x Materials / China 19 November 2012 Reassessing costs and benefits China Thermal Coal Sector Easing of perfect storm should create cyclical upside even for an industry with single-digit growth rates and long-term challenges While coal prices continue to be supported by supply and demand forces, cost differences should also play a role in stock picking Long-term investors should stay with Shenhua; upgrading China Coal to Buy as we see a better risk-adjusted return vs. Yanzhou Positive (initiation) How do we justify our view? Neutral Negative days in 2013. Continuing coal expect a meaningful breakthrough production cost rises could also lead until after 2014 based on our sum- to higher upside than downside risks of-the-parts forecasts. Also, we see for spot coal prices in 2013 (we the development of shale gas as a expect a 1% YoY rise), whereas long-term threat, either via US Dave Dai, CFA sector share prices factor in no price exports to Asia or China‘s own (852) 2848 4068 recovery. All these considerations exploration, which could impose [email protected] underpin our positive investment pressure on coal demand. thesis for thermal coal stocks in the Gary Zhou near term, especially following the What we recommend (852) 2773 8535 [email protected] recent strength of early indicators Shenhua is our top pick, as we like cement and steel. believe it offers sustainable earnings growth, warranted by vertical What's new Along with our positive macro integration. Having underperformed Thermal coal stocks look better assessment, we have looked at costs the market for three consecutive positioned over the next few quarters in detail. While strong cost years, China Coal offers an attractive on a risk-reward basis, following the management in 3Q12 was a positive valuation, in our view. We therefore easing of the ‗perfect storm‘ in 1H12. surprise, China Coal Energy‘s (China upgrade the stock to Buy (1) and This report marks the transfer of Coal) current cost structure is also believe it is a better recovery play coverage to Dave Dai. less sensitive to wage inflation and than Yanzhou (Hold [3]). Risks to policy changes vs. peers. Yanzhou our sector view would be a worse- What's the impact Coal Mining (Yanzhou) has been the than-expected demand recovery and Following a golden decade of most leveraged stock in past higher-than-expected cash costs. production growth (9% CAGR over upcycles, but its deteriorating 2001-11), industry production looks profitability from expansion into How we differ set to moderate to low single-digit low-margin mines in China and We are more bullish about demand (3%) growth rates onwards of 2013 Australia, together with its and coal prices for 2013 and we have with unsettling long-term concerns substantial exposure to labour cost a differentiated view on costs. (railway and shale gas). Still, hikes, looks set to make its profits following the ‗perfect storm‘ in 1H12, more vulnerable than peers. we expect a much better demand- Key stock calls supply balance in 4Q12E and 2013E. Given its higher earnings sensitivity New Prev. to contract prices, China Coal could China Shenhua Energy (1088 HK) Along with a demand recovery that benefit the most if contract prices in Rating Buy Buy should be supported by recent China converge with spot prices. Target 38.00 34.90 encouraging macro data, we also Even without full convergence this Upside p 23.6% expect improvements from cost- year, China Coal‘s track record China Coal Energy (1898 HK) driven supply discipline (18% of shows it has been able to realise Rating Buy Hold higher average prices than China Target 9.00 7.00 China‘s state-owned coal producers Upside p 21.8% were loss-making in 8M12), Shenhua Energy (Shenhua). We have a cautious view in the medium Yanzhou Coal Mining (1171 HK) normalising hydro output and Rating Hold Hold import reductions. We expect term, as China‘s aggressive railway Target 11.30 12.60 system inventory to destock from 31 expansion could alleviate the long- Upside p 0.4% days of consumption in 2012 to 28 lasting bottleneck, but we do not Source: Daiwa forecasts. See important disclosures, including any required research certifications, beginning on page 69 China Thermal Coal Sector 19 November 2012 How do we justify our view? Growth outlook Valuation Earnings revisions China coal: demand-supply growth trend Growth outlook During 2001-11, China‘s commercial coal output and (M tonnes) (%) domestic coal consumption (calculated on apparent 5,000 25 20 demand basis) rose at CAGRs of 9% and 10%, 4,000 respectively. However, we expect both of these growth 15 rates to moderate in 2012, and for the 2012-15 period, 3,000 10 we project respective CAGRs of only 3% and 4%. China‘s 2,000 5 th 0 latest 12 Five-Year Plan for the coal industry also 1,000 suggests a similar CAGR for coal production. (5) 0 (10) 1996 1997 1999 2000 2001 2002 2003 2004 2006 2007 2008 2010 2011 1998 2005 2009 2012E 2013E 2014E 2015E Commercial coal production Domestic Consumption Production YoY Consumption YoY Source: CEIC, Daiwa forecasts China Thermal Coal Sector: one-year forward PER trend Valuation The sector looks inexpensive to us, trading substantially (x) below its past-5-year mean. Yanzhou is much more 35 expensive than Shenhua and China Coal in terms of 30 2013 PERs based on our forecasts; hence, we have a Hold rating on Yanzhou (compared with Buy ratings on 25 24.6x Avg+2SD Shenhua and China Coal). 