Steel Pipe Industry Steel Pipes For The Nation, Cheap and Hot

We initiate ISSP with a BUY premised on 1) Its dominant position in domestic steel pipe market (~30% share); 2) A strong proxy to the oil & gas (O&G) pipes demand, construction/infrastructure developments and higher local content requirements in the automotive sector; and 3) Highly appealing 3.3x FY15F P/E, 15% ROAE and PEG of only 0.1x. We derive our DCF based TP at IDR390, implying an 8x 2015 PER.

Opportunities aplenty in O&G
Perusahaan Gas Negara (PGAS, BUY, TP: IDR6,500) projects lifted ISSP’s FY13 O&G pipe sales threefold vs FY12’s low base number. In FY14, we expect numerous projects to accelerate overall demand by 30.0-40.0%. These include Pertamina Gas (Pertagas)’s IDR2trn Semarang-Gresik pipeline. ISSP stands to gain a bigger slice of the market too after the number of players dropped to three (from five) after some firms failed their certification audits.

Positives in the automotive and construction markets
Recent massive investments in the auto parts industry and the increasing local content requirements should boost domestic demand for automobile pipes by more than 20.0-30.0% per year (2013-2014). Demand for construction and infrastructure pipes will be supported by the execution of Indonesia’s 15-year Economic Masterplan (MP3EI) projects.

Earnings jump
We see ISSP’s FY13 earnings surging by 170.0%, driven by 29.0% revenue growth and GPM expansion (FY13F: 18.8%; 1H13: 21.1%; FY12: 13.0%) – partially due to higher O&G pipes sales and the lag between selling price increases and raw material cost hikes driven by a weaker IDR. We estimate FY14F earnings growing by 30.0% on 28.0% topline growth.

Appealing valuation
ISSP’s current valuation is attractive at only 4.0-3.1x FY13-FY14 P/Es. Given its revenue mix of recurring and project-based income, and high exposure to the construction sector, we feel its valuations should be anchored to its construction peers, but at a discount. Thus, TP is set at IDR380, based on 7.0x FY14F earnings, 45.0% below the 12.7x FY14 P/Es of its peers.
Risks. These include: i) project delays, ii) high raw materials cost fluctuations, and iii) the high volatility of the IDR vs the USD.

Investment Thesis Summary
Valuation and TP
We initiate our coverage on ISSP with an IDR380 TP, pegged to 7.0x FY14F earnings, or 45.0% discount to the construction sector (please see Figure-23). 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.

ISSP’s current valuation is very appealing, with the counter trading at 3.1x FY14 P/E – a 75.0% discount to other infrastructure proxies within the construction sector. While we think that some degree of discounting is justifiable, due to its thin liquidity and small market capitalisation, we regard the current discount as being unreasonably wide. We reckon that this occurred simply because the market has been overlooking the stock. ISSP is definitely a BUY.

Investment thesis summary
We like ISSP 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 170.0%/30.0% in FY13F/14F
This solid performance will be supported by margin expansions, with FY13F/14F gross margins projected at 18.8%/17.2% vs 13.0%-15.4% in the last three years. It will also be boosted by expected robust 20.0-25.0% sales volume growth for pipe products.

These margin expansions will be mainly backed by: i) better product mix – especially by a higher portion of O&G and automotive pipes, ii) increasing productivity and efficiency from new machinery and improvements in existing production lines, and iii) higher economies of scale. Rising raw material prices could also temporarily boost margins in 2013, as selling prices increase faster than the recognition of rising costs. This is due to the 3-month inventory time lag, although we expect the effect to be normalised in 2014. ISSP’s positive catalysts moving forward are:

Increasing O&G pipes portion supports margins
We see contribution from O&G pipes sales to increase to 19.0% in FY14F from 5.0% in FY12. Notably, O&G pipes GPMs are ~30.0%, higher than ISSP’s 1H13 blended GPM of 21.1%. 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. It is also worth noting 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. ISSP plans to 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. These products have higher profit margins than the group’s current range of automotive pipes.

