Indonesia Construction Early Warning Signs

Driven by sanguine investor sentiments, the market cap of the Indonesian construction sector has expanded by 280% since 2012, outpacing its EPS growth potential of 18%-22% for 2013F. We propose a bellwether report to consider amid potentially weaker sentiments, while we continue to have a positive outlook on construction companies. At present, defensive stock picks serve as the best offensive strategy for a construction portfolio.

Limited expertise and raw materials cap earnings growth
Limited human capital is proving to be an issue, as the number of projects increases as well as the size of them. Companies are accelerating the promotions of half-baked engineers to support the robust project growth and as a result, cost overruns were evident in some of the more technically-advanced projects such as engineering procurement and construction (EPC) jobs. Cement and precast factories have also been operating at >95% capacity, while construction players compete for raw material supplies.

Positive sentiment lifts prices
Investors have a very sanguine attitude on the sector, beyond mere earnings expectations. However, this current sentiment-driven state is bound to be reversed if sentiments are affected by deteriorating macroeconomic data, weak Rupiah, and slow budget disbursement.

Valuation now less appealing vs. regional comparables
The sector is approaching an eerily close valuation to its comparable (both at 0.8x 2013PE/G). In fact, we now argue that Indonesian construction stocks should justifiably continue to be discounted to its comparables in light of: i) weak local currency, ii) adverse tightening bias, and iii) looming human capital constraints. There is room to grow, but it is now limited.

Construction story far from over
Approaching headwinds warrant defensive picks. We maintain an overweight call on the Indonesian construction sector as its fundamentals remain solid. The orderbooks of companies under our coverage are expected to last for another two to three years while FDI is at a record-high – ensuring an industry-wide 25% average CAGR over the same period. We like PT Wijaya Karya (WIKA) as it has taken steps to get around the “natural” constraints and it owns the strongest balance sheet among all other state-owned enterprises (SOEs), which will enable it to take on large projects.

EARLY WARNING SIGNS
Price appreciation shows that stout sentiment outpaces earnings growth. Will it last? Construction stocks within the Indonesian Stock Exchange have appreciated by an average of 230% in the past year, despite a sheer 39% y-o-y EPS growth in 2012. The market cap of the sector further expanded by 40% YTD, bringing the cumulative increase to 280%, outpacing the 18%-22% EPS growth expected for 2013. The industry’s 2013F P/E has accelerated from 14.5x at end-2012 to 17.0x today.

It is clear that investors are adopting a very sanguine attitude in regards to the Indonesian construction stocks beyond mere earnings expectations. Excess liquidity driven by the systematic weakening of Special Drawing Right (SDR) currencies and optimistic sentiment toward Indonesia’s investment cycle contributed to the upside. But will the sentiment-driven approach continue to dominate?

Time to pause and analyze
Judging from the strength of the Jakarta Stock Exchange (rallied by 15% YTD), the appetite for Indonesian Government Bonds (consistently 3x-4x oversubscribed on auctions), and the fact that net foreign purchases into Indonesian stocks has exceeded the FY12 total by some USD300m in 1Q13 alone, there are plenty to be confident about with regards to sentiment toward construction stocks. Yet based on the country’s recent macroeconomic data, it is hard to justify the future likeability of the Indonesian market compared to its peers. As highlighted in our equity strategy report Indonesia Equity Strategy: Time to Pause and Analyze, 4 Mar 2013, we are anticipating downside risks to the sector.

Negative real yields, weak Rupiah an early warning. The next catalyst for the sector would be the 1Q13 results, due sometime end-April and/or early-May. As per our last channel checks, Indonesian construction firms are poised to deliver another robust performance, with SOEs such as PT Pembangunan Perumahan Tbk (PTPP, NEUTRAL, TP IDR1,200) hinting of a ~40% y-o-y growth in 1Q13 earnings. While we think that the market has more than priced in this development, the IPO of high-profile construction firm Nusa Raya Cipta – a subsidiary of Surya Semesta Internusa (SSIA, BUY, TP IDR1,470) – in May/June would provide additional temporary buffer for sentiments. We are worried about the market fundamentals once the sentiment dries up:

Higher trade deficits likely, while capital goods import soften
After an improvement in January, Indonesia recorded a trade deficit of USD327.4m at end-February, bringing the YTD deficit to USD402.1m. This marked the fifth consecutive month of trade deficit for the country. The main drag continued to be energy-related imports on the current account side – the Indonesian Crude Price (ICP) went down from USD115/barrel in February to USD107/barrel in March, but the government would be unable to raise the current subsidized fuel price without causing a 20% discrepancy between the budget’s assumption (USD100/barrel) and the ICP. The populist government has also revoked any previous proposals to hike fuel prices amid the upcoming 2014 election. What we are worried the most is a downward trend in capital goods imports, which might indicate a softening of investment activities amid the depreciating Rupiah.

