Nylon Industry Seeing Signs Of Recovery

China’s chemical fibre industry has likely hit bottom after entering a downcycle from late-4Q08 to early-1Q09. Implications include the plunge in selling prices, lower production, decreased profitability, longer receivables and asset turnover, as well as heavy cutbacks in fixed asset investment (FAI).

Since early 2Q09, the chemical fibre industry has begun to experience a recovery, especially from May 09 onwards. The improvement appears quite substantial with production revisiting double-digit growth in May 09.

Recall in 4Q08 when prices fell sharply, nylon fibre makers suffered from both sales decline (as a result of lower selling prices) and severe margin erosion when they had to purchase chips at a higher price level and sold yarn products at a lower price level. The situation has since reversed and prices are now rising. Thus, we believe the benefits to fibre producers would also double in terms of higher sales and better margins.

The chemical fibre industry will soon enter the strong July-August season when fibre producers will fulfil more export orders for Christmas sales. Business climate and consumer confidence appear to be picking up in many western countries, especially the US. We therefore expect fibre makers to see more orders rolling in. Although textile and garment exports for July-August could still record a yoy decline due to relatively high base last year, we believe the chemical fibre industry will still benefit as the stronger demand will help the sector step further out of the trough, heading towards recovery.

Among chemical fibre stocks under our coverage, both Li Heng and China Sky (CSky) have witnessed increased sales and margins from Apr 09 onwards. We expect both companies to record qoq earnings improvement for 2Q09. We like Li Heng for its consistent capability to maintain production at full capacity and generate profits. As a market leader, we expect the company to benefit more from the industry’s recovery in terms of charging more decent prices and reporting better margins. For CSky, the underperformance at QZ may offset such benefits, to some extent. In addition, the risks associated with the company’s balance sheet could also give rise to potential problems. Maintain BUY on Li Heng with a target price of S$0.29, based on Hong Kong peers’ average FY10 PE of 5x. Reiterate HOLD on Csky. Our fair price is S$0.22, based on 4x FY10 PE. Entry price is S$0.15.

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