False Dawn or Light at the End of the Indonesian Tunnel?

My latest voyage was to check on some of our investments in Indonesia.  The situation as of June 2015 is not the one we had hoped to see, or indeed expected to encounter, as at year end 2014.  One should never hold up hopes too high for Indonesia, a country that continues to promise, but never ever fully delivers.  Still the potential remains as exciting as always and one day the place will blossom as it should.

The challenge here, as in many other countries, is a well-entrenched bureaucracy that is both corrupt and incompetent; a legacy of the days of Presidential/Military rule.  Since the arrival of democracy post the Asian melt down of the late 1990s there has been progress, but not enough.  The Anti-Corruption Commission has collected some notable scalps and is very popular but of late has been fighting off attacks from the police where as you would expect corruption is a particularly bad problem.

When Jokowi came to power after huge success as Mayor of Solo, and having had a real impact as Mayor of Jakarta, there were unrealistic expectations as to what he could achieve as President : unrealistic because he has no real power base except the people; and they only get to vote once every five years so can be safely ignored for the remaining 4½.  His own party is controlled by someone else and as of now in Parliament he does not have a majority.  Still chaos among his opponents enables him to assemble support for popular measures, and the President can force through quite a lot of change, especially administrative, without consulting the Parliamentary snake pit.

We should not ignore his accomplishments.  There has been real progress in pushing along infrastructure, with several high profile projects having broken ground including a badly needed port.  Several important toll roads are now moving along faster; but more, in fact much more, is required.  The multiplier effect in Indonesia of infrastructure investment is massive, and the country needs more of everything - now.

Part of the problem is that the government does not seem to know what it is doing.  Proposals are introduced, dropped, reintroduced, modified and then many vanish without trace while others end up enshrined into law.  Yet there is no clear pattern.  It seems like a lottery.  The process and outcome are impossible to predict.  This makes life difficult for investors.  Worse ministers in the cabinet contradict each other.  One says foreigners can now buy freehold apartments, another says they cannot.  One department is pushing a major land reclamation project along the sea shore of Jakarta, another is attempting to block it; Jokowi does not seem in control even of his own team.  Indecisiveness is bad for investment and companies cannot make long term commitments if there is too much change.  

Not surprising then that investors are having second thoughts, especially international institutions.  FDI remains a bright spot, especially from Japanese firms who are staking out a lot of strategically placed real estate; but funds flow both in bonds and equities has turned negative causing both the rupiah and the stock market to drift south. 

The good news, and there is some good news, is that much more of this and the Indonesian market will re-enter undervalued territory.  On a purchasing power priority basis the currency is already cheap – of course it can always get cheaper.  Funds flows have nothing to do with value but they do set prices.  The multiples of Jakarta listed companies, with a few glaring exceptions such as the local subsidiary of Unilever, are starting to look more sensible.  Then there are some sectors that are already bombed out, where a value investor can start to do analysis now.  Picking the bottom is always tricky especially when factors affecting the category are global : as they are with the areas of the Indonesia economy that have been hit especially hard.  These are of course the commodity linked complex of which coal is the most important, followed by palm oil, gas products, with a supporting role played by a chorus including coffee and rubber.

Coal is key.  The price has been heading lower for some time.  There is oversupply especially of the relatively lower quality, lower calorie content thermal coal where Indonesia is the world number one exporter.  As China cuts back and stacks the deck in favour of its own less efficient producers there had been hopes that India under Modi might take up the slack; but it was not to be.  Astonishingly one of the world’s worst run companies Coal of India has summoned up a new burst of energy from somewhere and is ramping up domestic production more rapidly than expected.  Less astonishingly the power industry in India remains a mess with new capacity behind schedule and massive bad debts affecting the whole energy chain.  Reform needs to start with getting people to pay their bills.  By some estimates between 30-40% of customers do not believe they should pay for electricity in India and most of these do not.  So no relief from there for Indonesian coal producers.

The obvious answer is Mine Mouth Power Plants.  Indonesia desperately needs more output.  There is widespread support for these projects even in Parliament where of course there are plenty of interested parties sizing up how much of the potential profit could end up in their pockets.  Some units are getting started, but implementation is likely to be patchy.  Still with coal shares beaten up – in some cases down over 80% - the market remains sceptical and has yet to attribute much, if any, value to early stage plans.  Yet MMPPs could add very significant value to several listed companies as early as 2017 and deserve close attention.  It is perhaps too early to dive in now.  The trick will be to decide just how far ahead investors will be prepared to look in a country with, to be polite, a patchy record.  1H 2016 perhaps?  This may not be music to the ears of the climate change green lobby, but Indonesia is too poor to turn up its nose at the one cheap source of fuel it has in abundance; so more coal fired stations are coming and the local economics are such that enough of these could turn the country into one of the low cost power locations in S.E.Asia.

Palm oil has also been hit hard; but lower prices appear to be luring buyers back.  Again China and India are the big customers.  In the short run Malaysian inventories are too high and will continue to be an overhang for the next couple of quarters.  The El Nino effect is usually a plus for plantation companies.  That phenomenon is in process though it is too soon to say whether its impact this time round will be serious or trivial.  The planters are also beneficiaries of a weak rupiah.  So far plantation stocks, while some have corrected, are not bargains, though there might be value in picking one name from this space for a diversified portfolio.

There are bargains on offer even today in the area of energy and related services.  This sector too is a major beneficiary of a weak rupiah.  Primary producers have seen share prices slump even when they produce more gas than oil; and even when gas prices have continued to edge up as the bbl equivalent equation still favours gas with oil at $60.  The market does not seem to be able to distinguish between the two so anyone who cares to dig deeper could uncover a pleasant surprise especially when focusing on cashflow rather than accounting profit. 

Support services are experiencing knock on price pressure.  Not all of that has worked its way through the system.  Offshore supply vessel providers and rig operators face demands for 20-30% discounts while capital projects are getting slashed and/or delayed especially in deep water.  This is not a pleasant environment.  The profit of some players has evaporated; but again the cashflow has not so debt is also going down and balance sheets in general are getting better, while the Enterprise Value shrinks into attractive EV/EVBITDA territory.  Time to nibble at least.  In theory these companies provide an almost seamless currency hedge.

Yet here too it is arguably too early to get fully involved, even if it is time to start a watching brief.  The moment to plunge in and bottom fish could come soon than most expect with the worst affected counters already off 80%.  The arrival of Swire on the shareholder register of the largest inter-island coal carrier hints of possible M&A.  Cabotage has not done the oil service companies much good but the local shipping market at least is getting some relief.  These are the sorts of bombed out businesses where a value investor should be sniffing around.  Last year growth was on offer in Indonesia.  The balance is beginning to tilt back to value.