China Essence - Extension of loan

Loan obligations updates ? According to China Essence's announcement, the Group will be required to repay 16.7% of the loan, i.e. RMB70 million (equivalent to US$10 million), on 31 August 2009. The repayment of the remaining full sum of the loan amounting to US$50 million will be extended by one year to 30 June 2010, with an interest rate of LIBOR plus 3.25% per annum.

Downgrade to HOLD; Target price maintained at S$0.25 We reduced our FY10F earnings estimates by 1.9% after adjusting for refinancing cost. We maintain our target price of S$0.25, equivalent 0.5x FY09 P/B. With an upside potential of 16%, we downgrade China Essence to HOLD.

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China Essence - Auditors have turned cautious

• Last Saturday, the Straits Times reported that the SGX is urging investors to be vigilant. At the same time, more auditors have been raising red flags about listed companies in the midst of this crisis.

• Due to high gearing levels and concerns about Companies ability to refinance or repay their debts, auditors have raised going concern worries over companies such as Frasers Commercial Trust and China Fashion, to name a few.

• With auditors turning more cautious, there is a risk that China Essence’s full year accounts may be qualified by its auditors.

• As at end December 08 (3Q), China Essence had short-term debts of RMB 460.9m and a long term debt (convertible bond) of RMB222.7m. Net gearing remained reasonable at 0.41x. Interest repayment ability was healthy with interest cover at 6.6x but operating cash flow for the 9 months was negative.

• Long-term debt – the long term debt which is a convertible bond is less of a concern at this point in time as bond holders are not able to demand redemption from the Company before maturity of the bond on 20th December 2011. While China Essence has the option of redeeming the bonds earlier, its current cashflow does not allow the Company to do so.

• Short-term debt – the greater concern is on the Company’s ability to repay/refinance its short-term debts of RMB460.9m. In July 2008, China Essence obtained a US$60m (RMB 409.6m or roughly 89% of its short-term borrowing) loan from DBS with a maturity date not exceeding 30th June 09.

• Given that China Essence market cap (approximately US$35.1m) is less than the amount loaned by DBS, we understand that there is a possibility that DBS will either demand full repayment of the loan or reduce the amount it is willing to lend to China Essence when the loan expires.
• Given that China Essence still has RMB262.6m in cash and receivables of RMB170.2m, the Company has leeway to manage the situation appropriately.

• Possible options include paying down some of the DBS loan with its cash balance and we understand that the Company has already started talks with domestic Chinese banks for banking lines.

• The Company is still profitable but the obvious risk is that a demand for full repayment of the short-term loan could cause auditors to highlight going concern risk since current cashflow are not sufficientfor full repayment of the loan. However, the Company could get financing from domestic banks and it would be foolhardy for its current major banker to jeopardize its borrower’s finances at this stage when cash flow generation capability still exists.

• At the same time, the share price was under pressure from sales by major shareholder, Dunross Investment Ltd which reduced its stake from 7.40% to 4.95% (9.6m shares) on 18th March 2009.

• Major shareholders have however been buying shares from the open market. CEO Zhao Libin bought shares on 26th March and 31st March at average prices of S$0.11373 and S$0.10958, bring his stake in the Company from 43.36% to 43.92%. Another major shareholder, Lee Kah Bao raised his stake from 4.984% to 5.099% on 3rd April with his purchase of 452,000 shares at an average price of S$0.135.

• On 27th march, the Company issued a statement to inform investors that they were considering various options in regard to the repayment of the DBS loan of US$60m.

• Maintain BUY with S$0.34 target price. This recommendation would be subject to the Company being able to resolve its debt issue. The dividend yield is only a ball park figure as we have assumed a 10% payout ratio which may not materialise since the Company is likely to seek cash preservation.

• China Essence has formed a bullish wedge pattern, and it is about to breakout of the said pattern. Trading volume has been increasing, suggesting that there is accumulation by strong hands.

