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We are neutral on Malaysia. Most of the negatives are well known and already priced in, in our opinion. We see selective positive trends emerging but we suggest a wait-and-watch approach. Economic recovery is well under way, credit growth is healthy and the ringgit is expected to stay strong. Exports to China have grown strongly and more IPOs look to be underway. We expect news flow to accelerate towards the latter part of 2H, with 2Q staying relatively quiet. Stocks to own for the next 12 months are KLK, Genting, Gamuda, IJM and AMMB.

There are five key themes for the market — a burst of economic energy; a stronger currency; robust credit growth, feeding China (exports worth RMB67 billion or RM31.53 billion in 2009) which is positive on palm oil; and IPOs likely to be revived in 2H2010.


Five points on market valuations, direction
1. Valuation challenge

This is a perpetual challenge and probably the most frustrating part of the market. Malaysia has long been considered expensive given the “trapped” liquidity in the domestic market. On a regional basis, Malaysia is trading at 33.7% PER premium to the region or 32.6% on a P/B basis. Market ROEs in 2010E and 2011E are slightly lower than the region at 14.2% and 15.3%, respectively (region: 14.8% and 15.6%).

More specifically, EPS growth momentum (27% and 16% for the same years), though on an upward trend since June 2009, is slightly inferior to that of the region at 29.1% and 18.3%, respectively.


2. Dividend yields ahead of the region
The only valuation parameter that stands out for the market is dividend yield. Malaysia’s net dividend yield of 3.2%-3.6% for the next two years is superior to that of the region at 2.1%-2.5%. Cash flow generation is still relatively strong and capital returns continue to be a dominant theme, e.g. DiGi.com, Telekom Malaysia, CIMB Group etc.


3. Our preferred sectors
We prefer the plantation, construction and power sectors. We are bullish on the palm oil price, given the robust demand for edible oils from emerging markets such as China and India, especially at a time of potential supply risk in the last quarter of 2010. Our top pick is Kuala Lumpur Kepong.

News flow in the construction sector has perked up with new contracts given out and margins recovering. We prefer Gamuda and IJM Corp. We believe that the economic recovery will benefit companies such as Tenaga given its exposure to the industrial sector and the group’s exposure to US dollar debt and coal cost as the ringgit strengthens.


4. Neutral position for the market
Our bottom-up index target for Deutsche Bank’s universe of stocks suggests an MSCI target of 511 (+4.8%) and FBM KLCI target of 1,389 (+4%). This compares against consensus, which suggests an upside of 2%. This suggests valuations 16.4 times PER 2010E, slightly ahead of the average of 15.6 times post-Asian crisis valuation, but still more than 20% premium to the region. The market is at best a neutral given the limited upside to the market based on our bottom-up valuation.


5. Three themes likely to dictate market direction
First, the government’s periodic announcements on further liberalisation measures. Secondly, potential new IPOs hitting the market. Thirdly, further detailing of the New Economic Model (NEM) by end-3Q 2010. We expect these catalysts, mostly towards 2H2010, to force some attention back into this somewhat out-of-favour market.

In addition, political “noise” could be a distraction given the ongoing disarray and infighting in the ruling party and the opposition party.

Five stocks to own in this market
This remains a stock specific market for outperformance. The overall market may not be attractive when compared with Indonesia or Singapore, but it does offer high-quality companies offering growth and reasonable returns. These companies, in our opinion, are KL Kepong, IJM Corp, Genting, AMMB and Gamuda.


KL Kepong
(RM16.66, buy, target price RM21.20)

A well-respected and well-managed proxy to improving palm oil fundamentals. Approximately 80% of its earnings are derived from palm oil and rubber. The company has estates in both Malaysia and Indonesia. The balance sheet remains strong, with gearing near zero in FY10 and FY11.This gives the group significant M&A firepower.

There are two key catalysts. First, we believe that the palm oil price will re-rate over the next two years given the robust demand from emerging markets. This is against a backdrop of underfertilisation among Indonesian small holders over the last 12 months and potentially lower yields as a result of the El Nino impact on Malaysian estates. Secondly, potential capital management and/or value accretive acquisitions.

We use the P/B=ROE-g/COE-g model to value KLK. Our target price of RM21.20 is based on a resulting P/B of 3.3 times and implied valuations at 17.6 times PER 2010E.

Risks to our view are a major downturn in the palm oil price, further losses from its retail arm, Crabtree & Evelyn and persistent adverse weather affecting productivity.

Genting Bhd
(RM6.60, buy, target price RM7.68)

Genting continues to offer steady growth in casino operations in Malaysia (24% of SOTP), exposure to Singapore gaming (44%) and consistent casino management fee (12%). The group’s net cash position places it in a favourable position to seek regional expansion opportunities.

