Cautious on China fertilizer; Buy CBC on valuation with potential catalyst

Deutsche Bank Markets Research Asia Hong Kong Energy Oil & Gas Industry China Fertilizer Date 21 January 2016 Recommendation Change Cautious on China fertilizer; Buy CBC on valuation with potential catalyst Reinstating coverage of China fertilizer sector with a cautious view ________________________________________________________________________________________________________________ Deutsche Bank AG/Hong Kong Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 124/04/2015. Vitus Leung Research Analyst (+852) 2203 6158 vitus.leung@db.com Johnson Wan Research Analyst (+852) 2203 6163 johnson.wan@db.com Key Changes Company Target Price Rating 3983.HK NA to 2.60(HKD) NR to Buy 0297.HK NA to 1.15(HKD) NR to Hold 000792.SZ – to 22.20(CNY) NR to Hold Source: Deutsche Bank Top picks China BlueChemical (3983.HK),HKD1.59 Buy Sinofert (0297.HK),HKD1.02 Hold QSLI (000792.SZ),CNY19.77 Hold Source: Deutsche Bank Valuation comps Valuation19-Jan-16FY16EFY17EFY16EFY17EChina BlueChem0.410.397.68.3Sinofert0.440.422.83.9QSLI1.391.292.84.0ReturnUpside19-Jan-16(%)FY15EFY16EFY17EChina BlueChem55%7.2%7.2%7.3%Sinofert6%1.7%2.5%3.8%QSLI12%0.3%0.4%0.6%P/B (x)ROIC (%)Dividend yield (%) Source: Deutsche Bank Severe oversupply of fertilizers in China is set to continue after heavy capacity investment in the past decade. The industry is in a trough after price falls of up to 40% since 2013, with many companies making losses. Unless supply discipline and consolidation accelerate in China, the sector is unlikely to turn around, as new capacity continues to be added. In this environment, we would only recommend stocks with a clear cost advantage, deep valuation discounts, a superior ROIC and export capability. China BlueChem (CBC, 3983 HK) is our only Buy recommendation on these criteria - it also has plans to enter the high-end chemical market. Challenging years ahead; remaining cautious on fertilizer sector We hold a cautious view on the fertilizer sector where we expect a worsening imbalance of supply over demand. In the next five years, we expect global urea, phosphate, and potash utilization rates to drop by 2.02%, 3.2% and 9.6%, respectively, if all planned capacity is realized between 2015-2020. However, we do not expect fertilizer prices to deteriorate further, as they are near the marginal production cost level with new capacity mostly at the higher end of the cost curve. China overall fertilizer demand growth is limited to 0-1% p.a. The Chinese government expects to limit fertilizer demand growth to a 1% CAGR in 2015-2020 with flat expansion after 2020. We believe it aims to address the imbalance in fertilizer applications, which has been excessive in nitrogen (N; mainly urea) and phosphate (P). Cost advantage and export capability, with higher ROIC, are essential for N and P producers. Cuts in N and P applications could benefit under-applied potash, where China lags behind other countries in lbs/acre terms. Potash accounts for only c.12% of China’s total consumption compared to a global average of c.17%. Liberalization in the China fertilizer sector aims to curb excess supply China has liberalized the fertilizer market by permitting exports in order to ease oversupply capacity in urea and phosphates to the international market, while withdrawing preferential treatment of producers in terms of electricity, VAT, and transport tariffs. The Chinese government aims to remove inefficient, polluting, and high-cost producers from current excessive supply. There has already been progress with the number of N & P fertilizer companies falling to 307/215 as of 2015 compared to 571/395 a decade ago. Sector pecking order: China BlueChem > Sinofert > QSLI We reinstate coverage of CBC (Buy rating with TP of HK$2.60, +62% total return) and Sinofert (Buy rating with TP of HK$1.15, +8% total return), and initiate coverage of Qinghai Salt Lake Industry (QSLI, Hold rating with TP of RMB22.2, +ve 12% return). We favor CBC as a cost leader among urea/DAP producers; it is also planning to penetrate the high-value-add chemical market. This would utilize CBC’s excess cash. On valuation, CBC is trading at 0.4x FY16E P/B and 7x FY16E P/E, a steep discount to the global peer average of 75% and 35%, while we expect CBC FY16E ROIC of 7.6% vs. the global peer average of 11.4%. Our pecking order among China fertilizer stocks is CBC, Sinofert, and QSLI, based on th