This article first appeared in The Edge Financial Daily, on March 8, 2016.

Petronas Chemicals Group Bhd
(March 7, RM6.85)
Maintain sell with a lower target price of RM4.66: We participated in the fourth quarter of 2015 (4Q15) analyst teleconference briefing, which was held on Feb 24, 2016. In the briefing, management guided for a 5% year-on-year (y-o-y) increase in ethane gas feedstock for 2016E (estimate), which will allow Petronas Chemicals Group Bhd (PetChem) to further boost the group’s olefin and derivatives plant utilisation. Also, it expects the Dalak pipeline, which was completed in end-2015 to help alleviate the methane supply constraint at its Labuan Mega Methanol Plant, to provide a further boost to fertiliser and methanol plant utilisation.

However, management is cautious about the group’s earnings trajectory going forward amid falling petrochemical product prices and sluggish demand in China, which is PetChem’s biggest export market. There is still no news about the ethane supply contract, which will expire in 2016, as negotiations with Petroliam Nasional Bhd are currently ongoing.

We expect PetChem’s earnings to contract by 21% y-o-y driven by margin compression arising from falling petrochemical prices amid a fixed cost base. Foreign-exchange tailwinds and higher utilisation will cease to provide a boost to margins in 2016E, which will allow pain from the falling average selling prices to finally set in. We expect its share price to derate once earnings begin to disappoint and the street cuts estimates towards our forecasts.

After a steep decline last year, petrochemical product prices in the Asian spot market fell by another 12% y-o-y in the first two months of 2016. We believe petrochemical prices could fall by 19% in 2016E, as we do not see any reason for petrochemical prices to rebound given the weak crude prices and sluggish demand conditions in East Asia. In light of PetChem’s fixed feedstock cost base, we expect this to lead to margin compression in 2016E, particularly as US dollar appreciation and utilisation trends will plateau this year. This led us to cut our 2016/2017E earnings by 23%/20%, and introduced our 2018E earnings, which are 30% below the consensus.

Further downside could come from the potential increase in ethane gas tariffs, following the renegotiation of the supply contract set to expire this year. PetChem is expensive at 25 times 2016E earnings per share (+1 standard deviation to its mean) valuation since listing. It is also at a 56% premium to peers, which we think is undeserving given the expected earnings contraction and ethane gas pricing risk. — Affin Hwang Investment Bank Bhd, March 7