Indonesia Construction, Surfing through Infrastructure Upcycle

We are re-initiating coverage on the construction sector with an OVERWEIGHT for the following reasons: i) valuations are reasonable compared to regional players, ii) the government’s infrastructure projects are expected to accelerate earnings growth, iii) there are lower risks in executing projects, as laws will be enforced, iv) the property market’s outlook is solid for the next two years, and v) there is a conducive political and microeconomic environment. We expect contractors to register net profit growth of 20%-30% over the next two years.

Despite construction stocks moving upwards by an impressive 97% YTD, it is not too late to invest as Indonesian companies’ valuations are modest compared to their growth potential. The sector is currently trading at 13.4x 2013f PER over a 22.9% market weighted average EPS CAGR, which translates to 0.7x PE/G – the lowest among regional peers. We are most excited about WIKA as its untarnished reputation has helped deliver strong order books. Meanwhile, we also like PTPP for its State Owned Enterprise status, as industry growth is primarily driven by government projects.

Strong revenue growth driven by heavy order book
We expect Indonesian contractors to see topline growth of 20%-30% for 2013-2014 when the government increases its infrastructure spending, as the country is grossly underdeveloped. Allocations from the state budget are set to grow from 2.1% of GDP in 2012 to 3.1% and 2.9% of GDP in 2013 and 2014 respectively.

There will also be public-private projects from the MP3EI, estimated at IDR486trn for the next two years, 80% above the current projects’ value of IDR285trn. The average take-up rates for all types of properties have been recorded above 80% for the past few years, and thus guarantee strong growth in property construction for the next two years as well.

Getting risks under control
We are excited that the Land Clearing Bill has found a home base at the National Land Administration Bureau (BPN), a body that monitors the completion of the most critical process of infrastructure development. We foresee that the political and macroeconomic situation will remain conducive for infrastructure projects, as interest rates would continue to be at a historic low on the back of soft inflation and the central bank has prioritized maintaining growth.

Valuation and Top Picks
The sector is currently trading at 13.4x 2013f PE, at par with JCI at 13.3x 2013f PER. The sector warrants a re-rating, as it is expected to grown by 22.9%, compared to its benchmark peers’ at 3.8% It also has the lowest PE/G ratio compared to its regional competitors at 0.7x. We initiate coverage on WIKA (Buy, TP IDR1,600) and PTPP (Buy, IDR950) in this report. We like WIKA and PTPP for its reputable operations and stellar order books.

Potential risks
For a sector mainly driven by government projects, risks may include: i) changes in government regulations especially as the 2014 presidential election nears, ii) financing ability and project IRR expectations as the government relies on public-private partnerships, and ii) thin trading liquidity.

Investment thesis
The passing of the much-awaited Land Clearing Bill early this year has positively jolted the construction sector, as the government shows their commitment to upgrade infrastructure. Market proxy stocks WIKA, ADHI, PTPP, and TOTL have increased by a minimum of 50% YTD. A market capitalization weighted average performance of the top four public companies showed a YTD increase of 97.7%.

Despite Indonesian stocks having performed very well YTD, we think that it is not too late to invest in the Indonesian construction sector given that: i) valuations are still quite reasonable compared to other regional players, ii) strong earnings growth is expected from the Indonesian infrastructure upcycle, iii) there is much upside potential from the government’s commitment to push for infrastructure development. The table below demonstrates that Indonesian companies’ valuations can be compensated by their growth potential.

Comparisons with India
The characteristics of Indonesia’s economy suggest that it should undergo significant infrastructure expansion to maintain growth. In mirroring India’s experience, both economies have relied heavily on private consumption to drive economic growth at more than 55% of GDP annually.

While focus on the demand side has conveniently supported the economy at a 6%-8% average GDP growth rate for the past couple of years, this strategy has grown increasingly dangerous without supply balancing it out. The foremost problem is the speed at which the prices are rising as demand expands, from assets to commodities to manufacturing to services. This situation may deal a long-term blow to businesses, making them unviable.

