Preannounced 1HFY23 attributable net loss at Rmb1.25-1.45bn
　　Nine Dragons Paper (NDP) preannounced that its 1HFY23 (ended December 30, 2022) attributable net loss could reach Rmb1.25-1.45bn (vs. a positive Rmb2.78bn in 2021), missing our and the market’s expectations due to higher-than-expected pressure from sluggish demand and high domestic wastepaper and energy costs.
　　Trends to watch
　　Earnings bottomed amid stagflation. The industry came under pressure in 2H22 from weak macro demand, failed price hikes, and high pulp and waste paper prices. This resulted in large-scale passive destocking in 3Q22, when NDP cut production by over 500,000t. The firm's earnings fell to their lowest point in a decade as it faced price hike difficulties, high inventory, high costs, and high expenses due to weak demand and market expectations. In 4Q22, domestic wastepaper price declines alleviated some pressure on raw material costs. However, prices and inventories remain murky due to low peak season demand and restrictions on production and transportation caused by COVID-19.
　　We estimate that NDP lost Rmb150-200 per tonne of papermaking in 1HFY23 (vs. a loss of more than Rmb400/t for its peers). Many small- and medium-sized papermakers closed down due to large losses. In the past five years (FY2018-2022), the firm's net profit per tonne averaged over Rmb300/t. Its earnings are at a historical low.
　　Valuation recovers slightly but remains low; demand recovery to boost paper prices. Our survey shows that leading firms' inventory lasted over three weeks, on average, before the Chinese New Year (CNY) holiday. Starting from the CNY holiday, NDP began shutdown maintenance, resulting in low market turnover and destocking at paper mills. Furthermore, some imported paper in China will enjoy zero tariffs in 2023. We think imported paper will have a limited impact on domestic product sales volume, as purchasers need to consider imported paper's delivery cycle, exchange rate risk, and service responsiveness. However, if market demand recovers only mildly, we think cheap imported paper may limit the room for price hikes by domestic industry leaders in 1H23. As a result, the recovery of industry fundamentals may come later than the market expects.
　　Looking ahead to 1HFY24 (the peak season for the papermaking industry), we see ample upside in paper prices and a large upside in net profit per tonne amid recovering demand and downstream restocking. We recommend NDP as one of our top picks in the paper sector.
　　Expansion of the firm’s papermaking and fiber businesses accelerated; balance sheet controllable. NDP announced it had a production capacity of over 18mnt as of 1H22. The firm estimates that its production capacity will grow by over 30% from the current level to 25mnt by the end of 2024. In the next two years, the firm plans to push forward its virgin kraft liner board (with higher profit margins, to strengthen its bargaining power in packaging papers), cultural paper, and ivory board businesses (to enrich its product mix and produce self-made pulp to strengthen competitiveness).
　　NDP continues to expand its production capacity for raw materials such as pulp and wood fiber. According to the firm's announcement, as of 1H22, it had sufficient syndicated funds and a remaining line of credit of about Rmb67.3bn at banks. We think the firm can adjust the borrowing currency and optimize interest rates based on fluctuations in actual interest rates to control its financial expense ratio. NDP's cash on hand and bank deposits equaled about Rmb9.7bn as of June 30, 2022.
　　Financials and valuation
　　Given the higher-than-expected pressure from sluggish demand and high domestic wastepaper and energy costs, we cut our FY23 earnings forecast by 129% to -Rmb865mn. Due to improving expectations for demand recovery in FY24, we raise our FY24 earnings forecast by 24% to Rmb5.4bn. The stock is trading at 0.6x FY23 and 0.5x FY24 P/B. Due to the recovery of the H-share market and valuation rollover to FY24, we maintain an OUTPERFORM rating and TP at HK$7.5 (implying 0.8x FY23 and 0.7x FY24 P/B), with 9% upside.
　　Risks
　　Disappointing demand; higher-than-expected new capacity; sharp corrections in the Hong Kong stock market; debt ratio rising too fast.