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China/Hong Kong | China Chemicals

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China Chemicals 8 December 2013

New trends give rise to new opportunities

China’s chemicals industry has been enjoying a moderate

profit recovery since 4Q 2012, following a two-year

downturn. We have articulated three emerging trends in

the chemicals sector and picked out five stocks that we

believe will benefit from these trends. Our top picks are

China Sanjiang (2198 HK, Outperform), L&M Chemical

(746 HK, Outperform) and Tiande Chemical (609 HK,

Outperform). These are relatively under-covered stocks

with high ROE of 15-32% and strong 2013-2015F EPS

CAGR of 23-35% on a low single-digit P/E for 2014.

Analyst Steven Lu (852) 2532 2560 [email protected]

mailto:[email protected]

China Chemicals Sector 8 December 2013

2

Table of Contents

New trends give rise to new opportunities .................................................................................... 3

Investment summary .................................................................................................................... 4

Investment snapshot .................................................................................................................... 9

Valuation and risks ..................................................................................................................... 11

Picking growth driven by new trends .......................................................................................... 16

Shifting from basics to higher value-added specialty chemicals ................................................ 19

Shifting from oil-based chemicals to coal-based chemicals ....................................................... 21

Environmental protection ........................................................................................................... 24

China Sanjiang (2198 HK) ......................................................................................................... 27

Lee & Man Chemical (746 HK) .................................................................................................. 40

Tiande Chemical (609 HK) ......................................................................................................... 52

SINOPEC Engineering (2386 HK) ............................................................................................. 63

China Lesso (2128 HK) .............................................................................................................. 78


3

China Chemicals Sector

New trends give rise to new opportunities We initiate coverage on China’s chemicals sector with

5 stock picks, which will benefit from 3 developing trends identified in this report. These stocks in our views are relatively less covered by the market, and exhibit above average ROE of over 15%. Some stocks, like L&M Chemical will soon enter an earnings recovery stage.

Moving up the chemicals’ value chain. In China, low-end basic chemical products suffer from oversupply while high-end specialty chemicals enjoy high margins and excess demand. Smart chemical companies have repositioned their product mix towards the specialty chemicals. China Sanjiang, L&M Chemical and Tiande Chemical are three companies successfully pursuing such a strategy. We forecast them to achieve high EPS CAGR for 2013-2015F of 23-35%, yet they have been overlooked by investors with little analyst coverage. At the moment they are trading at attractive 5.5-8.2x P/E for 2014F.

More investment in coal-based chemicals manufacturing projects. Insufficient supply of domestic oils forces China to find alternative feedstocks for chemicals production. Thanks to a new generation of coal-to-chemical technology and the abundance of low-cost coal in the northwestern region, we forecast China will rely on this technology and add almost 20m tonnes of coal-based light olefin capacity between 2013 and 2020F. Sinopec SEG, a major pioneer in using this technology in China, will clearly stand out as a beneficiary in the medium term. Earnings upgrade is foreseeable as China pushes ahead more spending in this development.

Higher demand for products related to environmental protection. China is speeding up construction of its urban water supply and sewage networks while beefing up its rural water conservancy and irrigation infrastructure to control water pollution. Thriving on strong demand for plastic pipes in the north, we forecast China Lesso’s sales volume growth to exceed consensus in 2013, resulting in a possible earnings upgrade.

China Chemicals – valuation summary

Stock CCBIS Price Target P/E (x)

EPS CAGR (%)

P/B (x)

ROE (%)

Company code rating# (HK$)* (HK$) 2014F 2013-2015F 2013F 2013F

Sanjiang 2198 HK O 4.23 5.35 5.5 33.1 1.5 32.0 L&M^ 746 HK O 4.21 5.48 8.2 35.0 1.6 15.1 Tiande 609 HK O 2.23 2.64 6.0 23.1 1.6 25.0 SEG 2386 HK O 11.30 13.06 8.7 9.2 1.8 21.6 China Lesso 2128 HK O 5.34 6.37 7.5 16.9 1.8 23.9 # CCBIS ratings: O = Outperform; N = Neutral; U = Underperform * Price as at close on 6 December 2013 ^ Note: EPS CAGR for L&M and SEG is for 2014F-2015F Source: CCBIS estimates, Bloomberg

China chemicals YTD performance 2013

42.0%

25.0%

14.8%

(6.4)%

(14.4)%

(24)% (16)% (8)% 0% 8% 16% 24% 32% 40% 48%

China Sanjiang

Tiande Chemicals

Sinopec Engineering

China Lesso

L&M Chemicals

Source: CCBIS estimates, Bloomberg

Steven Lu (852) 2532 2560 [email protected]



4

Investment summary

Picking growth driven by new trends

Since 4Q 2012, total profit from China’s chemicals industry has been recovering YOY, though at a slow single digit rate. We forecast the current profit recovery to continue in 2014, but unlikely to evolve into a high teen YOY growth across the industry based on two reasons : 1) China’s chemicals industry still suffers from overcapacity and pressure for further destocking; 2) the current economic restructuring (which aims at quality and not quantity in growth) in China will suppress risk of excessive fixed asset investment and spending and put a check on the extent of rebound in demand for chemicals.

Despite only a mild earnings growth prospect for the chemicals industry, we have confidence in identifying interesting profit trends in this highly fragmented industry. Different chemical products have different operating cycles. While some companies have floundered in difficult market conditions, other companies may have managed to increase profits. This was exactly what happened in the cyclical downturn of 2012, when some companies were able to exploit their particular characteristics to take advantage of certain industry trends. Here are some examples that did well in profit enhancement in the downturn of 2012:

1) Consumer chemicals with expanding end-user market. For example, Bloomage Biotec (963 HK, Not Rated), the global leader in HA (hyaluronic acid), which is used widely in cosmetics, eye drops and cosmetology, and Huabao International (336 HK, Not Rated), the leader in flavors and fragrances used in cigarettes and perfumes.

2) Home-grown high-end specialty chemicals substituting for imports. Companies at the forefront of this trend include Tiande Chemical, the global leader in ethylcyanoacetate (ECYA), a chemical used by super glue manufacturers; China Sanjiang, the largest privately-owned producer of ethylene oxide (EO), the raw material used in the manufacture of monoethylene glycol (MEG), surfactants, and super plasticizers; and Lumena (67 HK, Not Rated), the world’s largest producer of PPS resin.

3) Agricultural modernization and ecological agriculture. Examples of companies riding this trend include China XLX (1866 HK, Not Rated), one of the most cost competitive producers of coal-based urea and compound fertilizers, Century Sunshine (509 HK, Not Rated), a leading organic fertilizer and compound fertilizer manufacturer in China, and Sinofert (297 HK, Not Rated), China’s largest distributor and a major producer of a wide range of fertilizers.

Looking forward, we identify three major trends in China’s chemicals industry and five companies we believe will ride these trends to generate steady earnings growth in the coming years.

1. Shifting from basic materials to higher value-added specialty chemicals

In 2011, total revenue of China’s chemical industry reached US$1.02t. In terms of output value, China is the largest chemicals producer in the world. China’s chemicals industry saw rapid growth in the last decade, but now many basic raw materials and other bulk products suffer from overcapacity problem and have low utilisation rates. This applies mainly to basic chemicals, including nitrogen fertilizers, methanol, chloro-alkaline, sodium carbonate and vehicle tires, among others.

http://www.shell.com/global/products-services/solutions-for-businesses/globalsolutions/refinery-chemical-licensing/petrochemical-technology/ethylene-oxide-processes.html

http://www.shell.com/global/products-services/solutions-for-businesses/globalsolutions/refinery-chemical-licensing/petrochemical-technology/ethylene-oxide-processes.html

http://www.chemicalland21.com/petrochemical/MEG.htm


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Total revenue of China’s chemical industry achieved 13.2% YoY growth in 1H 2013, while profit was only up 10.6% YoY, much lower than the over 20% CAGR recorded for 2005-2010.

However, despite strong and stable growth in its chemicals industry, China continues to have a insufficient supply of many kinds of chemicals and is heavily dependent on imported materials, due to unbalanced development among subsectors within the domestic chemicals industry.

In China, there is general oversupply of low-end basic chemical products and a shortage of more sophisticated and higher valued items. There are several sectors with below 50% self-sufficiency ratios (like new chemical materials) in which China is a net importer.

As the chemical industry undergoes structural adjustment, demand for specialty chemicals will grow faster than the industry average. In 2012, revenue growth in specialty chemicals was 21% YOY while average growth for China’s chemicals industry was only 7% YOY. Of the specialty chemicals, high performance adhesives, high-quality fluorinated polymers, electronic chemicals and EO derivatives are high value-added specialty chemicals with over 30% annual growth rates in demand.

2. Shifting from oil-based chemicals to coal-based chemicals

In China, petrochemicals (olefins being one of the key products) are mainly produced from naphtha, hydrogenated tail oils and light diesel oils, which are derived from crude oil. In 2012, amounts of feedstock derived from crude oil accounted for over 80% of all feedstock used in China olefins production, while light hydrocarbons (including LPG and coal gas) accounted for only 7%, much lower than that of global average (about 43%) and that of middle east (about 75%)

In 2005-2010, equivalent consumption (direct consumption and consumption of the derivatives) of ethylene and propylene (two major olefins), increased at a CAGR of 10.6% and 9.8% YOY, while the self-sufficiency ratios in 2010 for ethylene and propylene in China sat at only 48% and 63%. To meet the growing future demand for ethylene and propylene and improve self-sufficiency, ethylene production capacity in China will have to increase to about 26.4 mtpa, representing an 11.4% CAGR for 2011-2016F.

In 2011, crude oil processed in China reached 447.7 mtpa, representing a CAGR of 8.1% in 2006-2011. This fell short of China’s requirements in crude oil. In 2011, approximately 56.5% of crude oil processed in China depended on imports. According to the 12th Five-year Plan, oil refining capacity in China is to reach 728 mtpa by 2016F, representing a 6.2% CAGR for 2011-2016F, much lower than the 11.4% CAGR for ethylene capacity during the same period.

If all of the new olefin plants that will be built in the future in China are based on naphtha (derived from crude oil), China would soon see a significant naphtha shortage. Based on our estimates, there will be a naphtha shortfall of 20 mt per year or more by 2018F. Thus, there is an urgent need for China to diversify its petrochemical feedstock to meet increasing domestic demand and improve its self-sufficiency rate.


6

Thanks to a new generation of coal-to-chemical conversion technologies and abundance of low-cost coal in the northwest, China is enjoying a surge in coal-to-chemical project investment. Almost 20m tonnes/year of coal-based light olefin capacity will be brought online between 2013F and 2020F.

3. Environmental protection

Water pollution

60% of China’s 661 cities face seasonal water shortages, more than 40% of its rivers are severely polluted, 80% of its lakes suffer from eutrophication, and about 300m rural residents lack access to safe drinking water. In 2011, the government’s annual “No.1 Document", which reflects its top priorities, outlined a plan to expedite water conservancy and sewage treatment within a decade. The plan is to quadruple total investment in water issues in the next ten years compared with the last ten years. This will entail a RMB4t investment in the next decade. Three major initiatives of the plan are:

1) Speeding up construction and renovation of underground water supply pipes (benefiting plastic pipe producers).

2) Improving water conservancy infrastructure for farmland and increasing the country’s effective irrigation area by 2.67m ha (also benefiting plastic pipes producers).

3) Accelerating the development of sewage treatment facilities to bring urban sewage treatment capacity up to 200m cubic meters per day by 2015F (which would benefit water treatment chemicals producers).

Air pollution

According to statistics from China’s Ministry of Environmental Protection (MEP), cities in the Yangtze River Delta, Pearl River Delta, and Beijing-Tianjin-Hebei region suffer over 100 hazy days every year, with PM2.5 (particles with an aerodynamic diameter less than 2.5 μm) concentration two-to-four times above World Health Organization guidelines.

The sources of PM2.5 are widespread. They can be derived from thermal power, iron and steel, cement, coal-fired furnaces and other industrial sources of emissions. A baghouse or fabric filter (FF) is an air pollution control device that removes particulates from the air or from gas released from power plants, steel mills, chemical producers and other industrial companies.

Baghouses came into widespread use in developed countries in the late 1970s after the invention of high-temperature fabrics capable of withstanding temperatures over 350°F. In China, due to the lack of high-temperature fabrics, electrostatic precipitators are mainly used. These have low and erratic collection efficiency compared with the 99% efficiency of baghouses.


7

Top picks

China Sanjiang (2198 HK, Outperform) – Market leader in specialty chemicals (EO): China Sanjiang is the largest EO producer in China, with 330,000t p.a. capacity. Due to the expanding market for EO derivatives as well as the drive to accelerate imports substitution of EO derivatives in China, the domestic EO market has been expanding dramatically in terms of total capacity, at an 18.2% CAGR for 2005-2010 and a 32.0% CAGR for 2010-2013. China Sanjiang has two mega projects under construction: MTO and a fifth EO/EG plant, expected to be completed in 1Q 2015F and 4Q 2014F, respectively. These two projects are vital if the company is to move up the value chain to ethylene (a feedstock of EO; 300,000t capacity p.a.), and move down to polyester-grade EG (an EO derivative). We expect the MTO and EO/EG projects to generate over 20% and 33% ROA, respectively, with capex of RMB2.3b and RMB1.3b. Our DCF-based target price translates to 6.9x P/E for FY14F, with potential upside of 26.5% over the next 12 months. We expect the announcement of the company’s 2013 results in March 2014F to include an announcement that the EO/EG projects will begin in 4Q 2014F. This should act as a catalyst to the share price.

L&M Chemical (746 HK, Outperform) – Market leader in CMS to see a profit turnaround. L&M Chemical is the only producer of CMS (chloroform-methanol-soluble) for external sales in Jiangsu and Zhejiang, a major fluorochemicals production region with reputed companies like 3F, Meilan and Arkoma. L&M Chemical built strong cost advantages by synergizing well with L&M Paper to realize about 30% gross profit margin for 2009-2012, significantly higher than industry peers. In July 2013, the CMS market in China began to recover, evidenced by an over 40% increase in CMS ASP in the past four months (July-October 2013). The company also constructed a new plant in Jiangxi, to produce fluorochemicals by combining the rich resource of fluorite in Jiangxi and its advantages in CMS (two key raw materials for fluorochemicals). The new plant (phase 1) was put into operations in 4Q2013. Our DCF-based target price translates to 10.7x P/E for FY14F, with potential upside of 30.2% over the next 12 months. We expect the announcement of the commence of its Jiangxi plant to be the catalysts

Tiande Chemical (609 HK, Outperform) – Global market leader of ECYA enjoying over 23% YOY growth in 2013-2015. Tiande Chemical is the largest producer of ECYA in the world, with a capacity of 22,000 tonnes per year. ECYA, as the main component of cyanoacrylate glues (quick bonding super glues mainly produced by global chemicals leaders like Henkel). As a vertically integrated producer, Tiande Chemical recorded relatively stable profitability with gross profit margin ranging from 22-29% (NPM: 13-17%) over past years. Tiande Chemical is constructing a new production line for sodium cyanide derivatives to catch up downstream growing opportunities, which is expected to be launched in 2014F. In addition, the company set up a JV with Henkel-the global leader in super glues in June 2012, and is building a plant with an annual capacity of 20,000 tonnes cyanoacrylate monomers. Our DCF-based target price translates to 7.2x P/E for FY14F, with potential upside of 18.4% over the next 12 months. We expect the announcement of 2013 results in March 2014 and commence of new production lines in 2014 to be the catalysts.


8

Sinopec Engineering (2386 HK, Outperform) – Beneficiary of coal-to-chemicals surge: SEG is the largest engineering company providing services to oil refining and chemicals industries in terms of revenue, with a domestic market share of 14.6%. Based on our estimates, the market size of exploration and design enterprises in oil refining and chemical engineering industry will grow at a CAGR of 20.5% from 2011-2016F. Among all submarkets, new coal chemical engineering will be the submarket with the highest growth rate, with a 42.0% CAGR for exploration and design enterprises from 2011-2016F, followed by petrochemicals engineering with a CAGR of 18.0%. SEG has a strong project pipeline, with the backlog reaching RMB101.5b by 1H 2013. Based on a stable backlog/sales ratio ranging from 1.8-2.4x in the past, we forecast SEG to generate a 15.5% CAGR of revenue from 2013-2015F. Our target price is based on 10.0x P/E for 2014, at a 25% discount to the average of global EPC peers (13.3x). We expect the possible announcement of more and big projects contracted in 4Q2013 and 1H2014 to be the catalysts

China Lesso (2128 HK, Outperform) – Beneficiary of policies supporting water conservancy and sewage treatment: China Lesso is the largest plastic pipes producer with 1,750,000t p.a. capacity. Demand for plastic pipes in China has been growing at a CAGR of over 25% for 2005-2012, and we believe the demand growth rate will at least exceed 10% for next 5-10 years, driven by government’s increasing investment on municipal pipes network and water conservancy construction. The plastic pipes industry in China is experiencing consolidation due to low concentration rate and most producers located in coastal areas. As the leader, we expected China Lesso’s sales volume to grow at a CAGR of 13.5%, higher than the 10.5% of the whole industry. As a result, its market share is expected to reach 11% by 2015 (9.9% in 2012). Our target price is based on 9.0x P/E for 2014, at a 7% discount to the average of plastic pipes producers listed in China/Taiwan. We expect the announcement of 2013 results in March 2014F to be the catalysts

Valuation comparison– China chemical stock picks

Stock CCBIS Market

cap Market price

Target price

Upside/ (downside) P/E (x) EPS growth (%) P/B (x) Div. Yield (%) ROE (%)

Company code rating* (HK$b) (HK$) (HK$) (%) 2013F 2014F 2013F 2014F 2013F 2014F 2013F 2014F 2013F 2014F China Sanjiang 2198 HK O 4,201 4.23 5.35 26.5 5.5 5.5 30 1 1.5 1.3 5.4 5.5 32.2 25.4 L&M Chemical 746 HK O 3,473 4.21 5.48 30.2 10.9 8.2 (12) 32 1.6 1.4 2.8 3.6 15.1 17.5 Tiande Chemical 609 HK O 1,889 2.23 2.64 18.4 7.7 6.0 22 28 1.6 1.3 2.6 3.3 25.0 24.4 SEG 2386 HK O 16,507 11.30 13.06 15.6 8.9 8.7 (5) 3 1.8 1.6 1.7 1.7 21.6 19.6 China Lesso 2128 HK O 16,345 5.34 6.37 19.3 8.2 7.5 28 9 1.8 1.5 2.9 3.2 23.9 21.6 # CCBIS ratings: O = Outperform; N = Neutral; U = Underperform * Price as at close on 6 December 2013 Source: CCBIS estimates, Bloomberg


9

Investment snapshot

China Sanjiang – stock price vs. HSCEI China Sanjiang (2198 HK; Outperform; TP: HK$5.35)

1.5

1.9

2.3

2.7

3.1

3.5

3.9

4.3

4.7

2-Jan-12 10-Apr-12 18-Jul-12 25-Oct-12 1-Feb-13 11-May-13 18-Aug-13 25-Nov-13

HK$

China Sanjiang HSCEI (rebased)

Initiate with Outperform and HK$5.35 target price, implying 26.5% potential upside. It is trading at 5.5x 2014F P/E and 1.3x 2014 P/B, which looks attractive compared with its 3-year EPS CAGR of 33.1%.

China Sanjiang has a track record of fast capacity expansion and stable profitability as the market leader of EO and its derivatives.

Its EO capacity will increase to 530,000 tonnes p.a. by 2014F from 330,000 tonnes p.a. in the end of 2012.

To ensure its profitability, the company is moving into the upstream (ethylene) before the EO market sees oversupply. The MTO project will be put into operation in 1Q 2015F, and will become another growth engine.


L&M Chemical – stock price vs. HSCEI L&M Chemical (746 HK; Outperform; TP: HK$5.48)

3.0

3.6

4.2

4.8

5.4

6.0

6.6

7.2


HK$

L&M Chemical HSCEI (rebased)


L&M Chemical maintained its gross profit margin above 30% as the most cost competitive CMS producer in China.

