Ferrochina -Strong Results

03/01/06 02:52 PM Subject: Ferrochina -
Strong results, but the best is yet to be!





FERROCHINA LTD (FRC:
S$0.62)
BUY (Upgrade)
Strong results, but the best is yet to be !

Net profit of RMB 146m is 3.6% below our forecast of RMB 151.6m.
Excluding
the IPO expense, net profit of RMB 159.2m is 5% above our forecast.
The
excellent performance was due to contribution from second production
line
which started in June 2005. Raw material price was volatile,
leading to
lower margins. Outlook is very positive because of acquisition
of
Everbright and potential acquisitions of XingYu and XingHai.
Profit at
existing XingDao operations will balloon after renovation of line
one.
Upgrade to BUY with a revised 12-month price target of S$1.10,
based on
comparative valuation vis-à-vis its Taiwanese competitors.

(I) Strong earnings growth from more efficient second production line
and
favourable price trend

· The 35% growth in net profit to RMB 146.1m in 2005 was due to
increased output of galvanized steel despite lower profit margin per
ton.

· Output increased following the completion of a second line which
started in June 2005. Operational efficiency at the second line was
superior to the first because of more and better machineries.

· Margins declined despite 4% higher average selling price in 2005.
This is because of price volatility in raw material, namely Hot and
Cold
Steel Coils.

· Price of hot rolled coil during 2005 declined from a peak of RMB
6,000 / MT in March to RMB 3500 / MT in September, and RMB 3000 / MT in
December. The finished product, Galvanized Steel declined from a peak
of
RMB 7200 / MT in March to RMB 5350 / MT in September and RMB 4,000 / MT
in
December. This spread between raw material and finished product
increased
from RMB 1000 to RMB 1850, and then fall back to RMB 1000.

· The above situation is in China. In the international market,
prices
of Galvanized Steel have fallen less steeply than that in China, partly
because overseas demand for Galvanized Steel has increased in the
post-hurricane construction boom in US, post earthquake rebuilding in
India
and Pakistan, and post-tsunami recovery in Thailand, Sri Lanka and
Indonesia.

(II) Outlook is superb: clear management strategy for growth is
applauded

(a) Existing business at XingDao

· Management disclosed that order book is filled for 1Q06 at higher
selling prices. Production efficiency has reached 100% for 1Q06, up
from
90% in 4Q05. Orders for 2Q06 are strong, but management is holding out
for
higher prices. This is due to strong overseas interest, particularly in
the
US. 1H06 net profit is expected to be significantly stronger than that
in
1H05. Management is focusing its marketing efforts in the international
market where prices of Galvanized Steel have fallen less than that in
China.

· Ferro China is building a cutting and slitting workshop, new
warehouse and docking berth facilities to complement existing
operations.
Upon completion in 3Q06, savings in transportation costs, and bringing
the
existing cutting service in-house, will add at least RMB 50 per MT of
output to net profit.

· Production line one will be upgraded to produce Galvanized Steel
coils with expanded product applications, including automobile and home
appliance industry. Hitherto, line one supplies only to the
construction
industry, although line two has expanded the product range to include
steel
for the construction of grain-storage silos. Line One will be shut for
three months in 3Q06.

(b) Purchase of Everbright

· We were wrong in our earlier assessment of Everbright. (See
report
dated 18 January 2006).

· We have underestimated the tremendous growth potential of
Everbright.
We have earlier assumed that the 6 Slitting and Cutting Lines, 1
Pickling
Line and 1 Cold Reversing Mill were all that the plant at Changshu
could
offer. Subsequently, we learn that 1 Continual Hot dip Galvanizing Line
would be added in 2Q06, 1 Color-coating Line in 3Q2006, 2 Cold
Reversing
Mills and 2 Continual Hot-dip Galvanizing lines in 2007. The existing
Pickling Line was only completed in Oct 2005 and the Cold Reversing
Mill in
July 2005. Hence, the reported RMB 155m net profit for FY2005 does not
represent the potential from Everbright.

· We have added our earnings projection for Everbright into
forecast
for Ferro China. The latter will have 35% of Everbright's earnings for
the
last 7 months of 2006, and 25% in 2007 and 2008 (20% if Everbright
successfully goes for public listing in Hong Kong in 2007 as proposed
by an
American investment bank). Everbright has secured investment from
Taiwanese
notebook maker Asustek and car-maker YuLong, as well as secured orders
for
at least 30% of its output from these investors. Margins for Everbright
are
projected to be better than that of XingDao, Ferro's existing sole
business.

(c ) XingYu and XingHai

· We HAVE NOT added projections for FerroChina's potential
investment
in two new steel processing plants, XingYu and XingHai. Construction of
these plants has started and production may start in 2007 or 2008 at
the
latest. We expect Ferro China to announce acquisitions of these two
plants
in 2006. Management has given an assurance that no new Ferro China
shares
would be issued for this acquisition.

· Xinghai has a license to manufacture and sell antisepticised
steel
coil and cold rolled steel coils (full hard); Xingyu has a license to
manufacture and sell cold rolled steel coils (soft). The shareholders
of
Xinghai and Xingyu have granted FerroChina a three year option (till 11
April 2008) to purchase the two companies.

(IV) Valuation and Recommendation

· We upgrade our recommendation to BUY with a 12-month revised
price
target of S$1.10. This is based on a target of 5x forward PE. Such
valuation parameter is calculated on the weighted average of its
Taiwanese
competitors and discount for the disparity in market capitalization and
years of establishment. Consideration has also been taken of the
potential
for equity dilution, arising from the forthcoming issue of preferential
shares.

Tan Khow Siong (65)
6232
3890
khow-siong.tan@dmgaps.com.sg