PE investment in new materials, how to avoid "a shot in the dark"?
2023-07-07
How can investment identify and follow future trends while also following the laws of development? At present, China is moving from a " large industrial country" to a "manufacturing power" What are the "trend" and "law" in industrial upgrading?
As a PE firm focusing on equity investment for more than ten years, JD Capital has served many outstanding Chinese companies in various sectors. In the "Assisting Made in China" column, we attempt to review and summarize the past investment experiences in multiple industries, and sort out the laws of industrial development, so we can continue to serve the new generation of "Made in China" through equity investment.
In this issue, we focus on new materials investments.
Shared by
Xiaohui Xing, Managing Director, Manufacturing Investment Department, JD Capital
Mingjun Ma, Director of Risk Control, JD Capital
In recent years, new materials have been one of the undoubtedly popular tracks in the primary market.
Each generation of equipment must have related materials to manufacture them. As the basis of economic construction, leaving materials, the industry will become a building in the air, and the development of the materials industry is also an important symbol of social progress.
Over the past 20 years, China's materials industry has developed rapidly, with the output of more than 100 materials such as iron and steel, non-ferrous metals, rare earth metals, cement, glass, and chemical fibers reaching first place globally. However, at the same time, it also faces many problems, such as the overall technical level of basic raw materials could be higher, material consumption, energy consumption and emissions are high, and core technologies, processes, and equipment are still partially dependent on imports.
With a new round of global industrial change, the restructuring of the materials industry has ushered in an important window of opportunity, and new materials have become a strategic emerging industry that countries must compete for. China's new materials industry is changing to a higher quality, better efficiency, better layout, greener and safer industrial development pattern.
Data from the Ministry of Industry and Information Technology of the People's Republic of China show that since 2012, the total output value of China's new materials industry has grown at a compound annual growth rate of more than 20%, accounting for 15% of the raw materials industry. By 2025, the total output value of China's new materials industry is expected to reach a scale of 10 trillion.
The new materials industry has become a rich mine sought after by all, but it is not easy to dig out the treasure in it.
According to JD Capital, materials belong to the typical "big industry, small market segments" The industry's overall scale is large, and the growth rate is fast, but the downstream applications are scattered, the market segments are numerous, the barriers between industries are high, and most of the companies with competitive advantages have not yet been discovered.
In the past ten years or so, JD Investment has invested and laid out many leading chemical material companies such as LB Group (002601. SZ), Yoke Technology (002409. SZ) and DOWELL (300535. SZ) based on the growth logic of the downstream market.
Nowadays, investment in new materials faces a more complex and changing internal and external environment, but what remains unchanged is the understanding of industrial laws and the logic of judgment based on the dimensions of technical barriers, production capacity cycle and cost advantages.
1.Previous generation materials investment:Downstream rapid volume release, process and cost determine the competitiveness of enterprises
The rise of China's materials industry was built based on economic development and large-scale centralized consumption production.
In 2001, as the wooden chase fell from the hands of Kamal, President of the Fourth Ministerial Conference of the World Trade Organization, in the following 20 years, China's economy grew 18 times, increasing its share of the world from 4% to 17.4% and becoming the second largest economy in the world. During this period, multiple factors accelerated the development of the domestic materials industry.
In terms of internal market, the downstream industry is highly prosperous, driving the rapid growth of upstream material market demand.
Regarding the external environment, after China acceded to the WTO, it took a series of measures to reduce trade barriers, such as tariff reduction, further opening up the market. On the one hand, the material industry has a huge export demand; On the other hand, the process of global manufacturing transfer to China has accelerated, and the domestic material industry has also developed.
In this context, JD Capital has laid out several competitive chemical material companies in industries with high downstream demand boom over the past ten years.
Chemical Materials refers to materials produced and processed through chemical or chemical engineering processes. This category covers many material types, including plastics, rubbers, fibres, coatings, adhesives, fertilizers, pesticides, cleaning products, cosmetics, etc.
Taking LB Group as an example, its main product, titanium dioxide, was widely used in the paint and plastic industries, which were closely related to the then-booming real estate, construction, and processing industries. Therefore, JD Capital judged at that time that the downstream demand would keep growing vigorously for quite a long time, thus driving the annual demand growth rate of titanium dioxide to 15%, which is higher than the GDP growth rate.
