While the 18.8% rise in the power tariff from 1 Jan onwards dealt a blow to  power-hungry  manufacturers  like  LMC,  the  19.4%  drop  in  its  share price  in  just  over  a  month  looks  overdone.  The  market  may  have overlooked  the  recent  cut in  cement rebates, which could be  sufficient to  cover the higher costs, while a revision in its list price  may  also  be just around the corner. We upgrade LMC to BUY, with a MYR9.61 FV.

• Power tariff revision  shock.  The  18.8%  hike in  electricity tariffs  from 1 Jan  this  year  was  a  jolt  for  power-hungry  manufacturers  in  Peninsular Malaysia.  As  electricity  makes  up  17%  of  LMC’s  production  cost,  its share  price  has  declined  19.4%/29.2% from  Dec 2013 when the power rates increase was announced and its June 2013 high respectively.
• Has  cement  price  gone  up?  We  made  some  surprising  discoveries when we visited  hardware  shops  during Thaipusam on Friday.  Cement manufacturers  may have acted faster than expected  by cutting  back  on rebates  offered  to suppliers, which ranged from  MYR0.50-1.00 per 50kg bag,  after the  new power tariffs  were announced  in Dec 2013.  While we are unable to verify  the  ex-gate price  of  cement  supplied by LMC,  this could  be  within  the  MYR15/tonne  increase  we  incorporated  into  our model  and  may  more  than  cover  the  hike  in  power  cost.  We  suspect CMS Cement SB’s move to raise its  selling prices  by 5-9% from 17 Feb onwards  could  also  be  a  prelude  to  rising  list  prices  in  Peninsula Malaysia.     
• Cement  market  still  benign.  We  are  also  relieved  to  learn  from  our sources  that  YTL  Cement  is  expected  to  commission  its  brownfield capacity  only  in  late-2014.  The  extra  volume  may  be  less  disruptive compared with newcomer Hume Cement’s offer of big discounts in order to  boost  its  distribution  network.  The  cement  demand  boost  from government projects may be timely in absorbing additional supply.
• Upgrade to BUY. After the selldown, LMC’s valuation has become more appealing. Despite being more expensive than most of its regional peers, its  premium  has  narrowed  and  its  dividend  yield  more  attractive.  That said,  the  share  is  now  trading  near  its  5-year  historical  P/E  and  P/BV mean.  This,  together  with  a  decent  dividend  yield  of  5.2/5.5/5.6%  for FY13/14/15  respectively,  prompts  us  to  upgrade  LMC  to  BUY  (from Neutral),  with  our  unchanged  MYR9.61  FV  based  on  a  20x  FY14  P/E (+0.5 STD/38% premium respectively to its regional peers).

Look Beyond Higher Electricity Tariffs
Power  rates  increase  gives  electric  shock.  From  1  Jan  2014,  higher  electricity tariffs took effect in Peninsula Malaysia. After the tariff increase, cement producers in Peninsula  Malaysia,  including  LMC,  still  enjoy  a  discounted  special  industrial  tariff (SIT) of 10% as electricity cost exceeds  5% of their total operating  expenses. As the provision of SIT is contradictory to the  Government’s  energy-efficiency policy,  it was decided that the discount would be phased out gradually and the SIT will be raised by 18.8%, which is 2% higher than the usual increase in industrial tariffs.

Jolt  to  LMC’s  share  price  overblown?  This  piece  of  news  is  no  doubt  an unpleasant surprise to  big power consumers like  LMC. While cement production is less power-hungry, with about 100-130 kWhr of electricity used per tonne of cement, power  makes  up  17-20%  of  production  cost  given  cement’s  relatively  lower  value compared with steel. The new tariffs raised production cost by some MYR6.00/tonne. However,  LMC share price has since plunged 19.4%  -  or 29.2% from its 12-month peak on 7 July 2013.  The question  facing investors  now  is  whether the sell  down in the past one month has been overdone.

