Trip takeaways: A bubble is brewing but it may not burst yet

Deutsche Bank Markets Research Asia China Resources Industry China Containerboard Date 12 July 2017 Industry Update Trip takeaways: A bubble is brewing but it may not burst yet Takeaways from Dongguan and Shenzhen paper trip on 5-6 July ________________________________________________________________________________________________________________ Deutsche Bank AG/Hong Kong Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 083/04/2017. Johnson Wan Research Analyst (+852 ) 2203 6163 johnson.wan@db.com Companies Featured Lee & Man Paper (2314.HK),HKD7.49 Hold Nine Dragons Paper (2689.HK),HKD10.50 Sell Source: Deutsche Bank Related recent research Date 1H preview: A strong beat at peak cycle margins Johnson Wan 11 Jul 2017 Source: Deutsche Bank Valuation and risks: We value NDP and LMP using FY18E PB vs. ROE. We value NDP using 0.9x FY18E PB on 11% ROE to derive its target price of HKD7.00/sh. Our TP implies 8.5x FY18 PE versus NDP’s mid-cycle average of 10.5x. We value LMP using 1.6x FY18E PB based on 18% ROE deriving our target price of HKD 8.06/sh. Our TP also implies 9.5x FY18 PE versus LMP’s mid-cycle average of 10.2x. We believe a lower multiple for the 2 companies is warranted given their peak cycle earnings in FY18, and higher earnings volatility ahead with new supply hitting the market in 2H17-2019. Versus its peer NDP, we believe LMP deserves a higher PB and PE multiple given its higher quality earnings growth & less cyclical earnings nature. LMP derives more than 51% of its earnings from South China where supply-demand and market concentration is better, and its product mix heavily skewed towards linerboard is also more favorable. Downside risks: weaker-than-expected demand, acceleration of new supply additions and unexpected OCC price hikes. Upside risks are the reverse. We met with the environmental bureau and paper mill and boxboard/box makers. We believe the recent paper price hikes have been mostly speculative in nature, starting with 1) a reduced supply due to production halts by leading paper mills, 2) abnormal restocking by downstream users anticipating a peak 4Q, and 3) higher OCC pricing due to reduced import quotas and aggressive Chinese bidding. Across the vertical chain, paper inventories are high at 4 months (normally 1-1.5 months) with most box makers over-stocked. Due to weak demand, small mills have begun cutting prices by RMB200-300/t while large mills have begun cutting purchase prices for domestic OCC by RMB150/t. gSales strategy changes since 4Q16 to hoard inventory and keep pricing high Since 4Q16, leading paper mills have altered their sales strategy by holding back production (NDP selling c.5.7-5.8mt for CY1H17 vs. a target of 6.2-6.5mt) and cancelling fixed price contracts with downstream. As a result, smaller mills have gained market share and are operating at higher utilization rates. An artificially tight supply environment has led to higher prices and speculative buying by box makers, with some renting extra storage space to hoard paper. Since purchases of paper are placed on credit, a sudden drop in the paper price could hurt the cash flow of box makers and lead to a price free fall. For now, paper mills and distributors have low inventories, so the price bubble may continue in 2H. After the recent round of hikes in June, CCTV reported on excessive paper prices on three separate occasions during 2-6 July. In 4Q16, NDRC had raided the premises of large mills to investigate price collusion. Boxboard/box makers barely surviving but caught in dilemma over paper prices Boxboard and box makers can no longer fully pass through the 14% hike in paper prices since Jun-17, considering that their net margins were only 2-3%. However, box makers don’t mind the higher paper pricing as it gives them an excuse to raise box pricing to their customers; they are also stocking up on paper inventories (1-3 months), having learnt their lesson from 4Q16. Box makers with higher exposure to the electronics segment were able to pass through paper price hikes due to the higher price points of end-products, unlike those in the lower-margin FMCG/toy/textile sectors, which have resisted price hikes. In order to survive, boxboard makers are in the process of upgrading their machines to newer, more efficient ones to reduce overheads, or choosing to simply turn aw