Indonesia Strategy, Navigating a Challenging 2014

While we are still cautious on Indonesia’s short-term equity market outlook owing to economic and political uncertainties, we are of the view that its long-term fundamentals are intact. We foresee 2014 GDP growth dipping to 5.4% while Bank Indonesia (BI) may have to raise the BI rate to 7.75-8.25%. As short-term macroeconomic fundamentals are weak, bottom-up is the key to finding alpha in the market.

Bracing for challenging times
Indonesia closed 2013 in a very different situation from what it faced in the first semester. Several macroeconomic imbalance episodes have resulted in contraction and the reversal of many economic indicators as at end-2013. Fears over US quantitative easing (QE) tapering and the worsening current account balance were the main culprits of the high volatility, especially the IDR’s depreciation. In the years ahead, Indonesia will face headwinds to economic growth as the Government’s policies are geared towards creating a stable – rather than an expansionary – economy.

Economic slowdown
We foresee 2014 GDP growth moderating at 5.4%. The headwinds will likely come from foreign trade and investment, although there will be some cushioning from private and Government consumption on the back of the General Election next year. Meanwhile, the 2014 outlook is for inflation of a low of 6.2% y-o-y. However, the IDR’s depreciation could pressure domestic prices, especially for goods that have high import content. We predict that the exchange rate will decline to the IDR11,300-11,800 per USD range and expect the BI rate to increase to the 7.75-8.25% range in 2014.

Changing political landscape
Indonesia is in waiting for the next election to see who will emerge as the country’s new leader. Uncertainties remain high, as the most popular candidate, Joko Widodo (popularly known as Jokowi), has not even been nominated. We believe Jokowi’s nomination will create positive market sentiment as political uncertainties fade. Despite the possibility of coalitions being formed among the political parties, the bargaining position of any new leader will be high given that the current voter sentiment is towards voting for a candidate irrespective of his party background.

Looking beyond 2014
Although the Indonesian market is facing high volatility and potentially more capital outflow, we believe the long-term outlook still remains intact. The weak IDR, high interest rate, and wage increase will be reflected in 2014’s results while a slowdown in demand may affect overall performance in the new year. Hence, we suggest that investors look beyond 2014 with a bottom-up approach. We like companies that tap into the low income segment that should benefit from government policies going forward.

Our picks are Astra Agro Lestari (AALI IJ, BUY, TP: IDR28,350), Arwana Citra Mulia (ARNA IJ, BUY, TP: IDR930), Bank Rakyat Indonesia Persero (BBRI IJ, BUY, TP: IDR10,100), Bumi Serpong Damai (BSDE IJ, BUY, TP: IDR2,400), Gudang Garam (GGRM IJ, BUY, TP: IDR46,500), Malindo Feedmill (MAIN IJ, BUY, TP: IDR4,000), Ramayana Lestari Sentosa (RALS IJ, BUY, TP: IDR1,650), Semen Indonesia (SMGR IJ, BUY, TP: IDR17,000), Tiphone Mobile Indonesia (TELE IJ, BUY, TP: IDR900) and Telekomunikasi Indonesia (TLKM IJ, BUY, TP: IDR IDR2,500).

Economy
Time To Step Up Productivity
“Everything must be taken into account. If the fact will not fit the theory – let the theory go”. – Hercule Poirot

Indonesia is set to close year 2013 with a situation that is very different from that in the first semester. Several macroeconomic imbalances have led to a contraction in growth as well as a number of economic indicators reversing into negative territory at the end of 2013. Fears over the US Federal Reserve (US Fed) tapering its QE programme, combined with a worsening current account balance, were the main causes of the high volatility, especially in the IDR. In the years ahead, Indonesia may face headwinds to economic growth, as current Government policies are directed towards achieving stability rather than being expansionary.

Several indicators will ease in 2013 vis-à-vis 2012
Growth in 2013 is estimated to moderate to 5.6% from 2012’s 6.2%, while inflation will end roughly at 8.5% y-o-y, due to the increase in the subsidised price of fuel. On the external front, the country’s 2013 current account deficit (CAD) will come in at around USD32.68bn – the highest deficit since the 1998 Asian financial/economic crisis. This deficit will be driven by a combination of high oil imports and declining commodity prices. Going forward, we do not expect oil imports to come down significantly in the absence of sound structural reforms.

Policy mix to counter effects of QE tapering
The Government has announced two economic packages aimed at stimulating Indonesia’s export performance. Separately, Bank Indonesia has increased its benchmark rate by 175 bps to curb inflation, narrow the current account deficit and manage the IDR’s volatility. To counter the latter, the central bank utilised official foreign reserves amounting to USD15.8bn this year. This is the first time Indonesia’s foreign reserves position has declined since 2008.

2014 to be fraught with challenges
Against the backdrop of tighter funding conditions, weak investments and low external demand, we expect 2014 growth to moderate to 5.4%. We see foreign trade and investment providing the swing to reverse the present direction, while private and Government consumption may provide some cushion in view of the upcoming general election.

Inflation to remain stable at a low range
On the inflation front, the outlook for 2014 is for a low 6.2% y-o-y. The stabilising prices of goods following the subsidised fuel price increase, combined with no further Government plans for another price hike, may possibly keep inflation at low levels. However, a significant depreciation in the IDR could pressure domestic prices, especially for goods that have high import content.

