We applaud Press Metal’s plan to double its Samalaju plant’s capacity, which would lift total  smelting capacity to 760,000 tpa (~1.5% of global primary  aluminium  consumption).  Maintain  BUY,  with  a  higher  TP  of MYR5.75 (68.1% upside) – at a 10% discount from our fully-diluted DCF valuation.  We  also  lift  FY16F  earnings  by  27.7%  as  the  new  plant  will most probably replicate its low-cost model, which is in the first quartile of the global cost curve.   

Phase III expansion. Press Metal’s 80%-owned subsidiary, Press Metal Bintulu  SB  (PMB),  has  inked  a  term  sheet  with  Syarikat  Sesco  for  the supply  of  an  additional  500  megawatts  (MW)  of  power  to  PMB  to undertake  its  proposed  Phase  III  expansion,  which  would  double  the present aluminium smelting capacity at its plant in Samalaju, Sarawak to 640,000  tonnes  per  annum  (tpa).  Together  with  its  smelting  plant  in Mukah,  the  expansion  could  see  the  group  expanding  its  smelting capacity to 760,000 tpa, which is about 1.5% of global primary aluminium consumption.  

Replicating  proven  low-cost  model.  Press  Metal  already  runs successful aluminium smelters in Sarawak, which are in the first quartile of  the  global  production  cost curve.  Although  the  tariff for  the  additional power  supply  is  confidential,  we  understand  from  management  that  the profitability of Phases II and III of the smelter is similar, after imputing a lower  capex  and  potentially  greater  efficiency,  for  the  new  plant. Meanwhile, the first drawdown of 330MW will start in end-2015, while the remaining  170MW  will  be  drawn  down  from  early-2018  onwards.  To  be prudent,  we  imputed  the  new  capacity  into  our  financial  model,  which assumes  contributions  only  from  2016  onwards  together  with  some higher costs. Thus, our FY16 estimates rise by 27.7% to MYR555m.     

BUY,  with  a  higher  TP  of  MYR5.75. We  are  excited  over  the  news  of the  capacity  expansion,  as  it  is  timely  for  Press  Metal  to  ride  on  the bottoming  out  of  aluminium  prices  and  expand  its  presence  in  the aluminium  industry.  Its  projected  record  earnings  indicate  that  the company can fund this project using internally-generated funds together with  bank  borrowings,  while  maintaining  its  generous  dividend  payout policy of 30%-50%. Thus, we reiterate BUY with a higher TP of MYR5.75 (from MYR4.72), which we derive from a 10% discount to our latest DCF valuation, on a fully diluted basis.  Key investment risks are on page 9

Smelting Operation In Expansion Mode

Phase  III  expansion.  Press  Metal’s  80%-owned  subsidiary,  PMB,  has  inked  a memorandum  of  understanding  (MOU)  with  Syarikat  Sesco  (SSB),  a  wholly-owned subsidiary  of  Sarawak  Energy  (SEB)  for  the  supply  of  an  additional  500MW  of electricity, whch would power its proposed Phase III of its aluminium smelter located at  Samalaju  Industrial  Park,  Sarawak.  PMB  expects  to  double  its  smelting  capacity for aluminium ingots in Samalaju, Sarawak to 640,000 tonnes per annum (tpa) from 320,000  tpa  presently.  Together  with  its  other  smelter  in  Mukah,  Sarawak  –  which has  a  120,000  tpa  –  the group’s  total  smelting  capacity  would  increase  to  760,000 tonnes  upon  the  full  commissioning  of  the  new  plant.  The  new  total  capacity translates to approximately 1.5% of global primary aluminium production. 
 
Power drawdown to be done in two stages. The additional power allocation will be made in two stages – the first drawdown of 330MW will start in  end-2015, while the remaining 170MW will be drawn down from  early-2018 onwards. If Press Metal fails to take in the power on time, it would have to pay a substantial compensation to SEB as  power  contracts  are  normally  on  a  “take-or-pay” basis.  Although the group  has only one year to complete the construction of the first 200 of a total 300 pots, we are confident that it will be able to meet the tight deadline. It has a proven track record in completing  the  construction  of  Phases  I  and  II  of  our  greenfield  smelter  projects  in Mukah and Samalaju within 14 months. Furthermore, Phase III is a brownfield project and the company already started land-clearing works on the site. 
 
