3Q21 net profit stood at Rmb161mn, in line with our expectation

Chenming Paper announced that its net profit in 1-3Q21 rose 103% YoY to Rmb2.18bn. In 3Q21, its net profit dropped 71% YoY and 81% QoQ to Rmb161mn, in line with our expectation.

Paper prices dropping sharply and hurting profit. Since 3Q21, inventory of ivory board has increased to high levels due to soft domestic consumption and disappointing overall demand. Inventory of printing and writing paper is also high due to competition from Indonesian imports, select exporters shifting to domestic sales, and change in education policies reducing demand for teaching materials. As prices of wood pulp peaked in mid-2021, investor confidence waned further and the firm’s ASP of major products declined sharply in 3Q21. Data from umpaper.com shows that sector ASP of ivory board and printing and writing paper fell 30% and 15% QoQ in 3Q21 (though the decline was milder for the firm’s actual ex-factory prices). In addition, spot coal prices increased quickly in 3Q21, and the firm’s power generation cost for its self-owned power plants may have sharply increased. We think the firm’s per-tonne net profit dropped sharply.

Gross margin (GM) of the firm was only 15% in 3Q21. Its GM fell 9ppt YoY and 18ppt QoQ in 3Q21. We think the paper sector was in its trough in 3Q21. Given recovering paper prices, we are upbeat on the firm’s QoQ earnings growth in 4Q21.

Cash flow ample; full-year debt reduction target to be achieved. In 1- 3Q21, the firm’s net operating cash flow dropped Rmb43mn YoY to Rmb7.2bn, with net profit to cash flow ratio of 331%. In 3Q21, its inventory fell Rmb944mn QoQ to Rmb5.96bn. The firm’s asset-to-liability ratio in 1- 3Q21 decreased 1ppt (vs. end-2020) to 71%, and will likely drop to 70% or below in 2021, in our view. Preferred stocks buyback increases profits of shareholders. In 3Q21, the firm bought back around Rmb2.37bn in preferred stocks. It has bought back around Rmb4.6bn in preferred stocks since early 2021.

Trends to watch

Improving supply and demand balance to bolster paper price recovery in 4Q21; per-tonne net profit likely to rebound. Looking into 4Q21, we expect the supply and demand conditions to improve as demand grows, supply contracts due to power curtailment and energy consumption control, and small businesses record losses. According to umpaper.com, Chenming Paper has raised prices of its printing and writing paper and ivory board by over Rmb300/t since October. Given that wood-pulp prices are dropping, we expect cost pressure of the firm to ease in 4Q21.

Moreover, if coal prices have fallen from QoQ highs, it could create upside growth potential for Chenming’s profit. We think the firm’s per-tonne profit will likely recover in 4Q21.

Control over energy consumption to benefit industry landscape in the medium term. Amid China’s efforts to peak carbon emissions and accomplish carbon neutrality, we expect China’s environmental regulations and control over energy consumption to further tighten in the medium term and the approval of new papermaking projects to slow sharply. We think that pressure of supply expansion will be milder than the market expects, and demand for ivory board may rapidly increase amid China’s ban on plastic and imported waste paper. We expect the market potential of ivory board to increase from 12mnt in 2020 to about 20mnt, and sector supply and demand to maintain a relatively tight balance in the medium term. In addition, our surveys show that small papermakers are unlikely to secure industrial land, self-owned power plants, and quota for energy consumption for new projects. We think that incremental pulp paper projects will mainly come from leading papermakers. As a result, we expect the industry’s competitive landscape to improve further. We think the firm’s medium-term average earnings and cash flow will improve significantly compared with the last cycle, which is conducive to driving recovery in average valuations.

Financials and valuation

As we revise our assumptions for price and net profit per tonne, we lower our 2021 and 2022 net profit forecasts 11% and 6% to Rmb2.46bn and Rmb2.89bn. Chenming A-shares are trading at 7.3x 2022e P/E, and H-shares at 3.3x 2022e P/E. We maintain OUTPERFORM for A-shares and H-shares, with target prices at Rmb10 (10x 2022e P/E with 41%upside) for A-shares and HK$5.50 (5x 2022e P/E with 47% upside) for H-shares.

Risks

Sharper-than-expected decline in wood-pulp raw materials; disappointing downstream demand; higher-than-expected supply of imported paper.