As shown by Bank Indonesia’s reluctance to increase the BI Rate in spite of repeated inflationary threats, steps to contain demand through monetary tightening are unappealing due to the economy’s dependence on consumption and weak export activities against a global backdrop. The expansion of economic capacity in these two countries has become the sole feasible solution to maintain real growth. At present, India’s Gross Fixed Capital Formation balances have shown negative growth, showing that new value added in the economy has been consumed rather than invested for additional capacity. In short, economic demand has persistently outpaced supply, causing inflationary pressures and deteriorating growth.

In a consumption-based economy such as Indonesia, the development of a supply side through the construction of first-rate roads, ports and other infrastructure has become an absolute necessity to ensure a stable economy and break the growth ceiling. Peculiarly, infrastructure spending in India currently stands at 8% of its GDP, compared to Indonesia’s 2%. At the time of writing, the Indonesian government is planning for a minimum of IDR200trn (USD 21.1bn) in infrastructure spending in the 2013 State Budget, up by 15% from 2012’s Budget allocation of IDR188trn (USD19.8bn). Despite this sharp increase, Indonesia’s spending still lags behind other peripheral nations.

The masterplan to accelerate and develop the Indonesian economy (MP3EI)
In May 2011, the Indonesian government launched a 15-year economic masterplan (MP3EI) to transform Indonesia into one of the world’s Top 10 economies, by focusing on infrastructure development from 2010 to 2025. The government identified at least 22 economic activities to be developed across the nation, through 389 identifiable projects. The infrastructure required to support these activities would require a minimum of USD187bn (45% of total) of investments in roads, ports, power & energy and so forth.

The traditional approach of funding infrastructure from the state budget is not sustainable because of limited public finances, so the short term implementation of these projects (split into three phases: 2011-2015, 2016-2020, and 2021-2025) would require steep private participation through a public-private partnership scheme. At present, the government has identified USD 51.2bn worth of infrastructure investments that should be completed between now and 2015 (up from the USD 47.3bn deemed feasible in 2011). Approximately USD 36bn of the value would have to be immediately provided by private parties.

The backward state of Indonesia’s infrastructure

To illustrate the ample opportunities of the projects, we have laid out the current state of Indonesian infrastructure below.

Roads
Indonesia’s road network is the poorest across all Emerging Asia economies, even falling below the similarly-challenged Philippines. At present, Indonesia has only 0.24km of roadways for each square km of land, which translates to 0.59km of road for every 1,000 residents. Our auto analyst has noted that the total number of motor vehicles in Indonesia increased by a 10% CAGR, despite a 2% growth of toll road networks annually. Indonesia’s toll road network currently stands at a mere 741km, or 0.4m for each square km of land. The government faces a very steep challenge to increase the Indonesian toll road network to 1,422km by 2014, where 46% of the target number is currently undergoing development along the Trans Java road project.

Ports
Annually, the World Economic Forum Global Competitiveness Index rates worldwide ports on a scale 0 to 7, with 7 being the best. Indonesia was rated 3.6 out of 7.0. Despite showing an improvement, Indonesia was the biggest underperformer compared to all other Emerging Asia economies except for the Philippines. In the MP3EI draft, the government has identified at least 81 port-building and improvement projects at a total value of USD12.7bn.

Electricity Generation
In a bid to prevent power shortages, the government launched two crash programs, each with a 10,000-megawatt capacity. The first phase of the program was launched in 2006 and was expected to conclude in 2010. Due to financing limitations, it faced severe delays and has yet to be completed. The government has followed up on this ailing initiative with a second phase as a part of the MP3EI masterplan, which was announced in 2009 and is to be continued until 2018. Learning from past experience, 65% of the USD 21.3bn required for the second phase would come from private investments.

