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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

 Growth outlook  China coal: demand-supply growth trend

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

 Valuation  China Thermal Coal Sector: one-year forward PER trend

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

 Earnings revisions  Bloomberg consensus revisions to 2012 net profit forecasts

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

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up that for Shenhua slightly by 0.3%, but reducing -

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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

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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. End of a golden decade; a ‘perfect storm’ bears down  Business comparison Operating Location of ROE margin EPS CARG Along with China‘s decade-long hyper economic growth, Company Revenue mix (FY11) coal mines (FY12E) (FY12E) (FY12-14E) the country‘s coal industry has enjoyed sustainably high Shenhua Coal mining 67% Power production growth over the past 10 years, especially generation 28% Inner Mongolia given that coal is the main fossil fuel (coal remains the Others 5% (most), Shaanxi 19.7% 31.0% 9.5% largest fuel source to generate electricity) to power the China Coal Coal mining 82% industrialized economy. During 2001-11, commercial Coke 6% Coal mining Shanxi (most), coal output and domestic coal consumption (calculated engineering 8% Shaanxi, on an apparent demand basis) have grown at CAGRs of Others 4% Shandong 10.2% 13.5% 9.0% 9% and 10%. However, we expect both of these growth Yanzhou Coal mining 96% rates to come off in 2012, and from 2012 to 2015, we Coal chemical 2% Railway only project 3% and 4% CAGRs. China‘s 12th Five Year transportation 1% Shandong Plan for the coal industry also suggests a similar CAGR Power (most), Shaanxi, for coal production. generation 1% Inner Mongolia, Heating supply 0% Australia 11.6% 11.3% -19.9%

 Coal demand-supply growth trend Source: Companies, Daiwa

(M tonnes) (%) 5,000 25 Opportunity lies beneath crisis 20 4,000 Looking into what has happened this year in more 15 detail, many analysts and investors described the 3,000 10 industry scenario in 1H12 as a ‗perfect storm‘, whereby 2,000 5 slowing demand coupled with resilient supply growth 0 1,000 and rising imports weighed on spot coal prices starting (5) in April. The spot coal price (represented by

0 (10) Qinhuangdao 5,500kcal, NAR) declined by 21% from

1996 1997 1999 2000 2001 2002 2003 2004 2006 2007 2008 2010 2011 1998 2005 2009

2013E 2014E 2015E 2012E April to the July trough. Commercial coal production Domestic Consumption Production YoY Consumption YoY The corresponding extent of share-price declines has Source: CEIC, Daiwa forecasts been largely due to the Bloomberg consensus downward revisions of earnings forecasts (see Accordingly, the slowdown in China‘s real economy following chart). Most analysts adjusted their forecasts this year has put significant pressure on the industry‘s after the 1H12 and 3Q12 results. However, compared demand growth and companies‘ earnings due to the with the latest mean average (updated since the 1H12 resulting falling coal prices and most recently, reduced results), we still see 6% and 3% downside for Yanzhou output. China‘s thermal coal stocks have mostly and China Coal earnings for 2012. underperformed the HSCEI index again YTD in 2012, marking the third consecutive year of underperformance since 2009. Shenhua and Yanzhou accordingly outperformed in 2011 and 2010. China Coal has underperformed since 2009. - 5 - China Thermal Coal Sector 19 November 2012

 Bloomberg-consensus revisions to 2012 net-profit forecasts  What could coal prices be pricing in vs. our forecasts? What is priced in Contract Spot Overseas (Rebased to 100) 105 Shenhua +3% -1% n.a. 100 China Coal +3% -1% n.a. 95 Yanzhou +3% -1% +3% 90 Daiwa forecasts Contract Spot Overseas 85 Shenhua +3% +1% n.a. 80 China Coal +3% +1% n.a. 75 Yanzhou +3% +1% 0% 70 Source: Daiwa forecasts 65