China CMS market is recovering due to supply reduction (exit of producers with low efficiency, ASPs of CMS rose by about 40% since July 2013).

L&M expended about RMB1.5b in Jiangxi to construct a plant for fluorated polymers production, put into operations in 4Q 2013, which will be the major growth drivers for next few years.



10

Tiande Chemical– stock price vs. HSCEI Tiande Chemical (609 HK; Outperform; TP: HK$2.64)

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

1.9


HK$

Tiande Chemical HSCEI (rebased)


As the global leader of ECYA (upstream of the ECYA- quick bonding super glues value chain), Tiande Chemical recorded a gross profit margin ranging from 22-28%.

Tiande Chemical is expanding its production lines continuously by launching new products. One new product is sodium cyanide derivative, which is expected to be launched in 2014F.

In addition, Tiande Chemical set up a JV with global leader of glues-Henkel Hong Kong, which is expected to move downstream-the production of super glues.


SEG – stock price vs. HSCEI SEG (2386 HK; Outperform; TP: HK$13.06)

8.5

9.0

9.5

10.0

10.5

11.0

11.5

12.0

12.5

24-May-13 30-Jun-13 6-Aug-13 12-Sep-13 19-Oct-13 25-Nov-13

HK$

SINOPEC SEG HSCEI (rebased)

Initiate with Outperform and HK$13.06 target price, implying 15.6% potential upside from the current price. It is trading at 8.7x 2014F P/E and 1.6x 2014 P/B, which looks attractive compared with international peers’ 13.3x P/E and 2x P/B.

Boosted by a demand surge in new chemicals, the engineering market of oil refining and chemicals is expected to grow at a CAGR of 20.5% for 2011-2016F.

SEG has a strong project pipeline on hand, which will drive its revenue to grow at a CAGR of 16% for 2013-2015F.

SEG has a track-record of maintaining a good EBITDA margin of above 13.0% .


China Lesso – stock price vs. HSCEI China Lesso (2128 HK: Outperform; TP: HK$6.37)

3.0

3.3

3.6

3.9

4.2

4.5

4.8

5.1

5.4

5.7

6.0

6.3


HK$

China Lesso HSCEI (rebased)

Initiate with Outperform and HK$6.37 target price, implying 19.3% potential upside. It is trading at 7.5x 2014F P/E and 1.5x 2014 P/B, which looks somehow attractive compared with its 3-yr EPS CAGR of 16.9%.

China Lesso is the largest plastic pipes producer in China. With overall demand in plastic pipes rising in China, China Lesso is positioned to benefit, especially from the current accelerating urbanization process.

Benefiting from growing demand for water conservancy and sewage treatment, China’s plastic pipe demand is expected to grow at above 10% pa.

China Lesso has a national network of production bases and sales channels; its market share is also expected to grow from 9.9% in 2012 to 11% by 2015F.

China Lesso recorded a stable gross profit margin around 25%.



11

Valuation and risks

Price performance discounting 2013 earnings expectation

Year-to-date in 2013, share prices of China Sanjiang, Tiande Chemical and Sinopec Engineering have risen 42.0%, 25.0% and 14.8% respectively, while the share prices of L&M Chemical and China Lesso fell 14.4% and 6.4%, respectively.

We believe the share price increases for China Sanjiang, Tiande Chemcials and Sinopec Engineering were in reaction to the expectation of strong earnings growth for 2013F. Based on our estimates, their EPS growth for 2013F is about 30.0%, 22.5% and 21.2%, respectively.

The share prices decline for L&M Chemical factors is due to an expected earnings decline in 2013F. Based on our estimates, L&M’s EPS growth for 2013F is about -11.8%.

We think the negative share price performance in the case of China Lesso reflects market concerns over property market tightening.

Absolute YTD share price performance in 2013

42.0%

25.0%

14.8%

(6.4)%

(14.4)%

(24)% (16)% (8)% 0% 8% 16% 24% 32% 40% 48%

China Sanjiang

Tiande Chemicals

Sinopec Engineering

China Lesso

L&M Chemicals


Prospects beyond 2013 not fully reflected

In our view, China Sanjiang and Tiande Chemical, have the potential to continue to outperform on the strength of their 2013F earnings and their earnings growth outlook for 2013-2015F. We expect both companies to beat market expectation for the period.

In the case of L&M Chemical, the market is still not factoring in the recovery in China’s CMS market and potential earnings growth from L&M’s Jiangxi plant in our view. As 2014F wears on, we believe the market will more fully appreciate these two factors, and the company will outperform accordingly.

We think Sinopec Engineering will also continue to outperform in coming year as we are more confident than the market about the capacity expansion in new coal chemicals in China.


12

China Lesso, may seem to have a degree of immunity to concerns about the China property market. Unlike its peers, China Lesso’s results show little damage from tightening in the market.

Valuation

For China Sanjiang, L&M Chemical and Tiande Chemical, we used a DCF-based valuation methodology for value assessment, while for Sinopec Engineering and China Lesso, we used P/E-based valuation methodology because there are a number of peers listed both regionally and globally available for comparison.

For the three companies for which we applied a DCF-based valuation, China Sanjiang had the highest WACC of 10.6% due to its relatively high cost of equity (13.3%). Based on our DCF-based valuation, L&M Chemical has the most upside potential of 30.2%.

For the two companies using P/E-based valuation, the target price of SEG is based on 10.0x P/E for 2014F, about a 25% discount to the average of global EPC peers. The target price for China Lesso is based on 9.0x P/E for 2014F, a 7% discount to the average of plastic pipe producers listed in China and Taiwan.

Valuation methodology for China Chemicals

China Sanjiang L&M Chemical Tiande Chemical SEG China Lesso Valuation methodology DCF DCF DCF P/E P/E DCF-based valuation WACC 10.6% 7.9% 8.4%

Cost of equity 13.3% 9.0% 9.0% Cost of debt 5.0% 4.0% 8.0% Debt/capital ratio 30% 20% 20% Effective tax rate 15% 15% 25%

Terminal growth rate 2.0% 2.0% 2.0% P/E-based valuation P/E ratio for 2014F 10.0x 9.0x Target price (HK$) 5.35 5.48 2.64 13.06 6.37 Upside/(downside) to current share price (%) 26.5% 30.2% 18.4% 15.6% 19.3% CCBIS rating O O O O O * CCBIS ratings: O = Outperform; N = Neutral Source: CCBIS estimates


13

P/E versus EPS CAGR

In terms of P/E for 2013F versus EPS CAGR for 2013-2015F, SEG has a relatively high P/E (8.9x) together with a relative low EPS CAGR (9.2%), mainly because of its size (with a net profit over RMB3b a year), its transparent (most projects are large-scale mega projects from Sinopec and others), and the strong supper from its mother company-Sinopec Group.

China Sanjiang has the lowest P/E (5.5x) together with a relative high EPS CAGR (33.1%), mainly because it is less understood by the market (no peers), has a higher gearing ratio (85% by the end of 2012) and an aggressive capex plan (capex for 2013 and2014F reaching RMB1.2b and RMB2.0b, respectively).

2013F P/E vs. 2013F-2015F EPS CAGR*

Sanjiang Chemical

L&M

Tiande

SEG

China Lesso

4x

5x

6x

7x

8x

9x

10x

11x

12x

0% 5% 10% 15% 20% 25% 30% 35% 40%

P/E

EPS CAGR Source: CCBIS estimates *Note: EPS CAGR for L&M and SEG is for 2014F-2015F


14

P/B versus ROE

In terms of P/B and ROE for 2013F, SEG has a relatively high P/B (1.8x) together with a relatively low ROE (21.6%), mainly because of its light asset business model and its relative low net profit margin (below 10%).

Tiande Chemical has the lowest P/B (1.6x) together with a relatively high ROE (25.0%), mainly because its high net profit margin (about 15%) with relatively high asset to equity ratio (1.5x).

L&M Chemical has the lowest ROE for 2013F, mainly because the CMS market was in a downward cycle in last two years and its revenue decreased significantly YoY, dragging down its total asset turnover (0.3x), although it has generated the highest net profit margin (24%).

2013F P/B vs. 2013F ROE

Sanjiang Chemical

L&M Chemicals Tiande

SEGChina Lesso

1.40x

1.45x

1.50x

1.55x

1.60x

1.65x

1.70x

1.75x

1.80x

1.85x

10% 15% 20% 25% 30% 35%

P/B

ROE Source: CCBIS estimates


15

Risks for China Chemicals

Key upside risks:

China Sanjiang: (1) expanded EO-Ethylene spread (we assumed a stable spread in our model); (2) earlier-than-expected completion of projects under construction; (3) more other incomes like gains from foreign exchange.

L&M Chemical: (1) rising CMS ASPs (we assumed they will remain at the current level in 2014F); (2) earlier-than-expected completion of Jiangxi facilities under construction.

Tiande Chemical: (1) lower raw material prices (chlorine); (2) earlier-than-expected completion of new production lines under construction.

Sinopec Engineering: (1) higher than expected revenue growth rate due to more mega projects contracted; (2) better EBIT margin due to good cost control.

China Lesso: (1) higher operating rates for its new production bases; (2) better gross profit margin due to declining raw material prices.

Key downside risks:

China Sanjiang: (1) lower EO-Ethylene spread due to more new added capacity and competition; (2) delays of projects under construction; (3) decline in other income such as gains from foreign exchange.

L&M Chemical: (1) dropping of CMS ASPs due to more supply (rising operating rates of the whole industry); (2) delay of Jiangxi facilities under construction.

Tiande Chemical: (1) higher raw material prices (chlorine); (2) delay of new production lines under construction.

Sinopec Engineering: (1) lower than expected revenue growth rate due to projects delay; (2) worse EBIT margin due to bad cost control.

China Lesso: (1) lower operating rates of its new production bases due to weak demand and more competition; (2) worse gross profit margin due to rising of raw material prices.


16

Picking growth driven by new trends

Chemicals industry will maintain a moderate profit recovery in 2014

From 1Q 2009 to 4Q 2010, China’s chemicals industry experienced a strong upward cycle that coincided with the economic stimulus during the same period in China. The strong upward cycle was driven by strong demand from downstream industries mainly including real estate, vehicles, textiles and consumptions.

From 4Q 2011 to 3Q 2012, China’s chemicals industry entered a downward cycle resulting from both weak demand due to the economic slowdown and surplus supply from recently added capacity due to the aggressive expansion by chemical companies in the upward cycle from 1Q 2009-4Q 2010.

From 4Q 2012 until now, the general YOY profit decline of China’s chemicals industry came to a halt. The chemical industry is recovering at a moderate pace featured by a low-digit but slowing growth rate for total profit.

YOY changes in total profit in China’s chemicals and manufacturing industries

(70)%

(35)%

0%

35%

70%

105%

140%

175%

210%

3Q07

4Q07

1Q08

2Q08

3Q08

4Q08

1Q09

2Q09

3Q09

4Q09

1Q10

2Q10

3Q10

4Q10

1Q11

2Q11

3Q11

4Q11

1Q12

2Q12

3Q12

4Q12

1Q13

2Q13

3Q13

Chemicals industry Chinese industrials Source: Wind, CCBIS research

Looking forward, we believe the chemicals industry will keep recovering at a moderate pace, instead of a strong bounce as happened between 2009-2010 due to:

1) The pressure of overcapacity and destocking is still heavy.

The overcapacity of many commodity chemicals is deteriorating due to the over 30% growth rate of fixed assets investment in chemicals industry in 2009-2011 and a 1.5-2.0 year construction period in general. Therefore, the utilization rates of many commodity chemicals have been falling since 2011, including nitrogen fertilizers, methanol and soda ash.

China’s chemicals industry is recovering at a moderate pace


17

Utilization rates of commodity chemicals (selected)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Nitrogen Fertilizers Methanol PP resins Soda Ash2011 2012 2013

Source: Wind, CCBIS research

On the other hand, the inventory levels of many commodity chemicals are also at a historical high, including fertilizers, synthetic materials, and coating

2) Demand will not have a strong bounce under economic restructuring

Under the background of structural reforms on China’s economic development, another aggressive economic stimulus of the magnitude of the RMB4t stimulus plan from 2009 is almost impossible. According to our strategy team, national GDP growth will decelerate slightly from 7.6% YoY in 2013 to 7.4% YoY in 2014F. In this case, demand for chemicals from downstream sectors like real estate, vehicles, textiles will keep improving, but won’t see a strong bounce.

Don’t ignore growing chemical companies benefiting from long-term trends

Although 2012 was marked by a big downward cycle for the chemicals, many companies nevertheless managed to increase net profit. These companies seemed to have been able to exploit the following trends.

1) Consumer chemicals with expanding end-users’ market, including Bloomage Biotec (963 HK), the global leader of HA used widely in cosmetics, eye drops and cosmetology, and Huabao International (336 HK) who is the leader of flavors and fragrances used for cigarettes and perfumes.

2) High-end fine chemicals substituting imports, including Tiande Chemical (609 HK), the global leader of ECYA used by super glues manufacturers all overall the world, China Sanjiang (2198 HK) who is the largest privately-owned producer of EO-raw materials of MEG, surfactants, super plasticizers with very low self-sufficiency rates in China, and Lumena (67 HK), the world’s largest producer of PPS resin relying on imports so far.

3) Agricultural modernization and ecological improvement, including China XLX, one of the most cost competitive coal-based urea and compound fertilizers, Century Sunshine (509 HK) is a leading organic fertilizer and compound fertilizer in China, and Sinofert (297 HK), the largest distributor and also a major producers of almost all kinds of fertilizers.


18

Net income growth rates of select chemical companies

Company 2010

(% YoY of net income) 2011

(% YoY of net income) 2012

(% YoY of net income) CHINA XLX FERTIL (1866 HK) 21 25 72 YIP'S CHEMICAL (408 HK) 69 (47) 37 CENTURY SUNSHINE (509 HK) 67 33 35 SINOFERT HOLDING (297 HK) N/A 27 30 BLOOMAGE BIOTE (963 HK) 19 20 23 CHANGMAO BIOCH-H (954 HK) 75 (46) 20 TIANDE CHEMICAL (609 HK) 207 2 20 CHINA SANJIANG F (2128 HK) 10 52 15 DRAGON CROWN GRO (935 HK) 13 (7) 10 HUABAO INTERNATI (336 HK) 21 20 9 CHINA AGROTECH (1073 HK) 169 325 8 LUMENA NEWMAT (67 HK) 37 72 7 CHINA LESSO GROU (2128 HK) 76 11 (2) CECEP COSTIN NEW (2228 HK) 49 13 (2) CHINA FIRST CHEM (2121 HK) 26 59 (7) YINGDE GASES GRP (2168 HK) 9 44 (7) CHINA BLUECHEM-H (3983 HK) 19 69 (9) FUFENG GROUP LTD(546 HK) 4 (37) (29) L & M CHEMICAL (746 HK) 99 45 (46) SATERI HOLDINGS (1768 HK) 203 (52 (64) DONGYUE GROUP (189 HK) 344 198 (67) SINOPEC YIZHEN-H (1033 HK) 218 (32) (143) SINOPEC SHANG-H (338 HK) 74 (65) (260) JILIN QIFENG-H (549 HK) (94) 418 (386) Source: Company data, CCBIS research


19

Shifting from basics to higher value-added specialty chemicals

Basic chemicals is struggling with slowdown and overcapacity

From 2007 to 2011, China’s chemical industry achieved revenue CAGR of 22.3%, reaching US$1.02t in 2011. In terms of output value, China is the largest chemicals producer of the world. Rapid development of China chemicals industry has made many basic raw materials and other bulk products suffering from overcapacity and low capacity utilization rate. Such basic chemicals include nitrogen fertilizers, methanol, chloro-alkaline, sodium carbonate and vehicle tires.

Overcapacity of basic chemicals Capacity utilization rates (2010)

35%50%

97%

65%50%

3%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Ammonia Methanol Calcium carbideCapacity of China Capacity of other regions of the world

60.9%

41.0%

25.0%

61.0%

0%

10%

20%

30%

40%

50%

60%

70%

Calcium carbide Methanol DME Acetic acid Source: CCBIS research

Source: CCBIS research

According to the China Petroleum and Chemical Industry Federation, the output of major chemical products was slow to increase in 1H 2013 due to weak demand in the absence of significant stimulus from the government and chemical manufacturers not unwilling to cut down on production. The main business revenue of the chemical industry recorded 13.2% YoY growth, while profit was only up 10.6% YoY, much lower than 20%-plus CAGR in 2005-2010.

Slowdown of the chemical industry

3,357

3,800

155 172

0

600

1,200

1,800

2,400

3,000

3,600

4,200

1H12 1H13

RMB b

Main business revenue Total profits Source: NDRC, CCBIS research

China has overcapacity for most of basic chemicals


20

High-end specialty chemicals are heavily dependent on imports

Despite strong and stable growth in chemicals industry, China continues to have a net chemical deficit and is heavily dependent on imported materials, because of the unbalanced development between subsectors within the chemicals industry.

In 2012, approximately 63% of chemical sales came from basic raw materials and other bulk chemical, including fertilizers and rubbers. However, the figure is usually below 40% in Japan and western developed countries.

Revenue breakdown of the chemicals industry in China by usage (2012)

Basic chemical and synthetic materials

41%

Fertilizers11%

Paints, inks,pigments, dyes

6%

Rubber11%

Specialty chemicals31%

Source: CEIC, CCBIS research

In China, there is a general oversupply of low-end basic chemical products and a shortage of more sophisticated and higher valued items. There are several sectors (like new chemical materials) in which China is a net importer and has a below 50% self-sufficiency rates. In the 12th Five-year Plan, China has set a goal of 80% self-sufficiency of specialty and fine chemicals by 2015F.

China’s self-sufficiency ratios in high-end specialty chemicals (2012)

46%

40%

50%

35%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

EO and itsderivatives

High qualityfluorinated polymers

High performanceadhesives/glues

Electronicchemicals

Source: CEIC, CCBIS research

As the chemical industry undergoing structural adjustment, specialty chemicals will grow faster than the industry average. In 2012, revenue growth in specialty chemicals was at 21% but only 7% growth for the average chemical industry. Among all specialty chemicals, high performance adhesives, high quality fluorinated polymers, electronic chemicals and EO derivatives are those with over 30% demand annual growth rates.

China has a less than 50% self-sufficiency ratios for many high-end specialty chemicals, i


21

Shifting from oil-based chemicals to coal-based chemicals

China faces significant shortage of traditional petrochemical feedstock-naphtha

In China, petrochemicals (olefins are one of the key products) are mainly produced from naphtha, hydrogenated tail oil and light diesel oil, which are derived from crude oil. In 2012, feedstock derived from crude oil accounted for over 80% of feedstock for China olefins production, while light hydrocarbons (including LPG and coal gas) accounted for 7%, much lower than the 43% share of light hydrocarbons in feedstock for olefins production in the world.

Breakdown of petrochemicals feedstock by type in China Breakdown of petrochemicals feedstock by type in the

World

Naphtha68%

Light diesel22%

Light hydrocarbons

(LPG, gas, etc.)7%

Other3%

Naphtha56%

Light hydrocarbons

(LPG, gas, etc.)43%

Other1%



Equivalent consumption (direct consumption and consumption of the derivatives) of ethylene and propylene (two major olefins) increased at a CAGR of 10.6% and 9.8% in 2005-2010, while the CAGR of ethylene capacity and propylene capacity reached 14.9% and 12.3%, respectively, during the same time. However, the self-sufficiency ratios for ethylene and propylene in China were still only 48% and 63% in 2010. To meet growing demand and improve self-sufficiency, ethylene production capacity in China is to be expanded to about 26.4 mtpa, representing an 11.4% CAGR in 2011-2016F.

Oil refining capacity and crude oil processed increased at a CAGR of 8.1% and 8.0% for 2006-2011. In 2011, crude oil processed was about 447.7 mt and approximately 56.5% of crude oil that is processed in China is imported crude oil. According to the 12th Five-year Plan, the oil refining capacity in China is expected to reach 728 mtpa by 2016F, representing a 6.2% CAGR from 2011-2016F, much lower than the 11.4% CAGR of ethylene capacity during the same period.