CAD to stabilise but still in negative territory. As far as foreign trade is concerned, the pressure on the current account may tilt it towards a bigger deficit, but this may be cushioned by high currency depreciation and growing funding costs. As a weaker IDR will make imported goods more expensive vis-à-vis domestic goods, this may dampen imports, while rising funding costs will deter companies from expanding capacity.

Consequently, imports of materials and capital goods will fall, but this will be at the expense of growth. Nevertheless, since fuel consumption is inelastic, oil imports will be kept at a constant, while the gas sector’s positive export outlook may cushion the oil & gas (O&G) sector’s net balance from falling too severely. All said, we expect the current account deficit to come in at around USD22.75bn in 2014.

Monetary stance to veer towards stabilisation, not expansion. In view of the present scenario, the monetary stance should bear a tightening bias, even though the inflation numbers are pointing towards a more positive outlook for the economy. The main reason for tightening, primarily, is to counter the threat of further depreciation in the IDR due to capital reversal and a widening CAD.

Moreover, since the central bank must keep its official reserves at internationally accepted levels, this will leave it with little ammunition to intervene should the IDR swing drastically. Under these circumstances, we predict the exchange rate will range between IDR11,300-11,800 per USD. We also expect the BI rate to fall to 7.75-8.25% next year.

Fiscal policy on autopilot due to the upcoming elections
On the fiscal side, the agreed budget deficit for 2014 was 1.7% of GDP. Meanwhile, plans such as the mineral ore ban and the new tax scheme should help to narrow the current account balance, although there are no significant plans to raise economic productivity. However, judging from the low debt to GDP ratio, there is plenty of room for the Government to manoeuvre, should the US Fed’s QE tapering make an unprecedented impact.

Under this worst-case scenario, we would like to urge the Government to provide extra room for productive stimuli for infrastructure and agricultural projects, or, at the very least, grant additional tax incentives. However, we do not expect there to be any essential fiscal measures, in view of the country’s upcoming elections.

The 2014 election should create a positive wave if the outcome is aligned with public expectations. Should the newly-elected Government be one that is anti-corruption in nature, there may then be improvements in bureaucracy and ease of doing business over the long term.

2014 Election Outlook
Indonesia in waiting
“It’s hard enough to predict economics without trying to predict politics.” – Larry Summers.

Political tension heightens
This has been keenly felt, with politicians and political parties already starting on their 2014 election campaigns. While the process itself is no longer an uncertainty, who the candidates are remains a question. However, in our view, the key points of the 2014 General Election are:
i. We believe the election process will be far from violent
ii. The candidate’s character and personality will determine his/her victory, with less influence from his/her political party
iii. Rising political tension has been felt and will peak in 2Q 2014
iv. The effectiveness of Susilo Bambang Yudhoyono (SBY)’s administration will decline further as the General Election approaches

An election year
Indonesia will face 2-3 rounds of elections (one Parliamentary and 1-2 Presidential) elections, which will take place in April-Sept 2014. Based on General Election Committee (KPU) data, 15 political parties will participate in the Parliamentary election. In terms of candidates, so far three President and Vice President candidates have been nominated by their respective parties to run for the Presidential election. Take note, however, that to be able to officially register a Presidential candidate with the KPU, a party must hold at least 20% of the seats in Parliament or form large enough a coalition with other parties, which will then register a candidate with the committee.

Currently, some names already put forward to run for the Presidential elections are Prabowo Subianto, Aburizal Bakrie and Wiranto. Meanwhile, the incumbent Democrat Party is still working out who to select as its Presidential candidate.

Voters pick the candidate, not so much the party
We are of the view that 2014 will be a milestone in Indonesia’s democracy, as the dominance of political parties is waning and voters have started looking directly at an individual candidate’s character and personality. This is typified by the Jakarta Governor election in 2012. Nevertheless, Presidential candidates still need political party support to run.

The expected scenarios
Jokowi has the highest chance of victory. From the latest polls, if the Indonesian Party of Struggle (PDI-P)’s popular Governor of Jakarta Jokowi is nominated by his party to run for the Presidential election, he will win it outright. However, it is still uncertain whether the PDIP will nominate him, although from recent developments, we think the party will nominate him. Nevertheless, it remains moot as to who his Vice President will be.

Parliamentary election
So far, only the PDIP and the Golkar Party have consistently led in the Top 2 positions in the polls. However, with parties barely able to get 20% of the votes – the threshold required for registering a Presidential and Vice Presidential candidate – we should see the formation of coalitions among the various political entities. What is different from the previous election is that the character of the President candidate will determine his/her victory, which should provide the country’s next President with a strong bargaining position in Parliament.

Opportunities versus risks
Looking at the current Government’s concerns on infrastructure as well as basic industrial development, we believe the next administration will continue to address these problems. Although the execution risk is the same, there are some expectations that this new Government would be able to better execute its development programmes, including continuing or even accelerating bureaucratic reform and eradicating corruption. We highlight some the opportunities and risks facing the next Government during its term:

Opportunities:
i. Development of basic industries through fiscal incentives
ii. Acceleration of infrastructure development
iii. Improvement in ease on doing business
iv. Cleaner Government
v. Bureaucratic reform

Risks:
i. The new Government focuses on populist policies
ii. Destructive challenges from Parliament
iii. Bigger government role in the economy with populist policies
iv. Slow action in responding to economic turbulence
v. Slow to reform the bureaucracy

Market Outlook
Surviving the storm
“In the long run, we may all be dead, as Keynes suggested, but we need to make sure that the short run doesn’t kill us first.” – Andrew Lo

Long-term outlook remains intact
We believe Indonesia’s long-term outlook remains intact, backed by its large 240m population – 74m of whom are in the middle class – and supported by a proven democratic platform. Furthermore, the country still has enormous potential in its abundant natural resources. However, short-term risks from the weakening IDR, a slowing economy and fears of QE tapering have to be addressed by the Government.

