Sime Darby - Major catalyst underway?

A potential sale of 10% stake could temporarily re-rate Sime Darby, perhaps to RM10 assuming the 26x PE peak valuation fetched during Synergy Drive initiative. However, actual synergy and share-based dilution are our concerns. Maintain SELL.

The Malaysian Insider reported that Sime Darby (Sime) was mulling a plan to offer up to 10% of its equity in new shares to an entity linked to the Chinese government. A new share placement would raise RM4.9b for Sime, based on the closing price of RM8.60/share (FY10 PE of 22x vs market FY10 PE of 17.7x). However, it was subsequently denied by Second Finance Minister Datuk Ahmad Husni Mohamad Hanadzlah although we noted that Najib had in the past weeks alluded to major investments by the Chinese government.

Potential short-term upside on newsflow. We assess that this deal is likely to materialise and could propel Sime to the mid-twenties PE multiples (i.e. peak valuation fetched during the 2007 mega merger Synergy Drive deal). Pegging a 26x FY10 PE multiple would value Sime at about RM10/share.

We view this as a potentially good re-rating catalyst for Sime as it:

Opens up greater opportunities to expand its downstream operation in China. During FY09 results briefing, management highlighted that the bulk of FY10’s RM7b capex would be used to expand its resource-based downstream activities. A tie-up with a Chinese party would nicely open up this opportunity and the RM4.9b proceeds could be utilised for the expansion.

A check on its productivity. As the Chinese party will have more emphasis on upstream operations, this could lead to greater efficiency from Sime’s large planting acreage of 550,000 hectares.

Small stake but a strong tie-up with world’s largest palm oil producer. A 10% stake seems too small for the Chinese government (which is known to be scouring the region for controlling stakes in plantation assets) but marks a good start to secure resources for China’s edible oil as well as biofuel requirements. Sime is currently the world’s largest palm oil producer, supplying about 5-6% (or 2.5m to 3.0m tonnes p.a.) of total global CPO. For China, forming a partnership with Sime could be a way of securing feedstocks for its rising domestic demand for edible oils, animal feeds and most importantly, biofuel. China is the largest palm oil importer, consuming 14-15% of total global palm oil supply annually.

Short-term pain, long-term gain. An assumed 10% new share issue would dilute Sime’s earnings by 9% and would translate into proceeds of RM4.9b. Meanwhile, a better profit from downstream expansion would only materialise in 3-4 years.

Deal cancellation and execution risks explored. Given the modest stake involved, the potential deal draws only the minor risk of the cabinet objecting on “selling a national interest”, which is also the largest market capitalised GLC. Our assessment also takes into account that the government would still be firmly in control after the share-based expansion, given the Permodalan Nasional Berhad (52% stake) and Employees’ Provident Fund (14%) present combined stake of >60%. A more pertinent downside risk is whether Sime could extract tangible synergy from this deal.

We would look towards upgrading our SELL call should Sime clinch the deal, which could temporarily lift its valuation back to the previous peak of 26-28x PE in 2007, implying a RM10 fair price. However, without a major exercise, the shares remain fundamentally overvalued. A lacklustre performance is expected in FY10 as the plantation division continues to suffer from flat CPO prices. Hence, until a deal materialises, we retain fair valuation of RM7.60 based on 20x FY10 PE.