If all of the new olefin plants that will be built in the future in China are based on naphtha (derived from crude oil), China would soon see a significant naphtha shortage. Based on our forecasts, by 2018F, there will be a 20 mt of naphtha shortage.

Therefore, China has to diversify its petrochemical feedstock to meet the increasing demand and improve the country’s self-sufficiency ratio.

Naphtha accounted for 68% of the feedstock used in China olefins production in 2012


22

Capacity expansion of ethylene in China Capacity expansion of oil refining in China

9.8 10.0 10.012.1

15.2 15.4

26.4

19.6 21.1 21.0

25.929.6

31.3

41.3

0

5

10

15

20

25

30

35

40

45

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

MT

Ethylene capacity Equivalent consumption

365402

441489 515 540

728

0

100

200

300

400

500

600

700

800

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

MT

Oil refining capacity Source: CCBIS research Source: CCBIS research

China is in the midst of a surge in coal-to-chemicals investment

There are three main technologies to help diversify sources of petrochemical feedstock.

1) Catalytic pyrolysis process (CPP) – it produces ethylene and propylene from paraffin base atmospheric residue, and is developed by China Research Institute of Petroleum Processing (RIPP). The world’s first commercial CPP unit with a capacity of 500 kt/a was set up and put into operation in June 2009 at the Shenyang Chemical Group’s Shenyang Wax Chemical Company.

2) Propane Dehydrogenation (PDH) and Olefin cracking process (OCP) – both of which are proven processes but are restricted by the availability of stable and inexpensive supply of propane and C4-C8 olefins.

PDH (up chart) and OCP (down chart)

Propane

Feedstock

UOP Oleflexprocess

Processes

Propylene

Product

C4 – C8olefins

Feedstock

Total petrochemicals/UOP olefin cracking

process

Processes

Ethylenepropylene

Product


3) Coal-to-Olefins (CTO) and Methanol-to-Olefins (MTO) conversion – which produce olefins using coal or methanol as feedstock. The first and the world’s largest MTO project was put into operation in September 2010 at Shenhua Ningxia. In terms of technology, stable and inexpensive supply of coal or methanol, we believe new coal chemicals will play a major role in China’s diversification of petrochemical feedstock.

Coal-to-Olefins and Methanol-to-Olefins are good choices for petrochemical feedstock diversification


23

CTO/MTO

CoalNatural gas

PetCoke

Feedstock

Ethylenepropylene

ProductProcesses

SynGas/methanol

MTOMethanol to olefins


China is in the midst of a surge in coal-to-chemicals investment, with the competitiveness of these projects, which are based on a new generation of coal-to-chemical technologies, hinging on the peculiar economics of China’s coal market.

According to our channel check, more than 120 coal-to-chemical projects have been announced in China. Although the number likely to be realized is much lower, the new capacity will easily outpace shale-based expansion in North America. Between 2013 and 2020, 13 million m.t./year of ethylene and propylene capacity will go online in the United States. During the same period, almost 20 million m.t./year of coal-based light olefin capacity will go online in China.

Key CTO projects in China (selected)

Developer Location Capacity of olefins ('000 tonnes) Capacity of olefins ('000 tonnes) Shenhua Baotou 600 Operating Shenhua Ningxia Coal Yinchuan, Ningxia 500 Trial production Shenhua Xinjiang 680 Under construction; Expect to run in 2016 Shenhua & Dow Chemica Yulin, Shaanxi 1220 Under construction; Expect to run in 2013 China Kingho Haixi, Qinghai 600 Under construction; Expect to run in 2015 Sinopec Zhongyuan Puyang, Henan 600 Phase I (300,000 tonnes) started to run since Oct-2011 Yanzhou Coal Yulin, Shaanxi 600 Early stage Yanzhou Coal Ordos 600 Early stage Shanxi Coking Group Hongdong,Shanxi 600 Under construction; Expect to run in 2013 China Coal Yili, Xinjiang 600 Under construction Hubei Yihua Group Xinjiang 600 Under construction Beijing Energy Investment Xinjiang 680 Early stage Datong Coal Datong,Shanxi 600 Under construction Zhongan Joint Coalification Huainan,Anhui 600 Under construction; Expect to run in 2013 China Coal Yulin, Shaanxi 600 Approved by NDRC; Under construction Expect to run in 2014 Shanxi Lanhua Coal Mining Jingcheng, Shanxi 600 Early stage Shaanxi Yanchang Yan'an,Shaanxi 600 Under construction PuCheng Clean Energy Pucheng, Shanxi 700 EPC contracted Shanghai HuaYi Wuwei, Anhu 500 Under construction Sinopec Zhijing Bijie, Guizhou 600 Approved by NDRC;Under construction; Expect to run in 2014 Anhui Huaihua Group Huainan, Anhui 490 Under construction Shanxi Huayun Coal Lanxian, Shanxi 434 Under construction; Expect to run in 2013 Huaneng Manzhouli 600 Early stage Nanjing Wison Nanjing, Jiangsu 295 Under construction; expect to run in 2013 Datang Duolun 1380 A part of capacity, or 460,000 tonnes, is operating now Shandong Energy Xinwen Yili, Xinjiang 600 Approved by NDRC; Under construction Ningxia Baofeng Energy Ningxia 600 Under construction; expect to run in 2013 Sinepec & Henan Coal Hebi, Henan 600 Early stage Shenhua Coal Yulin, Shaanxi 600 Under construction; expect to run in 2015 Shenda Chemicals Tengzhou,Shandong 200 Under construction; expect to run in 2013 Total 18,479 Source: Company data, CCBIS research


24

Environmental protection

Water conservancy and sewage disposal

60% of China’s 661 cities face seasonal water shortage, more than 40% of its rivers are severely polluted, 80% of its lakes suffer from eutrophication, and about 300m rural residents lack access to safe drinking water.

In the 12th Five-year Plan, the government set a target to further reduce 200m rural residents without safe drinking water and increase the urban sewage treatment rate from 77% in 2010 to 85% in 2015F.

Index of wastewater and other water pollutants in China (2001-2008)

132.1

95.6

101.0

90

100

110

120

130

140

2001 2002 2003 2004 2005 2006 2007 2008Wastewater emitted COD emitted Ammonia Nitrogen emitted

CAGR emissions (2001-2008):Wastewater: 4.2%Ammonia Nitrogen: 0.2%COD: (0.6)%

100 = 2001

Source: NDRC, CCBIS research

In 2011, the government’s annual “No.1 Document", which reflects its top priorities, outlined a plan to expedite water conservancy development within this decades. The plan is to quadruple total investment in solving water problems to RMB4t in the next 10 years, compared with the investment in the past decade. Some of the major measures include:

1. Speed up the construction and renovation of underground water supply pipes network (benefiting plastic pipes producers).

2. Improve water conservancy infrastructure for farmland and increase effective irrigation area by 2.67m ha (benefiting plastic pipes producers).

3. Speed up the sewage treatment facilities to make urban sewage treatment capacity reached 200m cubic meters per day by 2015F (benefiting water treatment chemicals producers)

In the 12th Five-Year Plan, the government set a target to reduce 200m rural residents without safe drinking water and increase the urban sewage treatment rate from 77% to 85%.


25

Rural water supply and urban sewage treatment targets

300

10077%

85%

72%

74%

76%

78%

80%

82%

84%

86%

0

40

80

120

160

200

240

280

320

2010 2015F

m

Rural residents without safe drinking water (LHS) Urban sewage treatment rate (RHS) Source: NDRC, CCBIS research

Air pollution

According to statistics from China’s Ministry of Environmental Protection (MEP), many cities in China’s Yangtze River Delta, Pearl River Delta, and Beijing-Tianjin-Hebei region suffer over 100 haze days every year, with PM2.5 (particles with an aerodynamic diameter less than 2.5 micron) concentration two to four times above the World Health Organization guidelines.

These key regions accounts for 14% of total land area, 48% of the total population and discharge 48% of SO2, 51% of NOx, 42% of dust and 50% of VOCs. In 2010, the annual average concentration of SO2 and PM10 in key regions was 40 μg /m3 and 86 μg /m3 respectively, which are 2-4 times greater than developed western nations.

Emission amount of air pollutants in 2012

22.678 22.736

14.661

0

5

10

15

20

25

SO2 emissions Nox emissions Dust emissions

m tonnes

Source: NDRC, CCBIS research

Many cities in China have over 100 “hazy days” every year,


26

Measurement of PM2.5 is rather complicated. Direct emissions of fine particulate matters in coal combustion, vehicles, fugitive dust, and biomass combustion produces 50% of PM2.5. Complex chemical reactions of SO2, NOx, VOCs, NH3 in the air create the other 50% secondary fine particulate matter. The sources of PM2.5 are widespread, coming from thermal power, iron and steel, cement, coal-fired furnaces and other industrial sources of emissions.

A baghouse or fabric filter (FF) is an air pollution control device that removes particulates out of air or gas released from power plants, steel mills, chemical producers and other industrial companies. Baghouses came into widespread use in developed countries in the late 1970s after the invention of high-temperature fabrics capable of withstanding temperatures over 350°F. In China, due to the lack of high-temperature fabrics, electrostatic precipitators is mainly used, whose collection efficiency is very low and vary significantly, compared with the 99% of baghouses.

CECEP Costin (2228 HK, Not Rated) currently has 3 production lines with production capacity of thermal resistant filtration materials of 21m sq m per year, which were put into operation only in 4Q 2011, and the sales is still at its incipient stage. In March 2013, the company signed a framework sales agreement with China Energy Conservation and Environmental Protection Group (“CECEP”), which purchased 29% of the stock rights of the company to become the single-largest shareholder.

China Sanjiang (2198 HK) 8 December 2013

27

China Sanjiang (2198 HK)

Vertical integration drives profit growth Company Rating:

Outperform (initiation)

We initiate on China Sanjiang with an Outperform rating. Our DCF-based target price of HK$5.35 (or 6.9x 2014 P/E). The stock is currently trading at a low 5.5x P/E and 1.3x P/B for 2014F. We recommend the stock because of the strong earnings growth (+80% yoy) in 2015 driven by new profit contribution from MTO operation, which will be a share price catalyst in 2H14.

The largest privately-owned producer of EO. China Sanjiang is the largest ethylene oxide (EO) producer with 330,000tpa capacity, followed by Sinopec Yangzi. As a raw material mainly used to produce core components of household cleansing and cosmetic products, China’s EO market has been expanding dramatically that outpaces capacity growth (even at 32.0% CAGR for 2010-13). Sanjiang’s capacity consistently maintained full utilization rates and it enjoyed high gross margins of 18-27% in 2007-2013.

Profit growth driven by vertical integration. Completion of the MTO and its 5th EO/EG plants in1Q2015 and 4Q2014 respectively, will help Sanjiang expand into new products (including ethylene, a feedstock of EO) and improve returns. The MTO and EO/EG project is expected to generate good ROA of over 20% and 33%, with capex of RMB2.3b and RMB1.3b, respectively.

An attractive target for a 2-yr investment time. China Sanjiang is expected to record a 30% YoY EPS growth for 2013F, followed by a flat year. However, its net profit is estimated to surge sharply in 2015F (a 80% YoY EPS growth) due to the significant contribution from new projects. We believe current price offers a good entry point for long term investors in view of an attractive P/E of only 5.5x for 2014.

Forecasts and valuation Year ended 31 March FY11A FY12A FY13F FY14F FY15F Revenue (RMB m) 2,078 2,521 4,779 5,939 13,282 YoY (%) 31 21 90 24 124 Net profit (RMB m) 407 467 607 614 1,104 YoY (%) 53 15 30 1 80 Diluted EPS (RMB) 0.404 0.470 0.611 0.618 1.111 YoY (%) 53 16 30 1 80 P/E (x) 9.0 7.7 5.5 5.5 3.0 P/B (x) 2.3 2.0 1.5 1.3 1.0 DPS (HK$) 0.150 0.180 0.229 0.232 0.417 Dividend yield (%) 3.3 4.0 5.4 5.5 9.9 ROE (%) 30.0 28.6 32.0 25.4 38.5 Source: Company data, CCBIS estimates

Price: HK$4.23 Target: HK$5.35 (initiation) Trading data 52-week range HK$2.78-4.73 Market capitalization (b) HK$4.2b/US$0.54b Shares outstanding (m) 993 Free float (%) 52 3M average daily T/O (m share) 5.5 3M average daily T/O (US$m) 2.7 Expected return – 1 year (%) 26.5 Price as at close on 6 December 2013

Stock price and HSCEI

1.5

1.9

2.3

2.7

3.1

3.5

3.9

4.3

4.7


HK$

China Sanjiang HSCEI (rebased) Source: Bloomberg




28

Vertical integration drives higher returns

The largest privately-owned producers of EO in China

China Sanjiang is a producer of ethylene oxide (EO, 80% of sales) and AEO (fatty alcohol ethylene oxide) surfactants (3% of sales) located near the Jiaxing port in Zhejiang province. EO is a major ethylene derivative, only next to polyethylene-PP and PVC in terms of ethylene consumption in China. There is a shortage of ethylene supply in China because domestic ethylene production is dominated by Sinopec group (and the SOE oil companies), which is reserved mainly for the producers’ internal use.

The use of EO for the production of ethylene glycol (EG) accounts for 70% of EO consumption by large refiners in their integrated processes. However, China’s commercial EO market consist mainly of surfactants and other fine chemicals producers, which manufacture core components of household cleansing and cosmetic products. In China, the supply of downstream EO products relies on imports as the self-sufficiency ratio is only 30-75% in recent years, implying a serious supply shortage problem.

EO and its products’ application areas Breakdown of “commercial” usage of EO (by volume)

(2010)

EOEthylene

Household cleaners

Polyester fiber

Cosmetics, ointments

Lubricants, cements

AEO Surfactants

Ethylene glycol

ethanolamine

Polyether/PEG

Other

AEO surfactants34%

Polyether/PEG34%

Ethanolamine18%

Other14%

Source: Company data, CCBIS research Source: Company data, CCBIS research

China Sanjiang built two ethylene tanks in the Zhapu port of Jiaxing, each with 22,000 cubic meters storage capacity in 2005 and 2011. The company uses imported ethylene as feedstock and has rapidly expanded its EO capacity from 60,000 tpa in 2006 to 330,000 tpa as at the end of 1H13.

As of August 2013, Sinopec group’s aggregate (including all subsidiaries and JV) EO production capacity amounted to 1,013,000 tpa, the largest in China. China Sanjiang is China’s second largest EO producer with a total capacity of 330,000 tpa, followed by PetroChina with 290,000tpa. However, in terms of single company capacity, China Sanjiang is the largest producer and controls a 12.4% market share in 2012.

In China, there is a shortage of ethylene in the market

Self-sufficiency ratio of EO derivatives range from 30-75%

The largest privately-owned EO producer, with a 12.4% market share in China


29

China Sanjiang – EO capacity expansion Capacity of major EO producers in China (1H13)

60 65

120 120

180

230

330

66 68

141 132

176

217

345

0

50

100

150

200

250

300

350

400

2007 2008 2009 2010 2011 2012 2013

'000 tonne

Designed annual capacity of EO Actual production volume

33

18.615 13.6

11 10 10 10 10 107.3 6 6 6 6

0

5

10

15

20

25

30

35

40

China

San

jiang

Sino

pec Y

angz

i

Sino

pec W

uhan

Sino

pec S

hang

hai

CNPC

Jilin

Sino

pec Z

henh

ai

CNPC

Liao

yang

Sino

pec M

aom

ing

BASF

-YPC

NORI

NCO

Akzo

Nobe

l

Shan

dong

Yuh

uang

Shan

dong

Che

nlong

Chan

gzho

u M

id-As

ia

Dyna

mic

Intl.

10,000 tonnes


China’s fast EO market (at 32% CAGR in 2010-13)

Driven by the strong demand for EO derivatives and import substitution by domestic producers, total capacity and actual production volume of EO in China saw an average annual growth rate of 18.2% and 14.7% during 2005-2010, respectively. By the end of 2010, total capacity and production volume of EO reached 1,153,000 tonne and 900,000 tonne respectively.

The expansion of the China EO market further accelerated after 2010. The total designed capacity of EO grew from 1,153,000tpa in 2010 to 2,654,000tpa in 2013, representing a 32.0% CAGR in 2010-2013.

Total EO capacity in China

50.0

115.3

156.6

196.6

265.4

0

50

100

150

200

250

300

2005 2006 2007 2008 2009 2010 2011 2012 2013

10,000 tonnes

Source: Company data, CCBIS research

During 2007-2013, the EO capacity utilization rate of China Sanjiang stayed well above 100%, leaving zero EO inventory. At the same time, the gross profit margin of the company was relatively stable, ranging 18.8% to 27.7% (the historical high of 27.7% in 2009 was due to extremely low oil prices while the historical low in 2013F is due to additional new capacity and low economic growth).

Total capacity and actual production volume of EO grew 18.2% and 14.7% annually during 2005-2010


30

Capacity utilization rate and gross margin of China Sanjiang

110%104%

117%110% 113% 116%

112%

23.9% 23.6%27.7%

22.8% 20.8% 21.0% 18.8%18%

28%

38%

48%

58%

68%

78%

88%

98%

108%

118%

128%

2007 2008 2009 2010 2011 2012 2013Utilization rate Gross margin


In China, there are still a number of EO projects under construction, including 100,000tpa from Dynamic International (Nanjing), 200,000tps from China Sanjiang, 400,000tpa from Far Eastern Union (Yangzhou) and 200,000tpa of Oxiranchem Chemicals (Yangzhou). Given a 2-year construction period, we expect the newly added capacity each year in 2014-15 will be less than that of 2013 (about 700,000tpa). The new addition (expected in 2014F) will represent only 15.8% increase over 2013 capacity, less than the average annual growth rate of 32% in 2010-2013. We believe the future demand in the coming two years will continue to outpace this capacity growth.

New EO projects under construction or development in China

Company Location Capacity (1,000 tonnes) Status Dynamic International Nanjing 100 Jun. 2014 (mainly for internal use) China Sanjiang Jiaxing 200 End of 2014 Jilin Bohai Jilin 60 End of 2014 Tengzhou Kaiyuan Tengzhou 60 End of 2014 Oxirainchem Yangzhou 200 1Q 2015 (mainly for internal use) Far Eastern Union Yangzhou 400 Mid. 2015 Source: CCBIS research

Expansion #1: MTO plant– a strategic move to the upstream

To ensure a stable and cost-competitive supply of ethylene, the feedstock of EO, China Sanjiang began the construction of a MTO (methanol-to-olefins) plant in October 2012 (China Sanjiang owns a 75% interest in the plant and the other 25% belongs to the chairman of China Sanjiang). MTO is primarily used to convert methanol into ethylene and propylene.

China Sanjiang MTO project

Project commencement October 2012 Project completion (expected) 1Q2015 Project input 1,800,000tpa methanol Project output 300,000tpa. ethylene and 390,000tpa of propylene Total Capex RMB2.3b ROA (expected) 20%+ Source: Company data, CCBIS research

Expected ROA for the MTO plant to exceed 20%, with a total capex of RMB2.3b


31

China Sanjiang will adopt the DMTO technology in the MTO plant. The DMTO technology is developed by Dalian Institute of Chemical Physics, and can produce 1.0 tonne of olefins using 2.5-3.0 tonnes of methanol. So far, there are four facilities in China with the DMTO technology: Shenhua Baotou, Ningbo Skyford, China Sanjiang (under construction) and Shanxi Coal Chemical (under construction).

MTO projects using DMTO technology

Company Location Methanol input (kt) Status Shenhua Baotou Baotou 1,800 In operation Zhejiang Skyford Ningbo, Zhejiang 1,800 In operation China Sanjiang Jiaxing, Jiangsu 1,800 Completed in 1Q2015 Shanxi Coal Chemical Shanxi 1,800 Completed by 2015 Source: Company data, CCBIS research

The MTO plant will not only supply 300,000tpa of ethylene to China Sanjiang (close to 80% of self-sufficiency ratio) but it also produces a new profitable product – propylene and its derivatives.

