Solid wood

Solid wood

James S

IT’S A SECTOR that is quite cyclical, given its commodity-based properties. Still, timber strikes a chord in local retail investors, as many old bull market darlings have been known to come from this sector in the past. Of late, some timber stocks have started to grab attention with their price movements. Compared with the past 12 months, most timber stocks have recorded an average total return of 112.2%, out-performing the Kuala Lumpur Composite Index (KLCI) by 80.2% (see Table 1).

Are timber stocks making a comeback for real, or is it just investors punting on these bull darlings of old? To be sure, news flows have turned positive recently on the sector and these in turn are stirring up investor sentiment. For example, the recent listing of Samling Group on the Hong Kong Stock Exchange (HKEX) has triggered privatisation talks on Lingui Developments Bhd, as the former still holds almost a 60% stake in Lingui.

In addition, there is market talk that Jaya Tiasa Bhd could embark on the same move, ie, transferring it listing to the HKEX as well. All these have brought the attention of investors back to the sector, especially to the smaller timber players. Further, most of the timber companies have also been showing improved earnings based on their latest corporate results (see Table 2). OSK Investment Banks Research, which released a comprehensive report on the sector in late March, thinks that the sector is poised for an upside rally this year, and is over-weighting a number of timber stocks.

Timber still a unique commodity to Malaysia

According to the report, timber is one of the major resources that are unique to Malaysia apart from oil and gas, palm oil and rubber. The sector is divided into three major sub-segments:

(i) timber concessions,

(ii) logging, and

(iii) plywood manufacturing segments.

Timber and timber-related products contributed about 4% of Malaysia’s total export revenue in 2005.

Based on the statistics published by the Forestry Department of Malaysia (see Table 3), the country has a total land area of 32.8 million ha, of which 59% or 19.4 million ha are forested areas. However, only 11.2 million ha are production forests, with the rest occupied by protected forests, reserved forests and tree crop estates (rubber, oil palm, cocoa and coconut).

Logging activities are mainly concentrated in Sarawak, which has the largest forested area in the country. Local logging companies generally secure timber concessions from the government. The harvesting period is normally above 10 years and harvesting plans must be submitted to the Forest Department before logging. Royalty payments on the concession are paid to the government regularly.

In Sarawak, the requirement of the government is that only 40% of the harvested round logs are allowed for export, with the remaining 60% being obligated to be used for downstream processing purposes. Round log export, however, is banned in Peninsular Malaysia, as one of the government’s efforts to promote downstream processing activities in the industry as well as to preserve the forested area of the country.

Structural change in place

With timber stock prices stirring recently, is the sector actually poised for a big move ahead? According to OSK Research, it is worth taking a look at the sector now, given that the rally in physical timber prices are actually being underpinned by strong global demand. Prospects for the sector, it believes, has improved a lot, as it is of the opinion that the industry has already undergone structural changes, resulting in better production efficiency and quality as well as a tighter corporate governance trends.

Rising market space

Besides Japan, analysts expect China, India and the Middle East to be the next key importers and growth areas for the sector. Traditionally, domestic tropical wood is particularly popular in Japan, as it can enhance building flexibility to resist earthquakes. The wood is mainly used for flooring, refurbishment and construction purposes.

India, on the other hand, uses tropical hardwood for railway sleepers. China is expected to emerge as a big importer of tropical wood in the future. In 2005, 8.3% of China’s imports of overall timber products came from Malaysia. There are four drivers leading to the increased demand for timber products here:

(i) a booming economy and consumption,

(ii) the ability of timber producers to capture more value-added features in the manufacturing process, and rising international demand for lower-cost timber products in China,

(iii) the insufficient resources available to meet increasing demand, and

(iv) the preparation for the 2008 Beijing Olympics, which is fuelling timber demand for sports and infrastructure construction works.

While most of these timber-consuming countries have already raised their import of woods significantly over the last two years, OSK Research reckons that timber consumption demand in these countries will remain firm, given their sustainable economic growth momentum.

Furthermore, the growing demand from Singapore also, due to the construction of two integrated resorts there, should not be under- estimated, it says. The research house adds that the above factors should drive Malaysia’s tropical timber to continue riding the up- trend wave in the future.

