Our  conference  call  with  Press  Metal’s  group  CEO  Dato’  Paul  Koon gave reassurance that it was  business as usual and  the  outlook of  the aluminium market remains upbeat.  We continue to like the company, as it is a world-class low-cost smelter in the first quartile of a global cost curve. As Press Metal is well-positioned to ride on improving aluminum fundamentals, we reiterate our BUY call and MYR8.30 FV (42% upside).

Straight from management. As Press Metal’s share price plunged froman  all-time  high  of  MYR7.46  to  its  low  of  MYR5.32  over  the  last  threetrading  days,  we  hosted  a  conference  call  for  institutional  investors  to speak  directly  with  group  CEO  Dato’  Paul  Koon  on  the  latest developments in the company and aluminium industry last Friday. 

Still well  on track.  Dato’ Paul  confirmed that he  was  not aware of any bad news concerning Press Metal’s operations or the aluminium industry as  a  whole.  While  he  said  that  aluminum  prices  on  the  London  Metal Exchange  (LME)  may  have  dipped  after  the  spot  price  surpassedUSD2,100  in August, he  deemed  the  recent  correction  as  healthy.  The premium paid over the LME cash price hit a record high, as the  4Q14 premium  for  the  Japanese  market  was  recently  set  at  USD420  vs USD255/USD365/USD404  a  tonne  in  1Q/2Q/3Q  respectively.Meanwhile, his bullish expectation of the aluminium market,  on the back of:  i) capacity cuts over the past few years, ii) moderate demand growth, and iii) the absence of new smelting capacity outside China beyond the few  facilities  that  are  currently  being  ramped  up,  is  in  line  with  ourinvestment thesis.      

Reiterate BUY, with a MYR8.30 FV. We continue to like Press Metal, as it is  a  world-class  low-cost  smelter  in  the  first  quartile  of  a  global  cost curve,  thanks  to  its  competitive  25-year  power  purchase  agreement (PPA), state-of-the-art smelting technology and strategic plant locations.The improved market dynamics are timely as its  smelters have returned to  optimum  production levels.  As  we  believe  the  recent  selldown  in its share price was not on a fundamental basis, we recommend investors to BUY on weakness. Our MYR8.30 FV is derived from a 10% discount to our  fully-diluted  DCF,  implying  undemanding  2.4x/2.1x  P/BVs  and 17.0x/11.9x P/Es on FY14F/15F estimates respectively.  

Key Takeaways From Conference Call
Business  as  usual.  At  the  start  of  the  conference  call,  Press  Metal’s  group  CEO Dato’ Paul Koon said that he was stunned over its share price falling in the past three trading  days  –  as  there  have  been  no  changes  to  its  business  fundamentals.  He confirmed  that  operations  at  all  its  units  are  running  normally.  Among  others,  its Samalaju  and  Mukah  smelters  –  with a total  combined  capacity of  440,000  tonnes per  annum  (tpa)  –  have  been  at  their  optimum  utilization  leve ls  since  April  2014. 

Apart from that, its three extrusion plants in Malaysia and China with a total combined capacity of 160,000 tpa are also running as usual.Aluminium  price  retracement  at  LME  is  healthy.  Dato’  Paul  admitted  thataluminum  prices  on  the  London  Metal  Exchange  (LME)  have  declined  after  the aluminium  spot price broke  above  the USD2,100 level in August  –  it last traded at USD1,913.50 a tonne. However, he deemed the correction as healthy since  this may help to form a  stronger  base for higher aluminium prices  in  the  future. In fact, he just returned from the  29th International Aluminium Conference  in  Abu Dhabi, from whichhe sensed that the general sentiment of aluminium players was bullish.

Physical  market  remains  tight,  thereby  elevating  the  premium.  Separately,  he said  the  4Q14 premium for  Main  Japanese  Port (MJP, the  benchmark premium forthe  Asia  Ex-China  market)  was  concluded  recently  at  USD420  a  tonne  vs USD255/USD365/USD404  in  1Q/2Q/3Q14  respectively.  The  escalating  premiumsuggests that  the  physical aluminium market remains tight.  He also pointed out that the  Midwest  Premium,  which  was  recently  recorded  at  USD500  a  tonne  following robust  demand  for  aluminium  in  USA,  was  driven  mainly  by  the  usage  of automotives.  Dato’  Paul  believes  this  may  be  a  leading  indicator that  premiums  in other markets may rise in the months to come.