Lower bulk rebate goes unnoticed. We had earlier argued that it may be difficult to further  pass on  the  power rates  hike to cement users, since  we originally assumed that  local cement  prices  will increase by MYR15/tonne  this year. Upon making some quick  checks  with  hardware  shops  in  the  Klang  Valley,  we  sense  that  cement manufacturers may have acted faster than we  had anticipated  to  slash the  rebates offered  to  suppliers  (ranging from  MYR0.50  to  MYR1.00  per  50kg  bag)  in  order  to mitigate  the higher  electricity and other costs. We also understand  the price of mass quality ready-mix (grade M20 and M25) cement has been raised by MYR5 per cubic meter (cu m) recently. While we are unable to verify the ex-gate price of cement in Peninsula Malaysia, we believe it will at least lie within the MYR15/tonne increase we projected earlier. This also suggests that the recent  realised  cement price increase will be more than adequate to cover the higher electricity cost.

Cement  list  price  may  go  up  soon?  Meanwhile,  the  cement  list  price  remains unchanged at MYR17.75 a bag in the Klang Valley despite the cut in bulk rebate. The hardware shops we visited are already feeling the pinch, as lower rebates only mean added  pressure  on  their  razor-thin  margins.  We  understand  doorstep-delivered cement  now  costs  up  to  MYR19  a  bag,  after  incorporating  transportation  and handling  fees.  Although  some  cement distributors  still  enjoy old rebates  from  orders that were locked in earlier,  most new orders from  January  would  only  qualify for the new,  lower  rebate.  Meanwhile,  most  distributors  have  also  heard  rumours  of  the cement list price being increased soon, although the quantum and timing of this is not yet  known.  With  CMS  Cement  SB  announcing  last  Friday  that  it  will  increase  its selling  price  in  Sarawak  by  5-9%  from  17  Feb  2014  onwards,  we  think  this  may provide Peninsula Malaysia players with a valid reason to follow suit.

More  cause  for  cheer  as  coal  price  declines.  We  find  comfort  in  the  persistent weakness in coal price, which remained below USD100 a tonne in 2013 and was last at USD82.80. Coal is a major component in cement production as a tonne of cement uses  up  to  150  to  170  kg  of  coal.  Meanwhile,  we  are  assuming  a  coal  cost  of USD85/95/95  per  tonne  for  FY13/14/15  respectively.  Our  assumption  for  FY13  is slightly higher than the 2013 average of USD84 per tonne, while our  FY14 and FY15 coal  cost  assumptions  are  higher  than  our  in-house  projection  of  USD85.60  and USD87.60 respectively. For illustration purposes, every 1% drop in coal price may lift LMC’s  earnings by about  0.9%,  but  we prefer to keep our original estimates for now as we are unable to ascertain the actual increase in current cement prices.

Government  infrastructure,  affordable  housing  to  the  rescue.  We  are  relieved that Budget 2014 did not propose the cancellation of any mega projects. Instead, the Government pledged to build more affordable homes. We are also 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. We hold the view  that  the construction of the Mass Rapid  Transit  (MRT)  Line  2  is  proceeding  as  planned,  and  developments  such  as these 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  Peninsula Malaysia  grew  2/9.2/5.8%  during  FY10/11/12  respectively,  while  cement  sales  in Sabah were 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, including in the peninsula.

Overall Market Dynamics Conducive 
Cement  industry  stands  out  in  the  basic  materials  segment.  Within  the  basic materials  sector,  we  continue  to  prefer  the  cement  industry  as  there  is  only  one producer  each  in  Sabah  and  Sarawak  while  the  market  in  Peninsula  Malaysia  is dominated  by an oligopoly.  We would describe  Malaysia’s cement market as “three markets in one country’’ as plants are operated by a  mixture of local producers and multinational  corporations.  LMC  leads  the  oligopoly  in  the  Peninsula  with  an estimated one third market share.

