IJM Corp: Revisiting India

Upgraded to “buy”, target price raised to RM5.50. We believe near-term news flow on potential awards could intensify in the months leading to the announcement of the 10th Malaysia Plan, and as IJM begins bidding more aggressively for contracts in India. The outlook for the non-construction divisions remains positive. We revise our earnings forecasts, and raise our target price following a change in methodology.

A more conducive environment for Indian construction. In our view, IJM’s recent lacklustre order flow in India was due to a deliberate decision by management to cut back on tenders amid an environment of high operating costs. Cost escalation clauses stipulated in government contracts failed to fully compensate contractors for the spike in raw material (steel and cement) prices in 2007-08. With the recent normalisation of building material prices and borrowing costs, we believe management will resume normal bidding for Indian jobs.

Subdued construction margins well flagged. We assume construction pretax margins of 2% in FY2010 and 3.5% in FY2011. We expect IJM’s construction margin to remain depressed in FY2011, given the still significant legacy contracts on the books (about a third of IJM’s RM3.2 billion order book as at March 2010). Nevertheless, this has already been well flagged by management to the market.

Earnings profile reflects conglomerate status. We forecast the construction division to only account for 12% of IJM’s FY11 earnings. We expect the property and building materials divisions to remain as IJM’s main earnings contributors, accounting for 31% and 30% of IJM’s FY2011 earnings respectively, while plantations and infrastructure would account for 17% and 10% respectively.

A possibly strong finish to FY2010. Our revised FY10 net profit implies earnings of RM100 million in 4QFY2010 (up 20% QoQ), driven by 1) stronger plantation earnings QoQ given higher CPO prices (average spot price of RM2,569/t in 4QFY2010 compared to RM2,263/t in 3QFY2010), and 2) a significantly lower tax expense (9MFY2010 tax rate was 31.4%).

Target price raised to RM5.50, upgraded to “buy”. We believe news flow on potential awards could intensify in the coming months. The results of some of IJM’s Malaysian tenders in particular, could be announced in the run-up to the announcement of the 10th Malaysia Plan. Positive order flow momentum could trigger a further re-rating of the stock in our view.

Sizable pipeline of potential tenders longer term. In Peninsular Malaysia, management is looking to tender for packages in the major infrastructure projects such as 1) the Pahang Selangor Water Transfer Project, 2) the Low Cost Carrier Terminal project, and 3) the Klang Valley Light Rail extension. In India, IJM could be bidding for larger scale (>RM1.5 billion in value) highway-related projects.

Watch out for India. Our channel checks reveal a more favourable operating outlook for contractors in India. We believe India could in the next 12 months, become a significant contributor to IJM with regard to order flow.

Problems in the past. In our view, the main issue that has besieged contractors in India in the past 24 months was not a lack of available jobs, but rather an aversion to bidding amid an environment of high operating costs. Cost escalation clauses stipulated in government contracts failed to fully compensate contractors for the spike in raw material (steel and cement) costs in 2007-08, resulting in significant margin erosion for contractors. As a result, contractors have been reluctant to bid for new jobs.

A more benign operating environment for contractors. The government remains committed to improving the country’s infrastructure, with the Prime Minister recently announcing a potential doubling of infrastructure spending in the next five years to US$1 trillion (RM3.21 trillion).The National Highways Authority has US$24 billion worth of projects to be put out to tender in the coming months.

IJM is looking to tender for projects in India. Potential awards would only be announced towards end-2010 in our view. Management reveals a preference to tie up with local partners to bid for larger (over RM1.5 billion in value) contracts. For BOT (build, operate, transfer) projects, IJM’s role would likely be constrained to civil works. Management has no near-term plans to expand IJM’s portfolio of infrastructure assets.

We revise our FY2010 and FY2011 earnings forecasts by 10% and -3% respectively. Our revised numbers imply earnings growth of 11% in FY2010 and 19% in FY2011. The revision to FY2010 earnings is attributable to 1) higher property and plantations PBT (as we raise property pretax margins and mark to market our CPO forecast), and 2) lower tax expense (lower tax rate assumption).

Property. We forecast the property division to account for 31% of IJM’s FY2011 earnings. We forecast IJM Land to grow earnings by 25% in FY2011 on higher sales (from RM1.16 billion in FY2010 to RM1.3 billion) and margins (15% pretax margins from 13.5% in FY2010 due to an improvement in sales mix). FY2011 billings would primarily come from projects in the Klang Valley and Penang. IJM Land’s unbilled sales stood at about RM800 million as at March 2010.

Building materials. We forecast the building materials division to account for 30% of IJM’s FY2011 earnings. We forecast Industrial Concrete Product’s (ICP) FY2011 earnings to fall 11% as we assume a 10% decline in revenue of pre-tensioned spun concrete (PSC) piles and lower pretax margin (from 25% in FY2009 to 22% in FY2010). In our view, margins for PSC piles were exceptionally high due to a large proportion of high-margined marine piles sold.

Plantations. We forecast IJM Plantations to grow earnings by 21% in FY2011 on the back of 4% higher CPO production and 6% higher ASP’s (we assume CPO price of RM2,400/t in FY2011). According to our estimates, plantations would account for 17% of FY2011 earnings.

Construction. We forecast construction earnings to double in FY2011 as we assume an increase in pretax margins of 3.5% in FY11 from 2.0% in FY2010. Nevertheless, construction would only account for 12% of IJM’s FY2011 earnings. Construction margins are likely to remain depressed given the still significant legacy contracts on the books (about one third of IJM’s RM3.2 billion backlog).

Infrastructure. We forecast infrastructure to account for 10% of our FY2011 earnings forecast. 100%-owned Kuantan Port, New Pantai Expressway and Besraya are the main contributors to our FY2011 infrastructure earnings. We expect the Indian assets to cumulatively remain loss-making.

Target price derivation. We raise our target price from RM4.50 to RM5.50, and upgrade the stock from “hold” to “buy”. The increase in our target price comes largely from higher valuations for the property and infrastructure divisions. We base our valuation on a sum of parts, where we value the construction, building materials, plantations and the Malaysian concession assets on a discounted cash flow basis (9.9% WACC and 2% LT growth), Malaysian property at RNAV, and the Indian property and concessions assets at book cost.

Historical valuation. While IJM’s current valuation has exceeded its historical mean, we expect further PE expansion (possibly testing the peak of 22x) amid an environment of 1) positive order flow momentum and margin recovery, and 2) positive news flow from both property and plantations. At our target price, IJM would trade at 21x FY2011 earnings and 18x FY12 earnings.