Aluminium market  fundamentals may improve.  In addition, Dato’ Paul also seesroom  for  the  all-in  price  of  aluminium  to  surprise  on  the  upside  amid  improving fundamentals,  due  to:  i)  capacity  cuts  over  the  past  few  years,  ii)  decent  demand growth, particularly in the W est, and iii) the underinvestment in new smelting capacity outside China beyond the few  facilities  that are currently being ramped up. This may translate  into a supply deficit in the global  aluminium  market from 2014 onwards  –which would be favourable to aluminium prices.

Expansion  depends  on  availability  of  power.  Dato’  Paul  explained  that  the  first criterion  for  investing  in  aluminium  smelting  is  the  availability  of  a  huge  volume  of power at competitive rates that are  not easily available at the moment. Sarawak  is unique, as it has vast potential for hydro power and the source is fairly near  the port. Considering  that  the  company  has  only  used  up  one-third  of  its  landbank  in Samalaju, Press Metal will  continue to explore opportunities  to expand its smelting capacity  –  although  all  this  is  subject  to  the  availability  of  power  from  Sarawak Energy.

30%-50%  payout  commitment  intact.  When  asked  about  Press  Metal’s  dividend policy,  Dato’  Paul  explained  that  its  aluminium  smelting  business  operates  on  the terms of  a cash settlement on delivery  of orders, which  has helped to boost its cash generating ability  following the full commissioning of its Sarawak smelters. Together with proceeds from the disposal of a 20% stake in Samalaju smelter which were used to pare down short-term borrowings –  which reduced its net gearing to  a comfortable 1.08x as at 30 June 2014 –  he said that management remains  committed to keeping its dividend payout policy at 30%-50%.

Still Bullish On The Aluminium Market 
We are relieved to learn from Dato’ Paul that all the company’s units are operating as usual. Meanwhile, we concur with his positive reading on  the  aluminium market  for the short to medium term. Therefore, we would like to recap a portion of our previous investment case that supports  our bullish view  on the aluminium market and Press Metal.

The new era of aluminium supply deficit. Our top-down research again witnessed 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 to a supply deficit in the global market (ex-China) from 2014 onwards  –  a development that is favourable for aluminium  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) projected a 2014 deficit at 930,000 tonnes.

China is 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 West China.  Furthermore,  the  country  has  imposed  a  15%  export  duty  on  aluminium ingots. This  is because the exporting of lower value-added commodities also implies 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.

Ex-China aluminium usage making a comeback?  According to data compiled by Bloomberg, world ex-China aluminium consumption rose 1% y-o-y to 25.2m tonnes in 2013. After years of moderate growth, we expect the  world ex-China’s demand for primary  aluminium  to  gather  momentum,  supported  by  positive  signs  of  returning confidence across all key sectors and markets. Aided by strong growth  in  Asia exChina and other developing economies, as well as  the US  economic recovery  and a continued  market  rebound  in  Europe,  we  conservatively  expect  global  aluminium consumption outside China to grow 3% in 2014.

Aluminium price upcycle just  the  beginning?  We also happy to learn that Dato’ Paul remains upbeat on the movement of aluminium prices  moving forward, which is well in line with our estimates. Meanwhile, we are not overly concerned on the short term  price  volatility  as  the  LME  market  involves  huge  speculative  elements,  with paper trading (derivatives) at 36x the world’s physical demand for the metal, or 68x non-Chinese  physical  demand.  Therefore,  we  think  the  LME  price  may  not  truly reflect the actual demand-supply dynamics in the market. We see room for the all-in price of aluminium  to surprise on the upside  with the emergence of a first aluminium supply deficit in 2014.

