Steel Pipe Industry Indonesia’s Ace In Steel Pipes

We initiate coverage on Spindo with a DCF-derived TP of IDR370 which represents a 100% potential return upside and recommend a BUY. Our TP implies a 7.0x FY15F earnings. Main triggers: i) its dominance in the domestic steel pipe market with a 30% share; ii) the company being a beneficiary of the nation’s growing gas infrastructure and construction sectors as well as rising local content in the automotive sector; and iii) appealing 3.5x FY15F P/E, with 16% ROAE and PEG of 0.1x.

Strong brand with big market presence
Steel Pipe Industry (Spindo) is the domestic leader with around 30% share of the steel pipe market, catering primarily to the construction and infrastructure related, oil and gas (O&G) and automotive industries.

Main beneficiary of growth in nation’s gas infrastructure
We expect the numerous gas pipe projects to propel overall pipe sales volume by 13-20% in 2014-15, driven by anticipated strong demand from big gas pipe players like Perusahaan Gas Negara (PGAS IJ, BUY, TP: IDR6,600) and Pertamina Gas (Pertagas). Spindo stands to gain a bigger slice of the market now that the number of players has dropped to three from five.

Proxy to growing infrastructure/construction and automotive sectors
Demand for construction and infrastructure pipes will be supported by the execution of Indonesia’s 15-year Economic Masterplan (MP3EI). Recent investments pouring into the auto parts industry and rising requirements for local content should boost Spindo’s automotive pipe sales volume by 15%-20% annually in 2014-2015. We expect the company to be on solid footing to meet rising orders from these industries.

Earnings jump on volume, margin expansion
We expect Spindo’s net profit to spike 30%/45% for 2014-15 on the back of: i) a better product mix of higher-margin pipes (ie O&G and automotive), ii) increasing productivity and efficiency from new machinery and improvements in existing production lines, and iii) economies of scale.

DCF-based TP of IDR370 implies a 7.0x 2015F P/E
Note that Spindo is trading at a 80% discount to the construction sector (>50% exposure to construction segment), based on the stock’s current 2015 P/E. Key risks: i) fluctuations in raw material cost, ii) volatility in USD/IDR, and iii) project delays.

Investment Thesis
Summary of valuation and target price
Initiate coverage with BUY. We initiate our coverage on Spindo with a 5-year DCF-based TP of IDR370, using a 11.8% WACC and 5% long-term growth rate assumptions. This implies 7.0x FY15F earnings, at a 59.2% discount to the construction sector’s 2015 P/E valuation. This valuation offers a 100% upside potential from the current share price.

Hefty discount to regional peers and construction sector
We think that the gap between Spindo’s current valuation and its regional peers steel pipe players’ should not be as wide as it is now (refer to Figure 43) given that these peers possess lower profitability on average – lower margins and ROAE levels. Furthermore, given the group’s mix of recurring and project-based income, as well as its high exposure to the construction and infrastructure industries, we think that Spindo’s current 76.1% and 79.6% discounts to the construction sector P/Es of 21.1x – 17.1x for 2014-15 should be narrower.

Despite Spindo’s thin liquidity and small market capitalisation, we see the stock as being undervalued. The company is a good investment catch in the small-cap landscape.

Investment summary
A dominant steel pipe player on strong growth mode. With Spindo having a dominant position in the nation’s steel pipe industry (~30% domestic market share) within various growing sectors, we expect its net income to surge 29.5%/44.5% in FY14F/15F. This solid performance should be supported by strong sales volume growth and margin expansion. Margins would widen on the back of: i) a mix comprising a higher portion of oil and gas (O&G) and automotive pipes, ii) increasing productivity and efficiency from the use of new machinery and improvement in existing production lines, and iii) higher economies of scale.

