HLI’s disposal of 175m ICPS in HCement and its concrete business for 348m  NARR  shares  is  value-accretive.  Its  shareholders  will  receive  1-for-1.08 NARR shares and end up with a direct stake in a company that is transforming into a sexy cement stock with better valuations. HLI is a growing  “dragon”  spurred  by  growth  in  all  its  divisions.  The  stock’s cum-dividend FV of MYR8.57 offers a 31.8% upside.

• A  value-accretive  exercise.  Hong  Leong  Industries  (HLI)  has  kept  a very low profile until its recent proposal to dispose of 175m  irredeemable convertible preference shares (ICPS) in Hume Cement SB (HCement), and its entire concrete business, in exchange for 348m Narra Industries (NARR MK, NR) shares that will be distributed as dividend  in specie, on a basis of 1.08 NARR share for every one HLI share.
• Still  a  growing  dragon  post  exercise.  HLI’s  prospects  remain  bright despite the ongoing asset disposal, as its: i) key Yamaha business unit is booking  healthy  growth,  ii)  tiles  and  fibre  board  unit  is  turning  around, and iii) other businesses continue to grow at a healthy rate. Meanwhile, the  redemption  of  HLI’s  high-cost  medium  term  note  (MTN)  using  its lower-yield unit trust investment will give rise to saving that will contribute up to MYR10m in annual net profit is timely, as it will compensate for any loss of income from its concrete business and ICPS dividend.
• NARR a sexy cement stock in the making.  Post the entire exercise, NARR  will  transform  into  a  “sexy”  cement  stock  from  a  lacklustre furniture  stock,  as  the  exercise  will  also  involve  it  acquiring  a  stake  in HCement from HLI’s major shareholder. This will provide investors with an attractive alternative to its rather illiquid, yet pricier, peers. The stock is even more alluring now that HLI is prepared to double capacity via the Phase 2 expansion of its plant when the time is right. However, this may translate into a lower, yet decent, 30% dividend payout.
• HLI’s  cum-dividend  FV  of  MYR8.57.  Valuing  HLI  prior  to  the completion  of  the  corporate  exercise,  which  is  targeted  for  end-FY14, involves  blending  the  value  of  its  stock  with  1.08  NARR  shares. Meanwhile, our SOP-based FV for HLI, on a standalone  basis post the exercise,  is  at  MYR6.12  while  NARR’s  MYR2.27  FV  is  based  on  15x FY6/15 P/E. All in all, we derive a cum-dividend FV of MYR8.57 for HLI, which offers an upside potential of 31.8%.

Do Not Miss a Bargain

Buy one get one “free”
More value in the pipeline.  Some  investors  have been grousing about HLI's share price, which has risen by almost MYR1 since the start of the Year of Horse. This has sparked questions  on  whether the  counter’s  recent run may have fully reflected  the company’s FV. That said, we have been working hard to ensure that  the  buying  of HLI stock will not be a decision an investor will regret. In fact,  we have confirmed all the  important  facts  with  management  and  made  our  in-depth  analysis,  which  has revealed that there is still decent upside potential in the company.Buy one get one “free”. On 10 Sept 2013, HLI entered into agreements with NARR for the proposed disposal of its entire share capital in Hume Industries (Malaysia) SB (HIMSB)  and 175m ICPS in HCement to  NARR for a total consideration of  MYR48m and  MYR300m  respectively.  HIMSB  is  a  wholly-owned  subsidiary  of  HLI,  which  is involved in the concrete business. The disposal considerations will be satisfied by the issuance of 348m new NARR shares at an issue price of MYR1  per each new share. Upon  completion of the proposed disposals, HLI will implement a proposed capital distribution  to  its  shareholders  of  345m  new  NARR  shares  on  the  basis  of  1,080 NARR shares for every 1,000 ordinary shares held in HLI. Therefore, buying  a  HLI share  today  will  eventually  entitle  an  investor  to  1.08  NARR  shares  for  “free”  post completion  of  the  proposed  exercise.  The  whole  exercise  is  expected  to  be completed  by  end-FY14,  which  means  that  both  HLI  and  NARR  will  feel  the  full financial impact from the proposed exercise in FY15.