Peninsula  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  mostly  meet  local  needs.  The  excess capacity  in  Peninsula Malaysia has led to  LMC  exporting some  clinker  from its Langkawi plant to improve its  overall  efficiency.  When  Hume  Cement,  the  youngest  player,  started  trial operations  in  October  2012,  cement  prices  came  under  pressure  until  1H13. Meanwhile,  with  YTL  Cement,  Cement  Industries  of  Malaysia  (CIMA)  and  LMC separately  planning  to expand their capacity on a staggered  basis over the next two years, the supply of the commodity will escalate moving forward.

New capacity  nothing to worry  for now?    Applying 2012 production numbers  as the base case, kiln utilisation 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 YTL Cement and CIMA’s new brownfield. However, the emergence of a price war  is dependent on the growth of domestic demand  and  manufacturers adjusting  their  production  according  to  demand.  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. We also  find  comfort 
after  confirming  with  our  source  that  YTL  Cement’s  extra  capacity  would  only  be ready  towards  end-2014  –  just  in  time  to  absorb  rising  cement  demand.  We  also believe  the  existing  capacity  growth  may  be  less  disruptive  to  the  market  as  the cement players  will  only  be  tapping  on  their  own  established  distribution  channels, unlike new player that may need to offer attractive prices to attract new distributors.

Share Price May Bounce Back

Room  for  upward  earnings  revision?  All  said,  in  view  of  current  developments within  Malaysia’s  cement  industry,  we  certainly  see  room  to  raise  our  earnings estimates.  Lafarge  only  exports  its  excess  tonnage  to  keep  its  plant  at  optimum utilisation as well as lower its average overhead cost. As such, it is the least sensitive to changes in export prices but  this also makes it  very sensitive to any movements in the  domestic  selling  price.  As  local  cement  price  has  risen  beyond  our  original estimates  of  MYR15  a  tonne  for  2014,  every  1%  increase  in  cement  price  may translate to 4.6%  potential improvement in bottomline.  Energy is the undoubtedly the single  largest  cost  element  capable  of  swinging  LMC’s  profitability,  but  we  do  not expect any further electricity tariff increase in the near future. That said, our coal price assumption is already way higher than our in-house projection.

4Q  the  seasonally  strongest  quarter.  We  also  decided  to  take  a  look  at  LMC’s quarterly earnings trend and found, to our  surprise, that 4Q is typically its  strongest quarter. We suspect that  this may due to:  i)  more renovation works being done prior to Christmas and Lunar New Year celebrations, and  ii)  contractors trying  to finish up their  existing  jobs  in  hand  prior  to  festive  celebrations  or  the  end  of  the  year. Therefore, we suspect the company  is likely to meet our full-year estimates despite our projections being slightly more bullish than our peers. This may also help to boost sentiment toward the counter.

Valuations  more  tantalising  now.  The  sharp  price  correction  following  the announcement  of  an  electricity  tariff  revision  and  its  eventual  implementation  have pushed LMC’s valuation to more appealing level. In a comparison of the valuations of cement  companies  in  the  fast-developing  South-East  Asia  (SEA)  region,  we  find Lafarge  a  tad  rich  in  P/E  terms,  especially  compared  with  Indonesian  players. We suspect  the  lower  valuations  of  Indonesia’s  cement  counters  is  due  to  the  slower growth in that country’s cement consumption, which only grew 5.5% in 2013 versus a few  years  of  double-digit  escalation.  Apart  from  that,  the  heavy  investments  to expand their capacity  have  also limited  their ability to pay  dividends, as opposed to LMC.  The company’s  forward  valuation  is  also more expensive than Siam Cement (SCC TB, Buy, FV:  THB 550)’s, possibly due in part  to political instability in Thailand. This said, Holcim Philippine (HLCM PM, NR) is trading at a premium to LMC.

Source: RHB