Rising portion of O&G pipes supports margins. We see revenue contribution from O&G pipes increasing to 15.7% and 18.6% in FY14-15F from 14.8% in FY13. Notably, O&G pipes fetch gross profit margins of ~30.0%, higher than Spindo’s 1H14 blended gross margin of 15.9%. The group is building a new plant in Gresik, Java, to produce electrical resistance welded (ERW) straight wielded pipes of wider diameters to cater to the needs of offshore O&G projects. Up to now, the shortage of domestic wide diameter ERW pipes has been partly met by imported goods. Note that the number of O&G pipe makers in Indonesia has declined to three from five as the licence of one company was recently suspended while another had its licence cancelled.

Higher volume from automotive pipe sales. We project stronger sale of pipes to automotive parts companies in view of: i) increased investments in automotive companies, and ii) interest in low cost green cars (LCGC) that require a high proportion of local components. Spindo plans to more than double capacity at its automotive pipes plants to meet rising demand. This expansion will also involve ramping up capacity to manufacture thick small pipes for 4-wheel (4W) vehicles, thus fetching higher profit margins than the group’s current automotive pipes, mostly for 2Ws.

MP3EI supports construction and infrastructure pipe demand. In May 2011, the Indonesian Government launched its 15-year MP3EI focusing on infrastructure developments from 2010-2025. These infrastructure projects will require a minimum USD187bn in investments on roads, ports, as well as power and energy. A large number of pipes will be needed as bridges and ports require foundation piles, while power and energy infrastructure need machinery pipes, etc. It is worth noting that Spindo booked 23.6% 3-years CAGR to 2013 for its sales volume to the construction segment.

Achieving cost efficiency as economies of scale rise. We believe that a higher production volume would give Spindo greater bargaining power in pricing when it comes to buying steel. In the long run, it also plans to restructure the production lines at its first plant in Rungkut, Surabaya (~33.0% of Spindo’s total production capacity). Improving its production lines would boost the plant’s production efficiency.

Business Overview
Making pipes for various industries
Spindo mainly produces wielded steel pipes for a variety of usage. It utilises hot rolled coils, cold rolled coils and stainless steel as its main raw materials. Below are the list of pipe products it manufactures, categorised by: i) wielding method, ii) product type, and iii) user industries.

Besides the products illustrated above, Spindo also sells steel plates and provides several value-added services, including galvanising, epoxy coating, 3-layer polyethylene coating, and cement lining.

Margins vary across industry segments. The construction sector is Spindo’s main revenue contributor (see Figures 3 & 4), but we expect higher contribution from the O&G sector in the near term, driven by upcoming major gas pipeline projects. O&G pipes play an important role as their gross profit margin (GPM) is the highest – at around 30.0%. In comparison, the GPM of pipes used in the construction, automotive, furniture industries and others is about 19.0%, 22.0%, 15.0% and 5.0% respectively. Note that these margins are only approximations to show the relative differences between the products, and actual margins may vary depending on product specifications.

Mix of recurring and project based pipe demand
Around 60.0% of Spindo’s revenue is from recurring sources and the rest is based on projects. The actual amount will vary from time to time, depending on project availability. We can roughly say that the majority of the company’s O&G-related revenue is project-based while sales to the furniture and automotive industries are recurring. Sales to the construction sector is from a mix of recurring (~one-third) and project-based (~two-thirds). Almost all of Spindo’s revenue is generated from the domestic market.

Industry Overview
It is estimated that the domestic consumption of pipes across the board exceeds 1m tonnes per year, with domestic production at around 600,000-700,000 tonnes. The rest is made up of imports. Since 2012, the import portion has risen quite significantly given that domestic producers were unable to meet the strong domestic demand for steel pipes. Meanwhile, we see a correlation between the import portion and the USD/IDR appreciation/depreciation. When the IDR appreciates against USD, the domestic players can to an extent charge prices that are more competitive than imported products’, and it is vice-versa when the IDR falls.

Brand recognition crucial in a saturated market
We understand that the steel pipe industry is a somewhat saturated market and is subject to fluctuations in steel/commodity prices, but we found from our channel checks that brand recognition does hold sway for some pipe customers. Given that Spindo’s products are recognised for their consistency in quality, we believe the company is capable of competing with both local and international products.

