The Cornerstone of Chinese Growth

07/22/2011 7:30 am EST

Focus: STOCKS

Yiannis Mostrous

Editor, The Capitalist Times

China’s soft landing means that growth will continue, and select infrastructure plays will continue to benefit, notes Yiannis Mostrous of Global Investment Strategist.

Like most investors, we’ve been troubled by the discouraging US jobs report for June which showed that only 18,000 jobs were created in the month. We hope that this is merely a sign of an economic soft patch that doesn’t foretell an outright deterioration in the labor market.

If this is merely more evidence of a soft patch, then the trend could reverse in a few months and help spur the global economy. But a stalled US economic recovery would negatively impact markets. Regardless, the US economy needs to grow jobs by about 150,000 each month to enjoy a relatively healthy recovery.

Although the US unemployment situation remains dicey, it’s not without precedent. Although the current rate of jobs growth is far below the ten-year average, it has matched the pace seen after the 1991 economic recovery, and has surpassed the pace of the 2001 recovery.

We are cautiously upbeat. The US and global economy have faced daunting headwinds this year, and have coped with these challenges relatively well.

The Federal Reserve’s leadership will do whatever it takes to avoid another recession and deflation. If the economy looks like it needs more help, the Fed will step in.

Turning our attention to another important economy, China continues to defy the doomsayers. Second-quarter numbers came in even better than we had predicted, indicating that the Chinese economy is in for another year of turbocharged growth.

The country’s economy expanded by 9.5% year-over-year in the second quarter, suggesting that China will post yearly GDP growth of more than 9%. Industrial production grew by 14% year-over-year in the second quarter, slightly lower than the first-quarter figure.

Industrial production was helped by a reduction of power shortages in some parts of China, higher steel production, and solid cement production. Second-quarter cement production increased by about 20% year-over-year, suggesting that China’s program to build millions of units of social housing has boosted the construction industry.

We reiterate our recommendation to buy Chinese cement manufacturers, particularly Anhui Conch Cement (Hong Kong: 914, OTC: AHCHY).

Anhui Conch Cement is China’s largest cement and clinker producer in terms of output, a distinction it’s held for the past 12 years. The state-owned company’s production capacity is mostly located in East China, South China, and Central China, though it has plans to expand into Southwestern China.

The firm’s estimated installed clinker capacity stands at 75 million tonnes. Clinker is a key component for the manufacture of Portland cement.

The company is expected to report first-half earnings in mid-August, and many analysts have upgraded their forecasts for Anhui Conch by nearly 90%. We believe the company will surprise to the upside, delivering first-half earnings growth of 100% to 150% while posting record profits.

Furthermore, the consensus estimates call for Anhui Conch to deliver more than 30% quarterly growth. The company’s second-quarter sales are expected to surpass 40 million tonnes, compared to 29 million tonnes in the first quarter.

That being said, the main risk to this assessment is the price Anhui Conch can command for its products, and margin erosion from high coal prices. Note that coal and energy historically have accounted for about half of the company’s production costs.

The company recently announced a memorandum of understanding with Indonesia’s Industry Ministry to boost the Southeast Asian nation’s cement capacity. Under the terms of the memorandum, Anhui Conch will invest $2.35 billion to build four cement plants with a total annual capacity of 15 million tonnes in Indonesia. The plants will be located in the South, East, and West Kalimantan, and in West Papua.

Anhui’s management seeks to bring its efficient production to the relatively high-profit market of Indonesia—the retail price for cement in Indonesia is about $100 to $120 per tonne, compared to $50 to $60 per tonne in China. However, the plan is in the feasibility stage, and will require final approval from both countries’ governments.

Anhui has budgeted two years for the project, and the company must deliver on all fronts. Anhui Conch has the most successful track record of any cement manufacturer in China, and it will need to duplicate its highly standardized manufacturing and operating models in Indonesia to reap any profits from the venture.

Furthermore, expanding into a new market always entails currency and geopolitical risks. Companies must often build their brand from the ground up in new markets. Nevertheless, a company of Anhui Conch’s size should seize upon opportunities to expand its presence beyond its home market, and the Indonesia deal could be an important development for Anhui Conch

On the domestic front, the Chinese authorities have ordered the closure of 782 outdated cement plants with a total capacity of 153 million tonnes (7% of China’s total capacity). This may benefit large cement producers such as Anhui Conch; much of the lost capacity will come from smaller producers.

Anhui Conch Cement is a buy up to HK$45. [Shares in Hong Kong closed under HK$39 on Thursday; the ADR has no significant volume, unfortunately—Editor.]

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