PP/10551/10/2007 January 9, 2007

MALAYSIA EQUITY Investment Research Daily News

Private Circulation Only Company Update

MOTOR Wan Azhar Mustapha Trading BUY Maintained +60 (3) 2333 8373 Price RM6.15 [email protected] Target RM7.30

Proton + VW = Skoda…?

Stock Profile/Statistics In this report, we have synthesized the prospects for Proton in the event VW emerged

Bloomberg Ticker PROH MK as the winner for this takeover saga. We have accredited VW success story on the re- KLCI 1113.02 birth of Škoda, a long suffering Eastern European marques before the entry of VW into Issued Share Capital (m) 549.21 Market Capitalisation (RMm) 3377.66 the fold. We have also highlighted the “before and after” of Škoda en-route to its 52 week H | L Price (RM) 6.75 4.48 eventual award winning models without losing its national identity. Hence, we are all for Average Volume (3m) ‘000 625.15 VW’s bid. Trading buy with immediate target price of RM7.30 vis-à-vis our sum of parts YTD Returns (%) -0.45 Net gearing (x) -0.02 value of RM9.19/share. Altman Z-Score 2.97 ROCE/WACC -0.07 Beta (x) 1.49 The Škoda Model. The success of Škoda is proven and well documented and hopefully some Book Value/share (RM) 10.64 of its magic does rub onto Proton. We traced the early days of Škoda before VW and try to get some insights of the impact after the acquisition by VW. Major Shareholders (%)

Khazanah Nasional 38.3 EPF 10.5 From an ugly duckling. Škoda have come a long way under VW with multiple awards in 7.3 the bag as proof. Škoda nowadays is the best success story post communism and is the

Share Performance (%) largest employer in the Czech Republic as well as the country’s main income generator, Month Absolute Relative contributing about 8% of the total GDP. 1m 3.33 -2.09 3m 25.51 9.05 6m 21.61 -1.65 Why VW is interested in Proton? We believed it has to do with (i) a ready hi-tech 1.0m 12m -2.14 -20.04 capacity manufacturing plant, and (ii) the potential of the Asean automobile market. It was speculated that VW may fork out RM2.0bn to control Proton’s manufacturing arm, which we

6-month Share Price Performance view as inexpensive compared to starting a greenfield project.

Would Proton benefit? It is still too early to tell but judging from the positive impact VW had on Škoda, hopes are high. On the face of it, we could see benefits coming from technology

6.40 transfer, R&D, product development and marketing.

5.90 A new shareholder imminent. Khazanah is talking to various parties but the four main 5.40 contenders are all local prospects from the overriding desire that Proton to remain under 4.90 national control. However, none of the companies, DRB-Hicom, , and Mofaz,

4.40 strike our fancy to take Proton up to the next level. Jul-06 Aug-06 Sep-06 Oct-06 Oct-06 Nov-06 Dec-06

Trading Buy with ample upside from valuation. Our valuation is based on 0.7x FY08 Price/Book ratio, translating into a target price of RM7.30/share. Furthermore, we do not expect Khazanah to let it go below the RM9.00 level given its costs to acquire the share was at between RM7.40 and RM9.10 per share.

FYE Mar (RMm) FY04 FY05 FY06 FY07f FY08f Turnover 6,470.30 8,493.29 7,795.29 5,556.04 5,781.82 Net Profit 510.14 650.15 25.80 -14.30 -6.15 % chg y-o-y (53.94) 27.45 (96.03) (155.43) (56.99) Consensus Net Profit - - - EPS (sen) 92.88 147.50 4.70 -2.60 -1.12 DPS (sen) 6.94 34.70 40.28 30.00 30.00 Dividend Yield (%) 1.13 5.64 6.55 4.88 4.88 ROE (%) 9.56 11.41 0.44 -0.25 -0.11 ROA (%) 6.27 7.36 0.31 -0.18 -0.08 PER (x) 6.62 4.17 130.92 -236.20 -549.21 P/BV (x) 0.61 0.57 0.58 0.58 0.59

