Action
We upgrade Nine Dragons Paper (NDP) to OUTPERFORM, and raise our target price 25% to HK$7.50.
What’s changed?
Shortage of raw materials and elevated production costs accelerate exit of small paper producers. Since China issued a regulatory ban on waste imports in 2017, small paper producers have found it hard to obtain the high-quality fibers (mainly imported old corrugated containers [OCC]) used to produce high-end container board. This has weighed on their operations and accelerated their exits from the market. Small companies continued to lose market share due to shortages of domestic waste paper and elevated production costs. In contrast, industry leaders have seen more opportunities to gain market share. Despite the sector downturn, we note industry leaders (mainly NDP and Shanying International) are still expanding production capacity and constructing new bases. We are confident that industry leaders will see earnings growth in the new sector cycle if demand recovers in 2023.
No need to be overly pessimistic; watch new opportunities amid valuation bottom. We note sluggish demand, difficulty in raising prices, and high inventories in 1-2Q22. As a result, the sector saw high costs, low prices, and low shipments in 3Q22. At end-July, NDP was the first paper producer to halt production. We estimate that the entire industry reduced production by over 1mnt, and NDP cut its production by more than 500,000t. After a large-scale suspension of production in August-September, the industry inventory level declined steadily over October-November, but remained relatively high. Moreover, paper prices are still falling despite the approach of peak season (Shanying International announced its October ASPs were down 5% and 12% compared with 2Q22 and 1Q22). We believe almost the entire industry booked losses in 3Q22. We believe the sector has bottomed, and we think there is no need to be overly pessimistic about the linerboard and corrugated medium segment as peak season is around the corner and demand for replenishment downstream is likely. Furthermore, prices of OCC are falling dramatically, which we believe may mitigate cost pressure. NDP is trading at only 0.4x FY23e P/B, and we think its valuation is at a low level with limited downside. We believe the firm’s valuation is attractive.
Developing fiber business and expanding to multiple categories; focusing on long-term growth and strengthening leading position. We believe raw materials are key to success in the paper industry. Therefore, improving the self-sufficiency rate of fibers and expanding into multiple categories are strategic choices for top firms to mitigate risks and stabilize profitability amid increasing uncertainty over demand. NDP announced it had production capacity of over 18mnt as of 1H22. The firm estimates its production capacity will exceed 25mnt by end-2024 (up more than 30% from the current level).
In the next 2 years, the firm plans to continue to develop virgin kraft linerboard (it has higher profit margins, strengthening the firm’s bargaining power in packaging papers), printing & writing paper, and ivory board paper. NDP aims to enrich its product mix and produce self-made pulp to strengthen competitiveness. Moreover, the firm continues to expand its production capacity for raw materials such as pulp and wood fiber. Corporate filings show NDP had Rmb67.3bn of undrawn bank facilities as of 1H22. We believe the firm can adjust the currency of borrowing based on actual interest rate fluctuations and optimize borrowing costs to control its financial expense ratio. The firm’s total cash and bank balance was approximately Rmb9.7bn as of 1H22.
How do we differ from the market? We do not believe investors should be overly pessimistic about leaders in the linerboard segment, as we think the valuation of the sector is at a low level with limited room for a decline. Meanwhile, NDP is steadily expanding its production capacity and optimizing the product mix, as well as producing high-quality fibers to improve the self-sufficiency rate of raw materials. Therefore, we are upbeat on industry leader NDP’s growth potential when demand recovers.
Potential catalysts: Demand recovery in the end market, and paper price hikes; NDP’s production capacity for pulp secured.
Financials and valuation
We maintain our earnings forecasts. The stock is trading at 0.5x 2022e and 0.4x 2023e P/B. We upgrade our rating to OUTPERFORM, and lift our target price 25% to HK$7.50 (implying 0.7x and 0.7x for both 2022e and 2023e P/B with 35% upside), as we expect risks weighing on sector valuation to ease.
Risks
Downstream demand remains weak; disappointing capacity expansion; sharp rise in debt ratio; intensifying competition.