China Essence Group Ltd, listed on SGX Mainboard in 2006, is a leading integrated producer of potato starch and potato starch-based products such as vermicelli, starch strips and five-grain noodles in the PRC. China's annual consumption of potato starch per capita is about 0.6 kg, which is low when compared with that of over 10 kg in Europe and Japan, reflecting a long term growth potential in the consumption of potato starch in the PRC.

However, near term demand is likely to be affected by China's slowing industrial output growth which registered a growth of 8.2% in October, compared with 11.4% in September. We expect revenue to grow in line with China's consensus GDP forecast of 8-9% for calendar year 2009~10. However, we forecast gross profit margin erosion to 38.9% & 34.5% for 2009-10F. As such, earnings are expected to decline 20.2% and 12.8% to RMB190m & RMB165.7m for FY09-10F respectively. As such, we resume coverage on China Essence with Hold recommendation.

Resume coverage with HOLD recommendation with target price of S$0.25 We value China Essence at 0.5x Price-to-Book (P/B) valuation, in line with peer's average P/B valuation, deriving our target price of S$0.25. Our estimates are 20% below consensus as we took a conservative stance amid challenging economic conditions.

We forecast China Essence's revenue to register 12% growth in FY09F to RMB957.8m and soften to 8% growth in FY10F to RMB1,034.7m, in line with China's consensus GDP forecast of 8-9% for calendar year 2009~10. However, we expect revenue to pick up in FY11F, with potato protein and potato fibre, China Essence new product segments expected to be launched in 3Q09F, contributing about 2% of total revenue in FY09F to approximately 16% in FY11F.

We understand that China Essence has revised the Average Selling Price of its potato starch products to help distributors boost their product sales at lower and more attractive rates in response to economic slowdown. On the other hand, raw material cost is expected to remain relatively stable while overheads costs are largely fixed in nature at least in the near term. As such, we expect the ASP revision to result in a 5.7ppt decrease in Gross Profit Margin to 38.9% in FY09F. We expect GPM to shrink further to 34.5% in FY10F, mainly due to slight decrease in GPM across all business segment as well as higher contribution from potato fibre segment commanding a lower GPM of approximately 20%.

We forecast earnings to decline 21.3% and 13.1% to RMB187.2m & RMB162.7m for FY09-10F respectively, mainly due to the decline in forecasted GPM as well as rising selling, general and administrative expenses with the increase in product segments.

China Essence is highly dependent on availability of potatoes, being the Group's main raw material. In addition, the Group requires a large quantity of water in its production of potato starch. Any supply disruption or price spike will adversely affect China Essence's profitability.