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Luyang Energy-Saving Materials (Luyang) announced a restricted stock incentive plan on the evening of January 17, 2024. We are upbeat about its long-term compound return thanks to its low valuation, high earnings, high dividends, and solid growth, and we reiterate it as one of our top picks.

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Unveils equity incentive plan to boost growth. The firm proposed an equity incentive plan to issue 10.55mn shares (2.1% of the total share capital, at Rmb7.16/sh) to 125 staff, including key executives and employees. Revenue and EBITDA each account for 50% of the performance evaluation, and 50% of shares can be unlocked if one of these two fulfills the target. To unlock, revenue should reach Rmb3.95bn, Rmb4.35bn, and Rmb4.79bn in 2024-2026, and EBITDA should rise to Rmb800mn, Rmb880mn, and Rmb968mn.

All shares will be unlocked if the firm's revenue and EBITDA both meet the targets. If the target is met with a completion rate of 90-99%, then 90% of shares will be unlocked. If the completion rate falls between 80% and 89%, then 80% of shares will be unlocked. No shares will be unlocked if the completion rate falls below 80%. Given weak market demand and fierce competition, we believe the firm's equity incentive plan, which was released following the change of its major shareholder, demonstrates the firm’s confidence in its growth prospects and has the potential to unite and motivate staff, in our view.

Net profit to rise despite headwinds; high dividend yield. The firm's assessment target is EBITDA, and we estimate that depreciation should be about Rmb100mn in 2024 (depreciation will fall significantly after the sale of rockwool assets). We expect net profit to reach Rmb627mn in 2024, up 8% from 2022. Excluding equity incentive expenses of Rmb32.57mn in 2024, net profit will increase by 13% from 2022. If the firm maintains a dividend payout ratio of about 70% in 2022, its dividend yield may reach 6.1% in 2024.

Improves supply to boost demand for ceramic fiber, contributing to carbon neutrality. The company has a high market share of nearly 40- 50% in the ceramic fiber market, and it performs better than small companies in the low-end market due to its cost advantages. In the high-　　end market, it boosts demand with high-quality supply through product matching and furnace design solutions, assisting energy-intensive companies in reducing energy consumption and carbon emissions while generating high earnings.

The firm acquired assets to enter new materials markets and create new growth drivers. Due to the acquisition of two types of assets, Yixing and Unifrax (Shanghai), from major shareholders in 2023, production line and transportation costs will weigh on the firm's earnings in the short term. In the long term, however, we believe its new products (ceramic fiber paper and liner) are closely related to the alternative fuel vehicle sector. As Luyang gains control of local production lines for key products and secures core technology advantages, we expect its new products to maintain rapid growth and profitability to improve as the auto industry grows.

Financials and valuation

Given the fierce market competition and short-term losses from asset acquisition, we lower our 2023 net profit forecast by 28% to Rmb517mn, and introduce our 2024 and 2025 net profit forecasts of Rmb627mn and Rmb715mn. The stock is trading at 11.4x 2024e and 10.0x 2025e P/E. Given the low risk appetite in the market, we maintain OUTPERFORM rating but cut our target price by 37% to Rmb19.00 (15.3x 2024e and 13.5x 2025e P/E), implying 34.5% upside.

Risks

Competition in the ceramic fiber market intensifies; integration of newly acquired assets disappoints.