Leader in tropical wood exports

The rising trend of demand is especially beneficial to Malaysia, as it is still the main player in the region for tropical wood exports despite competition from Indonesia, which is also a major round wood producer in the world with its 88.5 million ha of forest area as compared to Malaysia’s smaller 20.9 million ha.

Nonetheless, the supply of tropical timber from Indonesia has been tight due to the Indonesian Government imposing several protectionist moves to preserve its forests, which include the following:

* a ban on log exports for six months in October 2001,

* a permanent ban on exports of logs and wood chips,

* a cut in annual harvest quotas for logging companies, and

* a curb on illegal logging to protect the domestic timber industry.

As a result, more than two-thirds of plywood mills in Indonesia have closed down over the years, causing its plywood exports to decline by almost 67% from 2001 to 2005. The recent floods in Indonesia have also worsened the shortage in the industry.

In addition, Malaysian tropical wood should also command better pricing due to its superior quality and consistency in supply and delivery, says OSK Research. In general, Indonesian plywood manufacturers lack competitiveness due to their obsolete equipment, deficient infrastructure, inconsistency in quality and untimely delivery.

Although Indonesia has been actively promoting foreign direct investment (FDI) into its infrastructure system and it recently initiated talks with the European Union on its VPA (voluntary partnership agreements), which is aimed at establishing a proper and regulated trading system to sell its legal timber products to the EU, analysts say that these measures will only yield results in the long run. This is mainly due to the country’s longstanding illegal logging problems as well as unresolved yearly bush fire issues.

Apart from the strong demand and tight supply of timber in the region that has fuelled the rise in various Malaysian timber product prices over the years, analysts believe that there are also other factors that are also supporting the rising price trend. These include:

Imperfect substitutability

Softwood, a substitute product mainly produced in Russia, can only replace tropical hardwood to a limited extent. Even though it is cheaper compared to tropical log, it is not suitable to be manufactured into higher quality plywood, which is the product that most Japanese demand.

Quality certifications

Malaysia timber companies are likely to have greater competitive edge over their regional rivals such as Indonesia, China and Vietnam, as the global timber industry is increasingly putting greater emphasis on certified wood quality recognitions. Such certifications are to prevent illegally produced timber from entering into certain markets, such as the EU, Japan, etc, which have high requirements for wood quality.

Hence, analysts believe that big timber players in Malaysia, such as Ta Ann, WTK, Lingui, Jaya Tiasa and Subur Tiasa, which already have the relevant certifications, are bound to benefit from this industry trend, while the smaller timber players are also striving to obtain these recognitions. Some widely recognised certifications are JAS (Japan Agricultural Standard), COC (Chain Of Custody) by the Malaysian Timber Certification Council, and the upcoming VPA by the EU. These certifications are essential passports to market Malaysian timber products to various countries in the world.

Positive correlation between surging steel prices and the ringgit?

Due to the complementary nature of steel and plywood, OSK Research opines that the correlation between steel and plywood prices is somewhat strong (see Chart 1). As such, it reckons that the re- rating of some steel companies by the market recently should also imply a potential re-rating in timber companies. Interestingly, the research house also notes that the strengthening of the ringgit has not disturbed the up-trend in timber prices (see Chart 2). This could be due to the overall strong global commodity prices trend.

Overall sector due for a re-rating?

Given the various positive factors supporting the industry right now, OSK Research has rated the timber sector as `overweight’ and is calling investors to buy stocks in the sector for a rally ahead. But which are the players that are likely to benefit the most? We highlight some of the companies picked by the research house for investment plays (see also summary in Tables 4, 5 and 6).

Ta Ann Holdings

Besides benefiting from sustainable high tropical timber prices, OSK Research sees further earnings from the company’s Tasmanian operations flowing in. A second company mill in Tasmania is also in the pipeline, which will generate a similar level of income as the first investment from 1QFY08. Ta Ann is also expected to be able to reduce its generation cost by about RM7.0-RM8.0 million per annum when its RM25.0 million biomass plant in Sibu starts running next year. The research house rates Ta Ann a `buy’ with a fair value of RM11.60, representing 12.5X its FY08 earnings per share (EPS) estimate (post bonus issue).

