Tat Seng Packaging Group Ltd Proxy to China's manufacturing and consumer sectors

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1 Tat Seng Packaging Group Ltd Proxy to China's manufacturing and consumer sectors SINGAPORE MATERIALS NON-RATED NOTE What is the news? Tat Seng Packaging Group Ltd (Tat Seng) recently announced its FY16 ended December full year financial results. Tat Seng recorded a 16.7% year-on-year (y-o-y) growth in PATMI, despite 1.3% y-o-y lower revenue. A final dividend of 2.0 cents and 1.0 cent special dividend were proposed. In this report, we highlight the growth drivers for Tat Seng, and suggest a valuation for the stock. Investment action No stock rating provided, as we do not have coverage on Tat Seng. However, our back-ofthe-envelope dividend discount model (DDM) valuation of S$0.89 suggests that the market is currently mispricing the stock. Company description Tat Seng designs, manufactures and sells corrugated paper packaging products such as corrugated boards and cartons for the packaging of electronics and electrical, food, pharmaceutical and other products. What do we think? Proxy to China's manufacturing and consumer sectors Tat Seng's exposure to the manufacturing and consumer sectors is through the sale of corrugated containers and paper packaging products. The forward indicator of the Manufacturing Purchasing Managers Index (PMI) for China suggests that demand for corrugated containers and paper packaging products is to be maintained. Upstream players of the supply chain have also benefited Hong Kong Exchange-listed players from the upstream part of the supply chain such as Nine Dragons Paper Holdings (stock code: 2689) and Lee & Man Paper Manufacturing (stock code: 2314) have also benefited from the higher level of industrial and manufacturing activity in China. Figure 1. Price chart for selected players in the paper packaging supply chain HK$ Nine Dragons, LHS Lee & Man, LHS Tat Seng, RHS 3.00 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Source: Bloomberg, Phillip Securities Research (Singapore) S$ 0.60 Attractive dividend yield Tat Seng has a track record of paying dividends, and currently has a trailing yield of 7.0%, based on FY16's 4.0 cents dividends and the last close price of $ Not rated LAST CLOSE PRICE FORECAST DIV TARGET PRICE TOTAL RETURN COMPANY DATA 9 March 2017 O/S SHARES (M N) : 157 M ARKET CAP (USD mn / SGD mn) : 63 / WK HI/LO (SGD) : 0.57 / M Average Daily T/O (mn) : 0.04 MAJOR SHAREHOLDERS (%) HANWELL HOLDINGS 64.0% SEE M OON LOH 15.0% PRICE PERFORMANCE (%) 1M T H 3 M T H 1Y R COM PANY STI RETURN PRICE VS. STI Source: Bloomberg, PSR KEY FINANCIALS Y / E D ec F Y 13 F Y 14 F Y 15 F Y 16 Revenue (SGD mn) Gross profit (SGD mn) PATM I (SGD mn) EPS (cents) BVPS (cents) P/B (x) DPS (cents) Div. Yield (%) Source: Company Data, PSR est. Richard Leow, CFTe, FRM ( ) richardleowwt@phillip.com.sg SGD N/A N/A N/A 0.30 Mar-16 Jul-16 Nov-16 Mar-17 TSP SP Equity FSSTI Index Page 1 PHILLIP SECURITIES RESEARCH (SINGAPORE) MCI (P) 118/10/2015 Ref. No.: SG2017_0059

2 Company Background As disclosed on the company's website, "Tat Seng Packaging Group Ltd is a leading manufacturer of paper packaging products listed on the mainboard of SGX-ST since 7 September Tat Seng designs and manufactures paper packaging products for the packing of a diverse range of products according to customers' specifications, and sells other packaging related products." The raw materials used in producing Tat Seng's products include paper, printing ink and glue. Paper supplies for the Singapore operations are sourced globally, while paper supplies for the China operations are sourced domestically. Figure 2. Sample products and production facilities Source: Company website Two business segments by geography, predominantly in China Tat Seng reports its business segments by geography Singapore and China. 85% of FY16 revenue was from within China (FY15: 84%), with the rest derived from Singapore. Figure 3. Historical revenue by geography S$ mn Singapore China FY12 FY13 FY14 FY15 FY16 Source: Company, Phillip Securities Research (Singapore) Diversified customer base engaged in manufacturing and consumer sectors Tat Seng's customers include MNC and local manufacturers. Tat Seng discloses its customer base according to six sectors. For FY15, the three largest customer sectors were Printing, Publishing & Converters (40%), Medical, Pharmaceutical & Chemical (27%) and Electronics & Electrical (20%). There has been no change in relative distribution between customer segments over the last few years. Figure 4. Historical revenue contribution by customer sector Printing, Publishers & Converters Electronics & Electrical Food & Beverage 50% Medical, Pharmaceutical & Chemical Others Plastic & Metal Stamping 40% 30% 20% 10% Customer data for FY16 is not available as it is only disclosed in the annual report which has yet to be published. 0% FY12 FY13 FY14 FY15 FY16 Source: Company Annual Reports, Phillip Securities Research (Singapore) Page 2 PHILLIP SECURITIES RESEARCH (SINGAPORE)