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 and improved production line
In tandem with a higher production volume, we believe ISSP will have a higher bargaining power when it comes to buying steel at lower prices. Additionally, the group is also slated to restructure the production lines at its first plant in Rungkut, Surabaya. This plant was built in the 1970s and accounts for ~33.0% of ISSP’s total production capacity. Currently, the production lines at this plant are not well-managed and hence suffer from high wastage. Improved production lines will boost the plant’s production efficiency.

Steel Pipe Industry of Indonesia
Business overview
ISSP 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 ISSP’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 GPM is the highest at around 30.0%. By comparison, the GPM 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
While there is no formal data on the industry, it is estimated that domestic consumption of steel pipes across the board is nearly 1m tonnes per year, with domestic production at around 600,000-700,000 tonnes. The rest comes from imports. The bulk of the domestic production is made up of cheap, non-standard, low-grade pipes. 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 (see above) is 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 77.0% capacity utilisation – nearly reaching its actual maximum utilisation of 90.0%.

The group’s main sales product are standard pipes, which need a high level of quality and certification/standardisation. However, do note that, even in the non-standard segment, ISSP 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 – ISSP, PT Indonesia Steel Tube Works (ISTW) and PT Srirejeki Perdana Steel. The group’s sales 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.

Investment in the auto parts industry reached USD6.1bn in 2012, and this includes the entry of 200 new auto parts producers and Denso Corp (6902 JP, NR)’s third plant. As for 2013, the Government expects USD1.5bn in investment from 100 new Tier1-3 companies, including Bosch’s EUR10m investment for its first Indonesia-based manufacturing facility.

Meanwhile, ISSP’s planned expansion at its Karawang, Java, plant includes a line to produce an array of new products with small diameters but high thickness. Therefore, even though 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 39,000 tonnes in 2013 (+31.0% y-o-y) and 55,000 tonnes in 2014 (+39.0% y-o-y). The group’s automotive pipes are competitively priced vis-à-vis the imported parts.

O&G pipes
ISSP 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
Last year, there were five domestic producers, namely: i) ISSP, 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 recently 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-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. Projects in sight include Pertagas’ Semarang-Gresik and Gresik-Cirebon gas transmission pipelines, which will require around 90,000 tonnes of steel pipes each.

Given the favourable competition landscape, its expansion plans, and major projects in the pipeline, we expect ISSP’s O&G sales volume to reach 34,000 tonnes in 2013 (+298.0% y-o-y) and 54,000 tonnes in 2014 (+58.0% y-o-y).

Construction pipes
ISSP, with its Spindo brand, holds a very strong position in the construction 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.

However, the upcoming elections and high interest rate environment may put some risk on new high-rise developments in the next year.
Hence, we expect ISSP’s sales volume to the construction sector to increase to 183,000 tonnes in 2013 (+5.0% y-o-y) and 211,000 tonnes in 2014 (+15.0% y-o-y). Considering construction pipe and O&G pipe are produced by the same production facility, increasing portion of O&G pipes also contributes to the flattish 2013 expectations. Note that ISSP’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
ISSP sources its steel needs from several suppliers to ensure raw materials availability. The nature of the industry requires that the 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 ISSP the opportunity to generate higher margins in the short-term. Higher raw material prices will influence Krakatau Steel to raise its selling prices, which are used as the benchmark in the domestic steel-based market. Consequently, ISSP 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.

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 2011-2012. The increasing margins in 2011 was the result of higher contribution from O&G pipes and rising raw material prices, while, in 2012, the main reason for narrowed margins was the fall in raw material prices and the drop in O&G pipes contribution.

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 ISSP 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.

Sales of other products – especially of steel plates – can also be easily adjusted, given that they are spot sales. While plate products generally have low margins, these products are very useful in a declining raw materials price environment, especially when ISSP is looking to quickly offload a high price inventory item and replacing it with a lower priced one.

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.

ISSP 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. Net-net, a weakening IDR may support gross margins, but will add some forex loss.

