Saturday, April 26, 2008

Spinning the Wheel

"Never Say Never" - In investing, it is always important to keep an open mind. It helps one to assimilate new information and explore new areas. Many good investors are exceedingly humble and are always keen to learn more. In fact, given how rough markets are these days, an investor should drop his ego at the door before he steps into the trading room.

We are known in general for our aversion towards Singapore listed Chinese plays, popularly known as S-chips. Several corporate governance blow-ups in the last few years didn't help. Nevertheless, we are sure there is wheat amongst the chaff but because of distance and lack of track record, it is very difficult to do sufficient due diligence for us to get comfortable. Hence, we have steered clear and given them a wide berth.

Given that there are more than 100 S-chips, ignoring the entire sector essentially means limiting the fields where one can mine for value. Of course, one can argue that it is better to stick to the tried and tested and narrow one's circle of competence. But given the general market turbulence, the price of many S-chips have been hammered down to ridiciously low levels.

One of the recently battered S-chips is Li Heng which had the misfortune of being listed in the midst of the general market sell-off. It manufactures high end nylon yarn products in the PRC for the domestic market. The products are highly oriented yarn/partially oriented yarn, nylon fully drawn yarn and nylon drawn textured yarn. They sell them under its brand names Liyuan and Liheng. Purchases of the yarn use it to manufacture high end casual wear, sportswear, swimwear and even umbrellas and parachutes.

The industry is a competitive one. We are not here to spin a yarn to suggest that Li Heng possesses an imprenable edge. One can easily ratter off a long list of competitors - Yantai Chemical Fiber Nylon, Qingdao Zhongda Chemical Fiber, Guangdong Xinhui Meida Nylon, and China Sky Chemical Fiber (SGX listed). Other SGX listed companies like Sino tech fibre, CG Industrial manufacture chemical fibre too but they generally compete at the lower end of the quality spectrum.

Li Heng was listed in March at S$0.80. It quickly sunk under the IPO price amidst the sub prime hubris. It is baffling to think that subscribers of the IPO would dump the stock so quickly as the price slid southwards. After all, a fundamentally sound stock at S$0.60 would be more attractive than one at S$0.80, ceteris paribus; the good economists would append. This is especially so after it reported a good set of FY07 results in April.

Granted that its FY07 numbers benefited from a tax holiday, we still see earnings rocketing up going forward. Whilst the world is grappling with recessionary fears, the Chinese jugglenaut should continue rolling, hiccups notwithstanding. We expect Chinese consumerism to remain strong especially for basic necessities such as clothing. China is also a net importer of nylon as the local players do not produce enough to meet demand. Anecdotal evidence suggest that the total market demand is 1.4 mtons, of which 400,000 tonnes is imported. Hence, demand for Li Heng's products should remain robust going forward.

To meet the growing demand, management will be aggressively ramping up the production capacity, from 92,000 mtons in FY07 to 167,000 mtons in FY08. The internal target is to achieve 257,000 mtons by 3Q09. Note that its capacity in FY07 was nearly completely utilized.

To insulate itself and generate cost savings, it intends to use part of the IPO proceeds to build a polyamide plant. Polyamide is the raw material used to produce nylon. Vertically integration will enable Li Heng to shave off some cost and reduce its dependence on suppliers. Although the plant will only cover about 20% of its polyamide needs, this move will strengthen its bargaining power over suppliers of its raw materials. RMB appreciation does also allow it to offset increase in raw material prices. Despite these measures, operating expenses are expected to rise. The expansion of its sales network and wage inflation in the country will bite into its margins.

On its customers end, Li Heng possesses reasonably good bargaining power. It is not overly dependent on a single customer as it serves over 170 customers with none contributing to more than 5% of total sales. Given that Li Heng supplies as much as 20-50% of its customer's nylon, the firm does have some muscle to pass on costs.

There are no street coverage on the stock yet. But its market capitalization places it alongside China Sky as one of the largest S-Chips, warranting inclusion into major indices which track the performance of this sub-sector. Hence, it should pop up on the radars of analysts fairly soon. Until then, one needs to do his own maths. We did ours and think that Li Heng can, conservatively, achieve revenue of RMB 3800 million in FY08. This is on the back of 80% utilization of its enlarged capacity. However, given expense increases and the additional 12.5% taxation rate, net margins should fall from 32.8% (achieved in FY07). Management did guide that they think margins can remain above 30%. Our internal estimates peg their FY08 EPS to be between RMB 65 - 70 cents (about 18% yoy growth), or SGD 13 - 14 cents. At the current price of 80 cents, this translates to an FY08 PER of 5.7x - 6.2x. When analyst reports are issued, we expect the street to be more aggressive, factoring more optimism in their projections. They may be looking at a FY08 PER of 5x or less on the back of EPS of at least RMB 80 cents. Assigning a fair PER of 10x suggests that Li Heng's fair value is S$1.60, representing 100% upside from current prices.

We chose to look at things differently. For us, it is a decision on whether paying for Li Heng at an FY08 PER of 6.2x is good enough to rest easy at night. We rather leave room for more pleasant upside surprises!



Anonymous Anonymous said...

How is it possible that Liheng can do 30% margins while most of the competitors are either losing money or making single digit margins?
Yarn manufacturing is not a high tech biz with no barriers to entry.

If you can answer that question which I haven't been able to get a good answer to, then go ahead and invest in Liheng or for that matter Fibrechem, Sinotech Fibre, etc because they all trade at 5-6x p/e.
Personally, I think the margins are bogus.

8:41 AM  

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