Materials / Korea 24 February 2012 Initiation: buoyed by China's Korea Petrochemical Sector recovering demand • Monetary easing in China and limited capacity additions should underpin the buoyant petrochemical cycle up to 2014 • EG (ethylene glycol) and BD (butadiene) spreads likely to remain the strongest throughout 2012 • Top pick Honam; should benefit the most from robust cycle How do we justify our view? polyester market, while BD should Valuation enjoy strong auto-tyre demand. The sector is trading at a one-year Honam Petrochemical (Honam) forward PER of 13.1x, above its past- should be the key beneficiary of EG five-year average. We believe its and BD spread strength, in our view. current valuation is undemanding Jihye Choi given the robust petrochemical cycle (82) 2 787 9121 [email protected] PE/PP and ABS to turn round: outlook. The polyethylene/polypropylene Jun Yong Bang (PE/PP) spread has been most Outlook for petrochemical product cycle (82) 2 787 9168 PE/ vulnerable to monetary tightening and EG BD ABS TPA PVC [email protected] PP suffered from a weak cycle since 2010. More favoured Less favoured We expect it to start to pick up with monetary easing. We also expect the Investment case Spread outlook We initiate coverage of the Korea acrylonitrile-butadiene-styrene (ABS) Supply-demand Petrochemical Sector with a Positive spread to start recovering from its dynamics 2H11 trough later this year, led by a Capacity additions rating. We expect the petrochemical gradual IT demand pick-up. Demand outlook cycle to remain buoyant in 2012, on favourable supply-demand dynamics. Sales contribution by product Honam 20% 10% 38% PVC and TPA likely to lag: The Hanwha 44% 31% Catalysts PVC market is likely to remain LG Chem 30% 11% unattractive, due mainly to slow China’s monetary easing is a key Source: Daiwa forecasts Note: 2011 for Honam and LG demand driver: Given Daiwa’s view demand from China’s sluggish Chem, 2010 for Hanwha; LG Chem’s sales contributions are on its petrochemical business sales. that China will ease monetary policy construction market. The purified terephthalic acids (TPA) outlook does this year, we believe all the demand- Risks related negatives are already reflected not look bright either, as we expect major capacity additions this year to We see an unexpected drop in oil in current petrochemical spreads. We prices, and a slow recovery in expect further monetary easing in exceed growth in demand. demand (even amid monetary China to underpin the buoyant cycle. loosening in China), as the key risks. Honam is our top pick: We believe Honam is poised to benefit Limited capacity additions Key stock calls fully from the robust cycle with its scheduled: Capacity expansion at New Prev. naptha cracking centres (NCC) and petrochemical-oriented business portfolio and initiate coverage with a Honam Petrochemical (011170 KS) downstream facilities should be Rating Buy limited at least until 2014. Given a 2-3 Buy (1) rating. We also like LG Chem Target price W470,000 year construction period, unexpected (Buy [1]), which should be the key Up/downside S 31.3% capacity expansion is unlikely to beneficiary of an IT industry LG Chem (051910 KS) disrupt supply-demand dynamics. recovery and whose new businesses Rating Buy Target price W490,000 offer appealing growth potential. Up/downside S 20.7% EG and BD should perform best: Hanwha Chemical (Hanwha) seems We expect ethylene glycol (EG) and to lack business momentum but this Hanwha Chemical (009830 KS) looks priced in. We expect a gradual Rating Outperform butadiene (BD) spreads to remain Target price W32,000 strong throughout 2012. EG should earnings recovery from 2H12 and Up/downside S 11.9% initiate with an Outperform (2) benefit from China’s growing Source: Daiwa forecasts rating. Note: Please refer to page 3 for details. Important disclosures, including any required research certifications, are provided on the last three pages of this report. Korea Petrochemical Sector 24 February 2012 How do we justify our view? Growth outlook Valuation Earnings revisions Global NCCs: capacity additions Growth outlook We expect the petrochemical cycle to remain solid out to ('000 tonne) 2014 on the back of limited capacity additions scheduled 12,000 for NCCs and downstream products until 2014. 