We are upgrading our sector call on Building Materials to OVERWEIGHT due to: (i) potential trade action on excessive Chinese steel imports, (ii) steel sector valuations currently at trough level, (iii) near-term robust construction demand, and (iv) positive earnings outlook in the near-term. While the potential trade remedy on excessive Chinese steel import issue may only occur in 4Q14 or 1Q15, we reckon that investors should position ahead of 3Q14 in view of very attractive valuations currently. Lastly, building materials stocks under our coverage performed within expectations in 1Q14. Our preferred pick for the sector is ANNJOO (OP; TP: RM1.31) due to its compelling upside potential and production efficiency. Maintain OP on MASTEEL (TP: RM1.14) and MP on LAFMSIA (TP: RM9.50).

1Q14 results review. Steel players performed within consensus expectations. ANNJOO’s results came in at RM26.4m or 64% of consensus FY14 estimates which we deem as within expectations because the strong performance was due to a one-off major inventory clearance. MASTEEL’s results were also within expectations at RM5.7m or 23% of FY14 estimates. Cement players’ results were in line as LAFMSIA’s 1Q14 earnings was RM74.9m or 19% of FY14 estimates. Note that in the past three years, 1Q CNP made up 15% to 18% of LAFMSIA’s full-year CNP due to seasonally lower construction activity in the quarter.

Catalyst emerging while valuations at a trough level. As reported in The Star dated 28 May 2014, domestic steel producers are jointly seeking a trade remedy from MITI to alleviate the excessive imports of alloyed Chinese steel products. We expect potential preliminary trade actions to be implemented by late-2014 to early-2015. Domestic steel players should benefit directly from better pricing of steel bar and wire rod prices after seeing a steady decline over the last 2-3 years. Despite the positive news, the current market valuation on ANNJOO is close to –1.3x SD on its 5-year historical PBV while MASTEEL’s valuation is about -0.8x SD on its 5-year historical PBV. While the market is still largely pessimistic on the steel sector which explains very low valuations on steel stocks, we take a contrarian view that it is now a good time to invest in steel sector at near bottom valuations while anticipating catalyst to materialize by late-2014 or early-2015.

Robust construction demand driving volume growth. Despite a traditionally slower quarter, the construction sector reported strong 1Q14 GDP growth (+18.9% YoY), improving on both 4Q13 (+9.8% YoY) and 1Q13 (+14.2% YoY) construction growth. The key contributors were residential developments in Klang Valley and Johor, and major infrastructure projects under the ETP umbrella. Our in-house economic forecast for construction sector GDP growth is +11.5% in CY14 (vs. +10.9% in CY13) supported by healthy orderbook replenishment and the ongoing pipeline of major projects such as the MRT2, Rapid Pengerang and West Coast Expressway projects. We view this as positive for the building materials sector since both steel and cement industries are direct beneficiaries of construction growth. Note that building materials cost makes up approximately 30% of construction cost.

Positive earnings outlook; sector to benefit from lower input and production costs. We expect the steel industry to benefit from lower international scrap prices averaging USD364 per metric ton (MT) in 1H14 or 16% lower than 1H13 levels. Note that other major inputs such as coal, coking coal, and iron ore prices are also on a declining trend due to slower-thanexpected economy growth in China. In terms of production costs, despite the 19% electricity tariff hike seen in January, we believe that steel players under our coverage have largely absorbed the increases. ANNJOO has had the strongest performance because of better efficiency from its blast furnace production method, which is less reliant on electricity and natural gas. The results can be seen in its 4.0% operating margin, which is among the highest in the sector (sector average margin at 2.4%). As for MASTEEL, we think the impact of recent electricity tariff hike should be slightly higher against ANNJOO at about 1-2% overall cost increase. However, its strategic location in the Klang Valley reduces transportation cost and hence the Company margin has also expanded to 3.0% although it remains lower than ANNJOO.

Upgrade Building Materials sector to OVERWEIGHT with ANNJOO as our preferred pick. The favorable operating environment and compelling steel players’ valuations prompts us to upgrade our call on the Building Materials sector to OVERWEIGHT. In the near-term, good underlying construction demand will support volume sales, while margins are likely to be better in view of lower raw material and production costs. To remain conservative, we have yet to impute the effects of potential trade actions on steel stocks, but should the move materialize, we may consider increasing our TPs to account for the positive price effect on steel bar and wire rod prices. Our preferred pick for the sector is ANNJOO (OP; TP: RM1.31) due to its attractive upside potential. As the only blast furnace operator in the region, ANNJOO is able to benefit from both higher productivity and declining raw material prices to keep its industry-leading margins intact. Maintain OP on MASTEEL (TP: RM1.14) and MP on LAFMSIA (TP: RM9.50).

Source: Kenanga