By using self-produced ethylene to replace imports, China Sanjiang can save about RMB300/tonne of EO produced, equivalent to RMB90m a year (based on 2013 output). In addition, based on the Ningbo Skyford MTO and our estimate, the MTO plant is expected to generate RMB5.6b revenue a year with an 8-10% net profit margin, which is equivalent to RMB445.2m to RMB556.5m net profit a year.

MTO – estimated profitability on full capacity utilisation

Product Output volume (tonne) Sales (RMB m) Net margin (%) Net profit (RMB m) Ethylene 300,000 2,250 8-10 180-225 Propylene 390,000 3,315 8-10 265-332 Total 5,565 445-557 Source: Company data, CCBIS research

China Sanjiang acquired a 51% equity interest in Meifu Petrochemicals and Mei Fu Port for a total consideration of RMB327m in May 2013 by capital injection. Meifu Petrochemicals is engaged in the manufacturing of propylene while Mei Fu Port provides loading and storage services for ethylene and methanol imports. We believe the two companies will create synergies between the MTO plant after its completion. The company expects the newly acquired asset to generate RMB4b of revenue and RMB120m of net profit a year.

Expansion 2: EO/EG – a strategic move to downstream

For the first four EO facilities of China Sanjiang, EO is the main product while EG is the by-product. EG produced by these four facilities is of industrial-grade, which is only secondary in terms of quality and ASP, compared with polyester-grade EG. In early 2013, China Sanjiang began construction of the fifth EO/EG facility, which allows production to be switched between EO and polyester-grade EG. The facility will be able to produce (1) EO output at a maximum level of 240,000 tonne and EG output at a minimum level of 130,000 tonne and (2) EO output at a minimum level of 100,000 tonne and EG output at a maximum level of 250,000 tonne.

Expected ROA for the fifth EO/EG plantto exzceed 33%, with a total capex of RMB1.3b


32

China Sanjiang – EO/EG project

Project commencement Early 2013 Project completion (expected) End of 2014 Project input 160,000t p.a. of ethylene Project output 100,000-240,000t p.a. of EO and 130,000-250,000t p.a. of polyester-grade EG Total capex RMB1.3b ROA (expected) Over 33% Source: Company data, CCBIS research

The fifth facility allows for flexible adjustment to the product mix in response to the market demand of EO, EG and AEO surfactants. The plant can produce 130,000 to 250,000 tpa of polyester-grade EG and 100,000 to 240,000 tpa of EO, which is expected to generate RMB375m to RMB421m of net profit a year after full utilization. The new facility also allows industrial-grade EG to be converted to polyester-grade EG, which is expected to contribute a yearly net profit of RMB15m.

Fifth EO/EG facility – estimated profit contribution on full utilisation

Product Output volume (tonne) Sales (RMB m) Net margin (%) Net profit (RMB m) EO 100,000-240,000 1,000-2,400 12 120-288 EG 130,000-250,000 1,105-2,125 12 133-255 Processing 15 Total 390-436 Source: Company data, CCBIS research

The two expansion projects – the MTO and the fifth EO/EG facility will serve as an integrated production process for EOin China Sanjiang to improve its competitiveness and profitability. Together, they help the company produce propylene and propylene derivatives, new products which are expected to become a new growth driver of the company after 2015.

An integrated EO value chain of China Sanjiang



33

Strong operating cash flow to support expansion

Under its existing business model, all EO customers are on cash on delivery term (COD) and required to pay in advance before delivery of goods while feedstock suppliers are on 90-day letter of credit term with the option to extend the settlement of the letter of credits up to one year through trust receipt arrangements.

This special feature of its business model enables the company to generate strong operating cash inflows. According to our estimates, China Sanjiang will be able to generate about RMB1.1b and RMB1.9b operating cash inflow for 2014F and 2015F. In addition, the company has RMB204m cash and RMB981m pledged deposits on hand as at the end of 1H13.

Strong operating cash inflow

162 260 266

407 467 616 640

1,174

186 295 355

266

724 622

1,083

1,885

216 49

252 173

420

1,200

2,040

800

0

500

1,000

1,500

2,000

2,500

2008 2009 2010 2011 2012 2013F 2014F 2015F

RMB m

Net Profit Cash flow from operations Capex Source: Company data, CCBIS research

Capital expenditures for the MTO project and the fifth EO/EG project are about RMB2.3b and RMB1.3b respectively, giving the aggregate capital expenditure for the company iexpected to reach RMB3.6b. Around RMB1.2b, RMB2.04b and around RMB0.36b (here is capex for the MTO project and the 5th EO/EG project, while the total capex of RMB0.8b for 2015F include the 2nd MTO project under planning) will be paid in 2013, 2014 and 2015 respectively.

Besides its strong operating cash flow, China Sanjiang has also secured sufficient bank/debt financing arrangements:

1. Onshore syndicated loan of RMB1.6b (all-in effective rate of 6.5-7.0%, 6-year)

2. Onshore short-term bond of RMB700m (all-in effective rate of 5.22%, 1-year)

3. Offshore syndicated loan of US$100m (all-in effective rate of 4.3%, 2-year)

4. Various short-term loan or trade financing facilities

Expected operating cash inflow for 2013-15F


34

Capital expenditure and source of funding for the MTO project & the 5th EO/EG

Year Capex (RMB m) Internal resources (RMB m) Bank/debt financing (RMB m) Total (RMB, m) 2013 1,200 400 800 1,380 2014 2,040 680 1,360 1,860 2015 360 120 240 360 Total 3,600 1,200 2,400 3,600 Source: Company data, CCBIS research

Although the company has already secured source of funding for capex from 2013-15F, but the gearing ratio (to equity) is expected to reach 104%, 137% and 119% for 2013F, 2014F and 2015F, respectively. Therefore, we see the possibility of fund raising in equity market sometime within next 1-2yrs.

Valuation and risks

We initiate coverage on China Sanjiang with an Outperform rating. Our target price of HK$5.35 suggests a 26.5% upside potential. We derive our target price using DCF methodology with a WACC of 10.6% and a terminal growth rate of 2.0%.

The stock is trading at 5.5x 2014F P/E and 1.3x 2014F P/B with a 2013F ROE of 32.0%.

China Sanjiang – value estimation

Risk free rate (b) 4.5% Market risk premium (c) 5.0% Equity beta (d) 1.75 Effective tax rate (f) 15.0% Target gearing (g) 30.0% WACC 10.6% DCF/share (FY13F-FY22F)(HK$) 3.95 Terminal growth rate 2.0% WACC 10.6% Discount factor (FY22F) 0.37 RMB/HK$ 0.80 DCF/share (terminal value in FY22F) (HK$) 3.06 Total DCF/share(firm value)(HK$) 7.00 Less: net debt/share 1.63 Less: minority interests/share 0.03 DCF/share(equity value)(HK$) 5.35 Source: CCBIS research, Bloomberg

The key downside risks to our target price include (1) worse-than-expected spread of the feedstock ethylene price and the EO price; (2) worse-than-expected rising of methanol price; (3) later-than-expected come on-stream of the MTO project and the fifth EO/EG project.

Our DCF-based target price of HK$5.35 suggests 26.5% upside potential


35

Business summary China Sanjiang derives revenue from ethylene oxide (86% of revenue for 1H13), AEO surfactants (9% of revenue for 1H13) and other (5% of revenue for 1H2013).

China Sanjiang – 1H13 revenue breakdown

Ethylene oxide85.8%

Surfactants8.6%

Other chemical products4.8%

Processing services0.5%

Other0.2%


EO is the keyproduct of China Sanjiang in terms of revenue contribution. As at end of 1H13, the company has four EO facilities under operation and also a 50:50 JV EO facility, with a total capacity of 330,000t p.a.

EO facilities of China Sanjiang

Facilities Capacity (tonne) Commencement date 1st phase 60,000 Jan 2006 2nd phase 60,000 Dec 2008 3rd phase 60,000 May 2011 1st phase of JV 50,000 (total 100,000) Sept 2012 4th phase 100,000 Feb 2013 Total 330,000 Source: Company data, CCBIS research

The company also owns other wholly-owned or partially-owned subsidiaries under, including Jiaxing Yongming Petrochemicals, Sanjiang Chemicals (PRC), Mei Fu Petrochemicals, Mei Fu Port, and Zhejiang Sanjiang New Materials.

China Sanjiang – shareholding structure

Source: Company data


36

China Sanjiang – key assumptions

Year ended 31 December (RMB m) FY11 FY12 FY13F FY14F FY15F EO revenue Sale volume (tonne) 166,814 201,968 350,000 350,000 350,000 ASP (RMB/tonne) 10,413 9,939 9,600 10,000 10,000 Total EO revenue 1,737 2,007 3,360 3,500 3,500 Surfactants revenue Sale volume (tonne) 13,238 7,163 21,800 21,800 21,800 ASP (RMB/tonne) 14,005 12,001 10,500 10,500 10,500 Total surfactants revenue 185 86 229 229 229 Mei Fu revenue 1,020 2,040 2,040 MTO revenue 4,174 Fifth EO/EG plant revenue 3,170 Other revenue 156 428 170 170 170 Total revenue 2,078 2,521 4,779 5,939 13,282 EO gross profit 356 458 538 595 595 GPM (%) 20.5% 22.8% 16.0% 17.0% 17.0% AEO gross profit 34 16 41 41 41 GPM (%) 18.3% 19.1% 18.0% 18.0% 18.0% Mei Fu gross profit 51 102 102 GPM (%) 5.0% 5.0% 5.0% MTO gross profit 501 GPM (%) 12.0% EO/EG gross profit 571 GPM (%) 18.0% Other gross profit 30 38 51 77 115 Total gross profit 433 530 693 827 1,937 Total GPM (%) 20.8% 21.0% 14.5% 13.9% 14.6% Source: Company data, CCBIS estimates

China Sanjiang – consolidated income statement

Year to 31 December (RMB m) 2011 2012 2013F 2014F 2015F Revenue 2,078 2,521 4,779 5,939 13,282 COGS (1,645) (1,991) (4,086) (5,112) (11,346) Gross profit 433 530 693 827 1,937 Selling, general and administrative expense (80) (164) (244) (243) (545) Operating income Other income

353 149

367 244

449 352

583 286

1,392 174

Interest expense (32) (64) (76) (116) (184) Associates gains/(losses) (4) 10 – – – Pretax income 466 557 725 753 1,381 Income tax expense (58) (90) (109) (113) (207) Net income 407 467 616 640 1,174 Minority interests 0 – (9) (26) (70) Net income avail. to common shareholders 407 467 607 614 1,104 EPS (RMB) 0.404 0.470 0.611 0.618 1.111 DPS (HK$) 0.150 0.180 0.229 0.232 0.417 Source: Company data, CCBIS estimates


37

China Sanjiang – consolidated cash flow statement

Year to 31 December (RMB m) 2011 2012 2013F 2014F 2015F Net income 407 467 607 614 1,104 Depreciation and amortisation 93 106 135 228 387 Change in working capital: (624) 191 (114) 210 307 Interest expenses 32 64 76 116 184 Interest income (32) (107) (82) (85) (96) Other non-cash adjustment 200 2 0 0 0 Cash flow from operations 76 724 622 1,083 1,885 Capex (173) (420) (1,200) (2,040) (800) Proceeds from disposal of fixed assets 0 1 0 0 0 Investment in a jointly-controlled entity (67) (45) 0 0 0 Other investment (424) (112) 0 0 0 Decrease of restricted cash (509) (137) 0 0 0 Interest income 32 107 82 85 96 Cash flow from Investing (1,140) (605) (1,118) (1,955) (704) Shares issues/(repurchases) 0 (109) 0 0 0 Increase in borrowings 3,068 3,278 2,329 3,689 4,222 Repayment of bank loans (2,426) (3,185) (1,529) (2,329) (3,689) MinoritiesI (6 ) 0 9 26 70 Dividends paid to equity owners (34) (66) (182) (184) (331) Interest paid (32) (64) (76) (116) (184) Other 184 (30) 0 0 0 Cash flow from financing 754 (176) 551 1,085 88 Net Increase in cash (311) (57) 55 214 1,271 Cash and cash equivalents at beginning of year 601 291 234 289 503 Cash and cash equivalents at end of year 291 233 289 503 1,774 Source: Company data, CCBIS estimates


38

China Sanjiang – consolidated balance sheet

Year to 31 December (RMB m) 2011 2012 2013F 2014F 2015F Net fixed assets 1,135 1,453 2,525 4,343 4,761 Intangible assets 27 26 21 17 14 Prepaid land lease payments 52 79 77 75 72 Deferred tax assets 0 3 3 3 3 Other long-term assets 164 197 197 197 197 Total long-term assets 1,379 1,759 2,824 4,635 5,048 Inventories 222 396 873 715 2,811 Accounts and notes receivable 203 92 467 228 1,327 Pledged deposits 1,002 1,139 1,139 1,139 1,139 Cash and cash equivalents 291 234 289 503 1,774 Other current assets 488 797 797 797 797 Total current assets 2,206 2,658 3,566 3,382 7,847 Total assets 3,585 4,417 6,389 8,017 12,895 Trade and bills payables 335 701 1,426 1,236 4,673 Tax payable 25 62 75 78 144 Other short-term liabilities 132 291 291 291 291 Short-term borrowings 1,436 1,529 2,329 3,689 4,222 Total current liabilities 1,928 2,583 4,122 5,294 9,329 Long-term borrowings 0 0 0 0 0 Other long-term liabilities 47 28 28 28 28 Total long-term liabilities 47 28 28 28 28 Total liabilities 1,976 2,611 4,149 5,321 9,357 Issued capital 87 81 81 81 81 Reserves 1,495 1,697 2,122 2,552 3,325 Total shareholders' equity 1,582 1,778 2,203 2,633 3,406 Minority interest 28 28 37 63 133 Total equity 1,610 1,806 2,240 2,696 3,539 Total liabilities & equity 3,585 4,417 6,389 8,017 12,895 BVPS (RMB) 1.571 1.791 2.219 2.652 3.430 Source: Company data, CCBIS estimates


39

China Sanjiang – key financial ratios

Year to 31 December 2011 2012 2013F 2014F 2015F Growth (YoY, %) Revenue growth 31.3 21.3 89.5 24.3 123.6 Gross profit growth 20.3 22.4 30.6 19.3 134.2 EBIT growth 22.6 4.0 22.4 29.9 138.6 Net profit growth 52.9 14.8 30.0 1.1 79.5 EPS growth 52.9 14.8 30.0 1.1 79.5 Margin (%) Gross margin 20.8 21.0 14.5 13.9 14.6 Operating margin 17.0 14.6 9.4 9.8 10.5 EBIT margin 24.0 24.6 16.8 14.6 11.8 EBITDA margin 28.4 28.9 19.6 18.5 14.7 Net margin 19.6 18.5 12.7 10.3 8.3 Turnovers Inventory turnover days 36.2 56.7 56.7 56.7 56.7 Receivables turnover days 21.0 21.4 21.4 21.4 21.4 Payables turnover days 59.7 95.0 95.0 95.0 95.0 Leverage ratios (%) Debt-to-asset ratio 55 59 65 67 73 Debt-to-equity ratio 123 145 186 200 273 Current ratio (x) 1.1 1.0 0.9 0.6 0.8 Quick ratio (x) 1.0 0.9 0.7 0.5 0.5 Source: Company data, CCBIS estimates

L&M Chemical (746 HK) 8 December 2013

40

Lee & Man Chemical (746 HK)

An overlooked recovering CMS leader Company Rating:


We initiate Lee & Man Chemical with an Outperform rating. Our DCF-based target price of HK$5.48 (equivalent to 10.7x 2014 P/E). We recommend accumulating the stock as it has passed the cyclical bottom and is projected to return to fast earnings growth from 2H2013. Its projected high 35.0% EPS CAGR for 2014-2015F on an improving ROE of over 17% in 2014 justifies a re-rating.

Most profitable producer of CMS in China. Lee & Man Chemical (L&M) is the only manufacturer in Jiangsu and Zhejiang which produces CMS for external clients. L&M enjoys strong cost advantages by synergizing with L&M Papers, and realizing gross profit margin of over 30% (in 2009-2015F), significantly higher than industry peers.

Market recovery and new capacity to drive future growth. The CMS market in China suffered from a downtrend from 1Q11 to 2Q13 but it has shown recovery signs amidst a 40% price hike in the past four months. L&M is building a new fluorochemicals plant in Jiangxi Province, leveraging its advantage in large CMS production capacity and a stable supply of fluorite in the area (the two key raw materials). Phase one of the new plant was put into operations in 4Q13 and is projected to contribute about Rmb300m to operating profits a year on full operation.

Good entry level at current price. Since July 2013, ASPs of CMS have risen by 40%, and we anticipate the strong YOY earnings growth in 2H2013 results will trigger market interest in the stock, which skip investor’ attention during the past two years’ cyclical earnings d t

Forecasts and valuation Year to 31 December 2011 2012 2013F 2014F 2015F Revenue (HK$m) 1,808 1,521 1,331 2,393 3,610 YoY (%) 41 (16) (12) 80 51 Net profit (HK$m) 637 362 319 422 580 YoY (%) 78 (43) (12) 32 37 Diluted EPS (HK$) 0.772 0.439 0.387 0.512 0.703 YoY (%) 78 (43) (12) 32 37 P/E (x) 5.2 9.2 10.9 8.2 6.0 P/B (x) 2.0 1.8 1.6 1.4 1.2 DPS (HK$) 0.290 0.160 0.116 0.153 0.211 Dividend yield (%) 7.2 4.0 2.8 3.6 5.0 ROE (%) 38.4 19.1 15.1 17.5 20.6 Source: Company data, CCBIS estimates



3.0

3.6

4.2

4.8

5.4

6.0

6.6

7.2


HK$

L&M Chemical HSCEI (rebased) Source: Bloomberg




41

An overlooked recovering CMS leader

The most profitable CMS producer in China

L&M derive its revenue mainly from CMS and its by-product caustic soda, accounting for 85% of its revenues in 1H13. Salt and methanol, the two major raw materials, are readily available with stable prices, and accouned for over 70% COGS in 1H2013.

L & M’s major products and applications Revenue breakdown (1H13)

Salt(NaCl)

Caustic Soda(NaOH)

Chlorine(Cl2)

Hydrogen(H2)

Dichloromethane

Chloroform

Hydrogen Peroxide

Methanol

Paper, Soup, Pharmaceuticals

Pharmaceuticals, Adhesives, Refrigerants

Refrigerant-R22, solvents

Paper, Washing powder, textile

Caustic soda

47%

CMS (Dichloromethane&Chloroform)

38%

Hydrogen peroxide

11%

Other4%


CMS(chloroform-methanol-soluble), a mixture of chloroform and dichloromethane, are mainly sold to fluorochemical manufacturers in China because chloroform is used as a precursor to produce PTFE (a synthetic fluoropolymer) and R22 (a refrigerant) while dichloromethane is used as a solvent in the production of adhesives, pharmaceuticals and R32 (also a type of refrigerant).

The CMS industry has a relatively high entry barrier (due to an ozone-depleting by-product, carbon tetrachloride (CTC), production of which requires government approval). L&M has a patented technology that converts CTC into chloroform, known as the gas-phase catalytic hydrodechlorination reaction device.

Application of dichloromethane (by volume) in China, 2012

Application of chloroform (by volume) in China in 2012

Pharmaceuticals40%

Adhesives & solvents

31%

Refrigerant (HFC-32)

22%

Other7%

R-2290%

Industrial solvents & other

10%


Salt and methanol account for over 70% of COGS

The main customers are fluorochemical manufacturers in Jiangsu and Zhejiang


42

As at the end of 2012, China has a total capacity of 2,000,000t p.a. of CMS. The top three CMS producers, Zhejiang Juhua, Shandong Dongyue and Jiangsu Meilan, produce CMS mainly for their own fluorochemicals production.

