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18 March 2011

HONG KONG/CHINA EQUITY


Investment Research
_

Sector Update Private Circulation Only

Ng Sem Guan, CFA


+603 9207 7678 China Steel Sector RATING Neutral
semguan.ng@my.oskgroup.com

The Research Team


+603 9207 7686
Research2@my.oskgroup.com
Seeking The New Growth Engine
As China’s major steel mills issued loss alerts in 4QCY10 and its People’s
Congress just concluded a few days ago, we are revisiting the
recommendations we made some four months after our initiation report on the
nation’s steel sector. We reckon that the sector’s new landscape may not be as
bullish as we had projected as the Chinese government continues to cool the
economy to rein in inflation while global steel demand remains moderate. The
downward earnings revision on Angang (347.HK) and Magang (323.HK) after
their loss alerts also translate into lower ROE projections. This prompts us to
revise downwards our P/B methodology to the mean of the respective
company’s historical track record and tone down our PER multiples. We also
adjust for currency conversion to incorporate the strengthening Yuan, which in
turn compensates for the lower valuation multiple. The poor visibility and lack
of BUYs among our sector universe warrant us keeping NEUTRAL on the steel
industry.

The 12th 5-year plan. Premier Wen Jiabao closed Monday’s annual parliamentary
session of the 12th 5 year plan (2011-2015) with a focus on lowering China’s annual
economic growth target to a more sustainable 7% vs 7.5% previously, balancing
economic growth speed, creating jobs and controlling inflation. Among the key issues
discussed included China’s pledge to continue to eradicate poverty in 10 years by
"raising" the poverty line this year. We summarise the plan’s key targets in Exhibit 1.
th
Exhibit 1: Key figures in the 12 Five-Year Plan

Source: Government work report

OSK Research
See important disclosures at the end of this report 1
OSK Research China’s Steel Sector
18 March 2011

Property a hot topic. Among the hot topics discussed was the government’s
continued resolve to curb property speculation by monitoring and holding local
governments accountable for excessive housing price growth while providing
enough affordable houses for needy residents. The country will spend about
RMB1.3trn (USD197bn) to build 10m units of government-subsidized housing in
2011 and 2012 respectively, and 16m units each year from 2013 to 2015 (refer to
Exhibit 2). The Government also pledged to renovate 1.5m dilapidated rural houses.
While the huge allocation for social housing may spur requirement for long steel
products like steel bars and wire rods, we think this may translate into a slightly
lower steel tonnage used given the fact that: (i) the emphasis will be on building
more small-and medium-sized housing units, which will obviously reduce the need
for steel compared to private housing which generally have bigger built-ups, and (ii)
the excessive supply will prompt private developments to hold back on new
launches.

Exhibit 2: Social housing targets in China

m units built
18.0
16.0 16.0 16.0
16.0
14.0
12.0
10.0 10.0
10.0
8.0
5.8
6.0
4.0
2.0
0.0
2010  2011 2012 2013 2014 2015
(actual) target

Source: China Daily, OSK Research

Exhibit 3: Railroad mileage in China

km
140,000
120,000
120,000

100,000
86,000
75,000 78,000
80,000 70,000 73,000

60,000

40,000

20,000

0
2001 2003 2005 2007 2009 …… 2020F

Source: Statistics and planning by the Ministry of Railways

OSK Research 2
See important disclosures at the end of this report
China’s Steel Sector
18 March 2011

Focus still on FAIs. Over the next five years, China will continue to pour money
into railway construction, rail rolling stock, highways, airports, and ports. However,
we are a bit disappointed that the recent congress did not revise its target to expand
railway mileage. We had earlier projected that the government may bring forward its
targeted railway mileage of 120,000km by 2020 to 2015, possibly pushing up the
annual target for 6,000km in new tracks per annum from the current 3,000km. We
suspect this may have been due to the authorities’ move to sack its Railways
Minister, Liu Zhijun, following an investigation for "serious disciplinary violations".
Including the developments in the property market, this further suggests that long
steel demand in 2011 will be flat, against our original expectation of a mere 0.4% y-
o-y increase.

