With most basic materials  stocks we cover  having been downgraded  to NEUTRAL recently, on top of: i)  possibly  negative  sentiment on heavy industrial  players like steel and cement  following the power  tariff hike,and  ii)  two  steel  companies  being  categorized  under  PN17,  we  are NEUTRAL  on  the  sector.  However,  we  keep  our  selective  BUYs  on Sarawak and niche players.

• Factors that may stoke demand. We are relieved that Budget 2014 did not  propose  the  cancellation  of  any  mega  projects,  and  that  the Government had instead pledged to build affordable homes. We are also heartened  by  the  number  of  projects  currently  in  progress  vs  those nearing completion or were recently handed over. These factors point to accelerating demand for basic materials like cement and steel.
• However, fundamentals remain shaky. We continue to like the cement industry,  which is a monopoly in  East Malaysia and an oligopoly in West Malaysia.  However,  the  steel  industry’s  outlook  remains  dim  as  it  is largely  influenced  by  macro  factors  in  East  Asia,  with  China  still experiencing  a large  excess as well as  fragmented capacity.  On top of this,  imports of  wire rods  are still rampant  due to loopholes in the duty structure.  
• A  jolt  from  power  tariff  revision.  The  18.8%  hike  in  electricity  tariff effective from today jolted the power-hungry steel and cement producers in  Peninsular  Malaysia  when  it  was  announced  in  Dec  2013,  as electricity cost makes up ~10%/17-20% of steel/cement production costs respectively. As local steel players are  already  struggling to  stay afloat, the  more  expensive  power  is  a  blow  even  though  it  accounts  for  only 1.8% of total production cost vs 2.9% for cement players.
• Prefer Sarawak and niche players.  Although the overall  sector outlook looks gloomy,  we like companies that are  involved in niche products or businesses in Sarawak. The power hike once again reinforces our earlier view that the Sarawak Corridor of Renewable Energy (SCORE)  benefits from cheap energy, as  the state’s vast hydro energy resources  create a competitive  business  environment  for  heavy  industries.  We  also  like niche players involved in pipe-making and supplying  basic materials  to the oil & gas Industry.

Basic Materials Demand Looks Positive
Government  infrastructure and affordable housing  projects bring relief. We are relieved  that  there  was  no  proposal  to  cancel  any  mega  projects  in  Budget  2014. Instead,  the  Government  pledged  to  build  affordable  homes.  Meanwhile,  we  are heartened  by  the  number  of  projects  currently  in  progress  vs  those  nearing completion or were recently handed over. Barisan Nasional (BN)’s pledge to continue with  the  Economic  Transformation  Programme  (ETP)  as  well  as  to  upgrade  the country’s’ infrastructure should boost market confidence. In our view, the construction of  the  Mass  Rapid  Transit  (MRT)  Line  2  is  proceeding  as  planned.  These developments will spur demand for basic materials like cement and steel.

Cement demand to grow  5%.  Cement sales in Malaysia grew  by an average 5.9% annually  in  the  last  three  years.  RHB  estimates  that  cement  usage  in  Peninsular Malaysia  grew 2/9.2/5.8%  from  FY10/11/12  while cement sales in Sabah was more volatile, dropping 6% in 2011 despite rising 9.4% in 2010 and 7.8% in 2012. By state, Sarawak recorded the strongest annual growth of over 9% from 2010 to 2012, thanks to the  SCORE initiative and robust oil & gas  activities. With the Government being committed to infrastructure spending and affordable housing projects, we expect local demand for cement to go up by 5% annually in the short to medium term.

Long  steel  demand  inches  up.  After  the  pullback  in  steel  demand  post  global financial meltdown in 2008, long steel demand in Malaysia star ted  to improve from 2010  onwards.  Long  steel  demand  rose  8/4%  in  2010/11  before  jumping  15%  in 2012, driven by  higher  usage across all product  segments  last year. Meanwhile, we believe the demand for steel bars and wire rods are set to escalate on the back of the Government’s ETP projects and proposal to build affordable houses.

Flat  steel  consumption  somewhat  “flattish”.  Flat  steel  usage  in  Malaysia experienced  negative  growth  in  2008  and  2009.  Although  usage  grew  by  double digits in 2010, it slowed  down to 9.9% in the case of  hot rolled coils  (HRC) and 9.4% for cold rolled coils (CRC) in 2011. That said, both products recorded negative growth in 2012, with local demand for HRC weakening to 5.6% while that for CRC fell 1.7%.