Major CMS producers and capacity in China (in 2012)

Company Location Capacity (kt) Notes Zhejiang Juhua (600160.SH) Zhejiang 280 Internal uses Shandong Dongyue (189.HK) Shandong 260 Internal uses Jiangsu Meilan Jiangsu 240 Internal uses Shandong Jinling Shandong 200 Focused on the Shandong market Shandong Luxi (000830.HK) Shandong 200 Focused on the Shandong market L&M Chemical (746.HK) Jiangsu 160 Jiangsu and Zhejiang market Shandong Jinmao Shandong 120 Focused on the Shandong market Sichuan Honghe Sichuan 100 Chongqing Meizhou Chongqin 100 Source: Company data, CCBIS research

L&M is the only manufacturer in Jiangsu and Zhejiang which produces CMS primarily for external clients. These two provinces produce the majority of fluorochemicals in China, and housing other producers such as 3F, Meilan and Arkoma, which together service a wide diversity of customers. The close proximity to major customers helps the company control the escalating transportation costs.

L&M has great synergy with its affiliate company, L&M Paper (2314 HK, Not Rated) which provides electricity and steam (RMB71m in 2012; 7% of COGS) for the company. In return, the L &M sells its by-product hydrogen peroxide to L&M Paper (RMB6m in 2012; 0.4% of revenue). The cooperation allows L&M Chemical to drive higher profitability compared with its peers. Since 2009, the company reported an average gross profit margin of above 30% significantly higher than the industry average of around 20% all over the country.

L&M – gross profit margin

29.5%

44.5%

46.7%

34.3%

28.90%

25%

30%

35%

40%

45%

50%

2009 2010 2011 2012 1H2013 Source: Company data, CCBIS research

L&M Chemical is the only CMS producer for external sales in Zhejiang & Jiangsu


43

Recovery of the CMS market in China

The costs of raw materials are usually stable due to the abundant supply of salt and methanol in China, while the prices of CMS fluctuate substantially on supply-demand dynamics. Propelled by the strong demand from downstream fluorochemical manufacturers and the closure of R22 and CMS production lines in developed countries in 2009, the ASP of dichloromethane in China was up significantly from RMB1,900/tonne in January 2009 to RMB7,000/tonne in December 2010 while chloroform ASP was up from RMB2,000/tonne to RMB8,100/tonne over the same period.

From 2Q11 to 1Q13, the ASP of dichloromethane fell to RMB2,050/tonne and RMB1,400/tonne for chloroform due to aggressive expansion of CMS producers. According to our channel check, total capacity of CMS in China increased from 1,500,000t p.a. in 2010 to 2,000,000t p.a. in 2012.

ASPs of dichloromethane ASPs of chloroform

Source: www.chemsino.com Source: www.chemsino.com

Since July 2013, ASPs of dichloromethane and chloroform were up 45.1% and 40.2% YOY respectively. This provides clues that China’s CMS marketis gradually recovering after a 2 year cyclical downturn:

1. Lower utilization rates due to environmental regulation. Since June 2013, a 120,000t p.a. facility of Shandong Jinmao and a 40,000t p.a. facility of Shandong Haihua ceased production due to environmental regulation. The overall capacity utilization rate of the industry was at 50% from January-August 2013, much lower than the 80% seen in 2012.

2. Stronger support from the increasing chlorine prices (feedstock of CMS). The ASP of chlorine has increased over 100% since August 2013 due to falling utilization rate in the chlor-alkali industry on environmental regulation and disappointing profitability of caustic soda. While L&M Chemical is a vertically integrated producer of CMS with self-produced chlorine as raw material.


44

Capacity utilization rate of the CMS industry in China Prices of chlorine in China

Source: www.chem99.com Source: www.chemsino.com

New Jiangxi plant will begin operation in 4Q13

In March 2012, L&M began the construction of a new plant in the city of Ruichang, Jiangxi. The company intends to spend RMB1.9b for the development of its fluorochemical downstream products. The first phase of the plant started operation (with a 25,000 tonnes/year AHF facility was put into operation first) in 4Q13.

Details of L&M’s Jiangxi plant

Project start End 2011 Project completion (expected) 4Q13 (Phase 1) Location Ruichang, Jiangxi Area 1,630 acres Project output (first phase) AHF: 25,000 tonnes/year (under operation)

HFC-32: 20,000 tonnes/year (in trial operation) PTFE: 7,000 tonnes/year (to be put into operation in April,2014) HFP: 2,000 tonnes/year (to be put into operation in April,2014) Caustic soda: 60,000 tonnes/year (to be put into operation in April,2014)

Total capex RMB1.9b Source: Company data, CCBIS research

The abundant supply of fluorite in Jiangxi coupled with its own CMS production allows L&M to develop more downstream fluorochemical products (fluorite and CMS being the two main raw materials), including 25kt of AHF, 20kt of HFC32, 7kt of PTFE, 2kt of HFP and 60kt of caustic soda every year:

1. HFC32 and HFC125 (easily available in the market) can be combined in a 1:1 ratio to produce R410A, an environmentally friendly refrigerant that does not contribute to ozone depletion. It is expected to replace R22 gradually from 2013.

2. The 7kt of PTFE produced is a high-end PTFE resin, applied to LCD, paints, non-sticky coatings and fiber modifiers. In China, this type of PTFE is mainly supplied by Daikin Chemicals and other global fluorine resins producers.

3. The 2kt of HFP is a fluorochemical intermediate for producing fine chemicals.

New plant with capacity of 25,000 tonnes to complete in 4Q13

http://www.chem99.com/


45

Key products of the Jiangxi plant of L&M Chemical Production capacity breakdown of the Jiangxi plant by

product

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000

AHF HFC-32 HFC-125 PTFE HFP

tonnes/year

Source: Company data Source: Company data, CCBIS research

The completed Jiangxi plant (first phase) will output about 22.5kt, 18kt of R32, 6.3kt of PTFE, 1.8kt of HFP and 54kt of caustic soda every year under the assumption of a 90% utilization rate. Based on our estimates, the plant will contribute about RMB1.57b revenue and about RMB300m operating profit a year.

Jiangxi plant—estimation of profitability and contribution

Product Output volume

(tonne)* ASP

(RMB/tonne) Revenue (RMB m)

Operating margin (%)

Operating profit (RMB m)

AHF 22,500 20,000 450 10% 45 R32 18,000 15,000 270 30% 81 PTFE 6,300 5,250 33 30% 10 HFP 1,800 1,500 3 30% 1 Caustic Soda 54,000 15,000 810 20% 162 Total 1,566 299 *Assuming 90% utilization rate; Source: Company data, CCBIS research

Strong cash flow to support the expansions plan

L&M remained in a net cash position in 2011-2012 while its outstanding bank borrowings started to exceed cash balance in 1H13 on increasing spending to construct the Jiangxi plant. Phase I of the Jiangxi plant is close to completion and is expected to start to contribute to company profit in 1H14 and thus we believe financial position will improve. We project L&M to return to net cash position in 2015F.


46

Changes in L&M’s financial positions

521

967

1,417

1,689 1,7171,917 1,984

393

1,233

1,520 1,513 1,495 1,540

2,206

0

500

1,000

1,500

2,000

2,500

Dec.2010 Dec.2011 Dec.2012 Jun.2013 Dec.2013 Dec.2014 Dec.2015

HK$m

Outstanding bank borrowings Bank balances and cash Source: Company data, CCBIS research

Valuation and risks

We initiate coverage on L&M with an Outperform rating. Our target price of HK$5.48 suggests a 30.2% upside potential. We derive our target price using DCF methodology with a WACC of 7.9% and a terminal growth rate of 1.0%.

The stock is trading at 8.2x 2014F P/E and 1.4x 2014F P/B, with a 2014F ROE of 17.5%.

L&M –value estimation

Risk free rate (b) 4.5% Market risk premium (c) 5.0% Equity beta (d) 0.9 Effective tax rate (f) 15.0% Target gearing (g) 20.0% WACC 7.9% DCF/share (FY13F-FY22F)(HK$) 2.94 Terminal growth rate 1.0% WACC 7.9% Discount factor (FY22F) 0.47 DCF/share (terminal value in FY22F) (HK$) 2.41 Total DCF/share(firm value)(HK$) 5.35 Less: net debt/share (0.13) DCF/share(equity value)(HK$) 5.48 Source: CCBIS research, Bloomberg

The key downside risks to our target price include (1) worse-than-expected ASPs of CMS, caustic soda and hydrogen peroxide; (2) later-than-expected completion of the Jiangxi plant; and (3) worse-than-expected market conditions of fluorochemicals in the next few years.



47

Business summary

L&M is located in Changshu, Jiangsu and the company manufactures CMS and its by-products, caustic soda and hydrogen peroxide.

L&M –Revenue breakdown by product in 1H13

Caustic soda47%

CMS (Dichloromethane&Chlor

oform)38%

Hydrogen peroxide11%

Other4%


As at end of 1H13, L&M had a capacity of 160kt of CMS, 120kt of hydrogen peroxide and 240kt of caustic soda.

Capacity of L&M in 1H13

Product Capacity (tonne) Commencement date 1st CMS 40,000 June 2008 2nd CMS 40,000 February 2009 3rd CMS 40,000 June 2009 4th CMS 40,000 May 2011 Hydrogen peroxide 120,000 March 2010 Caustic soda 240,000 Source: Company data, CCBIS research


48

L&M – key assumptions

Year ended 31 December (HK$m) FY11 FY12 FY13F FY14F FY15F CMS revenue Sale volume (tonne) 168,642 180,920 180,000 180,000 180,000 ASP (RMB/tonne) 5,050 2,550 2,450 3,100 3,100 Total (HK$m) 1,065 577 551 698 698 Jiangxi plant revenue AHF (HK$m) 163 183 R32 (HK$m) 281 675 PTFE (HK$m) 361 1,114 HFP (HK$m) 94 113 Caustic soda (HK$m) 163 183 Total (HK$m) 831 1,496 Caustic soda (Jiangsu) revenue (HK$m) 582 664 609 609 609 Hydrogen peroxide revenue (HK$m) 117 114 120 125 125 Other revenue (HK$m) 44 167 50 50 50 Total revenue (HK$m) 1,808 1,521 1,331 2,393 3,610 CMS (including by-products) gross profit(HK$m) 845 522 412 519 519 Gross profit margin 46.7% 34.3% 31.0% 35.0% 35.0% Jiangxi gross profit(HK$m) 273 638 Gross profit margin 30.0% 30.0% Total gross profit (HK$m) 845 522 412 792 1,157 Total gross profit margin 46.7% 34.3% 31.0% 33.1% 32.1% Source: Company data, CCBIS estimates

L&M – consolidated income statement

Year to 31 December (HK$m) 2011 2012 2013F 2014F 2015F Revenue 1,808 1,521 1,331 2,393 3,610 COGS (963) (998) (918) (1,601) (2,453) Gross profit 845 522 412 792 1,157 Selling, general and administrative expense (200) (217) (186) (335) (505) Operating income 645 306 226 457 652 Other income 55 152 206 108 108 Interest expense

55 (13)

152 (38)

206 (57)

108 (69)

108 (77)

Associates gains/(losses) 0 (0) 0 0 0 Pretax income 688 419 376 496 683 Income tax expense (51) (57) (56) (74) (102) Net income 637 362 319 422 580 Minority interests (0.0) (0.0) (0.0) (0.0) (0.0) Net income avail. to common shareholders 637 362 319 422 580 EPS (HK$) 0.772 0.439 0.387 0.512 0.703 DPS (HK$) 0.290 0.160 0.116 0.153 0.211 Source: Company data, CCBIS estimates


49

L&M – consolidated cash flow statement

Year to 31 December (HK$m) 2011 2012 2013F 2014F 2015F Net income 637 362 319 422 580 Depreciation and amortisation 105 112 140 217 256 Change in working capital (57) 106 (63) (124) (82) Interest expenses 13 38 57 69 77 Interest income (26) (64) (91) (73) (73) Other non-cash adjustment (31) 69 0 0 0 Cash Flow from operations 641 623 362 511 758 Capex (151) (424) (900) (600) (300) Proceeds from disposal of fixed assets 39 0 0 0 0 Investment in a jointly-controlled entity (0 ) (20) (0) (0) (0) Other investment (1 ) (169) (0) (0) (0) Interest income 26 64 91 73 73 Cash flow from investing (87) (548) (809) (527) (227) Shares issues/(repurchases) 0 0 0 0 0 Increase in borrowings 803 562 519 373 224 Repayment of bank loans (251) (147) (219) (173) (124) (0) (0) (0) (0) (0) Dividends paid to equity owners (248) (165) (96) (127) (174) Interest paid (13) (38) (57) (69) (77) Other (7) 0 0 0 0 Cash Flow from financing 285 212 148 5 (151) Net increase in cash 839 287 (299) (12) 380 Cash and cash equivalents at beginning of year 393 1,233 1,520 1,221 1,209 Cash and cash equivalents at end of year 1,233 1,520 1,221 1,209 1,588 Source: Company data, CCBIS estimates


50

L&M – consolidated balance sheet

Year to 31 December (HK$m) 2011 2012 2013F 2014F 2015F Net fixed assets 1,125 1,346 2,112 2,501 2,551 Intangible assets 8 7 2 0 0 Prepaid land lease payments 63 278 278 278 278 Deferred tax assets 0 0 0 0 0 Other long-term assets 14 89 89 89 89 Total long-term assets 1,210 1,722 2,481 2,865 2,909 Inventories 96 76 82 194 229 Accounts & notes receivable 294 160 237 477 600 Pledged deposits 0 7 0 0 0 Cash and cash equivalents 1,233 1,520 1,221 1,209 1,588 Other current assets 1 7 0 0 0 Total current assets 1,623 1,771 1,540 1,880 2,417 Total assets 2,834 3,492 4,021 4,744 5,326 Trade and bills payables

190

152

163

386

455

Tax payable 15 13 14 19 26 Other short-term liabilities 220 219 173 128 84 Short-term borrowings 0 7 0 0 0 Total current liabilities 425 390 350 529 555 Long-term borrowings 747 1,198 1,544 1,793 1,942 Other long-term liabilities 3 10 10 10 10 Total long-term liabilities 750 1,208 1,554 1,802 1,952 Total liabilities 1,175 1,598 1,904 2,331 2,507 Issued capital 83 83 83 83 83 Reserves 1,576 1,811 2,035 2,330 2,736 Total shareholders' equity 1,659 1,894 2,117 2,413 2,819 Minority interest 0 0 0 0 0 Total equity 1,659 1,894 2,117 2,413 2,819 Total liabilities and equity 2,834 3,492 4,021 4,744 5,326 BVPS (RMB) 2.010 2.296 2.567 2.925 3.417 Source: Company data, CCBIS estimates


51

L&M – key financial ratios

Year to 31 December 2011 2012 2013F 2014F 2015F Growth (YoY,%) Revenue growth 40.7 (15.9) (12.5) 79.8 50.9 Gross profit growth 47.1 (38.2) (21.0) 92.0 46.1 EBIT growth 30.4 8.3 (14.0) 79.8 50.9 Net profit growth 77.8 (43.2) (11.8) 32.1 37.5 EPS growth 77.8 (43.2) (11.8) 32.1 37.5 Margin (%) Gross margin 46.7 34.3 31.0 33.1 32.1 Operating margin 11.1 14.2 14.0 14.0 14.0 EBITDA margin 44.5 37.4 43.0 32.7 28.1 EBIT margin 38.7 30.1 32.5 23.6 21.0 Net margin 35.2 23.8 24.0 17.6 16.1 Turnovers Inventory days 50.0 31.4 31.4 31.4 31.4 Reveivable days 60.3 54.4 54.4 54.4 54.4 Payables days 95.5 62.6 62.6 62.6 62.6 Leverage ratios Asset/equity ratio (x) 1.7 1.8 1.9 2.0 1.9 Current ratio (x) 3.8 4.5 4.4 3.6 4.4 Gearing ratio (total borrowing/total asset, %) 34.1 40.6 42.7 40.4 37.9 Source: Company data, CCBIS estimates

Tiande Chemical (609 HK) 8 December 2013

52

Tiande Chemical (609 HK)

Glue the two together Company Rating:


We initiate Tiande Chemical with an Outperform rating. Our DCF-based target price of HK$2.64 (equivalent to 7.2x 2014 EPS) suggests 18.4% potential upside. In our view, the stock is undervalued by trading at 6.0x P/E for 2014 on a high 23.1% EPS CAGR for 2013-2015F, and being a global market leader of ECYA. The improving global economy and narrowing equity risk premium will help precipitate a re-rating of the stock.

Global leader of ECYA, a raw material of super glue. Tiande Chemical (Tiande) is the largest producer of ECYA in the world, with a capacity of 22,000 tonnes per year. The global ECYA industry is highly concentrated, with the two largest producers accounting for over 80% of market share. As a vertically integrated producer, Tiande has a relatively stable gross profit margin of 22-29% (and net profit margin of 13-17%) over the past 3 years.

Growth drivers: new capacity and new JV. . Tiande is building a new production line for sodium cyanide derivatives (is one of the key feedstocks of ECYA and is also widely used in gold mining) to catch up with the growing downstream demand (expected to be launched in 2014). In addition, the company’s JV plant (expected to be completed in 2014) with Henkel (the global leader of super glue) to produce cyanoacrylate monomers allows it to expand to the midstream of the super glue chain.

A stable growing story. We forecast Tiande’s earnings to grow at around 20% pa continuously for 2012-2015F with an impressive ROE of over 21% for 2011-2015F. The company maintains a healthy financial position with net cash position for 2015F.

Forecasts and valuation Year to 31 December 2011 2012 2013F 2014F 2015F Revenue (RMB m) 972 1,004 1,280 1,658 1,891 YoY (%) 10 3 28 29 14 Net profit (RMB m) 132 159 195 250 297 YoY (%) 2 20 23 28 19 Diluted EPS (RMB) 0.156 0.188 0.230 0.296 0.351 YoY (%) (52) 20 22 28 19 P/E (x) 10.5 8.7 7.7 6.0 5.1 P/B (x) 2.2 1.8 1.6 1.3 1.1 DPS (HK$) 0.030 0.038 0.058 0.074 0.088 Dividend yield (%) 1.5 1.9 2.6 3.3 3.9 ROE (%) 22.6 21.9 25.0 24.4 24.5 Source: Company data, CCBIS estimates



0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

1.9


HK$

Tiande Chemical HSCEI (rebased) Source: Bloomberg




53

Glue the two together

Global leader of cyanide and its derivatives – upstream of glues

Tiande is a fine chemical company that mainly engages in the production and sales of cyanide and its derivatives, representing 87% of its sales in 1H13. A major use of cyanide and its derivatives is the production of ethylcyanoacetate (ECYA), which is the main component of cyanoacrylate glue – the quick-bonding super glue used to mend or bond anything from plastics to wood to metal.

Value chain of Tiande’s products Tiande – revenue breakdown (1H13)

Cyanide and its derivatives

87%

Alcohols products

5%

Chloroacetic acid and its

derivatives2%

Fine petrochemical

products4%

Other2%


ECYA is widely used in various industries such as the adhesives, the pharmaceutical and the pesticides industries. About 60% of the ECYA globally is used to produce quick-bonding adhesives; 21% used as intermediaries in producing pharmaceuticals; and about 12% is used by agricultural, dyeing and other chemicals.

Besides ECYA, cyanide and its derivatives produced by the company also include methylcyanoacetate (MCYA) and diethyl malonate (a by-product of ECYA). MCYA is widely used for medicines, pesticides, adhesives and other chemicals while diethyl malonate is used in the production of dyes, medicines and perfumes .

Applications of ECYA Annual capacity of Tiande by product

Adhesive60%

Pharmaceutical intermediates

21%

Agricultural, dyeing and other

chemicals12%

Other7%

0

5,000

10,000

15,000

20,000

25,000

ECYA MCYA Di-ethyl malonate

tonnes/year


ECYA is the main component of quick-bonding super glues used to bond anything from plastics to wood to metal

About 60% of ECYA is used to produce adhesives


54

Tiande is the largest ECYA producer in the world, with over 50% of market share globally. As both of the two raw materials – carbonochloric acid and sodium cyanide are fatally toxic and highly regulated in terms of production and transportation, ECYA has a very high entry barrier and is a highly concentrated niche market. The two largest ECYA producers account for about 80% of the market share in the world. The company also has nearly 50% of the market share for MCYA and diethyl malonate in the world.