HLI will still be a growing dragon post exercise.  Despite disposing 175m ICPS in HCement  and  its  entire  concrete  business,  we  still  see  room  for  HLI  to  grow  its bottomline.  The  ICPS  only  yield  a  2%  in  dividend  annually,  or  MYR3.5m  per  year, while the  concrete business  had  contributed  net profit of MYR3.8m/7m in FY12/13. The potential settlement of its MTN, by using the redemption of its investments in unit trusts, will see net  savings of  up to MYR10m per annum,  given  that  its MTN carry coupon rate  is  up to 8.57%  annually vs  unit trust  investments  that generate  a  return of around 5% per year. Hence, the exercise is timely as it will nicely compensate any loss  in  income from the ongoing exercise. HLI ’s  key  Yamaha  business unit  will book healthy profit growth again from FY15 onwards after FY14 is  expected to see a 4.7% y-o-y drop from the weakening MYR vs the JPY. The last few years have  seen HLI’s tiles  and  fibre  cement  board  (FCB)  unit  expanding  its  plant  to  cater  to  growing demand, although it  was hit by  teething problems initially.  With all expansions  now either concluded or coming to an  end,  and with demand expected to growth healthily –  coupled with the Government imposing  anti-dumping  duties  to counter fibre board dumping  from  Thailand,  we  expect  a  significant  bottomline  improvements  for  both units. HLI’s other businesses are also expected to continue growing at a healthy rate.

A sexy cement stock in the making. NARR will transform into  a sexy cement stock from  a  lacklustre  furniture  counter  via  the  injection  of  Hong  Leong  Manufactu ring Group  SB  (HLMG)’s  entire  equity  stake in  HCement  together  with  175m  HCement ICPS  by  HLI.  NARR  will  certainly  be  an  appealing  alternative  vis-à-vis  its  peers Lafarge Malayan Cement (LMC MK, BUY, FV: MYR9.61) and Tasek Corporation (TC MK, NR), which, while being illiquid, are  pricier.  NARR is even more attractive given its  plans  to double capacity via a Phase 2 expansion that  has already received its environmental  impact assessment (EIA) approval. Additionally, the  injection of HLI’s entire concrete business into NARR is also rather synergistic.

The exercise is value accretive for NARR. That said, we opine that investors would not have found NARR as appealing until the announcement of the ongoing corporate exercise.  Aside  from  being  tiny,  the  company’s  existing  principal  activity  is  rather mundane and is in the highly-competitive furniture industry. NARR is set to carry on with a  proposed 50% capital reduction  before  consolidating  its two  MYR0.50 shares into one MYR1share. NARR’s  last close of MYR1.56 implies  high-teens P/E based on  our FY6/15 estimates.  Other than  the fact that  HCement is a greenfield project, there  is  a  possibility  that  the  Phase  2  expansion  will  hinder  its  capability  to  pay  a generous dividend vs its peers. We prefer to estimate a 30% payout ratio and ascribe only a 15x P/E to NARR. Hence, its FV stands at MYR2.27.

HLI’s  share price only reflects  its standalone valuation.  HLI's prospects  remain bright  post  injection of  HCement’s ICPS and concrete business into  NARR.  For the time  being,  we  are  projecting  for  the  company  to  make  a  FY14/15  net  profit  of MYR154/MYR171m, or 4.1/11.3% increase on  a yearly  comparison. The inching  up in earnings  will be  driven by growth in all  its  businesses. That said, we have been conservative in valuing HLI based on  a  SOP  approach,  with  the  Yamaha  business tagged  at 12x P/E,  and the  building materials and other units  ascribed  with 10x P/E. Our SOP-based FV for HLI is at MYR6.12 on a standalone basis after the company's restructuring, which  implies  11.4x P/E and 1.5x P/BV on our FY6/15 projections.  It is also worth noting that HLI is generous  with dividends, with an unwritten payout policy of around 50%. At our FV, this translates to an attractive yield of 4.4%.