Raising household income. As expected, the Chinese government’s new plan is


committed to increasing the proportion of household income in the national wage
income. The government is implementing unprecedented policy initiatives to raise
Chinese residents’ disposable income, build a well-developed social safety network,
boost the development of economic housing, and promote consumer finance.
Together with growing urbanisation, with NDRC’s target of hitting an urbanization
rate of at least 50% or more in the next 5 to 6 years, we see all these pointing to
stimulated private consumption, which will spur consumption in the second and third
phases of upgrading (refer to Exhibit 4). While we reckon that private spending will
gradually shift towards flat steel requirement as materials to make cars, white goods
and so on, we now reckon that growth would be more modest given the longer shelf
life of those products compared to users in the developed nations. Also, the
restriction on car ownership in Beijing and other major cities may also limit growth in
annual consumption. Hence, we are reducing our consumption growth assumption
for flat steel from 9.7% to 8%.

Exhibit 4: China’s three phases of consumption upgrading

  First Phase Second Phase  Third Phase

Period  1960s to 1980s  1990s to 2000  2000s to present 


   

   
   
 
 

Benchmark Products 
   
 
 
 

 
     

Basic needs to small 
Focus  Basic necessities   Luxurious lifestyle 
family development 
Source: CISA, OSK

OSK Research 3
See important disclosures at the end of this report
China’s Steel Sector
18 March 2011

Lower steel consumption growth of 3%. The 12th 5-year plan will also see
inflation control as China’s top priority, as the government has highlighted that China
needs to achieve a more balanced and sustainable level of growth through stronger
domestic consumption. We note that the direction set by the Chinese government in
the new plan was well within our expectation. However, as the chain impact on steel
requirement was below our expectation, we are nudging down our annual growth
forecasts for long and flat steel consumption in 2011 and subsequently reduce our
overall steel consumption expectation in China for 2011 to 3% against our original
projection of 3.8%.

OSK Research 4
See important disclosures at the end of this report
China’s Steel Sector
18 March 2011

NEAR TERM OUTLOOK REMAINS VOLATILE BUT…

Loss alert on 4QFY10 by major mills. Meanwhile, Angang (347.HK) and Magang
(323.HK) recently issued statements on the HKSE that their 4Q results would be in
the red, with a possible RMB800m potential loss for Angang and RMB400m for
Magang. The potential losses were attributed to higher fuel and raw material costs,
which we suspect were due to the time lag between delivery of expensive material
in 3Q and its recognition in 4Q. We think the power restrictions imposed in 4Q may
have had a hand in the weaker numbers, given the government’s aim to cut energy
consumption and pollution. The share prices of both companies have subsequently
weakened, with Angang losing some 20% in market value. Therefore, we think the
weaker than expected results of the steel mills in 4Q, which are scheduled for
release by the end of this month, may well have been priced in.

Earthquake marginally positive for steel industry. Japan’s 9.0 magnitude quake
which struck the northeast coast may disrupt the country’s exports (being the 2nd
largest producer after China) although not severely given the mixed and sketchy
news related to Japanese steel millers. Recent reports from steel millers indicate
that the initial estimated damage may have been overplayed, with Nippon Steel
(which has integrated works at the east lip of Tokyo Bay) reporting that its furnaces
which initially stopped work for damage inspection have restarted. JFE Steel,
whose Chiba and Keihin works are on opposite sides of Tokyo Bay, denied earlier
reports that part of its Chiba plant was ablaze. It said a small fire actually broke out
at Keihin but was quickly extinguished and was not connected with its steel
operations. Blast furnaces at both works had been banked but those at Keihin
restarted on Sunday morning while those at Chiba are to restart soon. However,
other reports suggest that a number of mini steel mills in coastal Japan have
experienced evident damage, especially those near Sendai, it was confirmed that
there was flooding at two plants belonging to JFE Steel.

Exhibit 5: Key steel products exported by Japan in 2010

Others 
2% Iron/Semi Steel
Specialty Steel 13%
18%
Long Steel 
6%

Pipes
4%

Flat Steel 
57%
Export in 2010:
43.4m MT

Source: Japan Iron and Steel Federation, OSK Research

OSK Research 5
See important disclosures at the end of this report
China’s Steel Sector
18 March 2011

China steel mills may not fully capitalise on supply void. With 75% of Japan’s
exports comprising flat steel and specialised steel amounting to 32.6m tonnes (see
Exhibit 5), China may not be in the position to fill in the shortage gap given its
production concentration and expertise in long products rather than flats. While
some flat products from Chinese steel mills have attained automaker standard, they
are already heavily committed to their local customers given China’s booming auto
market. At this juncture, we are unable to quantify the amount of steel needed for
Japan’s reconstruction works, but based on its crude steel production of 120.2m in
2007 vs 109.6m in 2010, we believe Japan has the spare capacity to meet its
rebuilding needs without importing significant amounts of steel. In a nutshell, we
think the earthquake generally augurs well for steel mills, particularly for near term
margins, as the temporary vacuum left by Japanese mills may spur steel prices and
their absence in the spot material market may pull iron ore and coking coal price
down.