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Aug Sep Nov May Shenhua China Coal Yanzhou Short-term view – positive Source: Bloomberg  We examined the factors that we believe led to the  Changes in Bloomberg-consensus 2012 forecasts formation of the ‗perfect storm‘ in 1H12 and conclude 2012E forecasts Shenhua Yanzhou China Coal that the storm is likely to ease. Our view is that the No. of net-profit forecasts 37 31 36 industry should see a much better demand-supply No. of net-profit forecasts updated post the 1H12 results 29 26 29 balance going into 2H12 (especially in 4Q12) and % of forecasts updated 78% 84% 81% Mean (CNYm) 47,510 5,822 8,705 2013 with inventory destocking. We have included a Mean post the 1H12 results (CNYm) 47,301 5,448 8,443 detailed bottom-up calculation of coal demand and Downside 0% -6% -3% the latest updates on coal supply and imports. Source: Bloomberg, calculated by Daiwa  We forecast the spot coal price (Qinhuangdao 5,500 The forecasts for 2013 are much more uncertain for FOB) to reach CNY660/t before the end of 2012 and Yanzhou with 13% downside for the consensus average. the average price to increase by 1% YoY in 2013 (still below CNY800/t by the end of 2013, and below the  Changes in Bloomberg-consensus 2013 forecasts current price cap). 2013E forecasts Shenhua Yanzhou China Coal No. of net-profit forecasts 36 31 35  We look at the different scenarios for contract-price No. of net-profit forecasts updated post the 1H12 results 29 26 29 setting at the end of 2012 and assess how they could % of forecasts updated 81% 84% 83% affect the future earnings of different companies. A Mean (CNYm) 50,234 5,206 9,159 convergence towards spot coal price linkage would be Mean post the 1H12 results (CNYm) 49,648 4,553 8,698 positive for the coal companies in general, in our view. Downside -1% -13% -5% Source: Bloomberg, calculated by Daiwa  We analyse in detail the cost structures of different companies and the likely trends going forward. While the consensus earnings may be revised down further in the next few months, the limited earnings Medium-term view – cautious downside expected for Shenhua and China Coal suggests that most of the risks may have been priced  Our bottom-up analysis of the railway capacity into the shares already. expansion plan for transporting coal over the next few years suggests that a major transportation Based on our output and cost projections, we believe bottleneck breakthrough should only occur after current share prices are pricing in a 3% YoY increase in 2014; and it could be delayed by any stronger-than- contract prices (lower than +5% YoY in 2012) and a 1% expected pick-up in coal demand. YoY decline in the spot price. We believe the street‘s  We analyse the shale gas potential in the US and view on the spot price in 2013 could be too China, and how it would affect the share of coal in conservative, and we project a 1% YoY increase. China‘s energy consumption in the long run. Moreover, Yanzhou‘s current share price suggests a 3% YoY price recovery overseas (Australia), for which we We like Shenhua and China Coal see potential downside.  Our overall view on the sector is opportunistic in the short term, but we are concerned about the long term, especially with the easing of transportation bottlenecks and the potential threat to coal demand of shale gas, either from China itself or US exports in the future.