In addition, the existing and upcoming Administration needs to seriously increase Indonesia’s economic productivity in order to prevent the country from falling into the middle income trap faced by many developing nations.

Current account deficit (CAD) to improve
From October’s trade data, we think the worst is over. Our economist expects the CAD to decline in 2014; however, it will be at the expense of economic growth. Both the Government and BI have undertaken measures to address the CAD, such as raising import taxes, pushing for the usage of biofuel and increasing the BI rate.

However, disharmony in the implementation, eg the import tax on mobile handsets vs mobile handset spare parts, makes us sceptical on the short-term impact of such initiatives on the real sector. To sustainably improve the trade imbalance at current levels of purchasing power, the Government has to increase economic productivity and lower its dependence on imports by beefing up its infrastructure and basic industries.

QE tapering may spark off outflow of more capital
With uncertainties still lingering over the timing and size of the US Federal Reserves (the Fed)’s QE tapering, Indonesia’s CAD has become the game-changer for the financial market. The possibility of the Fed starting to scale back its asset purchase programme increases the market risk, as a post Fed QE tapering decision should see more capital flow out from the Indonesian market.

However, we still believe that the capital outflow will be gradual, in line with the liquidity adjustment in the advanced economies. However, we predict foreign ownership may still hover at around 60% – the market’s lowest level in a while – as the long-term outlook remains intact.

Political uncertainty casts shadow over market. With the expected candidate registration to be submitted to the KPU by May 2014 at the latest, we may see a market overhang before there is more certainty as to who will run for President in the coming General Election. During this period, we also see the current low trading values on the IDX continuing.

Jokowi’s nomination will ease the uncertainty
We think that the nomination of the PDI-P’s popular Jokowi will lower the uncertainty, as all the voting polls indicate that he will receive the highest number of votes should he be chosen to run for President. However, as at the date of this report, Jakarta’s Governor is not a Presidential candidate as yet, but we opine that his nomination will be announced before the Parliamentary election. His nomination will give his party the opportunity to gain votes during the Parliamentary portion of the General Election.

Limited election rallies
We expect limited election rallies in 2014 as the threat of capital outflow still lingers and the valuations of the JCI are still relatively high. The index is currently trading at a 13.6x forward P/E vs 9.4x FY05 P/E (early 2004) and 8.3x FY10 P/E (early 2009). In our opinion, the election rallies in 2004 and 2009 were driven by new expectations of the elected Governments, but valuations and global financial market liquidity were also key factors for the market performance post elections.

Election spending is real
Non-food household expenditure as a part of GDP rose 8.3% y-o-y and 6.0% y-o-y during the 2004 and 2009 election years respectively – higher than in normal years. Hence, if history is any guide, some sectors will benefit from election activities, especially private spending. Household spending during these election years translated into higher sales for some consumer products such as cigarettes and retail goods.

Election year spending is estimated by some economists to be in the IDR40-50trn range, which will boost GDP growth by around 0.2%. Furthermore, with the 2014 Budget’s 12.9% increase in personnel expenditure vs only 6.4% for material expenditure, we expect this to provide a boost to consumer spending next year.

Politics-driven market in 2014
The 2014 Election will determine the path of Indonesia’s economic development for the next five years. Hence, market movement will be heavily influenced by political developments.

JCI valuation reverts to long-term average
The JCI is currently trading at 13.6x forward P/E, higher than its 8- and 10-year average 13.3x and 13.1x P/Es respectively. The index is currently trading at a 12-18% premium, based on IBES and Factset data to regional market valuations. In our view, the drivers for the JCI in 2014 are:

Internal:
i. A Jokowi’s victory may trigger limited post election rallies and will raise the JCI’s valuation.
ii. GDP growth to slow to 5.4%, with the BI rate falling to the 7.75-8.25% range next year.
iii. We assume 10% and 15% EPS growth in FY14F-15F.

External:
i. QE tapering causing gradual outflow of capital, but the downside will be limited .
ii. Improvement in the CAD, however, the BI rate may still need to be raised to 8.25% in 2014.
iii. Bank of Japan’s own QE programme may improve liquidity amid the US Fed’s own tapering.

In terms of market direction, the key factors in predicting the outcome of the election are:
If Jokowi wins the election. We should see a rally as Jokowi is the favourite candidate and is preferred by the street – even his nomination as a Presidential candidate is expected to spark positive sentiment. We predict the JCI to be trading at 14.0x forward P/E at end-2014, or 5,000 pts.

Otherwise, uncertainties remain high. EPS growth will be the only cushion for a further de-rating of the market, which we think will only recover in 2015. We foresee the index trading at its 10-year average 13.1x forward P/E, or 4,650 pts.

Our Stock Picks
Although the Indonesian market is facing high volatility and potentially more capital outflow, we believe that the long-term outlook is still intact. The weak IDR and high interest rate will be reflected in 2014’s results, while a slowdown in demand may affect the year’s overall performance. We suggest that investors look beyond 2014 with a bottom-up approach. We like sectors that tap into the low income segment, which should benefit from Government policies going forward. We still prefer stocks that have higher long-term growth outlooks beyond 2014, but are also able to perform better in 2014.

