65143755

www.jpmorganmarkets.com

Asia Pacific Equity Research26 November 2013

Texhong Textile

Initiation

Overweight2678.HK, 2678 HK

Initiate with OW – Spinning into a fast growth phasePrice: HK$10.94

Price Target: HK$16.00

China

SMID-Caps

Andrew Hsu AC

(852) 2800-8572

[email protected]

Bloomberg JPMA AHSU <GO>

Leon Chik, CFA

(852) 2800-8590

[email protected]

Ebru Sener Kurumlu

(852) 2800-8521

[email protected]

J.P. Morgan Securities (Asia Pacific) Limited

YTD 1m 3m 12mAbs 122.6

%-25.5% -24.0% 182.5

%Rel 126.9

%-37.4% -37.0% 174.8

%

Texhong Textile (Reuters: 2678.HK, Bloomberg: 2678 HK)

Rmb in mn, year-end Dec FY11A FY12A FY13E FY14E FY15ERevenue (Rmb mn) 6,873 7,341 10,008 13,623 16,146Net Profit (Rmb mn) 61 487 1,010 1,321 1,669EPS (Rmb) 0.07 0.55 1.14 1.49 1.89DPS (Rmb) 0.08 0.22 0.34 0.45 0.57Revenue growth (%) 25.6% 6.8% 36.3% 36.1% 18.5%EPS growth (%) (92.7%) 694.3% 107.5% 30.8% 26.4%ROCE 3.1% 14.2% 22.7% 23.8% 24.7%ROE 2.8% 20.7% 35.5% 36.8% 36.0%P/E (x) 124.2 15.6 7.5 5.8 4.6P/BV (x) 3.7 3.0 2.4 1.9 1.5EV/EBITDA (x) 33.7 12.5 7.3 5.7 4.5Dividend Yield 1.0% 2.5% 4.0% 5.2% 6.6%Source: Company data, Bloomberg, J.P. Morgan estimates.

Company DataShares O/S (mn) 885Market Cap (Rmb mn) 7,607Market Cap ($ mn) 1,248Price (HK$) 10.94Date Of Price 26 Nov 13Free Float(%) -3M - Avg daily volume (mn) 1.013M - Avg daily value (HK$ mn)

12.68

3M - Avg daily value ($ mn) 1.6HSCEI 1,1387.21Exchange Rate 7.75Fiscal Year End Dec

See page 18 for analyst certification and important disclosures, including non-US analyst disclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

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Price Performance

2678.HK share price (HK$)

HSCEI (rebased)

We initiate coverage of Texhong Textile with an OW rating and a Dec-14 PT of HK$16.0, implying potential upside of 46% over the current share price. Texhong is a leading yarn and fabric producer, with over 1,200 types of yarn products and 2,700 types of fabric products. It is a global leader in Spandex yarns and is growing capacity aggressively.

Cost advantage of Vietnam plant. Texhong currently benefits from cheap cotton sourced from Vietnam. This cost advantage has allowed Texhong to take market share from yarn makers located in China.Unlike most of its domestic peers, the company has 40% of its production capacity outside of China, i.e., in Vietnam. The company also makes higher-end synthetic yarns in China and specialty yarns,where proximity to customers is an important differentiator.

A volume play, in a nutshell. New capacity is the key driver of sales and earnings growth for Texhong, in our view, as we expect gross and EBIT margins to remain relatively stable. The company has added new capacity in Vietnam (170k spindles started July 2013 with an additional 285k spindles by 2Q14) as well as in Shandong, China (~60k spindles,).In total, we expect capacity to record a CAGR of 38% from FY12-14E.

Valuation, price target and risks. In our view, Texhong's 1H13 results were strong, but we expect GM to be softer in 2H13, due to product mix changes. The share price has fallen by 25% over the past month (vs the Hang Seng Index: +4%), on fears of piling cotton inventory and regulatory action that could cause cotton prices in China to drop.Texhong currently trades at 5.8x CY14E P/E, 60% lower than its Asian garment peers at 14.4%. Our DCF-based Dec-14 of HK$16.0 implies CY15E P/E of 6.7x. Key risks include volatile movements in cotton prices, given the company’s high inventories, and narrower price differentials between international and domestic cotton prices.

[email protected] Leo Perry 08/15/15 02:26:03 AM Ennismore Fund Management

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Andrew Hsu(852) [email protected]

Key catalysts for the stock price Upside risks to our view Downside risks to our view

• Low-cost advantage in Vietnam plant • Volume play, riding on capacity expansion plans

• Stronger-than-expected market share gains and industry consolidation in the yarn sector• Higher-than-expected margins in new synthetic fiberproducts• Improving margins for cotton sourced from China

• Uncertainty in cotton policy in China• Risks that low costs in Vietnam plant are unsustainable • Volatile movement in cotton price given the company’s high inventories• Narrower price differential between international and domestic cotton prices

Key financial metrics FY12A FY13E FY14E FY15E Valuation and price target basis

Revenues (Rmb) 7,341 10,008 13,623 16,146 Our PT (Dec-14, DCF-derived) of HK$16.0 implies a forward P/BV (CY15E) of 2.1x and implies a forward P/E of 6.7x (CY15E). Our DCF assumptions include a WACC of 8.7% and a risk-free rate of 4.2%.

