Shengli Pipe：Riding on China's pipeline build-out

Produced by: The Royal Bank of Scotland N.V., (Hong Kong) Branch Equity | China | EnergyThis note should be read along with our sector report ( Out of the trough, 21 June 2010 ) for a better understanding of the investment argument Important disclosures can be found in the Disclosures Appendix. Shengli Pipe Riding on China's pipeline build-out Shengli Pipe is positioned to benefit from the significant expansion of China's oiland gas pipeline networks. Management plans to double production capacity (to1.34mt/year by 2012) and to develop new products and exports. We forecast a 25% net profit CAGR over 2009-2012. We initiate coverage with a Buy rating. Key forecasts FY08A FY09A FY10F FY11F FY12F Revenue (Rmbm) 1,107 3,050 3,636 4,887 6,314 EBITDA (Rmbm) 159.3 360.6 434.1 622.6 867.9 Reported net profit (Rmbm) 148.8 335.9 347.8 473.8 659.7 Normalised net profit (Rmbm)¹ 148.8 335.9 347.8 473.8 659.7 Normalised EPS 0.06 0.13 0.14 0.19 0.26 Dividend per share 0 0.02 0.03 0.04 0.07 Dividend yield (%) 0 1.09 1.73 2.36 4.1 Normalised PE (x) 27 12 11.6 8.48 6.09 EV/EBITDA (x) 25 8.15 7.57 5.71 3.91 Price/book value (x) 27 2.24 1.98 1.65 1.34 ROIC (%) n/a 214.1 46.5 31.9 29.1 1. Post-goodwill amortisation and pre-exceptional items Accounting standard: HK GAAP Source: Company data, RBS forecasts year to Dec, fully diluted A leading SSAW steel pipe manufacturer in China Shengli Pipe (listed on 18 December 2009) owns 22% of China’s spiral submerged arc welded (SSAW) oil and gas pipe capacity and aims to raise this to 34% by the end of 2010. SSAW is used in major pipelines and we expect Shengli Pipe to benefit from plans by oil majors to increase the length of China’s oil and gas pipeline network by 65% over 2009-2013. Expanding its product offering to tap other oil and gas steel pipe markets Shengli Pipe plans to launch one electric resistance welded (ERW) pipe production line in 2011 and one longitudinal submerged arc welded (LSAW) pipe production line in 2012. We see this as a positive development, as it should enable Shengli Pipe to expand its product mix to capture a larger market share. We expect Shengli Pipe’s dividend to double between 2009 and 2011, a view supported by management’s confidence in its expansion plans. Key risks are delays in construction and competition We identify two key risks to our investment case. Firstly, demand for SSAW pipes relies on oil and gas pipeline construction projects. Any delays due to a weakening of the economy could slow demand. Secondly, Shengli Pipe plans to enter the ERW and LSAW pipes businesses, where it will face competition from established manufacturers. Valuation: we initiate coverage at Buy with a DCF-based target price of HK$2.20 Our DCF-based target price of HK$2.20 is based on a WACC of 10.5% and a terminal growth rate of 3%. It implies 13.8x 2010F and 10.1x 2011F PE. Our target price suggests 20% upside potential from the current price. We initiate coverage with a Buy rating on the stock. 21 June 2010 Analysts Danny Huang Hong Kong +852 3988 7206 danny.huang@rbs.com David Johnson Hong Kong +852 2700 5293 david.l.johnson@rbs.com Nishi Doshi Hong Kong +852 3961 3330 nishi.doshi@rbs.com 38/F Cheung Kong Center, 2 Queen's Road Central, Hong Kong http://research.rbsm.com Price performance (1M)(3M)(12M)Price (HK$) 1.571.77n/aAbsolute (%) 17.24.0n/aRel market (%) 15.29.2n/aRel sector (%) 16.916.7n/a 1.251.501.752.002.252.502.75Dec 09Feb 10Apr 101080.HKHSCEI Market capitalisation HK$4.58bn (US$588.61m) Average (12M) daily turnover HK$63.14m (US$8.16m) Sector: BBG AP Oil & Gas RIC: 1080.HK, 1080 HK Priced HK$1.84 at close 18 Jun 2010. Source: Bloomberg Buy Target price HK$2.20 Price HK$1.84 Short term (0-60 days) n/a Market view Underweight Initiation of coverage Shengli Pipe | The Basics | 21 June 2010 2 The basics Catalysts for share price performance Shengli Pipe stands to benefit from the build-out of China’s oil and gas pipeline networks. The company aims to expand its spiral submerged arc welded (SSAW) pipe production capacity to 1mt/year by the end of 2010 from 0.54mt/year during the end of 2009. It also plans to expand into LSAW pipes and ERW pipes businesses. Significant growth in business, especially in 2011, would be a catalyst to the share price. Earnings momentum We estimate that the planned doubling of Shengli Pipe’s capacity over 2009-2012 will drive a 27% revenue and 24% net profit CAGR over the period. Shengli Pipe reports interim results in August. Valuation and target price Our DCF-based target price of HK$2.20 implies 13.8x 2010F and 10.1x 2011F PE. Our target price suggests 20% upside potential from the current share price. Our DCF is based on a WACC of 10.5%. We use DCF as it can better capture the impact of changes in orders on cash flow. How we differ from consensus Our net profit forecasts for 2010 and 2011 are 27% and 26% below Bloomberg consensus. Our target price is 16% below consensus, and