Our Top Picks are Arwana Citra Mulia (ARNA IJ, BUY, TP: IDR930), Bank Rakyat Indonesia Persero (BBRI IJ, BUY, TP: IDR10,100), Bumi Serpong Damai (BSDE IJ, BUY, TP: IDR2,400), Gudang Garam (GGRM IJ, BUY, TP: IDR46,500), Ramayana Lestari Sentosa (RALS IJ, BUY, TP: IDR1,650), Malindo Feedmill (MAIN IJ, BUY, TP: IDR4,000), Semen Indonesia (SMGR IJ, BUY, TP: IDR17,000), Tiphone Mobile Indonesia (TELE IJ, BUY, TP: IDR900) and Telekomunikasi Indonesia (TLKM IJ, BUY, TP: IDR IDR2,500). We also like Astra Agro Lestari (AALI IJ, BUY, TP: IDR28,350), which will benefit from the upswing in CPO prices.

Auto and Autoparts (Neutral): Potholes Ahead
We expect 2014 vehicles sales to encounter headwinds in the form of rising financing cost and competition. New players are flocking to Indonesia’s auto market and aggressively launching new models. We see this leading to narrower profit margins for auto makers and distributors. However, we foresee a brighter outlook for the auto parts segment as the export market starts to recover. We are overall NEUTRAL on Indonesia’s auto sector.

Vehicle sales go on slower gear
Higher financing costs as a result of the uptick in Bank Indonesia’s benchmark rate may curb consumers’ appetite for new vehicles as demand is quite sensitive to interest rates. We have a moderate view on the domestic 4W and 2W vehicle markets, and are projecting for slower sales growth of about 5% y-o-y in domestic 4Ws sales (to 1.3m units) and 5% y-o-y for 2Ws to 8.3m units. The FY14 sales growth would be slower than FY13’s 10% y-o-y for 4Ws and 11.5% y-o-y for 2W. Higher 4W vehicles sales will be driven by the low cost green cars (LCGC) launched in September while non-LCGC car sales may flatten. As the first-mover, Astra International (ASII IJ, NEUTRAL, TP: IDR6,900) will be the biggest beneficiary of LCGC sales growth.

Profit margins thin
Rising competition in the domestic auto market has led to auto makers and distributors finding difficulty in raising their sales price in the wake of increasing costs. In the past, Indonesia’s auto players had enjoyed relatively solid margins owing to their higher production capacity while their competitors faced supply constraints following the severe floods in Thailand in 2011 as well as nuclear power plant leak in Fukushima the same year. However, at end-2013, these same competitors had gotten back on their feet and ramped up their respective production capacity.

Auto parts outlook brightens
We gather from our discussions with the auto parts players that the export market, especially Europe, is likely to start recover next year. Meanwhile, the domestic market will also see robust growth, propelled by LCGC production as well as the government’s plans to push for higher use of local auto parts content. However, competition in the domestic tyre sub-segment will intensify as new players enter the industry.

Aviation (Overweight): Low Cost Carriers To Up The Ante
Intensifying competition and a depreciating IDR will be the headwinds facing airlines in 2014. GIAA will face fierce competition from Lion Air and Indonesia AirAsia, which will be expanding aggressively in 2014-15. We also see budget travellers growing more rapidly than premium travellers, which will pressure the full-service carriers (FSC). Given the recent price drop and upside potential going forward, we maintain our sector call OVERWEIGHT.

Bracing for short-term turbulence
Intensifying competition and depreciating currency have hurt airlines’ performance. Garuda Indonesia (GIAA) booked a net loss of USD22.3m in 9M13, dragged down by Citilink’s performance and higher operating costs. In 10M13, GIAA recorded 20.3m passengers (+22.1% YTD) and a 16.5% rise in revenue passenger kilometre (RPK), while average seat kilometre (ASK) jumped 18.5%. With capacity growing at a faster pace than seats being filled, the carrier’s passenger load factor eased 1.3ppts to 74.6%.

Competition heats up
We see 2014 will be another challenging year for full-service carriers (FSC) such as Garuda Indonesia, with low-cost carriers (LCC) such as Lion Air and Indonesia AirAsia set to expand aggressively. Lion Air is expected to add 39 planes in 2014, AirAsia seven planes and Garuda Indonesia around 22 planes. We expect competition going forward to be cross-segment and intensifying ahead of the establishment of the Asean Single Aviation Market (SAM) in 2015.

Robust passenger growth
Indonesia will still see robust passenger growth going forward with a CAGR of 11% from 2011-2015. It is worth noting that budget travellers will be around 59.1m passengers (+27.3% y-o-y) while premium travellers will be 22.9m passengers (+8% y-o-y) in 2014. Looking at the growth trend of passenger demand, we expect LCC’s performance to outpace that of FSC next year.

Maintain OVERWEIGHT
Intensifying competition and a depreciating domestic currency will limit the growth of FSCs such as Garuda Indonesia. Furthermore, we expect higher labour costs to weigh on aviation support business such as Cardig Aero Service due to the company’s inability fully pass on the cost increase, which will in turn erode margins. However, given the recent price decline and overall upside potential going forward, we remain OVERWEIGHT on the sector.

