Van Shung Chong
Stock Code 1001.HK
Price(as at 1/4/03) HK$0.97
Target Price HK$1.54
Transforming into success
Stabilized Steel Trading Cut-throat construction steel price competition in Hong Kong has ended and the negative impact should be already fully reflected. Through diversification into better established growth cities with a strong presence of Hong Kong developers like Macau and Shanghai and also increasing the higher profit margin engineering products like steel piling and soil nails, construction business will provide stable recurrent income.
Climbing Profit Margin For the near to medium term, VSC Group will focus on expanding the higher margin CAMP division. The coil or service centres that provides value-added services and the enclosure system manufacturing will be the future growth drivers. Overall profit margin is on the rise.
Benefiting from the Mainland Market The automobile industry, light industry, light home appliances and white goods industry, and information technology industry in China will continue to post strong growth. The coil centres and metal service centre of VSC Group will benefit from it.
Attractive valuation VSC Group is trading at FY04 expected P/E of only 4.4x, which is lower than 8-9x industry average. It is also trading at nearly 40% discount to its 2003E NAV. Due to the opening up of the vast PRC market, growth potential of its higher margin CAMP division will be large. VSC Group is repositioning itself to healthy earnings growth and it is a value buy.
Source: VSC Group, Tung Tai estimates
Established in 1961, VSC Group is a leading distributor and processor of quality industrial and construction materials. The group consists of two main divisions, namely, China Advanced Materials Processing Holdings (CAMP) and Construction Materials Group (CMG). CAMP consists of coil centre operation, enclosure systems, and plastic and machinery distribution, serving information technology, home appliances, construction and the automobile industry in China. CMG engages in stockholding and supplying construction materials, steel products and buildings products to Hong Kong, Macau and Southern and Northern China markets.
VSC Group has over 40 years of experience in import and stockholding of steel products for developers in Hong Kong. CMG accounts for about 80% of VSC Group’s turnover in which steel department had a turnover of $1,691M in FY01/02. During the period, the rebars market shrank with the adverse construction market by 33% and experienced fierce competition. Price of rebars was driven down from $2300 to $1600 low level and eroded profit margin. The group decided to withdraw from the competition despite its market share dropped to 40-45%. The price of rebars recently recovered to $2500 per tonne and gross margin is 8-10%. We believe the negative effect of price war has been fully reflected in last year and the interim results.
The department recorded operating loss in FY01/02, but loss was reduced in FY02/03 interim results. Revenue from a few projects should help the department to turn around and the showroom opened in April 2002 is expected to perform well.
Looking ahead, VSC Group will further diversify its construction material business into nearby cities. For example, more casinos and theme parks will be built in Macau. The Group will also target at construction projects in Shenzhen and Shanghai with local developers or mainland developers who have 7 to 8 years track record as customers. VSC Group will keep the prudent credit policy. On the whole, CMG division will see flat or small growth.
Future Growth Engine: CAMP
The operation of a coil centre is mainly buying finished steel, processing it and selling it to finished product producer. Coil centre provides value-added service to customers so that profit margin can be higher. Customers need not to keep inventory, rent space for the storage of bulk coils, install equipment for slitting and cutting of steel, etc.
The coil centre in Dongguan achieved sustainable growth in turnover and profit. Turnover increase from $158.9M in FY99/00 to $234.9M in FY01/02. Gross profit margin was maintained at about 20%. It is expected to be 25-30% in FY02/03. The current capacity of Dongguan Plant is 72,000 Mt per year. The estimated annual sales in 2002/03 is 58,300Mt, implying a 81% utilization rate. The capacity will increase 40% in April 03, targeting 72kMt sales in 03 and 86kMt in 04.
Despite the global economy slows down, the major customers of VSC Group, who engage in mass production of computers and visual/audio equipment, continued to place huge orders to the coil centre. Though the Group is not the sole suppliers of its customers, its supplies over 70% of rolled steel to them. As the trend of maintaining only a few suppliers continues, we believe the coil centre can be resilient to economic downturn. VSC Group has at least 2 to 3 years of relationship with its customers. Its customer base is well diversified that about 20 to 30 customers accounted for 50% of coil centre turnover.
Following the good results in Dongguan Plant, VSC Group decided in July 2002 to build a new coil centre in Tianjin. During the first year, capacity will be a third to half of Dongguan Plant i.e. 30kMt per year. The estimated full capacity will be similar to that of Dongguan Plant. The Tianjin Plant will commence operation around May this year. Capex of the plant is approximately $30M. Target sales is 24kMt and 48kMt in 2003 and 2004.