Strategic expansion plan
ISSP’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 77.0% vs the actual maximum utilisation of ~90%). Among its five existing plants, two have already exceeded 80.0% utilisation rate. The following is a summary of ISSPs capacity expansion plans:

i. The group’s most important expansion is 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 offshore O&G sector. Until now, the domestic supply shortage of large diameter ERW pipes has been filled by imports. ISSP is currently only produces straight wielded ERW pipes of up to 8-inch in diameter.
ii. Another important expansion to serve the O&G market is the immediate addition of 60,000 tonnes of spiral pipe annual production capacity – involving USD15m capex – to capitalise on the absence of supply from rivals Indal and Bumi Kaya amidst imminent major O&G projects on the horizon. Note that the production facility for O&G pipes can also be used to meet the demand for construction pipes.
iii. ISSP is increasing the capacity at its Karawang plant (currently at 82.0% utilisation) by more than 100.0% 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.
iv. ISSP is setting up a new plant in Sidoarjo, Java, to boost its furniture pipes production capacity.
v. The group is also looking to improve its existing facilities, including replacing some old machines, and increasing its slitting and milling capacity. Total expansion capex will be around IDR1.6trn over the next two years.

Besides adding capacity, the expansion and improvements at its various plants is expected to increase their productivity and efficiency in many ways. These positives are:
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. Faster production with new machines.
iii. Lower wastage, eg a larger slitting machine will be able to handle heavier steel coils, which, in turn, results in less welding and wastage.
iv. Reduced setting time – with more production lines, each production line will work on fewer variations, which will lead into less downtime when changing settings.
v. 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.
vi. We expect these improvements to impact margins positively in the near 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.

Moving forward, the group is keen to open production facilities in West Java to better serve the western half of the Indonesian archipelago.

Financial forecasts
We expect revenue to grow by 29.0%/28.0% in FY13F/14F, driven by: i) sales value growth of 12.0%/19.0% in construction and infrastructure pipes, ii) 312.0%/63.0% in O&G pipes, iii) 16.0%/34.0% in furniture pipes, iv) 37.0%/43.0% in automotive pipes, and v) 2.0%/15.0% in others.
We also expect gross margin to increase significantly in FY13F to 18.8% (from 13.0% previously), on the back of: i) better product mix with larger portion of O&G pipes sales (2013: 15.0% vs 2012: 5.0%), ii) higher economies of scale and production line improvements, and iii) lag between the increase in selling prices and raw material costs. As previously mentioned, amidst a weakening IDR, ISSP’s selling prices increase relatively quickly while its cost of goods sold is tied to a 3-month inventory cycle – this creates a temporary margin expansion.

We expect higher economies of scale and production line improvements, as well as increasing O&G pipes sales contribution, to continue having some positive effect on FY14F margins. However, we conservatively set a lower gross margin assumption at 17.5%, to account for the normalisation of the lag effect between selling prices and cost of goods.

With its expansion plans, net gearing is expected to increase to 0.7x at end-FY13F (from 0.3x as at end-June) and 1.1x at end-FY14F. The table below shows our operational assumptions.

1H13 results review
ISSP registered a 1H13 net income of IDR138bn, accounting for 46.0% of our FY13F forecast on revenue, which only reaches 39.0% of our full-year estimate. We expect stronger 2H13 revenue, considering that most of PGAS’ projects will be delivered in 2H. Moreover, 2H is seasonally a busier half for the rolling out of construction projects.

On a q-o-q basis, net profit dropped by 26.0% due to weakening GPM, as ASPs decreased in tandem with raw material prices (see Figure 14). We are keeping our forecasts conservative despite the recent weakening of the IDR, which may have temporarily expanded margins in 3Q13, as well as higher contribution from the O&G segment that generates a higher-than-average gross margin. We estimate FY13F gross margin to come in at 18.8%, lower than 1H13’s gross margin of 21.1%.

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 9.1x-7.0x FY13-FY4 earnings, at 44-45% discount from the construction companies’ average of 16.3x-12.7x FY13-FY14 P/E.

Its current valuation, at 4.0x-3.1x FY13-FY14 P/E, is a massive 75% discount against construction companies’ average FY13-FY14 P/E even though its profitability prospect is on par with peer average, with a similar current gearing level. The discount is even steeper vs regional peers, which have lower profitability on average. We initiate coverage on the counter with a BUY recommendation.