There are two key catalysts — potential earnings accretion-type acquisitions and profitability build-up from its newly opened integrated resort in Sentosa, RWS.

Driven by 32.5% two-year NP CAGR (mostly by growing contributions from RWS) and trading at 25% discount to market SOTP, Genting looks attractive to us on valuations.

The stock is trading at 8.6 times 2010E EV/Ebitda of 8.6 times versus its Macau peers at 11.8 times.

Our target price of RM7.68 is based on 10% discount to SOTP.

Risks to our view are smaller-than-projected Singapore gaming market impacting the profitability of RWS in Singapore and potential value-eroding acquisitions.


AMMB
(RM4.96, buy, target RM5.70)

Although AMMB is not a “beneficiary” in a rising rate environment, we like it for its longer-term potential as its transformation and credit quality improvement continue.

Catalysts include an ongoing market share “grab” of CASA deposits (AMMB lags well behind its peers) with an increasingly more effective distribution network. Also, quarterly reports suggest an improvement in asset quality and growth in non-interest income (from a low base).

We believe the structural changes being undertaken by AMMB’s management suggest the stock should trade at a premium to its historical averages. Our RM5.70 target is based ROE-g/COE-g methodology. We have assumed an ROE of 16%, which we believe is achievable, given better credit outlook than previously anticipated.

Risks to our view are the re-emergence of credit quality problems and a sharply higher-than-expected rate cycle impacting cost.


IJM Corp
(RM4.90, buy, target price RM5.40)

IJM is not just an infrastructure company, despite what we see as a popular misconception. The company offers well-rounded growth from industries we like. For FY10, we expect PBT contribution as follows — plantations (32%), property (28%), industrial (23%) and construction. We forecast two-year net profit CAGR of 28.1%.

A combination of rising palm oil prices, a recovery in construction margins (after a period of wafer-thin margins thanks to skyrocketing input prices), robust residential property demand in the upgraders’ market and improving contract news flow in the construction sector.

Our target price is based on SOTP (on the latest market prices of its listed subs: net debt, 2.2 times P/B on ex-Malaysian infrastructure assets, DCF of its toll roads and PER for the construction/industrial divisions). Our target price implies 2010-11E PER of 19.8 times and 16.2 times, respectively.
Risks to our view are lower-than-projected new order wins, weak palm oil price and a sharply higher interest rate cycle negatively impacting the property market.


Gamuda
(RM2.96, buy, target price RM3.30)

Gamuda remains a well-managed company offering exposure to a pick-up in the domestic construction scene. A pick-up in property sales, improving margins (1% increase in margins = 5.5% increase in net profit in FY10), a construction order book of RM5.7 billion, should help the company deliver a two-year CAGR of 34.5%.

There are three catalysts — new contract wins in large-scale government jobs (light railway), deal conclusion with Splash and the Selangor state water assets and improving property sales domestically and the unlocking of value of its landbank in Vietnam.

Our target price of RM3.30 is based on SOTP and implies 21.8 times PER 2010 (vs the market’s 16 times PER valuation but on lower growth of 27%), similar to its historical average valuations. This may seem expensive but the growth opportunity and diversified earnings stream should be borne in mind.

Risks to our view are a slow recovery in construction margins, forex devaluation in Vietnam, a significantly higher interest rate environment derailing the domestic property market and no large contract wins, as anticipated by the market.


Five questions and answers

Before we start on the market, what worries you most about the country, from a personal viewpoint? What are the “soft” issues I should also be aware of?
Teoh Su Yin (head of research): Two issues worry me —education and security. The country’s education system has become very polarised. Children are attending government schools that are no longer multicultural in nature (almost 90% of Chinese children go to Chinese schools because of the perceived better education offered) and, hence, have very little interaction with other races. This is not good.

Also, the government is still debating the use of English in various subjects rather than embracing the language all together, and this is despite extorting the importance of driving the services sectors.

In addition, security is increasingly an issue, though government statistics show a moderation in crime. The police force continues to be under-resourced, and public confidence in police protection and/or help continues to wane, in our opinion.


OK, what about the market? When will we see a true revival of this once loved emerging market?
Malaysia is at a crossroads. Prime Minister (Datuk Seri Najib Razak) has a mammoth task ahead of him to restructure the economy to one that relies less on external demand. Also, the market needs a structural “revival” but it will take several years to mend after being marginalised over the last 10 years. At just 3.8% of MSCI, there is little incentive for fund flows to view the overall market seriously, in our opinion. This is a low beta market with few large-cap listings in recent times. We think this has to change to renew interest in the market. As discussed earlier, foreign ownership in the market, at 20%, has barely moved in the last 12 months and foreign participation has eased to just around 26% YTD March 2010 (vs 42% in 2008 and 35% over the previous four years).

We believe interest in the market will come in two possible waves. The first, and smaller, wave is likely towards 4Q this year, when two possible events occur.