3 Five sites catering to local demand in China Tat Seng has five facilities in China namely, Suzhou, Jiangsu province; Hefei, Anhui province; Nantong Rugao and Natong Tongzhou, both in Jiangsu province and lastly, Tianjin. Favourable macro indicators for paper packaging demand Paperboard is used to produce corrugated containers and folding cartons. Corrugated containers/boxes are made from containerboard, which consists of the linerboard (smooth outer surface) and the corrugating medium (known as inside fluting). Paperboard and papers is the most widely used substrate globally According to leading packaging consultancy Smithers Pira, Paper and Board is the most widely used packaging substrate globally; accounting for 38% of global demand that was estimated to be worth US$776 billion in Global demand for Paper and Board has grown at a 10-year CAGR of 4.6% until Paper is used to produce two types of packaging: corrugated containers and folding cartons. Corrugated containers are the protective medium used in the transportation and storage of consumer and industrial goods. Folding cartons are the packaging that consumers see on store shelves. Figure 5. Global packaging demand in 2015, measured in US$ Glass 7% Other 4% Metal 14% Paper and Board 38% Flexible Plastics 16% Rigid Plastics 21% Source: Bloomberg Intelligence, Smithers Pira, Phillip Securities Research (Singapore) Corrugated box demand is tied to industrial production and manufacturing activity We focus our attention on China as 85% of Tat Seng's revenue is derived from within China. China's Industrial production consists of three broad categories: Manufacturing, Mining and Utilities. Manufacturing production has been higher than the overall industrial production. Manufacturing Production growth in China has moderated, but is still above 6% y-o-y. Figure 6. China Industrial & Manufacturing Production (% y-o-y) 12 Industrial, CHVAIOY INDEX Manufacturing, CHVAMANY INDEX Source: Bloomberg, National Bureau of Statistics of China, Phillip Securities Research (Singapore) The Manufacturing Purchasing Managers Index (PMI) is a forward indicator of demand for packaging products. Corrugated box demand is tied to manufacturing activity and China's PMI has maintained above the 50 expansion/contraction inflection point for the most part of the past five years. Page 3 PHILLIP SECURITIES RESEARCH (SINGAPORE)

4 Figure 7. China Manufacturing PMI, seasonally adjusted 54 CPMINDX INDEX Source: Bloomberg, China Federation of Logistics and Purchasing, Phillip Securities Research (Singapore) Boxboard (Folding carton) packaging is tied to consumer demand Consumer sentiment in China remains robust and this should support demand for folding cartons used for consumer products. Figure 8. China Consumer Confidence, December 1997 = CHCSCONF Index Source: Bloomberg, National Bureau of Statistics of China, Phillip Securities Research (Singapore) Company Financial Analysis Tat Seng's fiscal calendar ends in December and reports its financial results on a half-yearly basis typically in mid-august for 1H and late-february for full-year financial results. For FY16, Tat Seng's gross margin improved to 22.6% from 21.1% in FY15. Lower year-onyear (y-o-y) operating expenses and finance expense resulted in higher net profit margin of 7.0% from 5.7% in the preceding year. PATMI margin of 6.4% for FY16 was accordingly higher than FY15's 5.4%. Results at a glance (SGD mn) FY16 FY15 yoy (%) Comments Revenue (1.3) Lower revenue from China, mainly due to weaking RMB vs. SGD; actual revenue was 5.6% higher yoy in RMB terms, mainly due to increase in sales by Nantong Tat Seng Lower revenue from Singapore, mainly due to relocation of MNC customers, soft demand from electrical & electronics industries Gross profit Higher margin in China, from sale of corrugated board, rationalising of workflow and investment in automation EBIT % yoy lower OpEx, resulting in higher margin of 9.8% from 8.2% PATMI % yoy lower net interest expense, resulting in higher margin of 6.4% from 5.4% Source: Company, Phillip Securities Research (Singapore) Page 4 PHILLIP SECURITIES RESEARCH (SINGAPORE)

