INVESTMENT HIGHLIGHTS

• Geely to acquire 49.9% stake in Proton and controlling stake in Lotus

• May jumpstart turnaround given strategic advantages gained, but hinges a lot on market acceptance of new brand / models. Initial phase looks South East Asia-centric

• Vendors e.g. APM (NON-RATED), EPMB (NON_RATED) are plays into this theme given production and model expansion by Proton

• Bermaz Auto (BUY, TP: RM2.50/share) remains our top pick for company-specific catalysts and special dividends.

• UMW remains a contrarian BUY (TP: RM6.50/share) as the stock is undervalued amid a turnaround in earnings, balance sheet deleveraging and management’s renewed focus on EEVs for its auto division. 11% dividend yield is attractive.

THE TWO INTERCONDITIONAL DEALS:

The first deal. DRB to sell a 49.9% stake in Proton Holdings (net of carved out, non-automotive units) to Zhejiang Geely Holdings for: (1) RM170m cash (ii) Payment in-kind via the grant of rights to manufacture and distribute Geely’s Boyue model (a C-segment SUV and one of Geely’s best-selling models launched in Mar16) for RHD South East Asian markets (key RHD markets in ASEAN include Thailand, Indonesia, Singapore). DRB’s management is still in the midst of valuing the rights to the Boyue model.

The second deal. Proton to sell 100% stake in Lotus to: (1) Geely at a consideration of GBP51m (RM284m) for a 51% stake (2) Etika Automotive Sdn Bhd, a company ultimately owned by Syed Mokhtar at a consideration of GBP49m (RM273m) for the remaining 49% stake. Altogether, Proton will attain cash proceeds of RM557m from the sale of Lotus. The sale of Lotus is conditional upon the sale of stake in Proton to Geely.

The “Proton Holdings” referred to in the transaction will carve out existing non-core automotive related businesses i.e. property units (Proton City Development, Proton Hartanah, Proton Properties), stamping and certain component units; and will only comprise mainly Proton Shah Alam (PONSB), Proton Tanjung Malim, related sales and after sales companies of Proton as well as overseas units in Indonesia, UK, Thailand, Australia and China.

On top of this, key conditions involved in the deal are: (1) Relocation of Shah Alam facilities to Tanjung Malim within 6 years and the cost to be borne by Proton, (2) DRB to bear cost of rehabilitation of the Shah Alam land, (3) Geely to grant rights to Proton to rebadge, manufacture, sell, market and distribute identified Geely models in Malaysia for 5 years, with the intention to expand this to other South East Asian countries. DRB will retain management control over Proton but production is expected to be jointly managed with Geely.

The critical financial turnaround phase. Proton will receive cash injections totalling RM1.8b in the immediate term from: (1) An R&D grant of RM1.1b from the Government for previous R&D undertaken (Proton has been receiving R&D grants from the Government since at least the 2009 NAP), (2) The sale of Lotus will give Proton an additional RM557m cash boost to support near-term working capital or R&D.

Operationally, the initial phase of five years will see immediate product expansion as Proton will rebadge identified Geely models to be manufactured and sold in Malaysia (with plans to expand this to South East Asia. This should help Proton plug the gap in cash flows, help it to generate cash to plough into R&D of new models for next cycle beyond the 5 years for the rebadged models. Geely has a number of sedan models within the A, B, C and D segments under Emgrand, Vision and GC9 line-up – generates 12K-25K unit sales/month for Geely.

On top of this, the rights to manufacture and distribute Geely’s Boyue SUV model in RHD SEA markets should also drive meaningful volumes for Proton given its current absence in the SUV segment and should drive better cash flow generation. The Boyue is one of Geely’s best-selling models currently accounting for 22% (or circa 20K/month) of Geely’s sales in 4M17. The model was only recently launched in March 2016. A key risk is market acceptance of the Geely models which hardly had any presence in this region prior to the tie-up with Proton.

In this first phase however, plans look very much South East Asia centric and is mostly about expanding Geely’s presence here.