Revenue growth (%) 6.8% 36.3% 36.1% 18.5%EBITDA (Rmb) 877 1,539 2,050 2,580

EBITDA margin (%) 11.9% 15.4% 15.0% 16.0%Tax rate (%) 13% 13% 15% 15%

Net profit (Rmb) 487 1,010 1,321 1,669EPS (Rmb) 0.550 1.141 1.493 1.886

EPS growth (%) 694.3% 107.5% 30.8% 26.4% One year forward P/E Band

DPS (Rmb) 0.22 0.34 0.45 0.57

BVPS (Rmb) 2.89 3.53 4.57 5.89Operating cash flow (Rmb mn) 924 1,152 1,548 2,400

Free cash flow (Rmb mn) 279 (48) 148 741Interest cover (X) 5 11 12 14Net margin (%) 6.6% 10.1% 9.7% 10.3%

Sales/assets (X) 1.31 1.36 1.44 1.38Debt/equity (%) 119.9% 136.3% 133.8% 124.9%

Net debt/equity (%) 48% 53% 49% 36%ROE (%) 21% 36% 37% 36%

Key model assumptions FY12A FY13E FY14E FY15E

Sales volume ('000 tonnes) – Yarn 243 337 458 532

ASP (Rmb per tonnes) – Yarn 25,308 25,814 26,589 27,386Year end capacity (MM spindles) 1.100 1.840 2.158 2.482

Source: Bloomberg, Company data and J.P. Morgan estimates. Source: Bloomberg, Company data and J.P. Morgan estimates.

Sensitivity analysis EBITDA EPS JPMe vs consensusSensitivity to FY13E FY14E FY13E FY14E EPS FY13E FY14E

1% increase in yarn ASP 4.5% 4.7% 6.0% 6.3% JPMe 1.141 1.4931% increase in yarn volume 0.1% 0.6% 0.2% 0.7% Consensus 1.087 1.352

1% increase in cotton price -4.4% -4.4% -5.8% -5.9%1ppt increase in GM 6.5% 2.7% 8.6% 3.6%

Source: Bloomberg, Company data and J.P. Morgan estimates. Source: Bloomberg, Company data and J.P. Morgan estimates.

Comparative metrics

Company Name Mkt Cap P/E EV/EBITDA P/BV YTDCode Price (PT) $Mn FY13E FY14E FY13E FY14E FY13E FY14E Stock perf.

ECLAT (OW) 1476 TT 388 (350) 3,287 34.80 24.7 na na na na 271.6GLORIOUS SUN (NC) 393 HK 1.78 242 14.8 12.7 na 1.6 0.8 0.8 -21.2

SHENZHOU (OW)* 2313 HK 28.95 (32) 5,192 16.3 13.9 13.8 11.8 2.6 2.4 66.7TEXHONG TEXTILE (OW)* 2678 HK 10.94 (16) 1,241 7.5 5.8 28.9 6.4 2.4 0.0 126.5

MAKALOT (OW) 1477 TT 167.5 (206) 951 19.23 14.8 na na na na 85.3

Average 18.5 14.4 21.3 6.6 2.0 1.1

Source: Bloomberg, Company data and J.P. Morgan estimates. Prices are as of 26 Nov 2013. Note: Bloomberg consensus estimates for Not Covered (NC) stocks


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Investment summary

Positive share price drivers

Cost advantage of Vietnam plant. Texhong currently benefits from lower pricedcotton sourced from Vietnam compared to its domestic peers that use cotton from China. As a result of the Chinese cotton reserve policy introduced in 2011, the current floor price of cotton (until March 2014) is Rmb20,400/tonne (or US1.4/lb), double the international cotton price of ~US$0.8/lb. While the price policy initiative aims to maintain levels of cotton acreage, some Chinese yarn spinners are disadvantaged by high cotton prices. Unlike most of its domestic peers, 40% of Texhong’s production capacity is located outside of China, i.e., in Vietnam. As of 1H13, the company sells 80% of its product in China, thus it can profit from the price difference.

Texhong operates in the most upstream segment of the regional textile market. In our view, there are not many sizable comparables that can afford to build plants in Vietnam, due to their lack of scale and financial weakness. We note some indirect competitors have entered the Vietnam markets in recent years, with the aim to source low-cost cotton. However, we do not believe they will pose a considerable threat to Texhong in the near term, given their different product mix. Companies operating in Vietnam include dyed yarn spinners such as Bros Eastern (Not Covered [NC]) andHuafu Top Dyed Melange Yarn [NC].

Figure 1: Cotton price Rmb/ tonne

Source: Bloomberg.

Shenzhou (covered by Leon Chik, CFA) has followed a different strategy of using mainly domestic yarns (80% of total yarns purchased) for its production lines in China, due to the requirements of its customers as well as its wish to maintain good relationships with domestic yarn producers, according to management. We believe that this put Shenzhou at a disadvantage (from mid-2011 to mid-2013) when pitching for contracts against either domestic garment makers using imported yarns or other Asian garment makers outside of China. The biggest challenge over the past two years for Shenzhou, in our view, has been the much higher cost of cotton in China compared to outside of China due to import quotas and government support for prices to help domestic cotton farmers. The difference, adjusted for quality, freight and taxes amounted to about 20% in 2012, we estimate.

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A volume play, in a nutshell. The first phase of the northern Vietnam project of 170k spindles was successfully put into production in July 2013, pushing total production to 1.84 mn spindles. In FY14, the Shandong plant expansion will be about 60k spindles, while the second phase of the Northern Vietnam plant will be about 258k spindles, as per management. The company expects to commence commercial production by 1Q14 and 2Q14, respectively. Due to the slow application and approval process by local authorities for the Uruguay project, its completion may be delayed until 2015. In summary, Texhong will increase its average capacity by 40% and 36%, respectively, in FY13E and FY14E, and this should continue to power revenue and profit growth, in our view.

Diversified customer base. The client base of Texhong is very diversified (~1,600 customers), with the top 10 customers accounting for 20% of FY12 sales. The top five customers are Zhejiang Limayunshan Textile Co., Yixing Lucky G and L Denim Co., Yixing Lucky G and L Dyeing and Finishing Co., Shaoguan Shunchang Weaving Factory Co., and Guangdong Qianjin Jeans Co, all of which have over five years of trade relationship with Texhong, as per the company.

Negative share price drivers and risks to our thesis

Downside from cotton price liberalization a risk, but not that significant. Apart from the recent change in product mix (to low-margin, high count yarn), one of the reasons for the recent share price decline, in our view, is the possibility of more “market based” pricing of cotton in China, as per local media (cottonchina.org). One of the items that is not “market-based” is the current policy to boost the domestic price of cotton well above international levels. We note that this policy, which benefits cotton farmers and hurts domestic cotton yarn producers, has been in place for many years, thus it will not be easy to dismantle or change, in our view.

