China Paper & Packaging:We see fundamental changes

We expect net profit per ton (NP/t) to improve for the China Paper andPackaging sector in the long run with consumption-driven demand and supplyside improvement in raw material and processing capacity. Our top pick isNine Dragons based on the recovery story and driven by its high financingleverage and low historical earnings base.

    We transfer Chinese Paper and Packaging sector coverage to Laura Shi witha positive view and raise our 12-month target prices for:T Nine Dragons price target rises to HK$7.00 ps (from HK$5.00), andT Lee & Man to HK$5.50 ps (from HK$5.00).

    Supply / Demand Improvement§ Supply side catalysts are: 1) notable obsolete capacity closure; and 2) the‘Green Fence’ project tightening Recycled Paper (RCP) supply. Thesupply side improvement would result in a steeper cost curve in the packagingsector, and top names would be able to further expand their cost advantagegiven better raw material sourcing and advanced capacity techniques.

    Meanwhile, we expect a positive outlook for overall packaging demand in thenext 12 months. We expect Chinese retail sales to enjoy a normalisedseasonality effect from 2H13 onward, and overall consumption growth tooutperform GDP in the medium-to-long run.

    Target RMB50 NP/t increase in the next 12 months§ Though we see short term downside risk for earnings in Jun-Jul, thesupply/demand analysis presents a better sector outlook and indicates ahigher growth rate for linerboard prices than OCC prices given tight rawmaterial supply and therefore higher pricing power for big packaging plays.

    We therefore expect a ~RMB50 YoY increase of NP/t in the next 12 months,which would represent 31% net margin improvement for Nine Dragons and13% for Lee & Man. We also raise our assumptions of sustainable long-termmargin per ton for the two names, with Nine Dragons’ rising from RMB200 toRMB215-220 and Lee & Man’s increasing from HK$450 to HK$500.

    Nine Dragons our Top Pick§ We prefer Nine Dragons in the China packaging sector, given we expect it tobenefit from the high leverage in the upcycle as well as upside risk on itsfinancing efficiency. We maintain an OP rating and raise our 12-month TP toHK$7.00 from HK$5.00, based on 1.1x FY14E P/B which is lower than itshistorical average of 1.5x. The target price represents 12x FY14 PE (11x midcyclePE), which is around the historical mid-cycle valuation of 7x-15x butlower than the 16x-23x before the GFC.

    We continue to like Lee & Man as a defensive top paper producer in Chinawith high operating and financing efficiency. The company has a good trackrecord of conservative CAPEX and low OCC costs. We maintain our OPrating and raise our 12-month TP to HK$5.50 from HK$5.00, based on 1.6xFY13E P/B. We apply a higher range of the historical average P/B multiple(1.0x – 2.0x) as we expect its ROE to recover to the level seen in 2009-10.

    Executive Summary§ We remain positive on the packaging stocks givenT Earnings bottomed out during 2H12 and have enjoyed a rebound since the end of 2012T Higher raw material quality requirements and shutdown of obsolete capacity would increasemarket concentration and provide higher pricing power for the top producersT In the long run, Chinese packaging demand is likely to enjoy favourable consumptiondrivengrowth, as retail sales are likely to outperform GDP growth across China.

    SUPPLY – The key driver where we see a positive move§ The obsolete capacity closures in the sector reached their highest levels ever in 2012 (with annualclosure figures doubling over 3 years), and we expect the shutdowns to result in improvedsupply/demand in the coming years. As big names continue to introduce new capacity to capturethe opportunities arising, we think it is unrealistic to expect the over-capacity issue to be resolvedin the coming 2-3 years, and see the sector continuing with a cost-push model (given utilisationlargely remains at 80-90%). Instead, we expect a higher market concentration by the end of 2015(with Nine Dragons & Lee & Man’s products accounting for ~50% of the total market share).

    Meanwhile, the “Green Fence” project introduced by Chinese Customs earlier this year applieshigher quality requirements to Recycled Paper (RCP) imports and will raise average raw materialcosts for medium-to-small plays. Therefore we expect a steeper cost curve in the packagingsector, and that the expanded cost advantage for the dominant producers would provide furtherearnings upside on their margin performance.

    DEMAND – To outperform GDP growth§ After the consumption-driven muted demand in 3Q12, Paper & Packaging producers in Chinaenjoyed ~RMB80-100 NP/t rebound in the past 9 months though overall market sentiment for retailsales has not been particularly robust. We have a positive outlook on the packaging sector in thenext 12 months given that domestic retail sales would likely see a normalised seasonality effectfrom 2H13 onward, and overall consumption growth would likely outperform GDP in the mediumto-long run.

    PRICES§ Both linerboard and OCC prices softened in 1H13, which nevertheless delivered a good returnduring the period (we estimate RMB149 NP/t for Nine Dragons and HK$443 for Lee & Manbetween Jan-Jun 2013).

    Though we see short term downside risk for earnings in Jun-Jul, the supply/demand analysispresents a better sector outlook and indicates a higher growth rate for linerboard prices than OCCprices given:T The “Green Fence” project would tight overall RCP import volume and push up average rawmaterial costs of packaging operations – especially for medium-to-small names.

    Tighter than previous RCP supply in China would not only allow producers to pass on the costincrease to downstream clients, but also give producers an opportunity to ask for extrapremium.

    We therefore expect a ~RMB50 YoY increase in NP/t in the next 12 months, which wouldrepresent 31% net margin improvement for Nine Dragons and 13% for Lee & Man. We also raiseour assumption of sustainable long-term margin per ton for the two names, with Nine Dragons’rising from RMB200 to RMB215-220 and Lee & Man’s increasing from HK$450 to HK$500.

    Key risks to our investment thesis would come from:T Margin pressure will continue to exist in the short term if overall downstream demand in thepeak season does not enjoy a pick up during 3Q-4Q13.

    Government easing quality checks on RCP imports (The Green Fence project) and resultingin increased raw material supply from overseas.