According to JD Capital, in all competitive fields, the three core factors influencing a company's merits and faults and growth potential are total industry demand, business model and competitive situation. Therefore, it is important first to find industries with high growth potential and identify companies with competitive advantages among them.
Specifically in the materials sector, based on the high growth in overall industry demand at the time, the key to determining the competitive advantage of specific companies is the competitiveness of companies in "technology" and "cost".
1, Technology / Process
As the technology threshold of the chemical materials industry in this period is generally not high, there is no "People have none but we have" in many fields. Therefore, the competitive advantage of enterprises is mainly reflected in the process level, the point of which is whether to ensure stable production and service and higher product yield.
2, Costs
Chemical material enterprise cost consists of raw material cost, production cost, direct labour cost, cost of sales and so on. Among them, the cost of raw materials accounts for a relatively large proportion, for verifying the authenticity of raw material costs and trend judgment is the key.
In terms of authenticity judgment, since the core of some chemical material enterprises is in the formula, and the enterprises will not provide the proportion of raw materials in the finished products due to confidentiality considerations, it is necessary to determine the composition of the raw material cost of the product by extrapolating the raw material proportion based on the purchase volume of raw materials.
The judgment of raw material cost trends is more complicated. First, raw material prices are cyclical. Secondly, the cost is strongly related to technology, and the cost composition is different under different technology lines; the adoption of new process technology/formulation can also reduce the cost of raw materials.
At the same time, after due diligence of a large number of chemical material companies, JD Capital found that, as the upstream of the manufacturing industry, the material industry has its laws, and only by fully understanding the laws behind the industry can we grasp the investment pace and investment risks.
1, Strong cyclicality and regionalism
Cyclicality: Upstream raw material supply and downstream market demand show cyclical fluctuations. Therefore, the risk of overcapacity can be prevented to a certain extent through the prognosis of enterprise start-up rate (production) and downstream market trends.
Regional: Based on upstream raw materials and downstream products transportation cost considerations, chemical material enterprises usually have certain regional characteristics, and those closer to upstream raw materials or downstream markets have more advantages. (But today, new materials are developing towards refinement and high-end, often with higher unit prices, and are no longer as sensitive to transportation costs.)
2, Technical barriers to win first-mover advantage, scale, capital, and customer certification barriers to determine the long-term value
Technical barriers in the early development of the industry are more obvious. Still, in some segments of the industry in the development of a period, the technology gap between enterprises gradually narrowed, thus entering the state of technology and price competition, and gradually evolved to price-based competition. At this time, the scale advantage of enterprises, capital barriers, customer certification and other advantages will be further highlighted.
During the "rough growth" stage in the first decade, investment opportunities were mostly in bulk chemicals and basic materials enterprises, with low technical thresholds and industry concentration. In the background of sustained macroeconomic growth, based on the rapid release of downstream demand, enterprises can further develop into segment leaders by rapidly increasing production capacity with process barriers and establishing cost advantages through scale barriers.
2.New materials investment keywords:Lower localization rate + higher technical barriers
Today, new materials have become an important industry supporting China's leap from a large industrial country to a manufacturing power.
According to the Ministry of Industry and Information Technology, new materials can be divided into six categories according to their properties and functions: special metal functional materials, high-end metal structural materials, advanced polymer materials, new inorganic non-metallic materials, high-performance fibres and composites and frontier new materials.
Source JD Capital
Data show that China's new materials industry currently accounts for large global output, the growth rate far exceeds the global average growth rate, but the development is uneven. The middle and low-end materials self-sufficiency and the middle and high-end materials import dependence are serious is the status quo of China's new materials industry.
In 2018, the Ministry of Industry and Information Technology's research on more than 130 key basic materials from more than 30 large enterprises across the country showed that 32% of them are still blank in China, and 52% rely on imports.
Therefore, "domestic substitution" is still important for China's new materials industry. In the view of JD Capital, there is still great potential to invest in the "domestic substitution" of the new materials industry at this stage.
First of all, on the demand side, the total demand for new materials in the past was small because the proportion of cost in the end product was not high, so the downstream enterprises relied more on imports. But now, for cost control and supply chain stability, downstream enterprises are seeking domestic substitution, bringing more opportunities for Chinese new material enterprises.
