Humped by slow s/s strips revenue and low margin.
Closing Price S$0.06
Fair Value S$0.116 (+93%)
An industry expert, Ye Congfa (China Iron & Steel Research Institute), said that 90% of the 10 million tons of high-value, high precision, and, ultra-thin cold-rolled steel that are used in China, are being imported. This fundamental prompted its peer – China Gerui Advanced Materials – to add capacity of its cold-rolled steel strip production, including chromium-plating, to 500,000 tons. They expect to operate at 75% of current 400,000t capacity in 6 months. They are achieving a gross margin of 30%.
We are ceasing coverage because:
It is slow in increasing its utilisation of its stainless steel strips capacity, which formed the basis of our initial bullishness.
Selling prices in stainless steel strips have not recovered back to FY2007 highs while that of cold-rolled steel strips are back there.
Depreciation, the necessary evil in its period-cost nature, is punishing.
Its customers lie in sectors that dictate very low margins and 1Q11 saw these customers’ own margins lower; which could mean further squeeze on their suppliers.
Potential to re-focus efforts back to cold-rolled steel strips is very positive, though.
Its peer, China Gerui, which has been doing all the right things for the last few years, is expanding their chromed-plated steel strips capacity by 200,000t – a positive signal.
But we have waited long enough for Yǒng Xin to deliver. Its peer, China Gerui, has run far ahead.
In terms of valuation, the share price of Yǒng Xin is equivalent to marking it to the capex spend at China Gerui.
We disagree with this valuation as China Gerui could only add capacity in Henan, and not Jiangsu, near Wuxi, where Yǒng Xin is situated. Customer-mix and delivery cost differential exist.
We believe a fair valuation is to take China Gerui’s internal payback period of 2½ years at 30% gross profit margin, with some selling & distribution cost, and administrative cost and the standard tax rate as basis.
We arrive at a fair value of SG11.6¢.
We believe that this method of valuation will fall away once Yǒng Xin starts to deliver volume and better margins on its stainless steel strips.
We have done a forecast of FY2011, assuming the same pace of volume expansion in stainless steel strips and a 100% growth in cold-rolled steel strips. We assume a 3% gross margin in stainless steel strips and a 30% in cold-rolled strips. We assume zero contribution from chrome-plated steel strips.
Revenue and Gross Profit
FY10 y-o-y, Yǒng Xin’s high-precision stainless steel strips revenue increased by 15.4% from RMB137.4m to RMB158.5m.
Below our expectation
We had expected Yǒng Xin, in our forecast, to do RMB229.8m. This is 31% less and the industry is not under-performing. More worrisome is the revenue from its stainless-steel strips - at RMB67.5m - which is 39% below our forecast. The learning curve out of its Sendzimir mill production that we were banking on for it to drive its revenue and profitability has been taking much longer. December 2010 was the 31st month of use.
Below customers’ performance
Its customers have shown greater improvement in revenue over the same period:
BYD - +18%
Fiberhome - +44%
Jiangsu Hentong - +49%
Others, not listed in its annual report as customers but are peers to the above three, also showed up well:
ZTE - +52%
Jiangsu Zhongtian - +48%
Jiangsu Yongding - +61%
The only under-performer is Chengdu Putian, which attributed its failure to achieve expected returns to factors of equipment, management, operation and human resource.
Good potential in cold-rolled steel strips
Yǒng Xin stated in its FY2010 result announcement that it had “mitigated the lower sales from chrome-plated steel strips by selling more cold-rolled steel strips which have higher gross profit margin”.
To management’s credit, the RMB42.4m cold-rolled steel revenue works out roughly to 5,000t volume in 2010 vs about 2,600t in 2009 (+92%).
The cold-rolled steel strips capacity is 22,000t. This cuts both ways. Negatively, why only 5,000t? Positively, the potential is good. At an average selling price of RMB8,500/t at Gerui’s gross profit margin of 30%, this could give a gross profit of RMB43m. If we deduct another 14% (conservative number) for other expenses, there would still be RMB17m after-tax bottomline. At 213m shares, this works out to RMBf8 or over SG1.5¢ earning per share.
This is additional to whatever it could achieve with the stainless steel strips.
Stainless steel strips gross profit margin
Yǒng Xin also said that its gross profit margin had increased due to increase contribution from cold-rolled steel strips and improved margin of stainless steel strips.
There is no break-down of gross profit margin by steel-strip products.