Fundamentals Largely Not Conducive
We prefer the  cement  industry   within the  basic materials space. We continue to prefer  the  cement  industry  within  the  basic  materials  sector,  as  there  is  only  one producer each in Sabah and Sarawak while the West Malaysia  market is dominated by an oligopoly. We characterise Malaysia’s cement market as “three markets in one country’.  Plants  are  operated  by  a  mixture  of  local  producers  and  multinational corporations. Lafarge  Malayan Cement  (LMC  MK,  NEUTRAL, FV: MYR9.61)  leads the oligopoly in Peninsular Malaysia with a 40% market share. East  Malaysia’s  cement  market  on  strong  ground.  East  Malaysia  has  two separate  markets.  The  Sarawak  and  Sabah  markets  are  monopolised  by  CMS Cement  SB  and  Cement  Industries  (Sabah)  SB  (CIS)  respectively.  Meanwhile,  the import  of  clinker  is  rampant  in  East  Malaysia.  CMS  Cement  SB  –  a  wholly-owned subsidiary  of  Cahya  Mata  Sarawak  (CMS  MK,  BUY,  FV:  MYR8.57)  -  brought  in clinker mainly  to  supply  its  Bintulu grinding plant  while CIS  relies solely on imported clinker.  Furthermore,  cement requirement  in  Sarawak  has outpaced  CMS’  grinding capacity since 2012. Despite the uneven distribution of cement plants,  particularly in East  Malaysia  as  it  is  controlled  by  only  two  players,  we  see  no  room  for  new entrants in Borneo in the near future. Riding on the robust cement usage in  the “Land of the Hornbill”,  CMS  is investing  MYR150m in a new  1m  tonnes  per annum (tpa) grinding plant to boost its cement production.

West  Malaysia  cement  capacity  on  the  rise.  All  said,  seven  out  of  nine  cement manufacturers operate in the peninsula, where cement  import is limited as domestic capacity can meet most of the local requirement.  The excess capacity  in Peninsular Malaysia  has  led  to  some  exports  of  clinker  by  LMC  from  its  Langkawi  plant,  to improve  its  overall  efficiency.  Hume  Cement,  the  youngest  player,  started  trial operation  in October 2012,  which led to  cement prices  being pressured  until  1H13. Meanwhile,  YTL  Cement,  Cement  Industries  of  Malaysia  (CIMA)  and  LMC  plan  to expand their capacity on a staggered basis over the next two years, which will result in higher supply moving forward.

New capacity may be cause for concern.  Applying 2012 production  numbers as the base case, kiln utilization in West Malaysia is estimated to drop from 87% to 80% following  the  entry  of  Hume  Cement,  and  will  fall  further  to  69%  upon  the commissioning of new brownfield facilities by YTL Cement and CIMA. We believe the last price war, which  went on for 2-3 quarters in 2005,  was sparked by YTL Cement as  its  market  share  (in  terms  of  capacity)  grew  from  a  mere  10%  to  24%  after  it acquired a 65% stake in Perak-Hanjoong Simen SB in Dec  2004.  The price war  in 1999  lasted  for  three  months  due  to  the  drop  in  cement  demand  amid  a mushrooming  of  new capacity. Thus, the emergence of a new round of price wars is dependent on the growth of domestic demand over the years and suppliers adjusting their  production  according  to  demand  changes.  Meanwhile,  the  additional  volume from  Hume  Cement’s  late-2012  debut  was  swiftly  absorbed  by  escalating  local demand, judging from LMC’s sequential profit surge in 3Q13. Dim  outlook  for  steel  industry.  As  for  steel,  the  industry’s  outlook  is  largely dependent on macro factors in East Asia. China’s economy may have shown signs of stabilising,  but  the  steel  industry  is  still  struggling  to  survive  amid  excess  and fragmented capacity across the country. In Malaysia, the outlook for  steel mills (post their  recent  results  announcements)  reflect  concerns  over  the  threat  from  steel imports.  The relatively high materials cost, ie scrap metal  and iron ore, against the sluggish steel prices  (please  see  Figure 7) have resulted in  mostly negative margins for  Malaysian steel mills. The situation is expected to extend  to at least  the short to medium term, until the overall excess capacity situation in China eases.

