Chandra Asri the Largest Chemical Player in Indonesia

Synergy from the merger
Chandra Asri Petrochemical (TPIA), which was recently formed early this year through a merger between Chandra Asri and Tri Polyta Indonesia, has become the largest integrated olefins and poly olefins producer in Indonesia, providing a distinctive edge by possessing the only naphtha cracker in Indonesia with an integrated set of downstream-chain values.

Market leader in the chemical play
TPIA is a market leader in the domestic petrochemical industry with 55% market supply of share of ethylene, 40% for polypropylene, 40% for polyethylene, and 100% for styrene monomer. Most of TPIA product lines are sold to the domestic market and has limited production capacity leaving domestic downstream players importing their raw materials. Thus, we believe TPIA has a strong captive demand.

TPIA is in mode of capacity & debottlenecking expansion as to fulfill domestic demand and reducing downstream players’ dependencies on imported raw materials. We believe this is a good strategy to achieve economies of scale and to prepare its ammunitions for the petrochemical up cycle trend to its peak in 2015.

Strong infrastructure to serve robust demand
Indonesia provides a strong platform to TPIA’s accessibility to capture the domestic demand given the country’s strong GDP growth, rising middle income and low level of polyolefin consumption per capita compared to average South East Asia countries. We believe TPIA plays a dominant role in serving the booming consumer sector. Alluring to the mentioned fact, TPIA is set with a strong infrastructure platform such as adjacent location to its customers and Central Business District, Jakarta and provides an integrated operation pipeline.

Solid earnings growth and improving balance sheet going forward
We expect 35% CAGR 2011-12 earnings mainly supported by strong demand and selling price, translating to an operating margin improvement from 5% and 6% in 2011-12, before reaching 7% in 2013. Significant earnings jump will occur in 2015, which is in line with the petrochemical cycle peak.

In general, we perceive the balance sheet to be healthy due to relatively low debt level, bringing its net gearing of no more than 23% from 2011-2015. Despite this, cash to total asset is currently only around 9-12%, yet we do expect earnings to further gradually improve which will pick up ROE from 11% in 2011 to its peak level of 33% in 2015.

Solid fundamentals should be valued at a premium
We derive our target price of IDR4,250 with a BUY call based on our target PE of 16x 2012 PE. We believe our relatively premium target PE is justified and still has possibilities for an upward re-rating given TPIA’s solid fundamentals and promising outlook going forward. Furthermore, we have provided investors an attractive DCF valuation deriving at a target price of IDR6,974. However, we choose not to use DCF valuation to derive our target price given current negative free cash flow to support capex for expansion.

Chandra Asri Petrochemical holding a predominant position in Indonesia
As mentioned previously, Chandra Asri Petrochemical (TPIA) holds a predominant role in Indonesia petrochemical industry given its position as an integrated up-stream to down-stream petrochemical business in the full picture of the chain analysis. Given its exposure to the downstream level, TPIA is Indonesia’s leading petrochemical producer.

TPIA’s exposure in the petrochemical industry is distinctive among other players listed in JCI given its recognition as the largest integrated olefin and polyolefin producer in Indonesia and is the only naphtha cracker in Indonesia. TPIA is currently the market leader in the domestic petrochemical industry with 55% market supply share of ethylene, 40% for polypropylene, 40% for polyethylene and 100% market share for styrene monomer.

Possession of market share
TPIA posses a large pie of market share in the ethylene (55%), polypropylene (40%), polyethylene (40%) and styrene monomer business (100%). While the import market for ethylene (45%), polypropylene (53%), polyethylene (35%) is quite large. From this we see that Indonesia is structurally deficient as it relies heavily on imported products. We believe there would be a captive market for TPIA as soon as its expansion projects for its ethylene & polyethylene business are commenced. TPIA’s domestic exposure is moderately high for its main businesses such as ethylene (79%), polyethylene (94%), polypropylene (100%), propylene (98%) and styrene monomer (67%). This indicates that TPIA is an interesting proxy to the consumer sector.

Expansion as to capture the momentum
Most of TPIA product lines are sold to the domestic market given limited production capacity leaving most downstream players import their raw materials. However, TPIA is in mode of capacity expansion & debottlenecking as to fulfill domestic demand and reducing downstream players’ dependencies on imported raw materials. This is in line with TPIA’s expansion as to prepare for capturing the up cycle moment in the long-term. Inspite of TPIA’s strong secured polyolefin demand, Industry source Nexant, believes that Indonesia would still rely on imports over the period 2011-17.

STRONG SYNERGY FROM THE MERGER

Pre-merger, Chandra Asri was Tri Polyta’s propylene supplier for Tri Polyta’s polypropylene business. Post-merger, both of the companies are consolidated into one company, which enhances synergies between them. The merger of the two companies is named Chandra Asri Petrochemical (TPIA). We believe strong synergy will emerge from the merger as the company will: 1.) Achieve further down-stream integration, 2.) Increase customer diversification.

