Bareksa.com - We upgrade INCO to Buy (from Sell) with TP Rp3,200 due to: 1) Benefiting from nickel price upside when the export ban on nickel ore starts having significant impact on supply and Chinese nickel stocks clears in 2H14 2) Benefiting fully from CCP that reduces production cost by 5% in 2014 3) Strong earnings growth at 157% and 35% for 2014-2015F 4) Downside risk has subsided as consensus earnings downgrade already occurred
EBIT within expectation, net loss in 4Q on forex loss. FY13 revenue came in at US$921.6m (-5% YoY), forming 97% of ours and consensus esti-mates. EBIT was within expectation, forming 97% of ours and 92% of con-sensus. Higher forex loss (translation) has caused a net loss of US$8.6m in 4Q13 which brought FY13 earnings at US$38.7m (-43% YoY), forming only 64% of ours and 49% of consensus.

Volume growth of 5% and lower production cost in 2014. INCO plans to leverage its enhanced smelting capacity and process optimization, pro-ducing 5% more nickel, or 79,600 t in 2014. The company will fully benefit from converting expensive HSFO to coal on dryers (CCP) which will lower production cost by 5% in 2014.
Significant impact of export ban more likely in 2H14. LME nickel price has surged by ~12% in the past month to ~US$15,500/t, the highest level since April 2013. AME Group forecasts that the export ban impact on supply will not be felt immediately as there is ~25mt of nickel ore stock-piled at Chinese ports. Besides, LME nickel stocks remain at near all-time high at 269 kt currently. We expect nickel price to have more support for sustainable gain in 2H14, when the high inventory easing.
Upgrading ASP and 2014-2015F earnings. We have increased our nickel price forecast by 5% and 6.7% to US$15,750/t and US$16,800/t for 2014- 15F. We have upgraded INCO earnings estimates by 101% and 60%.
Valuation. Our TP Rp3,200 (+68% than previous) has been derived from DCF-based (WACC 13.7%, LTG 5%) which implies 27.3x 2014F P/E. The stock currently trades at 22.0x 2014F P/E and 8.4x 2014F EV/EBITDA.

2013 Operational Performances review
In 4Q13, nickel production fell to 18,299 t (-7% QoQ, -14% YoY) due to issues on electric furnace. The management confirmed that the issues have been resolved and no issues are expected in 2014. This has brought FY13 production of 75,802 t nickel in matte, or up by +7% YoY, slightly short of our expectation and the company guidance (i.e. +10% YoY increase or 77,788 t). The realization of its enhanced smelting capacity and production process optimization have contributed to the volume growth. Nickel deliveries increased by 8% YoY to 77,198 t, forming 98% of our forecast . ASP fell by 12% YoY to US$11,939/t, which was in line with our expectation.

2014 Guidance
The company plans to leverage its enhanced smelting capacity and process optimization in 2014 and produce 5% more nickel in matte, or around 79,600 t.

Cost improvement initiatives
Production cost/ton has decreased by 9% YoY or 7% YoY (if excluding inventory movement) to US$10,313. Lower fuel and lubricant costs, employee costs, ser-vices and contract costs have brought down production costs per unit. In 2013, the average price of High Sulphur Fuel Oil (HSFO) was 9% lower YoY. The HSFO usage per ton of production improved from 32.38 barrel to 30.75 barrel as the company improved its operating efficiency.
In 2H13, the company completed construction of coal conversion for the dryers (CCP). As the project ramped up in 4Q13, HSFO volume consumption was 28% lower QoQ, which resulted in 22% QoQ lower fuel and lubricant costs. In 2014, INCO will remain focused on cost saving initiatives to ensure its sustainability and competiveness in the long run. INCO should enjoy full benefit from converting expensive HSFO to coal, on main and side burners of dryers. Coal mills for running the CCP will increase diesel fuel consumption (3.5% more) which is insignificant compares to reduced HSFO volumes. The company estimates CCP to lower pro-duction cost by 5% in 2014.

2013 Financials performances review
INCO revenue came in at US$921.6m (-5% YoY) in 2013, forming 97% of ours and consensus estimates. 4Q revenue decreased by 7% QoQ to US$200.6m, primarily caused by lower production volume (-7% QoQ) and ASP (-2% QoQ).
The cost improvement from CCP and cost saving initiatives have started to show their benefit in 4Q through gross margin partly recovered to 12%, from 10.8% in 2Q and 3Q. EBIT margin recovered to 10.4% in 4Q, from 9.4% in 2Q and 3Q. FY13 EBIT was within our expectation, forming 97% of our forecast and 92% of consensus.

