Gallant @ 76 cts ( Property / Indonesia ) 0 comments

Final Poll Results: 5:1

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Main issues

1.Strong headwind for main businesses of Utilities and Industrial Parks

2.Lack of concrete plans for smaller segments of Resort Operations and Property Development

3.Valuation of >20X PE are scary; landbank should prudently be valued at book value

This is a straightforward stock: it is a direct play on the future fortunes of Batam and Bintan. Let's check out the fundamentals of these two islands.

Instead of looking at the much publicised analyst reports touting target prices of 88 cts-$1.02 these few days, I draw attention to one of the appendices of Gallant's IPO prospectus: Appendix B Outlook for Industrial and Resort/Tourism Developments in Batam and Bintan Islands; an independent market review report by Colliers. It contains some frank insights on the future prospects of these two islands.

The macro view is not rosy for industrial parks on these two islands. The main issues are increased regional competition, high fuel costs and interest rates; in particular one gets the sense that the prime concern is competition from other industrialised parks in Asia such as India, China, Vietnam and Malaysia. Accepting that Gallant's Batamindo Industrial Park (BIP) is the market leader among Batam's industrial parks, average occupancy rate of factory space has declined from 91% in 2002 to 83% in June 2005, while rental rates have reduced by as much as 50%. Bintan Industrial Estate (BIE) faces the similar set of challenging macro factors, exacerbated by the fact that it has no critical mass unlike Batam which has established its reputation for outsourced manufacturing. Industrial parks operation formed ~30% of Gallant's FY05 revenue.

Gallant also provides utilities services to industrial parks and resorts on Batam and Bintan, and the report has this to report of the services: tenant companies to BIP pay very high electricity charges, amounting to as high as 82% of the total recurrent cost incurred and payable to BIP for support of their operations (where such recurrent costs include rentals for factory and dormitory, electricity, demand charge for electricity, water, airconditioning and service fee); for companies that are occupying space that is purchased from BIP, electricity cost takes up an extremely high proportion at 91% of their total recurrent cost incurred; on an average basis, electricity charges constitute as much as 56% of the total recurring cost incurred by companies, constituting increased manufacturing cost pressure to companies operating in BIP. What this means, of course, is that there will have to be a tradeoff between Gallant's utilities and industrial parks division, because higher profits for one will erode competitiveness for the other. In addition, there are concerns over fuel price hikes putting an upward pressure in manufacturing costs, and no wonder: the Indonesian government has been progressively cutting fuel subsidies which effectively reduces the competitiveness of the industrial parks given the abovementioned high share of recurring costs occupied by electricity charges. Utilities formed ~60% of Gallant's FY05 revenue.

The tepid outlook for this 90% of Gallant's revenue pie (Utilities + Industrial Parks) is evidenced by the FY05 results, where industrial parks segmental profit declined 20% on 5% revenue growth, and utilities segmental profit declined 10% on 15% revenue growth.

And we are expected to ignore this and instead focus on the growth potential of the remaining 10% of the business.

What does this remaining 10% have to offer? Some optimistic reasons offered include recovery in visitor arrivals in Indonesia and increased business opportunities with the opening of the integrated resorts in Singapore. This segment was loss-making in FY04 and marginal in FY05; one wonders how much growth it could contribute to the group as a whole. The rumours about plans for a casino in Batam and the subsequent price run-up smell of speculation, given the unlikelihood of it happening.

Kim Eng's premise, on the other hand, is based on prospects for the property development business, which contributed nil to the group in FY04 and FY05. Gallant has 18,400 hectares of land held in its books at S$541m total (note: independent valuation by valuers). According to Kim Eng, Gallant expects that it can sell these lands for 5-30x its book value, based on indicative pricing, yielding a surplus of S$0.60/share (hence generating investor excitement); Kim Eng has "conservatively" only factored in the development of the Lagoi Beach Village (LBV) in Bintan.

Frankly, it is difficult to guess exactly which property valuation to believe, but I believe analysts are taught to err on the conservative side; that's the whole spirit behind book value accounting isn't it? We can always speculate on future selling prices of property but the fact is that Bintan (and probably Indonesia in general) is not exactly a "hot" destination and future resort developments are bound to be fraught with risk; developers seeking to buy land from the landowner (Gallant) would surely take this into account before bidding 5-30X book value for land parcels on which they might have problems recovering cost later.

As far as I can see, the most tangible piece of positive development is the recent agreement between Singapore and Indonesia to establish special economic zones (SEZs) on Batam and Bintan to revitalise investor interest, in a bid to strengthen the competitiveness of the industrial parks vis-a-vis regional competitors. However, detailed plans are not clear yet. The share valuation of Gallant, if we be generous and add back depreciation of $50M to FY04/05 pre-tax operating profit of $20M to yield $70M, is about 26X (given the nature of its business and large fixed capital investments, it is probably more relevant to consider EBITDA). The main business segments are facing headwinds which the abovementioned agreement is trying to reverse, not accelerating further growth. As for the other segments, the earnings projections and grand plans in the absence of concrete developments remind me of another stock --- Biosensors.