Overview

China Liansu Group Holdings Limited (Liansu) is a leading manufacturer of plastic pipes and pipe fittings in China. Liansu currently operates 12 production facilities for plastic pipes and pipe fittings across China. Liansu 's sales network consists of 29 sales offices and over 600 independent distributors. It covers customers across China. In terms of 2009 production volume, Liansu is the largest manufacturer of plastic pipes and pipe fittings in China, according to China Plastic Processing Industry Association (“CPPIA”).

Liansu manufactures over 70 series and over 7,000 specifications of plastic pipes and pipe fittings with dimensions generally ranging from 16 mm to 3,000 mm in diameter. Liansu primarily use PVC, PE, PP-R and other plastic resins as raw materials. Liansu's plastic pipes and pipe fittings are used in a variety of piping systems, including water supply, drainage, power supply and telecommunications, agriculture, gas supply, floor heating and fire-fighting. Liansu also provides a range of ancillary services, including pre-sale consultation, after-sales services, on-site guidance and technical support.

Liansu maintains an experienced research and development team. As at 30 June 2010, Liansu held 123 patents and have applied for an additional 140 patents in China and have 9 patent applications outside China that are pending. For the years ended 31 December 2007, 2008 and 2009, Liansu's R&D costs was RMB11.6 million, RMB11.2 million and RMB20.8 million respectively. Liansu will develop in the directions of research on high performance plastic pipes such as plastic-steel composite pipes, research on new plastic pipe systems such as pipes for irrigation and new pipe application technologies such as trenchless pipe technologies.

Investment Thesis

Economies of scale of market leadership. Liansu is currently the largest manufacturer of plastic pipes and pipe fittings in China. With Liansu's aggressive expansion plan, we expect Liansu to remain the market leader in foreseeable future. Hence, Liansu possesses strong pricing power to pass on higher costs. The economies of scale also provide Liansu with an advantage in raw materials and equipment procurement. R&D capability is also benefited from Liansu's large scales of operation and provides a strong boost for Liansu's revenue. Liansu's gross profit, operating profit margin and net profit margin has increase substantially together with sales volume from 2007 – 2010.

Robust growth of the industry. According to Market Avenue, China's demand for plastic pipes showed robust growth from 2005 – 2009, with CAGR of 23.4%.

In future, we believe there are three catalytic for the growth, 1) Urbanization, 2) Strong FAI and real estate investment, 3) Affordable housing construction.

The following graph shows sales volume of Liansu surged by 69% during the economic downturn in 2008/2009.

1) Urbanization. The urbanization rate in China was 46.6% for 2009. China's recent increase in urbanization has resulted in an increased urban infrastructure construction, expansion of cities, an increase in urban population, and a general improvement in the economies of many of China's cities. Urbanization has also helped to further develop China's construction and real estate industries, as indicated by the rapid increase of fixed asset investment and real estate investment, which has in turn helped to increase the demand for plastic pipes as part of the construction materials.

2) Strong FAI and real estate investment. The following graph shows the recent trend in FAI and real estate investment in China. The following graph shows a decent growth in FAI and real estate investment in China. Although the growth rate of FAI has decelerated in 2010, we believe the net amount can still provide a health growth in plastic pipes industry.

3) Affordable housing construction. The Ministry of Housing and Urban-Rural Development of the People Republic of China (MOHURD) announced on the 11th of January 2011 that the Chinese government will spend RMB1.3 trillion on the construction of 10 million affordable housing units in 2011; which accounted for 27% of the total real estate investment in China in 2010.

Aggressive expansion ahead. According to company's report, Liansu's designed production capacity will grow from 905,700 tonnes in 2009 to 1,840,660 tonnes in 2012, representing for a 200% increase. Hence, we believe the expansion plan will be the cornerstone for Liansu's future growth.

For the year 2010, Liansu is benefited from an expanded production scale and a continued improvement in production efficiency and productivity. Liansu is constructing an additional production bases in Changchun, Jilin. It isexpected to begin operation in the first quarter of 2011, with production capacities planned to reach 66,300 tonnes. Liansu additionally plans to identify suitable land in Sichuan and Shaanxi to further enhance its coverage over these regions.

Risk

Surging raw materials prices. In China's plastic pipe industry, product pricing is typically determined either through competitive bidding process or individual negotiations with the distributors or direct customers. Product pricing is dependent upon production costs and the prevailing market prices for similar products. Raw material costs is the largest component of Liansu's cost of sales, according for about 90% of the cost of sales, fluctuations in raw material prices can have a significant effect on the pricing policies of Liansu.

The principal raw materials for plastic pipes and pipe fittings are plastic resins such as PVC, PE and PP-R. Prices for plastic resins are generally subject to cyclical fluctuations and other market disturbances, including as a result of refinery capacity. In China, where PVC resins are primarily manufactured using coal and limestone, as opposed to petrochemicals that are primarily used in other parts of the world, PVC prices have been impacted by changes in PVC manufacturers` electrical and labor costs, changes in coal prices and fluctuations in the price of petrochemical based PVC resins on the global market.

In short term, due to the continuous improvement in global economies and surging inflation in emerging market, especially in China, we believe the price of plastic resins is going to elevate in 2011. There will be a bigger pressure on Liansu's profit margin and net margin in 2011 due to the raising costs.

Uncertainty about policy risk in China. China government is intensifying efforts to fight inflation and excess liquidity by raising the reserve requirement ratio (RRR) and interest rate hikes. China Liansu derived almost 100% of its sales from China's domestic markets in 2009. The nature of plastic pipes and pipe fittings is that demand correlates highly with construction activity (residential, commercial and infrastructure). Construction activity reached a high level in 2009, partly due to the government's Rmb four trillion stimulus package. However, China government's contraction monetary policy will have an adverse effect on FAI and real estate investment and hence a decreasing demand of Liansu's product.

Valuation

The following table shows our earnings forecast for Liansu from 2010 to 2012.

For the year 2010, Liansu is benefited from an expanded production scale and a continued improvement in production efficiency and productivity. Liansu is constructing an additional production bases in Changchun, Jilin. It isexpected to begin operation in the first quarter of 2011, with production capacities planned to reach 66,300 tonnes. Liansu additionally plans to identify suitable land in Sichuan and Shaanxi to further enhance its coverage over these regions.

Our forecast is mainly base three assumptions, 1. Robust historical growth of Liansu will be sustainable in future 2. Liansu's expansion plan will be implemented on schedule 3. Rebounding on ASP of Liansu's products.

Peers Table

We use the multiple comparables approach for the valuation of Liansu. The target 2011 P/E is calculated from the average P/E of the peer companies minus a 10% margin of safety which protect the investment when Liansu's performance fall short of our expectations. We rate Liansu a BUY with a 12-month target price of HK$9.1, based on 15x P/E for 2011. Currently Liansu is trading at HK$7.6, implying a 20% upside potential.

Financial report

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