If we input Gerui’s gross profit margin of 30% on its cold-rolled steel strips and do a deduction on Yǒng Xin’s overall gross profit, we find that its “improved margin” of stainless steel strips might not amount to a significant number.
Let’s try the following combinations.
If we assume that Yǒng Xin managed a 25% gross profit margin for cold-rolled steel strips and a slight gross LOSS of -5% for its chromed-plated steel strips, the balance equals only a 1.7% gross profit margin for its stainless steel strips.
If we changed the assumed cold-rolled number from 25% to 20% and keep the 5% loss, the stainless steel gross profit margin would improve to 4.8%.
Between a 30% margin for cold-rolled and a 5% for stainless steel, even the vast difference in selling prices (RMB8,400/t vs. RMB27,800/t respectively) would mean the cold-rolled product makes better RMBs by almost 2:1.
Price dynamics have changed
It is likely that the demand-supply dynamics over the last two years have stabilised. Until a drastic change appears quickly, Yǒng Xin‘s strategy of focusing on its stainless steel strips that did not pay off, would also not pay off in future. Additionally, this is punishing because cold-rolled steel strips are doing so well on margins. Look at this data:
In 2007, stainless steel strips carried a RMB44,000/t price tag. It went down to RMB24,000/t but recovered to just below RMB28,000/t in 2010. Cold-rolled steel strips were priced at RMB8,500/t in 2007, went up to RMB8,800/t in 2008 and came down to RMB8,400 in 2010. Chrome-plated steel strips have not recovered from the drop from RMB8,000/t to RMB6,000/t.
In terms of price and if 2007 was used as a basis, then one can say it was a right decision NOT to focus on chromed-plated but, at the same time, a wrong decision to focus on stainless steel vis-à-vis cold-rolled steel.
Difficult sector, too
If their customers are doing better, it means that they have bargaining power over their suppliers, which include Yǒng Xin.
Fiberhome lost some of its gross profit margin 25.14% (FY10) vs. 27.74% (FY09), down 2.6%age points, with 25.09% (1Q11). Jiangsu Zhongtian did 22.1% (FY10), 2.9%age points worse than 25.0% (FY09), with a lower 20.1% in 1Q11. Jiangsu Yongding did 21.2% (FY10), 1.1%age points down from 22.3% (FY09), with a much worse 9.9% in 1Q11 from 24% in 1Q10. Jiangsu Hentong clocked 29% (FY10) vs. 27.7% (FY09) before crashing to 18.2% in 1Q11; but, this was not as bad as Yongding’s because its 1Q10 was 20.3%.
This could mean their suppliers are getting a better deal; or, these guys are being squeezed and will squeeze their suppliers more. We tend to believe the latter.
These lie in the Telecommunication and Wireless cable sector.
BYD lost 4%age points in gross profit margin between FY09 and FY10. Being HK-listed, it does not do 1Q11 result. It is in Consumer Electronics and Automotive sectors.
Will BYD also squeeze its suppliers more?
One sees Gerui deriving 51.8% of its revenue from Food & Industrial Packaging, and 33.7% from Construction & Household Decoration, leaving only 14.5% from Telecommunication & Wireless Cable, and Consumer Electronics. Gerui states that it is the “supplier of choice when existing customers develop new products”. Perhaps the Telecommunication & Wireless Cable, and Consumer Electronics guys have too much of ‘a mind of their own’ and do not treat suppliers as their suppliers of choice, to begin with.
Suggestions
In terms of quantity, the last two years have proved that cold-rolled steel strips have won. From the announcements made so far, we could not understand if the slow pace of Yǒng Xin towards full production of stainless steel strips had been a case of marketing/sales or production under-performance. But 30 months (and, it would have been 36 months by the 1H11 result) had been a long wait.
Is it too late for Yǒng Xin to do catch-up? That is, if it re-focuses more of its efforts into oldrolled
(repeat: it increased by 92% its cold-rolled volumes in FY10 vs. FY09), as well as into the Food & Industrial Packaging, and Construction & Household Decoration sectors?
With the Chinese government focusing efforts to stimulate domestic consumption and improve the people’s standard of living into 2020, these two sectors should benefit abundantly too; if not, more so than the sectors that most of Yǒng Xin’s customers come from.
We hope that the efforts of the late Mr Pu Dexing that resulted in good profits in FY06 and FY07 would stimulate the current management to scale similar of better heights.