Two  types  of  long  steel  products.  Although  an  anti-dumping  duty  has  been imposed on imported  wire rods from same overseas producers since early 2013, we have  heard  that  the  import  of  such  products  remains  rampant  due  to  multiple loopholes in the duty structure.  On the flip side, steel bar imports have been  rather limited  as  these  are  normally  delivered  in  smaller  bundles  –  as  they  are  made according  to  specifications  by  contractors,  which  have  limited  space  to  store  this basic  material.  Thus,  steel  bar  users  prefer  local  producers  that  can  better accommodate  their  needs  and  do  not  mind  absorbing  the  10-15%  premium  over international  prices,  which  benefits  local  producers.  That  said,  the  premium   only provides  a  marginal net margin that is  insufficient  to cover losses incurred from the production of wire rods.  

Market dynamics  for flat steel may change.  Megasteel  SB  is the sole producer of hot  rolled coils  (HRC)  in  Malaysia.  However,  the  entrance  of  Southern  Steel  (SSB MK, Neutral, FV: MYR1.57) into strip (narrow-width HRC) production in 2014 will end Megasteel  SB’s  monopoly  in  this  segment.  We  also  may  see  Hiap  Teck  Venture(HTVB MK,  BUY, FV: MYR097)  investing in strip or HRC mills after its blast furnace and slab caster commence operations in 2014. Lion Corp (LCB MK, NR), which owns Megasteel SB, was recently designated as a PN17 company. The landscape of the HRC market is now dependent on the group’s success in restructuring or finding a white knight.

Secondary  flat  steel  players  stand  to  benefit.  The  entry  of  SSB  and  the restructuring  of  LCB  may  change  of  HRC  supply  landscape.  However,  cold  rolled coils (CRC) have substantial  installed capacity  although  utilisation has remained at <40%  due  to  low  production  at  Megasteel  SB’s  plant.  Malaysia  still  imports  huge amounts of CRC despite the substantial installed capacity, due to the need for highgrade CRC products from the electrical & electronics, automotive as well as oil & gas sectors,  as  well  as  other  industries.  Despite  a  20%  import  duty,  there  are  various exemptions  that  allow  buyers  to  import  flat  steel  products  without  paying  a  levy  –which gives room for some traders to capitalise on loopholes. Therefore, we prefer to monitor  the  change  in  market  dynamics  before  making  any  adjustments  to  our recommendation on CSC Steel (CSC MK, NEUTRAL, FV: MYR1.30).

Pipe demand may move up. There are essentially two main categories of pipes and tubes  –  seamed  (welded)  and  seamless.  Generally,  pipe  production  has  been affected  by  slower  domestic  demand  and  difficulties  in  getting  raw  materials  –  ie HRC, of which Megasteel SB is the sole producer.  Imports of pipes and tubes have been on the rise since 2010, owing to demand from the oil & gas sector and some dumping  from  the  South  Thailand  border.  Moving  forward,  local  demand may  only improve  substantially  in  the  event  of  a   major  water  pipes  replacement  programme carried out by the Government. The Langat II water  treatment  plant may add  c.50k tonnes to water pipes demand, from early 2015 to 2016. The successful restructuring of Megasteel SB and entrance of Southern Steel may change hot rolled coils (HRC) supply.  That  said,  we  will  need  to  keep an eye  on  developments to  determine  the eventual impact, although it will likely be positive for pipe makers. Meanwhile, we like HTVB among the local pipe makers.

A Jolt From Higher Power Tariffs
An  electric  shock.  The  electricity  tariff  hike  effective  from  today  is  an  unpleasant surprise to power-hungry steel and cement producers in Peninsular Malaysia.  Heavy industries in West Malaysia fall under the  “special industrial tariff’’ category, for which rates  will  be  raised  by  18.8%  i.e.  2%  higher  than  the  normal increase  in industrial tariffs.

Double whammy  for  local  steel  mills.  Malaysian steel  mills  are  barely  surviving,judging from their recent quarterly results. Local mill s are mostly operating electrical arch furnaces (EAF) which consume ~600 kWhr of electricity to produce a tonne of billets and 120-150 kWhr to manufacture a tonne of bars or wire rods from billets. The  new  electricity  tariff  will  translate  into  ~USD11  (about  MYR35)/tonne  (please refer to  Figure 1) extra steel-making conversion costs, thus putting more heat on the already-paltry  margins.  We  have  cut  our  estimates  by  22-63%  for  integrated  steel mills under our coverage  due to  the  new power tariff  being announced in early Dec 2013.  That  said,  the  impact  on  Ann  Joo  Resources  (AJR  MK,  NEUTRAL,  FV: MYR1.04) is less severe as its recently-commissioned mini blast furnace saves the company ~300 kWhr per tonne for billet production.

