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DeutscheBankMarketsResearchAsiaChinaResourcesIndustryChinaContainerboardDate12July2017ForecastChange1Hpreview:astrongbeatatpeak-cyclemargins1HCY17toseerecord-highcoreEPSgrowthof59%/47%yoyforLMP&NDP________________________________________________________________________________________________________________DeutscheBankAG/HongKongDeutscheBankdoesandseekstodobusinesswithcompaniescoveredinitsresearchreports.Thus,investorsshouldbeawarethatthefirmmayhaveaconflictofinterestthatcouldaffecttheobjectivityofthisreport.Investorsshouldconsiderthisreportasonlyasinglefactorinmakingtheirinvestmentdecision.DISCLOSURESANDANALYSTCERTIFICATIONSARELOCATEDINAPPENDIX1.MCI(P)083/04/2017.JohnsonWanResearchAnalyst(+852)22036163johnson.wan@db.comKeyChangesCompanyTargetPriceRating2314.HK6.25to8.06(HKD)-2689.HK6.61to7.00(HKD)-Source:DeutscheBankToppicksLee&ManPaper(2314.HK),HKD7.41HoldNineDragonsPaper(2689.HK),HKD10.56SellSource:DeutscheBankCompaniesFeaturedLee&ManPaper(2314.HK),HKD7.41Hold2016A2017E2018EP/E(x)8.97.98.7EV/EBITDA(x)8.57.47.4Price/book(x)1.61.71.5NineDragonsPaper(2689.HK),HKD10.56Sell2016A2017E2018EP/E(x)7.610.612.3EV/EBITDA(x)6.77.68.6Price/book(x)0.91.51.4Source:DeutscheBankValuationandrisks:WevalueNDPandLMPusingFY18EPBvs.ROE.WevalueNDPusing0.9xFY18EPBon11%ROEtoderiveitstargetpriceofHKD7.00/sh.Wekeptourmultipleunchangedat0.9xeventhoughitdoesnotfullyreflectthe11%ROEthatNDPwillgenerateaccordingtotheGordonGrowthModel.Weseehigherearningsvolatilityaheadwithnewsupplyhittingthemarketin2H17-2019,whichwillimpactutilizationratesandleadtomorecompetitivepricingbehavior.OurTPalsoimplies8.5xFY18PEversusNDP’smid-cycleaverageof10.5x.AlowermultipleisjustifiedtoreflectitspeakcycleearningsinFY18.WevalueLMPusing1.6xFY18EPBbasedon18%ROEderivingourtargetpriceofHKD8.06/sh.Whilethe1.6xPBmultipledoesnotfullyreflectthe18%ROEthatLMPisexpectedtogenerateaccordingtotheGordonGrowthModel,webelievealowermultipleiswarranted,givenhigherearningsvolatilityaheadwithnewsupplyhittingthemarketin2H17-2019.OurTPalsoimplies9.5xFY18PEversusLMP’smid-cycleaverageof10.2x.ThelowermultipleinFY18reflectsitspeakcycleearningsinFY18.VersusitspeerNDP,webelieveLMPdeservesahigherPBandPEmultiplegivenitshigherqualityearningsgrowthandlesscyclicalearningsnature.LMPderivesmorethan51%ofitsearningsfromSouthChina,wheresupply-demandandmarketconcentrationisbetter,anditsproductmix,heavilyskewedtowardslinerboard,isalsomorefavorable.Downsiderisks:weaker-than-expecteddemand,accelerationofnewsupplyadditionsandunexpectedOCCpricehikes.Upsiderisksarethereverse.Moredetailsp8.Weexpect1HCY17earningstobeatrecord-highs,withLMP/NDPseeingearningsupby59%/47%respectively.NP/ttoreachHKD800/RMB382forLMP/NDPonourestimatesvs.consensusFY17ENP/tatHKD571/RMB322.However,thesemarginsareunlikelytobesustainablewithlargermillslosingsharetosmallermillsonproductionhalts,highdownstreaminventoriesandsignificantnewsupplyin2018.Ofthetwo,wepreferLMPoverNDPgivenitshigherexposure(51%)inSouthChina,betterproductmixwithmorelinerboardandsolidmedium-termgrowthdriversintissue.Givenstrong1Hearnings,weraiseearningsandTPsbutmaintainHoldonLMPandSellonNDP.Upsidesurprises:containerboardpricingandtissuepapermarginsIntheabsenceofimprovedsupply-demand(utilizationtodropby3pptyoyto85%in2017),theresiliencein1H17paperpricinghasexceededindustryexpectationswithaveragecorrugatedmediumandlinerboardpricingup42%and38%yoy.Highpricingismainlyduetoastrategychangebyleadingproducers(lessrelatedtoenvironmentalrequirements)toincreaseproductionhaltsandhoardmoreinventory,thuscreatinganartificialshortage.Therefore,averagepapermillinventorydaysroseto15daysinMay-17versusonlysevendaysin2H16and10daysin1H16.LMP’stissuepapersegmentshouldalsosurprise,withmarginslikelyclosinginonHKD1,000/tduetoeconomiesofscaleandhigherpulpprices.Downsidesurprises:lowervolumes,higherOCCcostsandhigherimportsHowmuchvolumedidlargeplayersholdbackon?WebelieveNDPheldbackmorethanonemonthofsales,completingonlyc.5.8mtinsalesversus7.1mtin2HCY16,onourestimates.Thiscouldbeabigmissversusits1HCY17targetsof6.2mtand6.5mt(loweredtwice).Lowervolumesbybigmillsalsoattractedmorepaperimports(5M17up191%yoy)andmarketsharegainsbysmallerpapermillsnationwide.Ifthenewstrategyistocutbackonproduction,thenisthereevenaneedforNDPtoadd2mtofnewcapacityin2018?TheriseinCOGSmayalsosurprisesome,with1H17domestic/USOCCpricesupby43%and54%yoyduetoloweredimportquotas,higherfreightandstrongdemandintheUS.Thistrendseemsheretostayin2H17somaterialcosts(whichaccountfor70%+ofCOGS)shouldbeelevatedgoingforward.Peakmarginsin1H17andlikelylowermarginsin2H17and2018/19Onourestimates,1Q17wasthepeakmarginquarterwithLMP/NDP’sNP/thittingHKD1,061/RMB787/tandsubsequentlycorrectingtoHKD784/RMB309/tin2Q17.Mostinvestorsandindustryparticipantsbelievethat2H17willbethepeakseasonandthereforeASPswillgohigher.However,thecircumstanceshavechanged,withboxmakersnowfullystockedupat1-3monthsofinventories,andunabletopassthroughthecurrenthighpaperprice.The1H17averagecostforOCCwasRMB1,800/t+butevenifOCCcostsweretoremainflatfromhereonwards,OCCcostswouldbeRMB300