The current price of cotton in China is nearly double that of international markets.Adjusting for freight, handling and quality differences, we estimate the price in China is about 20% higher than international prices. The cost of cotton makes up about half the cost of cotton yarn, and therefore yarn made with domestic cotton would cost 10% more than yarn made with international cotton. This is the main reason why plants with overseas production (mainly Vietnam) would have higher profitability than a similar producer in China. However, the extra 10% cost advantage does not fall to the bottom line for several reasons. First, some domestic Chinese mills have quotas to import cotton (typically 20-50% of their needs) and second, we believe some domestic mills sell at lower profits or even losses in order to stay in business. The longer distance from Vietnam mills also prohibits them from making higher-end niche products that require shorter turnaround times. In reality, yarn mills in Vietnam may only have 3-4% superior margins to domestic mills, according to our estimates.

For Texhong, its production base would be roughly split 50:50 between Vietnam and China by the end of 2014. The Chinese mills will make synthetic yarns andspecialized cotton products. If the cotton arbitrage (higher cotton in China vs Vietnam) was to disappear, margins for the Vietnam plants of Texhong and other peers could come under pressure and some of the 3-4% superior margin may be lost, in our view. However, the Chinese mills of Texhong and its peers could see margins improve, although probably to a lesser extent than the decline in margins of the Vietnam mills.


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Taking everything into account, the elimination of the cotton arbitrage would beslightly negative for Texhong and could lower margins at the group level 1-2%.While we do not predict this to happen, this is already implied in both the current share price and our price target. Our PT works out to a 14E P/E of just 6.7x, which is well below the 10-15x fair value range that an industrial with similar earnings growth would trade at, in our view. We, therefore, do not see this risk as the cause for much downside. In fact, the longer-than-expected support for cotton prices in China could actually result in upside for the rating and share price for Texhong.

Rising cotton prices could hurt margins. Raw material costs account for a large proportion of COGS for most yarn spinners, including Texhong (~80%), whose major raw material is cotton. Raw material costs are a more significant component of cost for yarn spinners compared to fabric or garment manufacturers.

Table 1: Raw material cost/ COGS for textile companies

Specialty Raw material cost / COGS (%) RemarksTexhong Yarn 80% ~50% cottonPacific Textile Fabric 73%Shenzhou Garment 40% More labor intensive

Source: Company data

Thus, the profits of yarn spinners can be negatively affected when cotton prices rise sharply. That said, Texhong has diversified its cost base in recent years and increased its use of synthetic fibres.

Direct subsidies to farmers could hurt competitiveness. In an effort to lowerChina’s cotton price, central government may provide direct subsidies to cotton farmers, according to local media (cottonchina.org). Should this happen, Texhong would not be able to take advantage of the price gap between domestic and international cotton prices. As such, any decision to change the existing reserve policy would impact the cotton market, in our view.

Rising level of debt to fund expansion. The company’s total debt increased by 9% HoH to Rmb3.2 bn in 1H13 after the company issued US$200 mn of corporate bonds (‘19s) in April this year. Its unrestricted cash balance almost doubled HoH to Rmb958 mn despite having spent Rmb1 bn on capex in 1H13. Total debt/EBITDA improved marginally to 2.5x from 2.7x a year ago on strong EBITDA growth. Net debt/ EBITDA stayed a comfortable level at below 2.0x. However, net gearing ratio reached an historical high of 69.3% in 1H13, up from 48.5% in 2012. With a Rmb1.2 bn/Rmb1.4bn capex budget for FY13E/14E, respectively, Texhong is stretching its cash flow. The company may need to raise more capital, we believe, if its capacity expansion plan remains heavy.

Depreciation of the Rmb could result in losses. Texhong’s loans are dominated in USD, while its proceeds are primarily in Rmb. The company would be a beneficiary of Rmb appreciation.


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Valuation and share price analysis

DCF valuation

Our Dec-14 price target of HK$16.00 is based on a DCF based valuation (WACC of 8.7% and terminal growth of 3%) and equates to a forward P/E (FY15) of 6.7x. We believe this P/E is justified given the company's robust medium-term (2013E-15E) estimated net income CAGR of 29% and relatively stable operations (in terms of sales growth and margin volatility) compared to other textile-related in Asia, using J.P. Morgan and Bloomberg consensus estimates.

Over the past three years, Texhong has traded at a forward P/E range of as high as 74.2x (when the GM dropped significantly in 2H11due to the sharp increase in cotton price) to as low as 2x.

Figure 2: P/E bands

Source: Bloomberg, company data.

Figure 3: P/B vs ROE


Figure 4: One-year forward P/E band


Figure 5: One-year forward P/BV band


We compare Texhong’s current FY14E P/E with the following groups of peers: 1) Asian textile and apparel companies; and 2) leading industrial companies in China.

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Comparison to Asian textile/apparel peers

Texhong is trading at a 62% discount to the average FY14 P/E for garment peers in Asia and a 73% discount to the major Taiwanese peers, based on J.P. Morgan and Bloomberg consensus estimates. The discount is not justified, in our view. We believe the recent share price weakness is largely due to the company’s proposedchange in product mix and speculation of narrower domestic and international cotton price gap, which could hurt near-term margins. The reaction is overdone, in our view, and represents an attractive entry point.

Figure 6: Regional textile/garment companies’ sales growth

Source: Company data; J.P. Morgan estimates, Bloomberg consensus estimates for NC

companies

Figure 7: Regional textile/garment companies’ GPM trends

Source: Company data ; J.P. Morgan estimates, Bloomberg consensus estimates for NC

companies

We believe Texhong’s current valuation is inexpensive and does not take into account its structural advantages (high usage of low cost cotton and yarn overseas and robust capacity expansion in FY13E/14E).

Peer group valuation

Company Name Mkt Cap P/E EV/EBITDA P/BV YTDCode Price (PT) $Mn FY13E FY14E FY13E FY14E FY13E FY14E Stock perf.

