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Sunday, September 25, 2005

China Paper @ 26 cts ( Paper / China ) 19 comments



(P.S: Sorry for any disturbances the advertisements above may have caused you)

Main issues

1.Cyclical paper industry means PE should be taken in context

2.Low valuations similarly for a whole cross-section of commodities producers in other sectors

3.Questionable corporate governance suggested by auditor resignation

4.Strong capex spending does not seem to be accompanied by strong revenue growth


China Paper is now trading at 4.5 times trailing PE and has dividend yield of 7% based on its FY04 dividend of S$0.018. So what's there to advise against buying it?

First it should be noted that the paper industry is seen to be one of the classic cyclical industries, being one of the key basic materials together with steel, oil, shipping. Since these commodities generally do not follow product differentiation strategies it means they prosper greatly as a group when times are good and similarly tend to do poorly when the economy hits the skids. Generally, as advised by Peter Lynch, investors should not decide to invest in these sectors due to low PE valuations, for often the low PEs signal a peaking in the market for the commodities and a likely downhill ride from here.

And China's growth has been slowing down. This is now widely acknowledged in the papers for those who care to read them. It is not surprising given the government's commitment to moderating growth; the "soft landing" measures taken by them in April 2004 in cutting down investment in real estate and automobiles have had lasting effects. And don't forget the additional factors of the renminbi revaluation and high oil prices, both bad news for commodities manufacturers. Indeed, look at a few comparables for China Paper. China Flexible Packaging, a manufacturer of BOPP packaging, has experienced a downturn in margins and consequently share price recently; it is now at 6 times trailing PE. CHT, an adhesives producer, is now trading at 7 times PE. The anomaly of low PE is not just confined to China Paper, but for a large cross-section of China commodity producers and manufacturers, suggesting a marketwide view that growth prospects are unexciting.

Yet China Paper's 1H05 profits actually went up ~10% and margins even went up. That was surprising to any observer. Perhaps they had some negotiating power with customers, or were they truly an efficient paper producer? I was actually contemplating buying some but now with the resignation of Ernst & Young as their auditors that thought has been banished forever from my mind. China companies are known to have dodgy accounting conventions; while it is unfair to apply the same broad brush to all China companies, the resignation of a China company's external auditors will have to be seen as a corroboration of such a view for this particular company. If the accounting is dodgy, how can one trust the PE valuation and all that is associated with the statements? Note, also, that their financial controller/CFO (can't remember which position) also resigned early this year. You won't be able to find this piece of information on the SGX site now because good old SGX just keeps 3 months' worth of "minor" information.

Looking through the 1H05 financial statement, I also have some doubts. I have to admit that I only picked these up on my second reading. Firstly, looking at the balance sheet, there was only ~RMB50M fixed assets in Dec 2004 compared to >RMB200M fixed assets by Jun 2005. So how is it that revenue has only increased by ~6% over the last 6 months? Secondly, I am uncomfortable with the fact that they chose to present their cash flow statement over the last three months. Since they announce results every half-year, the cash flow should be for a six-month period, shouldn't it? The cash flow for the last three months (Apr-Jun 05), of course, looked generally good, with cash outflow of RMB40M due mainly to investment in new lines. If we, however, refer to the balance sheet and observe the RMB170M decline in cash assets over the past half-year, it follows that there was a RMB130M net cash outflow in Jan-Mar 05. By the way, going back to the first point, since the cash outflow suggests heavy capital investment in 1Q05 (and less in 2Q) there should be no excuse for the company not being able to raise topline growth higher than 6%, even if it ramps up production gradually.

Let's watch the action on Monday (tomorrow) and how the market will view China Paper following its latest announcement (resignation of auditors). If anything one should always expect to be surprised by the market. Who knows, it might rally because the info is "already out". But I still wouldn't buy it because I wouldn't be able to sleep well at night.

 

 

19 Comments:

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