WTK Holdings

WTK Holdings is OSK Research’s top pick for the timber sector with a `buy’ recommendation and a fair value of RM11.20, implying 12.5X the company’s FY08 EPS estimate, which is at the higher end of the stock’s historical price earnings (PE) range of 9.8x-13.3x. The research house likes WTK Holdings for its higher margin product portfolio.

The company’s floor base plywood enjoys a more than 40% pricing premium compared to its other plywood products due to its ability to meet Japan’s high quality requirement and compliance with the JAS. In addition, the company’s acquisition of Linshanhao should also further enlarge its exposure to the premium floor base plywood product in Japan.

Lingui Developments

Based on the sum-of-parts valuation methodology, the stock is valued by OSK Research at RM4.40, which is also fairly close to the stock’s implied valuation of RM4.44 based on the market capitalisation of Samling Global (which recently listed on the HKEX).

Nonetheless, OSK Research is cautious on Lingui, given its volatile earnings track record and higher gearing (net gearing more than 50%). Besides, it also holds a neutral view on the group’s New Zealand harvest, given the less attractive softwood prices as well as competition from Russia. As such, Lingui is only seen as a `trading buy’ play.

Leweko Resources

Meanwhile, OSK Research likes Leweko, assigning it a `buy’ rating with a target price of RM2.05, pegging the fair value to the company’s three-year average historical PER of 9.3X. Going forward, Leweko is seen as likely to post improved margins due to lower log costs harvested in-house for downstream activities, as well as a higher sales volume of new premium products.

Solid crude palm oil (CPO) prices are an added bonus to the group as it is also exposed to oil palm plantation, which contributes about 7% to its total revenue. Potential downstream acquisitions are also expected to support the long-term growth of the company.

Cymao Holdings

OSK Research believes Cymao is a value `buy’ in the sector. The research house has assigned a target price of RM2.60 on the stock based on 7.0X its FY07 EPS, which is in line with its small-cap peers’ average valuation range of around 5.0X-9.0X. Basically, the research house likes the company for its stable earnings and cash flows. Cymao also has a niche in the manufacturing of value-added plywood, which has premium pricing.

Potential merger and acquisition opportunities also may warrant a re- rating on the stock. It is believed that Cymao is planning to undertake some domestic as well as overseas acquisitions, as the company’s plywood manufacturing capacity has reached a 90% utilisation rate. Funding for the acquisitions could easily come from borrowings, given its low gearing (0.02x).

Maxtral Industry

OSK Research has a `neutral’ call on Maxtral, given its slower growth momentum going forward. The fair value of the stock of RM0.58 is derived from an average historical PE of 9.0X over the past two years, based on its FY07 FD EPS of 6.4 sen.

Although likely to benefit from stronger timber prices and expected energy cost savings through its turbine power generator, OSK Research, nonetheless, believes that the company actually lacks a real competitive edge. In addition, the group has not paid out any dividends to investors thus far, making it a less attractive investment compared to other players in the industry.

Dominant Enterprise

On the other hand, OSK Research likes Dominant, ascribing the stock a `buy’ recommendation and a target price of RM0.77, based on 7.0X its FY07F EPS. Dominant’s FY07 result is expected to almost double from last year. The better performance is due to higher contribution from its plywood trading operation, which accounts for more than 75% of the total group turnover.

OSK Research says this is due mainly to the company’s wide distribution network as well as its new plant in Muar, which came on- stream in June 2006. Meanwhile, the company is also planning to venture into Vietnam’s Ho Chi Minh City to increase its presence within the region. This proposed new plant in Vietnam will concentrate on laminated wood panel products manufacturing for export sales purposes.

Conclusion

Timber stocks are seen to be in for better times ahead, as a stronger global economy fuels higher timber demand amidst a decline in Indonesian exports. The overall bloom in commodity prices has also pushed up timber prices. Nonetheless, investors should be aware that the timber sector is more volatile that other sectors, given its cyclical nature and the current rise in commodity prices worldwide, the latter of which is likely to be fuelled partially by speculative funds as well.

Copyright 2007

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