Breakdown of the global ECYA market

Tiande Chemical56%

Hebei Chengxin33%

Other11%


Tiande is not only a global market leader in cyanide and its derivatives but also a vertically integrated producer with self-supply of carbonochloric acid, sodium cyanide and dehydrated alcohol.

By the end of 2012, Tiande has an annual capacity of 30,000 tonnes sodium cyanide, 40,000 tonnes of carbonochloric acid and 50,000 tonnes of alcohol, enabling the company to maintain a relatively stable profitability by avoiding the fluctuation of raw material prices to some extent.

Tiande – gross and net profit margin

25.4%

22.6%

26.1%

28.3%

14.7%13.6%

15.9% 16.1%

10%

12%

14%

16%

18%

20%

22%

24%

26%

28%

30%

2010 2011 2012 1H2013Gross profit margin Net profit margin


Tiande is a vertically integrated producer of cyanide and its derivatives, with raw materials being self-supplied


55

New products of cyanide and its derivatives

Cyanide and its derivatives are a core revenue contributor of Tiande as the company launched new cyanide products targeted at downstream industries over the past few years.

From 2009-2012, revenue from cyanide and its derivatives grew at a CAGR of 19.6%, boosted by new products and higher production capacities. The new products launched over the past few years include propyl cyanoacetate, sec-octyl cyanoacetate and cyanide cyclohexyl acetate.

Tiande’s strong growth in revenue of cyanide and its derivatives

515.5

782.5 844.3 882.5

424

538

0

200

400

600

800

1,000

1,200

2009 2010 2011 2012 1H2012 1H2013

RMB m


Sodium cyanide is a key feedstock of cyanide and its derivatives and it is also widely used in the mining of gold and other precious metals. Some of this product is used internally while the remainder is sold to external clients. The company is also exploring other downstream products and has begun building a production line for newly developed products. The new products will be launched in 2014.

As at end of 2011, China has a total capacity of sodium cyanide of 380,000 tonnes per year, of which 115,000 tonnes are in solid form while the rest is in liquid form. There are 25 producers of sodium cyanide in China and only two of them (Anqing Shuguang Chemicals and Hebei Chengxin) have an annual capacity of over 100,000 tonnes.

The demand of sodium cyanide in China is expected to grow 12-15% annually for 2011-15, with a total consumption of reaching 500,000 tonnes in 2015. Driven by strong demand, the price of sodium cyanide has been rising steadily, up from US$1,076/ tonne in 2005 to US$2,185/tonne in 2011.


56

Applications of sodium cyanide ASPs of sodium cyanide in China

Gold minining48%

Non-ferrous metals

2%

Chemicals intermediates

25%

Pesticide6%

Other19%

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2,400

2005 2007 2009 2010 2011

US$/tonne


JV with Henkel Hong Kong

On 2 June 2012, Weifang Dekel Innovative Materials Co., Ltd. (Weifang Dekel) was established as a joint venture between Tiande (55%) and Henkel Hong Kong (45%).

Henkel Hong Kong is a subsidiary of Henkel AG, which is a global consumer and industrial businesses producing well-known names such as Persil, Schwarzkopf and Loctite. Henkel AG’s preferred shares are listed on the German stock index DAX and it ranks among the Fortune Global 500.

Profile of Weifang Dekel

Company Weifang Dekel Innovative Materials (Weifang Dekel) Date of establishment 2 June 2012 JV Tiande Chemical (55%) and Henkel Hong Kong (45%) Total investment amount EUR32.4m Registered capital EUR10.8m Product Cyanoacrylate monomers Capacity 20,000 tonnes per year Expected commence date Mid-2014 Source: Company data, CCBIS research

Weifang Dekel manufactures cyanoacrylate monomers using ECYA produced by Tiande, which is then sold to Henkel AG for the production of cyanoacrylate glues. This joint venture offers solution good partnership match as Tiande is a global leader of ECYA while Henkel AG is a top producer of cyanoacrylate monomers and cyanoacrylate glues.

Weifang Dekel has a designed annual capacity of 20,000 tonnes of cyanoacrylate monomers. The JV will mainly purchase its feedstock ECYA from Tiande. Prior to the JV, Henkel AG bought about 5% of Tiande’s total ECYA output. After the completion of the 20,000 tonnes facility, Henkel AG and Weifang Dekel will purchase about 5,000 tonnes of ECYA from Tiande, representing about 25% of its total output. The plant is expected to contribute over RMB60m a year to the company after fully utilization.


57

Value chain of Weifang Dekel


Weifang Dekel enables Tiande to expand from its position upstream (ECYA) to the midstream (cyanoacrylate monomers) in the production chain of cyanoacrylate glue. Although cyanoacrylate monomer is still an intermediate product used to make cyanoacrylate glues, its market size is estimated to be over ten times that of ECYA. In addition, the cyanoacrylate monomer industry is not as concentrated as the ECYA industry. We believe Weifang Dekel will lead the market easily combining the advantages of both Tiande and Henkel AG.

Low gearing ratio and enough capital for expansion

Tiande has a healthy financial position with a gearing ratio (net debts/shareholders’ equity) below 10% for 2010-1H13, while capital expenditure doubled in 2010-2012.

As at end of 1H13, the company has RMB59.5m of pledged bank deposits and cash balances. The company is also expected to generate over RMB200m cash inflow from its operating activities in the next few years (RMB211m for 2012A). The total outstanding borrowings stood at RMB96.6m at the end of June 2013.

Based on our estimate, the company’s capital expenditure (mainly used for the new sodium cyanide production line and the JV plant) will be about RMB200m every year for 2013F-15F. We believe the gearing ratio will not rise significantly in this period.

Tiande – gearing ratio

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

0

100

200

300

400

500

600

700

800

900

2010 2011 2012 1H2013

RMB m

Net debt (LHS) Shareholders' equity (LHS) Gearing ratio (RHS) Source: Company data, CCBIS research


58

Valuation and risks

We initiate coverage on Tiande with an Outperform rating. Our target price of HK$2.64 suggests a 18.4% upside potential. We derive our target price using DCF methodology with a WACC of 8.4% and a terminal growth rate of 1.0%.

The stock is trading at 5.5x/4.7x 2014E/2015E PE, and 1.2x/1.0x 2014E/2015E PB with a 2014E ROE of 24.4%.

Tiande – value estimation

Risk free rate (b) 4.5% Market risk premium (c) 5.0% Equity beta (d) 0.90 Effective tax rate (f) 25.0% Target gearing (g) 20.0% WACC 8.4% DCF/share (FY13F-FY22F)(HK$) 1.80 Terminal growth rate 1.0% WACC 8.4% Discount factor (FY22F) 0.45 DCF/share (terminal value in FY22F) (HK$) 0.87 Total DCF/share(firm value)(HK$) 2.67 Less: net debt/share (0.03) DCF/share(equity value)(HK$) 2.64 Source: CCBIS research, Bloomberg

The key downside risks to our target price include (1) worse-than-expected gross profit margins due to unexpected fluctuations in raw material and product prices; (2) later-than-expected completion of the new production line and the JV with Henkel.



59

Business summary

Tiande derive its revenue mainly from the production and sales of cyanide and its derivatives (87% of sales, 1H13). ECYA, MCYA and diethyl malonate are the key products, with ECYA accounting for over 50% of the revenue in the cyanide business.

Tiande – revenue breakdown in 1H13

Cyanide and its derivatives

87%

Alcohols products5%

Chloroacetic acid and its derivatives

2%

Fine petrochemical products

4% Other2%


As at the end of 1H13, Tiande has four subsidiaries and one 55% owned JV with Henkel Hong Kong. All production facilities of Tiande are located in Shandong Province.

Subsidiaries and JVs

Enterprises Comments Weifang Common Chem Wholly-owned subsidiary founded in 1997; produces ECYA and ethanol Weifang Parasia Chem Wholly-owned subsidiary founded in 2004; produces sodium cyanide Weifang Binhai Petro-chem Wholly-owned subsidiary founded in 2005, produces iso-butylene Shanghai Dehong Chemical Founded in 2001, trading petrochemicals Weifang Dekel Innovative Materials JV with Henkel Hong Kong, founded in 2012, produces cyanoacrylate monomer Source: Company data, CCBIS research


60

Tiande – key assumptions

Year ended 31 December (RMB m) FY11 FY12 FY13F FY14F FY15F Revenues from Cyanide and its derivatives 844 882 1,100 1,210 1,331 YoY (%) 4.5% 24.6% 10.0% 10.0% New product 20 100 150 JV revenue 188 250 Other revenue 128 121 160 160 160 Total revenue 972 1,004 1,280 1,658 1,891 Cyanide and its derivatives 167.0 206.5 257.3 308.8 339.7 Gross profit margin (%) 19.8 23.4 23.4 23.4 23.4 New product 6 30 45 Gross profit margin (%) 30.0 30.0 30.0 JV 45 90 Gross profit margin (%) 30.0 30.0 Other 53 55 82 64 55 Total gross profit 220 262 346 448 529 Total gross profit margin (%) 22.6% 26.1% 27.0% 27.0% 28.0% Source: Company data, CCBIS estimates

Tiande – consolidated income statement

Year to 31 December (RMB m) 2011 2012 2013F 2014F 2015F Revenue 972 1,004 1,280 1,658 1,891 COGS (752) (742) (934) (1,210) (1,362) Gross profit 220 262 346 448 529 Selling, general and administrative expense (57) (56) (84) (109) (124) Operating income 163 206 261 338 405 Other non-operating income 5 (0) 5 12 19 Associates 0 0 0 0 0 Interest expense (7 ) (9) (6) (17) (27) Pretax income 162 197 260 334 396 Income tax expense (29) (38) (65) (83) (99) Net income 132 159 195 250 297

Minority interests

(-)

(-)

(-)

(-)

(-) Net income avail. to common shareholders 132 159 195 250 297 EPS (RMB) 0.156 0.188 0.230 0.296 0.351 DPS (HK$) 0.030 0.038 0.058 0.074 0.088 Source: Company data, CCBIS estimates


61

Tiande – consolidated cash flow statement

Year to 31 December (RMB m) 2011 2012 2013F 2014F 2015F Earning before tax 162 197 260 334 396 Depreciation and amortisation 42 45 53 69 84 Change in working capital (74) 6 (4) (72) 12 Interest expenses 0 0 6 17 27 Interest Income (0) (0) (0) (9) (16) Tax (29) (38) (65) (83) (99) Other non-cash adjustment (8) 8 0 0 0 Cash flow from operations 92 219 266 257 394 Capex (75) (133) (200) (200) (200) Proceeds from disposal of fixed assets 27 0 0 0 0 Investment in a jointly-controlled entity (0) (48) (0) (0) (0) Other investment (0) (0) (0) (0) (0) Decrease of restricted cash (3) 13 0 0 0 Interest income 0 0 0 9 16 Cash flow from investing (51) (168) (200) (191) (184) Shares issues/(repurchases) 0 0 0 0 0 Increase in borrowings 124 104 190 324 457 Repayment of bank loans (105) (139) (57) (190) (324) Dividends paid to MI (0) (0) (0) (0) (0) Dividends paid to equity owners (32) (21) (39) (50) (59) Interest paid (7) (9) (6) (17) (27) Other 1 0 0 0 0 Cash flow from financing (18) (64) 88 67 47 Net Increase in cash 23 (13) 138 131 267 Cash and cash equivalents at beginning of year 42 64 50 188 319 Effect of foreign exchange rate changes -0.71 -0.20 0.00 0.00 0.00 Cash and cash equivalents at end of year 64 50 188 319 586 Source: Company data, CCBIS estimates


62

Tiande – consolidated balance sheet

Year to 31 December (RMB m) 2011 2012 2013F 2014F 2015F Net fixed assets 399 473 620 750 867 Intangible assets 0 0 0 0 0 Prepaid land lease & equipment payments 58 76 76 76 76 Deferred tax assets 0 0 0 0 0 Long-term Investments 12 62 62 62 62 Other long-term assets 0 0 0 0 0 Total long-term assets 470 611 757 888 1,004 Inventories 86 59 123 112 152 Accounts & notes receivable 210 211 326 369 424 Short-term investments 0 0 0 0 0 Restricted cash 13 0 0 0 0 Cash and cash equivalents 64 50 188 319 586 Other current assets 16 30 0 0 0 Total current assets 389 350 637 801 1,162 Total assets 858 961 1,395 1,689 2,167 Trade and bills payables

92

83

218

171

272

Short-term borrowings 70 57 190 324 457 Current tax liability 10 13 23 30 35 Other short-term liabilities 0 0 0 0 0 Total current liabilities 171 153 431 525 765 Long-term borrowings 39 17 17 17 17 Other long-term liabilities 18 23 23 23 23 Total long-term liabilities 57 40 40 40 40 Total liabilities 229 193 471 564 805 Issued capital 8 8 8 8 8 Reserves 622 760 916 1,116 1,354 Total shareholders' equity 630 768 924 1,124 1,362 Minority interest 0 0 0 0 0 Total equity 630 768 924 1,124 1,362 Total liabilities and equity 858 961 1,395 1,689 2,167 BVPS (RMB) 0.744 0.907 1.091 1.328 1.609 Source: Company data, CCBIS estimates

SINOPEC Engineering (2386 HK) 8 December 2013

63

SINOPEC Engineering (2386 HK)

Beneficiary of coal-to-chemicals boom Company Rating:


Initiate with Outperform and HK$13.06 target price. Our target price of HK$13.06 is based on 10.0x PE for FY14F, which is at 25% discount to the average of global EPC peers. This high technology company benefits from increasing demand from China’s coal-to-chemicals conversion trend, but trades on a low 2014 P/E of 8.7x.

China’s largest engineering services provider for oil refining and chemicals. SEG is the largest engineering company providing services to oil refining and chemicals industries in terms of revenue, with a domestic market share of 14.6%. The leadership position enables it to enjoy economy of scale of operation and high ROE of above 18% in 2013-15.

Oil refining and chemicals engineering to enjoy strong demand growth. We project the market size of oil refining and chemical engineering industry will grow at a CAGR of 20.5% from 2011-2016F. Among submarkets, new coal chemical engineering has the highest growth rate, with a 42.0% CAGR from 2011-2016F, followed by petrochemicals engineering with a CAGR of 18.0%.

Strong projects pipeline boosted by more coal-to-chemicals conversion projects. SEG has a strong project pipeline, with the backlog up to RMB101.5b in 1H13, up 33% YOY from the end of 2012. Coal-to-chemicals projects represented almost half of total new orders in 3Q2013. We expect announcement of more mega coal-to-chemicals projects to be a catalyst in near term

Forecasts and valuation Year to 31 December 2011 2012 2013F 2014F 2015F Revenue (RMB m) 30,601 38,526 43,931 50,723 59,357 YoY (%) 2 26 14 15 17 Net profit (RMB m) 3,375 3,317 4,021 4,627 5,341 YoY (%) 17 (2) 21 15 15 Diluted EPS (RMB) n.a. 1.070 1.011 1.045 1.206 YoY (%) n.a. n.a. (5) 3 15 P/E (x) n.a 8.4 8.9 8.7 7.5 P/B (x) n.a 4.0 1.8 1.6 1.3 DPS (HK$) 0.000 0.000 0.189 0.195 0.225 Dividend yield (%) 0.0 0.0 1.7 1.7 2.0 ROE (%) 136.1 42.7 21.6 19.6 18.3 Source: Company data, CCBIS estimates

Price: HK$11.30 Target: HK$13.06 (initiation) Trading data 52-week range HK$8.48-12.44 Market capitalization (b) HK$16.5b/US$2.1b Shares outstanding (m) 1,461 Free float (%) 82 3M average daily T/O (m share) 10.6 3M average daily T/O (US$m) 14.6 Expected return – 1 year (%) 15.6 Price as at close on 6 December 2013


8.5

9.0

9.5

10.0

10.5

11.0

11.5

12.0

12.5

24-May-13 30-Jun-13 6-Aug-13 12-Sep-13 19-Oct-13 25-Nov-13

HK$

SINOPEC SEG HSCEI (rebased) Source: Bloomberg




64

Beneficiary of the coal-to-chemicals boom

China’s oil refining and chemical engineering leader

SINOPEC Engineering (Group) Co., Ltd. (SEG) provides engineering services for a broad range of industries including oil refining, petrochemical, new coal chemical engineering, inorganic chemicals, and pharmaceutical chemicals. The company engages in four main services: (1) engineering, consulting and licensing; (2) engineering, procurement and construction (EPC contracting); (3) construction contracting; and (4) equipment manufacturing.

As shown in the charts below, EPC contracting and construction contracting are its top two businesses, accounting for 50% and 38% of the 1H13 revenue. Engineering services to petrochemical, oil refining and new coal chemical industries accounted for 44%, 26% and 19% of SINOPEC’s revenue in 1H13, respectively.

Revenue breakdown of SEG by segments Revenue breakdown of SEG by submarkets

10% 10% 10% 11%

52% 45% 49% 50%

36% 42% 40% 38%

2% 2% 2% 2%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2010 2011 2012 1H2013Engineering, consulting and licensing EPC ContractingConstruction Equipment manufacturing

36% 40%33% 26%

28%

37%39%

44%

5%

8% 13% 19%31%

15% 16% 11%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2010 2011 2012 1H2013Oil refining Petrochemicals New coal chemicals Other industries


The entry barriers to the oil refining and chemical engineering industry in China are high not only because the industry is capital and technology intensive but also because of the government’s certification requirements. According to ICIS Consulting, the major players in the industry include SEG, China National Chemical Engineering (CNCE), China Huanqiu, China Petroleum Engineering Co, China Petroleum Engineering & Construction (CPEC) and Wison Engineering Services Co.

As a subsidiary of Sinopec Group, SEG has over 60 years of industry experience and has developed the strongest execution capability with respect to engineering and constructing large-scale oil refining, petrochemical and new coal chemical complexes. According to ICIS Consulting, SEG ranked among the top ten global contractors in 2011 based on revenue generated from services provided to oil refining and chemical industries. SEG was also China’s largest engineering company providing services to oil refining and chemical industries in both 2010 and 2011 in terms of revenue, with a domestic market share of 14.6% in 2011, followed by CNCE (11.1%), and China Huanqiu (10.6%).

Provides EPC contracting and construction services to clients in petrochemical, oil refining and new coal chemical industries.

A leader of China’s oil refining and chemical engineering industry, with a market share of 14.6% in 2011.


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Market shares of key players of China’s oil refining and chemical industry engineering industry by revenues (2011)

SEG14.6%

CNCE11.1%

China Huanqiu10.6%

China Petroleum Engineering

7.0%Wison3.9%

Other52.8%


Market demand to grow at over 16% pa during 2011-2016F

According to CICCC, the market size of oil refining and chemical engineering industry in China recorded a CAGR of 28.8% from 2006-2011 and reached RMB348.5b in 2011.

CICCC forecasts the industry market size will increase to RMB741.0b by 2016F, representing a CAGR of about 16.3% for 2011-2016F, supported by a 15.4% CAGR in fixed asset investments set in the 12th FYP for the oil and petrochemical industry.

China’s oil refining and chemical engineering industry

335473

621732

847

1095

2246

98 138 195 243 291 349

741

0

500

1,000

1,500

2,000

2,500

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

RMB b

Fixed asset investment Market size Source: Company data, CCBIS research

The oil refining and chemical engineering industry can be divided into two sectors–

(1) the exploration and design (E&D) sector (including consulting, engineering, EPC contracting, and construction supervision) and

(2) the construction sector (including construction, equipment installation, material erection). The E&D accounted for 37.2% of the market share in 2011 while the construction sector accounted for 62.7%, in terms of revenue.