Fabric

TEXWINCA (NC) 321 HK 7.73 1,353 12.1 10.3 Na 5.7 1.8 1.8 6.0PACIFIC TEXTILES (NC) 1382 HK 11.96 2,217 15.1 13.3 8.2 7.2 4.4 4.4 71.8

RAYMOND (NC) RW IN 267.90 264 14.3 9.6 2.9 1.2 1.2 -41.6HUNTSMAN CORP (NC) HUN US 22.49 5,430 14.9 9.8 6.4 5.5 3.0 3.0 41.4

ARVIND (NC)ARVND

IN 120.40 498 9.4 8.3 na Na 1.4 1.4 20.4

Average 13.2 10.3 5.8 6.1 2.3 2.3

Garment OEMECLAT (OW) 1476 TT 388 (350) 3,287 34.80 24.7 na na an Na 271.6

GLORIOUS SUN (NC) 393 HK 1.78 242 14.8 12.7 Na 1.6 0.8 0.8 -21.2SHENZHOU (OW)* 2313 HK 28.95 (32) 5,192 16.3 13.9 13.8 11.8 2.6 2.4 66.7

TEXHONG TEXTILE (OW)* 2678 HK 10.94 (16) 1,241 7.5 5.8 28.9 6.4 2.4 0.0 126.5MAKALOT (OW) 1477 TT 167.5 (206) 951 19.23 14.8 Na na na na 85.3

Average 18.5 14.4 21.3 6.6 2.0 1.1

BrandVF CORP (NC) VFC US 233.40 25,692 21.3 18.9 11.8 10.6 4.6 4.6 54.6

KOHLS (NC) KSS US 55.85 12,130 13.4 12.3 5.3 5.2 2.0 2.0 29.9TARGET CORP (NC) TGT US 63.76 40,241 13.8 13.5 7.6 6.9 2.5 2.5 7.8

Average 16.8 14.8 11.5 7.3 2.8 2.5

Source: Bloomberg, J.P. Morgan estimates. Note: Bloomberg consensus estimates for NC companies. Prices are as of 26 Nov 2013.

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We also analyze the DCF price sensitivity to WACC, and the terminal multiple.

Table 2: Base-case DCF analysis

HK$ MM 2007 2008 2009 2010 2011 2012 2013E 2014E 2015ECash flow estimatesSales 3,254 3,738 4,088 5,472 6,873 7,341 10,008 13,623 16,146 EBIT 279 265 363 985 158 677 1,276 1,691 2,112 NOPAT 252 239 315 1,710 142 499 1,114 1,475 1,801 Capex, net (470) (238) (179) (485) (425) (536) (1,200) (1,400) (1,659)Depreciation 73 95 110 128 172 201 263 359 467 Change in working capital (287) (244) 56 (611) (257) 69 (316) (354) 49 Free CF (excl. non-core)) (433) (149) 302 743 (368) 233 (140) 80 658

DCF Parameters AssumptionsLiabilities as a % of EV 30% Terminal growth 3.0%WACC 8.7% Risk-free rate 4.2%

Market risk 6.0%Enterprise NPV (10E-16E) 12,783 Beta 1.0+ Net cash (debt), current (1,658) Cost of debt 6.0%- Minorities (Market value) 0 Net debt/ Equity 53.1%+/- Other items 0 Implied exit P/E multiple (x) 7.5x= Equity value 11,124 / Number of shares 885

= Equity value per share (HK$) 16.00

Source Company data, J.P. Morgan estimates.

Table 3: Sensitivity analysis based on WACC and perpetual terminal growth rate

Terminal growth rate

16.0 1.5% 2% 2.5% 3.0% 3.5% 4.0% 4.5%

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CC

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10.2% 9.7 10.3 11.1 12.0 13.0 14.2 15.6

Source: Company data, J.P. Morgan estimates.


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Company background

Founded in 1997, Texhong is a leading yarn and fabric producer. It is the largest maker of fabrics containing Spandex in the world, with a market share of close to 30%, according to management. The company has over 1,200 types of yarn products and 2,700 types of fabric products. It currently has about 1.84 mn spindles (China: 1.11mn and Vietnam: 730k) to produce yarn. By the end of 2014, we expect the capacity split between China and Vietnam to be roughly 50/50. Texhong has 11 production bases in China and two in Vietnam and plans to add new capacity in Turkey and Uruguay (mainly in synthetics). The plants located in China focus on more synthetic blends as well as more specialty products, where proximity to the client is an advantage. The plants in Vietnam specialize in yarns with higher cotton content and more commoditized products where there is a cost advantage overChinese mills.

Texhong was founded by Chairman Mr Hong in 1997 and was listed on the Hong Kong Stock Exchange in 2004. Mr Hong and co-Chief Executive Officer Mr Zhucurrently hold ~53% and 15% stakes, respectively. Mr Hong has over 20 years of experience in the textile industry. Prior to establishing Texhong, he was a Vice General Manager of Jinjiang Yifeng Garment Weaving Company Ltd. He is also Vice Chairman of the Hong Kong General Chamber of Textiles Limited. Mr Zhu was Assistant to the General Manager of Nantong No. 2 Cotton Textile Factory prior to joining Texhong in 1997.

Customers and sale trends

The client base of Texhong is diversified (~1,600 customers), with the top tencustomers making up ~20% of FY12 sales. The top five customers are Zhejiang Limayunshan Textile Co., Yixing Lucky G and L Denim Co., Yixing Lucky G and L Dyeing and Finishing Co., Shaoguan Shunchang Weaving Factory Co., andGuangdong Qianjin Jeans Co. They are all have over five years of trade relationshipswith Texhong.

For the first 10 months of FY13, Texhong sold about 216k tonnes of yarns and is in the process of adjusting the product mix in order to achieve more than 100% sales to production ratio. Based on the adjusted product mix, yarn production volume is currently about 32k tonnes per month. Management expects the annual yarn production volume target of about 440k tonnes will be achieved from 2Q14.