Project  funding  well  in  place.  The  new  plant  is  expected  to  cost  less  than  the MYR2bn  that  it  had  spent  to  build  Phase  II,  even  though  Phase  III  has  a  similar capacity.  This  is  because  Phase  III  will  be  sharing  some  common  facilities  that  are already in place. Dato’ Paul Koon, Press Metal’s group CEO, said in its press release that  he  is  comfortable  that  the  company  can  fund  the  project  using  internally-generated funds together with bank borrowings. For the time being,  Press Metal has no plan to make a cash call from shareholders to fund this project. In fact,  our cash flow test shows that the company can still maintain its dividend payout policy at 30%-50% which it adopted since early this year – barring any unforeseen circumstances. Quantifying its funding requirement which we have estimated at MYR1.6bn capex for Phase III, we expect Press Metal’s net gearing to remain manageable at 1.05x/0.68x in  FY15/FY16,  thanks  to  our  projected  higher  earnings  for  consecutive  years  in  the medium term, ie post FY14, during which we anticipate it to record milestone profits.

Replicating Proven Low-Cost Model At The Right Time

Proven  low  cost  model.  Press  Metal  is  already  operating  successful  aluminium smelters in Sarawak that are in the first quartile of  the global production cost curve. Although  the  actual  tariff  for  the  additional  power  supply  is  confidential,  we understand  from  its  management  that  the  profitability  of  Phases  II  and  III  of  the smelter  is  almost  the  same  after  accounting  for  the  lower  capex  and  potentially improved  efficiency  for  the  new  plant,  based  on  its  enlarged  estimated  volume. Meanwhile,  its  Sarawak  smelters  are  benefiting  from  competitive  25-year  power purchase agreements (PPA), state-of-the-art smelting technology and strategic plant locations  that  reduce  its  logistic  costs.  Considering  Phase  III  will  be  located  at Samalaju  Industrial  Park  (SIP)  in  Sarawak  –  which  will  eventually  be  facing  a  deep sea  port  –  the  new  plant  will  be  more  competitive  in  terms  of  production  cost compared with its Phase I smelter in Mukah, Sarawak.

Timely  to  ride  on  aluminium  supply  deficit.  Taking into account the market’s estimate of a healthy 3% growth in aluminum demand  for the world (ex-China), and the  last  tranche  of  new  smelting  capacity  that  was  ramped  up  in  2014  as  well  as production  cuts,  we  estimate  there  will  be  a  deficit  of  510,000  tonnes  of  primary aluminium  in  2014.  Meanwhile,  we  expect  the  shortage  to  stay  –  at  least  in  the medium term – as any greenfield capacity normally takes two to three years to build. More importantly, securing long-term power supply at competitive rates will likely be a major  hurdle  in  establishing  any  greenfield  smelter.  Also,  the  re-commissioning  of plants under curtailment is likely to be time-consuming, as this involves the ramp-up of plants, renegotiation of new terms in PPAs that will likely come with higher tariffs, as well as re-employment and training new staff. 
 
Aluminium prices inching up. The London Metal Exchange (LME) aluminium cash price corrected after breaching the USD2,100 a tonne level in September. However, we notice that it is now back on an uptrend – it last traded at USD2,011 a tonne (as of  18  Nov),  which  was  a  sharp  rise  from a  low  of  USD1,858.75 a  tonne in  October. While we are unable to say with certainty that aluminium prices will not drop further, we  believe  the  increasing  deficit  in  supply  is  a  good  sign  that  aluminium  prices  are bottoming  out  at the  current  level  and  stand  a  good  chance  of  surprising  on  the pside.

Record-high premiums.  Premiums – a surcharge that consumers must pay on  top of  the  LME  price  to  take  delivery  of  aluminum  –  have  hit  record  highs  and  now account  for  more  than  20%  of  the  LME  price.  Historically,  it  has  been  around  10%. However, we think higher premiums are here to stay in order to adjust the mispricing in the paper trading market (pertaining to LME). The movement of premium charges is to make up for the price difference in the derivatives market and the actual physical market  where  prices  are  determined  by  physical  demand  and  supply.  Currently, Japanese  aluminium  buyers  are  facing  record-high  premiums  of  over  USD420  per tonne for 4Q14 delivery, compared with USD404 for 3Q14, USD367.50 for 2Q14 and USD255 for 1Q14. For the time being, spot market premiums in the Midwest (for US market)  and  duty-paid  premiums  in  the  Europe  market  have  already  exceeded USD500  a  tonne  –  which  suggests  that  premiums  may  increase  in  the  coming quarter (ie 1Q15) on stronger demand and limited supplies. 
 