Based on the National Electricity Corporation’s (PLN’s) estimate, the demand for electricity in Indonesia would grow by 9.5%-10.8% between 2009-2018. In contrast, In currencies, this is the abbreviation for the Polish ZlotNotes:The currency market, also known as the Foreign Exchange market, is the largest financial market in the world, with a daily average volume of over US $1 trillion. =Indonesia’s electricity generation has grown only at a 5% CAGR over the past decade. This has put Indonesia’s electricity generation per capita as the lowest in the region (only slightly above the Philippines) at a mere 71%-73% electrification ratio across the nation by end of 2012.

Airports
The growth of the middle class and liberalization of the aviation industry have pushed ten of the main Indonesian airports beyond its capacities. The three busiest airports in Indonesia, Soekarno-Hatta Jakarta, Juanda Surabaya, and Ngurah Rai Bali, have been running on excess capacity for at least the past three years. Last year, Jakarta’s Soekarno-Hatta recorded 51m passenger movements on a 32m capacity. In 2011, it beat Singapore’s Changi as the busiest airport in Southeast Asia. The government has subsequently identified 11 airport development projects costing USD 2.5bn in the MP3EI masterplan.

Railway
Similar to its road network, Indonesia posted the worst number of railway networks/land area in Emerging Asia at a mere 2.6 meters for every square km of land. Railway connectivity has become increasingly important and is repeatedly stressed upon in the masterplan, as many of Indonesia’s major products such as crude palm oil and mineral ores are located inland. There are at least 30 railway projects in the cards, valued at USD 19.7bn.

Water supply
Despite having one of the highest water resources per capita in Asia (at 11.4 km3/m people), only 81% of Indonesia’s population has access to tap water. The difficulty of developing and distributing a network of clean water in Indonesia stems from the decentralization of all water networks to provincially-owned companies, which fall under PDAM, a regional government-owned utility company. PDAMs in different areas have solely relied on provincial budgets in the past and have little to no access to financing. At present, there is a potential of USD 1.9bn in public-private investments for water utilities in Indonesia.

Information & Communication Technology (ICT)
The number of SIM cards in use in Indonesia currently stands at 98 units per 100 people. Based on Boston Consulting Group (BCG)’s research, Indonesia’s SIM card usage will top 100 percent of the population by 2015, meaning some users will have multiple devices. The ICT statistics on Indonesia are blindsided, as only 12% of Indonesia’s population uses the internet regularly. This latter statistics translate to less than 2% broadband internet penetration in the nation.

Meanwhile, only 5% of Indonesians own personal computers compared to 20% in China. The government currently targets a steep increase in internet penetration to 8% across the country by 2014, on par with BCG’s expectation that Indonesia’s internet users would triple by 25% by 2014. Presently, the average broadband speed is only at 1Mbps-4Mbps. The government identified USD12.6bn worth of projects for fiber optics development and broadband capacity expansion for 2010-2025.

FDIs hit new highs
The inflow of foreign direct investments (FDIs) shows that the country continues to be a magnet for investors. 50% of FDIs are geared towards the tertiary sectors, ie. construction, heavy sectors such as utilities, industrial, transportation and real estate. We think that this interest shows that the government’s plan to push infrastructure development has been reciprocated by private funding, guaranteeing project flows for construction companies in Indonesia as foreign money will remain in the country for multiple years.

Meanwhile, FY13’s FDI numbers in Indonesia are expected to reach USD17.3bn, up 42% from USD12.2bn this year. Total investment in the Indonesian real sector (both domestic and international) is expected to reach USD50.0bn in FY14, up 62.3% from this year’s USD30.8bn. Assuming Bank Indonesia’s 6.3% GDP growth projection for FY13 and 6.6% in FY14, we expect that FDI as a percentage of GDP would increase from 1.6% in 2011 to 2.9% in 2014. While these numbers seem impressive, we believe that they are not unattainable. It is important to note that despite robust economic growth, FDI to Indonesia has yet to reach its pre-Asian Crisis levels of 2.8% of GDP in 1996.