At the same time, according to the law of industrial development, when the industry support matures to a certain extent, the domestic replacement will gradually develop upstream.
China has spent the past 40 years or so experiencing almost completely the three industrial revolutions in the world's industrial history of 250 years, and the development path also shows a gradual breakthrough and perfection along the industrial chain from downstream to upstream.
In the downstream of the industrial chain, China has taken the lead in developing the terminal and assembly markets due to the clear and large scale of the end market demand, fast growth rate and high-profit margin. At the same time, the basic technology involved needs to be developed. Such as cell phones, computers, home appliances, etc., about 70-80% of the global assembly in China.
In the midstream of the industry chain in the components field, Chinese companies have now also occupied a larger share of the core components manufacturing capacity, which is constantly improving.
Now, the upstream of the industry chain will become the focus of development in the field of materials. The previous accumulation in the end market, application scenarios and mid-tier manufacturing have become the basis for domestic material substitution.
In addition, based on the current situation of domestic new materials enterprises, the founder and CTO of China Ceramics Materials, Song Xibin, define new materials as new in four aspects: new performance, new process, new application, and new demand. The maturity of China's end market determines that most Chinese new materials enterprises are better at meeting "new applications" and "new demands", i.e., in many foreign new materials that are relatively mature, through technical/technical breakthroughs, expand to new application scenarios, and meet new demands. Also, get the small volume trial production orders.
In fact, after researching many such companies, Jiuding CapitalJD Capital found that it has developed a certain "late-stage advantage".
First, the enterprise's target (material to be developed) and path (formulation or process) have been clearly defined, and the R&D and production cycle can be greatly shortened compared with the early foreign enterprises.
Secondly, the complete domestic supply chain support, engineer bonus and huge market demand provide advantages for Chinese companies. Once a company achieves a technological breakthrough, it can also achieve rapid cost reductions.
Third, China has a natural advantage as the world's largest market for new material applications. Companies are closer to the downstream and can quickly identify and respond to market demand, which ultimately translates into cost and technology advantages.
So, how to find valuable investment opportunities under the general logic of "domestic substitution"?
Data show that in 2021, the global new materials industry will be $3.3 trillion and reach $5 trillion in 2025, with a compound growth rate of about 14%. The total output value of China's new materials industry has grown at a compound annual growth rate of over 20% in the past decade and is expected to reach $10 trillion by 2025.
However, compared with the United States, Japan, Europe and other developed countries and regions, China is still at the stage of rapid development and catching up.
From the life cycle of industrial development, China's new materials industry is currently about 1/2 to 1/3 of foreign countries. According to the new materials from research and development to promotion, and then to the final application of several decades to calculate, China has developed a new material gap with foreign countries or more than ten years.
This means that the "domestic replacement" of the new materials industry is a slow process, not overnight. But once the technological breakthrough is achieved, there will be more room for development.
With a localization rate of 0-20%, the industry, to achieve technological breakthroughs, will enter a long period of wall-breaking penetration, and the development rate is slow, generally ranging from 3-10 years.
With a 20-50% localization rate, industry development accelerates, and enterprises obtain high growth. But at the same time, the phenomenon of technology spillover gradually increased, the industry competition intensified, the technology gap between enterprises narrowed, and price competition and lower gross margins gradually increased. Some enterprises are cleared out, and the concentration of the industry increases.
The localization rate of more than 50%, industry competition into the white heat, the industry or through mergers and acquisitions in the form of the birth of large leading enterprises.
Source: JD Capital
Therefore, considering the development cycle and long-term growth of different segments, JD Capital judges that the new material segments with a current localization rate of 10%-20% will have greater opportunities in the future.
However, it is worth noting that, while researching many enterprises, JD Capital also found that investment in new materials needs to be wary of the trap of "pseudo domestic substitution". In addition to the examination of the localization rate of the final product and technology, it is also necessary to determine the localization of the technical capacity of the product production chain. If the key raw materials and production equipment can be localized, the competitive advantage of domestic enterprises will be maintained.
Meanwhile, in the view of JD Capital, at this stage, investing in "domestic substitution" in the field of new materials is not simply focusing on the low-end substitution and imitation of the stock market.
