Steel Pipe For The Country

We initiate Spindo with a BUY conviction premised on: 1) Its dominant position in domestic steel pipe market (~30% share); 2) Strong proxies to the nation’s rise in gas infrastructure, construction developments and higher local content requirements in the automotive sector; and 3) Super appealing 3.3x FY15F P/E, 15% ROAE and PEG of only 0.1x. We derive our DCF based TP at IDR360, implying a 6.8x 2015 PER.

A strong brand and market presence
Established in 1971, Spindo (Steel Pipe Industry) is the domestic market leader (30% market share) in the steel pipe industry catering pipe orders prominently for the construction/infrastructure related, oil and gas and automotive industries.

Proxy to the rise in nation’s gas infrastructure
We expect numerous gas pipe projects to accelerate overall pipe sales volume by 20-45% in 2014-15 driven by expected strong demand from big gas pipe players such as Perusahaan Gas Negara (PGAS, BUY, TP: IDR6,600) and Pertamina Gas (Pertagas). Spindo stands to gain a bigger slice of the market after the number of players dropped to three (from five).

Proxies to the growing infrastructure/construction & automotive
Demand for construction and infrastructure pipes will be supported by the execution of Indonesia’s 15-year Economic Masterplan (MP3EI) projects. Recent massive investments in the auto parts industry and the increasing local content requirements should boost Spindo’s automotive pipe sale volume by 15%-20% per year (2014-2015). Spindo is on solid footing in providing continuous steel pipe orders to the aforementioned industries.

Earnings jump on volumes and higher margin mix
We expect net profit to increase by 29.5%/44.5% for 2014-15 on the back of: i) Better product mix from higher margin pipes (O&G and automotive), ii) increasing productivity and efficiency from new machinery and improvements in existing production lines, iii) higher economies of scale.

Hidden small-cap jewel
Current valuation is appealing at 4-3x FY14-FY15 P/Es. Given its revenue mix of recurring + project-based income and high exposure to the construction sector, we put its valuation anchored at 59% discount to construction players at 6.8x FY15F target P/E, with TP set at IDR360. Key risks are: i) high raw materials cost fluctuations, ii) USD/IDR currency volatility, iii) project delays.

Investment Thesis
Valuation and TP
We initiate our coverage on Spindo with an IDR360 TP, pegged to 6.8x FY15F earnings, a 59.0% discount to the construction sector. This valuation offers a 125.0% upside potential from its current price. Given the group’s revenue mix of recurring and project-based income, as well as its high exposure to the construction and infrastructure industries, we think that its valuation should be anchored to those of its construction peers.

Spindo’s current valuation is very appealing, with the counter trading at 4.4x/3.0x FY14-15 P/E – a 78% and 82% discount to the construction sector which are trading at 20x and 17x 2014-15 P/E. Despite Spindo’s thin liquidity and small market capitalisation, we see the the valuation discount gap to the construction sector is unreasonably large. We see Spindo is an eye-catching investment in the small-cap investment landscape.

Investment thesis summary
We like Spindo due to: i) its dominant position (~30.0% domestic market share); ii) high potential demand from O&G, construction, and infrastructure projects, as well as from the automotive industry; and iii) current appealing valuation.

We expect its net income to surge by 29.5%/44.5% in FY14F/15F
This solid performance will be supported by margin expansions, with FY14F/15F gross margins projected at 18.4%/18.9% vs 15.4%-17.1% from 2011 to 2013. It will also be boosted by expected robust 12.7%-19.8% 2014-15 sales volume growth for pipe products.

The margin expansions will be supported by: i) better product mix by a higher portion of O&G and automotive pipes, ii) increasing productivity and efficiency from new machinery and existing production lines improvement, iii) higher economies of scale.

Rising raw material prices could temporarily boost margins in a particular financial quarter, as selling prices increase faster than the recognition of rising costs (see Figure-19 & 20). This is due to the ~3-month inventory time lag, although we expect the effect to be normalised usually in the subsequent quarter. Margin volatility is inevitable, however, the success key is from Spindo’s pricing power to adjust its price based on the volatility of the steel-related price. Spindo’s positive catalysts are:

Increasing O&G pipes portion supports margins. We see contribution from O&G pipes revenue to increase to 15.7% and 18.6% in FY14-15F from 14.8% in FY13. Notably, O&G pipes gross profit margins are ~30.0%, higher than Spindo’s 1H14 blended gross margin of 15.9%. The group is building a new plant in Gresik, Java, which will produce electrical resistance welded (ERW) straight wielded pipes with wider diameters that will cater to the needs of offshore O&G projects.

Up until now, the shortage in domestic supply of wide diameter ERW pipes had 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 firm was recently suspended while another’s was cancelled.