20 19.3x Avg+1SD 15 13.9x Avg After the transfer of coverage, we are raising our NAV- based target price for Shenhua by 9% and our DCF- 10 8.6x Avg-1SD 5 based target price for China Coal by 29%. However, we 3.3x Avg-2SD lower our DCF-based target price for Yanzhou by 10% 0 due to its bleak outlook. Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: Bloomberg, Daiwa forecasts Bloomberg consensus revisions to 2012 net profit forecasts Earnings revisions The Bloomberg consensus 2012E EPS for Shenhua, (Rebased to 100) China Coal and Yanzhou have been revised down by 9%, 105 24% and 38%, respectively, year-to-date. There were 100 95 massive cuts in consensus earnings forecasts for 90 Yanzhou following its disappointing 3Q12 results, while 85 Shenhua and China Coal have seen slight upward 80 75 revisions recently. 70 65 In terms of our 2012 net-profit forecasts, we are revising 60 12 12 12 12 12 12 12 12 12 12 12 - - - - - - - - - - up that for Shenhua slightly by 0.3%, but reducing - Jul Apr Oct Jan Jun Mar Feb Aug Sep Nov China Coal‘s by 4% and cutting Yanzhou‘s by 20%. May Shenhua China Coal Yanzhou Source: Bloomberg, Daiwa forecasts - 2 - China Thermal Coal Sector 19 November 2012 Sector stocks: key indicators EPS (local curr.) Share Rating Target price (local curr.) FY1 FY2 Company Name Stock code Price New Prev. New Prev. % chg New Prev. % chg New Prev. % chg China Coal Energy 1898 HK 7.39 Buy Hold 9.00 7.00 28.6% 0.654 0.681 (4.0%) 0.739 0.719 2.9% China Shenhua Energy 1088 HK 30.75 Buy Buy 38.00 34.90 8.9% 2.373 2.366 0.3% 2.644 2.574 2.7% Yanzhou Coal Mining 1171 HK 11.26 Hold Hold 11.30 12.60 (10.3%) 1.047 1.309 (20.0%) 0.716 1.524 (53.0%) Source: Daiwa forecasts; note: prices as of close on 16 November 2012 - 3 - China Thermal Coal Sector 19 November 2012 Prepare for a short cycle ............................................................................................................... 5 End of a golden decade; a ‗perfect storm‘ bears down ............................................................. 5 Positive expectations for China‘s economic recovery ............................................................. 9 How do the sector cycles relate to the economy? .................................................................. 10 What is the most important share-price driver? .................................................................... 11 Demand, supply and prices .................................................................................................... 11 Perfect storm should ease in 2H12 ......................................................................................... 13 Regional coal-price outlook ................................................................................................... 20 Mine-mouth coal prices .......................................................................................................... 21 Near-term opportunity: convergence of spot and contract prices ........................................ 22 The benefits of vertical integration ........................................................................................ 24 Near-term risk: rising costs .................................................................................................... 25 Long-term risk #1: transportation bottleneck ....................................................................... 28 Long-term risk #2: threat from shale gas .............................................................................. 30 Appendix: the top players in the industry ............................................................................. 34 Company Section China Shenhua Energy ........................................................................................................... 36 China Coal Energy .................................................................................................................. 48 Yanzhou Coal Mining .............................................................................................................. 57 - 4 - China Thermal Coal Sector 19 November 2012 Annual share price return (%) Year Shenhua China Coal Yanzhou HSCEI Absolute Relative Absolute Relative Absolute Relative Absolute 1999 65.4 51.3 14.1 2000 0.0 17.7 -17.7 2001 15.1 6.8 8.2 2002 25.3 12.1 13.2 Prepare for a short 2003 153.2 1.0 152.2 2004 42.4 47.9 -5.6 cycle 2005 -28.3 -40.7 12.4 2006 119.0 25.0 27.7 -66.2 94.0 2007 154.3 98.3 385.1 329.2 148.2 92.3 55.9 2008 -64.5 -13.4 -74.8 -23.8 -63.2 -12.1 -51.1 Cyclical opportunities bode well for the 2009 131.7 69.6 130.8 68.7 201.6 139.5 62.1 sector over the next six months 2010 -14.2 -13.4 -14.7 -14.0 38.4 39.2 -0.8 2011 3.4 25.1 -31.0 -9.3 -30.2 -8.5 -21.7 Source: Bloomberg Note: Shenhua-H and China Coal-H were listed in 2006 and 2007.