10,000 Among the petrochemical products, we believe EG and 8,000 BD will continue their strong cycle, on the back of strong growth in demand from the polyester and auto- 6,000 tyre industries. We also expect the PE/PP spread to pick 4,000 up this year, thanks to China’s monetary policy easing, which should help drive demand for PE and PP. 2,000 0 2010 2011 2012E 2013E 2014E Source: Various sources including ICIS Korea Petrochemical Sector: 1-year forward sector PER bands Valuation The Korea Petrochemical Sector is trading currently at a ( one-year forward PER of 13.1x and a PBR of 1.9x (based (Wbn) (Wbn) on our forecasts). We believe the sector deserves to 60,000 5,000 trade at its peak-cycle valuations reached in 2011 (a PER 50,000 4,000 40,000 of 16.5x and PBR of 2.9x on a one-year forward basis) as 3,000 we expect: 1) the negative impact on demand from 30,000 2,000 China’s monetary tightening to reverse from this year, 20,000 and 2) sector earnings to be maintained at current all- 10,000 1,000 time high levels over 2012-14E. 0 0 2005 2006 2007 2008 2009 2010 2011 2012 Operating profit (RHS) PER 3.0x 8.0x 12.0x 16.0x Source: Data guide, companies, Daiwa forecasts Note: Operating profit is sum of that of Honam, LG Chem, and Hanwha Earnings revisions Companies: operating profit, Daiwa vs. consensus (2012E) Notwithstanding our positive view on Honam, our (Wbn) consolidated 2012 operating profit forecast for the 3,500 company is 11% lower than that of the Bloomberg 3,000 consensus, due largely to our weak earnings outlook for one of its subsidiaries, KP Chemical, owing to excessive 2,500 TPA capacity additions planned in 2012. Our 2012 2,000 operating profit forecast for LG Chem is 13% lower than 1,500 the consensus forecast, which we attribute to our less 1,000 favourable outlook for the PVC spread (due to a sluggish 500 construction market in China). Our 2012 operating profit 0 forecast for Hanwha is 36% lower than that of the Honam Petrochemical LG Chem Hanwha Chemical consensus, reflecting mainly our negative view on the near- Daiwa forecast Bloomberg Consensus term earnings outlook for its solar cell/module subsidiary, Source: Bloomberg, Daiwa forecasts Hanwha Solar One (HSO) (Not rated). - 2 - Korea Petrochemical Sector 24 February 2012 Executive summary Buoyed by China's recovering demand We initiate coverage of the Korea Petrochemical Sector with a Positive view, premised mainly on an improving demand outlook from China’s monetary easing and limited capacity additions scheduled to 2014. Our top pick is Honam. Investment thesis We initiate coverage of the Korea Petrochemical Sector with a Positive We see a robust cycle rating. We expect monetary easing in China to help drive an improvement in petrochemical demand throughout this year. We also expect to see ahead, on: 1) China’s limited capacity additions of NCCs and downstream capacity in the next monetary policy easing, three years, which should keep overall supply tight over this period. and 2) limited capacity We expect EG and BD spreads to remain robust, and those of PE/PP and expansions ABS to recover throughout this year. Valuation The sector trades currently at a one-year forward PER of 13.1x and PBR of The sector’s current 1.9x (based on our forecasts). We believe it deserves to trade at its peak- cycle valuations reached in 2011 (a one-year forward PER of 16.5x and PBR valuation looks of 2.9x), given our expectations of: 1) a reversal of the negatives from undemanding as we believe China’s past monetary tightening this year, and 2) sustained earnings at a robust cycle is current all-time high levels over 2012-14E. We set SOTP-based six-month sustainable target prices of W470,000 for Honam, W490,000 for LG Chem and W32,000 for Hanwha. Profit outlook For Honam, we forecast a similar parent-based operating profit for 2012 to Honam is our top pick; 2011, which we consider commendable given that: 1) the 2011 operating profit represented an all-time high, and 2) we expect it to maintain this operating should benefit fully from a profit level to at least 2013, driven by solid supply-demand dynamics from robust cycle; we also limited capacity additions and a recovery in demand from China’s monetary favour LG Chem, offering policy easing. For LG Chem, we also forecast a similar consolidated IFRS- sound growth prospects based operating profit for 2012 to 2011’s level, on the back of a gradual recovery in the IT industry and even amid a weak PVC cycle. We forecast Hanwha’s IFRS-based operating profit to fall by 18.3% YoY this year, on a decline in petrochemical earnings and weak earnings likely for HSO (both the petrochemical business and HSO enjoyed very strong earnings in 1H11). Key stock calls EPS (local curr.) Share Rating Target price (local curr.) FY1 FY2 % Company Name Stock code Price New Prev. New Prev. % chg New Prev. % chg New Prev. chg Honam Petrochemical 011170 KS 358,000 Buy 470,000 n.a. 34,433 n.a. 34,990 n.a. LG Chem 051910 KS 406,000 Buy 490,000 n.a.