LME aluminium prices broke the  USD2,000/tonne  mark  last week. While prices  have  consolidated,  the  present  level  and  record  premiums  are set to  benefit Press Metal’s smelters. We  prudently   revise  upwards our all-in  FY14/FY15  aluminium  price  estimates  to  USD2,200/USD2,400respectively  despite  the  belief  that  there  is  more  upside  coming. Reiterate  BUY,  with  a  higher  MYR7.38  FV  (from  MYR5.47),  a  20% discount to its fully-diluted DCF.

Aluminium prices  looking up.  Global aluminium producers have done well to curtail output. Coupled with the absence of new smelting capacity outside  China  (beyond  the  few  being  ramped-up  now)  and  moderate demand growth,  the  market  is  generally expecting  its  first supply deficitin  a  decade  from  2014.  This  favourable  development  has  lifted  the sector’s  fundamentals  and  seen  the  London  Metal  Exchange  (LME)’saluminium cash price breaking the USD2,000/tonne psychological barrierlast week. Additionally, the regional premium payable for metal deliveries to Japan for July-September also rose to a record USD400-408/tonne, ie 8-12% over the preceding quarter.

All geared for brighter days ahead. Press Metal is set to enjoy the fruit of years of aggressive investments  in  its  world-class low  cost aluminium smelters  in Samalaju and Mukah.  The improved  industry  dynamics are timely, as both of its smelters have been fully operational since April. The higher aluminium prices  should also mean extra dollars for every tonne of  metal  produced.  Although  we  believe  the  supply  deficit  may  offer further upside to all-in aluminium prices from the present level, we prefer to  be  prudent  and  revise  up  our  FY14/FY15  assumptions  by USD100/USD200/tonne to USD2,200/USD2,400/tonne respectively.

Reiterate BUY, with MYR7.38 FV (from MYR5.47). Press Metal’s track record prompted us to raise our value-added production estimate for the Samalaju smelter to up to 40% of total production by FY18. That, on top of  our  assumption  of  higher  aluminium  prices,  led  us  to  raise  our estimates  by  22.4%/35.5%  for  FY14/FY15. We  also  ascribe  a  nominal terminal value on it at MYR425m vs nil previously. Our fully-diluted DCFbased  FV  rises  to  MYR7.38  (20%  discount  to  our  DCF),  implying undemanding  15.0x/10.5x  P/Es  and  2.1x/1.8x  P/BVs  on  its FY14F/FY15F respectively. We believe its  verbal commitment of a 30%-50% dividend payout ratio may support a further re-rating. BUY.

Supply Deficit Leading To Aluminium Price Escalation
The  new  era  of  aluminium  supply  deficit.  We  continue  to  witness  improving fundamentals  in  the  global  aluminium industry  (ex-China). This is  due to: i) capacity being curtailed over the past few years  (see  Figure 1), ii) moderate  demand growth driven  mainly  by  higher  aluminium  usage  in  the  automotive  industry,  and  iii)  the absence of new smelting capacity outside of China beyond the few that are currently being ramped-up  (see Figure 2). This may translate into a supply deficit in the global market  (ex-China)  from  2014  onwards  –  a  development  that  is  favourable  foraluminium  prices.  Meanwhile,  we  estimate  a  deficit  of  510,000  tonnes  of  primary aluminium in 2014 in the global market (ex-China) (see Figure 3). Note, however, that aluminium producer  Alcoa (AA US, NR) recently raised its 2014 deficit projection to 930,000 tonnes from 730,000 tonnes.

China still an isolated aluminium market.  China is the world’s leading aluminium market,  accounting  for  over  48%  of  global  aluminium  consumption  currently. Nonetheless, the country  is not immune to the price and margin pressures  that are
affecting  producers  everywhere.  Smelters  with  older  capacity  in  East  China  have been closed due to high power costs while in the country's  north-western provinces (particularly Xinjiang), a new generation of greenfield smelters  –  using trapped coal reserves  as  a  cheap  source  of  power  –  are  driving  up  national  production.  High logistics costs are the main barrier to exporting  aluminium  to  East  China from WestChina.  Furthermore,  the  country  has  imposed  a  15%  export  duty  on  aluminium ingots. This is because the  exporting  of lower value-added commodities also means the export of China’s  scarce energy resources. We expect no changes to this  policy in  the  foreseeable  future.  Therefore,  we  believe  China  may  remain  an  aluminium market  that  is  removed  from the  rest  of the  world, at  least  in  the  short  to  medium term.

