Elevator Pitch
Xinyi Glass Holdings Ltd. (OTCPK:XYIGF) (OTCPK:XYIGY) [HKG:868], the largest float glass producer in China, is a beneficiary of favorable supply-demand dynamics and lower prices of soda ash, a key raw material. Given that its market leadership is expected to be unchallenged as a result of competitive advantages in economies of scale and the high costs of competitors switching to natural gas as a fuel source, the company is well-positioned to capitalize on the positive outlook for the Chinese flat glass industry in terms of higher product average selling prices and stable demand.
I arrive at a target price of HK$15.75 for Xinyi Glass based on a sum-of-the-parts valuation, which implies a 31% upside (including dividends) to Xinyi Glass' share price of HK$12.70 as of March 6, 2018, based on a two-year holding period. For my sum-of-the-parts valuation, I apply a forward P/E multiple of 12 times to my estimated FY2019 net profit of HK$4,606 million for Xinyi Glass, excluding share of profits from 29.5%-owned associate company Xinyi Solar, and add the value of Xinyi Glass's 29.5% stake in Xinyi Solar based on its last traded price on March 6, 2018.
Company Description
Xinyi Glass is a Hong Kong-listed Chinese glass manufacturer that also trades on an OTC basis in the U.S. It produces and sells a wide range of glass products, such as high quality float glass, automobile glass, architectural glass, and other glass products. Xinyi Glass has manufacturing facilities located in China (Shenzhen, Dongguan and Jiangmen in Guangdong Province, Wuhu in Anhui Province, Yingkou in Liaoning Province, Deyang in Sichuan Province) and Malaysia (Malacca).
The Float Glass, Automobile Glass and Architectural Glass product segments contributed 59%, 24% and 17% of Xinyi Glass's FY2017 revenue respectively. Xinyi Glass is a market leader in all three segments; it is China's largest float glass producer with a domestic market share of 10% and is the second largest player in architectural glass only trailing domestic market leader CSG Holdings. Xinyi Glass also boasts a 25% share of the global automobile Aftersales Replacement Glass market. The company generated 73% of its FY2017 revenue from China, and the remaining sales from North America, Europe and other countries. Xinyi Glass also has a 29.5% shareholdings interest in Xinyi Solar [HKG:968], a solar glass manufacturer.
I will be focusing primarily on Xinyi Glass' Float Glass product segment, as this segment accounts for more than half of the company's sales.
Favorable Supply-Demand Dynamics
Xinyi Glass is a proxy for the positive outlook of China's float glass market in the next one to two years resulting from favorable supply-demand dynamics, thanks to its status as the country's largest float glass producer.
China's float glass market is a beneficiary of a couple of regulatory tailwinds, particularly on the supply side.
Firstly, new tighter emission standards with respect to air pollutants would be imposed on flat glass manufacturers starting June 1, 2018. This is part of China's broader plan to make the country cleaner by targeting heavily polluted cities which China refers to as the "2+26" cities (Beijing, Tianjin, and 26 cities in the Beijing-Tianjin-Hebei and surrounding areas). As an illustration of the scale of the air pollution issue, a September 2017 South China Morning Post article titled "Grim news from the front line of China’s battle against air pollution" referred to Hebei as "China’s most polluted province" and cited Shahe, a town in Hebei that houses over 600 manufacturers producing 10% of the world's flat glass supply, as one of the key contributor to Hebei's air pollution woes. The tighter emissions standards (allowable PM2.5，sulphur dioxide, nitrogen dioxide emission rates to be reduced from 50/400/700 mg/m3 to 20/100/400 mg/m3) implies that more float glass factories might have to be shut down if they don't meet the new emission standards, thereby reducing supply in the Chinese float glass market.
Unlike most of its sub-scale peers (which use more pollutive sources of fuel such as heavy oil, coal gas, petroleum coke etc), Xinyi Glass uses natural gas as the primary fuel source for its high quality float glass production which reduces carbon emission levels. As a result, Xinyi Glass' float glass manufacturing lines are unlikely to be affected by the new tighter emission standards, and in fact, it is well-positioned to capitalize on the exit of its competitors in the market.
Secondly, China's Ministry of Industry and Information Technology announced a new policy regulating capacity replacement in the glass, steel, cement and industries that has come into effect since January 1, 2018. This is also part of China's broader policies with respect to supply-side reform to reduce overcapacity risks in certain of its key industries. For flat glass manufacturers who wish to build new plants or production lines in environmentally sensitive areas of the Beijing-Tianjin-Hebei region ("2+26" cities), they have to eliminate 1.25 tons of old existing capacity for every 1.00 ton of new additional capacity they add, which implies that overall flat glass supply should reduce.