Cum-FV of MYR8.57.  Considering the ongoing corporate exercise involves  dividend in specie  of 1.08 NARR share for every one HLI share, valuing  the latter  prior to the exercise’s  completion  requires  us  to  combine  the  value  of  HLI’s  and  1.08  NARR shares.  As  we  add  up  the  company’s  SOP  post  exercise  at  MYR6.12  plus  1.08 NARR  share  at  MYR2.27  each,  we  derive  a  cum-dividend  FV  of  MYR8.57,  which offers  an  upside  potential  of  31.8%.  The  present  market  value  of  NARR  also suggests  there is more upside from our FV,  as its last close suggests that HLI could be worth MYR9.49 on a cum-dividend basis at the former’s last close.

Still a Growing Dragon Post Exercise

A mini conglomerate
HLI is a diversified group. HLI has two principal business  activities: consumer and industrial products. The former is primarily involved in the manufacturing, assembly and  distribution  of  motorcycles  and  scooters,  as  well  as  their  related  parts  and products. This division is also involved in the manufacturing and sale of ceramic tiles. As  for  the  company’s  industrial  product  segment,  it  is  mainly  involved  in  the manufacturing and sale of fibre cement and concrete products. However, the ongoing corporate exercise will see HLI disposing its concrete business to NARR, which will leave  the  former’s  industrial  products  division  largely  focused  on  fibre  cement manufacturing  only.  Apart  from  this,  HLI  also  has  associate  companies  that  are involved in the manufacturing, assembly and distribution of motorcycles, motorcycle engines  and  spare  parts,  as  well  as  the  manufacturing  and  sale  of  newsprint  and 
related paper products.

Motorcycle division growing from strength to strength
Yamaha  franchisee in Malaysia.  Hong Leong Yamaha Motor (HLYM) has been the official franchise holder for completely-knocked-down (CKD) and completely-built-up (CBU)  Yamaha  motorcycles and all-terrain vehicles (ATVs) in Malaysia since 1978. HLYM has a plant in Sungai Buloh, Selangor, with an annual production capacity of 250,000 units that currently manufacture three moped, three automatic scooter and two street motorcycle models for the Japanese global giant.

Yamaha  –  a  key  player  in  premium  market  segment.  New  players  entering  the motorcycle market have pushed aggressively into the lower-end segment by offering large  discounts  and  other  incentives.  However,  total  industry  volume  (TIV)  has continued to grow, with FY13 posting a commendable 5.4% growth to 592,126 units vs  FY12’s  561,798  units.  This  was  attributed  to  Malaysia’s  sustained  economic growth  that  has  kept  demand  buoyant  and  upbeat.  HLYM  currently  holds approximately 33% of the industry’s total market share, slightly behind leader, Honda. That said, this share of the market affirms its position as a leading manufacturer and distributor of motorcycles in the country, particularly in the premium segment.Stable  sales  in  the  coming  years.  Although  Malaysia’s  motorcycle  industry  is  a relatively mature one, we expect the two-wheel segment’s TIV to grow by 3-4% y-o-y. 
A high proportion of Malaysia’s population is under the age of 30 and we believe this age  group  will  be  the  pillar  for  sustainable  strong  motorcycle  volume  sales  in  the coming  years,  especially  when  this  demographic  enters  the  workforce.  The  recent years have seen a significant number of large capacity motorcycles (popularly known as “big bikes”) on Malaysian roads and we understand that HLYM plans to introduce new  models  of  big  bikes  into  the  local  market  to  tap  into  the  growing  demand. Although  we  do  not  expect  the  company’s sales  to  shoot up  dramatically  from  the introduction of these new models, we do expect sales to be sustain able at current levels in the coming years. This will be driven by Malaysia’s and Asean’s economic growth, as well as the introduction of various new  Yamaha models for both the local and Vietnam markets.