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 As the market may continue to debate the level of  Daiwa earnings-forecasts and rating changes coal demand and prices next year, while waiting for New forecasts Previous forecasts % chg Rating 12E 13E 14E 12E 13E 14E 12E 13E 14E New Previous further economic indicators, we suggest investors Net income (CNYm) focus on each company‘s fundamental differences in Shenhua 47,205 52,588 56,636 47,053 51,205 56,327 0.3 2.7 0.5 Buy Buy China Coal 8,867 9,800 10,297 9,032 9,527 10,123 -4.0 2.9 1.7 Buy Hold costs and future strategies on top of pricing. Yanzhou 5,137 3,513 3,299 6,440 7,497 8,019 -20.0 -53.1 -58.9 Hold Hold  Having underperformed the HSCEI Index for three Source: Daiwa estimates consecutive years (including YTD 2012), due mostly  2013E EPS sensitivity to changes in thermal coal prices (%) to cost concerns, China Coal looks appealing short Every 1% increase in Contract Spot term as a recovery play, especially with the Shenhua +0.3 +0.9 consensus earnings revisions stabilising recently China Coal +1.9 +2.5 (not the case for Yanzhou). Yanzhou +0.7 +9.4 Source: Daiwa forecasts  Following China Coal‘s strong cost management in Note: Yanzhou’s spot coal includes both China and Australian coal prices 3Q12, we believe its future cost structure will be less exposed to cost elements with sustainable upside  2013E EPS sensitivity to changes in costs risk, such as labour costs and policy costs. We are Sensitivity 1% increase in cost Shenhua 1.2% comfortable with China Coal‘s realised coal prices, as China Coal 3.8% the company has been more successful than Yanzhou 10.0% Shenhua in the past at negotiating favourable Source: Daiwa estimates contract prices, and we expect China Coal‘s sales to shift more towards spot coal in the future in a bid to Bull-bear cases for earnings increase its average prices. Contract re-pricing at the year-end could also provide upside for the company  We analyse the impact of price and cost shifts on assuming it can negotiate higher coal sales prices. earnings in bull and bear scenarios. We see much bigger upside than downside for the  In our bull case, spot coal prices would strengthen company, and therefore upgrade our rating to Buy slightly and contract prices increase significantly on (1), from Hold (3), and see the stock as a recovery the back of full implementation of spot-linked momentum play. contract pricing. Cash costs would remain flat YoY  Shenhua is our long-term top pick, as we are mostly. convinced that the company will expand its vertically  Under our bear-case scenario, the spot price would integrated strategy, bringing further cost savings and drop by 2% YoY from the level in 2012, while there sustainable EPS growth for the overall business. would be no change in contract prices in 2013. Cash Although Shenhua‘s earnings are much more cost growth would be maintained at the past-5-year defensive than its peers to changes in coal prices and mean. costs, we believe that such earnings stability deserves a premium, especially with long-term  As a result, we see more upside than downside for investors looking for a stable player in the energy Shenhua and China Coal. (Refer to the discussions spectrum in their country portfolios. Given the high below on each of these variables and likely return in most of its business segments, we continue associated events.) to see the stock trading at a premium valuation to  Bull-bear case: impact of price and cost shifts on earnings close peers. Reiterate Buy (1) rating. Shenhua China Coal Yanzhou  Conventional wisdom could still favour Yanzhou as a Bull Base Bear Bull Base Bear Bull Base Bear more leveraged play on a demand recovery. Price Contract +32% +3% +0% +11% +3% +0% +5% +3% +0% However, despite its high earnings sensitivity to coal Spot +2% +1% -2% +2% +1% -2% +2% +1% -2% prices, Yanzhou‘s deteriorating profitability has also Overseas n.a. n.a. n.a. n.a. n.a. n.a. +1% +0% -2% led to its EPS becoming more sensitive to costs. With Cost +0% +5% +9% +0% +4% +7% +3% +6% +10% the company moving into more low-margin mines, FY13 earnings impact 27% 0% -10% 32% 0% -22% 46% 0% -68% we forecast a sequential net profit decline for the Source: Daiwa forecasts next few years, and expect its EBIT margin to drop below China Coal‘s. We see Yanzhou as a low-quality recovery play compared with China Coal, and therefore maintain our Hold (3) rating.

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Inexpensive valuations  On a relative basis, they are also cheaper than the regional peer average on both forward PERs and PBRs.  Most of the China thermal coal stocks under our coverage are trading currently at an attractive  Although we do not see EV/reserve as a fair discount to their own historical mean (except for comparison due to large differences in local markets Yanzhou), with the forward PERs and PBRs trading and profitability, the Chinese companies are trading close to 1SD below the mean. at PBR/PER discounts to most of their regional peers.

