Pine Agritech - Gross margin remains low despite lower input cost

Sales decrease continued in 2Q09. Due to the decelerating economy, consumers cut their discretionary spending on healthcare products, which resulted in Pine encountering weak demand and sales decline across all product categories in 1Q09. We expect this downward trend to continue for most of Pine’s products in 2Q09 (except its SPI product). Benefitting from the recovery in overseas demand, the utilisation rate of Pine’s SPI product was expected to improve from 42% in 1Q09 to approximately 50% in 2Q09, but still lower than its historical level of over 60%, as demand in the domestic market remained weak. Sales of its soy oligosaccharide syrup (SOS) products were still disappointing.

The utilisation rate for this product was hovering at low levels in 2Q09, probably reaching the same level as that in 1Q09 (6%), which was significantly lower than 44.7% in FY07 and 12.1% in FY08. The poor sales of SOS were within our expectation and we do not expect sales to rebound quickly, considering that consumers are cutting their discretionary spending. Moreover, since 4Q08, Pine has scaled back its advertising and promotional (A&P) campaigns in order to reduce operating expenses, which also caused the slowdown in SOS sales, given the current depressing market atmosphere and Pine’s weak brand recognition.

Gross margin remains low despite lower input cost. In line with the decrease in commodity prices, soybean cost for Pine fell by 15-20% yoy in 2Q09. The lower input cost, together with higher demand from the overseas markets which command higher ASPs as well as higher margins, will help Pine to increase the gross margin of its SPI products in 2Q09, to some extent. However, the collapsed sales of SOS would drag down the company’s overall profitability, causing Pine’s gross margin to be flat compared to 1Q09 (8.0% in 1Q09), lower than the 23.8% registered in 2008 and 20.5% in 2Q08.

High probability of recording a loss in 2Q09. Pine reported a net loss of Rmb22.6m in 1Q09. Although sales volume and gross margin for its SPI product would see some improvement in 2Q09, this will not boost Pine’s sales and net profit. The plunge in SOS sales, lower gross margins and heavy CBsincurred financial burden will further drag down its earnings, leading to a high probability that Pine might record a loss again in 2Q09.

Reiterate SELL on Pine Agritech. The net loss in 1H09 reflected the tough operating environment for the Group and we expect it to be the same in the near term. International soybean price has jumped 60% from its lowest point in 2008. Together with the probability of an output reduction in North China, domestic soybean price has continued to rebound since Jun 09. This will put further pressure on Pine’s profitability in the next few quarters. Pine’s earnings remain at risk as the demand for health products may continue to fall. Reiterate SELL. Our DCF-based fair price is S$0.06 (cost of equity of 17.4% and terminal growth rate of 3% on a 10-year horizon).

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