Zooming into Vietnam.  Yamaha’s market share in Vietnam stands at 22%, or less than the 33% it enjoys in Malaysia. The difference lies in the market segment, with the  Japanese  motorcycle  manufacturer  focusing  on  the  premium  segment  in Malaysia while Yamaha Vietnam sells affordable motorcycles in the Asean nation  –this  is  why  this  unit  books  thinner  margins  vis -à-vis  its  Malaysian  operations.  We understand that Yamaha Vietnam recorded exceptionally strong sales in FY12 and, hence, it is not surprising that sales dropped in FY13. Going forward, we expect a slowdown in Vietnam’s TIV. Hence, we estimate a drop in sales for FY14 vs FY13 but a slight increase in FY15 on expected improvements in Vietnam’s economy.

High  margins  to  be  sustainable  in  the  coming  years.  Historical  trends  have shown that HLYM enjoys a high EBIT margin of 14-16% while the EBIT margin of its Yamaha  Vietnam  associate  is  only  between  3%  and  5%.  Taking  into  account  the weakening  MYR  and  the  additional  costs  incurred  in  the  manufacturing  of motorcycles in the coming  financial  year  due  to  new  safety  regulations introduced, our FY14/15 EBIT margin estimates are around 14/15%. Going forward to FY15, and based on our in-house estimates, we expect the MYR to strengthen. Hence, the EBIT margin estimate for FY15 is higher compared to FY14.

Tiles division: a solid turnaround story
A key player in local tiles industry.  Guocera Holdings SB (Guocera) is Malaysia’s key tile manufacturer with a combined production capacity of 38.3m sq m per annum. It  has  a  strong  brand  presence  locally  and  globally,  and  approximately  30%  of  its sales come from the export market. Guocera has been in the industry for more than a decade and, although most of its products are priced at a premium, we believe the company’s selling  points lie in its superior product quality,  wide product range and strong  distributional  network.  Note  that  Guocera  had  no  new  product  launches  in 2011 and 2012, and only recently introduced its latest range of digitally-printed tiles in Nov 2013 that resemble wood or stone panelling. We understand that there will be a new product launch in March 2014.

Managing  threats  from  imports  and  higher  tariffs.  Tile  manufacturers  were already  bracing  themselves  for  the  1  Jan  2014  power  tariff  hike,  but  the  18.8% quantum came as an unpleasant surprise as electricity costs constitute about 11% of the manufacturers’ total operating costs. However, the hike will not pose a huge cost constraint to Guocera, as it recently increased the price of its tiles, which has acted as a buffer to the higher electricity bill.

Healthy  sales  growth  in  the  coming  years.  FY13  saw  Guocera  returning  to  the black. As we anticipate further utilisation rate improvement at its Kluang, Johor plant, we are positive on its earnings growth prospects going forward, especially with the construction and property sectors being expected to remain healthy. Meanwhile, we expect demand to pick up in the export market, buoyed by the economic turnaround in the US and the Eurozone. However, a single -digit sales growth is justified as we also expect keener competition in the industry, exacerbated by cheap imports from other manufacturers, particularly from China.

The storm has now passed.  FY12 was a loss-making year for HLI’s tiles division. However,  Guocera  rebounded  to  profitability  in  FY13,  as  prior  operational  hurdles have been cleared. Its Kluang plant, which was previously in red due to an expansion to double  the capacity of its porcelain production line, is now back in the black. They are looking to fire the second kiln this quarter as well to meet the growing demand. Guocera’s  Meru  plant  in  Selangor,  we  understand,  has  always  operated  at  full capacity.  Our  FY14/15  EBIT  estimates  are  MYR30.7m/43.8m,  which  take  into consideration the: i) gradual improvement in efficiencies, ii) higher utilisation rate, iii) 18.8% power tariff hike from 1 Jan 2014, and iv) increase in tile ASP.