Market size of China’s oil refining and chemical engineering industry is expected to growth at a 16.3% CAGR in from 2011-2016F


66

With the increasing popularity of the EPC model in China, total revenue of the E&D business grew at a CAGR of 32.8% during 2006-2011, higher than the 28.8% CAGR of the whole oil refining and chemical market in China. We forecast E&D to continue to grow strongly ahead at a CAGR of 20.5% from 2011-2016F, higher than the 16.3% CAGR of the whole industry.

China oil refining and chemical engineering industry

31.4

129.5

329.0

67.1

219.0

412.5

0

50

100

150

200

250

300

350

400

450

2006 2011 2016Exploration and Desing companies Construction companies

2006-2011 CAGRExploration and Design: 32.8%Construction: 26.7%

2011-2016 CAGRExploration and Design: 20.5%Construction: 13.5%


New coal chemical outpaces all other submarkets

Within the E&D sector, the petrochemical industry accounted for 40.9% of the total market size of RMB129.5b in 2011, followed by the inorganic chemical industry for 24.1% and oil refining industry for 8.3% while the new coal chemical industry only accounted for 7.3% in 2011.

Breakdown of China’s oil refining and chemical engineering industry by segment (2011)

Oil refining 8%

Inorganic chemical 24%

Petrochemical41%

New coal chemical7%

Other 20%


1. New coal chemical engineering

The new coal chemical engineering recorded a CAGR of 47.0% from 2006-2011, the fastest growing subsector which contributed to the increase of the total E&D market size, up from 4.4% in 2006 to 7.3% in 2011.

Market size of exploration and design sector is expected to grow at a 20.5% CAGR during 2011-2016F

Petrochemicals accounted for 40.9% of market share among the exploration and design sector in 2011


67

CICCC (China International Chemical Consulting Corporation) forecasts that the market size of new coal chemical engineering industry will expand at a CAGR of 41.6% from 2011-2016, reaching RMB90b by 2016F. We estimate that the market size of new coal chemical engineering by E&D will grow at a CAGR of 42.0% from 2011-2016F.

The market size of new coal chemicals growing rapidly

1.38 2.43 3.905.88

8.04 9.48

54.73

0

10

20

30

40

50

60

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

RMB b


The fast-growing new coal chemical industry is driven by government policy and supported by the abundant coal supply in China. The development of new coal chemical industry is a key measure for China to diversify its petrochemical feedstock. New coal chemicals include coal-to-olefins (CTO), coal-to-natural gas (CTG), and coal-to-liquids (CTL).

As at the end of 2011, China has four CTL units and four CTO units. The total production capacity of CTL and CTO projects reached about 1.6 tpa and 1.5 tpa. These projects are located in the Inner Mongolia, Henan, Shanxi and Ningxia.

Projects proposed or under construction in the new coal to chemical industry Project Capacity (end of 2011) New added capacity 2012-2016) Total investment (RMB b) CTO 1.5m tonne 15.7m tonne 391.5 CTL 1.6m tonne 19.2m tonne 250.0 CTG 0 81.5b m3 534.0 Total 1175.5 Source: CCBIS research

According to CICCC, total investment of projects proposed or under construction during 2012-16 will exceed RMB1t. Taking into account the stages of project implementation, completed investment is expected to reach about RMB618b in total.

Assume a 65% of market share by E&D, total new added market size of the new coa-to-l chemical engineering will reach RMB200b in 2012-2016F.

2. Petrochemical engineering

The petrochemical engineering segment within the E&D recorded a CAGR of 27.6% from 2006-2011 in terms of market size, slightly lower than the 32.8% CAGR of the whole E&D sector.


68

CICCC forecasts that the market size of petrochemical engineering industry will expand at a CAGR of 15.2% from 2011-2016F, reaching RMB241b by 2016F. We estimate that the market size of petrochemical engineering by E&D will grow at a CAGR of 18.0% from 2011-2016F

Market size of petrochemical engineering

15.623.6

35.340.8

48.152.9

121.02

0

20

40

60

80

100

120

140

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

RMB b


The rapid development of the Chinese economy has led to a strong demand growth for ethylene, a basic petrochemical raw material for various industrial intermediaries, such as ethylene oxide or glycol. The ethylene production capacity in China had a CAGR of about 9.3% from 2006-2011 or 15.4 mtpa by 2011. However, China’s ethylene self-sufficiency ratioe (domestic production divided by domestic ethylene equivalent consumption) was only at 49.5% in 2011, indicating strong needs for imports.

Supply and demand of ethylene in China (mtpa)

9.8 10 1012.1

15.2 15.4

9.2 10.3 10 10.7

14.215.5

19.621.1 21

25.9

29.631.3

0

5

10

15

20

25

30

35

2006 2007 2008 2009 2010 2011Ethylene production capacity Ethylene production Ethylene production


To increase the domestic olefin capacity and self-sufficiency ratio set in the 12th FYP, the construction or expansion of seven steam-cracking ethylene projects need to be completed during 2012-16 to add a 5.7tpa capacity in total, forecast by CICCC.


69

3. Oil refining engineering

The submarket of oil refining engineering within the E&D sector recorded a CAGR of 10.4% from 2006-2011, much lower than the 32.8% CAGR of E&D.

CICCC forecasts that the market size of the petrochemical engineering industry will expand at a CAGR of 5.1% from 2011-2016, reaching RMB27.6b by 2016F. We estimate that the market size of petrochemical engineering will grow at a CAGR of 6.0% from 2011-2016F.

Market size of oil refining engineering

6.6

8.4

10.14

11.52 11.710.78

14.43

0

2

4

6

8

10

12

14

16

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

RMB b


New coal-to- chemicals, petrochemicals and oil refining engineering contributed about 89% of SEG’s total revenue in 1H13. In particular, the contribution from new coal chemical engineering to total revenue of SEG is much higher than that of the whole oil refining and chemical engineering market, reaching 19% in 1H13 (compared with 7.3% of the whole industry). In contrast, petrochemical engineering revenue to total E&D revenue recorded a steady growth from 28% in 2010 to 44% in 1H13.

Strong project pipeline and stable margin

As at the end of 2012, SEG’s backlog (total estimated contract value of work to be completed) was RMB76.05b, representing a 17.9% CAGR from 2010-2012. Due to higher EPC contracting, the backlog rose to RMB101.5b by 1H13, up 33.4%.

In addition, taverage contract value amounted to RMB45.08b in 1H13, up 244.2% compared with RMB13.10b in 2012, reflecting accelerated large scale construction activities in the industry, which can benefit the industry leader, SEG..

Projects with new contracts signed in 1H13 (selected) Projects EPC contract value (RMB b) The DMTO-II unit for the 700ktpa coal-to-olefin project of Pucheng Clean Energy Chemical Co. 2.398 The 300ktpa polyethylene project and the 390ktpa polypropylene project of Zhejiang Xingxing New Energy Co. 1.819 The tank farm project for Shandong LNG receiving terminal project of Sinopec Qingdao LNG Co. 1.665 The 400ktpa phenol-acetone project of Shanghai Sinopec Mitsui Chemical Co. 1.23 The USA PTA and PET project US$1.15b The Engineering, Procurement, Construction, Commissioning(“EPCC”) contract for the Kazakhstan KPI project US$1.85b Source: CCBIS research


70

SEG maintained a stable backlog/sales ratio at 1.8x-2.4x in 2010-2012 due to stable revenue generation. We believe that SEG can maintain the ratio at about 2.0x.

SEG – backlog-to-sales ratio

1.8

2.4

2.0

0.0

0.5

1.0

1.5

2.0

2.5

2010 2011 2012 Source: Company data, CCBIS research

Over the past years, SEG maintained a relatively stable gross profit margin at 14.0-17.0% while its operating margin stayed with a narrow rangeof 10.0-12.0%, despite a slowing Chinese economy.

SEG – gross and EBIT margin

15.2%

16.6%

14.3%

11.1%11.9%

10.1%

8%

9%

10%

11%

12%

13%

14%

15%

16%

17%

18%

2010 2011 2012Gross margin EBIT margin



71

Valuation and risks

We initiate coverage on SEG with an Outperform rating. Our target price of HK$13.06 suggests 15.6% upside potential. We derive our target price using 10.0x P/E for FY2014F, at 25% discount to the average of global EPC peers. This reflects its lower earnings growth in 2013-14. Our estimated net income growth of 21%/15% for SEG in 2013-14 is lower than the global peer average of 21%/22% for the same period.

Peers comparison

P/E (x) P/B (x) Company FY13 FY14 FY15 FY13 FY14 FY15 Sinopec Engineering Group 2386 HK 8.9 8.7 7.5 1.8 1.6 1.3 Chinese competitors China National Chemical Engineering 601117 CH 10.7 8.9 7.3 1.9 1.6 1.3 East China Engineering 002140 CH 27.5 19.9 15.7 5.9 5.0 3.9 Regional competitors Ctci Corp 9933 TT 16.8 15.0 12.8 1.8 1.8 1.8 Engineers India Ltd ENGR IN N/A 9.3 8.9 2.2 2.1 1.9 Europe and US competitors Technip SA TEC FP 14.7 12.0 9.9 1.9 1.7 1.5 Saipem SpA SPM IM N/A 14.2 9.4 1.6 1.4 1.3 Tecnicas Reunidas SA TRE SM 15.9 14.3 13.1 4.4 3.8 3.4 Fluor Corporation FLR US 19.4 17.8 15.1 3.2 2.8 2.4 Average 16.3 13.3 11.1 2.7 2.4 2.1 Source: CCBIS research, Bloomberg

The stock is trading at 8.9x/8.7x 2013E/2014F P/E, and 1.8x/1.6x 2013E/2014F P/B with a 2014E ROE of 19.6%.

The key downside risks to our target price include (1) worse-than-expected margins due to increasing labor, materials and other costs; (2) less-than-expected new projects contracted in the future, and (3) Heavy dependence on a few key customers, including its controlling stakeholder, Sinopec.

Fair value estimated at HK$13.06


72

Business summary

SEG is one of the largest oil refining, petrochemical and new coal chemical engineering companies in China. Its petrochemicals, oil refining and new coal chemicals are the top three business segments, contributing 44%, 26% and 19% of revenue in 1H13, respectively.

In terms of services provided, ECP contracting, construction and engineering consulting are its top three segments, contributing 50%, 38% and 10% of revenue respectively in 1H13.

Revenue breakdown of SEG by segments (1H13) Revenue breakdown of SEG by submarkets (1H13)

Oil refining26%

Petrochemicals 44%

New coal chemicals

19%

Other industries11%

Engineering, consulting and

licensing10%

EPC contracting50%

Construction38%

Equipment manufacturing

2%


SEG was listed on the Hong Kong Stock Exchange on 24 May 2013. SEG’s predecessor, Sinopec Engineering (also known as SE), was established in July 2007 and was 100% held by Sinopec Group. SE acted as a platform under Sinopec Group for providing engineering services for oil refining, petrochemicals and other related industries. SE and Sinopec were reorganized in 2012 – Sinopec Group transferred its 100% equity interest in nine subsidiaries (including SGEC which was wholly-owned by LPEC) under its oil refining and chemical engineering business segment to SE.


73

Shareholding structure of SEG



74

SEG – key assumptions

Year to 31 December (RMB m) 2011 2012 2013F 2014F 2015F Total revenue Oil refining 12,301 12,556 13,184 13,844 14,536 YoY growth (%) 2.1 5 5 5 Petrochemicals 11,193 15,036 17,743 20,936 24,705 YoY growth (%) 34.3 18 18 18 New coal chemicals 2,582 4,928 6,998 9,937 14,110 YoY growth (%) 90.9 42 42 42 Other industries 4,525 6,006 6,006 6,006 6,006 COGS Subcontracting costs 9,654 12,466 14,211 16,627 19,952 % of revenue 31.5 32.4 32.3 32.8 33.6 Material and equipment costs. 8,200 12,662 14,561 17,036 20,103 % of revenue 26.8 32.9 33.1 33.6 33.9 Employee benefits. 3,576 3,940 4,531 5,346 6,148 % of revenue 11.7 10.2 10.3 10.5 10.4 Project management costs 1,371 1,355 1,355 1,355 1,355 % of revenue 4.5 3.5 3.1 2.7 2.3 Machinery costs 742 967 1,112 1,279 1,471 % of revenue 2.4 2.5 2.5 2.5 2.5 Other costs 1,983 1,609 1,609 1,609 1,609 % of revenue 6.5 4.2 3.7 3.2 2.7 Gross profit 5,074 5,528 6,552 7,470 8,719 Gross profit margin (%) 16.6 14.3 14.9 14.7 14.7 Source: Company data, CCBIS estimates

SEG – consolidated income statement

Year to 31 December (RMB m) 2011 2012 2013F 2014F 2015F Revenue 30,601 38,526 43,931 50,723 59,357 COGS (25,526) (32,998) (37,379) (43,252) (50,638) Gross profit 5,074 5,528 6,552 7,470 8,719 Selling, general and administrative expense (1,433) (1,740) (1,641) (1,895) (2,217) Operating income 3,641 3,788 4,911 5,576 6,502 Other income 79 85 81 81 81 Other gains/(losses) 5 (42) 0 0 0 Associates (9) 15 0 0 0 Interest income 672 526 460 634 790 Interest expense (143) (121) (91) (121) (252) Pretax income 4,244 4,252 5,361 6,170 7,121 Income tax expense (869) (935) (1,340) (1,542) (1,780) Net income 3,375 3,317 4,021 4,627 5,341 Minority interests (0) (0) (0) (0) (0) Net income avail. to common shareholders 3,375 3,317 4,021 4,627 5,341 Weighted avg. No. of shares (m) na 3100 3976 4428 4428 EPS (RMB) na 1.070 1.011 1.045 1.206 DPS (HK$) na na 0.189 0.195 0.225 Source: Company data, CCBIS estimates


75

SEG – consolidated cash flow statement

Year to 31 December (RMB m) 2011 2012 2013F 2014F 2015F Net income 3,375 3,317 4,021 4,627 5,341 Depreciation and amortisation 449 699 733 790 838 Change in working capital: (1,906) (1,355) (2,039) 3,501 (3,822) Interest expenses 143 121 91 121 252 Interest income (672) (526) (460) (634) (790) Other non-cash adjustment 300 (700) 0 0 0 Cash flow from operations 1,689 1,556 2,346 8,406 1,818 Capex (360) (1,200) (1,000) (1,000) (1,000) Proceeds from disposal of fixed assets 27 0 0 0 0 Investment in a jointly-controlled entity (0) (48) (0) (0) (0) Other investment (1,500) (430) (0) (0) (0) Decrease of restricted cash 16 13 0 0 0 Interest income 672 526 460 634 790 Cash flow from investing (1,817) (1,665) (540) (366) (210) Shares issues/(repurchases) 0 0 11,155 0 0 Increase in borrowings 124 104 1,157 2,157 3,157 Repayment of bank loans (105) (139) (157) (1,157) (2,157) Dividends paid to equity owners (351) (374) (603) (694) (801) Interest paid (143) (121) (91) (121) (252) Other 310 (149) 0 0 0 Cash flow from financing (184) (644) 11,461 185 (53) Net Increase in cash (313) (753) 13,267 8,225 1,555 Cash and cash equivalents at beginning of year 5,923 5,575 4,822 18,089 26,314 Effect of foreign exchange rate changes (34) (0.20) 0.00 0.00 0.00 Cash and cash equivalents at end of year 5,575 4,822 18,089 26,314 27,870 Source: Company data, CCBIS estimates


76

SEG – consolidated balance sheet

Year to 31 December (RMB m) 2011 2012 2013F 2014F 2015F Net fixed assets 3,463 3,834 4,201 4,508 4,763 Intangible assets 528 477 477 477 477 Prepaid land lease and equipment payments 2,010 2,867 2,766 2,670 2,576 Deferred tax assets 893 794 794 794 794 Long-term investments 99 107 107 107 107 Other long-term assets 0 0 0 0 0 Total long-term assets 6,993 8,079 8,345 8,555 8,717 Inventories 495 747 748 1,054 1,148 Accounts & notes receivable 4,809 6,074 7,039 7,663 9,795 Short-term investments 0 0 0 0 0 Restricted cash 37 24 24 24 24 Cash and cash equivalents 5,575 4,822 18,089 26,314 27,870 Contracts in process 4,569 4,584 4,584 4,584 4,584 Other current assets 21,926 12,799 12,799 12,799 12,799 Total current assets 37,412 29,051 43,284 52,438 56,219 Total assets 44,404 37,130 51,629 60,994 64,937 Trade and bills payables

6,635

8,366

7,208

11,597

9,951

Short-term borrowings 49 157 1,157 2,157 3,157 Tax payable 1,039 195 280 322 372 Amounts due To contract work 6,568 6,242 6,242 6,242 6,242 Other short-term liabilities 23,598 11,802 11,802 11,802 11,802 Total current liabilities 37,890 26,762 26,689 32,120 31,524 Long-term borrowings 0 0 0 0 0 Pension/postretirement liabilities 3,374 2,878 2,878 2,878 2,878 Other long-term liabilities 407 409 409 409 409 Total long-term liabilities 3,781 3,286 3,286 3,286 3,286 Total liabilities 41,671 30,049 29,976 35,407 34,810 Issued capital/paid-in capital 400 3,100 14,255 14,255 14,255 Reserves 2,330 3,978 7,396 11,329 15,868 Total shareholders' equity 2,730 7,078 21,651 25,584 30,123 Minority interest 3 3 3 3 3 Total equity 2,733 7,081 21,654 25,587 30,126 Total liabilities and equity 44,404 37,130 51,629 60,994 64,937 No. of shares outstanding (m) n.a. 3100 4428 4428 4428 BPS (RMB) n.a. 2.283 4.890 5.778 6.803 Source: Company data, CCBIS estimates


77

SEG – key financial ratios

Year to 31 December 2011 2012 2013F 2014F 2015F Growth (YoY, %) Revenue growth 2.4 25.9 14.0 15.5 17.0 Gross profit growth 11.8 8.9 18.5 14.0 16.7 Operating profit growth 12.7 4.0 29.6 13.5 16.6 NP growth 16.8 (1.7) 21.2 15.1 15.4 EPS growth 16.8 (1.7) 21.2 15.1 15.4 Margin (%) Gross margin 16.6 14.3 15.2 14.2 14.1 Operating margin 11.9 9.8 10.8 9.7 9.7 EBITDA margin 15.8 13.0 13.5 14.3 14.4 Net margin 11.0 8.6 8.7 9.3 9.5 Turnovers Inventory turnover days 5.7 6.9 7.3 7.6 7.9 Trade and notes receivables days 50.3 51.6 54.5 52.9 53.7 Trade and bills payables days 85.4 83.0 76.0 79.3 77.7 Leverage ratios (x) Asset/equity ratio 16.2 5.2 2.4 2.4 2.2 Current ratio 1.0 1.1 1.6 1.6 1.8 Quick ratio 1.0 1.1 1.6 1.6 1.8 Net gearing ratio (%) (80.2) (25.6) (64.4) (83.8) (72.6) Source: Company data, CCBIS estimates

China Lesso (2128 HK) 8 December 2013

78

China Lesso (2128 HK)

The pipes picked a pole position Company Rating:


We initiate on China Lesso with an Outperform rating. We expect the company may surprise the market positively with its stronger than expected demand growth from the northern region in 2H13 due to renovation of oil pipes, which may trigger investor interest in the stock. We estimate the target price to be HK$6.37, based on an estimated 9x 2014 P/E, almost in line with the average of listed producers of plastic pipes in China/Taiwan (9.7x 2014 P/E).

Demand growth for plastic pipes in China will exceed 10% pa in the next 5-10 years. Demand for plastic pipes in China grew at an average annual rate of over 20% in 2005-12. With an anticipated higher pace of urbanisation rate under China’s new leadership, we conservatively estimate an average 10% pa in 2013-2020 on increasing government investment on municipal pipe network and water conservancy construction. This will provide a potent long term demand driver for Lesso, which enjoys competitive cost advantage due to its larger scale of production.

Gaining market share amid industry consolidation. The plastic pipe industry in China is undergoing consolidation due to intense competition along the coastal areas. Despite this, China Lesso has been expanding market share (with better product quality and cost advantage), which we forecast to rise from 9.9% in 2012 to 11% in 2015.