Banks: Ripples Turning Into Waves
We stay Neutral on banks as we foresee earnings growth decelerating, with PPOP growth easing to 12% y-o-y while the risk of credit cost rising increases. Credit expansion will slow as GDP growth softens and interest rates rise. The tussle for funding is intensifying as the Rupiah LDR hits 95% while accelerating cost of funds may persist as we see more BI rate hikes ahead. There could be better entry points ahead.

Earnings growth to decelerate
We expect banks’ earnings growth to decelerate in 2014 as they digest a mixture of: i) slower credit growth of 17% (vs 4-year CAGR of 23%), ii) 14bps in aggregate net interest margin (NIM) compression, driven by a 35bps spike in cost of funds, and iii) a 17% growth in provision (or 1.1% of average gross loans).

Among the banks within our universe, we expect a pre-provision profit growth of 12% y-o-y (vs 4-year CAGR of 17%) and net earnings growth of 11% y-o-y. That said, we expect the earnings performance of the large banks to be superior relative to small banks owing to better pricing power, non-interest income profile and cost efficiency. We remain Neutral on banks.

Feeling the squeeze
The Rupiah loan-to-deposit ratio (LDR) hit 95% in October, indicating a tightening in liquidity. The war for deposits has intensified, especially with time deposit (TD) rates having gone up by 400bps in the last six months. We are of the view that funding rates will continue to inch up as we expect BI to raise benchmark rates by a further 50-75bps in 2014. Meanwhile, banks with low CASA and high LDRs will struggle to sustain growth and protect NIMs. Some banks are passing on their rising cost of funds but this may lead to diminishing incremental demand for credit.

Credit costs the main risk to earnings. As the macro economy slows down (2014F GDP growth of 5.4%) while prices stay elevated (2014F inflation of 6.2% y-o-y) and lending rates rise, non-performing loans (NPL) could mount, thus posing a threat to credit costs, which have been benign in the last three years.

Our Top Buys are BBRI and BJBR in the large and small cap universe respectively given their appealing P/BV and ROAE profiles.

Coal (Neutral): Awaiting Significant Improvements
While the seaborne thermal coal market may remain in surplus for the next 2 years, coal prices have hit bottom while a narrowing seaborne surplus may support a moderate rise in benchmark coal prices. However, the downside risks from a likely drop in China’s imports, weaker imports from price-sensitive India and greater-than-estimated rise in coal exports from Indonesia justify our NEUTRAL view on Indonesia’s coal sector. Prefer Bukit Asam (PTBA) on a relative basis.

Domestic demand to outpace exports
80% of Indonesia’s production of 540m tonnes of coal in 2013 will be exported, and 60% of domestic coal consumption will be used for power generation. Indonesia plans to add 24GW of coal-fired power capacity (60% of end-2012 total power capacity) between 2013 and 2019, which should increase the power sector’s coal usage by 100%. In addition, aided by higher demand and expanding capacities in cement and steel industries, we expect domestic demand to grow at a 13% CAGR vs 4% export CAGR during 2012-15.

Coal production growth to moderate
While coal producers have held back their capex plans, miners with large reserves remain committed to volume expansion over the long term. However, small coal producers with limited infrastructure and insufficient exploration programmes and who account for 15-20% of Indonesia’s total output, should have closed their operations amidst weak prices. In view of falling production from small miners and the slower volume expansion among the arge miners, we estimate 2014-15 coal production growth at 3-5% vs the 10-18% growth witnessed during 2011-13.

India to be key export market
India is the largest importer of Indonesian coal. With downside risks to Chinese coal imports and expectations of a structural rise in India’s coal imports, we expect miners to increase exports to India. Given India’s preference for low CV coal, we view the uncertainties over the long term direction of the INR and short term coal sales contract review as negative for miners.

Prefer Bukit Asam
We keep our NEUTRAL view on the sector as we do not expect strong improvement in coal prices and as earnings remain exposed to significant regulatory risks. We see PTBA as a stock to hold for its high volume growth and highest net margin among its peers.

Construction Material: Still Hot Despite Cooling Earnings Growth
Indonesian cement players will find it hard to pass on cost increases by raising selling prices since cement demand is waning in tandem with weaker property sales. National cement output is estimated to rise by 3.2m tonnes, or 5.5% y-o-y, to ~61m tonnes in 2014. Although we had lowered our earnings estimates earlier, Indonesia’s cement firms are still trading at attractive valuations. Maintain OVERWEIGHT, with SMGR as our Top Pick.

Cement demand slows
It will not be easy for Indonesian cement makers facing rising operating expenses to pass on all their cost increases by raising selling prices. Demand growth for cement has cooled in tandem with weaker property sales, as evidenced by the slower cement sales growth in 9M13. Domestic cement sales volume growth was relatively flat (+5.4% y-o-y) at 41.6m tonnes.

During the period, cement makers under our coverage – Semen Indonesia (SMGR IJ, BUY, TP: IDR17,000) and Indocement (INTP IJ, BUY, TP: IDR24,500) – saw lower profit margins as their higher sales prices proved ineffective in passing on all their costs increases to customers. SMGR’s EBIT margin narrowed to 29.0% in 9M13 from 31.3% in 9M12, while that of INTP slipped to 32.6% from 33.1% over the same period.

Excess capacity
The Indonesia Cement Association sees cement exports – which accounted for 2.5% of 9M13 national sales – potentially swelling by 150% y-o-y to 2m tonnes in 2014 from 800k tonnes in 2013. This is an indication of an oversupply in domestic production, as the margin of profit from export sales is lower than that from domestic sales. This year’s national cement production is expected to go up by 5.5% y-o-y, or 3.2m tonnes per annum, with the national cement plant utilisation rate currently at ~95%.

