China Zenith Chemical Group (362 HK)： Bellwether from the Northeast

China/Hong Kong Basic Materials Please read the analyst certification and other important disclosures on last page China Zenith Chemical Group (362 HK) 21 April 2010 Bellwether from the Northeast Company Rating: Sector Rating: Outperform (Initiation) Overweight (maintained)
Robust earnings growth outlook. We expect the company’s net income to increase by 37% YoY to HK$230m in FY10F, and by 53% YoY to HK$352m in FY11F, underpinned by a recovery in Polyvinyl Chloride (PVC) prices, expansion of PVC business and contributions from new products – vitamin-C and calcium carbide.
Higher than historical PER in PVC up-cycle. China Zenith is trading at PERs of 4.7x in FY11F and 3.3x in FY12F. As PVC and Vinyl Acetate (VA) demand are recovering rapidly while new business operations (vitamin-C and calcium carbide) will begin commercial operations in the next 12 months, the stock deserves to trade above its historical average PER of 4.8x. We initiate coverage with an Outperform rating and target price of HK$0.320 based on a PER of 5.9x in FY11F.
The proposed spinoff. The company announced the plan to spin off its PVC business in Mudanjiang in March 2010 to raise capital for an aggressive expansion plan. While investors may think debt should be raised instead of equity to finance expansion, channel checks suggested it is difficult for privately-run companies in Heilongjiang province to obtain bank credit, owing to the history of defaults by many private companies in the region. Another option for the company is bond issuance. We have not assumed any equity issuance apart from the exercise of existing warrants.
Key risks. Significant dilution from equity financing and/or spinoff of PVC operations, downsized expansion, project delay and budget overrun for the calcium carbide projects, and deteriorating account receivables are the major risks. Forecast and valuation Year to 30 June FY08 FY09 FY10F FY11F FY12F Revenue (HK$m) 1,666 1,096 1,517 2,689 4,049 Net profit (HK$m) 265 168 230 352 497 YoY change (%) 40 (37) 37 53 41 EPS – diluted (HK$) 0.07 0.04 0.05 0.05 0.08 Operating margin (%) 18.0 14.1 18.0 20.6 22.2 Net margin (%) 15.9 15.3 15.1 13.1 12.3 PER (x) 5.1 4.9 5.0 4.7 3.3 P/B (x) 0.5 0.3 0.3 0.3 0.2 ROE (%) 14.8 7.5 8.5 10.8 13.0 Source: Company data, CCBIS estimates Price: HK$0.255 Target: HK$0.320 (initiation) Trading data 52-week range HK$0.133-0.295 Market capitalization (m) HK$1,552 Shares outstanding (m) 6,088 Free float (%) 64 3M average daily T/O (m share) 68.9 Expected return (%) – 1 year 25 Closing price on 21 April, 2010 Stock price and HSCEI 507090110130150170190Apr-09May-09Jun-09Jul-09Aug-09Oct-09Nov-09Dec-09Jan-10Feb-10Mar-10Apr-10China ZenithHSCEI Source: Bloomberg Felix Lam (852) 2532 6748 felixlam@ccbintl.com Yan Tsui (852) 2532 6164 yantsui@ccbintl.com China Zenith Chemical Group (362 HK) 21 April 2010 2 Table of Contents Bellwether from the Northeast ...................................................................................................................................... 1 Executive summary....................................................................................................................................................... 3 What is China Zenith? .................................................................................................................................................. 5 Aggressive expansion to boost earnings ...................................................................................................................... 9 Balance sheet – a mixed picture................................................................................................................................. 12 Valuations ................................................................................................................................................................... 13 Financials .................................................................................................................................................................... 14 Key risks ..................................................................................................................................................................... 17 PVC market in China .................................................................................................................................................. 18 Favorable regulatory backdrop ................................................................................................................................... 23 Appendix 1: Company background............................................................................................................................. 25 Appendix 2: PVC production process ...............