Profit Warning: RMB150-200 million impairment loss

Yingde Gasses (The Group) announced a profit warning for a possible impairment loss on the value of assets in a range of approximately RMB150 million to RMB200 million for FY10. The possible impairment loss is due to the reduction of value of the Group's 75% equity interest in Zhangjiagang Yingde Gasses. Zhangjiagang Yingde Gasses is the only subsidiary in the Group engaged in the business of producing fluoride, sulphur fluoride, and nitrogen fluoride. The technical know-how brought by the Group's partner, Smart Excel Investment, failed to enable Zhangjiagang Yingde to produce commercially profitable products. The Group may initiate legal proceedings against Smart Excel Investment

The possible RMB150-200 million-loss accounts for approximately 23% to 29% of our 2010E earning before the impairment. We don`t think the failure will have a long-term effect, as this is a non-cash loss, and most likely a one-time write-off as the impairment loss counts for 68% to 91% of Zhangjiagang Yingde's total assets. However, it might take some time for investors to regain their confidence.

The unsuccessful investment does question Yingde's ability in choosing specialty projects and project management skills. The Group's business has been very concentrated in the steel sector, representing approximately 80% of its total revenue on average; thus, the failure of this specialty gases project could deter its short-term market diversification plan.

Valuation:

We believe that the impairment loss is an independent failure and will not have recurring impact. However, we are more cautious about the Group's ability to acquire and manage projects as the Group is aiming to diversify into the specialty gases market.

Its global peers are trading at an average 2011 forward p/e of 16.5x and p/b of 2.23x; while the domestic peers are trading at an average 2011 forward p/e of 16.9x and p/b of 1.97x. Yingde has a relatively short trading record, with its 2010 forward p/e averaged at 15.2x. Given Yingde's small market cap and its recent failure concerning its project acquiring and management skills, we give Yingde a `HOLD` rating with a target price of HK$7.00. The target price is based on a 2011 forward p/e of 11.5x and p/b of 1.9x

Major Impacts and Concerns on the Zhangjiagang Failure

Implications on other projects:

Hengyang Yingde is the only other project that the Group doesn`t have 100% control. While Yingde holds 70% of the stake, Hengyang Valin holds the remaining. Hengyang Yingde is a typical project handled by Yingde and there is no know-how dependency on Hengyang Valin, so unforeseeable risk is quite low.

Overly dependent on its partner:

The Group has a very concentrated business model and 80% of its total revenue comes from the steel industry. While the Group is aiming on market diversification, investing in an area without any expertise is risky. At the same time, management admitted that no technology verification or scrutiny was performed at the time of acquisition. Smart Excel Investment did not have any proven record in producing these high purity gases, namely fluoride, sulphur fluoride, and nitrogen fluoride. These gas consumptions mainly depend on imports into China, so if the Zhangjiagang project succeeded, it would be a first for Yingde and China as well.

Red flags had shown in early 2010 as the Zhangjiagang project was originally scheduled to come in operation by March last year. We believe that Yingde was over-focusing on its main on-site business and over sighted this project. The lack of expertise and experience of the on-site employees also contributed to the failure.

Yingde's next step

The Group said that there may be further research and development activities on this plant, but nothing is confirmed at this stage. We remain conservative of the outcome and did not include the potential success of this plant into our valuation.

Operation Results (1H10) and forward looking

By the end of 1H10, the Group had a total of 23 facilities in operation and 16 under development. Total installed capacity amounted to 452,800 Nm3/hr in terms of installed oxygen capacity, up by 6.7% compared with 424,300 Nm3/hr as of Dec 31, 2009. Total installed oxygen capacity is expected to amount to 1,008,800 Nm3/hr by 2013. Total industrial gas sold was up by 26.5% qoq, reaching 6,260 million Nm3.

Total turnover was up by 43.5% yoy, reaching RMB1,316 million, while gross profit reached RMB528 million, up by 59.5% yoy. Yingde's gross profit margin, 40.1% in 1H10, remains very competitive among its global peers.

While the unit prices of gases sold for their merchant customers sharply increased in 1H10, up by 47.2% yoy on average, Yingde's turnover from the merchant customers as a percentage of the total revenue increased to 18.3% from 10.7% 1H09. We appreciate Yingde's flexible customer structure so it takes advantage of the price hike.

Industry outlook

We re-affirm our positive industry outlook. First, industrial gas consumption growth is expected to outgrow the real GDP in the following five years, reaching a CAGR of 9% from 2008 to 2015e. Yingde derives more than 80% of its revenue from the iron and steel industry on average in the past 2 years, and we believe in the continuation of this trend. Demand for industrial gases by the steel industry in China is estimated to have a CAGR of 7% from 2010e-2015e, yet market share is expected to drop from 30% to 24%. This is partially due to the announcement made by NDRC in September 2009 regarding the restriction of overcapacity targeting the steel industry.

We do like Yingde's long-term contracts with on-site focus business model. The trend of outsourcing gas supply to independent gas suppliers from the state-owned steel and chemical companies will definitely benefit Yingde. CAGR of outsourcing market value in the following 5 yrs is estimated to be 11%, reaching 50% by 2015.

PEER COMPARISON

RISKS

1. Customers are highly concentrated; thus, loss of negotiation power may hurt the margins.

2. High exposure to the steel industry.

3. Intensive competition from the international market.

4. Impaired confidence due to the failure of the Zhangjiagang project.

FINANCIAL STATEMENT

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