Summary

The additional contributions from the businesses which were newly acquired offset the decline of old business, but its most products prices slumped, the revenue of China Rare Earth (the Company) shrunk in 2009. Meanwhile its profitability saw sharp drop. However, due to no similar provision was made, the Company turned loss to profit, with net profit realizing HK$85 million.

Taking consideration of incentive policies for new industries and tightening supply, the rare earth products prices will be optimistic. Plus with new profit growth by new projects, we expect net profit for the Company will reach HK$248 million and HK$ 361 million in 2010 and 2011, equal to HK$0.17 and HK$0.25 of the EPS. We conservatively give it the P/E with 15X to FY10 EPS, the 12-m TP of the Company will be HK$2.5, over 30% premium than current price. We initiate it Buy rating.

The performance entered the growing period again

China Rare Earth declared its 2009 annual report on 19th, April, which shows that the revenue and gross profit of the Company were HK$1.212 billion and HK$231 million, decreasing by 11% and 34% year-on-year. However, the Company turned loss to profit in the year, with net profit realizing HK$85 million.

Looking into its main businesses, it was the economic recession that negatively impacted the downstream demand. The refractory materials business shrunk on the whole, its sales of ordinary refractory materials and high temperature ceramics decreased about 25%, and the sales for the fused magnesium grain business was down by more than 60%. As for the rare earth business, the Company's rare earth oxides sales decreased about 30%. However, thanks to the additional contributions from the businesses via the acquisition of Xinghua Rare Earth and Dongye Rare Earth in 2008, its sales of rare earth and downstream products grew 32%. What's more, sales volume of its fluorescent materials in 2009 remained nearly the same as in 2008.

Against the different changes of sales volume, most of its rare earth products reported a decreased selling price with praseodymium oxide, neodymium oxide and terbium oxide mainly used in magnetic materials experiencing the biggest decline of more than 40% on average over 2008. The selling price of dysprosium oxide was also lower by more than 15% on average over last year. In addition, the selling price of yttrium-europium co-precipitates that mainly used in fluorescent materials also decreased by about 10% on average year-on-year, and the prices of fluorescent materials in 2009 was down ranging from 25% to 35%. However, price movements of refractory materials products varies, with prices of major products such as fused magnesium chrome bricks, alumina-graphite bricks and the Sialon series experienced fluctuations of less than 10%.

Overall speaking, The additional contributions from the businesses which were newly acquired offset the decline of old business, but its most products prices slumped, the revenue of China Rare Earth shrunk in 2009. Meanwhile, its gross margin drop over 6 percentage points to 19.06%. However, due to no similar provision was made, the Company turned loss to profit. In 2008, China Rare Earth made the provision of more than HK$300 million for the impairment of goodwill and machinery and equipment during the economic downturn.

Better financial situation than peers

Compared to its peers in China mainland, the performance of the Company in 2009 behaved generally. However, regarding its financial situation, the Company keeps at conservative and excellent level for both long term and short term solvency. Meanwhile, its cash and cash equivalent accounts for 33% in the total assets. All those indicate that the Company is able to expand the businesses and enlarged the leverage. In 2H09, China Rare Earth picked the phosphors and polishing powder to expand its businesses, which will become the Company's profit growth in our opinion.

Wide demand market for Strategic Metals

One of main businesses is to operate rare earth smelting and separation, ant then supply rare earth oxide, rare earth metals and downstream products. As the rare metals, rare earth has been used traditionally for many industries including the metallurgy, infrastructure, petrochemical engineering, glass, ceramics, agriculture, light manufacturing and textile. In the past few years, high-technology industry and advanced technology materials industry have become the main consumers of rare earth, with the share accounting for 50% above, which is also expected to reach 70%. In all, rare earth is experiencing a profound change from industrial gourmet powder to industrial food, and then holds the position of strategic metals.

Looking back on the history, global rare earth consumption had realized the CAGR of 6% from 2000 to 2008, far higher than the GDP growth rate. In China, the rate had been as high as 17%, also leading its GDP growth rate. Since 2003, new materials have consumed rare earth with the high 30% growth rate. In 2008, the consumption by new materials was 38.5 thousand tons, accounting for 53%.

