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Shanshui Cement (691): China second largest cement producer

Friday, June 20, 2008

5011

Shanshui Cement

Recommendation on 20 June 2008
Recommendation	BUY
Target Price	$5.700

Weekly Special - 002050 Sanhua

China Shanshui Cement Group (Shanshui Cement) is offering 650,800,000 shares, offer price range $2.7 - $3.65. 1000 shares per lot. Sponsors are Morgan Stanley, Credit Suisse and CCB International. Target price $5.7.

Corporate information

Shanshui Cement is the second largest producer of clinker and cement in China and the largest in Shandong and Liaoning Province, in terms of both production and sales volumes in 2007.

China Shanshui Cement Groups revenue has increased from RMB2,800.4 million in 2005 to RMB4,144.6 million in 2007 (CAGR 21.7%). Profit from operations increased from RMB261.9 million in 2005 to RMB431.9 million in 2007 (CAGR 28.4%). Their profit has risen from 105.8 million in 2005 to 214.6 million in 2007 (CAGR 42.4%). Its strategies are to strengthen the companys leading market position through consolidation in existing markets and continue to expand into new markets through acquisitions. Shanshui Cement is expected to have a net profit of RMB445 million in 2008, more than doubling its 2007 net profit.

Financial performance of Shanshui Cement

In the second half of 2007, Shanshui Cement has expanded into new markets in Shandong Province and established themselves in Liaoning Province by acquiring five cement producers in Shandong Province and Liaoning Province. In early 2008, they have acquired the exploration rights of approximately 100.0 million tons of limestone (RMB1,942.8 million) located in a mine in Liaoning Province to support their cement production in Liaoning Province.

Currently Shanshui Cement possesses 22 clinker production lines and 77 cement grinding lines in Shandong and Liaoning. In 2005 and 2006, Shanshui Cement produced 11 million and 14.9 million tons of cement, and 10.7 million and 12.3 million tons of clinker respectively. They plan to expand their production capacity through acquisition of existing producers as well as construction of new production lines. From producing a total of 17.3 million tons of cement and 13.9 million tons of clinker in 2007, they plan to increase their annual aggregate production capacities to 40.8 million tons of cement and 23.3 million tons of clinker by the end of 2008 and further to 43.8 million tons of cement and to 26.1 million tons of clinker by early 2009. The estimated capital expenditures for such expansion would be RMB 2,210.3 million.

Cement industry review

We believe that Shanshui Cement has its own unrivalled advantage, thanks to its geographical location and privileged status conferred by the PRC government.

1. Geographical locationProduction and sale of cement is a regionalized business. The abundant limestone reserves and coal mines significantly reduce cement production and transportation costs in Shandong as compared to other provinces. Cement prices are significantly affected by the transportation costs for both raw materials and finished products due to their low value-to-weight ratio. To minimize costs and to offer competitive prices, cement plants are usually situated in close proximity to limestone reserves and to target markets. These constraints prevent any one producer from dominating the nationwide cement market and competition is generally confined to various regions. High transportation costs discourage outside competitors from selling into existing markets and competing with local producers.

2. Privileged statusThe PRC government has increased barriers of entry to the cement industry. It requires that all newly established clinker production lines must secure sufficient resources to support operations for at least 30 years, and all newly established cement grinding plants should have a minimum annual production capacity of six million tons.

Chinas cement industry is highly fragmented. In 2006, there were over 5,200 independent producers. The average annual cement production capacity was 0.22 million tons per producer, which was much less than the global average outside the PRC. The annual aggregate annual production capacity of the 12 largest PRC cement producers accounted for approximately 25% of the total capacity in China by the end of 2007. Over the past three years, major PRC cement producers have accelerated their consolidation activities and increased their market shares. Large cement producers, with support from the government, have been growing rapidly through acquisitions. Smaller-scale cement companies are likely to be targets for further consolidation and acquisitions. The PRC government has been supporting larger and more efficient cement companies and helping fuel the consolidation trend with the issuance of several recent regulations. Large enterprises are encouraged to acquire small enterprises to accelerate industry consolidation. 12 national cement companies have been included in a list which will receive government support in the form of priority with respect to project approvals, land use right grants and credit approvals.

From 2002 – 2006, Chinas GDP increased from approximately RMB12,033.3 billion to approximately RMB21,087.1 billion, (CAGR 15.1%). As a result, Chinas cement consumption experienced a notable expansion (CAGR 14.5% from 2002 – 2006) driven by building and civil engineering construction activities. China is the largest cement producing country in the world, with a production volume of 1,236.8 million tons in 2006, accounting for over 50% of the global production.

Shandong is the largest cement-producing province in China.

Amounts and growth rates of GDP, cement consumption and production in China

Anhui Conch Cement Company Limited (914) produced 111.5 million tons of clinker and cement in 2007 and Shanshui Cement came the second, producing 27 million tons.

Risk Factors

The companys future growth depends to a significant extent on their ability to obtain external financing – the ability to raise funds within the company is weak.

High gearing ratios during the Track Record Period – The company has relied heavily on both short-term and long-term borrowings to make acquisitions. As of December 2005 to 2007, the debt has risen from 2,391.6 million to 4381.1million. Net current liabilities have risen from 2,270.7 million to 2,476.9 million.

Facing problems in integrating acquired businesses with their own – although the company had past successes in merging with established companies, this fast paced expansion may become a disadvantage if the companies they acquire have major flaws.

Facing intense competition from other cement producers – Chinas cement industry is very competitive. The company faces intense competition from those that are supported by well-established international players that offer financial and technological support.

The companys profitability and results of operations are subject to fluctuation in the supply and costs of raw material, coat and electricity. – The costs of raw materials, coat and electricity represent about 83.7% of their total cost of sales in 2007. Although they currently have their own limestone mine reserves, there is an uncertainty that they may not be able to acquire more limestone mines in future due to the fierce competition or any significant restrictions on the usage of the rights.

Comparison of financial performance of Shanshui Cement (691) and Asia Cement (743)

Conclusion

Second to Anhui Conch (914), Shanshui has the potential to consolidate its leading status in the northeast region of the fragmented cement industry, thanks to its geographical location and the PRC policy on the cement industry. Although the recent earthquakes and concerns over inflation prompt the PRC government to suppress price increase in cement, we believe that the policy is of a short-term effect to the revenue of the industry and that the mainland cement industry will continue to enjoy the fruits from industrialization and robust GDP growth in the longer run.

We also predict that the offer price of Shanshui shares to the public represent a substantial discount to the newly listed shares of Asia Cement (which is currently $5.72, 08 PE 23.8x) and to those of Anhui Conch (914), China National Building Material (3323) and TCC International Holdings (1136) (with 08 PE 25x – 31x), which is, like Asia Cement (743), a strategy used to enhance its share performance and attract investors attention.

The share performance of its newly listed neighbour Asia Cement is encouraging. We expect Shanshui Cement can be traded at about 30x 2008 PE, making target price to be $5.7, representing a 56.2% and 111% increase if its offer price is fixed at $3.65 and $2.7 respectively.

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