Indopoly Swakarsa Industry Steep Learning Curve and Narrowing Margins

IPOL’s 9M11 net income came in significantly below our FY11 estimates at IDR63bn
(-95% q-o-q or -59% y-o-y), comprising only 34% of our FY11 estimate. Its 9M11 gross margin was low at 18.5% (FY11f: 24.7%), driven by Biaxially Oriented Polyethylene Terphthalate’s (BOPET) low initial performance and unfavourable timing in raw material purchasing. We revised down our forecasts and changed our recommendation to NEUTRAL. Our new Target Price is at IDR143, which implies 10.0x–8.9x FY12–FY13 net income.

BOPET start slower
3Q11 gross margin came in at 15.5% and brought down the 9M11 gross profit margin to 18.5%, which is far from our FY11 gross margin target at 24.7%. The disappointing results came up against our initial forecast of a recovery in 3Q11, as the company major new product (BOPET) was starting to contribute. While BOPET sales have already started with 3k tonnes (of 20k tonnes annual installed capacity) sold in 3Q11, they have not contributed to the bottom line as the company needs substantial time to overcome the steep learning curve for these new products – only after which it can meet market standards and achieve the intended gross profit margin. On the other hand, the market price itself is far below our initial assumption and thus, we have revised down the BOPET price assumption from USD3.5/kg to USD2.3/kg for FY11.

Lower margin forecast
The sharp correction of raw material benchmark prices in June-July also pushed downward the general selling price. While it should normally work in the opposite direction, the two-month lag in inventory created a timing difference – whereas the selling price is already going down at the same time when the high-cost inventory is being sold.

The is especially evident in the fine food segment, where the selling price movement is based on market forces, compared to the cigarette segment which is more cost-plus in nature. We adopt a more conservative approach on the company’s ability to sustain its margin and thus, revise down the blended gross margin assumption to 18.4%-18.7%-18.8% from the initial 24.7%-27.1%-27.3% for FY11-FY12-FY13.

Forecast tweaked
In term of volume, 9M11 Biaxially Oriented Polypropylene’s (BOPP) total volume came in lower than our estimates of 51.5k tonnes (+0% q-o-q or -9% y-o-y). Hence, we lower our BOPP sales estimate by 8%-8%-8% and BOPET sales estimate by 44%-16%-5% for FY11-FY12-FY13. All in all, we reduce our net income forecast by 62%-65%-62% for the same period.

Downgrade to NEUTRAL
Factoring in the steep BOPET learning curve and lower margin, we roll our valuation to a FY12 base and derive a new Target Price of IDR143, which implies 10.0x–8.9x FY12–FY13 net income. Hence, we downgrade our recommendation to NEUTRAL. The counter is currently trading at 9.1x-8.1x FY12–FY13 net income.

Narrowing industry gross margin
Due to the escalating European crisis and muddy regional economic prospects, global prices of petrochemical products have been trending down since end-2Q11, including the PP and PET chip, raw materials for packaging. As a result, the global plastic packaging selling price is also going down. It creates a timing mismatch, where the inventory that has already been bought at a high cost could not be sold at a correspondingly high price and thus, squeezing the margins in 3Q11.

There is also the possibility that the packaging selling price will decrease faster than raw material prices, thus leading to a margin squeeze. While the effect may be temporary, we prefer to take a conservative stance and revise down the IPOL gross margin forecast, as raw material prices are sliding again in 4Q11, which may be a replay of what happened in 3Q11. On the positive side, we may actually see IPOL gross margin decreasing in a more stable manner compared to the competitor in the last two quarters. We expect this to occur as a result of the company’s better product mix (a high portion in the cigarette category is good as this industry is based on a cost-plus nature).