RHB Indonesia Morning Cuppa - 28 December 2016 - (Arwana Citra Mulia, Malindo Feedmill, Cement)

Good morning,

Arwana Citra Mulia: Improvements Internally But Market Demand Still Weak

Arwana indicated that there are significant developments in 4Q16, on:

1. Improved operational efficiency;

2. Higher sales volume;

3. Better sales mix.

Its market penetration in the medium-end segment was the main driver of stronger 4Q16 sales, despite weak ceramic demand nationally. Nevertheless, with still-soft national ceramic demand, we trim our forecasts on lower sales volumes. Our lowered TP of IDR550 (from IDR635, 22% upside), implies FY17F P/E of 25x. Key downside risk is cancellation of gas tariff cut as we have factored in lower gas tariffs. BUY.

¨ Better sales volume despite soft national ceramic demand. Arwana Citra Mulia (Arwana) indicated that 4Q16 sales are likely to reach 12.7m sqm (+16% QoQ, +11% YoY). Hence, FY16F sales volume may reach 47m sqm (+19% YoY), in line with our expectations. In addition, finished goods’ inventory days declined to 22-23 days in November (from 31 days in 3Q16).

¨ Higher UNO sales. By increasing its presence in the middle-end ceramic tiles segment via its UNO products, Arwana is likely to register better sales mix in 4Q16. UNO sales contribution increased to 38% in November (3Q16: 31%), while its lowest-end product, Best Buy’s sales contribution – which provides the lowest GPM – declined to 26% in November (3Q16: 51%).

¨ Lower cost per unit. Underpinned by higher capacity utilisation, Arwana can achieve better economies of scale through higher efficiency in gas usage, and has managed to reduce production costs per unit. Arwana said that its new plant-5 located in Mojokerto, East Java, is running at maximum capacity. In addition, the company has been able to reduce its product defect rate significantly. As a result, gross profit margin (GPM) is expected to improve.

¨ Promising 2017. Arwana’s management believes that 4Q16’s expected good performance is likely to continue in 2017, driven by:

i. Higher sales volumes – estimated to reach 52-55m sqm (11-17% YoY growth);

ii. Better sales mix –UNO and regular ceramic sales’ contributions to increase to 40% each, while Best Buy’sDony>Doncontribution to decline to 20%.

¨ Reduced earnings estimates and TP. On the back of still-soft national ceramic demand, we trim our earnings forecasts, driven by lower sales volumes– FY17F-18F sales estimates lowered to 53m sqm (from 55m sqm) and 58m sqm (from 63m sqm). Consequently, our FY17F/18F earnings estimates have been cut to IDR159bn and IDR240bn (-14.8% and -14.1%) respectively.

¨ We cut our TP to IDR550. At our revised TP, the implied FY17F P/E is 25x. Key downside risk to our call is the cancellation of gas tariff cut, which has been regulated in Presidential Decree No. 40/2016. Based on our channel checks at the Industrial Ministry, lower gas tariffs for the ceramic industry is still being discussed. We have factored in a USD1/mmbtu gas tariff cut in our forecasts. (Andrey Wijaya)

Link to report: Arwana Citra Mulia : Improvements Internally But Market Demand Still Weak

Link to Daily report: Indonesia Morning Cuppa - 281216

Company Update:

Malindo Feedmill (MAIN IJ, Trading Buy, TP: IDR1,500), Banking On Lebaran

Despite a weakened IDR and DOC price capping headwinds, Malindo deserves attention at this juncture. This is due to:

1. Its attractive valuation – it is currently trading at 10-9x FY16F-17F P/E, close to -2SD from its 5 years mean of 15x;

2. 4Q16 to be another strong quarter – average broiler and DOC prices at ~15% higher than FY15’s numbers;

3. Its share price should perform next quarter due to expectations of better sales volume prior to the Lebaran season.

We lower our FY17F-18F earnings by 6% and change our call to TRADING BUY (from Buy) with a lower DCF-based IDR1,500 TP (from IDR2,100, 26% upside). This implies 11x FY17F P/E, ie -1 SD from its 5-year historical trading band.

¨ Implications of the IDR’s depreciation and day-old chicks (DOC) price capping. Assuming FY17 DOC ASP of IDR4,800/bird, this segment’s margins should be similar to FY16’s estimates (9M16: 5.3%). In addition, we assume a USD/IDR exchange rate of 13,700 for FY17. This means every 1% depreciation in the IDR against the USD from our base case results in a 1% EPS reduction only. Note that Malindo’s latest USD/IDR debt composition stands at 10:90 vs the industry norm of 50:50.