The outlook of steel industry in China is optimistic. The booming economy induces strong domestic demand. According to statistics, steel demand in China grew 23% in the first two months of 2003 and may account for one quarter of global consumption this year. On a per-capita basis, Chinese consumption remained low, compared to the Western world.
In Southern China, there are about 100 coil centres. However, they mainly serve lower-end domestic market with hardly any reliable sales service or quality controls. VSC Group offers a chain of value-added services that caters to customers’ needs.
In 2002, exports of machinery and its accessories surged by 51.3% to US$50.8B in China. With the great market potential, VSC Group is investigating the feasibility to set up another plant in Guangzhou or Shanghai. It targets to have plants set up in both places by 2004/05.
VSC Group established its first enclosure systems manufacturing plant in Shenzhen, VJY, in 2001. VJY manufactures a variety of customized enclosure systems including whole cabinets, metal boxes and other accessories. These enclosure systems have widespread applications in telecommunication system, network system, exchange system and other related fields. With the high quality standard, VJY was granted ISO 9001 certificate in Jan 2002.
VJY is the qualified supplier of some well-known telecommunication firms such as Huawei, Zhongxing, and Emerson Group of US. Such tailor-made enclosure business accounts for 70% of turnover and the remaining 30% as standard enclosure, ATM, autoparts, etc. VJY’s current turnover is $30-40M with a 10% profit margin. The turnover target is $110M in FY03/04 and $150M in FY04/05.
Despite the global IT industry encountered the most severe downturn last year, figures from the Ministry of Information Industry (MII) showed the output of information industry in mainland grew by more than 20% in the first 10 months of 2002 to 1.5 trillion yuan. During the period, sales reached 1.04 trillion yuan.
The number of urban phone lines jumped over 80% from 74.6M by the end of 1999 to 136M by the end of 2002. Growth of cellular phones was even more fascinating. The number increased nearly five folds from 43.2M in 1999 to 206.6M in 2002.
Light industry also performed better than expected in 2002 in which home appliance exports grew 28.4%. The export is expected to rise more than 20% this year. The low production cost in China will continue to attract investments from overseas appliance makers and the demand for steel processing will increase.
To tap the tremedous automobile market in China, VSC Group is in negotiation with some major Japanese automobile manufacturers together with other Japanese subcontractors for joint venture in automobile parts. Details of the JV will be confirmed by the end of 2003. The proposed metal service centre will be built near the existing coil centre in Tianjin. The estimated capex is $80-100M.
China’s auto industry experienced spectacular growth last year. Sales increased by 36.65% y-o-y to 3.25M units in 2002. The rise was driven by domestic demand resulted from sustained economic growth. Chinese economy seemed to be immune to global economic slowdown.
Auto consumption environment was improved as many restrictions on market entry and auto consumption were curbed or abolished. As China has joined WTO, it will fulfill its commitment by further relaxing market entry standards. Hence market price of autos will go down and stimulate demand. China’s average car ownership ratio is about 1 to 2%, which is extremely low compared to an average 40% of the Western world, suggesting the market potential will be enormous. The accelerated pace of urbanization and improved infrastructure will also be catalysts. Demand will reach 4M units this year and we expect annual demand can reach 10M by 2010.
On the supply side, foreign investment will continue to increase substantially. For example, Honda in Guangzhou will double its capacity to 240,000 in 2004, while Nissan’s joint venture has set yield target of 550,000 in 2006. Besides capital, foreign companies will bring in new technology into the industry. The total automobile output is expected to reach 3.9M in 2003.
We believe VSC Group has bottomed out from previous years as price war in steel trading ended and the higher profit margin CAMP is going to expand quickly. In addition, there expect to be no more exceptional write-offs according to Management. Instead, some write back is expected from GFTZ fuel company. The company had committed a repayment of $0.8M each month, which amounted to $4.8M received in total. The $17M asset investment write-off can also be recovered.
Besides the consistently performing construction steel business, VSC Group is also now focusing on value-added services, such as coil centre and enclosure systems. The auto industry, IT industry and light and white goods industry will continue to boom in the PRC. With lower production costs, China will continue to be the “world factory”. More production bases will be moved into China by multi-nationals and demand for high quality steel processing with reliable services will increase. Therefore, VSC Group is heading in the right direction to capitalize the vast opportunity in China, hence repositioning itself for significant earnings growth in the next few years.
The current stock price is trading at 39% discount to $1.60 2003 estimated NAV per share, in which most are liquid assets. Estimated PER in FY04 is only 4.4x, which is very low as industry average is 8-9x. We believe VSC Group is positioning for healthy growth and it is a value buy.
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