Still OVERWEIGHT owing to undemanding valuations
Although we had cut our earnings estimates after factoring in slower cement sales growth and higher costs, Indonesia’s cement companies are still trading at attractive 12.0x FY14F P/Es, or c.1S D below their 5-year average rolling forward P/E. A demand surge arising from infrastructure projects will be the sector’s upside catalyst. Our top pick is SMGR as we see the company benefitting the most from rising cement demand given its large un-utilised capacity as well as diversified plant location.

Consumer (Neutral): Short-Term Snags, But Long-Term Promise Holds
Although the consumer confidence (CCI) and real-retail sales indices rose slightly in Oct, we see consumer spending, especially in discretionary goods, waning in the next 6 months. We also see production costs inching up in tandem with a weaker Rupiah as most of the raw material costs are correlated to foreign currencies. However, given the sector’s promising long-term outlook, we remain NEUTRAL, with our top pick being RALS.

CCI improves m-o-m but down y-o-y
Bank Indonesia reported that the CCI rose slightly to 109.5 in October from 107.1 in September, in tandem with softening y-o-y inflation, which dipped to 8.3% from 8.4% over the same period. However, on a yearly basis, October’s CCI of 109.5 was still lower than 2012’s 119.5. Notably, consumers typically cut back on spending, especially on discretionary goods, when confidence takes a beating. A Bank Indonesia survey also shows that sales prices may come under more pressure in January, fuelled by higher spending in relation to next year’s elections.

Real-retail sales weaken
Retail sales are typically stronger in the second half of the year. However, there was an anomaly this year, as real retail sales in Sept-Oct – excluding the high sales seasonality during the Lebaran – is estimated to have flattened to the same level as that in 1H13, driven by weaker vehicles and spare parts sales. We see financing costs inching up as the higher BI interest rate has led to some consumers postponing their spending on new vehicles.

Higher costs pressure profit margin
Based on 9M13 results, consumer companies – under our coverage – booked lower earning although growing top-line revenue. This is due to higher production costs, operating expenses and financing cost. We see that higher production costs to continue going forwards which in line with weaker Rupiah as majority of raw material costs related to foreign currencies.

Maintain NEUTRAL
Although the consumer sector is in for some short term headwinds, we still see a promising long-term outlook given that Indonesia’s income per capita is growing in tandem with a growing population of those in the productive age while a majority of Indonesians are young. Our top pick is RALS, which we see as the biggest beneficiaries of rising consumer spending in view of 2014’s elections.

Metal Mining (Underweight): Still In The Doldrums
A projected rise in nickel prices following the upcoming ore export ban in Jan 2014 will like be short-lived, based on our channel checks. We believe the positives from the IDR’s depreciation against USD have been priced into companies’ valuations, leaving no more potential upside. We have SELLs on INCO (IDR2,000 TP) and ANTM (IDR1,150 TP) given the tepid non-ferrous metal prices and regulatory uncertainties.

Nickel price increase from ore export ban should be temporary
The Government announced in early Dec 2013 that it will impose a full ban on raw mineral exports from 12 Jan 2014, although it has yet to provide concrete details on its implementation. This is based on the 2009 mining law which requires companies to process their ore domestically. Although the Government has given a 5-year time frame for domestic mining companies to build processing facilities, only a few companies have processing operations domestically.

As Indonesia is the largest nickel ore mine producer, accounting for 28% of the total global nickel ore production based on Wood Mackenzie industry data, a potential supply disruption is on the cards. However, our channel check suggests that the nickel price increase will be short-lived because the existing ore stocks in China will enable nickel pig iron (NPI) production to continue at its present rate at least until 4Q14.

INCO is safe but ANTM will be hurt by regulations
Vale Indonesia (INCO, SELL, TP: IDR2,000) is a 100% nickel matte producer which has already committed to the 2009 mining law as a proceed/value-added mineral. However, the regulations will be negative for Aneka Tambang (ANTM) as the company may lose revenue from its nickel ore segment should the ban be fully implemented. It is worth noting that ANTM’s 9M13 nickel ore revenue contributes 33.4% of the company’s total revenue.

Valuation
We have SELLs on INCO (IDR2,000 TP) and ANTM (IDR1,150 TP), largely due to depressed non-ferrous metal prices and regulatory uncertainties. We do not see any exciting catalysts for both these companies in the short run.

Plantation (Overweight): A Bountiful Year Ahead
We are Overweight on the Plantation Sector, which we believe will have a good year ahead with most companies experiencing stronger profitability. This will be driven by stronger demand for palm oil from both food and fuel sectors, higher ASPs due to lacklustre production growth from Indonesia and lower fertiliser costs.

Our average CPO price assumption is raised to IDR9,500/IDR10,200 per kg for CY14/CY15.
Overweight. We upgrade the Plantation Sector to Overweight from Neutral previously as earnings outlook brighten after 2 years of contraction. Our CPO price assumption for CY14 and CY15 is raised to MYR2,700/t (IDR9,500/kg) and MYR2,900/t (IDR10,200/kg) respectively from MYR2,600 previously.

Food demand continues to grow
With the global economy on stronger footing, there should be no faltering in demand from the food sector. 2014 could see palm oil regaining lost market share in China as a result of the government’s austerity drive. The austerity measure has hurt the restaurant business which is a heavy user of palm oil.