Note that the bulk of domestic production is made up of cheap, non-standard, low-grade pipes, while the group’s main products are standard pipes of high quality as well as certification or standardisation. Also, even in the non-standard segment, Spindo focuses on the higher-grade parts – a strategy reduces its exposure to the price wars that may occur among other pipes players. All said, there is limited domestic supply of straight wielded O&G pipes of large diameters.

Industry actual capacity fulfillment constrained by working capital
Note that while the annual domestic production capacity of steel pipes is theoretically around 2m tonnes, actual capacity is constrained by working capital needs. This indicates that the availability of short financing is extremely important. Considering that this problem has persisted for several years, we believe that the industry’s perceived over-capacity may not translate into actual production capacity.

In contrast, Spindo has bucked the trend by being able to post 76.5% capacity utilisation in 2013 compared with the 55.0%-70.8% levels from 2009 to 2012 – nearly reaching its actual maximum utilisation of 85% based on number of working hours.

Automotive pipes
There are only three domestic players in this segment – Spindo, PT Indonesia Steel Tube Works (ISTW) and PT Srirejeki Perdana Steel. The group’s sales from the automotive industry comprises mainly motorcycle frames and components (note that one motorcycle usually uses 10-12kg of steel pipes), bus frames and mechanical usage for 4W vehicles (eg seat frames, door impact beams, dashboard frames and machinery parts).

Sells automotive pipes to big names
Spindo sells directly to automotive manufacturers as well as to automotive parts (auto parts) makers. It is worth noting that all the big 2-wheel (2W) names, including Honda, Yamaha, Kawasaki, and Suzuki, as well as top six Japanese 4W producers (ie Toyota, Daihatsu, Suzuki, Honda, Nissan and Mitsubishi) are among the users of the group’s products. Its ability to cater to the just-in-time requirements of such auto parts manufacturers also proves its operating excellence.

Automotive segment hungry for pipes
In the meantime, additional demand is coming from the rising foreign investments in Indonesia’s auto parts and automotive manufacturing industries. This not only adds new capacity but also partly shifts the sourcing of parts to local sources vs from abroad. This is in line with the Government’s intention of increasing local content.

It is worth noting that Toyota plans to ramp up capacity to 230k units by this year (+91.% y-o-y), Honda to 180k units by 2014 (+50% y-o-y) while Daihatsu aims to triple its production capacity to 430k units/year.

Meanwhile, the planned expansion at Spindo’s Karawang, Java, plant includes a line to produce an array of new products with small diameters but high thickness that fetch margins that are higher than that from existing automotive pipes. Thus, even though Indonesia’s 2W and 4W vehicle sales may be impacted by higher interest rates and waning purchasing power, we still expect automotive pipe sales volume to grow to 40k tonnes in 2014 (+15.0% y-o-y) and 48k tonnes in 2015 (+20.0% y-o-y). The group’s automotive pipes are competitively priced vis-à-vis imported parts.

Oil & gas pipes
Spindo produces American Petroleum Institution (API)-certified black and spiral pipes. The straight wielded black pipes are used in onshore and offshore projects while the spiral pipes are only for onshore projects. The group plans to expand its production facility to make high-diameter black pipes (>8-inch) to meet demand from the offshore O&G segment.

Less intense competition in O&G pipe segment
The requirement for API certification is itself a barrier to entry to the O&G pipes segment. In 2012, there were five domestic producers, namely: i) Spindo, ii) PT Bakrie Pipe Industries, iii) PT Indal Steel Pipe, which is part of the Maspion group, iv) KHI Pipe Industries, a subsidiary of Krakatau Steel (KRAS IJ, NR), and v) PT Bumi Kaya Steel, which usually participates in large scale projects as part of a consortium).

However, Indal’s API certification has been annulled while Bumi Kaya’s has been suspended. This leaves only three players in the industry that can now battle to carve out a larger pie in the O&G steel pipes market.

