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Nine Dragons ahead of the curve in supply strategy

Tong Kooi Ong
Tong Kooi Ong • 6 min read
Nine Dragons ahead of the curve in supply strategy
SINGAPORE (Nov 26): China-based stocks have been among the world’s worst performers this year, as fears of the US-China trade war and a cooling economy have hit stock prices hard.
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SINGAPORE (Nov 26): China-based stocks have been among the world’s worst performers this year, as fears of the US-China trade war and a cooling economy have hit stock prices hard.

Our investment in Nine Dragons Paper Holdings (NDP), China’s biggest manufacturer of paper packaging products, is no exception. But rather than a sharp fall in earnings, the stock is suffering from a severe P/E compression. This is fuelled in part by additional concerns over the Chinese government’s environmental restrictions imposed on the paper sector, which have severely restricted the import of scrap waste paper, the key raw material for recycled packaging paper.

To recap, China’s paper mills have over the past year been struggling to cope with increasing government restrictions on scrap paper imports. The restrictions were first announced in July 2017, sparking a rally in scrap paper prices then, ahead of its implementation in January 2018. Import quotas of scrap paper were introduced for only large companies and the impurity ratio reduced from 1.5% to 0.5%. There has been talk that the import of scrap paper may be banned altogether in 2020.

The result was a sharp 53% y-o-y drop in the import volume of scrap paper into China in 1H2018, to 7.1 million tonnes. In 2012, imports accounted for 40% of China’s total scrap paper demand. This declined to 31% in 2017 and is expected to drop to 20% in 2018 with the restrictions in place.

More tellingly, there has been a huge divergence in prices between domestic Chinese and international prices, for both scrap paper and finished paper products.

In 3Q2018, for example, the price per tonne of domestic Chinese scrap paper was US$450 to US$470, owing to very tight local supply, compared with US$220 to US$270 for higher-quality scrap paper imported into China. Meanwhile, a surplus of poorer-quality scrap elsewhere resulted in prices per tonne of just around US$150 in other parts of Asia and about US$80 in the US.

The result of the multi-tier pricing structure is that bigger players such as NDP have been able to pass on higher costs by raising prices. They have also been able to secure limited supplies of imported scrap through quotas to lower average costs. The smaller players have no access to import quotas and face sharply higher costs. We expect industry consolidation, with bigger players such as NDP gaining market share and pricing power, which would also limit concerns over slowing demand growth.

Despite these challenges, NDP has fared well financially. For the financial year ended June 2018, its net profit surged 79% to RMB7.85 billion ($1.55 billion) on the back of a 35% growth in revenue to RMB52.78 billion, with earnings per share of RMB1.68. At HK$7.95, the stock is trading at a trailing P/E of just 4.2 times, and 0.9 times book. Most analysts expect flat sales in 2019 but earnings to decline 10% to 20%, depending on margin assumptions, which make valuations still very appealing. Indeed, despite its size, NDP is the cheapest listed stock in the sector, as can be seen in the accompanying table.

NDP has since very quickly restrategised its raw material supply chain by aggressively acquiring brownfield mills in the US over the last few months. This will immediately increase access to a secure and cost-effective source of raw material supply, as the US is the largest source of fibre and prices of scrap paper there have crashed because of the Chinese import ban. Indeed, NDP is well ahead of the curve compared with other Chinese players, which are only starting to evaluate greenfield projects outside China.

In May 2018, NDP acquired two mills in the US, in Rumford, Maine and Biron, Wisconsin for US$175 million ($240.4 million). The mill in Rumfold has a capacity of 550,000 tonnes of paper and pulp; the Biron mill has a capacity of 340,000 tonnes. The acquisition was done very cheaply, at just six times earnings before interest, taxes, depreciation and amortisation based on 2017 earnings and four times based on annualised 1QFY2018 earnings.

Last month, NDP announced a major expansion of the US mills. It will invest US$300 million, adding three recycled pulp production lines with a capacity of 3,100 tonnes a day. It will also convert one paper machine to produce corrugating medium and linerboard for containerboard, with a capacity of 700 tonnes a day. Except for the containerboard plant that will cater to the US market, the majority of the recycled pulp output will be shipped to China for internal use at its mills.

In addition, in August, NDP acquired a recycled paper mill in West Virginia, with annual capacity of 218,000 tonnes, for US$55 million. On Oct 10, it announced it was acquiring, for an undisclosed sum, an idle pulp mill with 100 acres in Old Town, Maine. The mill will restart in 1Q2019 and ultimately produce 275,000 tonnes annually of unbleached kraft pulp.

With the new lines and acquisitions, NDP will have a total estimated US recycled pulp capacity of some 1.3 million tonnes a year. That will supply about 10% of its China feedstock requirements, assuring it of a stable raw material supply and lower costs. NDP’s Asian operations have a total annual capacity of 13.6 million tonnes, with 13.1 million tonnes in China and 0.4 million tonnes in Vietnam.

The US market experienced its worst week ahead of the Thanksgiving holiday since 2011, with the Dow Jones Industrial Average down 2.9%. Weak investor sentiment persists amid growth concerns for the tech sector, a fall in oil prices and weak earnings from US retailers. Apple and declined 7.6% and 6.3% in the week of Nov 15 to 21. Our Global Portfolio returns stand at -10.7% since inception, while the benchmark index is down 6.8% over the same period.

Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

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