China FlexPack @ 50 cts (Packaging / China) 4 comments
(P.S: Sorry for any disturbances the advertisements above may have caused you)
1.Rising oil-derived raw material prices
2.High-shrinkage film segment affected by tobacco industry restructuring
3.Heavy capital investments
In the wake of the 200-point and 50-point collapses in the Dow Jones and the Nasdaq respectively yesterday it does seem like an opportune time for me to spotlight some stocks and later claim the credit for them falling as I predicted, when in fact it would be just a case of a falling tide sinking all boats. There is no question that come Monday the SGX will be under selling pressure from the start. Frankly, I constantly have to resist the temptation to do just that, and have to remind myself that (1) the purpose of the blog is to warn investors against stocks that appear to be overvalued, preferably when people are still continually buying them up, and (2) we are talking about medium-term performance here.
So, the timing of this writeup on China Flexible Packaging is not deliberately in-line with the Wall Street collapse; rather, it is in-line with the weekend when I have some time to survey all the SGX stocks for suitable candidates for hot-stocks-not. The thing is that many of the China stocks that have been revalued significantly do have credible stories and attractive single-digit PE valuations, so I can't really find any issue with many of them even now. Stocks like Celestial, Fung Choi, Hongguo are examples. On the other hand, there are stocks like Pine Agritech and China Paper which I have previously warned against but have appreciated anyway, so there.....(my views on the above two, incidentally, remain the same as before).
Back to the main topic, and one may note that China FlexPack has rebounded from a low of 39 cents recently to its current 50 cents, together with the other China stocks. But the industry problems that beset it, as indicated in its FY05 financial statement, must surely make any attempted bottom-fishing very dangerous.
The collapse in gross margin from 46% in 4Q04 to 28% in 4Q05 is attributed to a combination of two factors: (1)high raw material prices; (2)fierce competition. The raw material is petroleum-derived products (polypropylene) and hence the rise in raw material prices is not surprising. The fierce competition is reportedly due to imports but probably is also the inevitable result of the rapid investment in packaging machinery by other domestic firms. It would be fair to say that neither problem is going away any time soon. My view is that >US$50/barrel oil prices are here to stay due to rising demand from an emerging Asia. As for competition, capital equipment once purchased will have to be operated and hence supply will not decline, only increase: the onus is on demand to outpace supply in order for margins to recover, and that does seem terribly difficult judging from CFP's latest results. Furthermore, with China opening up, competition from imports can only increase.
Forget about PE valuations. The idea is to focus on the 4Q05 results and annualise it, since for the consumer products industry that CFP serves I would hardly expect strong seasonality. The fundamentals of the BOPP film packaging industry has changed tremendously over FY05, with the company being forced to alter its film production allocation towards low-margin low-shrinkage film and away from higher-margin high-shrinkage film. That China is cutting down the number of tobacco firms, a main customer of CFP's high-shrinkage film, is a fact, and for conservativeness one has to assume that the current 30:70 low shrinkage/high shrinkage production distribution is here to stay. Such an annualised FY05 PE based on 4Q results of RMB27M yields a PE of 9.6 times, hardly attractive considering (1)adverse input costs, (2)competitive conditions, (3)uncertain demand (particularly tobacco firms) as highlighted above. For the record, tobacco firms form ~40% of the firm's revenue (according to its IPO prospectus) and this is in the lucrative high-shrinkage film segment, so their decline is going to hit (and has hit) CFP hard. Management has reduced the production level of its new 5-layer BOPP high barrier films to half the original planned capacity. The current uncertainty due to the directive to consolidate the tobacco industry is another illustration of the dangers of investing in a historically central government- directed economy.
In fact, looking at the cash flow statement for FY2004 and FY2005, one wonders how much free cash flow the business has actually managed to generate. Profits in each of these two years was ~RMB230M, yet operating cash flow was only barely half, at ~RMB130M, even less post-tax (RMB100M). That means half of the profits had to be routed back as working capital. In fact, the other half, the operating cashflow, was also re-invested into capital investments and fixed assets (land rights) with the end result that cash assets remained unchanged. The acid test of the prudence of such capital investments must be profitability (NOT revenue) and it has remained stagnant (though part of it is due to high oil prices). Put in such a context, one may say that CFP has had to keep re-investing in capital equipment to keep up profit, and that, in Warren Buffett's dictionary, is not a good investment.
Note that the big investments are still a-coming. The company is going to invest another RMB280M to construct a new facility on the land that it had acquired. So investors can forget about any big payout on its substantial cash base (mostly from its IPO proceeds). At the same time, one has to wonder about the sustainability of its dividend payout, given such intensive capital investment and adverse industry conditions.
The good point about this company, of course, is its substantial operational scale and revenue base, and it's not one Chinese company that I would expect to collapse anytime soon. However, it does remind me of another China company, United Food, in several ways. Both are plays on the China consumer market, yet their products are more commodity-like than brand-driven. Both have strong cash base which led to further illusions of strength and institutional and retail following. The price falls of both were forewarned by massive placements by directors: Wang Tingbao in United Food's case, Zhong Yuan and Zeng Hanming in CFP's case (insider selling is a BIG redlight for China companies). Both companies succumbed spectacularly to industry downturns which revealed their lack of pricing power. The example of United Food suggests that earnings momentum in either direction (downwards in United Food's case) tends to be prolonged, and that it is better to align your money with a favourable trend instead of trying to bottom-fish.