Thirdly, significant flat glass supply was already taken out of the market last year, so this should support flat glass prices this year on top of the regulatory tailwinds highlighted above. In November 2017, nine flat glass production lines in Shahe, Hubei, were forced to shut down by the regulators because they did not obtain the relevant emission permits; the nine production lines boasted a combined production capacity of 5,800 tons per day, or approximately 3.5% of the entire Chinese market. A month later in December 2017, another three flat glass production lines with a combined production capacity of 2,050 tons per day were shut down as they had their existing emission permits revoked for falling short of regulatory standards. In other words, flat glass capacity of 7,850 tons per day (5.2% of China's total flat glass capacity) were removed from the market in end-2017. More shut-downs are expected considering the regulatory changes this year.
Moving from supply to demand, real estate construction and automobile manufacturing are the two largest consumers of flat glass, accounting for 75% and 10% of demand respectively. I will focus on the Chinese residential market, which is the single largest driver of flat glass demand. The Chinese residential market had a record year in 2016, with residential Gross Floor Area sold increasing 22% YoY to reach 1.38 billion square meters. In 2017, China's growth in GFA sold was a lower 5.3% YoY, but still positive. Given that there is a one-to-two year time lag between actual residential sales and demand for glass, flat glass demand from the Chinese residential markets should grow in FY2018 and FY2019 in the worst case.
Looking ahead at the prospects of the Chinese residential market in 2018, the general consensus is that residential GFA sold should be flat or slightly increasing. Real estate consultancy Jones Lang Lasalle (JLL) predicts that "sales volumes in China's Tier-1 cities are likely to hold relatively stable in 2018 under the expected tight monetary policy." Stock brokerage DBS Vickers takes the view that "GFA sales to remain largely stable or record a slight y-o-y increase on the acceleration of new launches by developers and policy adjustments from provincial governments." Favorable policy adjustments by provincial governments include bigger loans via the housing provident fund subsidies for certain first-time home buyers in Nanjing and subsidies for young working professionals in Zhengzhou, Wuhan and Xi'an. Furthermore, besides private residential demand, the Chinese government is driving glass demand as well by renovating homes with a target of 15 million between 2018 and 2020, of which 5.8 million homes are expected to be renovated this year. The Chinese residential market is off to a good start in 2018, with average new home prices in China’s 70 major cities up 5% YoY in January 2018. For the first 2 months of 2018, the largest 32 listed Chinese residential developers in aggregate witnessed a 7% YoY increase in average selling prices and a 35% YoY increase in sales volumes.
I expect China's flat glass supply to be down 3%-5% in 2018 and demand to remain firm, which would be supportive of rising flat glass prices. The early signs have been positive, flat glass futures traded on China's Zhengzhou Commodity Exchange rose approximately 14% YoY to close at RMB1,478 per ton on January 31, 2018. This should be very positive for Xinyi Glass' product average selling prices and revenues for the coming two years.
Key Raw Material Cost Pressures Expected To Ease This Year
Soda gas is a key raw material in the manufacturing of flat glass and is estimated to account for approximately 15% of Xinyi Glass' cost of goods sold, making it the second largest cost item after energy (natural gas and electricity).
Chinese domestic soda ash prices spiked approximately 35% YoY in the later half of 2017 to $305-315/ton. The good news is that soda gas prices might have peaked last year and are headed southwards in 2018. A decline in flat glass supply this year for reasons outlined above and high plant utilization rates (90%) and high inventory levels for local soda ash producers are the key reasons for the moderating soda ash prices.
This year, Xinyi Glass' management is guiding for "soda ash price trend would moderate compared with 2017." Similarly, Ciner Resources Corporation, a leading supplier of natural soda ash based in Turkey, is forecasting soda ash prices to decline by 1%-3% in 2018.
Even assuming that the predictions are wrong, Xinyi Glass has a "safety net" and an edge over competitors in the form of back-up plans to source more soda ash from its overseas network to mitigate any potential price fluctuation for soda ash. The company currently sources around 30% of its soda ash needs from the U.S. at prices at least 10% lower than domestic soda ash prices.
Scale Economies Reinforces Market Leadership
Based on the analysis in the preceding sections, it is clear that the outlook of the flat glass industry in China is favorable for incumbents which can benefit from the exit of sub-scale competitors that cannot meet emissions standards and lower raw materials resulting from a decline in soda ash prices. The next step is to determine if Xinyi Glass boasts sustainable competitive advantages to allow it to retain its market leadership to benefit from the industry uptrend.
As highlighted in the "Company Description" section of this article, Xinyi Glass is China's largest float glass producer with a domestic market share of 10%. I believe that Xinyi Glass can maintain or even expand its market share in the Chinese float glass market due to two factors: economies of scale and its use of natural gas as fuel (to be discussed in the next section).