OSK Research See important disclosures at the end of this publication 1

OSK Research PP/10551/10/2007 January 9, 2007

KEY HIGHLIGHTS

Mr. Right. Speculation is still rife that Proton is closing in on its strategic partner with the latest news that VW is making a u-turn and is in negotiation for the take over of Proton’s manufacturing arm. If so, we could see an arrangement similar to those of /Daihatsu structure whereby the Japanese principal is in control of Perodua’s manufacturing operations. We view it positively as there are benefits for Proton in terms of technology transfer and R&D, distribution network and access to more extensive product range.

In this report, we will look at the various possibilities in the event VW does really come into the picture. Meanwhile, we have also look back on how Škoda has evolved with VW and the potential benefits.

A brief history on Škoda. According to Škoda Auto, the company was founded in 1895 by Václav Laurin, a mechanic, and Václav Klement, a bookkeeper, both enthusiastic bikers, making their own bicycles, named Slavia. In early 1900, Laurin & Klement Co. (L&K) begun manufacturing motorcycles and 5 years on, the company made a major move setting itself to manufacture automobiles in 1905 with its first called the Laurent & Klement A. In 1925, L&K merges with the country’s largest industrial enterprise, Škoda Pilsen that gave birth to Škoda as a brand name with the establishment of an assembly-line production for automobiles and made its name in Russia and Eastern European countries. In fact the Škoda brand was the top choice in the Eastern Europe with market share at about 35%.

Škoda as a carmaker. Škoda has one plant in the city of Mlada Boleslav near Prague in the Czech Republic with a capacity of 180,000 units per annum. The production facility is labour intensive with only 1 product line for passenger cars.

Privatisation of Škoda. This idea came about after the 1989 revolution that saw the end of Communism. The fall of the Soviet Union also resulted in the collapsed of Škoda’s main markets in Eastern Europe. Furthermore, the new government was in the rebuilding stage hence the need to push Czechoslovakia economy back to its health. According to an article by Jonathan Ledgard, there were about 24 bidders for Škoda with both and VW down to the wire. Other conditions set forth were that VW would have to guarantee jobs and an injection of US$5.7bn to turn around the company. From having just one product line in small family car, the product expanded to include estate, 4WD, and saloons.

Prior to VW take over, Škoda production was at about 180,000 units per annum of which 75% were for the domestic market while the remaining exported to the Eastern Bloc countries. It was reported that in 1990, Škoda was in the red. Being in a major Eastern Bloc country, Škoda enjoyed strong demand from it allies where the Eastern European countries accounting to about 35% of its sales. Domestically, Škoda cornered the market with a market share of about 45%, or 140,000 units of cars sold in Czechoslovakia (Prior to the split with Slovakia). Initial approach from Renault was thwarted when VW made a last minute successful bid. In December 1990, the government decides on for cooperation with the VW Group where on April 16, 1991, Škoda joins VW, Audi, and Seat as the fourth marques.

Entry of VW. The acquisition by the Volkswagen Group is one of the major milestones for the company as it helped to transform the company from the brink of collapse to an economic powerhouse in the country.

Controversial. The deal was deemed controversial as the acquisition of Škoda was the first major privatisation deal in Eastern Europe after the collapse of the Soviet Union. The deal between VW and Škoda was signed on 16 April 1991, where US$416.0m was transacted for a 31% stake in the company and a further US$260.0m each in 1993 and 1994 to raise the shareholding to 70%. VW acquired the final 30% from the Czech government (undisclosed amount) in 2000

Not all rosy. The acquisition has its ups and down as VW discovered early on. The “normal” setbacks were unmotivated workers, operations in disarray, overstaffed etc. Thus the real headache began when VW began to consolidate Škoda with production cuts, lay offs and crucially decided to cut its planned investment of US$5.7bn to US$2.5bn, prompting massive protest from the government and workers. Subsequently, the matter was resolved without further damage to the deal.