Rupiah worst performer among regional infrastructure comparables
The Indonesian Rupiah has declined by 7.5% to the USD since the beginning of last year – IDR was at 9,690 to the USD at yesterday’s close. Further Rupiah deterioration amid deeper trade deficits would be a major negative sentiment for Indonesian construction stocks, as other countries with similar infrastructure story have seen their local currencies strengthening – the Thai Baht and Filipino Peso have strengthened by 7.3% and 6.8% respectively.

Negative real yields a concern, tightening bias may come ahead
Despite strong demand for Indonesian govies, we note that yields have risen since the beginning of the year – except for the series with the shortest duration. The bond market has shown a remarkable risk aversion that is currently lacking in equities. Indonesia’s March headline inflation rate (i.e. 5.90% y-o-y) finally surpassed Bank Indonesia’s benchmark prime rate (BI Rate) for the first time since 2011. Core inflation has remained soft, actually falling 11bps since the year started.

Yet the numbers warrant a closer inspection as inflationary pressures usually only peak around the Ramadhan season, which is five months away from now. If history is of any indication, Bank Indonesia’s commitment to economic growth would again result in its reluctance to increase the benchmark rate from the record low of 5.75% today – choosing instead for alternatives such as an increase to the overnight deposit facility rate (FASBI). All in all, both Indonesia’s benchmark rate and the 10-year IDR govies are currently providing negative real returns to the market.

Whether through FASBI or BI Rate, the government would have to provide tightening measures before Rupiah cracked the IDR10,000/USD psychological level. (Note that Indonesia’s foreign reserves have declined to USD104.8bn in March, the lowest since 2011). Given Bank Indonesia’s habitually unhurried response, the Rupiah is only going to get worse in the foreseeable future before it gets any better. Whilst many infrastructure projects have their budgets settled prior to groundbreaking, the eventual tightening may also result in higher cost of funds for property project owners.

Slow budget absorption on infrastructure sector
Indonesia’s recorded economic growth of 6.3% in 2012, propelled by strong domestic consumption amid weak commodity exports in the second half of the year, was lower than the government’s original target at 6.5%. The government targets a 6.8% growth this year, assuming a 4.9% inflationary target and an IDR9,300/USD exchange rate. We think that these numbers are very optimistic considering the current macro situation. More worrisome for the construction sector is that the Indonesian government had in 1Q disbursed a mere 5.6% (IDR194trn or USD20bn) of the funds allocated for capital expenditure, which comprised spending for assets and infrastructure projects needed to propel growth.

This was 2ppt lower than last year’s figure, indicating the lack of progress in the government’s efforts to accelerate budget disbursement. We have noted on our sector initiation Construction Sector Report: Surfing Up the Infrastructure Cycle, 9 Nov 2012 that Indonesian bureaucrats have been slow in utilising their budgets as concerns over the Corruption Eradication Commission’s (KPK) audits have escalated among high-level officials, with the latest high-profile “casualty” being the President’s own Party Chair.

In 2012, the government managed to disburse only 79.6% of the IDR176trn allocated for capex. Notwithstanding the very low gearings among Indonesia’s construction companies, we think that the current bullish market sentiment had largely overlooked this Indonesian-specific execution risk, as well as raw material and human capital capacity concerns, as a latent cap to the sector’s short-term earnings potential.

Natural cap to growth: technical expertise & raw material supply of increasing concern.
Anticipating a robust industry expansion, state-owned construction firms have in recent years recruited aggressively through their partnerships with state universities (arguably top-tier colleges in the country). PT Wijaya Karya (WIKA), PTPP, PT Adhi Karya Tbk (ADHI, NEUTRAL, TP IDR3,000), and PT Waskita Karya Tbk (WSKT, Not Rated) have each recruited 200-500 new employees within the past two years – accounting for 15%-20% of the their respective total workforce.

As the companies are expect a 20% attrition rate by year-end due to tightening labour market, some of them have reduced benchmark intake requirements. A junior project manager is now groomed to take on small projects (IDR50bn-IDR100bn) in merely 2-3 years, accelerated from the standard five-year practice – but constraint in human resources looms ahead as infrastructure and property projects get bigger and more advanced.

Low gearing guarantees that companies expand with little financial strain
However given the tight labour market, it is harder to find expertise as the companies expand to take on projects requiring intricate technical know-how, such as EPC jobs. Cost overruns apply for all EPC players in the market, with ADHI, PTPP, and WIKA recording 95%, 88%, and 94% cost of revenue to the business segment respectively – up from 88%, 78%, and 93% in 2011.

