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  • Shawn Lee

China Sunsine | Syzygy

Updated: 12 hours ago

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Key Points

  • Sunsine's share price fall over the past two years is largely attributed to weak ASP and more recently, the COVID-19 pandemic. That said, Sunsine's share price has shed 55% off its June 2018 high


  • As Sunsine is facing a confluence of multiple market downcycles accompanied by a plummeting share price, we believe current valuations present a favourable reward-risk skew


  • Sunsine's robust balance sheet is able to keep it afloat for ~8.5 years in our grey skies scenario


  • The market has likely overlooked the value Sunsine's massive net cash pile of S$256m (S$0.26/share or 67.5% of market cap). We believe Sunsine's cash acts as a deterrence to competition and enables Sunsine to have capital allocation flexibility


  • COVID-19 is likely to cause short-term pain, but long-term recovery is in sight. Recent alternative data shows traffic congestion levels recovering to near pre-COVID-19 levels in major cities like Beijing, Berlin, Melbourne, Shanghai, and Zurich


  • On a trailing basis, Sunsine is currently trading at 1.03x EV/EBITDA, 1.32x EV/EBIT and 0.72x P/B. Given Sunsine's strong track record of generating positive operating cash flows and maintaining profitability even during downcycles, we believe such depressed valuations are unjustified


  • Estimated fair value of S$0.59 (62.7% upside from the last closing price of S$0.365) using the PB/ROE valuation supported by a similar DCF-derived fair value of S$0.59


  • Sunsine has been heavily buying back shares in the wake of the pandemic outbreak, scooping up 3.4m shares at an average price of S$0.29. At this level, EV would hover above zero and buybacks would be value-accretive to long-term shareholders

Overview


China Sunsine Chemical Holdings (Sunsine) is the largest producer of rubber accelerator in the world and the largest producer of insoluble sulphur in the People’s Republic of China (PRC). 65% of Sunsine’s revenue is derived from the sale of rubber accelerators and 23% comes from its sale of anti-oxidant, while 10% comes from the sale of insoluble sulphur. Approximately 61% of sales are domestic, while the remaining 39% are International, serving more than 2/3 of the top 75 tire makers and more than 1,000 customers globally. An estimated 90% of the consumption of rubber chemicals is associated with the automobile industry, and 70% of the output is channeled into the production of car tires (Source: The Straits Times).


Sunsine adopts a cost-plus pricing model where the average selling price (ASP) of Sunsine’s rubber chemicals are adjusted to obtain a gross profit margin of approximately 30%.

Sunsine’s raw materials include Aniline (main material), Tert-butylamine, Cyclohexylamine, Ketone, Dicyclohexylamine, and Carbon Disulfide, most of which are derived from oil. The prices of these materials moving in tandem with oil prices. Sunsine has 5 production bases in Shanxian, Weifang, and Dingtao, all of which are in the Shandong Province in the PRC.



Sunsine trumps the second and third largest producers of rubber accelerators and dwarfs other insoluble sulphur producers in terms of production capacity.

Sunsine's stock price has been traditionally affected by ASP prices, Sunsine's earnings calls, US - China trade war and the recent COVID-19 pandemic.

Thesis 1 - COVID-19: Not broken, just bent


Solid balance sheet offers significant buffer against downturns

We believe that Sunsine’s robust financial position will enable it to tide through the current downcycle. As of FY19, the group boasts a cash hoard of RMB 1.28bn with zero borrowings. This translates to net cash per share of RMB 1.31 (S$0.26) or 67.5% of market cap. Sunsine’s prudent capital structure would prove invaluable during an economic downturn as the group would not be overburdened by excessive liabilities.

Furthermore, Sunsine’s superior leverage and liquidity metrics become particularly apparent when comparing with their peers. We observe that Sunsine outshines its competitors in all metrics shown. Therefore, on a relative basis, Sunsine offers the greatest downside protection amidst uncertain times.


Rigorous balance sheet stress test indicate strong ability to weather left-tail risks

We believe Sunsine is well-poised to withstand severe volume and ASP shocks given its strong balance sheet. To demonstrate this resiliency, we assumed a doomsday scenario where Sunsine's cash inflow plummets to zero, while the firm still pays its total current liabilities and projected maintenance CapEx. We discounted Sunsine's current trade receivables by a conservative 50% and paid off total liabilities in FY2021. We further assumed that no further liabilities will be incurred, which we believe is fair given our scenario that they will not be operating for the years projected.


In such a scenario, we observed that Sunsine would be able to comfortably draw down on their cash pile to pay off all its liabilities, and maintenance CapEx while ending FY2020-FY2027 with a positive cash balance. With the ability to stay afloat for the most part of 8.5 years while solely relying on their current cash level, we believe that Sunsine is in a good position to ride out this rough patch.

