Mandiri Sekuritas INKP Lost in translation

Indah Kiat, part of Asia Pulp & Paper, is the largest pulp and paper producer in Indonesia. Despite of its considerable size, the company defaulted on the payment of its debts in 2001 and faced a slew of litigations. The company claimed that the remaining litigation is by the US Exim Bank related to debt of around US$55mn. With around US$3.1bn of debt having been restructured, and negative R/E balance, we view dividend payment probability is remote. In addition, the company’s complex supply chain structure could prevent INKP from obtaining optimum profit from its products. Therefore, we initiate coverage on INKP with Sell recommendation with TP of Rp1,600/share, representing 27.3% downside from the current share price.

Industry outlook is bright. Despite flat demand from developed countries, low per-capita paper consumption in developing countries combined with higher-than-average PDB growth will support paper demand at least until the next decade. Latin American, Russian, and Indonesian producers have the advantage of the low costs due to abundant raw materials. World paper price is still in a rising trend after a slump in 2009.

However, still grey area at the company level. Company’s supply chain structure could prevent them from being a real integrated pulp & paper company. They source wood from an affiliated company Arara Abadi (AA) and sell the finished goods via a parent company’s distributor, exposing them to transfer pricing risks, indicated by their considerably lower and more volatile margins compared with their peers in Latin America and Russia. The company also books unproductive assets in t! he form o f US$300mn interest free-loan to AA, and US$37mn unused machinery that is difficult to sell due to incomplete construction. It could be better if, for example, the US$300mn interest free-loan is converted into ownership in AA.

Dividend payment probability is remote. As of 9M09, the company posted US$212mn R/E deficit. It has no plan for quasi reorganization. This condition, combined with heavy debt of around US$3.1bn, maturing during 2015-2024, could prevent dividend payment in the near future. Instead of paying dividend, it probably will retain its earnings to improve net debt-to-equity ratio that currently is at 1.4x and FY10F debt-to- EBITDA ratio that is at 6.3x.&nbs! p; The company also did not pay dividends during positive R/E period on 1997-2000.

Sell stance on INKP. We initiated coverage on INKP with a Sell stance based on a DCF based-TP of Rp1,600/share (10.9% WACC, 5.0% TG), implying a 9.9x PER10F. Currently, INKP is trading at PER10F-11F of 13.6-10.1x, which is expensive, considering complex supply chain structure and remote dividend potential. Key upside potential is improving supply chain structure and rising pulp & paper price.