  Global valuation comparison table Company name Stock code Rating Market cap PER (x) PBR (x) ROE (%) Div yield (%) EPS CAGR (%) USDm 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 12-14E Thermal coal CHINA China Shenhua 1088 HK 1 78,900 10.4 9.4 8.7 1.9 1.7 1.5 19.7 19.5 18.7 3.8 4.3 4.6 9.5 China Coal 1898 HK 1 12,640 9.1 8.0 7.7 0.9 0.8 0.8 10.2 10.7 10.5 3.2 3.6 3.8 9.0 Yanzhou Coal 1171 HK 3 7,140 8.6 12.6 13.5 1.0 0.9 0.9 11.6 7.4 6.6 3.6 2.0 1.9 -19.9 Shanxi Xishan 000983 CH NR 4,735 15.6 13.8 12.5 2.5 2.0 1.7 15.3 15.5 17.5 1.5 2.0 3.0 12.0 Datong Coal 601001 CH NR 1,856 16.0 15.4 12.8 1.4 1.3 1.2 3.4 4.6 7.3 1.4 1.6 2.5 11.7 Simple average 21,054 11.9 11.8 11.0 1.5 1.3 1.2 12.0 11.5 12.1 2.7 2.7 3.2 4.5 Weighted average 10.5 9.8 9.2 1.7 1.6 1.4 17.5 17.2 16.6 3.6 3.9 4.2 7.6 Indonesia Bumi Resources BUMI IJ NR 1,309 n.a. 10.9 5.0 1.2 1.1 1.0 0.9 11.8 21.6 1.5 3.1 3.1 n.a. Adaro ADRO IJ NR 4,574 9.9 9.9 8.3 1.8 1.6 1.5 18.7 17.0 18.5 4.0 3.4 3.4 9.5 PT Bukit Asam PTBA IJ NR 3,733 12.1 12.1 10.2 4.0 3.5 3.1 35.2 30.8 30.7 4.5 4.6 4.6 8.9 Simple average 3,205 11.0 11.0 7.8 2.3 2.1 1.9 18.3 19.9 23.6 3.4 3.7 3.7 9.2 Weighted average 9.4 10.9 8.6 2.6 2.3 2.0 22.7 21.7 23.6 3.9 3.8 3.8 8.0 India Coal India COAL IN 1 40,030 13.0 12.0 10.9 4.4 3.6 3.0 37.6 33.2 30.2 2.3 2.3 2.3 9.4 Thailand Banpu BANPU TB NR 2,981 9.2 8.9 7.6 1.2 1.1 1.0 13.5 12.5 13.4 4.5 4.6 5.2 10.3 USA Peabody Energy BTU US NR 6,728 12.4 12.7 8.4 1.1 1.1 1.0 9.4 8.3 12.1 1.4 1.4 1.4 21.5 Arch Coal ACI US NR 1,352 n.a. n.a. 172.2 0.4 0.5 0.5 -5.2 -4.3 0.1 3.0 1.9 1.9 n.a. Consol Energy CNX US NR 7,093 34.1 25.5 12.9 1.9 1.8 1.7 6.4 6.5 11.5 1.6 1.6 1.6 62.7 Simple average 5,058 23.2 19.1 64.5 1.1 1.1 1.0 3.5 3.5 7.9 2.0 1.6 1.6 42.1 Weighted average 21.4 17.5 25.1 1.4 1.3 1.2 6.7 6.3 10.7 1.6 1.5 1.5 38.9 Global simple average 13,313 13.7 12.6 22.3 1.8 1.6 1.4 13.6 13.4 15.3 2.8 2.8 3.0 13.2 Coking coal CHINA Mongolia Mining 975 HK 4 1,810 13.1 6.8 6.2 2.0 1.5 1.1 16.3 25.2 25.2 0.0 0.0 0.0 45.7 Shougang Fushan Resources 639 HK NR 1,937 8.4 9.0 9.4 0.8 0.7 0.7 8.6 7.5 7.0 4.7 4.4 4.4 -5.6 Hidili Industries 1393 HK NR 490 8.2 7.2 5.7 0.4 0.4 0.4 4.3 5.4 5.5 2.5 2.6 3.9 19.3 Southgobi 1878 HK NR 377 n.a. 24.8 8.7 0.6 0.6 0.6 -6.7 -1.5 6.9 0.0 0.0 0.0 n.a. Simple average 1,153 12.3 12.7 7.7 1.0 0.9 0.8 4.5 7.7 10.2 1.8 1.8 2.2 28.6 Weighted average 12.4 10.4 8.0 1.2 1.1 0.9 8.1 11.2 12.4 2.3 2.3 2.5 27.9 Source: Bloomberg forecasts for non-rated stocks, Daiwa forecasts for rated stocks Note: Updated as of November 16, 2012

 China coal sector: 12-month forward PER history  China coal sector: 12-month forward PBR history (x) (x) 35 5.0 4.5 30 4.0 25 24.6x Avg+2SD 3.5 3.4x Avg+2SD 3.0 20 19.3x Avg+1SD 2.7x Avg+1SD 2.5 15 13.9x Avg 2.0 1.9x Avg 1.5 10 8.6x Avg-1SD 1.0 1.2x Avg-1SD 5 0.5 3.3x Avg-2SD 0.4x Avg-2SD 0.0 0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

Source: Bloomberg, Daiwa forecasts Source: Bloomberg, Daiwa forecasts

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 EV/tonne (reserve) comparison sequential growth in 3Q12 (7.4% YoY), especially in