Higher  aluminium  prices  mean  an  increase  in  profit.  In  the  smelting  business, certain costs at smelting plants like electricity, overheads, maintenance, depreciation and  interest  costs  are  fixed  –  regardless  of  the  movement  of  aluminium  prices. However,  the  cost  of  its  key  material,  ie  alumina,  is  a  fraction  of  the  all-in  price  of aluminium, which we currently assume at 15.5%. Although the carbon anode price is not  directly  correlated  with  aluminium  price  movements,  it  moves  in  tandem  with aluminium prices to a certain degree. Therefore, as aluminium prices move up, only its key input cost will rise by an almost similar percentage, and the difference will add to  the  original  margin  spread.  However,  if  aluminium  prices  decline,  only  material costs  will  become  cheaper  while  fixed  costs  will  remain  the  same  –  which  would narrow profit margins.

Record Earnings On Escalating Volume And Aluminium Price

Sustainable medium-term volume growth. Thanks to the Phase III expansion, we are  now  projecting  a  sustainable  growth  in  Press  Metal’s  primary  aluminium production beyond 2015. As the first stage of the power drawdown is expected from Nov  2015,  we  are  now  projecting  a  40.0%  hike  in  primary  aluminium  production  at FY16 on a YoY basis. While stage two of the power take-up is expected only in 2018 – which is estimated to raise the group’s primary aluminium production by 13.4% YoY in  2018  –  we  estimate  its  FY17  production  volume  to  growth  5.7%  YoY,  partly  from the full-year production for stage one of the Phase III smelter. Meanwhile, we expect Press Metal smelters to run at 100% from 2020 unless there is a new expansion plan – as FY19 will bear witness to the last volume growth of 2.9% YoY being spilled over from the full production of stage two of the power drawdown.

Keeping  our  conservative  aluminium  price  assumptions.  Meanwhile,  the  LME aluminium  spot  price  –  and  its  premium  –  has  continued  on  an  uptrend  since  April, supporting  our  view  that  the  aluminium  market  is  bottoming  out.  Furthermore,  both LME aluminium cash contracts and physical premiums are higher than our long-term price assumptions of USD2,000/tonne and USD400/tonne respectively. That said, we prefer to keep our present price assumption but will closely monitor the situation and make necessary adjustments when a revision is warranted. 

Sensitivity to aluminium prices. Considering its power take-up is on a “take-or-pay” basis and the group’s proven operation records suggest production volume may not vary much from our estimates unless there is a new power drawdown schedule that PMB  and  SEB  will  agree  on.  That  said,  aluminium  prices  are  volatile  and unpredictable. Therefore, we decide to run a back-of-envelope test on Press Metal’s earnings  sensitivity  against  aluminium  price  movements. For simplicity’s sake, we used an all-in price, which includes spot aluminium prices quoted on the LME plus its physical premium for the test. We found that every USD100/tonne increase or drop in 
selling  prices  may  lift  or  cut  Press  Metal’s bottomline by around MYR58m  in  FY15. However,  in  FY16,  the  sensitivity  would  be  greater  at  MYR80m  for  every USD100/tonne  change  in  selling  prices  on  the  back  of  a  40%  rise  in  production volume.

Room  for  an  earnings  surprise.  We  expect  Press  Metal’s  4Q14  profit  to  come  in around  MYR90m  on  higher  aluminium  prices.  Based  on  the  all-in  aluminium  price estimate of USD2,400 in 2015, we anticipate the group’s earnings to improve further to  approximately  MYR105m  a  quarter  or  MYR417m  in  FY15.  On  the  back  of additional  volume  from  Phase  III  of  the  smelter  and  assumption  of  a  1.5%  YoY increase in the LME spot price to USD2,030 and flattish premium of USD400 a tonne, we  expect  Press  Metal  to  hit  another  record  milestone  with  a  profit  of  MYR555m  in FY16.  Although  we  already  projected  Press  Metal’s earnings  to  improve  year  after year until 2020, the current aluminium price movements suggest a high likelihood of 
an earnings upside, given our conservative assumption in our financial model.

Valuation & Recommendation

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 PPA that charges  competitive  prices,  as  well  as  its  strategic  location,  energy-efficient technology and low capex. While other costs may affect its smelting margin, the cost of  its  key  material,  alumina,  is  priced  at  a  percentage  of  aluminium  prices  on  the LME.  Hence,  its  production  costs,  to  a  certain  extent,  are  correlated  with  its  selling prices – which in turn reduce its operating risk. Furthermore, we keep a conservative aluminium price assumption with our long-term price estimate at USD2,400 a tonne, which  is  marginally  higher  than  the  10-year  average  price  despite  the  expected supply deficit that may drive the aluminium price much higher. Therefore, we believe a DCF approach would best capture Press Metal’s long-term value.