A push from biodiesel use
Malaysia is raising its mandatory biodiesel blend to 7% from 5% currently as early as Dec 2013 while Indonesia is pushing for a 3m tonnes of biodiesel (B100) consumption next year. We believe the move by the government of the world’s two biggest biodiesel producing countries will have a significant impact on palm oil demand. Note that never before has palm biodiesel received such a strong mandate. We note that some implementation hiccups should not be ruled out especially in Indonesia but will push through eventually. Biodiesel usage is one of the measures to help address the country’s ballooning trade deficit.

Stock/usage ratio to fall to multi-year low
Assuming Indonesia uses up 2m tonnes of CPO for biodiesel production (vs target of 3m tonnes), export grows by 5% and Indonesia’s production grows by 2m tonnes, stock/usage ratio will fall to 8% (vs 13% at end 2013), its lowest since 2009. Such low stock/usage ratio will likely result in CPO maintaining a very narrow discount against soybean oil.

Cheaper fertiliser a boon for sector With the weaker fertiliser demand and breakup of the potash cartel, fertiliser prices are going to be cheaper in 2014. In USD terms, composite fertiliser cost is 23% cheaper compared to Oct 2012 when plantation companies locked in their 1HCY12 requirements. With fertiliser prices coming down in 2014, plantation companies could enjoy lower unit cost of production, and hence margin expansion. In the worst-case scenario, cost of production will remain flat compared to multiple years of rising cost of production since 2006.
Our Top sector pick is still Astra Agro Lestari.

Poultry (Neutral): Growing Appetite Buoys Long-Term Prospects
We still see steady, long-term growth in Indonesia’s poultry consumption driven by rising population, personal income, and urbanisation. In the short term, we expect next year’s election to boost consumption and offset weakening purchasing power due to the last fuel price hike. Maintain NEUTRAL on the sector.

Robust long-term prospects
We expect Indonesia’s poultry consumption to grow steadily by 10-15% annually, driven by growing population (~1.5%/year) and higher consumption per capita due to rising personal income and urbanisation. Indonesia’s consumption per capita is still low at around 6.2-8.6kg/capit,a compared with Thailand’s 13.5kg/capita and Malaysia’s 37.2kg/capita.

Expect normal growth in 2014
Next year, we expect the day-old-chick (DOC) segments of the poultry industry to grow at the normal 10-15% level. We expect the country’s 2014 election to boost consumption and offset the negative impact of weakening purchasing price due to the last fuel price hike.

Slightly lower margins next year
We see a slightly lower gross margin of 1% in 2014 as DOC and broiler prices are set to normalise from high levels this year. Meanwhile, we conservatively keep feed margin forecast flat for 2014.

Maintain NEUTRAL
We maintain our NEUTRAL call on the sector, as we expect the sector to perform in line with our JCI target performance. We upgrade Charoen Pokphand Indonesia (CPIN IJ) to BUY as the counter is currently trading at a 15.4x FY14 core P/E, providing a 14% discount to its IDR3,775 TP (17.4x FY14 core P/E).

Meanwhile, we keep our NEUTRAL recommendation on Japfa Comfeed Indonesia (JPFA IJ), with our IDR1,410 TP pegged to a 12.4x FY14 core P/E. Our Top Pick remains Malindo Feedmill (MAIN IJ), with a 26% upside to its IDR4,000 TP or 15.2x FY14 core P/E, backed by its above-industry growth potential, high profitability and more appealing valuation.

Abundant long-term prospects
Indonesia’s poultry industry still has ample room to grow as the consumption of broiler meat has picked up to around 6.2kg/capita (USDA data) to 8.6kg/capita (Indonesian Poultry Breeder Association/GPPU data), which are relatively low compared to Thailand’s 13.5kg/capita and Malaysia’s 37.2kg/capita.

We expect Indonesian poultry consumption to steadily grow by 10-15% per year, driven by increasing consumption per capita due to rising personal income and urbanisation as well as population growth of ~1.5%/year.

While overlooked as a driving factor, urbanisation plays an important role in bringing people closer to the distribution line, which is a crucial factor considering that Indonesia is a archipelago and lacks infrastructure. People who have moved to more developed area also tend to eat a wider variety of food including broiler meat.

Based on World Bank data, the number of people living in the urban areas grew by a 4.2% CAGR from 1970-2010. Meanwhile, the Central Intelligence Agency (CIA), on its fact book, estimates a 2.5% CAGR in the number of Indonesians living in the urban area from 2010-2015.

Real Estate (Neutral): Long-Term Growth Intact
We remain Neutral on the sector, with expectation of a moderate FY14F pre-sales growth of 12% y-o-y. We believe the rising interest rates and government’s regulation to curb credit growth will ease speculative buying and temper the rapid growth in house prices since the last three years. In the long term, we believe Indonesia’s emerging middle class should continue to support property growth.

Reining in property prices
We expect a moderate pre-sales growth of 12% y-o-y for FY14F, assuming a healthy price increase of 10% y-o-y at maximum. We believe the new mortgage regulation to raise the minimum down payment for additional property purchases in Indonesia should limit speculative buying, which will help rein in the rapid growth in housing prices since the past three years. We expect property demand to decline as buyers would prefer to hold more liquid assets amid economic uncertainties.

Middle class to underpin growth
We continue to favour developers targeting the middle class segment, as they still manage to record 100% take-up rates for new clusters post the new mortgage regulation, which results in lower potential demand of 2-3x supply (vs as high as 20x of all units launched prior to the new regulation). Properties financed through mortgage are also not substantial for middle and mid-upper segments. These should reflect the health of middle income’s purchasing power.

