China Sunsine | 1H20 Update
Updated: 4 days ago
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Despite a gloomy macroeconomic backdrop and weakened demand, China Sunsine has maintained profitability, improved its net cash position, and is forging ahead with capacity expansion plans
26% year-on-year drop in revenue and 50% fall in gross profit attributable to a decrease in ASP and falling sales volume but underlying operating metrics exceeded our expectations
Sunsine continues to outpace its peers with industry-leading utilisation rates and expansion progress
Management expects to weather the crisis with effective cost management strategies and emerge with a greater market share
We maintain a positive outlook and patiently wait for the tide to turn in our favour. Our fair value estimate of $0.59 per share remains unchanged, based on our PB/ROE valuation supported by a similar DCF-derived fair value of S$0.59
China Sunsine Chemical (Sunsine) put out a business update on 12 August 2020, releasing its financial results for 1H20. As expected, revenue and profit fell year-on-year, but the underlying operating metrics exceeded our projections. After attending China Sunsine's Investor Dialogue on 13th August 2020, we have summarised our takeaways below. We also revisited our initial investment theses [HERE] and key points from the May AGM [HERE] with this new information.
1H20 Earnings Highlights
Revenue sank 26% y-o-y to RMB 1,042.6 mn, mainly due to a 21% drop in overall Average Selling Price (ASP) and a 7% lower sales volume compared to 1H19. Overall, Sunsine's topline performance in the first half of the year has exceeded our expectations in several aspects, namely utilisation rate, revenue, sales volume, and ASP.
Average Selling Price (ASP)
ASP decreased by 21.0% to RMB 13,560 per ton, compared to RMB 17,107 per ton in 1H19. This downward pressure in price was due to a reduction in costs of raw materials such as aniline, as well as weaker demand for chemicals from global tire manufacturers. However, these prices remain more positive than our earlier estimates which projected a fall to RMB 13,000 per ton.
As mentioned in our initiation, aniline is a key component in Sunsine's cost of production. 1H20 average Aniline prices at RMB 4,900 per ton have reached close to its 4-year lows of RMB 4,800 per ton in 2016, and management does not expect prices to dip much further. However, aniline inventory levels in China remain high, leading us to believe that prices will remain at depressed levels for some time before recovering. Sunsine's cost-plus pricing model allows Sunsine to yield greater absolute profits in a higher raw material cost environment as higher raw material prices are passed on to customers via a higher ASP.
Sunsine reported a 50.0% y-o-y decrease in gross profit and an 5.8 percentage point fall in gross profit margin from 29.0% in FY19 to 23.2% in 1H20. This is mainly attributable to declining ASP and Sunsine's high degree of operating leverage, and falls slightly below our estimated gross margins of 25.0% for 2020E.
Sunsine's profit before tax and net profit after tax (NPAT) fell by 64.0% and 69.0% y-o-y respectively, with NPAT margins hitting 4-year lows of 7.9%. This seemingly disproportionate fall in NPAT can be attributed to a confluence of the above factors and Sunsine's high operating leverage.
Notably, administrative expenses saw a 109.6% rise y-o-y due to one-off expenses such as a reversal of over accrual regarding the Chairman’s RMB 7.9 mn bonus made in 1H2019, as well as receivables impairments of RMB 4.0 mn. D&A expenses increased 16.1% owing to additional depreciation charges from downtime costs. Despite this increase, these expenses remain below our half-year estimates, as we continue to factor in conservative depreciation assumptions into our projections.
Sunsine’s 1H20 results have outperformed our projected FY2020E NPAT margins of 1.2% by 6.7 percentage points, while actual 1H'20 net profit figures are already 4.7x that of our full FY2020 projections, further displaying Sunsine's capacity to maintain profitability and deliver results beyond our fair value estimates.
Furthermore, as most of these additional expenses are non-recurring in nature, we expect NPAT margins to improve in upcoming quarters as operations return to normal.
Net cash flow from operations in 1H20 fell 32.6% y-o-y to RMB 208.8 mn, while net cash used in investing activities increased 306% y-o-y to RMB 108.8 mn due to large additions to PPE from Sunsine's capacity expansion plans. FCF conversion increased by 16 percentage points from 105% to 121% owing largely to working capital changes.
In spite of challenging headwinds and cyclical downturn in sector performance, we were pleased to note that Sunsine remained cash flow positive, maintaining their free cash flow (FCF) conversion rate above 100% and increasing their overall net cash position. The same could not be said for competitors such as Yanggu Huatai, which recently reported a cash flow negative 1H20.