Aluminium price upcycle  just beginning?  With the improved market dynamics  for the aluminium industry, the LME’s aluminium cash price is now back on the uptrend –it  last  traded  at  USD1,965.50/tonne  on  29  July,  a  sharp  rise  from  3  Feb’s  low  of USD1,634/tonne.  Last  Monday  (21  July),  the  LME  aluminium  cash  price  broke  the USD2,000 mark  for the  first time in 16 months, before consolidating just below  thislevel.  Additionally, the premium paid over  the  LME cash price hit a record high. This is because  Japanese aluminium buyers are mostly paying  record high premiums of USD400-408/tonne  for  July-September  shipments,  ie  up  8-12%  from  the  previous quarter.

Higher Aluminium Price Equals Rise In Earnings
The  relationship  between  aluminium  prices  and  profits.  Many  investors  are curious  as  to  how  escalating aluminium  prices  may  translate  into higher  profits  for Press  Metal.  In  the  smelting  business,  certain  costs  at  a  smelting  plant  –  eg
electricity,  overhead,  maintenance,  depreciation  and  interest  costs  –  are  fixed, regardless of the price movement of  aluminium. However, the cost of its key material –  alumina  –  is a fraction of the all-in aluminium price, which we currently assume at 15.5%.  Although  carbon  anode  prices  are  not  directly  correlated  with  the  price movement  of  aluminium,  the  former  moves  in  tandem  with  the  latter  to  a  certain degree. Therefore, as aluminium prices  move up, only its key input cost will rise by an almost similar percentage. The difference will add to the original margin spread. However, if aluminium prices  were to  decline, only material costs become cheaper. Fixed costs remain the same. Thus, the profit margin is narrowed.

Sensitivity to aluminium price.  We believe the volume growth is very much within management’s control and may not diverge  much from our assumptions. However, the  price  of  aluminium  remains  volatile  and  no  one  can  correctly  predict  its movement. Therefore, we decided  to run a back-of-envelope test on Press Metal’s earnings senstivity against the aluminium price movement. For simplicity’s sake, we used  an all-in price  for the test, which includes  the  spot aluminium price quoted on
the LME plus its physical premium. We found  that every USD100/tonne increase in the  selling price may lift Press Metal’s bottomline by around MYR48m. However, we also  believe that the actual impact of lower aluminium price may be slightly greater, as both alumina and carbon anode prices may not drop in similar proportionsMore  evidence  of aluminium prices  bottoming out.  Aluminium prices  plunged in 2009 due  to the  impact  of  the  US  sub-prime  crisis, but  rebounded to stable levels soon  after  that.  However,  prices  slipped  again  in  2011  and  have  been  on  a downtrend  since  then.  While  we  are  unable  to  say  with  certainty  that  aluminium prices  will  not  drop  further,  we  believe  the  supply  deficit  in  the  market  is  a  good indication that aluminium prices  are  –  at least  –  bottoming out at the  current level. Note that  while technological advances and economies of scale tend to bring down extraction  and  processing costs  over  time,  the  need  to exploit lower-grade poorer quality deposits and rising input costs – such as energy or chemical products – tendsto drive up  the cost of  production. In the long run, we believe the beneficial effects of technological advances will outweigh the adverse effects of higher production costs, thus  allowing  the  real  price  to  decline.  Nonetheless,  this  favourable  trend  cannot continue indefinitely,  as rising costs of bauxite and, above all, energy, will eventually offset  the  decline  in  the  cost of  production.  Other  drivers such as  exchange  rates, greenhouse gas regulations and the shape of the industry cost curve must also be taken into account.
Prudent  in  aluminium  price  estimates.  The  LME  aluminium  spot  price  –  and  its premium –  has continued  to  escalate  since April, supporting  our view that aluminium market  is  bottoming  out.  Last  week,  the  LME  cash  price  broke  its  psychological USD2,000 level, which lifted its all-in aluminium price to above USD2,400/tonne. This was way higher than our  assumption of  USD2,150  for 2Q14-4Q14, or  USD2,100 for 2014.  Hence,  this  prompted  us  to  revisit  our  aluminium  price  estimates.  We  also reckon  that  the  10-year  average  all-in  aluminium  price  is  USD2,325/tonne,  with  its peak recorded  just  prior  to  the global financial crisis in 2008  at USD3,400/tonne  and revisited  at  USD2,900/tonne in 2011. This  happened  despite  the  aluminium  industrystruggling to absorb the overall excess supply and capacity at that time. Although we believe  the  aluminium market  is  just  at  the  beginning stage  of  a  supply  deficit,  we prefer to keep our new  price  assumptions  conservative. Meanwhile,  our revision is focused  on  the  physical  premium,  which  keeps  breaking  new  records.  We  have decided  to  revise  upwards  our  2014/2015  premium  assumptions  by USD100/USD200,  which  lifts  our  all-in  aluminium  price  estimates  to USD2,200/USD2,400/tonne  (from  USD2,100/USD2,200)  respectively.  We  then assume USD2,000 as the long-term LME cash price, which is expected to  grow by a marginal  1.5%  thereafter.  Our  long-term  physical  premium  is  now  set  at USD400/tonne.

