Keep an eye on paper maker Nine Dragons for profit rebound, says BAML
Originally published at the South China Morning Post on January 28, 2016.
China’s paper sector is looking up despite weathering recent creases caused by the precipitous drop in the yuan.
Following a period of intense volatility in the yuan, paper companies in mainland China saw profits dragged down by foreign-exchange losses. Nine Dragons announced an exchange loss of about one billion yuan in the second half of last year, causing its profits to drop to 310 million yuan, which was 54 per cent of its net profit in the same period of 2014.
Yet paper firms are far from folding, analysts say, with stable demand and government policies aimed at tackling sectors struggling with overcapacity.
Excluding foreign exchange losses, Nine Dragons reported a profit increase of 780 million yuan or nearly 150 per cent from the same period the year before.
“It’s quite rare in the Chinese economy. You don’t have a lot of industries [where] the core results are in fact improving,” said Ivan Li, analyst at Tung Shing Securities. “The labour cost is always rising, but generally [they are] trying to replace more workers by machines, so maybe that’s one of the reasons. The industry is facing an interesting situation.”
This year, a mild recovery in demand on the back of strong e-commerce growth and a shift to high-end food and beverages will help boost utilisation by 88 per cent and prices 4 to 5 per cent, according to a report by Bank of America Merrill Lynch analysts Matty Zhao and David Ching. Production capacity would also drop up to 2 per cent from 2015 to 2017, the report said.
The government’s recent moves to clear inefficient firms in the sector had helped prices to firm up slightly, analysts said.
Beijing is expected to eliminate some capacity in Zhejiang and Tianjin this year, having sparked a mild recovery in demand and a price increase of 4 to 6 per cent after clearing inefficient firms in Dongguan last year.
“We are most optimistic on closure execution for the paper sector, given that it has a lower level of labour, low [state-owned enterprise] concentration and clear subsidy plans,” the report said.
The price of US old corrugated containers or recycled paper, a key raw material for the sector that can be bought from the US or domestically, has also dropped 6 per cent this year, counteracting the 1.3 per cent depreciation of the yuan against the US dollar, according to the report. Chinese paper mills have also shifted to using domestic recycled paper.
Cost reductions from lower coal prices and power tariffs had also helped the price recover, the report added.
“Nine Dragons is our top pick, given its higher leverage to a potential price recovery post-Lunar New Year, lower finance costs with reduced gearing and attractive valuation,” the analysts said.
Lee & Man Paper Manufacturing is expected to see net profit for 2015 grow 22 per cent on a 3 per cent sales gain, with a decline in recycled paper costs and value-added tax refund from July in the second half of the year, according to a report by China International Capital Corp released on Monday. Sales volume is expected to have grown steadily at 8 per cent.
“We maintain our buy rating on Lee & Man ... given its low cost, high operating efficiency, healthy balance sheet and it being a key beneficiary of the closure of smaller paper mills in Dongguan,” the CICC analysts said.
They estimate foreign exchange losses in the second half of 2015 at HK$100 million to HK$150 million. Yet they predict the firm’s core net dollar margin to increase HK$25 per tonne in 2016, excluding these losses.
“[Lee & Man’s] tissue business is still small, but its vague tissue capacity plan could cast uncertainty on cash flows,” the CICC report said.