Glass production is similar to any high fixed-cost manufacturing business where there are high breakeven costs and scale economies are key to profitability. As an illustration, a small float glass factory located in the U.S. with daily production capacity of 50 tons, would probably cost a few hundred million dollars at the minimum. Xinyi Glass, as the market leader in the production of flat glass with a daily capacity of 17,100 tons, enjoys significant economies of scale in a market where the 10 largest domestic producers of flat glass have a combined market share of 55%, and Xinyi Glass is the market leader and the only player with market share in the double digits (10%). In other words, Xinyi Glass is at least twice as large as a typical competitor in the flat glass market. This allows Xinyi Glass to spread its fixed costs over a larger revenue base and generate margins superior to its sub-scale peers.
Xinyi Glass spends approximately 3% of its revenue on research & development, R&D, every year. Due to scale economies, Xinyi Glass can spend double the amount of money on R&D in absolute terms, compared with a competitor that is half the size of Xinyi Glass (in terms of revenues) and also chooses to allocate 3% of its annual sales to R&D. There is a virtuous cycle at play here, where the strong gets stronger. The end-result is that Xinyi Glass grows its market share over time, as it enhances its competitiveness with higher quality products (made possible by larger R&D dollar spending) and improved production efficiencies by optimizing the manufacturing processes (which further improves its margins and allows for even more money to be spent on future R&D).
Choice of Natural Gas As Primary Fuel Source Makes Xinyi Glass Immune To Tightening Emission Standards
As highlighted above, Xinyi Glass utilizes natural gas as its primary fuel source for flat glass production, which suggest lower emission levels to meet regulatory standards. It means that the company can gain market share from the exit of competitors and also benefit from the resulting lower supply in the industry which provides support for flat glass prices.
More importantly, it is difficult for competitors utilizing other sources of fuel like heavy oil, coal gas, petroleum coke to make a switch to natural gas. One factor is that using a higher-cost fuel source like natural gas implies that the flat glass producer needs to manufacture higher-quality products which justify a price premium, something that the existing competitors competing at the lower end of the price and product quality spectrum (and utilizing cheaper and more pollutive fuel sources as a result) might find difficult to adapt to.
Another factor is the prohibitive cost (for low margin sub-scale players that are likely to have weak balance sheets) of re-configuring a single existing flat glass production line to utilize a new fuel source which is estimated to be around RMB50-100 million per line.
Valuation
I arrive at a target price of HK$15.75 for Xinyi Glass based on a sum-of-the-parts valuation.
I apply a forward P/E multiple of 12 times to my estimated FY2019 net profit of HK$4,606 million for Xinyi Glass, excluding share of profits from 29.5%-owned associate company Xinyi Solar, and add the value of Xinyi Glass's 29.5% stake in Xinyi Solar valued at HK$7,267 million based on Xinyi Solar's market capitalization of as at March 6, 2018.
I forecast Xinyi Glass' revenue to grow at a two-year CAGR of 13% from HK$14,727 million in FY2017 to HK$18,800 million in FY2019. The 2-year revenue CAGR assumption of 13% is higher than the company's 3-year historical revenue CAGR of 10.7%, as Xinyi Glass benefits from higher flat glass average selling prices in FY2018 and FY2019, higher demand from construction backlog driven by robust 2016 and 2017 Chinese property market sales and an expansion of production capacity outside of China with a new production line in Malaysia (second production line to start in 2H2018). I also expect Xinyi Glass' net profit margin (adjusted to excluding share of profit from associate Xinyi Solar) to increase from 22.5% in FY2017 to 24.5% in FY2019, as a result of operating leverage (higher sales on a large fixed-cost base) and lower soda ash prices. This results in a FY2019 net profit of HK$4,606 million for Xinyi Glass, excluding share of profits from 29.5%-owned associate company Xinyi Solar.
The forward P/E multiple of 12 times for Xinyi Glass is the mid-point of the stock's 10-year historical mean P/E of 10 times and one standard deviation above 10-year historical mean P/E of 14 times. Given that the flat glass industry is in a up-cycle for at least the next two years (thanks to capacity reduction), 12 times forward P/E is appropriate in my opinion.
Xinyi Solar's share price and market capitalization as of March 6, 2018 were HK$3.32 and HK$24.6 billion, respectively. I choose to use Xinyi Solar's current market capitalization as the basis for valuing Xinyi Glass' 29.5% stake, as I think Xinyi Solar's current valuations are reasonable at 9 times forward FY2018 P/E.
My target price implies a 24% upside to Xinyi Glass' share price of HK$12.70 as of March 6, 2018. This excludes the 3.7% dividend yield that Xinyi Glass offers based on a FY2017 dividend payout of HK$0.48. Including dividends to be collected over a two-year holding period, the total return potential for Xinyi Glass is 31%.
Variant View
The key risk factors for Xinyi Glass are a severe downturn in the Chinese property market (current indicators suggest otherwise as mentioned above), a reversal of current favorable regulatory tailwinds (impossible to predict policies with any certainty, but at least 5% of domestic flat glass capacity has been removed since end-2017) and a spike in the prices of domestic soda ash (partly mitigated by the fact that the company sources 30% of its soda ash needs outside of China as highlighted above).
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