Impressive ROE and healthy position. China Lesso’s high ROE of over 21% (in 2011-15) and expanding net cash position will enable it to take advantage of new opportunities during China’s accelerating urbanization plan.

Forecasts and valuation Year to 31 December 2011 2012 2013F 2014F 2015F Revenue (RMB m) 10,143 10,891 13,897 15,131 17,136 YoY (%) 32 7 28 9 13 Net profit (RMB m) 1,261 1,238 1,588 1,733 1,976 YoY (%) 11 (2) 28 9 14 Diluted EPS (RMB) 0.412 0.404 0.519 0.566 0.646 YoY (%) 11 (2) 28 9 14 P/E (x) 10.4 10.6 8.2 7.5 6.6 P/B (x) 2.6 2.2 1.8 1.5 1.3 DPS (HK$) 0.120 0.120 0.155 0.169 0.193 Dividend yield (%) 2.2 2.2 2.9 3.2 3.6 ROE (%) 29.4 22.7 23.9 21.6 21.0 Source: Company data, CCBIS estimates

Price: HK$5.34 Target: HK$6.37 (initiation) Trading data 52-week range HK$3.42-6.18 Market capitalization (b) HK$16.3b/US$2.1b Shares outstanding (m) 3,061 Free float (%) 31 3M average daily T/O (m share) 4.2 3M average daily T/O (US$m) 2.6 Expected return – 1 year (%) 19.3 Price as at close on 6 December 2013


3.03.33.63.94.24.54.85.15.45.76.06.3


HK$

China Lesso HSCEI (rebased) Source: Bloomberg




79

The pipes picked a pole position

The largest producer of plastic pipes in China

China Lesso is engaged in the production of plastic pipes and pipe fittings that are widely used for water supply, drainage, power supply, telecommunications and gas supply. The raw materials for production include PVC, PE, PP-R and other plastic resins. In 1H13, sales of plastic pipes used for water supply and drainage accounted for 78.3% of total revenue, followed by power supply and telecommunications which accounted for 17.2% of total revenue. 65.6% of the pipes sold in 1H13 were PVC pipes.

China Lesso’s products and application areas Revenue breakdown by product type(1H13)

Water supply40%

Drainage38%

Power supply & telecommunication

17%

Gas2%

Other3%


As at the end of 2012, China Lesso had an annual capacity of 1.75m tonnes with a total sales volume of 1.09m tonnes. In terms of production volume, China Lesso is the largest plastic pipes producer in China, with a 10% of market share. China had a total production volume of about 11m tonnes in 2012.

The China plastic pipe market is very fragmented. Only 20 out of the 5,000 producers have a capacity of over 150,000 tonnes per year. China Lesso’s capacity of 1.75m positions it as China’s leading manufacturing in the industry, ahead of , Yonggao, Gudi and Weixing which only sold 240,000 tonnes, 150,000 tonnes and 98,880 tonnes of pipe products in 2012 respectively.

China Lesso controls around 10% market share in China


80

Production volume of leading plastic pipe producers in China (2012)

Market share of major plastic pipe producers (2012)

1,085,000

240,000 150,000

98,880 80,553 25,000

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

China Lesso Yonggao Gudi Weixing Cangzhou Nachuang

tonne

China Lesso10%

Yonggao2% Gudi

1% Weixing1%

Cangzhou1%

Other85%


Increasing demand for plastic pipes

The total demand for plastic pipes in China reached 11m tonnes in 2012, significantly higher than the 5.1m tonnes in 2009 and 2.2m tonnes in 2005. The CAGR for plastic pipe demand in China was 23.4% for 2005-2009 and 29.2% for 2009-2012, exhibiting a rising momentum in recent years due to higher consumption and investment activities. China’s demand growth for plastic piples far exceeds the global average, which grew at CAGR of 6% for 2006-2012 (reaching 20m tonnes in 2012).

Demand for plastic pipes in China


Demand for plastic pipes in China grew much faster than the global average over past few years, mainly because:

1. Urbanization and increased investment on infrastructure and property. According to the National Bureau of Statistics, China recorded a CAGR of 25.1% for fixed assets investment and a CAGR of 24.1% for property investment during 2004-2008, which boosted demand for plastic used to transport for water, gas and electricity.

The demand for plastic pipes grew at over 20% pa, far exceeding global average of 6%. Output of pipes (10,000t) YoY


81

Fixed asset investment (RMB100m, left) and its YoY growth (%, right)


2. Replacing pipes made from traditional materials. The use of plastic pipes is encouraged by the government in recent years due to their better quality and lower cost compared with steel and cement pipes. In 2005, plastic pipes accounted for about 60% of urban water supply pipes and about 70% of rural water supply pipes sold in China. Under the 2015 Development Planning Outline for Chemical Materials Industry, the government required 85% of the urban water supply pipes and 90% of the water supply pipes in rural China to be made of plastic by 2015.

Percentage of plastic pipes by usage

70

60

80

70

30

20

85 8590 90

50

40

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Drainage pipes forbuilding

Water supply pipesfor buildings

Protective ducts forcable

Rural water supplypipes

Urban drainagepipes

Urban gas supplypipes

2005 2015 Source: Company data, CCBIS research

We forecast that annual demand growth for plastic pipes will exceed 10% in 12th FYP due to:

3. Acceleration in the construction and repair of municipal water pipe network. The China plastic pipe industry will produce 185,000km of municipal water supply pipes and repair 92,300 km of old water supply pipes during 2011-2015F. According to the Accelerating the Development of Energy-Saving Environmental Protection Industry Views in 2012, the State Council also suggested speeding up sewage pipe network construction to manufacture 160,000km of new sewage pipes during 2011-2015. The total length of urban water pipe networks in China will increase 78.7% from 556,732km in 2010 to 993,032km in 2015, representing a 2011-2015 CAGR of 12.3%.

The demand growth for plastic pipes in China will exceed 10% in the 12th FYP


82

Length of urban water pipe networks in China will gather expansion momentum

379430 447 480 516 556

993

0

200

400

600

800

1,000

1,200

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

km


4. Heavier agricultural irrigation and water conservancy construction. Plastic pipes have prominent advantages in water resources conservancy, especially for agricultural irrigation, drainage and drinking water supply in remote rural areas. The Chinese government is speeding up the water conservancy construction, targeting to invest RMB1.8t in the projects over 2011-2015, or 2.6 times of the total spending in 2005-2010. According to Ministry of Water Resources, agricultural irrigation and water conservancy will account for 20% of the RMB1.8t investment, implying an investment CAGR of 21% in 2011-2015F for agricultural irrigation and water conservancy.

Investment on water resources in China

6,923

18,000

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

20,000

2005-2010 2011-2015

RMB100m


Gaining market share amid industry consolidation

As at end of 2012, there were more than 5,000 plastic pipe producers in China, of which only about 20 producers had a capacity more than 150,000 tonnes per year. There were fewerthan ten producers with a production volume of over 100,000 tonnes a year.


83

The plastic pipe industry in China is more fragmented than in Europe and the US. The top ten players in China occupied less than 30% of the market by the end of 2012 compared with over 50% for the top ten players in the Europe and US market. Plastic pipe producers in China are restricted to a transportation radius of about 400-700km yet most of them are clustered around Guangdong, Zhejiang and other coastal areas, causing significant competition that forced industry consolidation in the past few years. We see leading players expanding their capacity and building national sales network production bases while smaller players are crowded out.

China Lesso – strategic network of production bases


In 1H13, China Lesso had 14 major production base and another 3 under construction. The company also has an extensive national sales network with about 1,600 independent distributors.

Company comparison

Company China Lesso Yonggao Gudi Capacity (‘000 tonnes, as at 2012) 1,750 300 200 Production volume (‘000 tonnes, as at 2012) 1,085 237 150 Number of production base 14 7 8 Main market (revenue contribution) Southern (60.3%) Eastern (66.1%) Central China (40.4%) Independent distributors 1,600 800 – Diameters of pipes 16-3,000mm 16-2,400mm – No. of patents – 198 50 Revenue (RMB m, 1H13) 5,692 1,309 845 Gross profit margin (1H13) 26.2% 26.4% 20.4% Source: Company data, CCBIS research

China Lesso expanded its production volume aggressively over the past few years, which grew at a CAGR of 30.6% in 2008-2012, higher than the industry average of 24.5%, helping it to lift market share from 8.1% in 2008 to 9.9% in 2012.

The company has also expanded its presence from southern China to other regions, such as southwestern China, eastern China and northern China through a strategic network of production base nationwide.

Based on our estimate, its production volume will grow at a CAGR of 13.5% for 2013-15, still higher than the CAGR of 10.5% for the whole industry for the same period. We believe China Lesso will continue to increase its market presence through industry consolidation to reach about 11% by 2015.


84

Production output of China Lesso Production volume growth for China Lesso by region

373,176

566,260

789,339

960,830

1,085,369

8.1%

9.6% 9.4%

9.6%9.9%

4%

5%

6%

7%

8%

9%

10%

11%

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

2008 2009 2010 2011 2012

tonne

China Lesso production volume (LHS) Market share (RHS)

69.8%60.3%

9.2%10.8%

9.1%9.9%

3.2%5.0%

5.1%6.7%

1.7% 3.4%1.4% 2.0%0.5% 1.9%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2009 2012Southern China Southwestern China Central China Eastern ChinaNorthern China Northestern China Northeastern China Overseas


Stable margin and strong operating cash flow

The main raw materials for plastic pipes are plastic resins such as PVC, PE and PP-R, which are manufactured from coal or petrochemical intermediates. The prices of plastic resins fluctuated significantly in recent years as a result of changes in coal and crude oil prices. Cost of raw materials accounts for about 90% of COGS in general, and PVC accounts for about 60% of the total cost of raw materials because over 65% of plastic pipes sold by China Lesso are PVC pipes.

The spot price of PVC in China rose from RMB7,000 per tonne in December 2009 to RMB8,200 in June 2011.

Despite significant fluctuations in raw material prices, the profitability of China Lesso remained relatively stable over the last few years. The gross profit margin stood at 22.8%-26.4% while its EBITDA margin ranged from 16.2% to 19.5%.

China Lesso – margins retreating but above industry average

22.8%

26.4%

24.2% 24.3%

15.3%

17.9%

15.0%13.9%

16.7%

19.5%

16.7% 16.2%

12%

14%

16%

18%

20%

22%

24%

26%

28%

2009 2010 2011 2012Gross Margin EBIT Margin EBITDA Margin



85

Trade receivable days and inventory turnover days also remained stable at a healthy level. The company’s operating cash inflow remained above its capex during 2009-12. The company’s gearing ratio (total borrowing/total asset) has stayed at a level lower than 30% during 2010-12.

China Lesso – operating efficiency

608 650

1,391 1,280

587 525

991 1,068

23

27 26 29

59 61 58

68

12 1510

16

0

10

20

30

40

50

60

70

80

0

200

400

600

800

1,000

1,200

1,400

1,600

2009 2010 2011 2012

RMB m

Operating Cash Flow (LHS) Capex (LHS) Trade receivable days (RHS)Inventory turnover days (RHS) Payable days (RHS)



86

Valuation and risks

We initiate coverage on China Lesso with an Outperform rating. Our target price of HK$6.37 is derived based on P/E methodology and a 9.0x 2014F P/E, at 7% discount to the average of regional plastic pipes producers. Low P/B value, strong cash position, high ROE and a stable earnings growth, underpinned by China’s sustained urbanisation program will trigger investor interest in the stock.

Peers comparison

P/E (x) P/B (x) Company FY13 FY14 FY15 FY13 FY14 FY15 CHINA LIANSU (OW)* 2128 HK 8.2 7.5 6.6 1.8 1.5 1.3 ZHEJIANG WEIXI-A (NC) 002372 CH 15.5 12.3 9.9 2.3 2.2 1.9 CHINA GEN PLAST (NC) 1305 TT 10.1 10.3 11.1 1.2 1.1 1.1 YONGGAO CO LTD-A (NC) 002641 CH 9.6 8.6 10.4 1.1 1.7 1.5 Average 10.9 9.7 9.5 1.6 1.6 1.4 Source: CCBIS research, Bloomberg

The key downside risks to our target price include (1) worse-than-expected growth of sales volume due to competition; (2) worse-than-expected gross profit margin due to fluctuation in raw materials prices; and (3) higher-than-expected increase in operating expenses due to more production bases.

Business summary

China Lesso was established in Shunde, Guangdong in 1996 and is mainly engaged in the production and sales of plastic pipes and pipe fittings. In 1H13, 65.6% of revenue came from pipes manufactured from PVC resins, while the rest were manufactured from PE, PP-R and other plastic resins. In term of end users, 40.3% of plastic pipes sold by China Lesso were used for water supply while 38.0% were used for drainage, followed by power supply, telecommunication, gas supply and other.

1H13 revenue breakdown by application areas 1H13 revenue breakdown by product type

Water supply40%

Drainage38%

Power supply & telecommunication

17%

Gas supply2%

Other3%

PVC66%

Non-PVC34%

Source: Company data, CCBIS research=


Target price of HK$6.37


87

China Lesso – key assumptions

Year ended 31 December (RMB m) FY11 FY12 FY13F FY14F FY15F Plastic pipes revenue PVC pipes sale volume (tonne) 753,777 855,732 1,082,250 1,155,960 1,279,200 PVC pipes ASP (RMB/tonne) 8,870 7,999 8,000 8,000 8,000 PVC pipes revenues 6,686 6,845 8,658 9,248 10,234 Non-PVC pipes sale volume (tonne) 207,053 229,637 291,375 311,220 344,400 Non-PVC pipes ASP (RMB/tonne) 15,624 15,690 15,700 15,700 15,700 Non-PVC pipes revenues 3,235 3,603 4,575 4,886 5,407 Total plastic pipes revenue 9,921 10,448 13,233 14,134 15,641 Other revenue 222 443 665 997 1,495 Total revenue 10,143 10,891 13,897 15,131 17,136 Gross profit 2,452 2,649 3,474 3,782 4,284 Gross profit margin (%) 24.2 24.3 25.0 25.0 25.0 Source: Company data, CCBIS estimates

China Lesso – consolidated income statement

Year to 31 December (RMB m) 2011 2012 2013F 2014F 2015F Revenue 10,143 10,891 13,897 15,131 17,136 COGS (7,691) (8,242) (10,423) (11,348) (12,852) Gross profit 2,452 2,649 3,474 3,782 4,284 Selling, general and administrative expense (933) (1,137) (1,458) (1,512) (1,712) Operating income 1,519 1,512 2,016 2,271 2,572 Other non-operating income 148 116 80 119 155 Associates gains/(losses) 0 (0) 0 0 0 Interest expense (111) (146) (188) (233) (267) Pretax income 1,557 1,482 1,907 2,156 2,460 Income tax (296) (251) (381) (431) (492) Net income 1,261 1,231 1,526 1,725 1,968 Minority interests 0 7 7 7 7 Net income avail. to common shareholders 1,261 1,238 1,533 1,732 1,975 EPS (RMB) 0.412 0.404 0.501 0.566 0.645 DPS (HK$) 0.120 0.120 0.150 0.169 0.193 Source: Company data, CCBIS estimates


88

China Lesso – consolidated cash flow statement

Year to 31 December (RMB m) 2011 2012 2013F 2014F 2015F Net profit 1,261 1,238 1,533 1,732 1,975 Depreciation and amortization 174 253 326 382 422 Change in working capital (113) (311) 38 (25) (653) Interest expenses 111 146 188 233 267 Interest Income (27) (53) (50) (90) (127) Other non-cash adjustment (14) 7 0 0 0 Cash flow from operations 1,392 1,280 2,035 2,232 1,884 Capex (991) (1,068) (1,000) (800) (600) Proceeds from disposal of fixed assets 1 0 0 0 0 Investment in a jointly-controlled entity (0) (20) 284 (0) (0) Other investment (0) (0) 10 (0) (0) Interest income 9 100 50 90 127 Cash flow from investing (981) (987) (656) (710) (473) Shares issues/(repurchases) 5 41 0 0 0 Increase in borrowings 803 562 1,262 1,796 2,196 Repayment of bank loans (251) (147) (596) (1,262) (1,796) Dividends paid to equity owners (248) (165) (368) (416) (474) Interest paid (111) (146) (188) (233) (267) Other 5 (630) (8) (66) (76) Cash flow from financing 204 (485) 102 (181) (417) Net increase in cash 614 (192) 1,481 1,341 994 Cash and cash equivalents at beginning of year 1,500 2,115 1,923 3,462 4,876 Cash and cash equivalents at end of year 2,115 1,923 3,404 4,803 5,870 Source: Company data, CCBIS estimates


89

China Lesso – consolidated balance sheet

Year to 31 December (RMB m) 2011 2012 2013F 2014F 2015F Net fixed assets 2,471 3,288 3,972 4,390 4,568 Intangible assets 3 10 0 0 0 Prepaid land lease and equipment payments 648 1,084 1,084 1,084 1,084 Deferred tax assets 2 4 4 4 4 Long term investment 161 284 0 0 0 Other long-term assets 0 0 0 0 0 Total long-term assets 3,285 4,670 5,060 5,478 5,656 Inventories 1,294 1,766 2,104 2,110 2,662 Accounts and notes receivable 748 1,010 1,234 1,209 1,557 Short-term investments 0 10 0 0 0 Cash and cash equivalents 2,115 1,922 3,404 4,803 5,870 Other current assets 348 405 0 0 0 Total current assets 4,505 5,113 6,742 8,122 10,089 Total assets 7,790 9,783 11,802 13,600 15,745 Trade and bills payables 191 512 674 617 845 Tax payable 114 99 132 144 164 Short-term borrowings 70 596 1,262 1,796 2,196 Other short-term liabilities 657 832 832 832 832 Total current liabilities 1,032 2,039 2,900 3,389 4,037 Long-term borrowings 1,675 1,629 1,629 1,629 1,629 Other long-term liabilities 96 87 87 87 87 Total long-term liabilities 1,771 1,716 1,716 1,716 1,716 Total liabilities 2,803 3,755 4,616 5,105 5,753 Issued capital 132 133 133 133 133 Reserves 4,855 5,877 7,042 8,358 9,859 Total shareholders' equity 4,987 6,010 7,175 8,491 9,992 Minority interest 0 18 11 4 0 Total equity 4,987 6,028 7,186 8,495 9,992 Total liabilities & equity 7,790 9,783 11,802 13,600 15,745 BVPS (RMB) 1.629 1.963 2.344 2.774 3.264 Source: Company data, CCBIS estimates


90

China Lesso – key financial ratios

Year to 31 December 2011 2012 2013F 2014F 2015F Growth (YoY,%) Revenue growth 31.5 7.4 27.6 8.9 13.3 GP growth 20.6 8.0 31.1 8.9 13.3 Operating profit growth 9.8 (0.4) 33.3 12.6 13.3 NP growth 11.4 (1.8) 23.8 13.0 14.0 EPS growth 11.4 (1.8) 23.8 13.0 14.0 Margin (%) Gross margin 24.2 24.3 25.0 25.0 25.0 Operating margin 15.0 13.9 14.5 15.0 15.0 EBITDA margin 16.7 16.2 16.9 17.5 17.5 Net margin 12.4 11.3 11.0 11.4 11.5 Turnovers Inventory turnover Days 57.7 67.8 67.8 67.8 67.8 Trade and notes receivables days 25.7 29.5 29.5 29.5 29.5 Trade and bills payables days 10.3 15.6 15.6 15.6 15.6 Leverage ratios (x) Asset/equity ratio 1.6 1.6 1.6 1.6 1.6 Current ratio 0.6 0.6 0.6 0.6 0.6 Net gearing ratio (%) (7.5) 5.0 (7.2) (16.4) (20.7) Source: Company data, CCBIS estimates


Rating definitions Outperform (O) – expected return > 10% over the next twelve months

Neutral (N) – expected return between -10% and 10% over the next twelve months

Underperform (U) – expected return < -10% over the next twelve months

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