Pantech ... Aug11

InsiderAsia.

- Sales in 1QFYFeb12 up 31% q-q and 6% y-y
- Demand pick up expected to gain momentum
- To resume double-digit growth in FY12-FY15
- Very attractive FY12E P/E of 7.1x with 5.9% net yield

Pantech Group Holdings’ earnings results for 1QFYFeb2012 were broadly in line with our expectations.
Turnover improved to RM95.3 million, up 30.8% from the lows in 4QFY11.

Trading sales accounted for roughly 68% of total turnover while the manufacturing arm contributed to the balance.

As previously mentioned, the recovery in the domestic oil & gas sector had been relatively slow since the end of the global financial crisis. As such, while trading sales, which cater primarily to domestic demand for pipes, fittings and flow control products (PFF), improved to RM65.2 million in 1QFY12, from RM51.7 million in 4QFY11, they remain at levels well below the highs recorded before the crisis.

Positively, domestic demand is visibly picking up momentum on the back of the rollout of projects under the various government initiatives, including those under the Economic Transformation Programme (ETP).

The recovery in Pantech’s manufacturing arm has been much sharper, boosted by export demand for its PFF products. Manufacturing sales rose to RM30.2 million in 1QFY12, up from RM21.2 million in the immediate preceding quarter and RM22.8 million in 1QFY11. Apart from stronger overseas demand, sales were also boosted by contributions from the company’s new stainless steel manufacturing plant in Johor Baru.

Utilisation for the first six production lines at this new plant has been rising smartly over the past few months. Nevertheless, the plant remains in the red, having started operations only early this year.

Meanwhile, the old plant in Klang is running at full capacity. Pantech has order books up to October 2011 and is currently negotiating for contracts beyond this period.

As a result of start-up losses at the new plant, operating profit for manufacturing declined to RM1.3 million in the latest quarter, down from RM1.7 million in 4QFY11. Pantech expects the new production lines to
turnaround in 2HFY12.

The decline in manufacturing operating profit was offset by higher trading operating profit, of RM8.9 million, up from just RM4.8 million in 4QFY11. Total operating profit improved to RM10.2 million, compared with RM6.5 million in the immediate preceding quarter, but still lower than the RM12.3 million recorded in 1QFY11. The lower margin – turnover was up 5.6% y-y – was attributed to greater pricing competition with demand still in the nascent stage of recovery.

Pantech’s total net profit stood at RM6.2 million, an improvement from RM5.1 million in 4QFY11 – but lower compared with the RM8.4 million in 1QFY11 due to lower operating margin as well as a higher effective tax rate.

Earnings Outlook
We expect Pantech’s earnings to continue to improve in the coming quarters, as project rollout in the domestic oil & gas sector gains momentum. Indeed, we forecast the company’s revenue and net profit will register double-digit growth annually for the next few years.

Outlook for the domestic oil & gas sector, Pantech’s single biggest customer group, is robust. The Malaysian government has pinpointed the sector as one of the key focus areas under its ETP. The sector accounted for a
substantial share of the total value of the projects that have been announced so far.

The gradual rollout of these projects over the next few years will translate into greater demand for downstream support services, including demand for Pantech’s PFF products. The company’s trading division caters, primarily, to the domestic market.

At the same time, outlook for its manufacturing division – where the bulk of products are currently exported worldwide – is also upbeat. Pantech’s carbon steel PFF manufacturing facility in Klang is effectively
running at full capacity. To cater to the expected demand growth, a new piece of land adjacent to its existing plant (acquired in FY09) is being outfitted to manufacture, primarily, high frequency induction long bends. It will also house a heat treatment facility. The new plant is slated for completion by end-2011.

Meanwhile, operations at the new stainless steel manufacturing plant in Johor Baru are progressing on track. All six initial production lines are up and running with utilisation already reaching 85%. Pantech has orders in hand up to October 2011 and is currently negotiating for better prices for contracts beyond this period.

Pantech is in the midst of adding machineries for another four lines at the facility – which would expand its current production range to include biggersized pipes and also fittings.

If all goes to plan, total production capacity at this plant will rise to 12,000 metric tonnes per annum by 1Q2012, from the current 7,000 metric tonnes per annum.

The company is also actively exploring various options to further expand its range to encompass higher value exotic products such as copper-nickel, duplex and super duplex pipes and fittings that are corrosion resistant.
The move would expand its customer base and market reach – and is the final piece in Pantech’s five-year plan to hit sales target of RM1 billion. Bythen, the company expects manufacturing sales to account for at least 40% of total sales. Domestic demand will also account for a higher percentage of manufacturing sales, as a result of import substitution.

Valuation and Recommendation
We expect Pantech’s sales and net profit to register strong double-digit growth annually for the next few years on the back of strengthening demand supported by the company’s expansion plans.

To be sure, net profit was still weak in 1QFY12, although an improvement from the immediate preceding quarter. This was attributed to pricing competition as there is currently excess capacity in the industry with demand just starting to pick up pace. Margins will gradually improve as the slack is taken up by strengthening demand.

Thus, we believe that Pantech’s earnings will be much stronger in 2HFY12 compared to the first half of its financial year. We are fine-tuning our earnings forecast. Net profit is estimated at RM37.7 million in FY12 – up 30% from the RM29.4 million in FY11 – and is expected to grow further to RM46.1 million
by FY13.

Based on our forecast, the stock is trading at very modest P/E valuations of only 7.1 and 5.8 times, respectively for the two years. Plus, the stock is trading below its net asset of 72 sen per share.

Pantech’s valuations compare very favorably against most oil & gas stocks listed on the local bourse, which are now trading at P/E multiples of around 15 times earnings, on average.

Thus, we believe there is significant upside potential for Pantech, particularly for those with a slightly longer investment horizon. We maintain our BUY recommendation on the stock.

Investors can also expect attractive yields
On top of potential capital gains, shareholders can also look forward to prettygood yields from the stock.
Dividends totaled 3.3 sen per share in FY11. With stronger earnings going forward, Pantech is likely to gradually raise its dividends. We estimate dividends will rise to 3.5 sen per share in FY12, which will earn shareholders an attractive net yield of 5.9% at the current share price. This is above the average yield for the broader market as well as prevailing interest rates on bank deposits.

Warrants and ICULS for lower entry price points
For lower entry price points, investors could consider the company’s ICULS and warrants.
Pantech has some 735 million outstanding ICULS, carrying a 7% coupon rate with a conversion ratio of six to one, exercisable at anytime up to December 2017. Based on the current share price of 59.5 sen, the ICULS,
Pantech-LA, would be “in the money” at roughly 9.92 sen. They last traded at 10.5 sen.

The company also has some 74.8 million outstanding warrants, Pantech-WA. The warrants have a longer maturity period, up to December 2020, and exercise price of 60 sen. The warrants are now trading at 28 sen, implying a 48% premium.

Upon full conversion of the ICULS and warrants, Pantech’s share base will be enlarged to some 650 million shares from 452.6 million at present. The larger share capital – in step with its growing business – would improve liquidity and increase the stock’s attractiveness to investors over time.