Indonesia moving to gas
Over the near-, medium- and long-term, we believe that there will be abundant O&G projects since the Government plans to construct a gas transmission pipeline between East and West Java. In the longer term, it also expects to extend a similar pipeline to the eastern part of Indonesia, between the Kalimantan and Sulawesi islands.

We are of the view that these projects are necessary since the Government is switching to gas, given that it is a relatively cheaper and cleaner form of energy compared with oil. Meanwhile, Indonesia has become a huge net importer of oil, and these imports have weighed on the country’s current account and resulted in nation’s state budget falling into deficit.

Currently, the national gas pipeline stretches over 12,000km, only 19.7% of the national masterplan’s target of 61,000km by 2025. This opens up an abundance of opportunities for Spindo to secure O&G pipe projects in the long run. Given the favourable competitive landscape, the company’s expansion plans as well as the major projects in the pipeline, we expect Spindo’s O&G sales volume to reach 33k tonnes in 2014 (+20.0% y-o-y) and 48k tonnes in 2014 (+45.0% y-o-y).

Construction pipes
Spindo brand well-known in construction pipe segment
The group’s Spindo brand puts it in a solid position in the construction steel pipe market, to which it sells its products through various channels, including direct sales to the end-user, and sales through contractors, distributors and agents. Its closest rivals in this segment are Bakrie Pipe, which makes building products, and KHI Pipe, which sells piling products.

Wide product range for construction industry
The group’s products used in the construction of infrastructure and buildings include, but are not limited to, scaffolding, jetty pilings, ceiling frames, dome frames, hydrants, electricity distribution and telecommunication cable poles, water distribution, power plant machinery and fencing.

High-rise buildings, hospitals, schools, airports, jetties and ports are all examples of building types that use these products. This segment has received a substantial boost from infrastructure developments under the MP3EI, which include power plants, bridges, and airports and ports. In addition, there is also a rising trend whereby companies are constructing their own private jetties.

Strong after-sales service a big plus
We expect Spindo’s construction sector sales volume to jump to 196k tonnes in 2014 (+10.0% y-o-y) and 232k tonnes in 2015 (+18.0% y-o-y). Note that although its construction pipes are priced at a premium to imported pipes, they come with a quality assurance, and the company also provides easily available after-sales services to its customers.

Raw materials and inventory dynamics
Relying on multiple suppliers
Spindo sources its steel from several suppliers. The nature of the industry is such that big domestic players keep relatively high inventory considering the: i) local suppliers’ capacity limitations and order execution risks, ii) inconsistency in time taken to transport imported raw materials, and iii) the frequency of sudden orders from construction clients requiring short delivery times.

Fluctuating steel price and the dynamics of margins
Rising steel prices give rise to opportunities for Spindo to generate higher margins in the short term. Higher raw material prices will influence Krakatau Steel (KS) to raise its selling prices, which are used as the benchmark in the domestic steel-based market. This also gives Spindo – which keeps 3-months’ inventory – room to raise its selling prices while still using the existing inventory sourced at lower prices. However, the opposite happens when raw material prices decline.

Higher exposure to local raw materials
Spindo purchased raw materials from KS in 1H14 given the latter’s better delivery time and cheaper prices since its JV with Posco. This should slightly minimise Spindo’s foreign exchange risk exposure given that the company mainly purchases raw materials from KS in IDR and over a short distance.

This temporary positive correlation between margins and raw material prices was clearly seen in 2008-2009, when prices escalated in 2008 and took a dive in the following year. In 2010, gross margins returned to normal as raw material prices stabilised (see Figure 21).
In recent years, with the global steel oversupply creating range-bound prices, the impact of quarterly fluctuations in raw material prices has been minimised on an annual basis. Nonetheless, fluctuating prices still have an impact on margins, along with changes in the product mix, as was the case in 2011-2013.

The speed at which selling prices are adjusted in response to changes in raw material prices varies depending on market segments. Margins for O&G projects depend more on product specifications, as pricing and raw material sourcing are usually finalised at the beginning of the project, thus subsequent changes in raw material prices will not affect margins. Spindo does not keep inventory in the O&G segment, given the varying demand. Similarly, the automotive industry also has a price scheme, with selling prices based on raw material costs.