Further catalysts in 2013: controlling executional risks
The progress of the Land Clearing Bill in the early months of 2012 proved to be a boost for construction stocks. For investors, this means that the Indonesian government is actually serious about pushing the nation into an investment upcycle, providing a legal framework for the land-clearing processes required for infrastructure development. However, executional risks have long been a traditional hiccup despite the legal framework.

This is why we are excited about two risk-reducing catalysts that would be a boon for construction counters moving into 2013:
i. Actual implementation of the Bill starts in January 2014; BPN to be responsible for process completion. With the Bill in hand, the government will soon tackle another challenge in its implementation. With a three-month deadline since the issuance of the Presidential Decree in September, government bureaucrats are currently finalizing three final points in the land clearing process. To give enough time for current projects to proceed under the current legal framework. One of the crucial issues is the National Bureau of Land Administration’s (BPN) role, as it has been mandated to develop a new sub-division to take charge of infrastructure-focused land clearing. We think that the infrastructure momentum would continue building for FY13 and beyond.

ii. LKPP to take over project tenders and streamline processes. Based on our discussions with various State-Owned Companies (SOEs), the government is contemplating placing the responsibility of overseeing all multi-year project tender processes to the National Procurement Office (LKPP). At present, each infrastructure project is bid out by respective departmental users (i.e. roads and bridges by the Ministry of Public Works, ports and railways by the Ministry of Transportation, etc). The current structure has led to inefficient State Budget absorption, as bureaucrats sit on the sidelines on project proposals because concerns over the Corruption Eradication Commision’s (KPK) audits have escalated among the high-level officials.

We think that this is a concern, as 60%-70% of the budget is goes to administration and bureaucracy fees. In effect, only 30%-40% of the absorbed value is actually used for investment spending in infrastructure, education and the like. Budget disbursements averaged a mere 30%-40% for the first six months of the past years, hence a bulk of project tenders are jammed in the last three months of the year, causing delays due to contractors’ capacity constraints. We are excited about this plan, as the move of project tenders from departmental authorities to LKPP would streamline bidding processes and accelerate the projects to faster completion.

Property development to continue through 2014
Property construction for public companies in Indonesia ranges from 20% (WIKA) to 80% of revenue (TOTL). According to World Bank data, Indonesia’s economic growth has rapidly urbanized its population, which in turn, boosted demand for property. Presently, approximately half of Indonesia’s 246m citizens live in large cities. Jakarta alone holds 10% of this number, making it the most reliable proxy for the insatiable appetite for property.

In the past decade, Indonesia’s nominal GDP per capita grew by a whopping 281%. Urban population, coupled by a rising middle class, has driven the Indonesian property boom. We do not see this trend weakening soon, as take-ups for every single property type in Jakarta (i.e. retail space, offices, and high-rise buildings) continue, and the supply of properties are registering at all-time highs.

However, we anticipate that a large supply of property, all through to 2014, along with the upcoming presidential election, would dampen additional supply through mid-2015 as in happened during past two elections. The chart below shows proportional changes in the Jakarta Property Index, reflecting consumers’ appetites in the property market. We see that after 2013, high-rise building developments would be less prominent. Thus, construction companies with capabilities and contracts in infrastructure building would be the industry’s darlings in the foreseeable future.

The competitive landscape
The construction research company BCI Asia reported that new contracts in Indonesia would reach IDR 285trn by end-FY12. Meanwhile, the construction industry is highly fragmented, with the Indonesian Contractors Association (Gapensi) recording more than 120,000 corporate membership names in 2012. Based on new contract values, PTPP and WIKA possess a mere 5.9% and 5.8% of market share respectively. Large infrastructure projects are generally dominated by SOEs WIKA, PTPP, and ADHI due to their sheer capacity and links with the government. Going forward, we see that SOEs would continue to benefit from the uptick of government-initiated infrastructure projects.

A still-conducive macroeconomic situation
We believe that construction sector contribution to Indonesia’s growth would continue to accelerate, supported by low inflationary pressure and stable interest rates. Bank Indonesia has repeatedly supported this notion by maintaining the BI Rate despite inflation, only raising the benchmark interest rate twice in the past decade.