Raw materials such as cement and industrial concrete are increasingly pushing supply capacity
Indonesian cement companies are expected to run at up to 95% capacity for the foreseeable future. Meanwhile, and on top of the margin rationale, companies such as PTPP has decided to build its own concrete plants to ensure smooth progress for the New Priok Port mega-project as reliable industrial concrete supply for the project has been hard to find in the market. WIKA Beton, the largest pre-cast and concrete producer in the nation with 60% of total market share, has also been running at more than 95% capacity utilization.

Cheap valuation & industry re-rating argument still holds?
We have argued towards the end of last year that the Indonesian construction sector was dirt cheap compared to its regional comparables with similar infrastructure theme, such as Thailand. We further argued that the valuations of Indonesian construction stocks thus deserved an upward adjustment (an industry-wide re-rating) in light of the robust growth. On the back of recent price appreciations, latent earnings cap to Indonesian companies, and upward revision to Thai’s earnings expectations as their expertise and earnings expand beyond the Thai border to include other Southeast Asian economies, Indonesia’s construction sector is approaching an eerily close valuation to its comparable (both at 0.8x 2013PE/G).

In fact, we may now argue that it is justifiable to continue valuing Indonesian construction stocks at a discount in light of: i) weak IDR, ii) adverse tightening bias, and iii) looming human capital constraints – note that Thailand’s Sino-Thai Engineering and Construction (STEC) and Toyo-Thai Corp (TTCL) are some of the best construction companies in the region with strong technical know-how in high-tech transportation and EPC projects with clients across the Southeast Asia region.

The good news: Indonesia’s construction story far from over
Despite the current macro overhang, we maintain an overweight call on Indonesia’s construction sector as its fundamentals are projected to remain solid for the foreseeable future. The orderbooks of companies under our coverage are expected to last for another two to three years, ensuring an industry-wide 25% average CAGR over the same period. Accompanied by resilient consumption as a domestic growth driver, the country continues to be a magnet for real money, with Indonesia booking another record high Foreign Direct Investments (FDI) of USD660.9m in 2012, up 10% y-o-y.

Investment activities have also continued to grow to record-high levels, with construction-related investments as the main driver. With the government’s commitment to attract more investments into the country, total FDI is expected to scale up even higher this year, to USD17.3bn or up 42% y-o-y. Assuming Bank Indonesia’s GDP growth projection of 6.3% for 2013 and 6.6% in 2014 (lower than the government’s official budget assumption at 6.7% in 2013), FDI as a percentage of GDP would increase from 1.6% in 2011 to 2.9% in 2014 – to finally return to its pre-1997 Asian Crisis level. The main problem of the sector is not its inability to grow, but the fact that the market has charged valuations worthy of a higher growth prospects.

Quick recap: solid industry fundamentals, upside imminent but limited
Short term risk may come from macro headwinds. We have so far demonstrated that the gains in Indonesia’s construction stocks were driven by the recent bullish sentiments. We think that the market has conveniently overlooked the “natural” cap to these companies’ earnings growth. This sentiment-driven approach could potentially turn sour in the short term due to the overarching macro sentiment. While we think that the latter would dictate that these stocks face short-term performance hurdles, Indonesian construction companies still command some of the healthiest balance sheet in the region. (i.e. the highest is PTPP, projected to be at 1.6x by end-2013 while Thai’s CK would be at 2.8x).

Indonesian construction stocks also offers for sustainable growth with a large upside potential on the back of the government’s continued push into investment activities and strong appetite for the Indonesian property sector (i.e. 25% industry net earnings growth at our conservative estimate over the next two years).

The best defense is a good offense
From Sun Tzu to Machiavelli, the age-old military combat adage rings clear at times of war “The best defense is a good offense”. We would like to reiterate this principle as we move into new stipulations with regard to the construction sector. WIKA is definitely not the cheapest in the industry, trading at 21.2x 2013 P/E, but quality comes at a price and it remains our top pick as the stock offers the best defensive strategy, based on strong fundamentals:

i) WIKA Beton (the largest pre-cast and concrete producer in Indonesia) helps to ensure the company’s supply of raw materials, ii) the group’s aggressive outreach to Indonesian top universities through scholarships and financial aids and its salary base, the most competitive in the industry, ensures human capital sustainability, iii) robust investment portfolio ensures a winning rate for construction jobs from its investment projects – as an equity holder, it has the “right to match” the lowest bids, and iv) the company offers the strongest balance sheet among all state-owned construction firms, which enables it to take on larger infrastructure projects with the least financial strain.

Where we may be wrong
Any of the following conditions may push for upside risks on our call: i) better than expected Indonesian macroeconomic data and ii) lack of alternatives in the Jakarta Stock Exchange to warrant for portfolio rebalancing. Comes 2H13, we would have to revisit our views as the new Land Clearing Bill application in January 2014 may boost sentiment for infrastructure-related sector such as construction.