China Sky @ 1.02 (Textiles / China) 0 comments

Final Poll Results: 6:2

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Main issues

1.Textile industry might face over-supply

2.Sole supplier risk

3.High P/NTA

China Sky was listed at 55 cents in early October 2005 and in a dramatic surge starting in 2006, propelled by a re-rating of China stocks, has nearly doubled to its current $1.02. Sharp-eyed market watchers would note the two main factors recently driving its price progress: a focus on the China textile sector (also benefiting stocks like CG Tech and Fibrechem) and steady buying by Hong Leong Group's investment vehicle.

Hong Leong's investment banking arm being the IPO underwriter and its mother group buying up the post-IPO shares on the market is an interesting situation, and suggests two possibilities, one good one not so good (figure out for yourself). However, note that most of the buying was at around 50-60 cents in December 2005. What's the possibility that Asia Fountain (Hong Leong's investment vehicle) will pull off an FMR-Global Voice stunt and start selling off for a swift two-bagger within 2 months? Prominent investors don't necessarily guarantee anything: just look at Junma (2G) or New Lakeside (NTUC).

Anybody believing that China Sky is still cheap given its strong growth is being delusional. An IPO is always undertaken in a good year (for example, in this case it is undertaken in the year just before state tax benefits start to expire). Management have indicated themselves that FY2005 will not experience similar growth to previous years.

Make no mistake, China Sky is a company of reasonable operational scale, profitable and exhibiting prudent management. But for DBS, in a recent analyst report, to claim that it will become the biggest nylon fibre producer in China when it expands capacity from 39000 tons/annum in 2005 to 72000 tons/annum in 2006 requires an assumption that other players in the same industry won't similarly invest in new capacity. At 7.8X trailing PE trading at 55 cents China Sky was a bargain; at >14X PE trading at $1.02 the stock is rather risky.

The DBS report, though recommending a Buy and a high 1-year target price of $1.16 for the stock, actually contains information which if interpreted another way suggests an alternative action -- hold, at best. Let's consider the industry position for China's textile industry: according to the China Chemical Fibre Association (CCFA), demand for chemical fibres is estimated at 16m tpa in 2005 and is expected to rise by 10% in 2006, while domestic production is expected to increase by 15% yoy given the addition of new capacities in China --- I don't know how DBSV identifies that as a favourable trend but I would see it as another case of supply outweighing demand and driving down margins, much like what has happened for steel and many manufacturing industries.

That is the overall industry position. For those argue that China Sky has got a high-growth niche in nylon which caters to more affluent consumers (that's a good story --the China consumption story cannot be disputed), think about the industry structure and the ease of entry ie. the supply side. The nylon fiber industry is comparatively less fragmented than the polyester fibre market, consisting of mainly state-owned enterprises --- if you tell me that's a good thing for China Sky I'll be damned. That just suggests strong financial capability to invest in new nylon-producing capacity by these SOEs. Additionally, barriers to entry into the industry can't be high --- China Sky only started in late 2002! It appears that what is needed is only some production lines, experienced management, and initial access to capital (undoubtedly supplied by the pre-IPO investors, which, incidentally, includes people like Tommie Goh, Chew Hua Seng and Tan Kim Seng). The initial recognition of the nylon niche was critical to early-stage growth which was phenomenal, but things may now get tighter.... nobody can hold on to a 30% margin when moat to entry seems to be rather shallow. Sky China's current competitive strength, I would see, is the huge cash base post-IPO, giving it the financial capability to buy new production capacity.

China Sky is considered quite upstream in the production chain (chip suppliers-->fiber manufacturers-->textile manufacturers--->garment manufacturers; CS is the fiber manufacturer) and hence raw material costs would be rather important. Indeed, according to the IPO prospectus, raw material constitutes >90% of COGS (direct input costs); the raw material is polyamide chips which are derived oil products. The price of oil is hence a key risk. In its 3Q (first post-IPO) result China Sky revealed that it had managed to pass on higher raw material costs to customers (indeed, gross margin actually improved) yet it will be difficult to maintain such a situation in the face of a cost-push headwind (Fibrechem's margin has been decreasing from mid-30% to mid-20%). The raw material risk is exacerbated by the fact that China Sky sources nearly 90% of its chips from 3 main suppliers in Xiamen, and note this: these 3 suppliers in turn all import their supply of manufactured chips from a Taiwan company. That, of course, is as good as saying China Sky has only one main supplier of raw material. A Taiwan-China spat is going to be a major problem if it leads to trade disruption between the two countries. What are the company's supply risk management contingencies? That must be one big question to ask of them.

Between Fibrechem and China Sky, which is better? In terms of industry prospects, the latter has been touted as the better choice (ie. nylon>polyester) but I would argue that in terms of investment valuation the latter's price surge has made it inferior. It is now trading at 4X NTA (while Fibrechem is at 2X) and PE valuation implies 15% long-term growth: looking at the figures above for textile industry prospects and China's boom-bust investment cycles (even in the midst of a booming economy) this is just not on.

References:
(1) DBS Vickers Feb 1 analyst report on China Sky