In the construction industry, Spindo typically sells to: i) distributors with short-term projects – for which prices are easily adjusted, and ii) industry users with longer-term projects – for which prices are usually agreed upfront. Nevertheless, note that the longest upfront order is only up to around 3-4 months, which is the same as the inventory period for raw materials.

Forex fluctuations also affect margins in the same way as changes in raw material prices, with the additional effect of forex gains or losses. On the cost side, purchases from foreign sources are directly affected by the USD exchange rate, while purchases from domestic sources are also indirectly affected, as suppliers typically adjust their selling prices based on the USD-IDR rate.

Additional forex risk from using 4-6 months USD L/C facilities
Spindo is usually able to adjust its selling prices to account for changes in raw material costs. However, considering that the majority of its imports use 4-6 months USD letter of credit facilities, the group bears additional forex risk. To cover this risk, it needs to tweak its selling prices on anticipated future USD rates.

On the sales side, the price adjustment pace is similar to that of changing raw material prices. The only difference is that there is a natural hedge for O&G pipe sales, which are mostly denominated in USD.

Strategic expansion plans
2014/2015 production capacity may shoot up 22.4%/30.6%. Spindo’s strategic expansion plan to capture new markets – while continuing to serve its growing existing ones – may result in its capacity more than doubling over the next three years. There is urgency for such an expansion, given the group’s current high average utilisation rate (70.0% vs the actual maximum utilisation of ~85%). We expect Spindo’s production capacity to spike by 22.4% in 2014 and 30.6% in 2015, mainly from ERW steel pipe expansion in Gresik, Karawang and Sidoarjo.

Spindo’s capacity expansion plans are as follows:
i. The group will build a new plant in Gresik with two production lines that can manufacture 12-inch ERW straight wielded pipes and >20-inch ERW straight wielded pipes to cater to the O&G sector. Until now, domestic shortages of large-diameter ERW pipes have been filled by imports. Spindo currently only produces straight wielded ERW pipes of up to eight inches in diameter. It also plans to capitalise on the absence of supply from rivals such as Indal and Bumi Kaya amid upcoming major O&G projects, by building a 8,000 tonnes/month plant to produce 4-10 inch pipes by 2015. Note that the O&G pipe production facility can also be used to meet demand for construction pipes.

ii. Spindo is increasing the capacity at its Karawang plant to meet surging local automotive pipes demand spurred by recent investments in the automotive and auto parts industries. The expansion includes ramping up production capacity of thick small pipes to serve 4W vehicle needs – a new market for the group. In 3Q14, Spindo will install additonal 4,700 tonnes/month machine capacity to bring its Karawang plant capacity to 7,900 tonnes/month (+146.9% y-o-y) from 3,200 tonnes/month. The second machine will come in 1H15, with additional capacity of 4,900 tonnes/month. This will bring the Karawang plant’s total capacity to 12,800 tonnes/month by end-2015.

iii. Spindo started commercialising its Sidoarjo operations in April 2014 with an intial running capacity of 1,500 tonnes/month, before gradually ramping up to its capacity target of 3,000-3,500 tonnes/month.

Capacity expansion could also improve productivity and efficiency. Besides adding capacity, the expansion and improvements at its various plants are expected to increase productivity and efficiency. For instance:
i. Better plant layout to reduce unnecessary movement of goods and increase production speed. Spindo’s first and second plants started out small and grew increasingly larger, which resulted in non-optimal production layouts. Some production lines at these two plants will be moved to the group’s new Sidoarjo plant, thus freeing up space for the optimisation of floor space.
ii. Lower wastage. Eg a larger slitting machine will be able to handle heavier steel coils, resulting in less welding and wastage.
iii. Reducing setting time. With more production lines, each production line will work on fewer variations, which will lead into less downtime when changing settings.
iv. Efficient per unit labour cost. Despite its various expansion plans, Spindo intends to cut down hiring by optimising its existing workforce, given that the improved layouts and newer technologies will lower the number of labour needed to handle the same number of production lines.