We have assumed sales would grow by 36% in both 13E and 14E based on a 39%and 36% increase in yarn sales volume and a 2% and 3% increase in yarn ASP in 13E and 14E, respectively. We expect other segments to register only modest growth. We expect the utilization rate to come in at ~100% in FY13E/14E. 1H13 sales increased by 8.5% YoY to Rmb3.6 bn mainly on a moderate increase in sales volume of yarns, the company’s major products that accounted for 86% of sales.

New capacity is set to come online gradually in 2H13 and FY14. The first phase of the northern Vietnam project of 170k spindles was successfully put into production in July 2013, pushing total production to 1.84 mn spindles. In FY14, the Shandong plant expansion will be ~60k spindles, while the second phase of the Northern Vietnam plant will be ~258k spindles. They are expected to commence commercial production by 1Q14 and 2Q14, respectively, according to management. Due to the slow application and approval process by local authorities for the Uruguay project, its completion may be delayed to 2015, according to management.


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Figure 8: 1H13 Sales breakdown by region

Source: Company data.

Figure 9: Sales and GPM

Source: Company data. J.P. Morgan estimates.

Figure 10: 1H13 sales breakdown by product – (Both stretchable and non-stretchable yarns can be sub-divided into cotton, denim and synthetic fibre)


Cost structureCotton, which represents ~45-50% of the company’s cost of sales, is the largest raw material component for Texhong. Allenburg is the largest supplier of cotton to Texhong, followed by Glencore.

Cotton prices have fallen to the lowest level YTD in November, as the markets fretted that China is gearing up to release cotton from its stockpile, a move that would quickly ripple through the global cotton market. According to Texhong management, the company can typically pass on the cotton cost to consumers swiftly with only a two- to three-week time lag. Cotton price movements in FY14 will likely be dependent on China government policy on cotton reserve pricing, in our view. We project the per-unit cotton cost to be lower in 2H13 vs 1H13 largely due to falling cotton prices since 2Q13. We expect every 1% increase in cotton price to lower 13E/ 14E EPS by 5.8%/ 5.9%.

China

81%

Vietnam

3%

Macau

16%

0%5%

10%15%

20%25%30%35%40%

2009 2010 2011 2012 2013E 2014E 2015E

Gross margin Sales growth

Stretchable core-

spun yarns

64%

Other yarns

23%

Fabrics

13%


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Figure 11: Cotton price Rmb/ tonne

Source: Bloomberg.

Synthetic fiber (spandex, rayon, viscose and polyester) is the second-largest raw material cost, representing ~30-35% of Texhong’s cost of sales. Its major suppliers include Invista and Hyosung.

Figure 12: FY13E cost breakdown

Source: J.P. Morgan estimates. Non-cotton mainly consists of synthetic fiber

MarginsDue to the change in product mix (producing more high-count yarn, which commands lower margins, in order to meet market demand), 2H13 GM is likely to be softer. Texhong prefers to produce low-count yarn because of its higher margins, as more cotton needs to be used and thus it can take advantage of the China vs international cotton price difference, according to management. The SG&A ratio and staff cost expense ratio should remain roughly flat in 2H13 and FY14, on our estimates.

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International China

Cotton , 45.0%

Non-cotton, 34.9%

Direct labour, 8.2%

Depreciation, 3.3%

Utilities, 6.2% Consumables, 1.3% Others, 1.1%


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Figure 13: GM by product (1H13)


Balance sheetLeverage manageable. Total debt increased by 9% to Rmb3.2 bn as at Jun-13 compared to Dec 12, after the company issued US$200 million of corporate bonds (‘19s) in April this year. Its unrestricted cash balance increased to Rmb958 mn from Rmb530 mn in Dec-12, even after heavy capital expenditure of Rmb1 bn in 1H13.Total debt/EBITDA improved marginally to 2.5x from 2.7x a year ago on strong EBITDA growth. Net debt/EBITDA stayed a comfortable level at below 2.0x.

1H13 trade and bills receivable higher on advance purchases of overseas cotton. Inventories increased by 51% HoH to Rmb2.1 bn due to an increase in advance purchases of overseas cotton. The company’s cotton inventory was around 100ktonnes, amounting to Rmb1.3 bn, as per company data. Trade and bills payable as a result increased to Rmb2.6 bn. Trade and bills receivables decreased to Rmb520 mn from Rmb812 mn. We expect trade and bills receivables to return to a more normal level in 2H13.

Stable dividend payout ratio. Texhong has maintained a dividend payout ratio of ~30% over the past five years. We forecast a stable dividend payout of 30% p.a. for the next three years, which translates into a 2014E forward dividend yield of 4.5%.

Capex plans. Capital expenditure in 1H13 was Rmb ~1bn, which was mainly related to the newly added capacity in China and Vietnam. We estimate capex of Rmb 1.2bn for 2013E. For 2014E, we expect Rmb 1.4bn.

25.7% 26.9%

17.0%14.5%

22.8% 20.4%

8.0%5.3%

15.7%

0.0%

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20.0%

30.0%

1

Stretchable core-spun cotton yarn Stretchable core-spun denim yarn

Stretchable core-spun synthetic fiber yarn Other cotton yarn

Other denim yarn Other synthetic fiber yarn

Stretchable grey fabrics Other grey fabrics

Garment fabrics


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SWOT analysis

Strengths

Texhong is a leading yarn and fabric producer. It is the largest maker of fabrics containing Spandex in the world, with a market share of close to 30%, according to management

The company has a diversified portfolio of products, with over 1,200 types of yarn products and 2,700 types of fabric products

The company enjoys low cost advantages in Vietnam. It has about 1.84 mn spindles (China: 1.11mn and Vietnam: 730k) to produce yarn

Texhong will increase its average capacity by 40% and 37%, respectively, in FY13E and FY14E, which should continue to power revenue and profit growth

Texhong’s client base is diversified (~1,600 customers), with the top 10 customers accounting for ~20% of FY12 sales