Higher volume from automotive pipes sales
We project stronger pipe sales to automotive parts companies, given the: i) recent increased investments in automotive companies, and ii) strong interest in low cost green cars (LCGC) that require high usage of local components. Spindo plans to more than double the capacity of its automotive pipes plants to cater to the higher demand. This expansion includes capacity to manufacture thick small pipes for four-wheel (4W) vehicles which have higher profit margins than the group’s current range of automotive pipes (mostly for 2W).

MP3EI supports construction and infrastructure pipe demand
In May 2011, the Indonesian Government launched its 15-year MP3EI, which focuses on infrastructure developments from 2010-2025. These infrastructure projects will require a minimum of USD187bn in investments on roads, ports, power & energy, etc. A large amount of pipes will be needed, ie bridges and ports need foundation piles, power & energy need machinery pipes, etc.

Cost efficiencies from higher economies of scale
In tandem with a higher production volume, we believe Spindo will have a higher bargaining power when it comes to buying steel at lower prices. The group also in the long-run plans to restructure the production lines at its first plant in Rungkut, Surabaya (~33.0% of ISSP’s total production capacity). Improved production lines would boost the plant’s production efficiency.

Catering Pipes For Various Industries
Business overview
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 methods, ii) product types, and iii) user industries.

Besides the abovementioned products, ISSP also sells steel plates and performs several types of value-added services, including galvanising, epoxy coating, 3-layer polyethylene coating, and cement lining.

The graphs below highlight that the construction sector is Spindo’s main revenue contributor. However, 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 is the highest at around 30.0%.

By comparison, the gross profit margin of construction, automotive, furniture and other types of pipes stand at around 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. Actual margins may vary depending on product specifications.

Around 60.0% of ISSP’s revenue comes from recurring sources, while the rest is based on projects. The actual number will vary from time to time, depending on project availability. Roughly, we can say that the majority of its O&G-related revenue is project-based, while sales to the furniture, automotive, and other industries are recurring. Sales to the construction sector is a mixture between recurring (~one-third) and project-based (~two-thirds). Almost all of the group’s revenue is generated from the domestic market.

Industry overview
It is estimated that domestic consumption of pipes across the board is more than 1m tonnes per year, with domestic production at around 600,000-700,000 tonnes level. The rest comes from imports. Since 2012, the import portion has increased quite significantly given that the domestic producers can’t meet the strong domestic demand for steel pipes. Additionaly, we see a correlation of the import portion against the USD/IDR appreciation/depreciation.

When IDR appreciates against USD, the domestic players to an extent can charge competitive price against import products, vice versa when IDR depreciates. Given Spindo’s products are diversed with premium brands on the line, we believe Spindo is able to compete with local and international products. Take note that the bulk of the domestic production is made up of cheap, non-standard, low-grade pipes. Note that there is limited domestic supply of straight wielded O&G pipes of large diameters.

Note that, while the annual total domestic production capacity of steel pipes is theoretically around 2m tonnes, actual capacity are constrained by working capital needs. This indicates that short financing lines are extremely important. Considering that this condition has persisted for several years, we believe that the industry’s supposed overcapacity will not turn into actual production capacity. By contrast, ISSP has bucked the trend by being able to post 76.5% capacity utilisation in 2013 from the 55.0% – 70.8% level back in 2009 – 2012 – nearly reaching its actual maximum utilisation of 85% based on working hours.

The group’s main sales products are standard pipes, which need a high level of quality and certification/standardisation. Also, even in the non-standard segment, Spindo chooses to focus on the high-grade parts segment. This strategy reduces its exposure to the price wars that occur between the lower grade pipes players.

Automotive pipes
Within this segment are only three domestic players – Spindo, PT Indonesia Steel Tube Works (ISTW) and PT Srirejeki Perdana Steel. The group’s sale to the automotive industry consists mainly of 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).

ISSP sells directly to automotive manufacturers as well as to automotive parts (auto parts) makers. It is worth noting that all the big two-wheel (2W) names, including Honda, Yamaha, Kawasaki, and Suzuki, as well as Top 6 Japanese 4W producers (ie Toyota, Daihatsu, Suzuki, Honda, Nissan and Mitsubishi) are among the users of the group’s products. Its ability to serve the just-in-time system of the auto parts manufacturers also proves its operational excellence.

More importantly, additional demand is coming from the increased foreign investment into the Indonesian auto parts and automotive manufacturing industries. This will not only add new capacity, but partly shift the sourcing of parts to local sources vs from abroad. This is in line with the Government’s intention to increase local content.

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

Meanwhile, Spindo’s planned expansion at its Karawang, Java, plant includes a line to produce an array of new products with small diameters but high thickness which have higher margins compared to the existing automotive pipes. Therefore, even though Indonesia 2W and 4W vehicle sales may be impacted by higher interest rates and moderated purchasing power, we still expect automotive pipes sales volumes 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 the imported parts.