First, the potential listing of two Petronas subsidiaries, as announced by the government, and secondly, as and when further details of the NEM are released. The larger wave of interest is possibly late 2012, but only if PM Najib is able to win the next general election convincingly. His ability to reshuffle the cabinet effectively will likewise be an important signal to indicating how quickly he can implement the changes required to revive this market. Those would be the catalysts for the market. Until then, we believe he will be able to effectively implement a select number of initiatives.


What about the political environment?
Malaysia is not Thailand, but nor is it free of political noise. Despite significant press coverage on the country’s vulnerable politics since March 2008 when Barisan Nasional, the ruling coalition, lost a significant number of seats in key states, the political environment has actually been relatively stable. Street protests have been rare and racial/religious conflicts, if any, have been limited, even though dramatic publicity was generated.

There have been several by-elections and party defections. And there have also been the odd arrests of political activists. Overall, the political environment looks relatively stable for a country which only recently “discovered” democracy.

We believe political noise has become the norm, especially now with a more vocal and significant opposition party in parliament. The opposition party is still struggling to unite its three diverse component parties, and it does not help when the opposition leader, Datuk Seri Anwar Ibrahim, is distracted by a high-profile court case. The ruling party, too, is trying to reunite all component parties after significant infighting, like MCA.

Many veteran foreign institutional investors remember Malaysia as almost politically risk free during the Mahathir era. But since March 2008, the political environment has changed and, we believe, will weigh on the market sporadically. Nevertheless, the ruling party still holds a strong parliamentary majority of about 63%, and much can still be done with such a margin, though not as easily as when it had a long-standing two-thirds majority prior to that.

There are a large number of quality stocks that do not rely on the political environment to succeed. The plantation sector is one. The sector is reliant on global consumption and is not dependent on government regulations or contracts.


If I had to invest in one sector in Malaysia, which would it be and why?
The palm oil sector. We are bullish on the long-term fundamentals of palm oil. Not only it is the most efficient edible oilseed (yield of four tonnes/hectare vs less than two for most others), demand is fast growing, thanks to strong off-take from emerging markets such as India and China. Increasingly, rapeseed and corn are feeding the ethanol/bio-diesel industries in developed markets, leaving palm oil as the main edible oil to fill demand in the food/confectionary market in the EU. Palm oil surpassed soybean oil as the dominant oilseed in 2005 and now commands 27% market share of the top 17 oilseeds globally.

Greater NGO policing, under-fertilisation by Indonesian smallholders in the last 12-18 months, El Nino impact on yields in East Malaysia and labour constrains in planting up new hectarage in more remote parts of Indonesia suggest potential supply risk in the medium to longer term. This is against a backdrop of robust demand for basic food products in faster growing economies like China, India, Southeast Asia.

Our preferred exposures to the sector are KL Kepong, listed in Malaysia; Golden Agri Resources (S$0.60, buy, target price S$0.72) in Singapore; and Astra Agro Lestari (22,650 rupiah, buy, target price 31,800 rupiah) in Indonesia.


I understand valuations are steep and there are longer-term structural issues keeping a lid on the market, but are there stocks in Malaysia offering exposure to higher growth Asean markets?

Yes. In addition to the companies we mentioned earlier, such as Genting, there are three-four in the big-to-mid-cap space. First, CIMB offers the Asean financial footprint, which offers exposure Indonesia and as well as Thailand and Singapore. We estimate that by 2012, non-Malaysia would account for 30%-35% of total earnings.

Secondly, Maybank offers exposure to Indonesia, Pakistan etc, with offshore earnings, we estimate contributing 35% of profits by 2012.

Thirdly, Axiata offers regional telco exposure to India and Asean markets. We estimate that about 40% of Axiata’s SOTP is derived from non-Malaysia. These entities are Excelcomindo in Indonesia, which has benefited from strong net adds and Ebitda margin expansion.

The management’s yield strategy and cost controls have also paid off. Other assets such as Idea Cellular (9%) in India continues to face competition, whereas M1 (S$2.09, hold target price S$2.00) (4%) in Singapore, on the other hand, has benefited from improving economic conditions. Dialog (5%) in Sri Lanka demonstrated signs of recovery into the 4Q, with Ebitda improvement. Meanwhile, Celcom in Malaysia continues to report robust revenue growth and improved margins.

Fourthly, more than 80% of Sime Darby’s earnings are derived from non-Malaysia. The bulk of it is palm-oil related (60%-70% of Ebit), followed by the industrial division, which is largely the Caterpillar franchise in Australia and, to a certain extent, China (16%), and auto businesses (5%) in Singapore, Hong Kong and China. Our ROE/COE model values the company at RM10.20, implying PER 16 times 2011E.


This article appeared in The Edge Financial Daily, May 5, 2010.

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