Water Concession in Selangor

Puncak Niaga is believed to be seeking an extension to its water concession in Selangor by another 20 years in return for not raising its tariffs that are due in Jan-09. Sources said that the proposal was submitted to the federal government a few weeks after it sent a notice to SPAN seeking a tariff hike of 37%.

Syabas' 30-year concession to supply water to Selangor, Kuala Lumpur and Putrajaya would end in 2034. The 37% water tariff hike due in Jan-09 is its highest tariff increase throughout its concession period. An approval for an extension of Syabas' concession would mean that tariff increases would be spread-out with lower quantums and would ultimately benefit consumers.

WIMAX

Certification for WiMAX equipment on the 2.3GHz spectrum could be delayed longer than expected and this will impact the country’s rollout of wireless broadband services using the technology.

• The certification by the WiMAX Forum may only happen by end-09 or even later, said Nokia Siemens Networks, the manufacturer of such equipment because the US is close to a WiMAX rollout, scheduled for June, but only on the 2.5GHz spectrum which has been given priority. In fact, the certification for 2.3GHz could face a long delay. Thus, the four WiMAX licensees in Malaysia would be caught out by the delay.

• If they choose to roll out their services as planned without the certification, interoperability between base stations, access points and networks could be - compromised, said Nokia Siemens Networks. Going on without certification could also lead to technical glitches in their WiMAX services in the future, the manufacturer added.

• A possible solution would be for MCMC to swithc spectrums but that is unlikely as it would leave the four Wimax service providers in a lurch as the 2.5GHz spectrum has already been assigned to seven other wireless broadband service providers, which together have taken up the maximum capacity for that frequency. It is also an unlikely scenario as these WiMAX service providers have already invested in 2.3GHz equipment and has started infrastructure work from June last year.

Latest on Digi

DiGi's new CEO Johan Dennelind firmly believes that there is “still a lot of room for growth and 3G will be the driver of growth, as will mobile broadband’’ despite talk that the mobile market has reached saturation at 80% penetration. DiGi will expand its coverage to 95% of the population from the current 90%.

• The 3G spectrum is a priceless commodity that opens huge growth avenues for DiGi. It would be DiGi’s growth platform which allows it to grow its capacity and core business. “It also gives us a licence to compete in the broadband space. We want to be part of bringing Internet on mobile phones here and we would do it with the DiGi twist. But to do that, we must first find out what would trigger consumers to our direction."

• On MNP, “People in Malaysia are very number focussed and it is very difficult to take their cell numbers away. But in an MNP environment, you can keep your number, so why not go for better value, quality and coverage? “Our basic belief is that we try to do simple things and the way we are going to approach MNP is to bring the best value, coverage and quality and that definitely could be a decisive factor for users (to switch networks)."

• Dennelind expects newer players to use pricing as component mix to attack the stronghold of established players. That is why margin pressure can be expected.

Corporate Credit Deteriorates in Europe on Euro

European corporate credit quality is sinking at an ``alarming'' rate as rising oil prices, the possibility of a U.S. recession and the euro's strength restrain the region's economy, Moody's Investors Service said.

Moody's assigned 32 ``negative'' outlooks to European companies in the first quarter, almost triple the 11 that were ``positive,'' the New York-based ratings firm said in a report today. The gap is the widest since 2001 and indicates deteriorating credit quality in 12 to 18 months, Moody's said.

``The negative outlook gap is quite alarming,'' Moody's economists Christine Li and Kimberly Forkes wrote in London. ``Uncertainty about the U.S. recession, nervous financial markets, higher input costs for business and an appreciating euro are restraining the euro-zone economy.''

The International Monetary Fund in Washington estimates economic growth in the 15-nation euro region will slow to 1.4 percent this year from 2.6 percent in 2007. Moody's Chief Economist John Lonski said in a March 27 Bloomberg Television interview that the U.S. is already in a ``mild'' recession, after growth slowed to a 0.6 percent annual rate in the final three months of 2007.

Losses at banks are hampering lending, and will have a ``greater and more prolonged'' impact on non-financial businesses, Moody's said. Banks reported $308 billion of writedowns and credit losses tied to the collapse of the subprime mortgage market, according to data compiled by Bloomberg.

Oil, Euro

Crude oil futures soared to $119.90 a barrel in New York last week, the highest since trading began in 1983. The euro rose 7 percent against the dollar this year, reaching a record $1.6019 on April 22.

A 1 percentage point increase in the euro's real exchange rate reduces export growth 0.6 percent within a year, according to a note this month from Frankfurt-based Deutsche Bank AG, the biggest currency trader. The euro appreciated 9.8 percent over the past year against a basket of currencies, according to an index from the Bank of England that's adjusted for inflation.

