Nine Dragons Paper seeks IPO to fund aggressive expansion

China's largest container board manufacturer targets $400 million.
ChinaÆs largest manufacturer of containerboard, Nine Dragons Paper, starts pre-marketing today (February 6) for an IPO that could raise up to $400 million at the top end of the range. At this level, it will represent the largest listing in Hong Kong since The Link Reit in late November.

Lead managers BNP Paribas Peregrine and Merrill Lynch will be hoping that the recent dearth of sizeable IPOs in Hong Kong and the strong growth prospects for the containerboard industry in China should result in a lot of interest for Dongguan-based company.

Nine Dragons will be offering up to 1 billion new shares, or 25% of the company, with an option to sell a further 150 million shares in case of strong demand. The deal will have the usual 90/10 split between institutional and Hong Kong retail investors.

Based on syndicate research profit estimates, the company will be valued at 10.7-11.7 times projected 2006 earnings of roughly Rmb1.1 billion ($136 million). This equates to a discount of up to 23% compared to Nine Dragons' closest comparable, Lee & Man Paper Manufacturing.

The latter is also listed in Hong Kong and is currently trading on a 2006 P/E multiple of about 14 times . This follows a strong run that has seen the company's share price more than double to HK$9.55 from its September 2003 IPO price of HK$4.17.

ôInvestors should find this valuation gap attraction given that Nine Dragons is almost twice the size of Lee & Man in terms of installed capacity and has a more aggressive expansion plan,ö one observer notes.

Nine Dragons opened its first mill in 1998 and today produces high-performance corrugated board, coated duplex board and liner board. Alll three are used as packaging material - a commodity in huge demand in ChinaÆs rapidly growing manufacturing industry. Its customers also include food producers.

The company now has 10 machines at its two production sites in Dongguan and Taicang - just outside of Shanghai - and is planning to add at least three more by 2008. The new machines, which will come on stream at fairly even intervals during the three-year period, will boost its annual production capacity to about 5.5 million tonnes from three million tonnes today. They should help boost the company's market share above its current 16% level.

By contrast, Lee & Man will boost its capacity by 25% to two million tons by the first quarter of 2007 when its eighth paper machine will begin operations. It will also add another 300,000 tones of capacity in the second half of that same year when a new plant in Chongqing is scheduled to come on line.

ChinaÆs container board producers are currently only able to meet about 90% of the countryÆs demand. The country produced about 18 million tonnes of containerboard in 2005, while consumption reached 20.6 million tonnes.

Analysts say that unless the Chinese economy stalls dramatically, demand should continue to increase. According to the China Paper Industry Association, demand for paper and carton board combined in China will have grown to 80 million tonnes per annum in 2015, making the country the second largest consumer in the world.

The company is also said to be favourably situated to capture new customers given the location of its plants in the Pearl River Delta and Shanghai. capturing new customers. It also has its own power plant (with a generation capacity of 24 MW per hour), which it should be unaffected by the power shortfalls that keep hitting the countryÆs high-production areas particularly in summer.

The capital expenditure needed to cover Nine DragonÆs capacity expansion will be close to Rmb4 billion ($496 million), but according to people familiar with the company, it will have sufficient cash flow to cover the purchase of two of three machines it has planned for.

Each time new capacity comes on board, it should result in a strong boost to the bottom line, as has also been the case for its listed rival. Lee & Man reported a 59% increase in its net profit for the six months to September 2005 to $309.35 million on a 49% rise in revenue to $1.86 billion, citing improved economies of scale.

Credit Suisse projects Lee & Man will manage a compound annual growth rate of 28% in profits in the coming three years, which would make it one of the fastest growing Hong Kong-listed mid-caps.

According to syndicate research, Nine DragonsÆ net profit is forecast to soar about 200% to between Rmb1 billion ($124 million) and Rmb1.2 billion ($149 million) this year. Revenues are expected to amount to between Rmb8 billion and Rmb8.3 billion.

The company is 100% owned by America Chung Nam, a US-based collector and trader of old corrugated cardboard (OCC), which is a key raw material for the production of container board. ACN is one a key supplier of recycled paper to the mainland market through various joint venture paper mills and in 1996 it thought it would make sense to set up its own production facility for quality packaging materials.

Nine DragonsÆ first machine started operations 18 months later with an installed capacity of 200,000 tons per year.

ACN supplies the great majority of Nine DragonsÆ OCC. On the one hand this can be seen as a sign of strength as the company has a virtually guaranteed feed of raw materials. However, some analysts that raw material costs will increase once the company becomes a listed entity and has to disclose how much it pays.

Analysts believe Nine Dragons has been privy to a discount to 1-2% compared with the prevailing market price, and note that there is no guarantee this situation will continue once it is no longer a wholly-owned entity of ACN.

As is typical for privately-owned Chinese companies û even those that are leaders in their industries û investors are also likely to ask for some additional risk premium to account for the lack of a corporate governance track record. In this respect, Nine Dragons will be watched closely by the investment banking industry, which expect mid-sized privately-owned Chinese companies to feature prominently among regional equity issuers this year.

The IPO is expected to price in the last few days of February after a global road show that will take the management to Asia, Europe and the US. The trading debut is planned for the first week of March.
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