Stock Name: TCHONGCompany Name: TAN CHONG MOTOR HOLDINGS BHDResearch House: OSK
Automotive sector
Maintain overweight: Last Friday, DRB-Hicom (Not rated) announced a MoU with Volkswagen AG to jointly assemble Volkswagen cars at its plant in Pekan, Pahang. This comes two months after the car maker's talks on potential collaboration with Proton (buy; TP: RM5.67) were aborted. It is expected that three new models will be rolled out, with the first completely knocked down (CKD) to start production by the end of 1Q2011.
Just two months after talks on a potential collaboration with Proton were aborted, DRB Hicom last Friday announced the MoU with Volkswagen.
We are not surprised by the move as both DRB-Hicom and Volkswagen have been in discussion over the past two years. But priority was given to Proton on whether the national car maker would be interested in collaborating with the German automaker because its plant is underutilised.
In Proton's announcement in early June of the termination of the talks with Volkswagen, the company said it feared localising the Volkswagen (or rebadging it) may cannibalise its own vehicle sales.
As the deal now has been secured by DRB, we opine that Volkswagen's intention to make Malaysia its sedan exporting hub has been firmed up, especially with the inking of the deal with DRB as a last resort.
We understand that the Pekan plant has an estimated production capacity of up to 60,000 units per annum, and that it currently assembles the Suzuki and Mercedes marques.
Volkswagen is targeting to roll out three CKD models, with the first production to be rolled out by the end of 1Q2011.
It is uncertain which models are likely to be rolled out but, but we believe it could be the Golf, Beetle and Passat, as these are Volkswagen's top three selling models in Malaysia currently. As at June 2010, Volkswagen had sold 273 Gold GTIs, 96 Beetles and 90 Passat, with all three models combined representing as much as 68% of the total volume sold (total 668 units).
In terms of volume sales, within the passenger segment, Volkswagen ranks 16th among automakers. It is also worth mentioning that going forward, DRB-Hicom will also likely start the CKD assembly of the Audi (also part of the Volkswagen Group) by 2012, for which it intends to increase yearly sales from 700 to 1,000 units.
Will Volkswagen be cheaper then? Unfortunately for consumers, we think it will be quite a while before the Volkswagen becomes more affordable, as initial production rollout will have minimal localisation of content.
As an indication, when BMW Group announced that it would start local assembly of the BMW 523i, the entry-level F10 5-Series was priced at RM398,800 (completely built-up) when launched in May. The locally assembled model is only RM15,000 lower in price at RM383,800 (OTR, without insurance, with BMW service inclusive + repair), although it is in the higher excise duty tax bracket. This essentially means that one who is more mindful of quality would still potentially buy a CBU model, even if it costs RM15,000 more.
We see autopart players as the winners from the localisation of the Volkswagen production line in Pekan, especially those that have established strategic tie-ups or JVs with foreign players such as Bosch (EPMB, buy; TP RM0.75) and Autoliv (Hirotako, Not rated). Autoliv is a worldwide leading airbag supplier and Volkswagen is its third biggest customer, accounting for up to 12% of its total revenue.
Bosch, another global autoparts supplier through EPMB, will likely be making brake modules and components for Volkswagen.
While the deal secured by DRB is an opportunity missed for Proton in mitigating underutilisation of its plant, we see no impact on Proton as Volkswagen serves a niche in the mid-high end market. MBM Resources (buy; TP: RM4.57), which also owns a Volkswagen distributorship through Federal Auto, also stands to benefit from the higher sales contribution of the CKD Volkswagen over the longer term, although in the near term sales could slow down as some potential buyers may defer their purchases until a cheaper CKD model is rolled out.
Meanwhile, news reports have quoted Proton managing director Datuk Syed Zainal Abidin as saying that the government may decide on the possibility of merging the two national automakers (Proton and Perodua) by year-end.
Note that neither of the companies have an inkling what kind of consolidation the government may be proposing. We continue to believe that a consolidation would potentially be met with resistance from Perodua, which is currently in a more favourable position in terms of market share and its lucrative business model, on which the car maker would be unwilling to compromise.
Likewise, Daihatsu Motor Co Ltd, which is essentially Perodua's key technology partner (whose models Perodua re-badges) and a shareholder with significant management influence (with a 20% stake) in Perodua's decision making, is also heavily reliant on sales contribution from its Asian subsidiaries.
Perodua Manufacturing (Malaysia) and PT Astra Daihatsu (Indonesia), which together contribute some 20% of Daihatsu's revenue, are the second largest geographical contributors after Japan. We understand that Daihatsu's re-badging concept in Asia fetches higher operating margins relative to the domestic division in Japan.
Furthermore, issues such as integrating the two automakers' technologies and production lines will prove daunting and difficult in the near term. Total industry volume (TIV) for the month of July continued to be strong, with a year-on-year (y-o-y) growth of 13% and month-on-month of 8.3%.
Year-to-date July growth stood at 18.6%, and indications are that August numbers will be higher than July's due to the rush for delivery before the Hari Raya Aidilfitri exodus begins.
However, from September onwards, sales are likely to deteriorate due to the seasonally slower period given the number of festive seasons ahead, coupled by the year-end holiday period. We continue to maintain our TIV projection of 585,719 units, representing a y-o-y growth of 9% for 2010.
We continue to maintain our overweight call on the auto sector. Auto-parts makers EPMB (buy; TP: 75 sen) and Delloyd (buy; TP: RM3.90) also stand to benefit from higher output from both Perodua and Proton, with the former also possibly benefiting from the upcoming localisation of Volkswagen's models.
Our sector top pick is Tan Chong (buy; TP: RM5.73) given the stock's sound fundamentals and earnings trajectory, for which we expect revenue and earnings to grow at a CAGR of 27% to 35% over the next three years as it transforms into Malaysia's major non-national auto exporter to the region come FY2013-14. We also like Proton and MBM Resources (buy; TP: RM4.57) for national marque exposure, noting that both will experience vehicle sales growth on the back of a better operating landscape.
We are, however, still neutral on UMW (TP: RM6.62) in view of its ailing oil and gas division owing to the unfortunate delay in deploying the Naga 2 and Naga 3 jack-up drilling rigs. ' OSK Investment Research, Aug 16
This article appeared in The Edge Financial Daily, August 17, 2010.
