YZJ has increased future profitability

FAIR VALUE: S1.600

- Yangzijiang (YZJ) buys remaining 80% of Jiangsu Huayuan, which holds the Jinjiang City Dunfeng Ship Dismantle Co., Ltd shipbreaking operations for a total consideration of CNY240m, equivalent to 1.0x book value. We find this purchase attractively cheap, with a payback period of less than 2 years on expected operational volumes.

- Introduces new natural currency hedge: Ships bought for demolition are paid for in USD, with the steel output being sold in CNY. This creates a natural currency hedge to the shipbuilding operations where input purchases are bought in CNY and ships sold in USD.

- Introduces new steel-price hedge: The shipbreaking operations will be more profitable in high-steel-price periods when shipbuilding margins will be squeezed, and the converse is true. The steel-price hedge thus reduces one layer of risk inherent in all shipbuilders.

- Introduces business operations hedge: Shipbuilding and shipbreaking are mutually counter-cyclical. With the shipbuilding cycle in the trough, shipbreaking looks strong for the next few years. Globally, more than 30% of bulk carriers are more than 20 years old (their usual lifespan). With the Baltic Dry Index at loss-making levels, shippers will be incentivized to send older ships for demolition. YZJ thus enjoys the benefits of being on both ends of the market.

- We expect growing contributions in FY12F and FY13F: We expect shipbreaking volumes of 330,00MT and 550,000MT in FY12F/13F, from the current 200,000MT, at a margin of 11%/17%. This translates into a bottom-line contribution of CNY100m/275m over the next two years— a 2.5%/7% increase in our forecasted net profits for FY12F/13F. This also implies a <2-year payback period, which from a business owner point of view is a steal.

- Shipbuilding operations remain strong: Next year, YZJ will start building large containerships, on which revenue recognition is much more rapid. Though we expect gross margins to ease from today’s 28% to about 23%, the higher revenues will make up for this fall, allowing net profits to grow slowly, but steadily, from today’s record highs. YZJ’s profitability implies ROE of 30%, ROIC of 36% this year.

- Valuations extremely compelling: YZJ is now trading at forward P/E of 4.3x, and given our dividend expectation of 6c this year, it currently yields 6.5%. P/B is 1.3x against its historical average of 3.3x, with an EV/EBITDA of 3.1x.

- Maintain $1.60 FV and BUY: We continue to value YZJ at 8x FY11F P/E for a FV of $1.60. In one stroke, YZJ has increased future profitability while simultaneously reducing its overall risk by implementing three hedges against currency, steel price, and business risks. This is killing four birds with one stone.