Prudent in aluminium price estimates. We reckon that the 10-year average all-in aluminium  price  is  USD2,338/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 industry struggling 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  price  assumptions conservative. Meanwhile,  we projected  all-in aluminium price estimates  of  USD2,200and  USD2,400  per  tonne  for 2014/2015  respectively. We then assumed  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 set at USD400/tonne.

Press Metal a Prime Beneficiary Of a Bullish Aluminium Market

World-class  low-cost  aluminium  smelter.  Press  Metal  is  a  leading  Malaysianaluminium  company  currently  operating  two  aluminium  smelting  plants  with  a  total combined  capacity  of  440,000  tonnes  per  annum  (tpa).  Samalaju  and  Mukah smelters  are world-class low-cost smelters in the first quartile of a global cost  curve,thanks  to  a  competitive  25-year  power  purchase  agreement  (PPA),  state-of-the-art smelting technology and strategic plant locations.  As both smelters reached  optimum utilisation  levels  in  April  and  we  estimate  their  combined  primary  aluminium production  to  rise  to  405,200  tonnes  in  FY14  and  435,600  tonnes  in  FY15,  vs 290,772  tonnes  in  2013,  the  company  is  well-positioned  to  ride  on  improving aluminum fundamentals.

Higher  aluminium price elevates  profits. In the smelting business, certain costs at a smelting plant  –  eg electricity, overheads, maintenance, depreciation and interest costs – are fixed, regardless of the movement of aluminium prices. 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 movement of aluminium prices, 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 would  add to the original margin spread.  However,  if  aluminium prices  were  to  decline,  only  material  costs  become cheaper. Fixed costs remain the same. As such, the profit margin would narrow.

Leverage on aluminium price. Below, we decided to run a back-of-envelope test on Press  Metal’s  earnings  sensitivity  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 prices  may be slightly greater, as both alumina and carbon anode prices may not drop in similar proportions.

Earnings  set  to  surge  in  coming  quarters.  Press  Metal’s  2Q14  core  net  profit doubled  q-o-q  and  tripled  y-o-y  to  MYR60m,  as  we  had  anticipated.  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 MYR90m (4Q14), with quarterly profits to normalise around MYR94m in  FY15 to make up a full-year profit of MYR375m.

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.  That said, we find that  Press  Metal’s  global  peers  are  current ly  trading  at  11.3-33.0x  FY14  and  8.7-17.9x 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  11.7x  FY14  and  8.4x  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  could  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 with our FV at  MYR8.30.  Press Metal is well-positioned to ride on improving aluminium fundamentals. We continue to like the company, as it is a worldclass  low-cost  smelter  in  the  first  quartile  of  a  global  cost  curve.  We  believe  the stock’s  recent selldown was  at no fundamental basis. Thus, we advise  investors to BUY on share price weakness.  Our MYR8.30 FV is derived from a 10% discount to our fully-diluted DCF, implying undemanding 2.4x/2.1x P/BVs and 17.0x/11.9x P/Es on FY14F/15F estimates respectively. We also note that management has  verbally committed  to  a  dividend  payout  policy  of  30%-50%,  barring  any  new  investment potential which may support a further re-rating on the company’s share price.

Key Investment Risks

Volatility in aluminium price and demand. Press Metal’s operations are undeniably vulnerable  to  fluctuations in  prices  and  volume  of  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 item like lower overhead s, 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 the price 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  profit-after-tax  (PAT)  level  are around USD1,700/tonne for Press Metal Sarawak SB (PMS) and USD1,765/tonne for 
Press Metal Bintulu SB (PMB).

Reliable  power  supply.  Smelting  plants  are  greatly  dependent  on  reliable  power supply. The latest damage to its Mukah smelter from a power outage has highlighted the  importance  of  a  stable  power  supply.  That  said,  we  believe  that  the unprecedented incident has served as a lesson to Press Metal to improve its  backupplant should such an outage reoccur. Also, we think Sarawak Energy has learnt from this past error and would  ensure an uninterrupted minimum level of electricity supply to its Sarawak plants to keep the aluminium in a molten state in the event of a  serious power  failure.  Although  the  insurance  compensation  from  the  last  incident  is  still pending,  we  believe  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  the  group’s  operations  may  severely  impact  its earnings and cash flow generation.

Source: RHB