China Coal September. With more stimulus measures in the Peabody Energy pipeline and destocking coming to an end, they forecast Bukit Asam growth to rebound strongly in 4Q12 (to 8.2% YoY). Bumi Resources Daiwa forecasts GDP growth of 7.8% YoY for 2012 and Arch Coal Hidili Coal 8.0% YoY for 2013. Consol Energy Indika (Kideco) The latest support for our argument is the rise of the SouthGobi Energy official manufacturing PMI, which improved from 49.8 Fushan Energy for September to 50.2 for October. Of the 11 sub- Shenhua Energy Banpu Public Co indices, 10 rose in October. Notably, four (new orders, Yanzhou Coal purchase quantity, imports, and input prices) recorded Adaro Coal their highest readings for six months, and two Bayan Resources (production and new export orders) had their highest Straits Asia ITM readings for five months. Overall, the October PMI shows more signs of a recovery, suggesting that the set 0 2 4 6 8 10 12 14 16 18 20 of strong economic data for September should be (USD/tonne) Source: Bloomberg, companies, Daiwa sustained in October. As Chi and Mingchun believe destocking will end and the impact of recent stimulus measures will become more obvious, they expect a Positive expectations for China’s strong rebound in IP and GDP growth for 4Q12. economic recovery In our opinion, such a recovery track will have a positive impact on coal demand, in that it should boost Chi Sun, Daiwa‘s China economist, and Mingchun Sun, the intrinsic demand from key coal users, like power, Daiwa‘s regional head of economic research, have steel and construction materials and chemicals, which recently highlighted their positive stance towards a we explain in detail in the following section. recovery in GDP in China for 4Q12 and 2013 (see our China Weekly Economic Monitor: Stronger growth in October of 9 November 2012). Despite weaker-than- expected GDP growth for 3Q12, Chi and Mingchun remain upbeat on China‘s economy in 4Q, based on

 China macroeconomic indicators: actual and Daiwa forecasts 1Q12 2Q12 3Q12 4Q12E 1Q13E 2Q13E 3Q13E 4Q13E 2011 2012E 2013E Real GDP YoY % 8.1 7.6 7.4 8.2 8.5 8.6 8.0 7.0 9.3 7.8 8.0 CPI YoY % 3.8 2.8 1.9 2.1 2.2 2.8 3.7 4.3 5.4 2.6 3.3 PPI YoY % 0.1 (1.4) (3.3) (2.0) (0.2) (0.2) 2.1 2.7 6.1 (1.6) 1.1 Fixed assets investment (nominal, YTD) YoY % 20.9 20.4 20.5 20.5 20.5 20.2 19.2 18.0 23.8 20.5 18.0 Retail sales (nominal) YoY % 15.8 13.9 13.5 13.8 14.6 15.3 15.4 14.9 17.1 14.2 15.0 Industrial production YoY % 11.5 9.5 9.1 9.6 9.9 10.3 10.1 9.8 13.8 9.9 10.0 Exports YoY % 7.6 10.5 4.5 11.0 7.2 10.0 10.7 11.7 20.3 8.4 10.0 Imports YoY % 6.9 6.5 1.4 15.7 9.0 15.0 14.0 20.0 24.9 7.7 14.0 Trade balance USDbn 0.3 68.5 79.4 31.9 (2.4) 58.5 67.9 (0.1) 155 180 124 Exchange rate (end of period) CNY/USD 6.29 6.32 6.28 6.25 6.20 6.15 6.12 6.10 6.30 6.25 6.10 M2 YoY % 13.4 13.6 14.8 14.0 13.7 13.2 12.6 12.0 13.6 14.0 12.0 1-year base lending rate (end of period) % pa 6.56 6.31 6.00 6.00 6.00 6.00 6.25 6.50 6.56 6.00 6.50 1-year deposit rate (end of period) % pa 3.50 3.25 3.00 3.00 3.00 3.00 3.25 3.50 3.50 3.00 3.50 Required reserve ratio (end of period) % 20.0 19.5 19.5 19.5 19.5 19.5 19.5 19.5 20.5 19.5 19.5 Current account balance % of GDP 2.8 2.6 1.5 Foreign reserves (end of period) USDtn 3.3 3.2 3.3 3.4 3.4 3.5 3.5 3.5 3.2 3.5 3.5 Fiscal balance % of GDP (1.8) (1.5) (1.6) Source: CEIC, Daiwa forecasts