The ability to maintain the BI Rate has become increasingly important as the government is pushing for a target 7.0% growth, as the President is looking to end his last term on a high note. Bank Indonesia has lately maintained economic stability by utilizing other solutions, such as increasing banks’ capital adequacy ratio.

We are confident that this policy would continue beyond 2014, benefiting the Indonesian construction sector, as the current Coordinating Minister of Economy has been known to be a contender for the next presidential election. Hence, the success of infrastructure projects, as well as economic acceleration through consumer property loans, would continue to remain a top-notch priority for the two most important figures in Indonesian development planning.

State-owned companies are the industry’s darlings

We like SOEs the most for the following reasons:
i. A higher proportion of government projects guarantees stable cash flows. Unlike private projects where construction companies are expected to receive cash revenue only after a certain level of completion, the government disburses cash flows every month, with the amount adjusted according to the level of completion. SOEs, with a larger proportion of government projects, naturally generate more stable cash flows, a higher level of receivable turnover and a lower risk of bad debts.

ii. Government to prefer SOEs for previously foreign-dominated projects. Based on our channel checks, the government has “mandated” project owner Indonesian ministries (e.g. Ministry of Public Works, Ministry of Transportation, etc) to push more projects to local firms, especially State Owned Companies. This mandate especially include projects such as EPC, which the SOEs previously have no or little capability.

iii. Diversified revenue streams. Most construction companies try to diversify from their core business in an effort to pump up margins. The construction segment’s cost of revenue is at about 90%-92% as the bulk it comes from purchasing building materials. WIKA has successfully grown its pre-cast concrete subsidiary WIKA Beton, which recorded comparatively less cost of revenue at 87%. WIKA Beton contributed 23% to total revenue in 1H12. PTPP and ADHI have both been involved in real estate development and power generation. The private company TOTL recently entered into a joint organisation with the Ramada hotel chains for operations of a condotel in Tanjung Benoa, Bali. DGIK announced in 2010 that it was moving into the electricity generation business, although the operations have yet to book any revenue from its expenses as per 1H12. We are more comfortable with the SOE’s side businesses, as they largely leverage upon synergies with core construction businesses.

iv. Infrastructure to be the industry growth driver. We foresee a slower pace of growth in the property sector beyond 2013, despite a strong infrastructure pickup. SOEs, which take priority for all infrastructure projects due to their government links and expertise, would be beneficiaries of the Indonesian investment upcycle.

Valuation and Top Pick
We re-instate coverage on Wijaya Karya (WIKA) with a strong BUY and IDR1,600 TP, reflecting a 17% upside from its current share price. As we roll over our valuation to FY13, we base this TP on 14.6x target PER over its FY14 EPS. WIKA is our Top Pick for its long-standing relationship with state oil & gas company Pertamina and the nation’s power company PLN, which spells solid growth in its high-margin EPC business. We also like WIKA’s diversified operations, strong balance sheet, and its status as the most liquid construction company. We think that WIKA deserves a premium over its competitors.

We also like PTPP, which we initiate with a BUY and IDR950 TP for FY13 based off 11.3x target PER over its FY14 earnings, a 16 % upside to the current share price. PTPP managed to post a strong 20.3% CAGR earnings growth between FY10-FY12, but we mostly like PTPP for its familiarity with Pelindo (the Indonesian Port Authority), which helps it to possess 40% winning rate the upcoming mega-port projects. The company is also restructuring its cost of funds, leading to ~300bps reduction from current rate by FY13.

Potential downsides
We may be too sanguine on our call should the following take place: i) changes in government regulation as the current president is due to leave office in 2014, ii) as project financing largely relies on private funding appetite, low internal rates of return on some projects may deter some partnerships and cast a shadow over the infrastructure boom, and iii) low trading liquidity may hinder the construction companies in reaching its fair price.