Pantech ... Oct11

By InsiderAsia.

- Sales in 2QFYFeb12 up 5.5% q-q and 3.5% y-y
- Demand gradually gaining momentum
- To resume double-digit growth in FY12-FY15
- Very attractive FY12E P/E of 5.7x with 7.4% net yield

Pantech Group Holdings’ earnings results for 2QFYFeb2012 were broadly in line with our expectations.

Turnover improved to RM100.6 million, up 3.5% from the previous corresponding quarter and up 5.5% q-q. Trading sales accounted for roughly 60% of total turnover while the manufacturing arm contributed to the balance.

The recovery in domestic demand, which accounts for the bulk of the company’s trading sales, is still sluggish – although off the lows. As a result, margins from the trading arm are still at the lower end of its historical range.

Positively, we expect demand – and profitability – to gradually pick up steam over the next few quarters on the back of rollout of oil & gas projects under the various government initiatives, including the Economic Transformation Programme.

The manufacturing arm, on the other hand, is doing comparatively better on the back of the strong recovery in overseas markets. Sales continued to trend higher, to RM40.6 million in 2QFY12, up from RM30.2 million in
1QFY12 and RM25 million in 2QFY11.

The carbon steel manufacturing facility in Klang is operating at full capacity. Operations at the new stainless steel manufacturing plant in Johor Baru are also progressing well. All six initial production lines are up and running at almost full capacity. The lines broke even at end-2QFY12 – and should start to contribute positively in 2HFY12.

Lower losses from the new manufacturing plant more than offset the slight contraction in trading earnings before interest and tax (EBIT). EBIT for the manufacturing arm improved to about RM3.4 million in 2QFY12, up from RM1.3 million in the immediate preceding quarter.

As a result, net profit improved to RM7.2 million in the latest quarter, up from RM6.2 million in 1QFY12.

Earnings Outlook
Pantech is upbeat on the outlook going forward and that its expansion plans are progressing on track.
The recovery in demand for the company’s pipes, fittings and flow control (PFF) products is expected to gain traction, both in the domestic and export markets. Despite prevailing uncertainties over the global economic outlook, the company is maintaining its cautious optimism.

Global economic growth is still positive, albeit revised lower from previously forecasted numbers. Prices for crude oil have held up well through the volatility in financial markets. Crude oil futures on the New York Mercantile Exchange are currently hovering around US$88 per barrel, a level that is supportive of
exploration and production activities in the oil & gas sector.

Meanwhile, even though prices for crude palm oil (CPO) have weakened, demand is still expected to remain fairly resilient. CPO futures on the Bursa Derivatives market are currently trading around RM2,900 per tonne – well above the average production costs for plantation companies and thus, should continue to drive acreage expansion plans underpinned by expectations of rising demand.

The oil & gas and oil palm related sectors collectively account for the bulk of Pantech’s sales for pipes, fittings and flow control products. As mentioned above, the recovery in domestic demand is still somewhat
sluggish. Nevertheless, capital spending in the domestic oil & gas sector is expected to be quite robust for the foreseeable future.

The Malaysian government has pinpointed the sector as one of the key focus areas under its Economic Transformation Programme, accounting for a substantial share of the total value of the projects that have been announced so far.

The national oil company, Petroliam Nasional intends to spend some RM250 billion over the next five years, to develop new projects, including marginal oil fields, as well as undertake enhanced oil recovery from existing oil fields.

Elsewhere, private sector projects such as the Dialog Group’s Pengerang deepwater petroleum terminal are also expected to spur greater investment in the oil & gas related sectors in the country going forward.
The gradual rollout of these projects will translate into greater demand for downstream support services, including demand for Pantech’s PFF products.

Pantech’s manufacturing arm has recovered quite smartly from the slump in overseas demand in the aftermath of the global financial crisis. Sales hit a trough in 2QFY10 and have been trending higher since – despite the
strengthening of the ringgit. The weaker US dollar translates into lower sales for the company in ringgit terms.