Further downstream integration
The benefit of TPIA having further down-stream integration is that the polypropylene business has strong demand with resilient outlook (5.5% CAGR 2011-2017). Secondly, TPIA would provide secured supply of propylene for polypropylene produced.

Customer diversification enhancement
TPIA has an expanded customer base with its merger to the polypropylene business which leads to a widespread customer concentration and increase opportunities for cross-selling with combined sales force.

BUSINESS FLOW & OUTLOOK

TPIA is the only company in possession of naphtha cracker in Indonesia, coupled with strong up-downstream integration. The 1,700k tonnes/annum naphtha cracker capacity is further processed into down-stream integrations with several varieties of naphtha capacity for different usages. The 1,700k tonnes/annum capacity naphtha cracker is set to be used several key products such as ethylene (600k tonnes of naphtha/year), propylene (320k tonnes of naphtha/year), Pygas (280k tonnes of naphtha/year) and Crude C4 (220k tonnes of naphtha/year).

Ethylene and propylene are considered as olefin base chemicals
TPIA is able to further process olefins (ethylene and propylene) into further down-stream to polyolefins (polyethylene and poly propylene) and styrene monomer. Its ethylene product (600k tonnes capacity of naphtha/year) is further processed into further down-stream which are polyethylene (300k tonnes of naphtha/year) and styrene monomer (100k tonnes of naphtha/year).

Polyethylene and Styrene monomer are mainly sold to the domestic market. The remaining 200k tonnes of naphtha are raw ethylene products are sold directly to domestic industrial customers. The company projects a capacity expansion in the polyethylene business in 2014 from the current capacity of 337k tonnes/year to 532k tonnes/year.

Pre-merger, Chandra Asri (CA) was a propylene supplier to Tri Polyta Indonesia (TPI), and then TPI processed the propylene to polypropylene. However, post-merger, the propylene-polypropylene has been fully integrated. Propylene with a naphtha capacity of 320k tonnes/ year is directly processed into polypropylene, and then sold to the domestic market.

TPIA’s Pygas and Crude C4 production are directly sold mostly to Asia customers.

Strong infrastructure platform
TPIA’s production facilities are located in Cilegon, Java, just a 2-3 hour drive from Central Jakarta. Furthermore, TPIA provides easy access to its customers by providing direct pipelines which are connected through its production facilities. TPIA posses a pipeline which connects its production facilities, tank farms and jetty facilities. This provides TPIA with a distinctive edge in terms of cost efficiencies and shorter delivery time.

Alluring to the mentioned fact, this would provide an incentive for local producers to purchase its supplies to TPIA as it is cheaper (no shipment cost) and much more convenient compared to importing. With an adjacent location to its customers, this will make the deliveries much more reliable.

FINANCIAL OUTLOOK – Monetizing The Economic Scale

Strong sales growth
We believe TPIA will book a 13.9% CAGR 2010-13 consolidated revenue mainly derived from revenue contribution of its polyethylene business (21%-24%) and polypropylene business (31%-33%). We expect a strong sales growth and an increase in gross margin level in 2014-15 supported by strong sales volume and asp, which is in line with the industry’s cyclical peak.

Sales volume growth attractive
A naphtha expansion means expansion to TPIA’s olefin, Pygas and Crude C-4 business. TPIA’s production expansion will start running mostly on 2014-15, in line with the company’s strategy to capture the momentum of the petrochemical industry’s up-cycle.

We see ethylene sales volume of 199 k tonnes/year to be stable in the upcoming years until 2014, however we do expect a significant sales jump in 2015 to 299k tonnes/year (+50% y-o-y) due to its capacity expansion. We believe TPIA would have a captive demand amid capacity expansion thanks to the current industry’s deficiencies of relying mostly on imports due to limited domestic supply.

TPIA’s polyethylene business has high demand going forward, thus we assume its production plant would sustain its full capacity utilization for 2 years before a new capacity expansion in 2014 which would bring utilization rate to drop to around 80%. However, we believe TPIA would be able to start running in full capacity again of around 532k tonnes/year in 2015.

We expect a gradual increase in styrene monomer demand as to capture full utilization rate going forward. Note that there is no production expansion plans for styrene monomer. We expect Py-gas production capacity expansion to 413k tonnes/year from 280k tonnes/year will start to operate in 2015. As for Crude C-4, a production capacity expansion to 364k tonnes/year will start commencing in 2015 from 220k tonnes/year.

Economic of scale matters
We believe operating margin to improve gradually going forward from 5% in 2011 to 8% in 2014, before a gradual margin improvement to 16% in 2015. We believe it is consistent margin improvement going forward strong lies on the basis of economic of scale.