5 Track record of revenue growth Tat Seng has been able to grow its revenue, albeit at a slowing pace in recent years. Figure 9. Historical revenue since listing S$ mn Revenue, LHS yoy change, RHS % % 20% 0% 0 FY15 FY14 FY13 FY12 FY11 FY10 FY09 FY08 FY07 FY06 FY05 FY04 FY03 FY02 Source: Bloomberg, Phillip Securities Research (Singapore) FY16 (20%) Resilient gross profit margin with gross profit tracking revenue growth Tat Seng has defended its double-digit gross margins, stabilising at around 20% for the last five fiscal years (FY12 to FY16). Gross profit shows long-term growth, albeit at a slower pace in recent years, in line with the slowing revenue. Figure 10. Historical gross profit margin since listing 35% 30% 25% 20% 15% 10% 5% 0% FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 Source: Bloomberg, Phillip Securities Research (Singapore) Figure 11. Historical gross profit since listing S$ mn Gross profit, LHS yoy change, RHS 60 FY13 FY14 FY15 FY16 60% FY15 FY14 FY13 FY12 FY11 FY10 FY09 FY08 FY07 FY06 FY05 FY04 FY03 FY02 Source: Bloomberg, Phillip Securities Research (Singapore) FY16 40% 20% 0% (20%) Page 5 PHILLIP SECURITIES RESEARCH (SINGAPORE)

6 Volatile net profit to common shareholders Net profit has been volatile but has always been profitable nonetheless. Figure 12. Historical net income to common shareholders since listing S$ mn Net income, LHS yoy change, RHS FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 Source: Bloomberg, Phillip Securities Research (Singapore) FY15 FY16 200% 150% 100% 50% 0% (50%) Strong balance sheet that has little debt Current ratio has maintained above 1.0x, indicating that there are no problems in short-term liquidity, while the cash ratio is on an uptrend over the last five years. Figure 13. Balance Sheet: Current ratio & Cash ratio 1.6x 1.4x 1.2x 1.0x 0.8x 0.6x 0.4x 0.2x 0.0x Current ratio Cash ratio FY11 FY12 FY13 FY14 FY15 FY16 Source: Company, Phillip Securities Research (Singapore) Tat Seng's debt-to-total-equity ratio stands at 33%, while its cash balance remains robust at a net-cash position (cash minus total borrowings) of S$8.3 million as at the end of FY16. This compares against current market capitalisation of S$89.6 million. Positive free cash flow in four out of the last five years Tat Seng had maintained a positive free cash flow (cash from operating activities, less net CapEx) in the last five years except in FY12. Free cash flow S$ million FY12 FY13 FY14 FY15 FY16 Cash from operating activties Less CapEx, net (9.6) (10.0) (8.3) (6.5) (9.1) Free cash flow (0.6) Source: Company, Phillip Securities Research (Singapore) Slight lengthening of the cash conversion cycle The cash conversion cycle has been on an increasing trend, but averaged 32 days over the last five years. Cash conversion cycle FY12 FY13 FY14 FY15 FY16 AVERAGE Days sales outstanding Days inventory on hand Days payables Cash conversion cycle (days) Source: Company, Phillip Securities Research (Singapore) Page 6 PHILLIP SECURITIES RESEARCH (SINGAPORE)

7 History of paying dividends with trend of increasing payout ratio Tat Seng has been paying an interim dividend every year, and started paying a final dividend in FY13. Dividends since FY13 have been declared twice a year interim and final. The total payout ratio has also been increasing, indicating the company's improving ability to pay out cash. Figure 14. DPS and Payout ratio cents Interim, LHS Final, LHS Special, LHS Payout ratio (total), RHS 33.1% 37.9% 45% 43.3% 40% 35% 30% % 25% % FY12 FY13 FY14 FY15 FY16 Source: Company, Phillip Securities Research (Singapore) Company Valuation We value the stock using a dividend discount model (DDM). Our cost of equity of 10.4% includes a country risk premium component for Tat Seng's exposure to China, and a smallfirm/illiquidity premium. Despite the seemingly high cost of equity, we highlight that it is nonetheless lower than the firm's current return on equity (ROE) of 14.3% and lower than all of the last five year's ROE. What this means is despite the seemingly high cost of equity, the company has been able to create value for its shareholders. Our back-of-the-envelope valuation suggests that the stock is currently under-valued We use the Gordon growth model for our back-of-the-envelope DDM valuation. FY16 earnings per share (EPS) grew 16.7% y-o-y. We do not believe this to be sustainable as this is a mature firm in a mature industry. We do not assume a high growth stage; our model transitions to the stable long-term growth stage immediately next year. Accordingly, the growth rate for earnings per share will converge to the long-term growth rate of 1.0% immediately next year. Likewise, we assume that payout ratio is ramped-up to 90% next year (from 43% in FY16), on the basis that there are no projects left in a mature industry for the firm to invest in, and cash is substantially returned to shareholders. V = E 0 * payout ratio * ( 1 + long-term growth rate ) / ( cost of equity long-term growth rate) = S$ * 90% * ( 1.01) / ( 10.4% 1.0% ) = S$0.89 Our assumptions are internally consistent Based on our assumption of 1.0% long-term growth rate we derive: Payout ratio = 1 ( long-term growth rate / ROE) = 1 ( 1.0% / 14.3% ) = 90.3% Our valuation of $0.89 gives a trailing price-to-book (P/B) multiple of 1.34x. This is internally consistent with the justified P/B that is calculated from: P/B = ( payout ratio x ROE ) / ( cost of equity long-term growth rate ) = ( 90% x 14.3% ) / (10.4% - 1.0%) = 1.37x The firm should command a P/B multiple >1.0x, in view of its consistently high ROE, and value-creation as ROE is higher than the cost of equity. ROE is the driving variable in the justified P/B multiple; the P/B multiple is less sensitive to the payout ratio because a mature stable growth phase is implicit in the Gordon growth model, so a high payout ratio is implicit in the input to the model as well. 20% Page 7 PHILLIP SECURITIES RESEARCH (SINGAPORE)