Long-term outlook remains attractive
We believe Indonesia’s property sector will remain attractive despite expectations of lower pre-sales growth and margin compression from higher labour and building material costs in FY14F. We think all property companies under our coverage are sufficiently resilient against a worsening operating environment, buoyed by sufficient liquidity, flexibility to conserve cash, and existing landbank reserves.

BSDE our Top Pick
Bumi Serpong Damai (BSDE IJ, BUY, FV: IDR2,400) is currently trading at a 67% discount to NAV at 12.5-10.7x FY14-15F P/Es, which is reasonable given its: i) abundant cash that gives it more flexibility to finance its current and future developments, ii) large landbank which mainly resides in greater Jakarta or outside Jakarta/Java areas, and iii) a growing recurring income.

Telecommunications (Neutral): Gaining Data Mileage
We rate the Indonesian telco sector a NEUTRAL for 2014 given the combination of: i) macro-economic/political headwinds, ii) earnings pressure from higher data opex/decelerating revenue growth, and iii) sustained capex spending. We are OVERWEIGHT on the ITC for their sturdy earnings prospects. A stock-picking strategy identifying companies with discernible price catalysts and a good execution track record is favoured. Telkom and TBIG are our Top Picks.

Mobile revenue likely to grow at single digit clip for 2014 on rational competition
We expect industry mobile revenue to grow by mid- to- high single digits in 2014 versus the projected 6-8% in 2013, mainly driven by the strong data revenue expansion from rising smartphone penetration (est. 18% of mobile base at end-2013) and benign competition. As with their regional peers, Indonesian telcos are witnessing rapid voice revenue erosion although the impact is mitigated by the ongoing price repair in the market, which we expect to continue into 2014.

Data priced too cheaply
Indonesia’s mobile operators continued to command one of the lowest data tariffs in the region on a per KB basis, making it difficult for them to monetise data despite the surge in data traffic. We expect falling price-points of smartphones to further stimulate data demand and improve the economics of data for the telcos, which should translate into better profitability in the longer term.

Capex to stay elevated
With the exception of XL, we expect the capex for Telkom/Telkomsel and Indosat (ISAT) to remain high in FY14, with the focus on 3G investments. XL has guided for a moderation in FY14 capex due to savings from the combined network with Axis.

M&As to shift into higher gear
The merger between XL and Axis has set a new benchmark for further M&As in the sector. We view the consolidation in the industry as positive and inevitable in reducing competitive risks and in weeding out smaller operators which lack the financial and spectrum resources to compete on a larger scale.

NEUTRAL on telcos, OVERWEIGHT on ITC
The local macro-economic (slowing consumer sentiment) and political headwinds (presidential elections) will likely damp market sentiment in 2014, with telco stocks likely to perform in line with the JCI at best on the back of their defensive earnings profile. We are OVERWEIGHT on the independent tower companies (ITC) due to their stronger growth prospects, with healthy tower growth indicating telcos’ strong appetite for towers. The mobile operators are still ramping up the number of 3G node- Bs as smartphone penetration continues to rise.

Tobacco (Overweight): Election To Light Up 2014 Outlook
We believe the cigarette sector will benefit from rising consumer spending during next year’s election. Historical data suggests that excise duty purchase and national production growth are robust during election periods. This should bode well for GGRM and WIIM. Our Top Pick is GGRM for its strong market position and signs of recovery. GGRM, which has underperformed the market by 28% YTD, is trading at a 30% discount to its 3-year historical forward P/E.

Strong growth during historical election periods
Based on excise duty purchase volume from 2002-2012, cigarette volume recorded the fastest growth during the election periods in 2004 (+10.1% y-o-y) and 2009 (14.2% y-o-y). This was mainly spurred by the growth in machine rolled cigarettes (SKM) excise duty purchase, which increased by 14.9%/18.2% y-o-y in 2004/2009 respectively.

By contrast, excise duty purchase growth in non-election years was in the range of -3.0% to 7.7% y-o-y (see Figure 1). The strong excise duty purchase growth during the election period is typically correlated with strong national production growth (see Figure 2). Therefore, we believe the upcoming election in 1H14 will boost industry cigarette sales in 2014-15 as government pump priming activities are expected to boost cigarette consumption.

Strong SKM exposure to benefit from election
We see that companies with strong exposure to SKM products especially in the mild product segment will benefit the most from the election boost as demand for SKM products typically grows faster than that of other cigarette types. Wismilak Inti Makmur (WIIM, BUY, TP: IDR1,000)’s 9M13 SKM revenue accounted for ~86% of its cigarette revenue, while Gudang Garam (GGRM, BUY, TP: IDR46,500)’s 9M13 SKM revenue made up 90% of its total cigarette revenue.

It is worth noting that GGRM’s 9M13 sales volume growth for the mild segment outpaced that of the industry (GGRM: +33% y-o-y; industry: +5.3% y-o-y). We expect GGRM and WIIM to book 2014-15 aggregate revenue growth of 13.1% and 11.4% y-o-y respectively.

Solid fundamentals; good entry point
We like GGRM for its strong position in the industry and signs of recovery. GGRM is trading at a 30% discount to its 3-year historical forward P/E. Meanwhile, we like WIIM’s strong business growth from its low base position. We note that there is a mispricing in the market against both companies’ solid fundamentals.