Value-added  to boost margins.  As a smelter is normally required to run at  optimalutilisation upon commissioning, this leaves little room for any volume growth. Thus, the only way to raise revenue is by moving the products up the value chain. Following
the  recommissioning  of  Press  Metal  Sarawak  SB’s  (PMS)  plant  in  Mukah, management  decided  to  focus  on  billet  production  there.  While  Press  Metal  also successfully implemented the A356 ingot line at PMS, it has decided to focus only on
billet  production.  Therefore,  management  installed  another  A356  ingot  line  atSamalaju, with production kicking off in late 2013. Going forward, Press Metal Bintulu SB (PMB)  will focus on A356 ingots  on top of the standard  “P1020”  ingot.  Note that
A356 comprises a blend of aluminium and 8% silicone,  and  is used in alloy wheels manufacturing. Meanwhile, we project  for Press Metal  to produce up to 15%/20% of its  production  capacity  at  the  Samalaju  A356  line  in  FY14/ FY15  respectively.
However, with its proven track record in A356, we decided to assume production for A356 to continue  to  grow to 30%/35%/40% for FY16/FY17/FY18 respectively. Both billets  and  A356  ingots  enjoy  a  premium  of  around  USD150-200/tonne  to  the
standard P1020 ingot and cost no more than USD70-80/tonne to produce. Thus, the company is set to improve its overall profitability.

Earnings  set  to  surge  in  coming  quarters.  As  we  raise  our  aluminium  price assumptions, we accordingly make changes  to our earnings estimates in the coming quarters.  For  the  time  being,  we  expect  all-in  aluminium  prices  to  average  at USD2,300/tonne  (3Q14)  and  USD2,365/tonne  (4Q14),  and  middling  around USD2,400/tonne  in  2015.  Based  on  those  assumptions,  we  expect  Press  Metal  to record a core profit MYR80m (3Q14) and MY90m (4Q14),  with quarterly profits  to normalise around MYR94m in FY15 to make up  a full-year profit of MYR375m. We are  excited  on  the  projected  earnings,  as  the  coming  2Q14  profit  (announcement scheduled for mid-August) is expected to almost double q-o-q and triple y-o-y.