When quantities are there, the gross margin will improve as the depreciation cost of the plant & equipment would be better absorbed.
Necessary evil
Average 2007-8 depreciation charge for plant & equipment was RMB7.3m while the same average for 2009-2010 was RMB13.6m. So, about RMB6m was the charge for the stainless steel equipment. Period cost can be a necessary evil when capacity utilisation is low.
If a portion of this RMB6m is added back into the margin (RMB5m, assuming 15% utilisation), gross profit margin would have been an additional 7.4%age points of gross profit margin. Although accounting policy dictates period cost accounting and the accounting principle of conservatism demands it, we are only suggesting (in terms of investor education) that this point could be brought up. Of course, there should be assurance that the equipment could last longer than the accounting policy ‘life’ and macro-economic or obsolescence factors are not against it.
Another bullish factor
Its peer, Gerui, has 50,000t chroming capacity in its original 250,000t capacity. When the new capacities are installed, chroming capacity will come up to 250,000t out of 500,000t. This means additional 200,000t of chroming capacity would be added.
On the assumption that Gerui continues to be correct, then there should be some upside in the chromed-plated sub-segment, in terms of gross margin (at least, as Gerui is still promising a 30% gross margin for all sub-segments). We remember that Yǒng Xin had a 72% and 78% utilisation in its 18,000t chromed-plated capacity in FY06 and FY07 respectively. The lower 72% capacity of 13,000t, as compared to the FY10 achieved 8,000t, means a 62% upside.
Time to revive old relationships? Not really if we looked at the prospectus as these customers are the fibre optics people, who would really squeeze their suppliers. Is there a change in the making? We really do not know.
Forecast FY2011
In terms of revenue, we will up the cold-rolled sub-segment by 100% to 10,000t from FY10 and keep the FY10 pace for stainless steel sub-segment. We use a zero gross profit for its chromed-plated sub-segment.
In terms of gross profit margin, we will keep the 30% in cold-rolled and 3% for stainless-steel sub-segment.
We will use a variable percentage of revenue (FY10 basis) for its selling & distribution, and administrative expenses.
Valuation and Recommendation
Despite the non-performance of its stainless steel sub-segment, we are doubtful that the
market is correctly pricing Yǒng Xin.
If we take a “mark-to-market” reference to Gerui’s expansion cost, we find Yǒng Xin’s
carrying cost of RMB151m (FY10’s property, plant and equipment net book value) as high.
Gerui did additional 250,000t capacity on US$56m or RMB360m. However the first 150,000t
cost US$42m or RMB270m.
As a proportion, Yǒng Xin’s 40,000t would be “marked” as RMB72m.
On a median share price of SG7.5¢ in the last 5 months, the market-cap is RMB84.5m. At
RMB72m, the SG price works out to be SG6.4¢, which is about the share price now.
Is the market valuing Yǒng Xin at this “mark-to-market” price?
If it is, then it is wrong because it would be no-deal, if we assume the parties are talking.
Gerui is in Henan and Yǒng Xin is in Wuxi, Jiangsu.
Customer-mix is different. There must be a value to owning these customers. Even if it wins these customers by some aggressive marketing/selling, the transport cost of finished goods to these customers would be higher from Henan than from Jiangsu.
There are other factors but for simplicity sake, let’s assume these are not relevant.
Gerui works on a 2½ years pay-back. On its 30% gross margin and a selling price of RMB8,500/t, a 40,000t capacity could deliver RMB255m of gross margin over 2½ years. Less 2.4% selling & distribution cost and 7% administrative cost (Yǒng Xin’s FY10 numbers), it could deliver RMB175m. Less another 25% for taxation, this goes down to RMB131m.
Therefore, we value Yǒng Xin at RMB131m or SG24.75m.
This works out to be SG11.6¢ a share, on fair value basis.
Of course, if Yǒng Xin starts to deliver much higher cold-rolled steel strips at 30% gross profit margin and take-off on its stainless steel strips production, then the above argument falls away.
There is no recommendation as we are ceasing coverage.
Ceasing coverage
We believe it has taken too long to deliver on its stainless steel strips production, which was the basis of our initial bullishness.
We believe its current customer mix resides in the wrong sectors of Telecommunication & Wireless Cable, and Consumer Electronics; as compared to its peer Gerui’s concentration, which is in the Food & Industrial Packaging, and Construction & Household Decoration sectors.
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