1HFY23 results miss our and market expectations
　　Nine Dragons Paper (NDP) announced results for 1HFY23 (ended December 31, 2022): Revenue fell 9.5% YoY and rose 3.8% QoQ to Rmb31.2bn; and net profit turned negative YoY to -Rmb1.39bn (vs. +Rmb2.78bn in 1HFY22). The firm’s results missed our and market expectations, mainly due to sluggish demand and elevated costs. Our comments are as follows:
　　We believe it was difficult for NDP to raise prices due to weak demand, and the firm’s earnings bottomed. We note the sluggish demand in 3Q22 despite the peak season, and the firm had difficulty in raising prices. NDP’s expenses were high as it halted production to reduce inventory. We think the firm’s earnings have bottomed. Prices of waste paper fell in October-December, which we believe slightly mitigated the cost pressure. However, we think the core demand did not improve. We estimate that the firm’s 1HFY23 ASP dropped 12% YoY to Rmb3,628/t, and net profit per tonne turned negative to -Rmb162/t (vs. about Rmb330/t in 1HFY22).
　　Adjustment of loan currency reduced financial expenses. The firm’s 1HFY23 financial expenses increased 68% YoY to Rmb560mn, mainly due to increased loans for capacity expansion. The firm announced that as of February 22, its proportion of renminbi borrowing was 84% (vs. 62% at end-2022; renminbi borrowing interest rates at only around 3.5%). We believe the adjustment of loan currency substantially reduced the firm's financial expenses.
　　Tight cash flow due to capacity expansion. NDP’s net operating cash flow and free cash flow totaled Rmb2.72bn and Rmb8.05bn for 1HFY23. The firm guides its capex at about Rmb7.5bn for 2HFY23. We think its cash flow will likely remain under short-term pressure.
　　Trends to watch
　　Slower-than-expected recovery of fundamentals; price hikes to start when demand recovers.
　　Data from RISI shows that domestic waste paper prices have been falling rapidly since mid-2022. As of mid-February, the ASP declined over Rmb130/t from 2H22 to about Rmb1,960/t for 1Q23YTD. We believe NDP’s cost pressure has slightly eased. However, we think it is difficult to raise prices in the containerboard market at present, given the weak recovery in domestic demand and the intensifying competition from imported paper.
　　The firm recently announced that it halted production of 11 facilities for maintenance at its Dongguan base. It expects to reduce production by about 100,000t over February-March. We believe the firm’s halted production reflects the slow recovery of demand and the impact on the market due to tariff reduction and exemption for imported paper . Moreover, we think it shows that industry leaders focus on increasing (or at least turning around) earnings rather than market share gains over the near term. They are gradually shifting inventory pressure to the downstream, in our view.
　　We expect net profit per tonne to rise quarter by quarter in 2023, and fundamentals to recover during the peak season in 2H23. We see ample upside in the firm's share price, earnings and valuation, and large upside potential in FY24. We suggest keeping an eye on possible price hikes as demand recovers.
　　Short-term cash flow pressure from capacity expansion; balance sheet manageable.
　　According to corporate filings, NDP had about 21.3mnt of designed production capacity (including paper and pulp; pulp production capacity at 2.6mnt) as of end-2022, up 12% from end-1H22. The firm estimates its designed production capacity will increase 53% to 32.50mnt by end-2024.
　　In the next two years, NDP plans to continue developing virgin kraft linerboard and ivory board paper. We believe its expanded product portfolio could strengthen the firm’s bargaining power in packaging papers. We think the firm will likely continue to optimize its product mix. Furthermore, NDP seeks to produce pulp and wood fiber to strengthen advantages in costs. Corporate filings show that NDP had Rmb62.4bn of undrawn bank facilities as of end-2022. The firm’s cash on hand totaled about Rmb9.7bn as of end-2022.
　　Financials and valuation
　　We maintain our 2023 and 2024 earnings forecasts and valuations. The stock is trading at 0.6x and 0.5x FY23e and FY24e P/B. We maintain an OUTPERFORM rating and TP at HK$7.5, (implying 0.7x FY23e P/B and 0.6x FY24e P/B), with 12% upside.
　　Risks
　　Weaker-than-expected end-market demand; sharper-than-expected impact from imported paper; fiercer competition.