Weaknesses

Raw material costs, mainly cotton, account for ~80% of Texhong’s COGS. Rising cotton prices could hurt margins

In an effort to lower China cotton prices, there has been proposals to Chinese government to offer direct subsidiesto cotton farmers. Should this happen, Texhong would not be able to take advantage of the pricing gap between domestic and international cotton prices. As such, any decision to change the existing reserve policy would impact the cotton market

Texhong is stretching its cash flow, with its net gearing ratio reaching an historical high of 69.3% in 1H13. The company may need to raise more capital if the capacity expansion plans remain heavy

Opportunities

New production facilities in Uruguay and Turkey can bypass import tariffs and shorten transportation duration

Rebound in demand in China from a low base to boost domestic growth

Benefit from the ongoing industry consolidation and gain market share

Development in new synthetic fibre products

Threats

Texhong is adding new plants in Uruguay (120k spindles) and Turkey (60k spindles), which are free trade production zones to Brazil (3% of Texhong sales) and the EU (3% also), respectively. These new plants can have execution risks

Uncertainty in terms of cotton policy in China

Risks that the low costs in Vietnam plant are unsustainable over the longer term

Volatile movements in cotton price given the company’shigh inventories

Narrower price differential between international and domestic cotton prices


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Financials

Table 4: Key assumptions

Year-end Dec 2011 2012 2013E 2014E 2015ESales volume ('000 tonnes) –Yarn 190 243 337 458 532ASP (Rmb per tonnes) – Yarn 30,500 25,308 25,814 26,589 27,386Year end capacity ('000 spindles) 1.000 1.100 1.840 2.158 2.482


Table 5: Revenue mix

Rmb MM, year-end Dec 2011 2012 2013E 2014E 2015EYarn 5,789 6,147 8,694 12,178 14,556YoY 32.0% 6.2% 41.4% 40.1% 19.5%% of total 84.2% 83.7% 86.9% 89.4% 90.2%Grey fabrics 966 1,028 1,131 1,244 1,368YoY 5.1% 6.4% 10.0% 10.0% 10.0%% of total 14.1% 14.0% 11.3% 9.1% 8.5%Garment fabrics 117 167 183 202 222YoY -18.2% 42.3% 10.0% 10.0% 10.0%% of total 1.7% 2.3% 1.8% 1.5% 1.4%Total 6,873 7,341 10,008 13,623 16,146YoY 25.6% 6.8% 36.3% 36.1% 18.5%


Table 6: P&L statement

Rmb MM, year-end Dec 2011 2012 2013E 2014E 2015ETotal Revenues 6,873 7,341 10,008 13,623 16,146 YoY change (%) 25.6% 6.8% 36.3% 36.1% 18.5%Cost of sales (6,317) (6,217) (8,122) (11,101) (13,049)YoY change (%) 51.7% -1.6% 30.6% 36.7% 17.5%Gross Profit 556 1,124 1,887 2,522 3,097 YoY change (%) -57.5% 102.3% 67.8% 33.7% 22.8%Gross Margin 8.1% 15.3% 18.9% 18.5% 19.2%Selling expenses (152) (203) (277) (841) (997)Administrative expenses (209) (227) (310) (422) (500)Other Income/(Expenses) 22 6 8 10 12 EBIT 158 677 1,276 1,691 2,112 EBIT margin 2.3% 9.2% 12.8% 12.4% 13.1%Net Interest Expense (78) (123) (119) (142) (155)Net Income Before Taxes 83 557 1,157 1,549 1,958 YoY change (%) -91.2% 567.9% 107.6% 33.9% 26.4%Tax (22) (71) (148) (229) (289)Effective Tax rate 26.6% 12.8% 12.8% 14.8% 14.8%Minority Interests (0) 0 0 0 0 Net Income 61 487 1,010 1,321 1,669 YoY change (%) -92.7% 694.3% 107.5% 30.8% 26.4%Net margin 0.8% 6.6% 10.1% 9.7% 10.3%Number of shares (FD) 885 885 885 885 885 Diluted EPS (CNY) 0.069 0.550 1.141 1.493 1.886DPS (CNY) 0.082 0.219 0.342 0.448 0.566

Source: J.P. Morgan estimates, Company data.


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Table 7: Interim estimates

Year to Dec (Rmb MM) 1H12 2H12 1H13 2H13E 1H14E 2H14ETotal Revenues 3,325 4,016 3,609 6,400 7,463 6,160Gross Profit 446 678 771 1,116 1,455 1,066EBIT 237 439 543 733 933 758Net Income Before Taxes 165 393 502 655 855 695Net Income 145 341 447 563 729 592Diluted EPS (HK$) 0.164 0.386 0.505 0.64 0.823 0.67RatiosRevenue split 45.3% 54.7% 36.1% 63.9% 54.8% 45.2%GPM 13.4% 16.9% 21.4% 17.4% 19.5% 17.3%EBIT margin 7.1% 10.9% 15.1% 11.5% 12.5% 12.3%NPM 4.4% 8.5% 12.4% 8.8% 9.8% 9.6%YoYRevenue 11.8% 3.0% 8.5% 59.3% 106.8% -3.7%GP -20.1% Na 72.8% 64.5% 88.8% -4.4%EBIT -31.6% Na 129.1% 66.9% 71.7% 3.4%NP -43.3% Na 207.8% 64.9% 63.1% 5.2%

Source: J.P. Morgan estimates, Company data.

