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Sector Watch- Malaysian Cement

In feb 2006, I read an research report on the Malaysian cement industry. Bought into 1 of the Malaysian cement company and sold subsequently with some profit when it rose on some M&A news. However, I am still bullish in the Malaysian cement sector as I see the ability and the need of the regional economies in infrastructural spendings.

Just spoken with an friend in the construction industry in Malaysia, he sees stability in cement price in Malaysia. And when ask the risk is in the downside or the upside, he see upside risk in cement price.

Separately, I also read the following: "No new capacity has been built in the last five years. And UOB-Kay Hian's Yee does not expect new capacity in the next five years, citing difficulty in getting government approval, financing and rising replacement cost as strong disincentives."

It is my opinion that with the government-imposed ceiling selling price of 198/MT, it will take a lot of foresight and courage to invest in new capacity.

Summarised below the key points of the February report on Malaysian cement industry:

1. We believe the cement sector is bottoming out as sector dynamics continue to improve. The end of the price war in Jun 05 has resulted in the sector returning to profitability after two quarters of severe losses.

2. Oligopolistic market. Since the 1997 financial crisis, the number of big cement players has reduced from seven to four who now control 97% of the market. The current cartel has successfully doubled cement prices in the past six months and organised plant shutdowns to maintain better demand-supply balance. Cement prices rebounded 80% after price war ended. The price war, which has characterised the sector for the past five years, climaxed when cement average selling prices dropped by 37% from RM158/tonne to RM100/tonne in 1H05. This resulted in the sector suffering its first loss in five years. Cement prices have since rebounded to RM185/MT and are gradually rising on better supply-demand balance.

3. 9th Malaysia Plan (9MP) may surprise on the upside. The market currently has very low expectations of a construction sector revival fuelled by the 9MP as allocation is expected to be similar or even potentially lower than the 8MP (RM150b-170b). However, newsflow in the construction sector has improved in the past two weeks. The government plans to proceed with the new Johor-Singapore bridge (estimated cost RM1.1b). A second bridge in Penang (estimated cost RM2.6b) or major road infrastructure upgrade is also likely as the Prime Minister has promised Penang, his home state, some goodies in the 9MP.

We think the 9MP may surprise on the upside given the looming UMNO and general elections in 2007 and 2008 respectively. This could be a catalyst for the construction sector which has suffered a downcycle in the past nine years.

5. Some business drivers to watch out for:
a. utilisation rate (Sector capacity utilisation has increasedfrom a low of 60% in 2001 to 72% currently)
b. coal price (coal constitutes about 15% of total all-in cost)
c. electricity tariff (Electricity constitutes only about 14% of total all-in cost, compared to coal’s 15%)
d. transportation cost (expected to rise as the government cuts back on diesel subsidy to reduce the country’s budget deficit)
e. government-imposed ceiling price of RM198/MT

6. Investment strategy:

Bottom of the cycle. The cement sector has fallen by a massive 68% from the peak in 1994. It has turned attractive as: a) earnings have returned to profitability in 3Q05 after severe losses in 1H05, with profits from 4Q05 onwards likely to be stronger as average price is rising, and b) downside risk mitigated by all-time low valuations and high dividend yield (FY06: 4.3% vs regional’s 3.0%). We believe cement companies’ share prices have yet to reflect the strong earnings recovery, which opens up a great buying opportunity. We think the cement
sector is more attractive than the construction sector as the latter suffers from: a) too many players, b) continued losses, and c) rising building material prices globally.

Valuations at all-time low. The cement sector P/BV has fallen from a peak of 3.8x in 1993 to a severely depressed 0.6x currently, a massive 84% plunge. Current valuations match 1998 post-financial crisis level of 0.6x. A recovery to mid-cycle valuation of 0.7x P/BV suggests a 20% upside for the sector.

Attractive compared to regional peers. The Malaysian cement sector currently trades at a 33% discount to regional peer’s FY06 EV/EBITDA (5.8x vs 8.7x). Using EV/tonne, Malaysian cement sector still looks attractive at RM247/MT, a huge 43% discount to regional peers’ RM434/MT (ex-Siam Cement) and 54% below replacement cost of RM539/MT (US$145/MT). Average P/BV and P/CF are also undemanding, at just 0.8x and 8.1x compared to regional’s 2.9x and 13.2x respectively.

posted by gsg @ 2:30 PM