Nowadays, major economies are seeking new growth engine after economic recession, and the low-carbon and new energy industry have been picked to be promoted. In China, the wind energy has taken above 100% growth in consecutive four years, electric automobile industry is facing the consumption upgrading and the stimulus plan for new energy vehicles. What's more, the government is promoting the lighting policy with saving energy, and planning to popularize electricity-saving lamp to 150 million units, 25% higher than that of 2009. Apparently, many parallel industries have adopted the application of rare earth products including rare-earth permanent magnetic material, rare-earth hydrogen storage material, catalysts and fluorescent powder. We expect the rare earth demand will keep a rapid growth in medium term, with 20% rate in 2010.

To meet new needs, China Rare Earth adopted two projects in 2009. Firstly, the Company entered into a joint venture agreement in China with OSRAM, a leading global lighting manufacturer, on 18 October 2009. The total investment cost of the whole project would be EURO43.5 million with the Company owning a 49.9% interest. The major products of the joint venture are tri-band phosphors for the lighting industry, and the annual production capacity will be 2,000 tons when in full operation. Secondly, the Company has also finalised the planning of construction of the high-end LCD rare earth polishing powder production line which will be located at the existing plant in Yixing. Upon completion of the project, the Company's annual production capacity of polishing powder will reach 2,000 tons. With regard to their downstream demand, the former is in accordance with the policy guidance of energy saving, and the latter is expected to edge out the import. In all, new projects both face good challenges and will become the new profit growth of the Company.

The supply will be tightened methodically due to the administration of quotas

As the rare metals, rare earth resources are distributed intensively on the earth, with 80% located in China, Russia, America and Australia, among which China has taken the first position in rare earth resources, production, consumption and export. However, because of the negligence on dominant minerals like rare earth in previous years, China's bargain power on rare earth products has been weakened gradually, and the prices increase of rare earth are very limited, far below than that of copper and iron ores.

However, China has carried out the export quotas and tariff administration on rare earth since 2006, which make the rare earth export decline gradually. Since 2008, Jiangxi and Inner Mongolia have begun to store up their rare earth resources. All those indicate that the government has taken long term program to assure the development of China's rare earth industry. Furthermore, compared to increasing demand, present policies will let the supply of rare earth be tightened methodically. In our views, economy recovery and newly emerging industries will boost the demand for rare earth. In medium and long term, the supply of rare earth will gradually be in shortage, which will benefit their prices. As a matter of fact, the selling prices of some rare earth products have showed a significant upwards trend, among which the average selling prices of praseodymium oxide, neodymium oxide and dysprosium oxide have risen 50%-60% than that of 2009. We think the downturn period of rare earth market has passed and their prices will become optimistic. Driven by the upwards prices and expanded sales, the profitability of China Rare Earth will regain rapidly, with the gross margin expected to reach 30％ or higher.

Demand for refractory materials will still be hopeful

The other main business of China Rare Earth is about the refractory materials, which are used for the iron & steel and glass industry relative to infrastructure and real estate. Recently Chinese government has strengthened the regulation on real estate market, especially on the speculative demand. New policies have triggered the worry over shrinking demand.

However, it is worth noting that the housing land-use supply will increase 135% according to the housing land-use plan in 2010, which shows the determination to increase the housing supply of the government. What's more, to construct the central and western regions of China and medium and small towns is still the focus of developing strategy. In general, we think present market is misunderstanding the policies. The demand for real estate and infrastructure may see increasing trends, but not shrinking tendency.

Risk

Expansion of production capacity is below expectation;

The controlling policies become stricter and the real estate market shrinks sharply;

The prices increase of rare earth products are less than expected.

To buy actively because high growth is foreseeable

Taking consideration of incentive policies for new industries and tightening supply, the rare earth products prices will be optimistic. Plus with new profit growth by new projects, we expect the revenue of the Company will be HK$1.69 billion and HK$1.969 billion respectively in 2010 and 2011, with 39% and 16.5% growth. Net profit will reach HK$248 million and HK$ 361 million, increasing 192% and 46% respectively, which amount to HK$0.17 and HK$0.25 of its EPS.

Considering the growing perspective of the Company, we take P/E as the valuation method. Tracking its peers in mainland, the valuation level of China Rare Earth rank the lowest and show a big discount. For the same industrial fundamentals, we conservatively give it the P/E with 15X to FY10 EPS, the 12-m TP of the Company will be HK$2.5, over 30% premium than current price. We initiate it Buy rating.

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