We reiterate our OVERWEIGHT rating on the sector with expectations that industry players will benefit from stable ASPs and more manageable costs, leading to margin normalization. Despite the weak demand visibility, metal prices should stay firm supported by ongoing supply consolidation which should in turn stabilise steel prices and reduce earnings volatility for steel product manufacturers. Locally, the demand for ferrous metals and their value-added products are well driven by the roll-out of major local infrastructure projects. We also foresee significant growth opportunities for water pipe manufacturers on the back of revival of water infrastructure projects. Positive developments include PBA (Not Rated) planning to complete three water pipeline projects worth RM189m over the next two years, alongside Sarawak’s allocation of RM1.08b for water pipe upgrades. Our sector top picks are PMETAL (OP; TP: RM5.80) and ENGTEX (OP; TP: RM0.81).

Watching for China's demand rebound to lift aluminium prices. Aluminium prices have been see-sawing in the past two months, ranging between USD2,200/MT and USD2,500/MT over the period. This is despite aluminium prices expected to stay firm on the back of surprisingly strong consumption in China during the early part of the year. Outside China, demand has been bolstered by the expansion of renewable energy projects and increased electric vehicle (EV) production. However, we remain cautious about the sustainability of demand in China as it is contingent on the recovery of infrastructure and property sectors, both of which face an uncertain outlook. On the supply side, the shutdown of fossil fuel-powered smelters, particularly coalbased facilities, driven by heightened environmental concerns, coupled with Western sanctions on Russian aluminium producers, will likely continue to constrain supply.

We project a higher average aluminium price of USD2,500/MT in CY24 vs. USD2,255/MT in CY23, while we expect SiMn prices to remain firm at above USD9,000/MT for the rest of the year on elevated ore prices. Conversely, at a YTD average of USD1,277/MT, prices of FeSi have come off 12% as compared to the average of USD1,437/MT for the whole of 2023 (buoyed by broad-based speculation on commodities during 1HCY23). We expect FeSi prices to remain soft for the rest of the year on a high stock level amid weak demand.

Chinese steel mills on the brink of output cuts. China’s steel production is equivalent to that of the entire world combined, with an annual output of approximately 1b tonnes. Although a significant portion of this production remains within the domestic market, recent trends indicate a substantial increase in steel exports. China steel exports reached 53m tonnes in 1HCY24 vs 44m tonnes in 1HCY23. The current landscape in China's steel industry presents a more acute situation than the downturns experienced in 2008 and 2015. This deterioration is primarily driven by escalating economic challenges stemming from the ongoing property debt crisis and declining manufacturing activities. Despite a recent reduction in China's benchmark lending rate, market sentiment remains uninspired. Despite loss margins for Chinese steel mills having widened seen in the 1HCY24 reporting season, these losses have not yet led to significant production cuts. A more stable steel market is anticipated to materialise only when steelmakers begin to reduce output. We foresee a consolidation phase in China’s steel industry as high inventory levels and mounting supply pressures are likely to compel mills to decrease production, thereby supporting price stability.

On the local front, the demand for steel should improve along with the roll-out of mega public infrastructure projects such as the Mutiara Line of Penang LRT, Kuching ART and MRT3. The good news is that stable steel prices translate to stable steel product prices, reducing earnings volatility of steep product producers including ENGTEX and ULICORP (OP; TP: RM2.30). Meanwhile, ENGTEX and ULICORP are likely to see margin improvements as the stronger MYR reduces their costs.

Pipe makers in a bright spot. The sentiment towards water-related stocks has improved following water tariff hikes translating to strengthened cash flows of water operators, allowing them to kick start their capex programmes including non-revenue water (NRW) reduction initiatives. We believe a pick-up in pipe replacement orders will be kicking in by 4QFY24 and accelerate into FY25 as the tendering and funding process among Pengurusan Aset Air Bhd (PAAB), water operators, and contractors typically takes at least six months to be finalised. We are confident the upcoming budget will allocate significant funds to the water sector. In addition, the demand for water pipes will be supported by the development of Sungai Rasau Water Supply Scheme Phase 2 in Selangor. Encouragingly, there have been several positive developments, including PBA (Not Rated) planning to complete three water pipeline projects valued at RM189m over the next two years, alongside Sarawak’s RM1.08b allocation for water pipe upgrades.

In the immediate term, stabilisation of product prices such as steel prices bottoming out should provide stability to the ENGTEX’s earnings. Recall, fluctuations in steel prices (CRC, HRC, etc) can significantly impact its profitability due to its large revenue base.

Our sector top picks are:

1. PMETAL given: (i) structural cost advantage over international peers given its access to low-cost hydro-power secured under four long-term PPA contracts ending between 2034 and 2040, (ii) strong secured alumina supply with stakes in two alumina miners, i.e., Japan Alumina Associate (40%) and PT Bintan (25%) which supply 40% of its requirements, and (iii) green investment appeal as a clean energy source producer.
    
2. ENGTEX given: (i) the huge potential in the water pipe replacement market locally, (ii) its dominant market position in both large-diameter mild steel (MS) pipes and ductile iron (DI) pipes, and (iii) its strong earnings visibility underpinned by significant order backlogs and a strong pipeline of new projects.

Source: Kenanga Research - 2 Oct 2024