and make BMW more cost competitive in Malaysia. However, we still maintain SELL recommendation with unchanged TP: RM2.15 due to its steep valuation.

Trade war a non-issue. Management does not expect trade war to happen between US and China. Even there is trade war, management guided more than 95% of its sales of Caterpillar equipment and BMW cars in China has already been localized and hence not subject to import limitation or tariffs, which may affect Sime Darby’s sales in China.

Accounting adjustment. Management explained the charge out of RM43m for industrial segment in 3QFY18 was due to accounting software glitch since implemented in 1QFY18, which has been resolved in current quarter. The glitch resulted under recognition of costs in 1QFY18 to 3QFY18, which was all expensed out in 3QFY18. Hence, there is no change to 9MFY18 core earnings and margins for Industrial segment.

Strong demand for Industrial. Demand for industrial equipment in Australia coal mining remained strong with order books jumped almost 3-fold to RM1.4bn (by end 3QFY18). Despite the higher expected sales, management indicated lower effective margin going forward, given the higher sales mix from equipment delivery (lower margin) and lower sales mix from spare parts, service and maintenance revenue (higher margin).

New BMW engine plant. Sime Darby has already commenced the production of BMW engine plant on 3 May in Kulim with a total capacity of 10,000 engines p.a. (on current single line production). The plant is producing 12 engines/day.in the initial stage and subsequently ramping up to 40 engines/day. With the localized engine, BMW production in Malaysia will be able to achieve 30% localization rate (CKD threshold) and thereby enjoying lower cost of production and management is exploring other potential parts to be localized. Management indicated no plan for export purpose. However, management is able to add another production line to double up the capacity. The start-up loss is up to RM4m in FY18, before turning profitable in FY19.

Forecast. Unchanged.

Maintain SELL, TP: RM2.15. Maintain SELL recommendation with unchanged SOP derived TP: RM2.15. We believe Sime Darby’s share price has run ahead of its fundamental value. Valuation is relatively steep at this juncture with unattractive dividend yield.

Source: Hong Leong Investment Bank Research - 30 May 2018