OSK Research See important disclosures at the end of this publication 2

OSK Research PP/10551/10/2007 January 9, 2007

Life with VW. The impact from VW’s acquisition was immediately felt, as it promptly upgraded Škoda's manufacturing facilities (which is now regarded as one of the world's most modern plant) and reconstructed the value chain to streamline the vendors and increased employment from 24,000 to 26,000 of which 900 are its R&D staff.

Strong capacity expansion. Since 1991, production capacity at Škoda increased to a whopping 500,000 cars per annum from 180,000 of which more than 80% are exported worldwide to 70 countries. The increase in production was achieved mainly via overseas expansion where it has assembly plants in Bosnia, Poland, India and China.

From an ugly duckling… Škoda is currently the biggest employer in the country, with 150,000 employees (4% of Czech's workforce) and also the single largest contributor to the economy, contributing to about 8% of Czech Republic GDP.

Remain true to its roots. A Škoda can never be mistaken as a German. It is always known to be the car company from the Czech Republic, even for those hardly passionate about cars.\

Table: Changes at Škoda under VW

Pre VW Post VW Manufacturing capacity (units/annum) 180,000 500,000 Sales volume 173,000 530,000 Total sales in Czech Republic (units/annum) 140,000* 75,000 No. of employees 24,000 26,000 Product line 1 4 * Sales under Czechoslovakia

Source: Škoda Auto

Key factors behind the success of Škoda.

According to the company, the success of Škoda were down to several factors, namely:

(i) Technology know-how. VW has turned around Škoda’s manufacturing facility to become of one the best plants around. (ii) Placing of top managers. The company placed experienced and knowledgeable personnel at Škoda to overhaul the company’s way of doing things (iii) Extensive product development. The revival of a brand starts with the quality drive to put back the manufacturer on the map and to attract customers back into the showrooms. (iv) Strong financial backing. A dose of massive capital injection where VW duly provides.

Why VW would want Proton? The simple answer is a ready manufacturing plant and access into Asean market.

Infrastructure is already in place. VW is mainly interested in the manufacturing plant to set up its production base in Asean region. Hence it is not surprising that Proton with its world-class manufacturing plant in is the prime target. For VW, controlling the manufacturing plant makes more economical sense rather than to start a greenfield project for its production requirements. Proton’s Tanjung Malim plant has a designed capacity of 1.0m cars per annum with the capability to produce multiple models on the same assembly line. At present, the plant is underutilised with installed capacity at just 150,000 units per annum.

Asean car market is sizeable. In 2005, there were 2.1m vehicles sold in the Asean region which is higher than India, South Korea, and Australia & New Zealand.

OSK Research See important disclosures at the end of this publication 3

OSK Research PP/10551/10/2007 January 9, 2007

Chart 1: Automobile Demand in 2005

Automobile Demand in 2005

Australia & South Korea, N. Zealand, 1.2m 1.1m Asean, 2.1m India, 1.5m

Japan, 5.9m China, 5.8m

Source: Japanese Automobile Manufacturer’s Association

This number is expected to be even higher by 2010 to tune of 2.8m, making it one of the biggest markets in the world behind Europe, USA, Japan and China.

Chart 2: Global Automobile Demand in 2005

Global Automobile Demand in 2005

2010e: 2.6m

Japan, 5.9m Asean, 2.1m Europe, 21.0m China, 5.8m

2010e: 9.0m

South Korea, 1.2m India, 1.5m Australia & North America, N.Zealand, 20.0m 2010e: 1.1m 1.9m

Source: Japanese Automobile Manufacturer’s Association

Hoping for similar effect on Proton... The key difference between VW-Škoda deal and the potential VW-Proton deal is that VW takes full control of the company. Having a free reign is an essential without interruption from third parties. By having a controlling stake in Proton’s manufacturing arm as against to having full control of Proton, gives rise to concern that VW may put a cap on the level of assistance to Proton. We do not discount this to happen but so far, news has been favourable with VW indicating its willingness to provide the necessary assistance to Proton but it is still inconclusive...