Strives to improve distribution channels
Management also aims to improve the group’s distribution channels, including building its own distribution and warehouse centre in Tangerang, Java, to better serve the Jakarta market, as well as to boost the performance of its Makassar distributor.

In addition, management sees the possibility of having its own distribution channels in Manado, Sulawesi, and Sorong, Irian Jaya. Spindo expects an improvement in its distribution channels to bring it closer to its customers in order to enhance its brand and quality awareness – especially in the non-project construction segment. This is part of management’s strategy to shift customer preference towards its better-quality, locally-manufactured pipes from cheaper, lower-grade imports. In the long run, Spindo intends to seek opportunities in the export market.

Financial forecasts
We expect FY14F/15F revenue to grow 13.0%/21.7%, driven by revenue growth of: i) 10.0%/18.0% for construction and infrastructure pipes, ii) 20.0%/44.0% for O&G pipes, iii) 15.0%/15.0% for furniture pipes, iv) 15.0%/20.0% for automotive pipes, and v) 15.0%/15.0% for others.
We also expect FY14F/15F gross margins to widen to 18.4%/18.9% (from 17.1% in FY13), on the back of: i) a better product mix comprising a larger portion of O&G pipes sales, and ii) higher economies of scale and production line improvements. Its expansion plans will result in Spindo’s net gearing rising to 0.8x at end-FY14 and 0.9x at end-FY15F. The table below shows our operational assumptions.

1H14 results review
1H14 net income accounts for 49% of our FY14 target
Spindo recorded a 1H14 net income of IDR128bn (-7.3% y-o-y), accounting for 49.0% of our FY14F forecast. Going forward, we expect a stronger 2H14 net profit, driven by higher sales volume and a higher blended margin mix. Moreover, 2H is seasonally busier due to the rollout of construction projects.

Spindo’s 2Q14 net profit dropped 51.1% q-o-q, despite its gross profit ticking up 4.6% q-o-q on higher gross margin (17.5% in 2Q14 vs 14.6% in 1Q14). The q-o-q net profit decline was due to higher opex and a forex loss vs a forex gain in 1Q14.

Valuation
Intitiate coverage with BUY and DCF-based TP of IDR370
We use a weighted average cost of capital (WACC) of 11.6% and a long-term growth rate of 5% to derive our DCF-based TP of IDR370. Our TP implies a 7.0x 2015 P/E, which is still at a 59% discount to construction companies’ average 17.1x 2015 P/E.

Peer comparison
Fundamentally speaking, despite Spindo’s lack of liquidity in the market, we think that the company’s valuation discount to its regional peers should not be that wide (see Figure 44) as its regional peers have lower profitability on average (in terms of margins and ROAE levels).

In view of Spindo’s revenue mix comprising a combination of recurring income and project-based income – which creates some cyclicality – as well as its high exposure to the construction sector, we think the stock’s current 5.0x-3.5x 2014-2015F P/Es should not be at the steep 76.1% and 79.6% discounts to the construction sector’s 21.1x-17.1x 2014-2015F P/Es.

Key Risks
The key risks are: i) fluctuations in raw material cost, ii) volatility in USD/IDR, and iii) project delays.
Fluctuations in raw material cost. Since the company is highly dependent on raw materials for production, it is subject to fluctuations in raw material prices. This creates short-term uncertainty in terms of margin visibility.

Volatility in USD/IDR
Spindo obtains its raw material from imports denominated in USD and also source it locally in IDR. Its imports involve 4 to 6-month L/C facilities while most of its sales are transacted in IDR, except that from its O&G segment. Hence, a depreciation in the IDR vs USD may give rise to a foreign exchange loss in the company’s P&L.

Project delays
There are risks relating to funding of Spindo’s expansion. The company must take into consideration its future cash flow and the pay-back period before investing in large projects.