Oil & gas pipes
Spindo produces American Petroleum Institution (API)-certified black and spiral pipes. The straight wielded black pipes have onshore and offshore projects use, 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 serve the demand from offshore O&G segment.

The API certification requirement creates 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 (part of the Maspion group), iv) KHI Pipe Industries – a subsidiary of Krakatau Steel (KRAS IJ, NR), and v) PT Bumi Kaya Steel (it is usually part of a consortium for large scale projects). However, Indal got its API certification cancelled, while Bumi Kaya’s certification was suspended. This leaves only three players in the industry that now have the opportunity to carve out larger slices of the O&G steel pipes pie.

In the near, medium and long-term, we believe that O&G projects will be plentiful, seeing how the Government plans to connect a gas transmission pipeline between East and West Java. In the longer-term, the Government expects to also connect a gas transmission pipeline to the eastern part of Indonesia, between the Kalimantan and Sulawesi islands. These projects are a necessity in our view as the government is switching to gas given its relatively cheaper and cleaner energy compared to oil. Meanwhile, Indonesia has become a huge net oil importer and has caused a current account deficit to the nation’s state budget.

Currently the total national gas pipeline length is 12,000km, only 19.7% of the national gas pipeline development masterplan of 61,000km by 2025. This indicates abundance of opportunities for Spindo to obtain O&G pipe projects in the long-run. Given the favourable competition landscape, its expansion plans, and major projects in the pipeline, we expect ISSP’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
With its Spindo brand in possession, the group holds a very strong position in the construction steel pipe market, where it sells its products through various channels. These include direct sale to the end-user, and sales through contractors, distributors and agents. Its closest rivals in this segment are Bakrie Pipe for building products and KHI Pipe for piling products.

The group’s wide range of products are used in the construction of infrastructure and buildings, which include – but 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 the group’s construction products. This segment has been substantially boosted by the infrastructure developments under the MP3EI, which include power plants, bridges, airports and ports. In addition, there is also a rising trend by companies keen on constructing their own private jetties.

We expect Spindo’s sales volume to the construction sector to increase to 196k tonnes in 2014 (+10.0% y-o-y) and 232k tonnes in 2015 (+18.0% y-o-y). Note that Spindo’s construction pipes are priced at a premium against imported pipes, but they are supported by quality assurances and the company does provide easy-to-reach after-sales services to its customers.

Raw materials and inventory dynamics
Spindo sources its steel needs from several suppliers to ensure raw materials availability. The nature of the industry requires that the large domestic players keep a relatively high inventory level, considering the: i) local suppliers’ capacity limitations and order execution risks, ii) time inconsistency in transporting imported raw materials, and iii) high frequency of sudden orders with short delivery time from clients in the construction industry.

Rising steel prices gives Spindo the opportunity 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. Consequently, Spindo also has the room to raise its selling prices while still using its existing inventory sourced at lower prices – the group keeps a three-month inventory. However, the opposite happens in a decreasing raw material price environment.

Spindo has gained exposure in purchasing raw material from KS in 1H14 given the better delivery time and better price ever since JV with Posco. This should slightly minimize the foreign exchange risk exposure given that the raw material purchased from KS are majority in IDR currency and short distanced.

This temporary positive correlation between margins and raw material prices was seen clearly in 2008-2009, when prices escalated in 2008 and then went on a downtrend in the following year. Then, in 2010, gross margins returned to normal as raw material prices stabilised.

In recent years, with the global steel oversupply creating range-bound prices, the impact of the quarterly raw material fluctuations was 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 that selling prices are adjusted in response to changes in raw material prices varies depending on each market segment. The margins for O&G projects depend more on product specification, as pricing and raw material sourcing are finalised at the beginning of the project. Hence, subsequent changes in raw material prices will not affect the expected margin, as Spindo does not keep inventory for this segment given the high variation in demand. Similarly, the automotive industry also has a price scheme, with selling prices based on the cost of raw materials.

Sales to the construction industry is a mix of selling to: i) distributors for short-term projects – whereby prices are easily adjusted, and ii) users for longer-term projects – with prices usually agreed upfront. Nevertheless, note that the longest upfront order is only for around 3-4 months, which is the same with 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 rate, while purchases from domestic sources are also indirectly affected, as suppliers typically adjust their selling prices based on the USD-IDR rate.

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. Hence, to cover this risk, its selling prices need to be tweaked with future USD rates in mind.

On the sales side, the price adjustment pace is similar to the case of changing raw material prices. The only difference is that there is natural hedge on O&G pipes, as sales of these are mostly in USD.