European Central Bank President Jean-Claude Trichet told reporters at a conference in Frankfurt last week the bank is concerned that the euro's surge may hurt the economy.

Moody's Changes

Moody's cut ratings on 35 companies in the first three months and upgraded 17, the worst ratio since the third quarter of 2006, the firm said.

Financial companies were hit hardest by credit market turmoil, with downgrades rising to 17 from 14, the most since 2003 and ``a sign of rising financial stress,'' Moody's said. There were 10 more downgrades than upgrades among lenders.

Default rates among high-yield, high-risk borrowers will rise in the next 12 months, Moody's said. High-yield debt is rated below Baa3 by Moody's.

The extra yield investors demand to hold European high-yield bonds rather than similar-maturity government debt soared to as much as 815 basis points in March, the widest since 2003, Merrill Lynch & Co. indexes show. The gap increased from 496 basis points, or 4.96 percentage points, at the end of 2007.

Dangers of Small Cap Stocks

MANY investors would be indifferent to investing in large cap stocks and small cap stocks. The inherent dangers of investing in small caps need to be investigated so that investors have a better grasp of the risks involved.

There is a very popular local fund manager who has performed admirably, largely thanks to his picks in mid and large caps. However, his track record was compromised somewhat by his picks among small caps; in fact, it was pretty dismal.

The biggest attraction of small caps is the huge growth potential. Most successful large cap companies started at one time as small businesses. Small caps give the individual investor a chance to get in on the cheap. Everyone talks about finding the next Genting, YTL or IOI Corp. However, the reality is that very few small caps make the grade.

It is certainly easier to grow from a market cap of RM100mil to RM500mil but it's a totally different scale to grow from RM1bil to RM5bil. At some point you just can't keep growing at such a fast rate due to restrictions in the sector size.

While there are some funds that do invest in small caps, by and large the majority of funds are averse to them. That's because the fund would have to be small in size to invest in small caps. If you are managing a US$500mil fund, it's difficult to have sizable positions in small caps. No fund manager wants to look at 100 companies in their portfolio – the monitoring costs are too overwhelming. For mid size to large funds, to invest successfully in small caps would require hitting a lot of home runs every year – a debilitating task.

The coverage on small caps would also be scant at best. Lack of coverage means lack of exposure. Lack of exposure means the stock will not appear on their radar screen. What this means to the individual investor is that, because the small-cap universe is so under-reported or even undiscovered, there is a high probability that small-cap stocks are improperly priced, or usually under-priced.

The biggest drawback to investing in small caps is in the management. Typically, they comprise entrepreneurs who built the company from scratch to its listing capacity. We have to differentiate between people who had a great idea and those who have the ability to grow a company.

Statistics reveal that these entrepreneurs hold onto the company for far too long and do not have the expertise to take the business to the next level. It takes more professionalism and market savvy to turn a RM100mil company into a RM500mil company. Too many entrepreneurs are unwilling to appoint more professional managers, or are blinkered of the need to do so.

There are varying notions of what constitutes a small cap company. In the US, it is generally regarded as companies with market cap of less than US$500mil (which would be regarded as a mid cap in Malaysia and most of the smaller South East Asian countries).

Truth is, there are no hard and fast rules. I would categorise small caps in Malaysia as those with a market value of below RM500mil (because there are just so many of them) and then have another category for those under RM300mil as micro-caps. If we were to push the threshold higher, it would envelope the majority of stocks on the Bursa.

To better spot the better small caps is to examine the company's strategy and execution ability. First, the business needs to be scalable. Secondly, the company must know its market, competitors and its competitive edge. It also must have a clear plan to grow organically or via acquisitions. In addition, there must be increasing professionalism in the way business is run – be it at management or board level. There must exist a clear understanding of cost and capital requirements. Last but not least, is the execution ability. There should be goalposts or milestones marked and reached.

Small caps are able to ride a wave better because they are more agile given their size. The crunch comes when there is a recession or dramatic slowdown in their sector. Many small caps will perform well in a bullish environment but wither easily when the wind blows harder.

A lot of small companies arise from carving a niche in technology. However these companies also suffer swiftly from technology improvements and trend changes. Most do not have sufficient resources to commit at such an early stage into research & development in order to stay ahead of the development and technology curves.

Small caps usually do not pay much dividend as most of its profits will be reinvested to fund growth. This is an additional risk as no or little yield will mean investors would be buying for pure capital appreciation.

My final thought on the issue is that through my observation, I have noticed a certain danger of complacency among owners of small caps. Many entrepreneurs are satisfied once they get their companies listed on the stock exchange. In Malaysia, many of these owners stand to make RM10mil-RM50mil following a listing. Indeed, an attractive sum that can tempt many to “retire” and lose their drive to elevate the company.