Negative  for  West Malaysian cement companies. While cement production is less power-hungry, with around 100-130 kWhr of electricity used per tonne of cement, it accounts  for  17-20%  of  production  cost  given  cement’s  relatively  lower  value compared to steel. As such, we trimmed our FY14 estimates on LMC – the only West Malaysia  cement producer in our universe  –  by 9.5%, assuming no changes to our cement selling price assumption.  Some may argue that higher costs  arising from the higher  electricity  tariffs  may  be  partially  passed  on  to  cement  users  in  Peninsular Malaysia.  Nonetheless,  we  think  this  may  not  be  as  easy  since  we  had  earlier assumed a MYR15/tonne increase in the local cement price.

Sarawak players escape the “heat”. While cement manufacturing is a key business of  CMS,  it  is  not  subject  to  the  new  tariffs  as  power  generation and  distribution in Sarawak  is  operated  by  Sarawak  Energy  (SEB),  which  is excluded  from  the latest revision.  Press Metal (PRESS MK, BUY, FV: MYR3.79), which consumes 680MW of power  at  its  aluminium  smelting  operation  in  Sarawak,  will  also  not  be  affected. PRESS’ power tariff is based on the pre-agreed escalation clause at 1.5% per annum under its 25-year power purchase agreement signed with SEB.

Prefer Sarawak And Niche Players

Sarawak  companies  set  to  SCORE.  Although  the  overall  outlook  for  the  sector looks gloomy, we continue to like players involved in niche products or businesses in Sarawak. The latest development once again substantiates  our earlier view that the Sarawak  Corridor of Renewable Energy  (SCORE)  benefits from cheap energy, with the  state’s  vast  hydro  energy  resources  helping  to  create  a  competitive  business environment  for  heavy  industries  like  aluminium  smelting,  cement  production  and others.

CMS  an  excellent  proxy  to  SCORE.  CMS  is  a  professionally  managed conglomerate based in Sarawak. The initiatives rolled  out by SCORE  should  benefit the group’s existing cement, construction materials, construction, road mai ntenance and property divisions. Its  20%-owned OM  Materials (Sarawak), or OMS  associate and the phosphate project under  Malaysian Phosphate Additives SB (MPA),  are set to  benefit  from  attractive  power  tariffs.  In  addition  to  SCORE-driven  growth,  we believe  there  is  more  upside  to  its  51%-owned  subsidiary,  Samalaju  Property Development SB (SPD). We expect the clinker business to turn around in FY13 as the plant is now back in operation.

PRESS’  earnings all ready to surge.  PRESS  is not unaffected by  the dim  outlook for  the  commodities  sector,  as  aluminium  (which  it  smelts)  is  among  the  worstperforming  metals.  Still,  we  remain  impressed  with  its  potential  143.6%  y-o-y earnings  surge  in  FY14  despite  having  trimmed  our  aluminium  price  assumptions, thanks to the competitive power tariff under SCORE and its plant’s strategic location. The company also plans to expand its value-added production to enhance earnings. We  are  also  excited  by  its  strategic  asset  swap,  Press  Metal  Bintulu  SB  (PMB)’s commissioning,  the  recommissioning  of  its  Mukah  plant  and  its  recently-inked landmark deal with Sumitomo.  The price  paid by Sumitomo  for a  20%  stake in PMB at  MYR444m  implies  a  standalone  valuation  of  MYR2.2bn,  which  is  double  the group’s latest market capitalisation.

We  also  like  other  niche  players.  We  also  like  Pantech  (PGHB  MK,  BUY,  FV: MYR1.43)’s  growth  potential,  particularly  for  its  manufacturing  division.  Meanwhile, sales  at the company’s  trading division  may pick up, driven by Petronas’ aggressive capex spending. We are  also upbeat  on HTVB on the back of a potential increase in the  demand  for  water  pipes  if  pipe  replacement  projects  kick  off,  as  mentioned previously.

Source: RHB