The company’s carbon steel PFF manufacturing facility in Klang is effectively running at full capacity. To cater to the expected demand growth, a factory is being built on a piece of land adjacent to its existing plant. The additional machineries to manufacture, primarily, high frequency induction long bends, are slated to commission by end-2011. The factory will also house a heat treatment facility.

Meanwhile, Pantech is in the midst of adding machineries for another four lines at its new stainless steel facility. The additional lines will expand its current production range to include bigger-sized pipes and also fittings.

If all goes to plan, rated production capacity at this plant will rise to 13,500 metric tonnes per annum by early 2012, from the current 7,000 metric tonnes, and will be reflected in the company’s FY13 earnings. Total capex is estimated at roughly RM40 million and RM50 million for FY12-FY13, respectively.

The manufacturing arm has already secured a full order book for the rest of the current financial year. Plus, we expect margins to gradually widen – the initial six lines have broken even while the new lines should start to
contribute positively by 2HFY13. They will also enjoy better economies of scale.

Looking further ahead into 2013, Pantech is actively exploring various options to further expand its range to encompass higher value and margin alloy products such as copper-nickel, duplex and super duplex pipes and
fittings that are corrosion resistant.

The move would expand its customer base and market reach – and is the final piece in Pantech’s five-year plan to hit sales target of RM1 billion by FY15. The company expects manufacturing sales to account for at least 40% of total sales. Domestic demand will also account for a higher percentage of manufacturing sales, currently derived mainly from exports, as a result of import substitution.

Valuation and Recommendation
Pantech’s well-laid out strategy should enable it to achieve double-digit annual growth over the next few years – based on the expected strengthening in demand that is supported by the company’s expansion plans.

Net profit is rising, albeit still at a gradual pace. This is due to pricing competition as there is currently excess capacity in the industry with demand just starting to pick up pace. Margins were also weighed down by start up costs at the company’s new stainless steel plant.

We believe that Pantech’s earnings will be much stronger in 2HFY12 compared to the first half of its financial year. Thus, we are keeping our forecast unchanged.

Net profit is estimated at RM37.7 million in FY12 – up 30% from the RM29.4 million in FY11 – and is expected to grow further to RM46 million by FY13. Based on our forecast, the stock is trading at very modest P/E valuations of only 5.7 and 4.6 times, respectively, for the two years. Plus, the stock is
trading below its net asset of 72 sen per share as at end-Aug 2011.

Pantech’s valuations compare very favorably against most oil & gas stocks listed on the local bourse, as well as the broader market’s average valuations.

Thus, we believe there is significant upside potential for Pantech, particularly for those with a slightly longer investment horizon. We maintain our BUY recommendation on the stock.

Investors can also expect attractive yields 
On top of potential capital gains, shareholders can also look forward to attractive yields.

Dividends totaled 3.3 sen per share in FY11. With stronger earnings going forward, we believe Pantech will gradually raise its dividends. We estimate dividends will rise to 3.5 sen per share in FY12, which will earn shareholders an attractive net yield of 7.4% at the current share price. This is well above the average yield for the broader market as well as prevailing interest rates on bank deposits.

Warrants and ICULS for lower entry price points 
For lower entry price points, investors could consider the company’s ICULS and warrants.
Pantech has some 735 million outstanding ICULS, carrying a 7% coupon rate with a conversion ratio of six to one, exercisable at anytime up to December 2017. Based on the current share price of 47.5 sen, the ICULS,
Pantech-LA, would be “in the money” at roughly 7.92 sen. They last traded at 9.5 sen.

The company also has some 74.8 million outstanding warrants, Pantech-WA. The warrants have a longer maturity period, up to December 2020, and exercise price of 60 sen. The warrants are now trading at 21.5 sen, implying a 72% premium.

Upon full conversion of the ICULS and warrants, Pantech’s share base will be enlarged to some 650 million shares from 452.6 million at present. The larger share capital – in step with its growing business – would improve liquidity and increase the stock’s attractiveness to investors over time.