Valuation And Recommendation
Lack  of  direct  peers.  As  Press  Metal  owns  the  country’s  first  smelter  (thus becoming the first aluminium smelter counter under our coverage), we conducted  a cursory global peer comparison based on consensus estimates. Most of its peers are
fully  integrated and some are also involved in other commodities. We find that  Press Metal’s global  peers  are  currently  trading  between  14.1-35.7x  FY14  and  8.7-21.4x FY15 P/Es  (see  Figure 11), which are at significant premiums to  its  earnings-based valuations.  Our  earnings  estimates  show  that  the  company  is  currently  trading  at undemanding  P/Es  of  10.5x  FY14  and  7.5x  FY15.  We  also  decided  to  run  a simulation  based  on  various  aluminium  prices  (FY15  earnings)  to  derive  Press Metal’s FVs on different P/Es (see Figure 12).

Conservative DCF assumptions. The bulk of Press Metal’s earnings will be derived from its aluminium smelting business, which benefits greatly from a 25 -year  power purchase agreement  (PPA)  that charges competitive prices, as well as its strategic location, energy-efficient technology and low capex. While other costs may affect its smelting margins, the cost of its key material  – alumina – is priced at a percentage of aluminium  prices  on  the  LME.  Hence,  Press  Metal’s  production  costs,  to  a  certain extent, are correlated with its selling  price. This,  in turn,  reduces  its operating risks. Furthermore, we keep a conservative aluminium price estimate, as mentioned above. Therefore, we deem DCF to be the best proximate to derive Press Metal’s long-term value.

Reiterate BUY, FV revised up to MYR7.38 (from MYR5.47). Other than revising our aluminium price assumptions and value-added production, which  resulted  in  higher earnings projections, we also decided to ascribe  a  nominal terminal value to Press Metal’s  DCF.  In  the past,  we  had  assumed  a  zero  value. Our  fully-diluted terminal value of MYR425m is based on  a  conservative terminal growth rate of  -20%. All-in, we derive  a fully-diluted DCF of  MYR6.7bn. After applying  a  similar 20% discount, our  FV  results  in  a  value of  MYR7.38/share. We  believe  that  our  new  FV  remains undemanding,  as  it  implies  15.0x/10.5x P/Es  and 2.1x/1.8x P/BVs  on  its  FY14/FY15 numbers,  thus reiterating  our BUY recommendation. We also note that management has recently committed verbally to a dividend payout policy of 30-50%. This is barring any  new  investment  potential,  which  may  support  a  further  re-rating  on  the company’s share price.

Key Investment Risks
Volatility  in  aluminium  prices  and  demand.  Press  Metal’s  operations  are undeniably  vulnerable  to  fluctuations  in  prices  and  volume  in  both  domestic  and export  markets.  In  particular,  its  primary  aluminium  business  is  sensitive  to
commodity  price risks. Meanwhile, we are not overly concerned over the demand for its primary aluminium products, as the commodity is widely tradable. The company enjoys cost advantages in terms of competitive power as well as other cost items like lower  overheads,  which  will  ensure  profitability  at  its  Samalaju  smelting  plant. Meanwhile, the current low aluminium price has dragged many major smelters into the red and we have no assurance that price s  will not drop further. We conducted  a stress  test  for  Press  Metal,  vis-à-vis  the  aluminium  price,  to  gauge  the  breakeven points of its smelting operation in Sarawak. The breakeven points at the PAT level are around USD1,700/tonne for PMS and USD1,765/tonne for PMB.

Reliable  power  supply.  Smelting  plants  are  greatly  dependent  on  reliable  power supply. The latest damage to Press Metal’s  Mukah smelter from a power outage has highlighted  the  importance  of  such  stability.  That  said,  we  believe  that  this unprecedented incident has served as a lesson to Press Metal to improve its backup plant should such outages  reoccur again. Also, we think  that  Sarawak Energy has learnt  from  this  past  error  and  will  ensure  an  uninterrupted  minimum  level  of electricity supply to  Press Metal’s  Sarawak plants. This will allow the latter to  keep the aluminium  at its plants  in a molten state in the event of a ser ious power failure. Although insurance compensation from the last incident  is  still pending, we believe that  sufficient insurance coverage may help to minimise losses. While the probability of  such  an  event  recurring  is  fairly  remote  now,  any  temporary  curtailment  of electricity supply to  Press Metal’s operations may severely impact its earnings and cash flow generation.

Source: RHB