HLBank Research Highlights

Wood Manufacturing - Demand Is There But So Are Headwinds

HLInvest
Publish date: Wed, 14 Jul 2021, 09:50 AM
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This blog publishes research reports from Hong Leong Investment Bank

We expect the furniture and panel board makers’ earnings to recover in 2H21 on the back of (i) transition to Phase 2 which allows their factories to reopen, (ii) pent up demand from FMCO and (iii) strong furniture sales especially to the US market. Nonetheless, the key challenges that these companies are facing include (i) elevated raw material cost and freight rates and (ii) persistent foreign labour shortage. We maintain our NEUTRAL stance on the sector as key challenges remain for the sector despite stronger sales. Our top picks for the sector are Homeritz (BUY, TP: RM0.71) and Evergreen (BUY, TP: RM0.67).

Furniture export for 4MCY21. The wooden furniture export value post-MCO1.0 has rebounded from its trough to a level higher than pre-MCO1.0 (0). The higher export value was contributed mainly by (i) increase in export to US due to its diversion of orders from China to the SEA region as a result of the trade war; and (ii) rise in demand for home office furniture due to the new WFH norm. From Figure #2, wooden furniture export value for 4MCY21 was RM2.58bn (YoY: +69.6%). The higher export value YoY was due to (i) low base effect (MCO1.0 was implemented SPLY); and (ii) higher export to the US market. US continues to be the largest export market for wooden furniture consisting 62.2% of the total export value for the period (compared to 58% SPLY).

How does this translate to our coverage companies top and bottom line? Referring to Figure #3, the revenue and core earnings for all 4 companies under our coverage rebounded strongly in 3Q20 from its low in 2Q20 due to (i) pent-up demand post MCO1.0; and (ii) stronger sales especially to the US market. In the following 2 quarters, revenue remained on an uptrend and at a level higher than pre-MCO1.0 level for Homeritz and Evergreen, while for Lii Hen and Hevea, revenue fell in 1Q21 as there were Covid outbreaks in their factories resulting in loss of production capacity. The core earnings came down in 1Q21 for Lii Hen, Hevea and Homeritz mainly due to (i) the rising raw material cost for all 3 companies and (ii) weaker operating leverage for Lii Hen and Hevea due to the loss in production capacity. Evergreen, on the other hand saw an improvement in its earnings in 1Q21 as better margins were achieved from higher ASP (which more than offset the rise in raw material costs).

Global shipping containers shortage. Since July 2021, the effects of Covid-19 has left global shipping lines with backlogs and delay due to labour shortages, reduced capacity in logistic systems, congestion at ports as well as quarantined cargo. The shortage of containers has resulted in unprecedented exorbitant freight rates globally. From what we gathered, freight rates have increased by at least 3x for the companies under our coverage. According to the Malaysian National Shippers’ Council, the shipping containers shortage is expected to persist until the end-2021. Although most of the furniture export prices under our coverage are quoted on FOB basis (i.e. shipping charges are borne by customers). Nonetheless, part of the shipping cost is implicit in the prices quoted to customers as part of the cost will be absorbed by the suppliers when they quote. Unlike medical supplies and gloves which are considered as essential goods during the pandemic, furniture are discretionary goods, thus, suppliers will have a lower pricing power and are unable to fully pass on the rising cost to the customers.

Raw material price increase. Since 4Q21, almost all key raw material costs have risen significantly. Log cost increased due to the prolonged wet season, while glue cost increased due to the rising Brent crude oil price (Figure #44). Other imported raw materials such as leather and foam similarly increased due to (i) the rising freight rates; and (ii) panic buying from customers to stock up on supplies in view of the shipping containers shortages.

Persistent labour shortage. Despite having strong sales (order book of between 2-9 months), the furniture and board makers are having difficulty scaling up production due to persistent foreign labour shortage as a result of closed borders from Covid-19.

Covid-19 production disruptions and FMCO. Out of the 4 companies we cover, 3 of them (Lii Hen, Hevea, Homeritz) had production disruptions in their factories due to Covid-19 outbreak during 1H21. The implementation of FMCO and NRP Phase 1 has also resulted in more than 28 days of loss in annual production capacity. Lii Hen, Hevea and Homeritz will feel the full brunt of the Phase 1’s impact as 100% of their operations are in Malaysia but to a lesser extent for Evergreen (~60% of its top line contribution from Malaysia). Looking ahead, the transition to Phase 2 (expected by end-July), should see operations resume as furniture related manufacturing would be placed in the “positive list” (which is allowed to operate at 80% of capacity).

2H21 outlook. Although 2Q21 will undoubtedly be a weaker quarter sequentially due to FMCO, we expect earnings of furniture and panel boards makers to recover in 2H21 on the back of (i) transition to Phase 2 which allows their factories to reopen, (ii) pent up demand from FMCO and (iii) strong furniture sales especially to the US market. If the current USD strength persists in to the 2H21, this will also benefit the companies as they are export oriented (Lii Hen: >90% export, Homeritz: >90% export, Heveaboard: >85% export, Evergreen: ~60% export). Nonetheless, the key challenges that these companies are facing include (i) elevated raw material cost and freight rates and (ii) persistent foreign labour shortage.

Forecast. We take this opportunity to update the forecasts for Lii Hen and Homeritz to account for the loss of production capacity from FMCO. Our core earnings forecasts for FY21 falls by -25.9% for Lii Hen and -16.5% for Homeritz. In addition, we also lower Lii Hen’s earnings for FY22 by -5.3% to account for higher raw material cost assumption. Note that we have already updated the forecasts for Hevea and Evergreen in their respective company reports dated 14 June 2021.

NEUTRAL. We maintain our NEUTRAL stance on the sector. Although the furniture industry is enjoying a surge in demand with furniture export sales higher than preCovid level, unfortunately, the furniture and panel board makers are unable to enjoy the full benefit from this as they continue to face headwinds as elaborated earlier (FMCO, elevated raw material cost, freight rates and labour shortage).

Lii Hen (BUY, TP: RM3.52). In addition to the earnings cut, we also roll over our valuation base year to mid-FY22 at 10x PE. All in, our TP remains unchanged at RM3.52. We upgrade our rating to BUY (from Hold earlier) as valuation has become more palatable following its share price weakness (-24.6% YTD).

Hevea (HOLD, TP: RM0.51). We tweak our P/B multiple on Hevea from 0.8x to 0.7x (roughly -0.8SD below 5-year mean), as we are taking a more cautious stance on its earnings prospects (given its weaker pricing power and operating leverage relative to its peers). Consequently, our TP lowers to RM0.51 (from RM0.58 previously) based on FY22 BVPS. Maintain HOLD call.

Our top picks for the sector are Homeritz (BUY, TP: RM0.71) and Evergreen (BUY, TP: RM0.67). We like Homeritz for its position as an ODM manufacturer which gives it a competitive advantage over its peers in terms of product pricing. In addition, Homeritz’s new factory which has partially started operating will provide further upside to its earnings in the future. Furthermore it is currently trading at undemanding valuation with FY22 PE of 8,9x (or 5.2x ex-cash PE). We also like Evergreen as we anticipate its earnings to recover in 2H21 on the back of (i) its healthy order book; and (ii) the strength in ASP supported by the strong demand from the local furniture makers as well as from the US market. In addition, compared to its peers, Evergreen operations were relatively less impacted by the FMCO as its operations in Thailand and Indonesia are still ongoing during this period.

Source: Hong Leong Investment Bank Research - 14 Jul 2021

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