Jiutian @ 59 cts ( Chemicals / China ) 6 comments
Final Poll Results: 7:3
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1.Hopes for 2007 capacity expansion turbo-boosting profits may be unfounded given long time lag
2. Chemicals' ASP trend exhibits volatility
When a stock IPOs in a booming market it naturally gets an excellent valuation, both in the primary market and in the subsequent trading market, and this price level somehow anchors itself in the minds of investors/traders such that they associate this price level and valuation with the stock, sometimes undeservingly in my view. Stock pricing is sometimes, or even often, a matter of luck and timing.
Consider Jiutian. Its May 06 IPO price was 29 cents, and it jumped to >70 cents on its first day of trading. It then corrected sharply with the broad-based selloff in mid-May, but has since recovered some lost ground to around the 60-cent level recently. Yet, is its 16-17X PE (based on latest FY05 results) justified? I think not.
Jiutian operates in the specialty chemicals sector, which although less subject to commodity-like pricing pressure experienced by commodity chemicals producers like SP Chemicals (which explains the latter's single-digit PE pricing... <5X!!) nevertheless has to conform to average selling prices (ASPs) set by the prevailing market demand-supply conditions. The group operates in three chemicals segments: DMF, methanol and industrial gases, but based on segmental revenue and expansion plans it appears that DMF (which also includes methylamine, a secondary product) is the most promising segment and one that the company plans to concentrate its resources on. The production process for methanol, methylamine and DMF is sequential, where produced methanol is further processed to produce methylamine, which in turn is used to produce DMF; Jiutian can choose whether to sell the intermediate products directly to customers, or to use it as feedstock for downstream products. It is clear that it intends to do the latter ie. a vertically integrated operation, where a significant proportion of methanol produced is channelled into the production of methylamine and DMF. It thus makes sense that to analyse this company, DMF prices become the most important factor.
To get an idea of DMF's average selling price trend, we refer to its prospectus: the ASP (exclusive of VAT) in FY2004 (when its DMF started operations) and HY2005 were RMB 5,044/ton and RMB 4,837/ton respectively. The group also admitted to further ASP decline in 2H05 causing lower sales for that half, which it attributed to the result of trade tensions between the PRC and Europe and the US over textile exports. Instead of seeing its customer base as diversified (pharmaceutical, electronics, textiles), one might see the reverse side of the coin and conclude that the derived nature of demand for DMF is susceptible to fortune swings in any of these sectors. The "China consumer demand" card has been played too many times by IPO issuers that we should not use rose-tinted lenses to view the firms' prospects (see China Flexible Packaging for a prime example). One should also note that domestic DMF prices are often dictated by the three big producers China-Zhejiang Jiangshan Corp, Anhui Huaihua Corp and Hualu Hengsheng Group, all much larger producers than Jiutian, which leaves the company to be a price-follower.
In the short-term and the long-term, it is difficult to see strong profit growth potential for the stock. Short-term, two factors will drive growth: rising ASP and revenue growth. The former, as described above, might not be a straightforward upward rise, and the company can only be a passive beneficiary; there is the further cap on any strong price hikes due to competition from foreign imports. The second factor might be possible due to Jiutian's 50% capacity increase (from 20,000 to 30,000 tonnes in mid-05) but Jiutian's muted 2H05 performance arising from this capacity increase indicates that this is no sure thing (indeed, overall revenue from all segments actually dropped). In the medium to long-term, I guess investors are looking at the planned threefold increase (to 90,000 tonnes) in DMF and methylamine to justify the current high PE valuation. Without offering any quantitative figures, I throw a few buckets of cold water that could dampen bullish expectations: firstly, execution risk from now till 2H07 leading up to the construction of the new facility; secondly, it is inconceivable to me that Jiutian would still be the sole producer of DMF within 500km by then (a competitive advantage it is trumpeting to the world) given the pace of investment and the liberalisation of the chemicals industry to foreign MNCs both in imports and distribution (fully in end-2005); thirdly, the fact that it saves on energy costs by using coal to power its production process (as compared to others using more expensive natural gas, another competitive advantage, says Jiutian) is incompatible with the China government's new drive for sustainable development and environmental protection; fourthly, the raw material price agreement with former parent Anyang will be subject to review in 3 years' time in 2008 (yes, that's when the new plant is just completed), at which time I would expect a major readjustment if oil prices remain stubbornly high; and last but not least, the tax exemption that was the strongest factor in the 100% profit growth from FY04 to FY05 would partially expire in FY07, following which only 50% tax exemption would apply. The confluence of all these factors around the period when the new plant (on which so many hopes lie) is completed means that hopes for a corresponding threefold increase in profit then might be premature.
For a more sober look at the specialty chemicals industry, one can check out Megachem, a Southeast-Asia based specialty chemicals distributor whose gyrating fortunes since listing must serve notice that things can turn out poorer than expected. For a more sober look at how China's undoubted growing demand for chemicals (inline with economic development) can be divergent with the individual fortunes of chemicals companies' bottomlines, one only has to look at SP Chemicals, a much bigger player (but as noted above, in commodity chemicals).
(1) ChinaPU 2003-DMF Market Review