Sunsine’s strong balance sheet continues to provide sound fundamental support for further challenges and future development. In addition, the company's low debt levels will help Sunsine tide through this crisis and emerge stronger than its rivals. On a whole, China Sunsine's large cash pile grew 14.1% from FY19 to RMB 1,333.0 bn, with a net cash position of 84.5%.
Outlook and Management Guidance
Management indicated that the group will focus on lowering costs through operational improvements, such as reducing raw material consumption and eliminating wastage, but will remain socially responsible by resisting job and wage cuts across its business segments. The company expects its recent and upcoming expansion initiatives to bear fruit during subsequent economic recovery as it seeks to consolidate its industry-leading position with further gains in market share.
Despite a muted macroeconomic recovery, Sunsine continues to lead industry peers in utilisation rates (UTR), averaging 83% UTR for 1H20 compared to competitors such as Yanggu Huatai, with 2 factories averaging around >70% due to intermittent closures, and Tianjin Kemai operating at less than 50% UTR. This far exceeds our initial estimate that Sunsine would operate at ~60% capacity for 2020E, thus displaying the company's defensive capabilities due to its strong financial position, market share, product range and historical track record.
Sunsine also possesses advantages in financing compared to its peers, allowing it to undergo faster capacity expansion at lower cost of capital. Recently, competitor Tianjin Kemai filed for an IPO to raise funds for further expansion, but terminated their application in June (Source: XueQiu). This marks the third failed IPO attempt within five years. Similarly, Yanggu Huatai had to issue a further RMB 500 mn of equity in 2018 to finance its recent infrastructure developments, diluting existing shareholders. In comparison, Sunsine is able to finance acquisitions and new projects with its significant cash reserves, or take on fresh borrowings upon its currently debt-free balance sheet. This positions Sunsine well to emerge from this crisis stronger than its peers.
Management provided updates on its three capacity expansion plans. Both the Phase II of 20,000-ton Accelerator TBBS facility and the Phase I of 30,000-ton Insoluble Sulphur facility project are on track. The former has begun commercial production but capacity utilisation remains low due to weak demand from downstream tire manufacturers. Management has announced a 1/2 year delay in construction for its 30,000-ton Anti-oxidant TMQ facility due to a delay in approval by the relevant environmental and safety agencies.
Acquisition of waste disposal company Heze Yongshun Environmental Protection Technology was completed for RMB 43 mn, or 4.7x FY19 P/E of RMB 9.1 mn. Based in Shandong province, Heze Yongshun treats hazardous waste with an annual capacity of 15,000 tonnes. We expected the acquisition to generate considerable cost savings as Sunsine generated around 5,000 tonnes of waste last year and incurred RMB 25 mn in costs for their treatment and disposal.
Management has indicated plans to forgo renewal of Sunsine's "High Tech Enterprise" status, which has bestowed tax benefits in previous years. Because of the large number of criteria required to qualify for the status, management believes the likelihood of a successful application is low and has suspended application till next year. Our valuation from the initiation has factored in this tax hike, with an assumed tax rate of 26.5% from 2020E onward.
Our View on Sunsine's Outlook
Despite a downward y-o-y trend in operating metrics, Sunsine's recent earnings update yields plenty of positive takeaways, with the fall in demand from tire manufacturers less substantial than expected and ASP remaining relatively resilient despite oversupply and decreasing input costs.
We note how Sunsine was able to outperform its peers in key metrics, and remains the most likely candidate to come out of the pandemic with superior market share and profitability in our view. With developmental expansion on schedule and significant cash reserves, we believe this justifies our projections for Sunsine's future increase in sales volume, as it seeks to consolidate its foothold as the industry leader.
From a macroeconomic perspective, while the route to a full economic recovery remains hazy, we opine that the worst has passed in China, and have previously expressed optimism regarding an uptick in intercity automobile travel as the domestic economy reopens. Management updates support this view, with 2Q20 showing considerable improvement in both sales and utilisation rates compared to Q1, when the pandemic first spread and cities initially entered lockdown.
In addition, management reassured that Sunsine would continue executing on its value-accretive buyback mandate, providing an artificial support level to limit Sunsine's downside risk. Under Sunsine's renewed share repurchase mandate put forth on 5 May 2020, management would be able to acquire 10% of the group's total issued shares. Currently, Sunsine has acquired only 11.1 million out of the limit of 97.2 million shares, which represents a significant headroom for share repurchases. Coupled with recent valuations falling close to Sunsine’s last average purchase price of S$0.32 per share, this displays the potential for further value-accretive buybacks to take place.
