The gradual pickup in construction activity is unlikely to translate to better operating margins for Ann Joo. The marginal rise in steel bar and billet are insufficient to mitigate higher raw materials price (i.e. iron ore and scrap metal). To cushion the risk, Ann Joo is looking to the export market where the demand is more stable. We revise lower our forecast by -7.9% and -2.1% in FY19 and FY20 to account for higher raw material price. Downgrade to SELL, with TP: RM1.41 based on 8x P/E and FY19 EPS. With share price up 41% YTD, we feel this is an opportune time to take money off the table.

Better demand prospects may not translate to better earnings. We anticipate the gradual pick up construction activities (low base effect, as the implementation of some large-scale projects were scaled back post GE14) will result in higher construction steel demand (in particular from 2H19 onwards). However, the anticipated pick up in construction steel demand will not translate to better operating margins (at least in the near term). The marginal rise in steel bar and wire rod prices are insufficient to mitigate considerably higher key input prices YTD, in particular, iron ore (which has risen by 28.4% YTD to USD92.9/mt) and scrap metal (which has risen by 6% YTD to US$333/mt), triggered by the Vale Dam incident. We believe it could take a while for world supply of iron ore supply to be restored as Vale, the world’s largest iron ore producer, has recently cut its iron ore supply estimate by up to 75m tonnes in 2019, accounting for 12% of the global iron ore production. This would in turn, result in mismatch between prices of steel and iron ore, hence dragging earnings of steel producers in the near term.

Ramping up exports. In an attempt cushion the manufacturing division’s weak near term demand outlook, management is looking to ramp up exports of its manufactured products (in particular, rebars) to Southeast Asia (SEA) and Middle East regions further, where demand for construction steel products remains stable.

Tax allowance to partly cushion weak near term earnings prospects. On a more positive note, we note that Ann Joo will be able to cushion the weaker earnings prospects in FY19 by utilising its RM500m tax allowance (arising from the investment in its blast furnace). Recall, the tax allowance will be utilised to offset the normalised taxation for 5 years (which started since 4Q18).

Forecast. In view of headwinds from rising raw materials price, we lower FY19 and FY20 forecast by 7.9% and 2.1% respectively.

Downgrade to SELL with lower TP of RM1.41. Following the downward revision in our earnings forecasts, we downgrade our rating on Ann Joo to SELL (from Hold) with a lower TP of RM1.41 (from RM1.53 previously) based on 8x revised FY19 fully diluted EPS of 17.6 sen. Despite the recent improvement in construction sector sentiment, we of the view that Ann Joo’s outlook will be clouded by higher raw materials price and thus, earnings delivery is poised to be on a weaker trend. With share price up 41% YTD, we reckon this presents an opportune time for investors to take money off the table, especially given the headwinds from rising raw material price.

Source: Hong Leong Investment Bank Research - 17 Apr 2019