OSK Research See important disclosures at the end of this publication 4

OSK Research PP/10551/10/2007 January 9, 2007

What in store for Proton? The discussion of the pros and cons of such move is rather complicated and have far- reaching impact not only to Proton but to the vendors and related industry that is highly dependent on the long term survival of Proton. It was reported that VW is proposing to take control of Proton’s manufacturing arm with the scheme similar to what Perodua has with Daihatsu. The immediate benefit is that Proton would remain as a national asset with the control at the holding company being Malaysian.

Chart 3: A New Corporate Structure?

Proton Holdings Bhd

Volkswagen AG

49% 100% 100% 100% 100%

51% Financial Manufacturing Engineering Marketing Properties Others Services

In a nutshell, the entry of a strong and capable partner is viewed positively for the following reasons:

(i) Access to world class R&D. This is crucial for the development of new products and quality control in the field of chassis development, engine & transmission, product testing and safety requirements, to name a few. No doubt that Proton has a world class engineering company in Lotus, but in the case of VW, the group has much more to offer especially for the development of lower-cost large-volume cars compared to Lotus which in itself is a niche market player. In the VW stable, the technological strength is quite impressive, namely Audi and its sports division Quattro GmbH, Lamborghini and , and not to mention that Porsche is a major shareholder of VW. Though some of this may not filter down to Proton but it is good to know that the possibility is there. This is where VW makes a more compelling choice as Proton’s partner.

(ii) Access to a wider market. VW brand equity is proven worldwide and we have witness the impact it had with other lesser marques such as Škoda and SEAT. Since VW took over Škoda, this Czech Republic car maker has become the country’s biggest contributor to the GDP and has consistently performed well in Europe it even listed a amongst the top sellers in the continent.

(iii) Joint development of new products. Joint-development is the norm nowadays as a cheaper means of producing cars or components. VW is doing it within the companies under its stable, while PSA Citroen is doing it with and BMW. Hence, Proton would certainly benefit from this as a mean of expanding its product range since these established car makers have a more complete range of vehicles, from a small car to large MPVs and SUVs.

Affordable by VW standard. VW spend in excess of €1.5bn (RM7.05bn) to privatise Škoda and this works to around €8,300 (RM39,000) per unit capacity (€1.5bn/180,000 production capacity), not inclusive of the US$2.5bn (RM9.0bn) invested thereafter. This makes the proposed acquisition of Proton rumoured to be around RM2.0b relatively cheap (VW has cash hoard of about €8.0bn) At RM2.0bn, over the 1.0m designed capacity, the unit price is approximately at RM2,000 per unit capacity (equivalent to €730.0 per unit capacity) which is cheap but then again, at Škoda VW paid a premium to control the business.

Sacrifices need to be made. We believe that a strong partner with extensive experience and resources can better help push Proton onto higher level however none of the local companies have met those criteria as yet hence we reckon VW to be the best solution for Proton..

What if VW takes control of Proton and turn it into the Asian version of Škoda? Would consumers complain? Would the country be proud with Proton making great strides into the global automotive markets despite being controlled by a foreign company?

We have so far read the success story of Škoda under VW and yet the Škoda brand remains faithful to its roots. The success of VW-Škoda is proven and well documented but such success demands great sacrifices.