Furthermore, the above doomsday scenario is extremely unlikely as Sunsine has demonstrated a strong track record in maintaining positive operating cash flows and profitability even during cyclical downturns.


Favourable end demand composition hedges against fears of muted auto sales

We believe derived demand for Sunsine’s rubber chemicals will remain largely intact given that the tire replacement market accounts for ~70% of aggregate tire demand. This implies that tire production is more likely to be driven by the total vehicle population rather than auto sales. Given the steady climb in registered vehicles in China, Sunsine’s sales volume should remain healthy in our view.


However, we acknowledge that Sunsine’s sales growth is likely to slow in the near term as traffic levels wane. This is largely due to lockdown measures in multiple Chinese cities starting Jan 2020, which has reduced auto traffic levels tremendously. With dampened vehicular usage, it would be reasonable to assume tire replacements would be put off until government measurements are eased.


Short-term outlook will also be soft as the replacement tire market enters its downcycle. Auto tires are estimated to be due for replacement every three years or after hitting 30,000km in mileage (Source: Torque). Not surprisingly, we observed that volume growth for Sunsine’s products display a trend that would ebb and flow in a three-year cycle. According to historical data, FY20 should mark the start of the next cyclical trough. That said, we note that Sunsine has been able to maintain sales growth even during downcycles.

Hard-handed pandemic response sets stage for recovery of traffic levels

Tire replacement demand should mount a recovery as China eases stringent lockdown measures. Recent data already suggests that traffic levels are starting to normalise in Chinese cities. To illustrate this, we analysed recent traffic congestion levels in Beijing, the largest city in China, which was badly hit by the pandemic. Data from the week of 3rd May 2020 – 9th May 2020 and 9th May 2020- 15th May 2020 depicts that vehicular traffic is returning to pre-COVID-19 levels as the city gradually reopens for business.


In our view, this is rightly so as auto traffic will be quicker to recover in tandem with economic activity compared with other modes of transport like flying. This is due to the flexibility of automobiles as both short and long-distance means of commuting.


We also expect the same trend to play out in other countries as shelter-in-place measures ease, which would bode well for global tire demand with rebounding auto usage. The recovery in congestion levels in other major cities like Berlin, Melbourne and Zurich indicate that the rebound in traffic levels is not isolated to China.

Thesis 2 - Wide moat: Seizing market share in the chaos


We believe that Sunsine’s defensive moat, signified by consistently elevated ROICs, will allow it to continue to grow its market share amidst this market chaos. Its moat could expand due to several factors:


Presence of large cash hoard provides strong signalling effect

We believe that Sunsine’s massive cash hoard has been largely misunderstood by the market as this typically signifies an inefficient capital allocation. In contrast, we believe that a large cash hoard sends a strong signalling effect of Sunsine’s ability to survive a price war, deterring competitors and new entrants. Having a large amount of cash could also result in more favourable credit terms by suppliers and reduced opportunistic behaviour by customers.


The option view of cash is also likely being overlooked. In this uncertain business climate, having sizable cash coffers would be useful from a capital allocation perspective. This would allow Sunsine the flexibility to deploy capital in an effective manner, such as through expansion plans or value-accretive share repurchases.


Tightening of environmental regulations raises barriers to entry

Tighter environmental regulations like the Pollutant Discharge Permit system introduced in November 2016 have been raising the barriers to entry into the rubber chemical industry. As a result, incumbents were pressured to heavily ramp CapEx to comply with new measures. For illustration, Sunsine saw total compliance expenditure soar by 50% from FY16-17. Notably, we observed a ~1.5x increase in PPE expenditure, which was mainly focused on meeting environmental regulations given that capacity remained constant.

We also believe that the new measures resulted in asymmetric cost pressures for weaker players, leading to an industry-wide consolidation in favour of Sunsine. In 2018, 25% of all chemical companies operating in the Shandong province were closed but output only fell by 5%. Across the board, more than 80,000 Chinese factories were forced to shut down due to more stringent environmental standards. Meanwhile, Sunsine has seen a steady increase in their domestic market share, rising 2 percentage points y-o-y to 33% in FY2017.

As China reaffirms its commitment to improving environmental standards in the long-term, Sunsine remains well-poised to thrive given its heavy commitments to sustainability. We thus expect barriers of entry into the rubber chemical industry to remain elevated, further cementing Sunsine’s leading position in the rubber chemicals market.


Quality control underpins customer stickiness Given the drawn-out qualification process for rubber chemical suppliers, customers face high switching costs away from a quality supplier like Sunsine. This is supported by accreditation by top global rubber tire producers like Bridgestone, Goodyear and Michelin. Over the years, Sunsine has also expanded its clientele to include 50 of the top 75 global tire producers, up from 45 in 2007. In our view, this is a testament to the reliability and quality of Sunsine’s products.