Utilization rate
TPIA has a large captive market regardless of post-expansion, directly this brings a positive impact to the company in utilizing its plants. TPIA has high utilization rates for its ethylene, polyethylene and polypropylene businesses ranging of some more than 80% since 2005. Ongoing years, TPIA has been able to improve its utilization rates given strong demand from its customers. Even in 2010, three of the businesses mentioned has utilization rate above 94% except for certain years due to maintenance purposes.

Pre-2010, styrene monomer utilization rate is relatively lower compared to TPIA’s other business units. However, we have seen historical gradual improvements from 57% in 2007 to 76% in 2010. We expect a higher utilization rate for its styrene monomer business going forward. We believe with TPIA’s utilization rate will increase going forward supported by strong demand.

Capex plan
TPIA plans to allocate USD112m, USD249 and USD175m for 2011-12-13 capex respectively. Most of capex allocation will be allocated for debottlenecking and expansion. We assume a declining capex from its peak in 2012 amounting to USD249m under the assumption of budget needed for capacity expansion as to capture up cycle momentum.

VALUATION

Attractive valuation even in high PER
We derive our target price at IDR4,250, implying a 16x 2012 target PE, which align with market target PE but at a premium to the peers. We think the high valuation is worthy considering the unique position of TPIA as the only direct benefactor of both of 1) upward margin cycle in the global industry position and 2) Indonesian strong domestic trend which will be monetized in near-mid future and will result in higher profitability and stronger balance sheet. In term of PBV, currently TPIA is trading at 1.3x and 1.2x 2011-12 P/BV, which is a 28% and 25% discount to its regional peers.

Attractive DCF valuation showing a bargain
Based on our DCF valuation, fair value of the company is at IDR6,974, providing a huge potential upside of 121% which is more than double. However we use the DCF only for comparison purpose as the fair value is mainly derived by TPIA’s long-term positive earnings view which may pose an execution risk as how we believe general investors would perceive.

INVESTMENT RISK
1. Volatility risk. The volatile cycle of the petrochemical industry may affect TPIA’s profitability. According to our sensitivity analysis, a USD100/tonne decline in TPIA’s polypropylene business (the highest revenue contribution of some 30%) could affect TPIA’s bottom line margin from a net margin of 2.9% to 1.6%.

2. Raw material cost hike. TPIA still imports its naphtha raw materials which we believe is a risk as it has a contagious effect TPIA’s other businesses due to the fact that all of its chemical products rely on naphtha as a source of raw material. According to our sensitivity model, a 3% increase in naphtha cost will have a 47%, 37% and 28% decline for our 2011-12-13 bottom line respectively. We view a lesser impact on naphtha will incur further on given hikes on selling price.

3. Competition threat. Several foreign investors planning to invest a chemical plant in Indonesia is perceived as a threat to TPIA. Medias highlighted that Lotte Group, a conglomerate company based in South Korea, plans to invest USD5bn in Indonesia through its subsidiary Honam Petrochemical Group. Honam Petrochemical group acquired Titan Chemicals in 2010 (Malaysia based). This may threaten TPIA’s strong position as the leading petrochemical player in Indonesia.

4. Indonesia economic growth is a catalyst to TPIA’s performance. TPIA serves as a proxy for exposure in the consumer sector, therefore any signs of an economic slowdown will have an impact to TPIA’s performance. Recent update given from our economist team is that there are no expectations for the central bank to embark on any rate hikes in the very near term in light of a less upside inflation momentum. However we still do anticipate one 25bp-hike to 7.0% in the final quarter of 2011.

COMPANY BACKGROUND

Chandra Asri Petrochemical (TPIA) is an integrated petrochemical company as a result from a vertical merger of two affiliated petrochemical companies, PT. Chandra Asri and Tri Polyta, which are subsidiaries of Barito Pacific. The merger was effective on 1 January 2011. Embodied with its strong position of possessing the only naptha cracker in Indonesia, TPIA is simply the largest integrated olefins and polyolefins producer in Indonesia.

This puts TPIA in a dominant position as the leader in the petrochemical industry with 55% market supply share of ethylene, 40% for polyethylene and is the only producer of styrene monomer in Indonesia. Its strategic location in Cilegon enables the company to have proximity to and interlinked with customers’ facilities and also close to the seaport.

Chandra Asri (CA) and Tri Polyta Indonesia (TPI) separate background. CA started its commercial operation back in 1995. The company produces olefin and by-products as well the derivatives (polyolefin) such as polyethylene and styrene monomer. Prior to merger, the missing down-stream integration is CA’s downstream derivative (polyolefin) to the polypropylene businesses. Pre-merger, CA’s and TPI’s main shareholder was Barito Pacific holding 70% and 77.9% respectively. CA was TPI’s supplier of propylene before the merger. TPI commenced commercial operation of its polypropylene business in 1992 with CA as the main raw material supplier.