Li Heng - Prospects Are Looking Brighter

The key message during the plant visit last week was that 3Q ‘09 bottom-line is expected to continue to recover from 2Q ‘09 (RMB38mln), 1Q ‘09 (RMB10.2mln) as well as 4Q ‘08’s (loss of RMB8.7mln) depressed levels, but still not enough to reach 3Q ‘08’s high base of RMB 259mln.

We estimate 3Q ‘09 bottom-line to recover 32% qoq to RMB50mln (no forex gain included versus forex gain of RMB13mln in 2Q ‘09).

This in turn reflects sales volume remaining steady as new local customer additions (+17 yoy to 195) help to offset weakness from export customers, while average selling prices recover 27% sequentially on the back of stronger demand as well as higher raw material costs.

While raw material prices are also expected to increase, fortunately, the company buys 2 months worth of inventories, hence will benefit from the lag effect of lower cost inventories.

As a result, gross profit margin is expected to recover from 2Q ‘09’s 10.6% to about 15% in 3Q ‘09, but still down from 3Q ‘08’s 31%. (Gross margin was 9.2% in 4Q ‘08 and 12.9% in 1Q ‘09).

The new polyamide chip plant which is used to produce part of their raw materials is expected to help them improve overall margins by 2-3% points when it ramps to full utilization in 1H 2010. The cost of the plant is about RMB571mln with depreciation per year estimated to be between RMB55-60mln (to start accounting for depreciation in 4Q ‘09).

Due to improved prospects, management has restarted their previously stalled expansion plans, targeting to add 70,000 mt of new production capacity by 1H 2010, increasing total production capacity from 167,000 mt to 237,000 mt.

The capex cost of RMB200mln is not a problem with the company’s net cash holdings of close to RMB1bln. Management said that they will maintain their at least 20% payout ratio at the end of the financial year.

The number of analysts visiting the company’s plant is down significantly from the one organized in early 2008, likely reflecting the company’s dismay operating performance and problems associated with S-Chips in general. However, we believe that as the company continues to deliver on their improving bottom-line performance, successfully executes its expansion plans and delivers on their dividend promises, investor interest will return.

While the stock has risen 19% since our upgrade last week, we still see upside potential given its improving prospects (especially with easier yoy comparisons due to low base effect from 4Q ‘08 onwards) and 0.7x price to book despite improving bottom-line and ROE performance, hence maintain BUY. (Founder and Chairman Chen Jianlong owns 42.7% of the company, CEO Chen Feng owns 10.32% while David Loh of UOB owns 10.47%).

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