OSK Research See important disclosures at the end of this publication 5

OSK Research PP/10551/10/2007 January 9, 2007

Proton to remain a National Car. So far, four local parties have expressed interest in taking control of Proton, namely (i) DRB-Hicom, (ii) Sime Darby, (iii) Naza and (iv) Mofaz. In opting for one of the 4 local parties, one has to ponder the benefit that these companies can bring to Proton. So far we have found none. Proton is a car manufacturer not a car assembler unlike the proposed suitors. Having assembly plants and doing “badge- engineering” is not car manufacturing nor having extensive sales experience makes you a good car maker. The only benefit if any, is that Proton would remain under Malaysian control. The government is adamant that Proton will not be sold to foreign companies and we do not expect the stance to change this time around. It was reported that VW is looking to control the manufacturing arm of Proton in a scheme similar to that of Perodua/Daihatsu rather than buying an equity stake in Proton Holdings. This scheme would enable Proton to remain a national asset, which will be the case.

Domestic sales to remain weak. Sales outlook for Proton remain sketchy with the prevailing weakness probably to extend into 1H07. Given its deteriorating market share, Proton needs to address the product mix which is lagging versus competition. New models are in the pipeline and this should help improve sales next year. It was reported that three new models would be introduced in 2007.

No longer a leader. Proton sales for 2006 has fallen dramatically exceeding 20% y-o-y on the lack of product mix in the hotly contested sub-1.6L saloon market as well as sub-1.0L segment. As a result, its market share in the passenger car has fallen from 42% in 2005 to 31% this year, losing its crown as the top brand in the country to Perodua with a 42% market share. To address this, Proton has embarked on an aggressive sales campaign in 2H06 but so far the results has been less than encouraging as their range is not as comprehensive and competitive as the other marques.

New launches crucial for sales growth in 2007. Proton is reportedly has two new models in the pipeline namely, (i) a new 1.6L saloon which could be based on the Gen-2, and (ii) a small MPV. Expectations on the new models are undoubtedly high but overall impact can be limited should Proton decides to stop the production of the Wira and Saga for the domestic market as these two models provides the volume for Proton at the moment. For 2007, we expect automobile demand to remain soft in 1H but estimated TIV to show a moderate growth of about 2%, underpinned by (i) aggressive pricing strategy amid stiffer competition, (ii) introduction of new models to act as catalyst for higher sales and (iii) gradual improvement in consumer confidence.

Valuation & Recommendation

Despite the flawed fundamentals, persistent speculation regarding Proton will help to act as catalyst to spur trading interests on the stock. To recap, Khazanah paid between RM7.80 and RM9.10 for their stake and it is highly doubtful that Khazanah would want to sell at a loss.

Our call. The near term outlook for Proton is rather uninspiring amid the uncertainty over its market share. Nonetheless, we view Proton as a Trading Buy with target price at this current juncture at RM7.30 based on 0.7x FY08 P/Book, which is comparable to and Hyundai P/Book at between 0.7x and 0.9x each as well as at a discount to PSA Peugeot Citroen P/Book which at about 0.9x. Furthermore, the consistent news flows on this issue revitalising interests on the counter, translating into potentially stronger share price movement. Using the break-up method, the fair value of Proton is at RM9.19/share.

Table 1: Break-up Value

RM'm Manufacturing facilities 3,284.3 Proton Edar 384.0 Lotus 493.0 Land & building 556.0 Net cash 328.7 5,046.0 No. of shares 549.2 Break-up value per share (RM) 9.19

OSK Research See important disclosures at the end of this publication 6

OSK Research PP/10551/10/2007 January 9, 2007

FYE Dec (RMm) FY04 FY05 FY06 FY07f FY08f Turnover 6,470.30 8,493.29 7,795.29 5,556.04 5,781.82 EBITDA 679.27 1009.73 489.07 485.41 511.30 PBT 592.06 779.00 36.00 -1.00 9.00 Net Profit 510.14 650.15 25.80 -14.30 -6.15 EPS (sen) 92.88 147.50 4.70 -2.60 -1.12 DPS (sen) 6.94 34.70 40.28 30.00 30.00

Margin EBITDA 10.50% 11.89% 6.27% 8.74% 8.84% PBT 9.15% 9.17% 0.46% -0.02% 0.16% Net Profit 7.88% 7.65% 0.33% -0.26% -0.11%