1Q earnings likely to surge. The escalating steel prices in late 2010 followed
through into the Lunar New Year 2011, further boosted by heightening raw material
prices of coking coal to iron ore as a result of severe flooding in Queensland,
Australia. The uptrend also encouraged traders to take up additional physical steel
positions in anticipation of a further price increase. However, steel mills under our
universe have mostly contracted part of their iron ore based on the quarterly
benchmark pricing. Therefore, their actual realised iron ore cost would be lower due
to the time lag impact of the random average contract prices in 4QCY10 and
1QCY11, plus the remaining portion that was acquired from the spot market (refer to
Exhibit 6). Furthermore, Chinese mills procure nearly all their coking coal from local
miners that are not severely impacted by the shortage caused by the Queensland
floods although selling prices did actually inch up a bit. Therefore, we expect a sharp
rebound in steel mills’ financial performance moving into 1Q.

Exhibit 6: Iron ore contract prices vs spot prices

USD per MT Quarterly Contract Prices Spot Prices

200.0
180.0
160.0
140.0
120.0
100.0
80.0
60.0
40.0
20.0
0.0
1‐Dec‐10
1‐Oct‐10
1‐Aug‐10
1‐Apr‐10

1‐Apr‐11
1‐Nov‐10

1‐Jan‐11
1‐May‐10

1‐Sep‐10

1‐Feb‐11

1‐May‐11
1‐Jun‐10

1‐Jul‐10

1‐Mar‐11

Source: TSI, OSK Research

OSK Research 6
See important disclosures at the end of this report
China’s Steel Sector
18 March 2011

2Q earnings likely to be satisfactory. As for 2Q, the heightening spot price from
December 2010 to February 2011 that is used to benchmark the 2QCY11 contract
price has seen FOB West Australia 62% Fe iron ore increase to USD173.66 per Dry
MT (dmt), or up 23% q-o-q. However, most of the mills may have stocked up
additional iron ore bought at contract pricing, and may cut down on procurement in
2Q. Also, steel mills may opt to purchase iron ore in the spot market given that the
brief absence of Japanese mills may further bring down the spot price. As the recent
calamity in Japan may have created a supply void in the regional market as Japan is
the main steel exporter, this may also lift steel price to certain degree. We are also
hopeful that more works may have begun after the long Lunar New Year
celebration, thus boosting physical steel demand.

Poor visibility in 2H. While we are excited over the potential earnings recovery in
1HCY11, we remain cautious on the poor earnings visibility beyond six months. The
economic uncertainties, extent of damage from the Japan earthquake, potential
policy changes in China and other factors, will have enormous implications on the
steel industry outlook. We also worry of a potential repetition of 2HCY10 in 2011, as
steel demand and prices are normally weaker in 3Q due to the summer season in
Northern Hemisphere countries. Meanwhile, we still keeping our fingers crossed for
a quick improvement after the summer, and thus maintain reasonably optimistic on
the financial performance of steel mills under our universe.

OSK Research 7
See important disclosures at the end of this report
China’s Steel Sector
18 March 2011

VALUATION AND RECOMMENDATION

Lower ROE estimates hence P/B? Following the loss alerts from Angang and
Magang, we have revised downwards our earning estimates for both companies in
the next three years. In addition, we have been sceptical on the earnings
projections of Chongang (1053.HK) on the back of potentially high interest and
depreciation charges after its heavy relocation and new plant investment.
Subsequent to the earnings downgrade on the two heavyweights within our
universe plus the conservative estimates for Chongang, it seems that the majority
of the steel companies’ earnings may only return to the mean level instead of our
original expectation of +1 standard deviation. Therefore, we are toning down our
P/B valuation methodology to benchmark against the respective mean of the
companies’ historical trend (please read the respective companies’ reports for more
details).