8 Financials Income Statement Balance Sheet Y/E Dec, SGD mn FY12 FY13 FY14 FY15 FY16 Y/E Dec, SGD mn FY12 FY13 FY14 FY15 FY16 Revenue ASSETS Cost of sales (144.9) (171.8) (179.1) (182.5) (176.8) PPE Gross profit Intangibles SG&A (23.2) (26.7) (29.2) (30.5) (30.2) Others Others (0.75) 0.36 (0.39) Total non-current assets EBIT Inventories Net Finance (Expense)/Inc (2.17) (2.56) (2.44) (1.71) (1.04) Accounts Receivables Profit Before Tax Cash Taxation (1.37) (2.69) (3.88) (4.03) (5.48) Total current assets Profit After Tax Total Assets Non-controlling interest (0.28) PATMI, reported LIABILITIES Short term loans Accounts Payables Others Total current liabilities Long term loans Others Per share data (cents) Total non-current liabilities Y/E Dec FY12 FY13 FY14 FY15 FY16 Total Liabilities EPS, reported DPS, ordinary EQUITY DPS, special Non-controlling interests BVPS Shareholder Equity Cash Flow Y/E Dec, SGD mn FY12 FY13 FY14 FY15 FY16 CFO Profit before tax Adjustments Valuation Ratios WC changes (3.21) (5.95) (3.35) (3.81) Y/E Dec FY12 FY13 FY14 FY15 FY16 Cash generated from ops P/E (x), adj Others (4.21) (5.62) (7.26) (4.85) (5.42) P/B (x) Cashflow from ops Dividend yield (%) Growth & Margins (%) CFI Growth CAPEX, net (9.57) (10.03) (8.27) (6.53) (9.14) Revenue 7.8% 19.9% 4.1% 3.1% -1.3% Others Gross profit 36.4% 25.4% 3.7% 7.7% 5.8% Cashflow from investments (9.42) (9.86) (8.03) (5.14) (8.89) EBIT 56.0% 58.8% -9% 19.3% 18.8% PATMI, reported 74.2% 53.0% -19.8% 31.1% 16.7% CFF Margins Capital contribution, net Gross profit margin 19.4% 20.3% 20.2% 21.1% 22.6% Loans, net of repayments 5.44 (4.00) (7.37) (6.22) 4.64 EBIT margin 6.1% 8.1% 7.1% 8.2% 9.8% Dividends (1.57) (1.57) (3.14) (3.26) (5.15) PAT margin 4.1% 5.7% 4.3% 5.7% 7.0% Others (1.62) 1.04 (0.11) (0.70) (0.74) PATMI margin 4.3% 5.5% 4.2% 5.4% 6.4% Cashflow from financing 5.22 (4.53) (10.63) (10.19) (1.25) Key Ratios ROE (%) 12.1% 16.2% 11.3% 13.3% 14.3% Net change in cash 4.82 (3.26) (7.62) ROA (%) 4.8% 6.3% 4.7% 6.1% 6.7% Effects of exchange rate (0.43) (1.15) Ending cash Net Debt or (Net Cash) (3.4) (8.3) Pledged cash Net Gearing (%) 2.0% 2.6% 2.8% Net Cash Net Cash Source: Company, Phillip Securities Research (Singapore) Estimates *Forward multiples & yields based on current market price; historical multiples & yields based on historical market price. Page 8 PHILLIP SECURITIES RESEARCH (SINGAPORE)

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