Moving Up Value Chain

Moving Up Value Chain
Asia Pacific Market 

We initiate coverage on Zelan with a BUY recommendation and a RNAVbased target price of RM13.00. The construction company is in a sweet spot - profit margin to expand as it moves up the value chain in power plant construction and benefiting from new plant up opportunities in Asia and Middle East. The potential sale of its IJM stake will unlock values and raise RM736m or RM2.61/share cash at current market price.

Moving up value chain

Zelan is an engineering, procurement and construction (EPC) contractor specialising in power plant projects. It is moving up the value chain to become a partner in bidding consortiums and main contractor for power plant projects from being just a subcontractor in the past. We expect high -margin new projects to improve average construction pre-tax margin to 12-13% in FY08-10CL from an average of 10% in FY06CL. We estimate every 1%-point improvement in construction pre -tax margin will boost FY08CL EPS by 6.3%. Zelan is also looking to take up equity stakes in new independent power plant (IPP) projects to generate recurrent earnings and expand its orderbook.

Growing orderbook

Zelan secured the Rembang power plant project in Indonesia and Shuqaiq 2 integrated water desalination and power plant (IWPP) plant in Saudi Arabia recently, tripling its construction orderbook to RM4.5bn currently from RM1.6bn as at end-2006. Prospects for new projects are good as new power plant demand is rising in India, Indonesia and Middle East, and construction capacity is tightening in these areas. We assume Zelan will secure RM2bn worth of new projects in our earnings forecasts.

Unlocking values

We believe Zelan is likely to dispose its 19% stake or 94m shares in IJM as its stake will be diluted to 11-12% following the latter's merger with Road Builder. Furthermore, we estimate Zelan is sitting on unrealised gain of 37% at current IJM share price o f RM7.80 (estimated book value is RM5.70/share for its IJM stake).

Attractive valuations

Current FY08CL PE of 15x is undemanding considering projected EPS Cagr of 50% and average ROE of 20% for FY08-10CL. Stripping out the market value of its IJM stake, Zelan's core operations are trading at attractive annualised 07CL PE of 9 x. This compares to annualised 07 PE average of 18x for energyrelated global construction companies.