The Dragon Roars

With the KLCI making an impressive run-up in the last two weeks, we were thinking about making a call to take profits today. Coincidentally the Chinese Dragon choose yesterday and today to wake up from its slumber, which has increased our optimism and at the same time making it harder for us to determine the direction of the KLCI ahead. After some research suggested a high correlation between the KLCI and the Shanghai bourses, it is more difficult to be on the pessimistic side of the market.

China Bottoming up
With the Shanghai stock market having corrected by around 50% to the 3000 level, the Government has decided that it is time to bring the retailers back into the market. The Government announced a string of measures to encourage retailers back into the market. Among the measures are:

~ Tax on stock transactions reduced
The transaction tax on stocks has been reduced from 0.3% to 0.1% which essentially has done away with the previous hike which was implemented a year ago.

~ Restriction on large equity sales
China has also restricted the sale of large blocks of shares via the open market. Under new regulations, large blocks of shares exceeding 1% of a company’s total shares will have to be sold off the market in a venue where negotiations can be conducted. The authorities would also have to be notified of the sale one month in advance. This move would stave off substantial shareholders unloading huge blocks of stocks in the open market and help restore retailer confidence.

KLCI highly correlated with Shanghai Composite Index
Our research has shown that the correlation between the KLCI and the Shanghai Index is an impressive 93%. This would suggest that the KLCI is a very strong follower of the direction of the Shanghai Index. Now that the Shanghai Index has a strong upward bias, it is obvious that the KLCI will see a similar uplifting force too.

Note of caution: KLCI not guaranteed to go upwards
A note of caution though, an upward direction is not guaranteed for the KLCI as currently Europe’s liquidity problems and the US housing downturn does not justify the KLCI going up too fast in such a short time span. There are currently two conflicting forces at play which is the bullish China factor and the bearish economic downturn in Europe and US. The clash of these two equally strong forces will bring about very high volatility to our local KLCI in the short term.

Strategy: Take gradual profits and trade in China Call Warrants
With the KLCI already running up by over 5% in the last two weeks, it might be appropriate for traders to start taking profits gradually and slowly and wait for more meaningful entries. To gain some perspective, most of our recommended stocks over the last few weeks have rallied by as much as 20%-50%, which signals that local stocks are slightly toppish now. It’s never wrong to lock in profits in rallying stocks and look for more meaningful entries later. Traders still on the buying side can still find trading opportunities in China call warrants and safer counters which have not made movements yet such as Axis Real Investment Trust, Dutaland and Affin Holdings. Long term investors on the other hand may take this bullish opportunity to also take partial profits and marginally reduce their exposure while maintaining the core of their holdings to ride through the volatile next few months.

In short, traders are advised to take profits on high movement stocks and can still find safe opportunities in quality stocks which have not moved. Investors can take small gradual profits and choose to hold on to their core of holdings to ride out the volatile storms ahead.

Sime Darby

We have increased our EPS forecast for Sime Darby by 3% for 2008-2009, and our SOP-based price target by 4% to RM11.40. The changes reflect better-than-expected progress in the plantations business, somewhat offset by more conservative estimates for some other divisions. Overall, we remain bullish on CPO and Sime is the world’s largest listed plantation company by hectarage. The stock is also cheap, trading on 12.9x CY08 earnings, a 20% discount to the peer average. Maintain BUY for 20% upside.

We have increased earnings from the plantations business by 4-7% for 2008-2009 due to quick-than-expected improvements to FFB yields, particularly in Indonesia. However, we have cut previously aggressive forecasts for Sime’s property division by 18% this year and 21% in 2009, due to a slowdown in mass residential property and some merger integration issues. We have also cut earnings for the heavy equipment division by 7% for 2008-2009 – again, we were probably too aggressive originally. All up, our earnings increase by 0.2% in 2008 and 3% in 2009-2010. Plantations remain the dominant business, representing 71% of 2008CL earnings.

We remain bullish on CPO prices, forecasting RM3,400/t for 2008-2009. The biofuel drive in the US and Europe is one of the key contributors to the global shortage of edible oil. The current production of corn ethanol requires 3.2bn bushels per day, and more capacity is being added. A marginal supply of edible oil will come from Indonesia and South America. Palm plantation companies are set to benefit from rising prices due to supply shortages, as soy, palm, rapeseed and sunflower oils are perfect substitutes.

Sime Darby is the largest listed plantations company by hectare and the second largest by market cap. It is also one of the cheapest at 12.9x CY08 earnings. We believe risks to earnings are on the upside, due to current CPO prices being above our forecast and still conservative estimates on improvements to the plantations business. The main near-term risk for the stock is any potential hike to Malaysia’s CPO taxes. The taxes are under review now, but we believe any increase is likely to be relatively small and nowhere near as prohibitive as the export taxes imposed in Indonesia.