What could come beyond the initial 5 years? As part of the deal, DRB and Geely will agree on a 10-year Business Plan, though this has yet to be clearly spelt out in the announcements. We think this will likely involve (1) Joint development of South East Asean specific models (2) Expansion of markets for the co-developed models into Geely’s existing markets, (3) Possible manufacturing facility sharing in Geely’s existing market for Proton – China for example, imposes very high taxes on imported CBUs e.g. 75% excise duty, 30% import duty. It not feasible for Proton to expand in a big way overseas by exporting CBUs out of Malaysia given the import duty and tax structure on imported cars in overseas markets. (4) Volvo already has its assembly facilities in Shah Alam which is slated for regional production, but we do not rule out possible relocation to Proton’s facilities in the longer run.

What Geely did with Volvo? What Geely did with Volvo (which is positioned as a premium brand targeting the developed markets) could give a hint on what is to come from the partnership with Proton (which will likely be positioned as an entry level brand for emerging markets).

(1) Joint development by the Geely-Volvo partnership of a Compact Modular Architecture (CMA) platform for compact cars & joint development of an affordable luxury SUV model

(2) Creation of a joint Geely-Volvo R&D entity

(3) Creation of a separate brand called Lynk & Co to sell the co-developed models. The brand is positioned as an upper market model, versus Volvo’s premium positioning and Geely’s mass market positioning. This helps to avoid diluting Volvo’s brand premium.

(4) Development incentive processes such as platforms, engine and transmission are shared. Part sourcing is also shared with Volvo (5) Three of Geely’s nine manufacturing plants in China are shared with Volvo; the plants are owned by Geely (being the cash rich partner) but are operated by Volvo for Volvo-specific and Lynk & Co models.

Is this a fair deal for DRB? Obviously, DRB (NON_RATED) had to take haircuts relative to its initial investments in Proton (of RM3b for 100% stake) and RM1.96b investment (100% stake) in Lotus. However, performance of both companies has deteriorated significantly since 2012. Based on the current status i.e. Proton made a net loss of RM987m in FY17F and entails net asset of only RM30m while Lotus registered a net loss of RM68m and entailed RM82m of net assets in FY17; the deal looks favourable on a P/NTA basis.

PLAYING THIS THEME AT THE CURRENT PHASE

While DRB is the obvious beneficiary if the plans go through, a safer bet to play into the theme at this juncture, we think, would be via the vendors. While there is no indication on rationalisation plans for the vendors, we take comfort in the fact that most of the listed vendors are Tier-1 suppliers anyway. The expansion in product line-up i.e. Boyue which will be exported to key South East Asian markets and importantly, the Geely models to rebadged and sold in Malaysia means product and volume expansion; and tehrefore will provide opportunities for increased supplies to Proton, which is a key client (accounting for 30%-50%of revenues typically) of local vendors. Some of the key listed Tier-1 vendors include APM (NON_RATED) and EPMB (NON_RATED).

Bermaz Auto (BUY, TP: RM2.50/share) is still our top sector pick: Key share price catalysts over the next 12 months: (1) Attractive dividend yield of 9% underpinned by net cash which accounts for 12% of market cap and solid 8% FCFE yield (FY17F). The listing of BAuto Philippines will bump yields up further given potential one-off special dividends. (2) Value unlocking from the listing of BAuto Philippines (BAP). Current market cap attributes practically no value to BAuto’s stake in BAP relative to the 16x indicative IPO valuation and historical sector valuation of 12x (for Malaysian autos). Ex-cash, BAuto trades at just 9x CY17F earnings. (3) A more than doubling in associate earnings contribution to group (via 30%-owned Mazda Malaysia SB and 29%-owned Inokom) given a massive export market expansion which will triple MMSB’s prospective market. (4) Launch of the new CX5 and new CX9 which will drive a recovery in volumes and margins.

UMW remains a contrarian BUY at unchanged TP of RM6.50/share. (1) Demerger of O&G units will deleverage balance sheet, drive earnings turnaround and allow better focus on core divisions (2) Reversal of prior years’ market share loss given UMW Toyota’s renewed focus on EEV models which will drive structural cost reduction and price advantage (3) A more than quadrupling of M&E division earnings once its aerospace division reaches full scale production (4) UMW is underowned and at 12x FY18F earnings, trades below its historical average PER of 13.5x. (5) An attractive 11% dividend yield if investors were to realise the value of UMWOG shares to be redistributed to UMW’s shareholders by Jul17.

Source: MIDF Research - 25 May 2017