China XLX Fertiliser - Heading into better quarters (CIMB)

NEUTRAL Upgraded

S$0.35 @27/06/11

Target: S$0.39

• Upgrade to Neutral from Underperform; negatives priced in. CXLX’s share price has retreated 43% since our downgrade on 7 Jan 11. We believe the sharp drop has priced in its negatives. CXLX has been maintaining above-industry margins, while coal-cost pressure and production declines due to power cuts should be over for now. Margins and earnings in the next two quarters should be marginally better. Our earnings estimates and target price of S$0.39 (7x CY12 P/E, 50% discount to peers) are unchanged. We expect near-term catalysts from improving urea ASPs and stabilising margins for key product segments, although longer term, we remain wary of costlier coal input and fund-raising needs from aggressive expansion.

• Changing trends appear favourable. Urea prices are likely to stay strong in FY11 due to the season for fertiliser applications in 2Q and the export window that will open in 3Q. Anthracite coal prices have moderated from their highest level. The increase in minimum purchase prices for major grains should further drive fertiliser demand. However, ASPs as a whole could still be volatile because of overcapacity in China while methanol producers are still facing cost pressures.

• Dilutive fund-raising threat over for the moment? Given CXLX’s ambitious expansionary plans and coal-mine acquisition, cash calls could still be imminent. The good news is we believe dilutive equity-raising to fund this huge capex would not be considered, given current share-price weakness.

Upgrade to Neutral; negatives in the price

Production and prices improving. China’s fertiliser production was 5.7m MT in May 11, 0.9% more than the same period last year. Urea production was 5.3m MT, up 1% yoy. In our earnings assumptions, we have modelled in moderate increases for June and July, considering improving water and power supply and the stimulating impact of exports on production. This is in line with the data we track. However, urea production generates little profit at the moment, as higher ASPs are accompanied by higher coal costs for most industry players. We do not reckon total fertiliser production will go up more than 3% in Jun-Jul 11.

Power-supply rationing for fertiliser plants (aimed at controlling pollution) in 1Q11 had ceased. Many urea producers have resumed normal operations in North China. Urea prices have moderately improved in the short run. CXLX’s reduced production in 1Q11 (which had resulted in lower sales volume at moderately lower ASPs) should be a non-event going into the rest of the year.

Trends to look out for

Coal prices declining, with reopening of coal mines after consolidation. Urea prices are likely to stay strong in FY11 due to the season for fertiliser applications in 2Q and the export window that will open in 3Q. Anthracite coal prices had jumped in FY10, especially in 4Q10, but since 1Q11, have moderated from their highest level. This should alleviate cost pressures. M15 (15% methanol fuel additive in gasoline) has been implemented in Shaanxi, Shanxi and Shanghai etc. in China and nationwide application is expected in 2Q11. The Chinese government had increased the minimum purchase prices for major grains on 10 Feb 11, which should further drive fertiliser demand from Chinese farmers.

Longer term, we remain wary of costlier coal input and the cost of plant closures for maintenance. ASPs as a whole could still be volatile because of overcapacity in China while methanol producers are still facing cost pressures.

Progress of expansion. The acquisition of coal mines by CXLX is an attempt by the group to secure feedstock, which could eventually lower its product costs and afford it some protection from rising coal prices. In the next 12 months, we believe management will be concentrating its efforts on the construction of a fourth urea plant. When completed in FY13, this should further help cost efficiency.

Dilutive fund-raising threat over for the moment? Given CXLX’s ambitious plans for a fourth and fifth plant and coal-mine acquisition, cash calls could be imminent. However, we believe dilutive equity-raising to fund this huge capex would not be considered given current share-price weakness. With the recent success of various PRC companies in raising Rmb bonds from the market, this method of funding may avail itself to CXLX. For now, the lack of a credit rating may be the biggest deterrent.

Valuation and recommendation

Upgrade to Neutral from Underperform; negatives priced in. CXLX’s share price has retreated 43% since our downgrade on 7 Jan 11. We believe the sharp drop has priced in its negatives. CXLX has been maintaining above-industry margins, while coal-cost pressure and production declines due to power cuts should be over for now. Margins and earnings in the next two quarters should be marginally better. Our earnings estimates and target price of S$0.39 (7x CY12 P/E, 50% discount to peers) are unchanged. We expect near-term stock catalysts from improving urea ASPs and stabilising margins for key product segments, although longer term, we remain wary of costlier coal input and fund-raising needs from aggressive expansion.