• Technical indicators are also positive with the MACD and RSI hooking upwards. RSI has breached its resistance earlier. The bullish divergence on its MACD is supportive of our bullish call. Resistance is seen at S$0.15 and S$0.175.

• It appears that the bulls are about to shift into overdrive soon. Traders should buy half now and the rest near the S$0.11-0.12 levels before the impending breakout. Place a stop at S$0.105.

China Essence - Potato protein & fibre production updates; in line with our expectations

Potato protein successfully passed production trial runs and independent third party test ? China Essence has sent sample products to an independent third party accreditation board, the China Commercial Union of Feed Quality Supervision and Testing Centre, which successfully passed all the test as of 20 November 2008, after successful test trials for the production line of potato protein took place for 10 days in November 2007 and 3 weeks in September 2008. As noted in our previous report dated 13 Feb 2009, China Essence has commenced large-scale production in late September 2008 and has sent samples of potato protein to local and international distributors for further testing. The Group is cautiously optimistic that it will be able to secure orders from these customers and anticipates this to be a key performance driver in the 4Q09, though we remain skeptical. We understand from management that the Group has the ability to ramp up production quickly once firm orders are received from the customers for the next harvest season.

Potato fibre to commence production in May 2009 ? As with potato protein, China Essence has completed the trial run of the potato fibre production facility and have successfully passed 2 rounds of tests conducted by the same accreditation board as of 13 January 2009. The Group has sent sample products, to be fed to piglets and calves on a trial basis, to an animal-rearing organization under the local Heilongjiang government to conduct further testing and expect testing to be completed by May 2009. According to China Essence's announcement, there are approximately 40,000 tonnes of dried unprocessed potato skins under storage and rescheduling of commercial production of potato fibre from December 2008 to May 2009 will lead to cost savings in fuel.

Upgrade to BUY; Target price maintained at S$0.25 We maintain our FY09F earnings estimates, as we have adjusted our estimates in our report dated 13 February 2009. Based on last transacted price of S$0.205, China Essence is trading at 2.2x FY09F P/E and a 60% discount to FY09F book value. Given that stock price has fallen 7% since our last report from the broad market sell off, we believe value has emerged with 22% upside potential to our target price of S$0.25, pegged at an unchanged 0.5x FY09F P/B. As such, we upgrade China Essence to BUY.

China Essence Group Ltd - Results slightly ahead of our forecasts; warns of challenging times ahead

Earnings ahead of our forecast ? China Essence reported a net profit of RMB81.2m in 3Q09, reflecting a yoy decline of 19.5%. 9M09 earnings of RMB161.3m accounted for 86% of our forecasts versus approximately 70% of consensus estimates. Selling and distribution cost and administrative expenses decreased 13.8% and 27.6% respectively, leading to a 2% increase in 3Q09 operating profits.

Challenging outlook ahead ? Given the dynamic and rapidly changing global business environment, management has guided for a challenging outlook for FY09~10F. To sustain demand, the Group has further reduced the selling price of potato starch in Jan 2009 by approximately 10% or RMB500/tonne.

Potato protein and potato fibre updates ? China Essence has commenced large-scale production in late September 2008 and has sent samples of potato protein to local and international distributors for further testing. The Group is cautiously optimistic that it will be able to secure orders from these customers and anticipates this to be a key performance driver in the 4Q09, though we remain skeptical. China Essence has completed the trial run of the potato fibre production facility and would likely to commence in May 2009, later than expected. As such, we have pushed back contribution from potato fibre to 2Q10F.

Maintain Hold; Target price of S$0.25 We raise our FY09F earnings estimates by 3.0%, due to a better than expected 3Q09, implying a 61.2% qoq decline in 4Q09F earnings amid the challenging economic climate. Given that the stock is already trading at 2.4x FY09F P/E and a 57% discount to book value, we maintain HOLD, valuing China Essence at S$0.25, pegged at an unchanged 0.5x FY09F P/B.