Table 8: Balance sheet

Rmb MM, year-end Dec 2011 2012 2013E 2014E 2015ECash and Cash Equivalents 463 530 712 569 897 Inventories 1,289 1,422 1,938 2,638 3,126

Trade & bills receivables 640 812 1,108 1,508 1,787 Due from customers for contract work (273) (234) (296) (483) (689)Deposits, prepayments & receivables 538 493 672 432 395 Total Current Assets 2,657 3,023 4,134 5,146 6,205 Property and Equipment, Net 1,992 2,229 3,166 4,208 5,399 Lease prepayments 0 0 0 4,313 5,524 Deferred tax 50 57 77 0 0 Total Assets 4,930 5,625 7,378 9,459 11,729

Trade & bills payables 502 865 1,179 1,605 1,902 Due to customers for contract work 417 309 548 969 1,493 Borrowings 144 206 276 299 323 Income taxes Payable (14) 3 79 160 221 Total Current Liabilities 1,094 1,444 2,082 3,033 3,938

Bank loans 1,712 1,564 2,094 2,271 2,448 Other Noncurrent Liability 52 59 80 109 130 Noncurrent liabilities 1,765 1,623 2,175 2,380 2,577 Total Liabilities 2,858 3,067 4,256 5,413 6,515

Share capital 94 94 94 94 94 Reserves 424 444 1,007 1,931 3,100 Total Shareholders' Equity 2,072 2,558 3,122 4,046 5,215 Minority Interest 0 (0) (0) (0) (1)Total Shareholders' Equity 2,072 2,558 3,122 4,046 5,214 Total Liabilities and Equity 4,930 5,625 7,378 9,459 11,729



16



Table 9: Cash flow statement

Rmb MM, year-end Dec 2011 2012 2013E 2014E 2015EEBIT 158 677 1,276 1,691 2,112 Depreciation and Amortization 172 201 263 359 467 Working Capital Changes (257) 69 (316) (354) 49 Tax Paid (109) (22) (71)Cash Flow From Operations (36) 924 1,152 1,548 2,400

Capital expenditures (425) (536) (1,200) (1,400) (1,659)Investments and others (16) 2 0 0 0 Cash Flow from Investing (441) (645) (1,200) (1,400) (1,659)

Free Cash Flow (477) 279 (48) 148 741

Debt 619 (79) 621 229 220 Other Financing (249) (281) (391) (170) (185)Cash Flow from financing 371 (212) 230 (291) (414)

Change in cash (106) 67 182 (143) 327 Cash beginning 569 463 530 712 569 Foreign exchange changes 0 0 0 0 0 Cash at end 463 530 712 569 897



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Texhong Textile: Summary of FinancialsIncome Statement Cash flow statementRmb in millions, year end Dec FY11 FY12 FY13E FY14E FY15E Rmb in millions, year end Dec FY11 FY12 FY13E FY14E FY15E

Revenues 6,873 7,341 10,008 13,623 16,146 EBIT 155 673 1,276 1,691 2,112% change Y/Y 25.6% 6.8% 36.3% 36.1% 18.5% Depr. & amortization 172 201 263 359 467

EBITDA 327 873 1,539 2,050 2,580 Change in working capital (257) 69 (316) (354) 49% change Y/Y (70.5%) 166.9% 76.2% 33.2% 25.9% Taxes (109) (22) (71) (148) (229)

EBIT 155 673 1,276 1,691 2,112 Cash flow from operations (36) 924 1,152 1,548 2,400% change Y/Y (84.2%) 333.5% 89.8% 32.5% 24.9%EBIT Margin 2.3% 9.2% 12.8% 12.4% 13.1% Capex (442) (536) (1,200) (1,400) (1,659)Net Interest (78) (123) (119) (142) (155) Disposal/(purchase) - - - - -Earnings before tax 82 549 1,157 1,549 1,958 Net Interest (78) (123) (119) (142) (155)% change Y/Y (91.3%) 572.2% 110.7% 33.9% 26.4% Other 1 2 0 0 0Tax (22) (71) (148) (229) (289) Free cash flow (422) 495 56 269 873

as % of EBT 27.2% 13.0% 12.8% 14.8% 14.8%Net income (reported) 61 487 1,010 1,321 1,669 Equity raised/(repaid) 0 0 0 0 0% change Y/Y (92.7%) 694.3% 107.5% 30.8% 26.4% Debt raised/(repaid) 619 (79) 621 229 220Shares outstanding 885 885 885 885 885 Other (106) (148) (143) (170) (185)EPS (reported) 0.07 0.55 1.14 1.49 1.89 Dividends paid (142) (133) (248) (350) (448)

% change Y/Y (92.7%) 694.3% 107.5% 30.8% 26.4% Beginning cash 569 463 530 712 569Ending cash 463 494 712 569 897DPS 0.08 0.22 0.34 0.45 0.57

Balance sheet Ratio AnalysisRmb in millions, year end Dec FY11 FY12 FY13E FY14E FY15E Rmb in millions, year end Dec FY11 FY12 FY13E FY14E FY15E

Cash and cash equivalents 463 530 712 569 897 EBITDA margin 4.8% 11.9% 15.4% 15.0% 16.0%Accounts receivable 640 812 1,108 1,508 1,787 Operating margin 2.3% 9.2% 12.8% 12.4% 13.1%Inventories 1,289 1,422 1,938 2,638 3,126 Net margin 0.9% 6.5% 10.1% 9.7% 10.3%Others 265 259 377 432 395Current assets 2,657 3,023 4,134 5,146 6,205. Sales per share growth 25.6% 6.8% 36.3% 36.1% 18.5%LT investments 0 0 0 0 0 Sales growth 25.6% 6.8% 36.3% 36.1% 18.5%Net fixed assets 1,992 2,229 3,166 4,208 5,399 Net profit growth (92.7%) 694.3% 107.5% 30.8% 26.4%Total Assets 4,698 5,625 7,378 9,459 11,729 EPS growth (92.7%) 694.3% 107.5% 30.8% 26.4%.Liabilities Interest coverage (x) 4.2 7.1 12.9 14.4 16.7Short-term loans 144 206 276 299 323Payables 502 865 1,179 1,605 1,902 Net debt to equity 67.2% 48.5% 53.1% 49.5% 35.9%Others 448 373 627 1,129 1,713 Sales/assets 1.5 1.4 1.5 1.6 1.5Total current liabilities 1,094 1,444 2,082 3,033 3,938 Assets/equity 219.9% 222.9% 228.9% 234.9% 228.8%. ROE 2.8% 20.7% 35.5% 36.8% 36.0%Long-term debt 1,712 1,564 2,094 2,271 2,448 ROCE 3.1% 14.2% 22.7% 23.8% 24.7%Other liabilities - - - - -Total Liabilities 2,858 3,126 4,315 5,472 6,574Shareholder's equity 2,072 2,558 3,122 4,046 5,214BVPS (Rmb) 2.34 2.89 3.53 4.57 5.89

Source: Company reports and J.P. Morgan estimates.