Exhibit 7: ROE of steel mills under our universe


ROE (%) Angang
Magang
30.0
SCIE
25.0 Chonggang
20.0 China Oriental

15.0

10.0

5.0

0.0

‐5.0 2005 2006 2007 2008 2009 2010F 2011F 2012F

‐10.0

‐15.0

Source: OSK Research

Exhibit 8: New fair value of steel mills under our universe

Valuation applied (FY11) Fair Value (HKD) Last Price  Up/Downside 


Company Ticker
PER (x) P/B (x) New Existing (HKD) (%)
Angang 347.HK 12 1.33 10.97 11.11 10.36 6%
China Oriental 581.HK 8 0.90 4.35 4.25 2.57 69%
Chongang 1053.HK 10 0.66 1.94 1.92 1.94 0%
Magang 323.HK 12 1.01 3.96 3.77 4.11 ‐4%
SCIE 697.HK 10 1.30 1.41 1.80 1.11 27%

Source: OSK Research

OSK Research 8
See important disclosures at the end of this report
China’s Steel Sector
18 March 2011

Tweaking PER and currency conversion. The lower earnings also prompt us to
take a quick look at our PER valuation range. We decided to apply PER multiples
ranging from 8x to 12x based from the previous 10x to 16x level on the following
criteria: (i) the historical PER trading band, (ii) the company’s prospects moving
forward, and (iii) the liquidity of a particular stock. We also reckon that the Yuan
(RMB) has been strengthening against the Hong Kong dollar (HKD) over the years
and our economist also projects a possible five-percentage appreciation y-o-y by
the end of 2011. With the exception of SCIE (697.HK) which presents its financial
accounts in HKD, other mills under our coverage report their financial performance
in RMB. Therefore, we are making the necessary currency conversion from RMB to
HKD, plus our in-house projection of a possible five percent appreciation, to arrive
at a more appropriate peer comparison.

Maintain NEUTRAL. Our latest fine tuning in the valuation parameters together
with the incorporation of currency conversion translate into a very marginal impact
on our fair value except for SCIE as the company does not enjoy any currency
appreciation considering that its numbers are already fairly reflected in HKD. As
there is no major change in our fair value and SCIE still offers a decent upside to
the new target price, we are keeping all our recommendation on the respective
companies, with a BUY call on China Oriental and SCIE, while Angang, Magang
and Chongang are maintained at NEUTRAL. With the majority of our
recommendations being NEUTRAL and given that we are turning a bit cautious on
the overall outlook, we reiterate our NEUTRAL rating on China’s steel sector.

Stock Ticker Closing at 17 Mar FV Mkt Cap Volume PER (x) FY0  FY1   Rel. Performance % P/BV Rating
HKD (HKD bn) (m) FY1 FY2 ROE % DY % 1‐mth 3‐mth 12mth (x)
Angang 347 HK 10.36 10.97              69.0  13.2 36.1 14.0 1.4 1.4 ‐6.0 ‐8.8 ‐31.5 1.2 NEUTRAL
China Oriental 581 HK 2.57 4.35                7.5  0.2 6.0 4.0 13.2 3.5 ‐27.4 ‐17.6 ‐16.1 0.8 BUY
Chongang 1053 HK 1.94 1.94                6.8  1.2 149.8 16.3 1.2 0.0 ‐3.9 ‐3.5 ‐25.2 0.5 NEUTRAL
Magang 323 HK 4.11 3.96              33.6  18.9 37.9 14.8 0.9 1.0 ‐0.3 4.0 ‐17.0 1.0 NEUTRAL
SCIE 697 HK 1.11 1.41                9.1  29.8 10.8 7.1 ‐12.5 2.9 ‐1.6 ‐0.8 ‐39.5 1.0 BUY

OSK Research 9
See important disclosures at the end of this report
OSK Research China Steel Sector
March 18, 2011

OSK Research Guide to Investment Ratings

Buy: Share price may exceed 10% over the next 12 months
Trading Buy: Share price may exceed 15% over the next 3 months, however longer-term outlook remains uncertain
Neutral: Share price may fall within the range of +/- 10% over the next 12 months
Take Profit: Target price has been attained. Look to accumulate at lower levels
Sell: Share price may fall by more than 10% over the next 12 months
Not Rated: Stock is not within regular research coverage

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OSK Research
See important disclosures at the end of this report