Strategic expansion plan
Spindo’s strategic expansion plan to capture new markets – while continuing to serve its growing existing ones – will 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 (now at 70.0% vs the actual maximum utilisation of ~85%). We expect Spindo’s production capacity to increase by 22.4% and 30.6% in 2014-15 mainly coming from ERW steel pipe expansion (Rungkut, Warugunung, Sidoarjo, Gresik. The following is a summary of Spindo’s capacity expansion plans:

i. The group’s will expand in the development of 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, the domestic supply shortage of large diameter ERW pipes has been filled by imports. Spindo currently only produces straight wielded ERW pipes of up to 8-inch in diameter. Also Spindo plans to capitalise on the absence of supply from rivals such as Indal and Bumi Kaya amidst imminent major O&G projects on the horizon by building the 8,000tonnes/month plant capacity for 4-10 inch pipes by 2015. Note that the production facility for O&G pipes can also be used to meet the demand for construction pipes.

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

iii. Spindo started commercializing its Sidoarjo operations in April 2014 with intial runninig capacity at 1,500tonnes/month before gradually ramping up to its capacity target of 3,000 – 3,500 tonnes/month.

Besides adding capacity, the expansion and improvements at its various plants is expected to increase their productivity and efficiency in many ways such as:

i. Better plant layout to reduce unnecessary goods movement and increase production speed. ISSP’s first and second plants started out small and grew gradually larger, which resulted in non-optimal production layouts. These two plants will see some of their production lines moved to the group’s new Sidoarjo plant, freeing up space for the optimisation of their floor space.
ii. Lower wastage, eg a larger slitting machine will be able to handle heavier steel coils, which, in turn, results in less welding and wastage.
iii. Reduced 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 planned expansions, ISSP intends to minimise labour additions by optimising its existing human resources, given that the improved layouts and newer technologies will lower the labour requirements to handle the same number of production lines.
v. We expect these improvements to impact margins positively in the future.

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

Management also sees the possibility of opening its own distribution channel in Manado, Sulawesi, and Sorong, Irian Jaya. ISSP is targeting for its distribution channel improvements 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 to better quality, locally manufactured pipes by ISSP from cheaper, lower grade imported ones. If possible, Spindo in the long-run may also seek for such large export market opportunities.

Financial forecasts
We expect revenue to grow by 13.0%/21.7% in FY14F/15F, driven by: i) sales value growth of 10.0%/18.0% in construction and infrastructure pipes, ii) 20.0%/44.0% in O&G pipes, iii) 15.0%/15.0% in furniture pipes, iv) 15.0%/20.0% in automotive pipes, and v) 15.0%/15.0% in others.
We also expect gross margin to increase in FY14-15F to 18.4% and 18.9% (from 17.1% in FY13), on the back of: i) better product mix with larger portion of O&G pipes sales, ii) higher economies of scale and production line improvements.

With its expansion plans, net gearing is expected to increase to 0.8x at end-FY14 and 0.9x at end-FY15F. The table below shows our operational assumptions.

1H14 results review
Spindo registered a 1H14 net income of IDR128bn (-7.3% y-o-y), accounting for 49.0% of our FY14F forecast. We expect stronger 2H14 net profit driven by higher sales volumes and higher blended margin mix. Moreover, 2H is seasonally a busier half for the rolling out of construction projects.

2Q14 net profit dropped by 51.1% q-o-q despite gross profit increased by 4.6% q-o-q on higher gross margin (17.5% in 2Q14 vs 14.6% in 1Q14). This is due to higher opex and a forex loss compared to a forex gain in 1Q14.

Appealing valuation
In view of ISSP’s revenue mix – a combination of recurring income and project-based income which creates some cyclicality – as well as its high exposure to construction, we think the stock’s valuation should be treated as a construction support, the valuation of which is based on construction peers, but at a discount. Therefore, we set the company’s valuation at 9.8x-6.8x FY14-FY15 earnings, at 52%-59% discount from the current construction companies’ average of 20.4x-16.6x FY14-FY15 P/E.

We think that the discount gap should not be that large especially to Spindo’s current valuation given that Spindo is also a strong proxy to construction and infrastructure growth. Furthermore, Spindo’s exposure to oil and gas sector provides catalyst for margin expansion.

Despite Spindo’s lack of liquidity in the market, fundamentally speaking, we think that the valuation discount gap to regional peers should not be that wide (refer to figure 35), given that its regional peers have lower profitability on average (regional peers have lower margins and ROAE levels). We initiate coverage on the counter with a BUY recommendation and TP of IDR360.

Although we derive our TP of IDR360 using a based P/E target method, we provide investors with Spindo’s 5-years DCF calculation method to provide viable options in valuing the company as a guidance to respective investment decisions. We use WACC assumption of 11.6% and long-term growth rate of 5% and derive a fair value of IDR400, which is 11% above our TP.

Looking at both valuation methods, we see that Spindo is currently undervalued and should deserve a premium re-rating in the market despite liquidity being an issue.