Furthermore, rubber chemicals only account for a mere 3% of tire manufacturing costs. As such, we believe it would not be prudent for tire producers to risk switching from a quality rubber chemical supplier for meager cost savings. Accordingly, Sunsine should continue to benefit from prolonged customer loyalty.

Thesis 3 - The recovery: Larger share of a larger pie


Our previous two theses support the notion that Sunsine would not only survive the downturn but continue to thrive and capture market share in the process. Therefore, at current valuations, the market is overlooking Sunsine’s ability to sustain its long-term profitability in our view. Moreover, the cyclical upswing in replacement tire demand is likely to be supported by longer-term tailwinds in the Chinese auto market.


Fiscal stimuli could drive commercial vehicle demand

We expect China’s vehicle population to increase as a result of the Chinese government’s fiscal response to COVID-19. Commercial vehicle demand could rise with increased government spending, which is already showing signs of increasing with a 30% y-o-y spike in commercial vehicle sales in the April print (Source: Channel News Asia). We also expect private vehicle sales to be nudged along as commuters avoid public transport due to infection fears. As private vehicles provide a greater peace of mind, demand could increase as the economy recovers.

Chinese Government's support for Electric Vehicles

We also expect China’s vehicle population to be driven by the Chinese government's growing support for electric vehicles (EVs). Beijing has extended subsidies and tax reliefs for EVs beyond the originally planned end-2020 by two years (Source: Channel News Asia). This is also bolstered by the lifting of restrictions that cap the number of new vehicles put on the road (Source: Channel News Asia). We believe that the extension in subsidies will not be a one-off given the fact that the Ministry of Industry and Information Technology has increased its 2025 target for EV sales to comprise 25% of all Chinese car sales, up from the current target of 20% (Source: Nikkei).


Demand for Sunsine's products will remain healthy should these factors play out, as they would support the cumulative growth of the vehicle population in China. Accordingly, demand for rubber tires and chemicals will be buttressed by both the OEM and replacement market.

Planned capacity expansion to meet demand

We believe the demand acceleration will be matched by Sunsine’s timely capacity expansion. By 2021, Sunsine’s production capacity for rubber accelerator, insoluble sulphur, and anti-oxidant, will increase by 21%, 100% and 67% respectively. The ramp in capacity is justified as plant utilisation rate for Sunsine three key products of accelerators, insoluble sulphur and anti-oxidants are already over 90%.


Possible increase in pricing power

We believe that the consolidating rubber chemical industry and Sunsine’s current strategy of being a volume leader will allow it to gradually build its pricing power. With an even greater market share, we believe Sunsine could have greater flexibility to expand gross margins in the future.

Valuation


At present, Sunsine is trading at valuations not seen since the previous downcycle in 2015, where aniline prices plunged 30% y-o-y. P/B levels remain depressed, hovering close to the 10-year low. Meanwhile, EV/EBITDA and EV/EBIT also paint a stark picture of cratered valuations, with levels hovering 2 standard deviations away from the 10-year average.


Based on our financial model, which you can [download here], we derived a fair value/share of S$0.59 for Sunsine using the PB/ROE valuation as our primary valuation method. This represents an upside of 62.7% from the last closing price of S$0.365. We also supported our valuation with a Discounted Cash Flow Model (DCF) using the Gordon Growth Method and Exit Multiple Method, which both yielded a fair value/share of S$0.59. We will adjust the model accordingly as the ongoing narrative develops.


P/B-ROE Model

We utilised the P/B-ROE model to estimate Sunsine's fair P/B ratio. This model mathematically implies that if a firm’s long-term ROE exceeds its cost of equity, its P/B ratio should remain above 1x.

To determine a good proxy for long-term ROE, we used the 1st-quartile ROE over a 10-year period. To compute cost of equity, we employed the CAPM. We obtained values of 13.5% and 13.13% respectively. Under these 2 core assumptions, we arrived at a fair P/B of 1.1x, considerably higher than the 0.72x Sunsine is currently trading at. Accordingly, this implies that Sunsine should trade at a fair value of S$0.59, representing a ~62.7% upside from the current price of $0.365.

We further sensitised the target price with the key assumptions of ROE and cost of equity. We obtained a fair value range of S$0.22-S$1.29.


Discounted Cash Flow Model


Key DCF assumptions:


  1. WACC of 13.1% - derived using the CAPM

  2. Capacity expansion of 80,000 tons in 2021 - as stated in the FY2019 annual report

  3. Utilisation Rate of 60% for FY2020 and FY2021, 90% thereafter - we factored in a decline in utilisation rate due to COVID-19 to a historical low of 60% for FY2020 and FY2021 and expect it to return to historical levels thereafter

  4. ASP of RMB13,000/ton for the next six years - we expect a decline in ASPs due to the decrease in oil prices and projected it to remain at depressed levels due to the lack of visibility for oil prices, as well as to remain conservative.

