Preannouncing 1HFY24 attributable net profit at Rmb200-400mn
　　Nine Dragons Paper (NDP) preannounced that its 1HFY24 net profit reached Rmb200-400mn in 1HFY24 (vs. a loss of Rmb1.39bn in 1HFY23), missing our and market expectations, mainly due to weak domestic demand and a sharper-than-expected impact from imported paper.
　　Trends to watch
　　Net profit per tonne averaged about Rmb30 in 1HFY24, staying at a historical low. In 1HFY24, domestic demand was lackluster despite the peak season. We note that short-term restocking drove up paper prices slightly, but this was not sustainable. Meanwhile, we see rising pressure from production capacity expansion (we estimate domestic production capacity increased by more than 4mnt in 2H23, including 1.1mnt from NDP and 1mnt from Sun Paper). Meanwhile, imports rose by 4.58mnt (up 1.52mnt YoY). We think supply and demand conditions are under pressure, and there is no foundation to support a hike in the prices of containerboard and corrugated medium.
　　Over the past three years, we believe the industry has been facing insufficient domestic demand, coupled with a ramp-up in capacity expansion. Starting from 2023, unexpectedly high volumes of imported paper have been suppressing the already weak price increase trend for containerboard and corrugated medium in China, in our view.
　　We estimate net profit per tonne at about Rmb20-40 in 1HFY24 based on sales volume of 10mnt, with losses likely in 3Q23. Prices of ivory board paper, coated duplex board, and printing & writing (P&W) paper recovered notably in 4Q23 (accounting for around 20% of total sales volume), and we think this may have contributed significantly to the firm's stronger-than- expected earnings in 4Q23.
　　Sharper-than-expected impact from imported paper, but impact from incremental supply easing marginally. In 2023, China eliminated tariffs on some imported paper. Data from the General Administration of Customs of China (GACC) shows that the full-year import volume of containerboard and corrugated medium reached 8.54mnt in 2023, an increase of 2.9mnt YoY. The previous high was 6.16mnt in 2021, as　overseas paper producers focused on the domestic market due to strong demand.
　　We think the elimination of import tariffs highlights the cost advantage of imported paper (previous tariff rate at 5-6%) amid weak domestic demand and incremental supply. Moreover, we note that paper imports from Southeast Asia have directly affected the southern China market, leading to price competition. NDP’s key base is located in Dongguan in southern China (representing about 30% of paper production capacity of the firm).
　　In 2024, we believe the volume of imported paper is likely to remain at a historical high, but the impact of incremental supply may ease notably as the market may gradually mitigate such impact. Meanwhile, we think rising marine freight rates may further increase the cost of imported paper, easing the impact on domestic paper prices.
　　Product mix improving; energy cost advantage recovering. According to corporate filings, the firm plans to add 6.26mnt of papermaking capacity and raw materials in FY24-26 (up 26% from FY23). It guides for FY24-25 capex at Rmb13bn and Rmb5bn, implying that the firm is still expanding its production capacity.
　　However, unlike in previous capacity expansion cycles, NDP is focusing on replenishing raw materials and expanding product categories in the current cycle. We expect the firm to build a multi-category portfolio by end- FY25 (traditional capacity for containerboard and corrugated medium to represent about 75% of the firm's papermaking capacity by then) and own 6.83mnt of pulp and wood fiber. We expect the firm’s product mix to keep improving.
　　We believe leading companies with captive power plants did not enjoy advantages in energy costs, as coal prices stayed elevated in 2021-2023 (smaller plants relying on externally sourced steam face significant cost variations). We note that the industry cost curve was at one point flattened. However, we think leading companies may regain their energy cost advantages once coal prices fall below Rmb1,000/t (for example, cost advantages may increase by Rmb30-40/t for every Rmb100 decline in coal prices).
　　Financials and valuation
　　Given weaker-than-expected demand recovery, we cut our FY24 and FY25 earnings forecasts 60% and 25% to Rmb1.0bn and Rmb2.6bn. The stock is trading at 0.3x FY24e and 0.2x FY25e P/B. Considering earnings forecasts revision and valuation is recovering as net profit per tonne has turned positive, we maintain OUTPERFORM and cut our target price 22% to HK$4.9, implying 0.5x FY24e and 0.8x FY25e P/B with 69% upside.
　　Risks
　　Weaker-than-expected demand; higher-than-expected incremental supply in the sector; sharper-than-expected impact from imported paper; higher- than-expected gearing ratio.