On the contrary, breakthroughs and innovations in mid- and high-end material technologies are the key to winning the competition. The follow-up still needs to return to the essence of business. Whether to achieve cost reduction and efficiency or meet market demand is the key to determining the long-term competitiveness of new materials enterprises.
3.Big industry, small market segments:How to tap into underwater projects?
The new materials industry is a typical "big industry, small market segments", large scale but many market segments, small and scattered; all kinds of products have significant differences in Know-how, market channels, and core competitiveness.
This means that new material enterprises should be focused enough at the beginning but also pay attention to the creation of core technology. The investment in new materials is to use a ten-year perspective, from the market size, technology, cost and other levels of the evolution of the competitive landscape of different markets to do judgment.
1, Market size
New materials are closely related to downstream market demand. However, nowadays, the era of rapid macro market growth driven by the general rise of upstream materials in the industry has passed, and the judgment of the scale of each downstream segment and its future growth trend is the key.
For example, in many industries, although the future exponential growth potential is limited, the current market size is large enough (at least 3 billion yuan or more), and certainty is strong. In this regard, we believe that there are still opportunities for companies that can quickly meet the "existing demand" (demand that imported products have verified) and improve the localization rate through technological breakthroughs at this stage.
Take OCA (Optical Clear Adhesive) as an example; its market demand depends on the downstream demand for cell phones, tablets, computers, and other types of panels. According to JD Capital statistics, the industry's overall size is about 15 billion yuan, with a localization rate of less than 10%, and mostly low-end products. In the past two years, many domestic enterprises have gradually absorbed advanced technology by introducing technical teams, foreign mergers and acquisitions, etc., which will usher in rapid growth in the future.
In another category, the current market size is small, but the growth rate can be expected to be very fast. In these markets, opportunities for materials companies often arise from satisfying "replacement needs" while fulfilling "creative needs", where new materials replace old ones and create new application scenarios.
PET copper foil, for example, is considered a good alternative to traditional lithium battery collectors (aluminum and copper foil) as a new material for power batteries. Aerogel, another energy-efficient thermal insulation material usually used in the construction industry, can also be used in power batteries for thermal insulation and shock absorption, a "demand creation".
The penetration rate of both materials in power batteries is currently very low. If large-scale applications can be realized in the future, dual-power growth will be achieved with the increase in penetration rate and the growth of the power battery industry.
However, it is worth noting that new materials' validation cycles differ.
For example, if the market has verified imported OCA, domestic products only need to follow the path of imported products to verify reliability; the period is usually six months to two years, more certainty. In contrast, new materials such as PET copper foil, which meet new demands, require a longer time to verify in actual application, with higher uncertainty but correspondingly higher investment premium.
2, Technology
Technology barrier is the key to establishing barriers for new material enterprises; otherwise, it is easy to fall into a price war and disorderly competition brought by overcapacity. And the choice of different technical routes directly determines the survival of enterprises.
According to JD Capital, choosing different technology routes depends on which route is more adaptable to downstream demand. However, this adaptability tends to change with the cycle, technological improvement, etc. For example, the supply and price of upstream raw materials will affect the cost of new materials, affecting downstream procurement. Improvements in Technology or processes will also drive the application of a particular technology route.
Therefore, for investment, the technology route must be judged on a 10-year cycle to exclude interference to a certain extent to see the end game.
3, Cost advantage
Cost determines how far new material companies can go in the long run. The technology level is similar, especially when the localization rate in the subdivision industry reaches more than 20%. When competition intensifies, the company has no cost advantage, or it will be eliminated.
4, Team
The new material field requires extremely strong professionalism from the founding Team. However, JD Capital believes experienced talents who focus on a certain niche area for a long time are more valuable than lab-type talents.
Because materials are empirical science, the testing index of materials has only relative significance; the corresponding performance of the material combined with the corresponding process to make products that meet the requirements, "good to use", is far more important than the "good test index".
In general, for investors, the new materials investment threshold is high. The difference between sub-sectors is large; only each sub-sector, in-depth study of its downstream applications, production process, process technology, raw material composition, product specifications, etc., to earlier and faster to find the real value of underwater projects.