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Other Companies Discussed in This Report (all prices in this report as of market close on 26 November 2013)Shenzhou International (2313.HK/HK$28.95/Overweight)

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Important Disclosures

Lead or Co-manager: J.P. Morgan acted as lead or co-manager in a public offering of equity and/or debt securities for Texhong Textile within the past 12 months.

Client: J.P. Morgan currently has, or had within the past 12 months, the following company(ies) as clients: Texhong Textile.

Client/Investment Banking: J.P. Morgan currently has, or had within the past 12 months, the following company(ies) as investment banking clients: Texhong Textile.

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Texhong Textile (2678.HK, 2678 HK) Price Chart

Source: Bloomberg and J.P. Morgan; price data adjusted for stock splits and dividends.


mailto:[email protected]


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Date Rating Share Price (HK$)

Price Target (HK$)

23-Sep-13 OW 25.00 32.00

The chart(s) show J.P. Morgan's continuing coverage of the stocks; the current analysts may or may not have covered it over the entire period. J.P. Morgan ratings or designations: OW = Overweight, N= Neutral, UW = Underweight, NR = Not Rated

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Coverage Universe: Hsu, Andrew Tak Jun: China Lesso (2128.HK), Greatview Aseptic Packaging (0468.HK), TCL Communication Technology (2618.HK), TCL Multimedia (1070.HK)

J.P. Morgan Equity Research Ratings Distribution, as of September 30, 2013

Overweight(buy)

Neutral(hold)

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J.P. Morgan Global Equity Research Coverage 43% 44% 12%IB clients* 57% 49% 39%

JPMS Equity Research Coverage 42% 50% 8%IB clients* 76% 65% 57%

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Shenzhou International (2313.HK, 2313 HK) Price Chart

OW HK$32

Source: Bloomberg and J.P. Morgan; price data adjusted for stock splits and dividends.

Initiated coverage Sep 23, 2013.



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be based on the month end data from two months prior.) J.P. Morgan Broking (Hong Kong) Limited is the liquidity provider/market maker for derivative warrants, callable bull bear contracts and stock options listed on the Stock Exchange of Hong Kong Limited. An updated list can be found on HKEx website: http://www.hkex.com.hk. Japan: There is a risk that a loss may occur due to a change in the price of the shares in the case of share trading, and that a loss may occur due to the exchange rate in the case of foreign share trading. In the case of share trading, JPMorgan Securities Japan Co., Ltd., will be receiving a brokerage fee and consumption tax (shouhizei) calculated by multiplying the executed price by the commission rate which was individually agreed between JPMorgan Securities Japan Co., Ltd., and the customer in advance. Financial Instruments Firms: JPMorgan Securities Japan Co., Ltd., Kanto Local Finance Bureau (kinsho) No. 82 Participating Association / Japan Securities Dealers Association, The Financial Futures Association of Japan, Type II Financial Instruments Firms Association and Japan Investment Advisers Association. Korea: This report may have been edited or contributed to from time to time by affiliates of J.P. Morgan Securities (Far East) Ltd, Seoul Branch. Singapore: JPMSS and/or its affiliates may have a holding in any of the securities discussed in this report; for securities where the holding is 1% or greater, the specific holding is disclosed in the Important Disclosures section above. India: For private circulation only, not for sale. Pakistan: For private circulation only, not for sale. New Zealand: This material is issued and distributed by JPMSAL in New Zealand only to persons whose principal business is the investment of money or who, in the course of and for the purposes of their business, habitually invest money. JPMSAL does not issue or distribute this material to members of "the public" as determined in accordance with section 3 of the Securities Act 1978. The recipient of this material must not distribute it to any third party or outside New Zealand without the prior written consent of JPMSAL. Canada: The information contained herein is not, and under no circumstances is to be construed as, a prospectus, an advertisement, a public offering, an offer to sell securities described herein, or solicitation of an offer to buy securities described herein, in Canada or any province or territory thereof. Any offer or sale of the securities described herein in Canada will be made only under an exemption from the requirements to file a prospectus with the relevant Canadian securities regulators and only by a dealer properly registered under applicable securities laws or, alternatively, pursuant to an exemption from the dealer registration requirement in the relevant province or territory of Canada in which such offer or sale is made. The information contained herein is under no circumstances to be construed as investment advice in any province or territory of Canada and is not tailored to the needs of the recipient. To the extent that the information contained herein references securities of an issuer incorporated, formed or created under the laws of Canada or a province or territory of Canada, any trades in such securities must be conducted through a dealer registered in Canada. No securities commission or similar regulatory authority in Canada has reviewed or in any way passed judgment upon these materials, the information contained herein or the merits of the securities described herein, and any representation to the contrary is an offence. Dubai: This report has been issued to persons regarded as professional clients as defined under the DFSA rules. Brazil: Ombudsman J.P. Morgan: 0800-7700847 / [email protected].

General: Additional information is available upon request. Information has been obtained from sources believed to be reliable but JPMorgan Chase & Co. or its affiliates and/or subsidiaries (collectively J.P. Morgan) do not warrant its completeness or accuracy except with respect to any disclosures relative to JPMS and/or its affiliates and the analyst's involvement with the issuer that is the subject of the research. All pricing is as of the close of market for the securities discussed, unless otherwise stated. Opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMS distributes in the U.S. research published by non-U.S. affiliates and accepts responsibility for its contents. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information. Clients should contact analysts and execute transactions through a J.P. Morgan subsidiary or affiliate in their home jurisdiction unless governing law permits otherwise.

"Other Disclosures" last revised September 28, 2013.

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