Steel Pipe Industry Nation’s Stamp Mark For Steel Pipes

We initiate Spindo with BUY conviction premised on: 1) Its dominant position in domestic steel pipe market (~30% share); 2) Main beneficiaries 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 with 13% ROAE and PEG of 0.1x. We derive our DCF based TP at IDR370, implying 7.0x 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.

Main beneficiary 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 margin expansions
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 4.7-3.3x FY14-FY15 P/Es. We derive our DCF-based TP at IDR370, implying 7.0x 2015 PER. Spindo is trading at 80% discount to the construction sector (Spindo has high exposure >50% to this segment) based on current 2015 P/E valuation. Key risks are: i) high raw materials cost fluctuations, ii) USD/IDR currency volatility, iii) project delays.

Investment Thesis
Valuation and target price summary
Initiate with a BUY. We initiate our coverage on Spindo with 5-years DCF-based TP of IDR370 (using 11.8% WACC and 5% long-term growth rate assumptions), implying 7.0x FY15F earnings, a 58.0% discount to the current construction sector’s 2015 P/E valuation (please see Figure-33). This valuation offers a 113.9% upside potential from its current price.

Trading at a hefty discount to the regional peers and construction sector
We think that Spindo’s current valuation discount gap to regional peers steel pipe players should not be that wide (refer to figure 39) given that its regional peers have lower profitability on average (regional peers have lower margins and ROAE levels). Also, 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 Spindo’s current valuation discount of 77.0% and 80.3% discount to the current 2014-15 construction sector P/E of 20.4x – 16.6x should not be that wide.

Despite Spindo’s thin liquidity and small market capitalisation, we see the stock is undervalued. Spindo is an eye-catching investment in the small-cap investment landscape.

Investment summary
A dominant steel pipe player on strong growth mode
With Spindo having a dominant position in the nation’s steel pipe industry (~30% domestic market share) within various growing sectors, we expect its net income to surge by 29.5%/44.5% in FY14F/15F. This solid performance will be supported by strong sales volume growth and margin expansions. 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.

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) Increased investments in automotive companies, and ii) 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 also 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 Spindo’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, Spindo also sells steel plates and performs several types of value-added services, including galvanising, epoxy coating, 3-layer polyethylene coating, and cement lining.

Margins varies across industry segments
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 is 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.

Mix of recurring and project based pipe demand
Around 60.0% of Spindo’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 Spindo’s revenue is generated from the domestic market.

Its Relatively Strong Brand Presence Softens Price Wars Exposure

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.

Brand recognition gives an appeal in the saturated steel pipe market
We do understand in the sense that steel-pipe industry is somehow a saturated market and is linked to steel-commodity movements, however based on our channel-check, brand recognition does give a certain appeal to pipe customers. Given Spindo’s products has strong brand recognition in the market with proven consistent in quality standards, we believe Spindo is capable 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.

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 higher-grade parts segment. This strategy reduces its exposure to the price wars that occur among other pipes players. Furthermore, there is limited domestic supply of straight wielded O&G pipes of large diameters.

Industry actual capacity fulfillment constrained by working capital
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, Spindo 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.

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).

Sells automotive pipes to the big names
Spindo 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.

Strong demand for pipes in the automotive segment
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.

Lesser competition in the O&G pipe 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.

The nation is moving to gas
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 massive oil imports 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 Spindo’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
Well-known “Spindo brand” in the construction pipe segment. With its Spindo brand in possession, the group holds a 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.

Wide range of products for the construction industry
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.

Providing strong after-sales service
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
Relying on multiple suppliers
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.

The dynamics in margins when steel price fluctuates
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.

Higher expsorure to local raw materials
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.

Bears additional forex risk from using 4-6 months USD L/C facilities. 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
Production capacity to increase by 22.4% and 30.6% in 2014-15
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.

Capacity expansions also improves productivity and efficiency. 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. Spindo’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, Spindo 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.

To improve distribution channel
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. Spindo 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 Spindo 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
1H14 net income accounts 49% to our FY14 net profit target
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
Intitiate with a BUY with DCF-based TP of IDR370. We use 11.6% weighted average cost of capital (WACC) and long-term growth rate of 5% assumptions to derive our DCF-based TP method. Our TP of IDR370 implies 7.0x 2015 PER, still at a 59% discount from the construction companies’ current average of 16.6x 2015 PER.

Peers comparison
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 39), given that its regional peers have lower profitability on average (regional peers have lower margins and ROAE levels).

In view of Spindo’s revenue mix – a combination of recurring income and project-based income which creates some cyclicality – as well as its high exposure to construction sector, we think the stock’s current valuation of 4.7x-3.3x 2014-2015F PER, should not be traded at such steep 77.0% and 80.3% discount to the construction sector which is at 20.4x -16.6x 2014-15 PER.