With the anticipation of hitting record high earnings of RM4.6bn (+10% YoY) in FY18, but FY19 earnings may not be exciting given our concerns on a weaker oil prices outlook leading to potential O&D pricing weakness. We reckon that the re-rating catalysts would rest on stronger oil prices outlook and favourable transfer pricing guidance on PIC’s feedstock. Thus, we initiate coverage on PCHEM with a HOLD rating at a TP of RM9.74 (+6% upside), based on 10x EV/EBITDA, an 11% premium to its regional peers.

PIC to lead volume growth. PCHEM is the leading integrated chemicals producer in Malaysia and one of the largest in Southeast Asia with total production of 12.7m mtpa. We expect the PIC project to increase its existing capacity by another 1.78m mtpa (net to PCHEM) or 14% by 2H19 with more diversified naphtha based products such as PP and INA.

Net beneficiary of stronger oil price and USD. PCHEM’s uniqueness is its integrated cheap gas feedstock model from Petronas, cushioning the negative impact from narrowing polyethylene spread while still benefiting from stronger oil prices. Our sensitivity analysis suggests that USD1/bbl increase in crude prices would lift net profit by 0.5%-0.8% in FY18-20. Meanwhile, PCHEM is also a beneficiary of stronger greenback, with every 1% appreciation of USD against RM leading to 1.5% increase to PCHEM’s net earnings.

Potential special dividend? During Budget 2019, it was announced that Petronas will pay RM54bn dividend including RM30bn special dividend next year to the Govenment. While we reckon bulk of the increase in dividend will come from Petronas’ upstream segment, PCHEM also stands the highest chance to increase its dividend among all the Petronas’ listed subsidiaries given its (i) the lowest average 3- year payout of 52%; (ii) strongest balance sheet (net cash position of RM9.4bn as of 3Q18); and (iii) completing its major capex cycle by FY19. At payout ratio of 52%, PCHEM is likely to deliver decent dividend yield of 3.3%/3.2%/3.6% in FY18/19/20 with every 10% increase in payout suggesting 0.6% uptick in dividend yield.

Rising FCF pave way for new growth. With PIC’s capex cycle completing in FY19, we estimate total FCF to grow 136%-31% to RM3.9bn-RM5.0bn, strengthening its net cash position to RM7.4bn-RM9.9bn (RM0.93-RM1.23/share) in FY19-20. As such, assuming 70:30 debt equity ratio, PCEHM is in a position to take on up to USD10bn capex projects, which is 3.7x larger than PIC’s committed capex. The completion of PIC, in our view, will provide a good platform for PCHEM to further diversify into derivatives and specialty chemicals.

Forecast. We forecast FY18 core earnings to hit record high at RM4.6bn (+10% YoY) after factoring weaker 4Q18 due to weaker petrochemical prices. PCHEM’s bottom line is projected to drop marginally by 1% in FY19 but to grow by 10% in FY20 assuming (i) average crude prices of USD68/bbl and USD71/bbl; (ii) forex rate of RM4.20/USD; and (iii) overall plant utilisation of 86%-91%.

Initiate with a HOLD, TP: RM9.74. We are initiating coverage on PCHEM with a HOLD rating at a TP of RM9.74 (+6% upside), based on 10x FY19 EV/EBITDA. This represents 11% premium to its regional peers and we believe such premium is justified based on its superior profitability as evident by excellent EBITDA margins of 34%-38% in FY18-20 (vs industry average of 21%) and robust balance sheet. Despite so, we have HOLD rating given our concerns on a weaker oil prices outlook in FY19 leading to potential O&D pricing weakness. We reckon that the re-rating catalysts would rest on stronger oil prices outlook and favourable transfer pricing guidance on PIC’s feedstock.

Source: Hong Leong Investment Bank Research - 14 Dec 2018