¨ DOC margins expansion capped. Assuming mild growth volumes (+5%) for its feed and DOC segments – as well as the aforementioned assumptions above – Malindo ought to deliver +10% EPS growth in FY17 vs our prior expectation of +20%. Our prior forecast expected the DOC segment’s margins to improve further from FY16’s numbers – driven by improved supply/demand dynamics, notably the DOC price hovering at IDR5,700-6,000/bird prior to the price cap announcement.

¨ The key lies in the magnitude of the feed price adjustments. Locally-produced corn, which makes up ~20% of feed’s raw materials, has seen a price increase of 20% YoY. The poultry companies, Malindo too, are managing to maintain feed segment margins by replacing corn with wheat and increasing feed prices. Going forward, the firm is looking to increase feed prices again. With relatively stable and supportive broiler prices, Malindo might be able to pass on the additional costs and recoup the DOC segment’s lower margins.

¨ Banking on good 4Q16 results and Lebaran. With DOC prices averaging at >IDR5,500 in 4Q16, Malindo is set to deliver another quarter of strong results. These are scheduled to be announced by end-Mar 2017. Furthermore, the share prices of poultry firms tend to perform during the end 1Q until 2Q historically. This is due to strong demand for chickens prior to Lebaran. This might lift Malindo’s valuations from their current, depressed levels.

¨ Key risks to our call are weakness in the IDR and margins compression if the Agriculture Ministry disagrees with the feed price adjustments. (Norman Choong, CFA)

Link to report: Banking On Lebaran

Sector Outlook:

Cement (Neutral), Competition Likely To Remain Intense……despite higher sales

We expect domestic cement sales to pick up, driven by:

i. Accelerated government infrastructure projects;

ii. Higher property sales, supported by lower mortgage rates.

Still, competition is likely to remain intense, triggered by the overcapacity situation. EBIT margins are likely to narrow, driven by higher costs following coal price increase. Hence, although valuations are attractive, we remain NEUTRAL on the sector, with Semen Indonesia (SMGR IJ, NEUTRAL,TP: IDR9,800) as our Top Pick.

¨ Better sales ahead... Cement sales are expected to rise on:

i. Ramping up of government infrastructure projects, thanks to abundant revenue from the tax amnesty programme which is likely to provide more funds for government spending;

ii. Increase in property sales on the back of lower mortgage rates and the relaxation of the loan-to-value (LTV) threshold;

iii. Rising prices of commodities such as coal and CPO – the main sources of income for people residing outside of Java – should boost consumer spending.

These factors should lead to higher cement sales in our view. We expect the sector’s cement sales volume to grow by 7% YoY in FY17F.

¨ …but competition likely to remain intense on overcapacity. Despite better sales ahead, we expect the increase in supply to be faster than the growth in demand. National production capacity was 83m tonnes pa as at end 2015. As at end 2016, there was 6.4m tonnes pa of new capacity, and we expect an additional 5m tonnes pa of new capacity in early 2017. Hence, we anticipate further declines in production utilisation rates to 70% and 69% in FY16 and FY17 respectively (from 75% in FY15).

Given the overcapacity in production, we note that Indonesia’s cement producers have continued to reduce selling prices to boost sales volumes and maintain market share. We estimate that the combined new cement players’ market share increased to 9.8% in 3Q16 (2Q16: 9.5%, 1Q16: 8.3%).

We believe new cement companies are likely to continue selling cement at huge discounts. Indocement (INTP IJ, NEUTRAL, TP: IDR15,700), the second largest Indonesian cement maker, recently launched its second-tiered brand, Rajawali, priced much lower than Tiga Roda, its first-tiered brand, in order to compete with new players. This indicates rising price competition in the industry, which would spill over to next year.

¨ Higher production costs. Indonesian cement makers are likely to face new challenges stemming from higher fuel costs starting 1Q17. In our sensitivity analysis, cement companies’ earnings are likely to decline by 6-7% for every 10% increase in coal prices. This year, cement producers are still benefitting from relatively low fuel costs, as the bulk of coal purchases – which accounted for 25-30% of 9M16 COGS – were made with 1-to 6-month contracts where prices were fixed.

¨ Neutral sector stance. Although Indonesian cement companies are trading at attractive valuations, near to -2SD of 5-year average rolling forward P/E, we expect competition in the domestic cement industry to intensify. Hence, we maintain our Neutral stance on the sector.

¨ Our Top Pick is Semen Indonesia since the company is the biggest beneficiary of the recovery in cement sales growth across the country. It has a dominant market share both within and outside Java. (Andrey Wijaya)

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