Below expectations. Perwaja's 1HFY12 net profit of RM18.5m came in short of our and consensus estimates, representing only 37.9% and 42% of the full year's projections respectively. 2Q's bottom-line shrank by 86% q-o-q despite iron ore pellets still priced at a smaller premium of USD35 per tonne (compared the high of USD70 per tonne in 2010 and 2011) to iron ore fine prices. We suspect the 1Q numbers were abnormally strong due to it benefiting from cheaper-than-market material costs. This was due to its aggressive inventory impairment in 4QFY11. Newly-delivered raw material costs in 2Q have risen compared to the previous quarter. The EBITDA margin narrowed to only 6.6% in 2Q vs 13.3% in 1Q, despite a 53.2% q-o-q rise in sales amid better demand for Direct Reduced Iron (DRI).

A prompt uplift from new income, perhaps. Meanwhile, we are cautious of Perwaja's near-term outlook on the back of falling steel and material prices, which may push the company into the red. Nonetheless, we are hopeful that its iron ore mining income may materialise no later than 4Q, as projected by the management in their results announcement. This is on top of our confirmation of the opening of its initial mine operation just last month. While iron ore spot prices have dropped below USD100 a tonne since last week, this is just a knee-jerk disposal by a handful of panicked sellers after China reported a depressed set of economic data. The ore price is likely to rebound as Chinese mills may prefer to import at this price level, which comes way cheaper than the cash production costs of their own mines in Mainland China. Meanwhile, the new income stream from mining may take a few months to reach its optimum level, while the low-cost open pit mining method may still help to partly offset the lower earnings from its existing iron and steel making business. It is prudent to expect only 100k tonnes of iron ore to be sold in FY12, followed by a gradual improvement in volume (refer to Figure 1).

Greater assurance. Mining operations aside, Perwaja has also kicked off the construction of its iron ore concentration and pelletisation plant, which will likely be ready by the end of 3Q2013. While we are disappointed with the delay of its commissioning, the first shipment of its concentration machines have already arrived at the Kemaman plant and the other parcel is en route to Malaysia. We also understand that its financier for the new plant just issued the company a Letter of Credit (LC), which means that construction works can begin immediately after the commissioning of its concentration plant by end-2012. That said, the in-house iron ore mining activities will be timely in supplying ore for processing in its new plant. To be prudent, we also projected some anticipated technical hiccups during the start-up stages of the new plant.

A conservative margin assumption. With more defined development now, we have incorporated the value enhancement from Perwaja's concentration plant where iron ore fine can be sold at better margins of USD25 a tonne in FY13 compared to FY12; further margin increases of USD3 a tonne p.a. can be expected until it reaches USD35 a tonne. The margin for pellet processing is also conservative, at USD10 a tonne and may slowly increase to USD25 a tonne in FY16 given that shipment cost savings may already be inching to USD20 a tonne. Based on the revised assumption, we arrived at a new DCF for the combined iron ore mine and ore-processing plant of RM1.75 a share.

Maintain TRADING BUY. Although we are cautious on the steel industry's outlook against a backdrop of weaker economic conditions, we recognize that there will be a timely boost to Perwaja's earnings coming from cheaper in-house iron ore that will be further enhanced by its in-house processing. We have made some major revisions in our earnings model following the recent developments, with the key assumption stated in Figure 1. Post-adjustment, our FY12 earnings are slashed by 78.5% to RM10.5m and FY13 profit is slightly lower at RM128.5m from RM135.5m previously, as we factor in lower selling prices for billets together with the higher cost of pellets for the existing iron- and steel-making businesses. We also lower our book base valuation based on 0.5x FY12 BV or -1 standard deviation of its historical trading range but are adding a 30% of the DCF value of its iron ore and new ore processing plant in the light of the company's further developments. As the result, our FV is tweaked slightly to RM1.12 from RM1.13, as we keep our TRADING BUY rating on the stock.

Source: OSK