Lastly, management also stated Sunsine's commitment towards paying a yearly dividend to shareholders despite the recent downturn. This is positive as it signifies that shareholders' interests are top of mind in management's capital allocation decisions.
1) ASP hike due to a cyclical upswing in raw material prices
As mentioned above, Sunsine's cost-plus model allows it to pass on input costs to its customers by raising ASP. A rebound in aniline prices could serve as a catalyst to drive Sunsine's topline improvement.
2) Successful headway in COVID-19 vaccine development
An approved vaccine and mass vaccination could lead to the re-rating of the consumer discretionary sector and spur derived demand for Sunsine's products. Other analysts have also opined that this could spark a sell-off in bonds and rotation out of technology into cyclical stocks. This could potentially provide the much-needed boost to Sunsine's share price.
3) Earnings surprise due to strengthening demand from light and commercial vehicles sales
Recent government stimulus, such as Beijing's RMB 4.75 trn package, focuses heavily on regional infrastructure projects. This would result in greater demand and usage of commercial vehicles in the construction process, which could in turn drive an uptick in sales volume and production for tire manufacturers, Sunsine's downstream customers. Similarly, a sustained recovery in light vehicle sales would also bode well for end demand for Sunsine's products.
1) Further ASP Compression
With ASP already at historical lows, further compression could result from intensifying competition and aniline prices falling to an even larger extent. Given that industry trends generally point towards major players attempting to ramp-up their sales volume, oversupply amidst a weak backdrop of demand risks pushing down ASP and Sunsine's top line.
However, management believes that domestic demand will keep pace with the production increase, as upcoming infrastructure projects borne from government stimulus would, in turn, lead to a greater need for commercial vehicle usage, and as a result, the manufacturing of tires for replacement and renewal.
2) Execution risk as Sunsine struggles to utilise excess capacity
The success of Sunsine's rapid expansion pipeline is contingent on the company's ability to win production orders and maximise UTR at a competitive ASP. Despite the promising increase in total production capacity in the coming years, Sunsine will have to continue building and enhancing customer relationships to fulfill optimal utilisation levels.
We believe this execution risk is mitigated by Sunsine's excellent historical track record of achieving consistent and stable industry-leading utilisation rates.
3) Second Wave of Infections
Despite daily new cases across China having dwindled and stabilized around the low double digits, the threat of a second wave is ever-present. This could once again deal a devastating blow to recovering downstream demand, entail the closure of Sunsine's production facilities and jeopardize its ongoing expansion projects through the supply chain and construction delays.
4) Permanent Shift in Working Paradigms
Companies are increasingly willing to allow employees to work from home, with companies such as Twitter, Square, Groupe PSA, and Slack stating that they plan to allow employees to work from home indefinitely. This up-and-coming trend of "work from home" could visibly manifest via a fall in motor vehicle travel in the long term, post-COVID future.
Sunsine is trading at 0.61x P/B (at the time of writing), which is starkly different from our previously calculated 1.1x fair P/B. With recent management updates validating, and often exceeding, our short term estimates, we believe the recent downward price action is unjustified and that our fair value estimate of S$0.59 remains a conservative reflection of Sunsine's intrinsic value.
Since our last article on 28 May 2020, China Sunsine has fallen from S$0.38 to S$0.32 at the time of writing, marking a 15.7% decline on thinly traded volume. Despite the bearish sentiment that appears to be expressed through recent share price movement, the recent half-year performance has exceeded our expectations and provided us with heightened clarity and confidence in China Sunsine’s ability to withstand the pandemic. We have been closely monitoring global tire demand and motor vehicle usage and will continue to revisit our thesis in subsequent updates. We continue to believe that the sell-down of China Sunsine is unjustified and that our long-term investment thesis remains robust.
Thanks for reading,
Ryan and Shawn
Disclaimer: We are long China Sunsine at an average price of S$0.365. This article is not an investment (buy/hold/sell or otherwise) recommendation, this is only for educational and discussion purposes. This article is not tailored to the specific circumstances of any reader. I/we/The Snowball do/does not purport to be in the business of providing financial advice and the contents of the article should not be regarded as such.
Cover photo source: Zachary Keimig
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