ROE 9.56 11.41 0.44 -0.25 -0.11 ROA 6.27 7.36 0.31 -0.18 -0.08

Balance Sheet Fixed Assets 3192.07 3804.54 3881.80 3893.75 3857.10 Current Assets 4937.68 5026.49 4430.97 4215.88 4190.48 Total Assets 8129.75 8831.02 8312.78 8109.63 8047.58 Current Liabilities 2078.74 2210.03 2341.06 2314.04 2418.65 Net Current Assets 6051.00 6621.00 5971.71 5795.58 5628.93 LT Liabilities 448.45 760.71 101.06 98.75 97.30 Shareholders Funds 5602.55 5860.28 5870.65 5697.08 5531.66 Net Gearing (%) 0.11 0.17 0.15 0.17 0.18

OSK Research See important disclosures at the end of this publication 7

OSK Research PP/10551/10/2007 January 9, 2007

Škoda cars at a glance…

Source: Škoda Auto, Autosoviet.org, OSK Research

The First, Laurent & Klement A (1905)

Škoda Rapid (1980s)

Škoda 422, The first Škoda branded car (1910s) Škoda Favorit (1980s)

A best seller, Škoda Favorit (1936)

Škoda Felicia, 1994 (1st car under VW)

Škoda’s first luxury car, the Superb

Škoda Octavia (1997)

Škoda Tudor Berlina, The first model post WWII

Škoda Fabia (2000)

Škoda 440 aka Octavia (1954)

Škoda Superb (2002)

Škoda Felicia (1956)

Škoda Roomster (2006).

Škoda MB1000 (1960s)

Škoda 110R (1970s) Škoda Octavia Scout 4x4 (2006)

See important disclosures at the end of this publication 8

OSK Research Private Circulation Only

OSK Research Guide to Investment Ratings

Buy: Share price may exceed 10% over the next 12 months Trading Buy: Share price may exceed 15% over the next 3 months, however longer-term outlook remains uncertain Neutral: Share price may fall within the range of +/- 10% over the next 12 months Take Profit: Target price has been attained. Look to accumulate at lower levels Sell: Share price may fall by more than 10% over the next 12 months Not Rated: Stock is not within regular research coverage

All research is based on material compiled from data considered to be reliable at the time of writing. However, information and opinions expressed will be subject to change at short notice, and no part of this report is to be construed as an offer or solicitation of an offer to transact any securities or financial instruments whether referred to herein or otherwise. We do not accept any liability directly or indirectly that may arise from investment decision-making based on this report. The company, its directors, officers, employees and/or connected persons may periodically hold an interest and/or underwriting commitments in the securities mentioned.

All Rights Reserved. Published and printed by :-

OSK RESEARCH SDN. BHD. (206591-V) (A wholly-owned subsidiary of OSK Holdings Berhad)

Shin Kao Jack

Kuala Lumpur Hong Kong Singapore

Malaysia Headquarters Malaysia Research Office Hong Kong Office Singapore Office OSK Securities Bhd. OSK Research Sdn. Bhd. (206591-V) OSK Asia Securities Ltd. DMG & Partners Securities Pte. Ltd. 20th Floor, Plaza OSK 6th Floor, Plaza OSK 1201-1203, 12/F, #22-01 Ocean Towers Jalan Ampang Jalan Ampang World-Wide House 20 Raffles Place 50450 50450 Kuala Lumpur 19 Des Voeux Road Singapore 048620 Malaysia Malaysia Central, Hong Kong Tel : +(65) 6438 8810 Tel : + (60) 3 2333 8333 Tel : + (60) 3 2333 8333 Tel : + (852) 2525 1118 Fax : +(65) 6535 4809 Fax : + (60) 3 2175 3333 Fax : + (60) 3 2175 3202 Fax : + (852) 2537 1332 E-mail : [email protected]

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