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Tuesday, March 27, 2007

Luzhou Biochem @ 65.5 cts ( Sweeteners / China ) 0 comments

Final Poll Results: 6:5

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Main issues

1.Raw material risk might escalate as corn prices remain high

2.Substitution demand abates as sugar prices fall

The main dynamics that drive my coverage of this stock are similar to that for China Sun last August. The key issue is still that of commodity prices.

Except that here we're looking at two materials. They are corn and sugar.

The main business of Luzhou is production of corn sweeteners, which comprises nearly 70% of FY06 revenue. A smaller proportion is taken up by corn starch and miscellaneous by-products, which take up the other 30%.

Corn is the common and the main raw material for these products, and accounts for a big proportion of the direct costs that comprise over 80% of FY06 revenue. Sugar, on the other hand, is important for another completely different reason: it was the high price of sugar in early 2006 that prompted a shift to corn sweeteners as a substitute, hence raising Luzhou Biochem's margins then.

A series of corn price charts from 2004-06 taken off CBOT (Chicago Board of Trade) is shown below for comparison:

Corn prices

Sugar prices

The drastic surge in corn prices that has sustained its momentum into 2007 has its origins in the use of corn for production of ethanol, further propelled recently by George Bush's plans to strongly support ethanol as an alternative fuel. The high corn prices has already claimed China Sun as a victim, as well as its peer on the Hong Kong Exchange, Global Bio-chem. Both are trading substantially lower.

As for sugar, it surged in early 2006 on the back of demand from ethanol production, particularly in Brazil. However, strong supply due to rising plantings and bumper crops has overwhelmed demand leading to a continued slide in prices through 2006. What is clear is that the substitution demand effect for corn sweeteners will be affected by this abundance of sugar, the incumbent choice.

It is not surprising that Luzhou Biochem's gross margin has declined year-on-year starting from 3Q06 onwards. There is a double squeeze: pricing pressure and possible demand reduction on the revenue side, and upward cost pressure on the raw material (corn) side. Although it enjoys a 9.5X trailing PE valuation, it was in a year where the sugar substitution effect was in full play. It is difficult to see it happening again in 2007.

Luzhou was fully aware of this and has been expanding production rapidly in an attempt to compensate for possible slowing margins by growing production volume. The success of this strategy is still uncertain; meanwhile the commodity price trends suggest that Luzhou could be in for a bad 1Q07, as corn prices sustain their heights while sugar prices dip below their 1Q06 price levels one year ago. The investors who bought the recent placement of 36M new shares at 73.5 cents might, indeed, eventually constitute an overhang instead of a support.

(1) CBOT Commodity Prices

I agree that Luzhou Biochem is a hot-stock-not: Agree/Disagree




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