Let us not forget the fibre cement board business
Two fibre cement plants.  HLI has two manufacturing plants that produce cellulose fibre cement products  -  one in Petaling Jaya, Selangor, and the other in Ipoh, Perak. The combined annual installed capacity of the two plants is approximately 225,000 tonnes per annum (tpa) before expansion plans to boost capacity at both facilities by 30% each were put in place. We note that HLI invested approximately MYR60m to increase the capacity, which resulted in a temporary disruption to operations at  the plants. As a result, HLI’s EBIT margins from its FCB division dropped substantially in FY13 vis-à-vis the last two financial years. The expansion is deemed necessary, as existing capacities at the plants are now fully utilised. Note that HLI is also involved in the roof tile manufacturing business but this division’s contributions over the past few financial years have been less than MYR2m per year. Hence, we keep our earnings estimate at that level.

The worst is now over for FCB. There are positives to look forward to. Despite the expansion at the Petaling Jaya plant being only slated for completion by the end of FY14, we understand that works at the Kanthan facility have been completed. Going forward,  we  expect  a combined  FY14/15  net  profits  of  MYR23 .6/MYR30.6  for  both the FCB and roof tiles businesses. These will be driven by: i) better EBIT margins on improved  utilisation  post  plant  expansion,   ii)  extra  capacity  to  cater  for  increasing demand in a market buoyed by the robust growth of the construction sector, and iii) an  anti-dumping  duty  rate  imposed  on  FCB  imported  from  Thailand.  On  the  latter, note that the Government imposed a 13.96-63.1% preliminary anti-dumping duty rate on FCB imports from Thailand effective until 29 March 2014 from 30 Nov 2013

Healthy contribution from other associates
Other  associates  to  enjoy  organic  growth.  Hicom-Yamaha  Manufacturing Malaysia SB’s contribution to HLI has always been in the MYR2m-3m range. In line with the growth of sales of Yamaha motorcycles locally, we estimate a contribution of MYR2.6m/MYR2.7m  for  FY14/FY15.  While  the  newspaper  publishing  industry globally  has  been  perceived  as  a  sunset  industry,  this  is  really  not  the  case  in Malaysia. We expect Malaysian Newsprint Industries SB’s contribution to HLI to rise slightly higher than in previous financial years, or MYR8.5m/MYR8.6m for FY14/FY15 as it further improves its utilisation and operating efficiencies.

The dragon will continue to grow post exercise

Growth  in  all  divisions.  HLI’s  key  business  unit,  Yamaha,  is  set  to  book  healthy profit growth in FY15 onwards after its performance in FY14 is expected to drop 4.7% y-o-y  on  the  weakening  MYR  vs  the  JPY.  The  last  few  years  have  also  seen  the company’s  tiles  and  fibre  board  units   expanding  their  plant  capacities  to  cater  to growing  demand,  although  they  were  hit  by  initial  teething  problems.  With  all expansions now complete/coming to an end, and healthy demand growth expected  –coupled with the Government imposing anti-dumping duties on FCB  –  we expect  a significant improvement  in  both  units’  bottomlines.  HLI’s  other  businesses  are  also expected to continue to grow at a healthy rate.

Room  for  earnings  expansion.  Despite  injecting  175m  HCement’s  ICPS  and  its entire concrete business, we still see room for HLI to grow its bottomline. Meanwhile, the  ICPS  will  only  yield  2%  dividend  per  year,  or  MYR3.5m  annually,  while  the concrete business will contribute net profit of MYR3.8m/7m in FY12/13. The potential settlement of the  company’s MTN  –  using the redemption of its investments in unit trusts  –  will allow HLI to save up to MYR10m per annum, given that its MTN carry coupon  rate  is  up  to  8.57%  annually  vis-à-vis  unit  trust  investments  that  generate returns of around 5% per annum. This is timely, as it will be able to compensate any loss  of  income  from  its  ongoing  corporate  exercise.  HLI's  prospects  remain  bright despite  injecting  HCement’s  ICPS  and  concrete  business  into  NARR.  For  the  time being, we are projecting for the  company  to  make a net profit of MYR154m/171m in FY14/15 or a 4.1/11.3% increase y-o-y. The inching up in earnings is being driven by growth in all its divisions.

Source: RHB