HONG LEONG INDUSTRIES (HLI MK) Tapping On The Growth Of Hume Cement

We are increasingly positive on the growth prospects of Hume Cement, underpinned by its plant’s improving efficiency and a potential doubling in production capacity to cater to more markets. Given the relatively lofty valuation in Narra, investing in Hume Cement through HLI (HLI investors to receive 1.08 Narra shares for every share held) could be a more attractive option. Upgrade HLI to BUY with a higher target price of RM7.95. WHAT’S NEW • Increasing target price to RM7.95. As we are more optimistic on the operational efficiency and utilisation rate of the Hume Cement plant 18 months after production commencement, we raise our forecast for Hume Cement’s 2015 net profit to RM70m (from RM55m) and thus Narra’s 2015 net profit forecast to RM80m. Pegging at a higher 18x of (previously 17x) 2015 PE for Narra, our SOTP target price for HLI is raised to RM7.95, from RM7.16. • To double cement production capacity in 2 years’ time. We understand Hume Cement’s plant utilisation rate has hit 82-85% and the company intends to double the capacity via Phase 2 expansion adjacent to its existing plant. This potential RM500m-600m expansion will see Hume Cement’s capacity surpassing that of some peers (potentially becoming the third-largest cement player) and improving its economies of scale. After ramping up its capacity, Hume Cement plans to penetrate the southern regional markets which it has yet to have a presence. And in the longer term, it may also consider moving downstream to the ready-mix cement market. • Potentially to use par value for share price adjustment. Separately, we understand that so far, Bursa seems to have no issue with HLI’s proposal to use the par value to adjust its share price to reflect the distribution of Narra shares to HLI shareholders (1.08 Narra shares for every HLI share). If so, after the shares go ex Narra distribution, HLI’s share price will be adjusted by RM1.08, which is significantly lower than the potential distribution value of Narra of >RM5/HLI share (based on Narra’s present valuation). STOCK IMPACT • Restructuring exercise expected to complete in end-September. Management is hopeful of completing the restructuring exercise by end-September. The company is currently waiting for the court’s approval for capital reduction and distribution. Hume Cement doing well in FY14. After achieved an impressive RM7.8m net profit in FY13 with only one quarter of official commissioning production, we understand Hume Cement is likely to achieve more than RM50m net profit in FY14. Moving into FY15, we believe the higher utilisation rate and gradual improvement in efficiency will allow Hume Cement to see further bottom-line improvement. Hume Cement’s good limestone reserves make it more efficient than peers who source for limestone externally. Our 2015 RM70m net profit forecast assumes 1.6m-tonne production and RM295/tonne net selling price. • Expecting sustainable earnings and dividend payout post restructuring. HLI’s earnings are sustainable or stronger in FY15-16, after stripping out Hume Cement’s ICPS and Hume Concrete. We expect better prospects from its other building material segments (significant turnaround at Guocera tiles division as well as additional capacity and better pricing in the fibreboard business) to offset the exclusion of Hume Concrete’s earnings from the group. In addition, Hume Cement currently does not contribute any earnings to HLI’s bottom line, with the exception of dividend income from the ICPS. • Prospective dividend yield of 4.7-5.2%. While there is no formal dividend policy, management guided that HLI will continue paying out at least 50-55% of its earnings (FY15F DPS of 27-30 sen). This implies a prospective yield of 4.7-5.2% after HLI’s share price goes-ex, assuming a RM1.08 share price adjustment. EARNINGS REVISION • No change to our earnings forecasts but we increase Narra’s 2015 net profit forecast by 23%. VALUATION/RECOMMENDATION • Upgrade to BUY with a higher target price of RM7.95, derived by adding: a) the implied value of Narra share at RM3.39/HLI share (HLI’s shareholders will be receiving 1,080 Narra shares for every 1,000 HLI shares), and b) a 20% holding company discount to our SOTP valuation of RM5.70 for HLI’s remaining assets. Our valuation methodology is unchanged and we revise Narra’s 2015 PE valuation from 17x to 18x. • 18x 2015F PE for Narra is reasonable. We deem an 18x (previously 17x) 2015F PE for Narra is fair, given that peers are trading at an average of 19x 2015F PE. Furthermore, we believe Hume Cement has better growth prospects as it plans to significantly raise production capacity in the intermediate term.