Fine-tuning parameters used in our DCF valuation. Given that our house recently introduced  an  in-house  risk-free  rate  and  equity  risk  premium,  we  decided  to  adopt those new assumptions into our DCF model. Apart from that, we also decided to be more  prudent  in  our  assumption  for  the  company  structure  from  its  balance  sheet value to projected market value. Therefore, our WACC assumption for Press Metal is revised up accordingly to 8.2% from 7.4% previously, mainly on a higher weightage calculation  to  equity.  Nonetheless,  we  also  find  our  terminal  value  at  -20%  being overly conservative, despite our assumption of a possibly higher electricity tariff post the expiry of the present PPA – which would imply lower cash generation capability. As such, we have revised it to -5% and arrived at a higher terminal value. 

Reiterate  BUY,  MYR5.75  TP.  After  accounting  for  all  the  adjustments  mentioned above  and  incorporating  the  Phase  III  expansion  into  our  financial  model,  our  DCF value  rises  to  MYR9.2bn.  Our  DCF  calculation  also  continued  to  incorporate  the potential  dilution  from  the  group’s  redeemable  convertible  secured  loan  stocks (RCSLS)  and  warrants  which  were  issued  in  late  2011  to  partially  finance  its Samalaju  plant.  Considering  that  the  realisation  of  earnings  from  Phase  III  is expected  in  FY16,  we  decided  to  apply  a  10%  discount  to the stock’s fully-diluted DCF  valuation  to  derive  a  new  TP  of  MYR5.75  (from  MYR4.72).  Therefore,  we reiterate  BUY  on  Press  Metal,  which  remains  our  Top  Pick  for  the  basic  materials sector.  
 
New TP still comparable to global 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. Meanwhile, its global peers are currently trading within 9.6-31.3x FY14 and 6.8-16.2x FY15 P/Es but our new TP of MYR5.75 implies a 24.1x/15.2x P/E on FY14F/FY15F projections.  While  it  appears  to  be  almost  at  the  higher  range  of  its  regional  peer valuation, we think investors must look at our valuation for its FY16  - a year in which most  of  its  peers  have  no  expansion  plans  in  the  pipeline  even  as  Press  Metal’s Phase III expansion would further trim its implied P/E to only 11.4x – which would be its peer average’s projected P/E for 2015.  Therefore,  our  earnings  base  valuation remains  reasonable  (while  there  is  also  room  for  its  valuation  to  expand),  as  we strongly believe our earnings estimates were largely too conservative. 

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 would ensure the profitability of its Samalaju smelting plant. Meanwhile, the current low aluminium prices have dragged many major smelters into the red and we have no assurance that prices 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 USD1,800/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 highlighted the importance of the stability of energy supply. That said, we believe that this unprecedented incident served as a lesson to Press Metal to improve its backup plant should such outages reoccur. Also, we think that SEB has learnt a lesson 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  serious  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.

Financial Exhibits

Press Metal to record a sustainable earnings growth at least for the medium term, driven by rising aluminium prices and the projected commissioning of Phase III of its smelter plant in Samalaju from Nov 2015

We see significant cash flow improvement from 2Q14 onwards, as proceeds from the disposal of a 20% stake in Press Metal Bintulu (PMB) were collected on 1 Apr. Apart from that, robust cash generation by its smelter plants would also result in its  operating cash flow improving substantially 

Financial Exhibits

Its balance sheet is set to improve substantially from FY14 as its Sarawak smelters return to full operations, while 
receiving proceeds from the disposal of a 20% stake in PMB. Therefore, Phase III of its smelter in Samalaju can be funded by a combination of internally-generated funds and bank borrowings

 Key ratios are set to keep improving from FY14 onwards

Our key assumptions are based on relatively conservative aluminium prices and premiums vs the significantly-improved fundamentals of the aluminium industry

SWOT Analysis

Company Profile

Press  Metal  is  a  Malaysian-based  aluminium  company  with  an  extensive  global  presence.  Today,  the  Group  has  a  downstream extrusion operation that is integrated with its greenfield aluminium smelting plants in Mukah and Samalaju in Sarawak, which  have an annual combined capacity of 440,000 tonnes. This, together with the newly proposed Phase III smelting plant in Samalaju, raises the Group’s combined aluminium smelting capacity to 760,000 tpa – which is approximately 1.5% of global aluminium consumption.  The company also operates aluminium extrusion plants in Selangor, Malaysia, and Guangdong and Hubei, both in China.

Recommendation Chart

Source: RHB