Capital Cycle of China Sunsine Chemical (SGX:CH8)’s Industry

In my previous article, I wrote about why we should not invest in cyclical businesses such as automobile manufacturers. Today, I will share about the implications for its suppliers. For example, when homebuilding businesses suffer, banks suffer as well. All of us know that consumer debts and housing loans are big portions of a bank’s revenue portfolio.

Disclaimer: I have no competence in this sector, I am making wild assumptions based on my limited understanding. You should not take every word I say as the absolute truths. The companies are used as examples only.

Introduction

This article is inspired by China Sunsine’s recent profit guidance. It is expected to report a material increase in consolidated net profit, compared to the corresponding period from 1 July 2017 to 30 September 2017.

China Sunsine (CS) is an SGX-listed Chinese company that manufacturers rubber chemicals in China. Some of its products are accelerators and anti-scorching agents. These products are used in tire manufacturing process to modify its tire properties to be sturdier and heat resistant. It has over 1,000 customers including Michelin, Goodyear, Bridgestone, and Yokohama. I have nothing but excellent words for its management. Although it was previously a state-owned enterprise, Xu Cheng Qiu is considered the founder of the company. He bought out the company. As a small company, he turned it around and build on it further. Today, CS is one of the largest rubber accelerator makers.

UPDATE: After meeting the management, I wrote another article here.

Since it is a Chinese company, investors tend to worry about the impact of the trade war. Jennie Liu, China Sunsine’s spokesperson, eased the anxiety. In a Business Times article, she shared that CS’s export to the US market was roughly 2% in the first half of 2018.

By any measure, CS looks like a value stock with the right fundamentals. It has operating margins of 21.9% and ROE of 33.2%. The business has plenty of cash. It is reporting good cash flow and it has performed a trial-run of its new 10,000-ton TBBS production.

On 7 August 2018, CS reported a revenue growth and profit before tax of 34% and 131% respectively.

But what’s wrong?

The management has done a great job and they benefited from higher average selling prices of their products. This was caused by some players exiting from the industry because they did not comply with the relevant environmental regulations. The limited supply in the market pushed up the average selling prices.  The management also shared, over time, more producers will start to comply and resume their productions. This will intensify competition. When supply returns, the price of rubber chemicals will drop and normalise. (source: Q2 FY2018 results)

Referencing to the share price chart above, the share price of CS rallied upon the release of positive profit guidance. When the earnings are released, the stock price crashed. What’s wrong?

All investors need to know the underlying products (rubber additives) of CS is a commodity.

Commodities have capital cycles and it is affected by business cycles.

Part 1: Capital Cycle

When huge capital starts to pour into the industry, it expands the supply of the commodity. It sounds good. But when the equation shows the supply is more than the existing demand, it pushes the price of the commodity down.

You can see, a lot of supply is taken out of the market equation because of non-compliance to environmental policies. This allows CS to report supernormal profits. What happens when the supply returns into the industry? If anyone of us is purchasing CS’s shares right now, do take note, we are purchasing a business at its peak margins. The nearer it reaches to peak earnings, it is nearer for the cycle to revert. When earnings drop, the forward Price-to-Earnings will increase.

When an industry earns high-profit margins on an undifferentiated product, it will attract competitors. Competitors drive down profit margins.

Know this, when we invest in any businesses, the past twelve months of earnings serve as a guide. We are interested in the future twelve months of earnings.

Therefore, CS’ share price dropped despite reporting high profits because markets are expecting their margins and earnings to correct in next 1 – 2 years.

Using Morningstar, here is another clue. CS margins are at peak in its 9 years of the business cycle. Everything is in a cycle for a commodity. I see a likely normalisation of margins happening as more supplies will be added back to the chemical additives industry.

Part 2: Business Cycle

I see that the car sales in China stagnant or slowing down slightly, however, more supplies are coming into the industry. Car sales are tied to the state of the economy. When people do not feel confident about the economy, they will hold back on their big-ticket items which may affect car sales. When interest rates tighten, the entire economy will cool down as well.

When car sales decline, the volumes of tires will decline, so will the demand for rubber additives.

To gauge the car sales in China, I used the monthly sales of Great Wall Motor, Geely and BAIC Motor. Interested readers, please read this article.

When to buy?

The market is self-correcting. It has its own ways to resolve overcapacity or under capacity. We should buy this industry when it suffers from overcapacity, that is where you know capital investments will reduce and the average selling prices will normalize upwards.

You can check out 1Q FY2013, the revenue increased by 19% while the profit before tax dropped by 32%.

The situation must look bleak enough to create opportunities for us. As the conditions get better, by year-end FY2013, CS reported 108% higher profits than the corresponding previous year.

Concluding Remarks

This movement of cycles is not unique to chemical additives. It applies to recreation vehicles, specialty chemicals, and other industries. Companies do not earn supernormal profits all the time and we need to be cautious when we are investing in peak earnings/margins. The key is I do not know when their competitors will restart their plants and how it will affect the average selling prices. Again, I could be totally wrong and I am willing to accept that.

I’ll share another example. Dongyue sells liquid alkali, fluoride salt, and fluoride chemicals. It is listed on SEHK under the ticker HK.189,

(Share price of Dongyue HK.189)

There are two peaks in 2010-2011 and 2018.

The earnings peaked in those periods as well.

This morning, the share price of CS has gone up. Will the same pattern play out when the company reports their earnings? Let’s see!

Once again, thank you for spending your precious time reading my article! If you wish to receive more content, please subscribe to my mailing list at http://eepurl.com/dBVcg9.