Nine Dragons... lowest valuation play on e-commerce

Nine Dragons... lowest valuation play on e-commerce

Tong Kooi Ong
27/04/18, 05:01 pm

SINGAPORE (Apr 30): Stocks in my Global Portfolio ended mostly lower in the past one week, mirroring weakness in global equity markets. Investors are nervous when it comes to equities, particularly as worries grow over rising interest rates.

Yields on 10-year US Treasuries rose above 3%, a level not breached since early 2014. While this is still at the lower end of the historical range, it is a marked shift from the years of ultra-low rates.  

Our best-performing stock for the week was DIP Corp, up 11% in local currency terms. Many read last week’s article as our attempt to find an excuse and justification for having chosen DIP in our portfolio — the stock fell more than 26% in a week. The fact is it did fall — market reacted badly to its latest quarterly results — but it is also a fact that in the week of April 23, we saw a remarkable recovery in its stock price.

We stand by our conviction. We believe DIP’s fundamentals are intact, with a secular uptrend in demand. Perhaps the market has come around to seeing our point of view on DIP. In any case, the fact that analysts exist is exactly because markets are imperfect. 

We are wrong sometimes, and sometimes we are one up on the market.

Shares in Alphabet ended the week 4.9% lower, despite reporting better-than-expected 26% y-o-y revenue growth for 1Q2018. The negative reaction may be attributed in part to the overhang of regulatory risks over data privacy. The company is also spending heavily on R&D, infrastructure and human resources to support future growth. However, investors, as we mentioned before, tend to focus on short-term margins impact.

Meanwhile, shares for newly acquired Nine Dragons Paper Holdings were also marginally in the red for the week. The company is the largest maker of containerboards in Asia, with the majority of its mills located in China and others in Vietnam.

Its main products are kraft linerboards and test linerboards, made mainly from recycled old corrugated containers (OCC) as well as virgin pulp. The containerboards are then sold to its customers in rolls of a continuous sheet of paper to make corrugated boards in packaging boxes — for export and domestic consumer goods such as F&B, electronic, pharmaceutical and household products.

We are upbeat on the outlook for paperboard packaging. One of the key drivers for packing boxes is the rapid growth in online sales, which also tend to use smaller boxes (compared with those used by traditional retailers). Smaller pack boxes require significantly more square metres of containerboards to ship the same amount of goods. Currently, only about 7% of China’s total containerboard consumption is for online sales.

In addition, the price outlook for containerboards in China is also positive, owing to strict enforcement of the country’s environmental protection measures. They include tightened standards on imported OCC, from 3% of non-paper content to 0.5%, effective January 2018.

Imported OCC accounted for as much as 40% of total local demand last year. This year, import quotas for OCC have fallen sharply. Size has its advantages — the bulk of quota is issued to the three largest players. Nine Dragons is the biggest, with capacity of some 14 million tonnes, more than double that of its closest competitor, Lee & Man Paper Manufacturing.

The company’s controlling shareholder has a strong OCC sourcing network in the US and plans to build a plant (together with Nine Dragons) to process low-grade OCC into pulp that can be shipped back to China to bypass China’s import quota for OCC.

At the same time, the government is also clamping down on small, polluting paper mills and imposing tighter environmental regulations on mills, further checking supply in the short term.

Owing to the above-mentioned factors, the resulting shortage has seen domestic OCC prices in China rising above the cost of imported OCC. That gives Nine Dragons a competitive advantage in costs.

Given the strong underlying demand, tight supply and higher domestic raw material prices, the biggest paperboard makers opted to cut back on production in favour of raising selling prices. Containerboard prices continue to average higher y-o-y — even though they are off the peak registered in October 2017 (see Chart 1).

This resulted in stronger sales and earnings for Nine Dragons for 1HFYJune2018. Even though sales volume contracted nearly 11% y-o-y, revenue was up 34%, lifted by the 51% increase in average selling prices.

Earnings before interest, taxes, depreciation and amortisation doubled from RMB1,915 million ($401.5 million) to RMB4,329 over the same period, with Ebitda margin rising to 23% from 15% previously. Aside from higher selling prices, Nine Dragons also gained from the relatively cheaper imported OCC costs.

Improved cash from operations pared gearing to 63% from 76% at end-FY2017.

Nine Dragons shares are trading at a price-to-earnings ratio of only 6.4 times and enterprise value to Ebitda of less than six times — very modest valuations for the market leader (see Chart 2). The company has a market capitalisation of about HK$55 billion ($9.3 billion). In fact, the stock is cheaper than its Chinese peers, Lee & Man and Shanying International Holdings Co (see Table 1).  

Looking ahead, China’s relatively fragmented containerboard industry — the three largest companies account for only 40% share of total market — is expected to consolidate further. Industry consolidation will be driven by tighter environmental regulations (compliance costs), rising raw materials (widening gap between imported and local OCC) and labour costs that will, in the long run, favour the largest manufacturers with economies of scale and strong balance sheets.

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.

This article appeared in Issue 828 (Apr 30) of The Edge Singapore.

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