4Q13 net loss on forex loss (translation) causing FY13 earnings miss
In 4Q13, the company incurred US$19m of foreign currency loss on translation adjustment. The company also booked around US$12m of project development costs in 4Q13. The increase in other expenses has primarily caused the net loss of US$8.6m in 4Q13. The other expenses have brought FY13 earnings lower at US$38.7m (-43% YoY), forming only 64% of ours and 49% of consensus.

Nickel Market View
The Indonesian government implemented a blanket ban on the export of un-processed ore on January 12th, 2014. The initial market’s reaction to the export ban was initially positive with nickel price lifting ~4.8% from US$13,830/t to US$14,500/t in the first three weeks of January 2014. However, the gains were short-lived, and prices had fallen to levels at the beginning of the month. This was expected given the nickel market remains in oversupply situation with excess inventory. Nevertheless, the average nickel prices in January were 1.1% higher MoM at US$14,076/t and in February were at US$14,192/t or 0.6% higher MoM.
According to AME Group, the impacts of the export ban on supply will not be felt immediately as there is about 25mt of nickel ore stockpiled at Chinese ports as at January 2014. The stocks are enough to support Chinese Nickel Pig Iron (NPI) production for 6 to 9 months. Indonesian nickel ore is the preferred feedstock for new generation RKEL (Rotary Kiln—Electric Furnace) smelters, which generally require nickel grades in ore of at least 1.5%. It is estimated that production from RKEP smelters account for about 50% for total Chinese NPI production. Once ore stocks run out, approximately 200kt of Chinese NPI production capacity will fail to secure feed. In 2013, China produce approximately 450kt of nickel in NPI. The market may not have to wait for 6 to 9 months before a supply response is seen from the Chinese NPI sector. It is reasonable to assume that nickel ore prices are increasing rapidly in China. Given the limited supply, and already low smelter mar-gins, ore prices may increase to the point that only the lowest-cost NPI smelters are able to afford them. Should this happens, the excess supply in the nickel market will ease and stocks elsewhere may start to decline.
LME nickel stocks remain at close to all-time high levels at about 269kt currently. When the high inventory level starts to clear, we expect nickel prices to have more support for sustainable gain in 2H14. In fact, nickel prices have increased by ~12% in the past one month to ~ US$15,500/t, the highest level since April 2013. It appears that the supply side restriction may already have an impact to nickel price, earlier than anticipated.

Forecast Changes for 2014-2015F
In line with the company guidance for 2014 (5% YoY volume growth), we have trimmed our production assumption by 2% to 79,600 t. As for 2014, we take into account a major shutdown plan for electric furnace #1 upgrade, which requires around 23—25 weeks and scheduled for beginning 2015 or earlier. The shutdown may reduce annual output between 6,000 to 9,000 t. We have reduced our vol-ume assumption by 10% for 2015F. As we forecast nickel price recovery in 2014- 15F, we have increased our nickel price forecasts by 5.0% and 6.7% to US$15,750 and US$16,800 respectively.
The changes have brought 2014F revenue up by 3% and 2015F revenue down by 7%. Our revenue forecasts are at 103% and 89% of consensus. We have upgraded our 2014-15F earnings by 101% and 60% respectively. Our earnings estimates are at 97% and 82% of the consensus.

Valuation and Recommendation
We derive our valuation based on DCF-method (WACC 13.7%, LTG 5%) to arrive at new target price of Rp3,200/share (+68% than previous). Our TP implies 27.3x 2014F P/E and 20.3x 2015F P/E. The stock currently trades at 22.0x 2014F P/E and 8.4x 2014F EV/EBITDA.
We upgrade INCO to Buy (from Sell previously):
1) Benefiting from nickel price upside when the government ban on nickel ore export starts having a significant impact on supply and Chinese nickel stocks clears in 2H14.
2) Benefiting fully from CCP that reduces production cost by 5% in 2014.
3) Strong earnings growth at 157% and 35% for 2014-2015F.
4) Downside risk has subsided as consensus earnings downgrade already occurred for 2014-15F by -20% and -14% respectively since our last report 3

*Franky Kumendong is PT Buana Capital's market analyst. This article is part of the Equity Research of PT Buana Capital