  5. Stable gross margins - we project gross margins to be stable at 25% in the model as Sunsine adopts a cost plus pricing model

  6. EV/EBITDA multiple expansion from the present 1.0x to 6.0x by FY2025 - driven by full recovery of the economy by FY2025, we expect a re-rating of the multiple back to pre-COVID levels of ~6.0x

  7. Terminal Growth Rate of 2% - a conservative estimate compared to the GDP growth of China

Furthermore, Sunsine’s recent buyback activity sends a strong signal to investors that the firm is undervalued. Since the pandemic outbreak, it has purchased 3.4m shares at an average price of S$0.294. We believe Sunsine’s share repurchases are value-accretive to existing shareholders, especially when 50% of NAV is backed by cash. Therefore, we do not foresee significant impairments to NAV.


We estimate that Sunsine’s post-outbreak buyback activity has already boosted FY19 pro-forma NAV/share by 0.15%. Should P/B continue to remain substantially below 1x, future share repurchases will be beneficial to long-term shareholders.

This is a classic “heads I win, tails I win” set-up. Should stock price rise, shareholders will reap capital gains. Should prices fall, management has signaled its ability to conduct value-accretive buybacks. This gives rise to a favourable reward-risk ratio for the long-term shareholder.

Risks


1. COVID-19 escalation The COVID-19 pandemic has slowed global vehicle use and new vehicle sales volume. Any escalation of COVID might lead to a second wave of country-wide lockdowns around slow the demand for tires and rubber chemicals and Sunsine’s supply chain.

2. Factory shutdowns The lifting of lockdowns in China might result in a second-wave of COVID-19 of community spreading in the Shandong province. While there are measures in place to mitigate the risks of community spreading, like any other factory, Sunsine runs the risks of community spreading pausing production in its facilities.


3. FX exposure

Sunsine operates out of China and has transactions in foreign currencies like the USD and the EUR. Based on FY19 pro-forma figures, Sunsine estimates that net profit would fluctuate by +/- 2.92% for every 2% change in USD/RMB. This effect is less magnified for the EUR, in line with Sunsine's geographical sales mix.

Catalysts


1. Revision of Sunsine's share buyback mandate

Sunsine’s management has stuck to a share buyback mandate since September 2018 and most recently has been buying at an average price of S$0.29. Prices have surpassed the S$0.29 level since. Any updates in management’s share buyback mandate to a more aggressive one during the coming AGM (27 May 2020) may be beneficial for long-term shareholders.

2. Potential privitisation

Sunsine's chairman holds a ~60% stake, with percentage free float being less than 30%. Sunsine also has no debt on its balance sheet, combined with the fact that they are able to generate a high amount of free cash flow and demonstrate high returns on investment persistently over time. This makes Sunsine a prime target for privatisation through an LBO.


3. Automobile Sales Surprise

With tire replacement demand expected to remain healthy, any positive surprise in worldwide automobile sales figures presents additional upside to the demand for Sunsine’s rubber chemicals. We believe that this scenario is plausible given China's latest vehicle sales growth 4.4% y-o-y in April 2020 (Source: Channel News Asia). However, this should be carefully monitored as commenters have warned that April vehicle sales in China may not be indicative of the impacts of the COVID-19 on the automobile industry (Source: Caixin).

Conclusion


We believe Sunsine is in the midst of a perfect storm; the combined effect of the replacement tire downcycle, oil price crash and the COVID-19 pandemic certainly indicates short-term pain. Therefore, while we acknowledge that short to mid-term earnings might have a weak showing, we are fairly optimistic Sunsine will emerge stronger from this challenging episode just like it has over multiple downturns.


With the uncertain business climate, our investment thesis might take months to play out. However, as long-term investors, we are prepared to wait for the inflection point. As always, we believe that it is better to be months early, than a day too late.


Thanks for reading,

Shawn Lee


Disclaimer: We are long Sunsine at an average price of $0.38. This is not a buy recommendation, this is only for educational and discussion purposes.


Cover Photo Source: Robert Laursoo


Erratum:

16th May 2020: We note that FY19 capacity was 172,000 tonnes rather than the 192,000 we mentioned previously. We have since updated these figures. As a result, our DCF fair value per share for both the Gordon Growth and Exit Multiple methods have been slightly altered down to S$0.59 (Previously S$0.60 and S$0.61 respectively). The PDF model has also been updated. We apologise for the mistake.


19th May 2020: We have updated Sunsine's insoluble sulphur peer from "Sinochem" to "Sennics". We understand that while Sinochem is the parent company of Sennics, listing Sennics as a peer provides a more accurate representation. We apologise for any confusion caused.


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