- 9 - China Thermal Coal Sector 19 November 2012

 Historical sector share-price performance

How do the sector cycles relate to (Rebased to 100) the economy? 900 QE1 QE2 QE3 800 700 The sector is viewed by many investors as being high- 600 beta and leveraged on economic activity. However, 500 examining historical share-price performances 400 compared with other materials sectors, including 300 200 coking coal, steel, cement, aluminium and copper, it 100

seems that thermal coal is a mid-cycle performer. 0

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09 10 11 07 08 12

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According to Felix Lam, Daiwa‘s Hong Kong/China -

Jan Jan Jan Jan Jan Jan

Sep Sep Sep Sep Sep Sep

May May May May May head of materials, while all material stocks are cyclical May in nature, some tend to move earlier than the others. Cement Thermal coal Coking Coal Steel Copper Aluminum Source: Bloomberg, grouped by Daiwa In China, cement and steel usually react ahead of Cement: CNBM, Anhui Conch; Thermal coal: Shenhua, China Coal, Yanzhou, Yitai-B; Coking coal: Shougang Fushan, Jizhong energy-A, Shanxi Xishan-A; Steel: Angang, others. In our view, this can be explained by the Magang structure of China‘s economy, with fixed asset investment (FAI) being a primary driver in recent In conclusion, it is apparent that the share-price years. Even though domestic consumption has been performance of the thermal coal sector tends to lag that playing an increasing role in the nation‘s GDP, FAI of other early indicator sectors, especially the coking- (mainly public infrastructure) remains the major tool coal sector. During the market recovery through 2009 for government to lift the economy, especially when it after the 2008 financial crisis, the coking-coal sector faces external challenges. reaped most of the gains during the earlier part of 2009 while thermal coal did not catch up until the end To build infrastructure, cement and steel are the of 2010. obvious bulk materials needed. While copper, aluminium, and other non-ferrous metals are also used Looking at the recent rebound in share prices since the in infrastructure construction, their demand is July bottom, the thermal sector only rallied by 4% sensitive to manufacturing industries and export throughout 3Q12, and by a further 4% in October, markets. These areas are facing challenges and tend to while the steel and cement stocks picked up strongly in recover at a later stage of an economic cycle. As a result October (see following table). non-ferrous metal stocks lag behind cement and steel stocks when the market rebounds on expectations of an  Quarterly sector share-price performance economic recovery. Thermal coal Coking coal Steel Cement Copper Aluminium 1Q07 30.9 81.7 19.5 22.0 19.6 11.9 Among all the major commodities, thermal coal prices 2Q07 65.5 69.5 18.7 123.5 38.9 63.5 3Q07 97.2 60.7 63.3 35.8 91.4 69.6 are usually among the latest to run up, as 60% of 4Q07 7.8 16.6 -30.3 9.1 -23.9 -28.0 thermal coal is used for generating electricity in China. 1Q08 -36.1 -14.0 -18.9 -30.1 -23.3 -21.9 Demand for electricity does not fluctuate as much as 2Q08 7.7 48.3 -0.5 -10.3 4.2 -28.5 industrial and construction activity along an economic 3Q08 -43.1 -59.2 -51.3 -43.1 -50.5 -48.7 cycle in China. Notably, cement and construction 4Q08 -21.6 -30.8 19.7 8.5 -25.1 -11.5 related steel products are local materials, while non- 1Q09 22.6 13.6 -5.3 33.5 42.3 9.1 2Q09 53.2 102.2 71.3 44.7 57.2 64.9 ferrous metals and coal are well-traded globally. This 3Q09 13.3 3.8 4.6 11.9 36.5 15.3 also explains why cement and steel move ahead of 4Q09 40.5 38.1 19.5 -5.9 5.9 1.1 others in the China cyclical material space. 1Q10 -2.5 -13.4 -18.8 -7.4 -4.5 -6.2 2Q10 -12.1 -30.5 -28.8 -14.9 -16.2 -24.9 3Q10 21.2 20.4 36.8 43.7 33.7 21.6 4Q10 11.6 7.3 -9.6 11.8 30.0 -3.1 1Q11 4.4 -1.4 -4.3 38.8 1.6 4.4 2Q11 -3.0 -11.9 -17.4 9.5 -0.4 -11.4 3Q11 -26.1 -34.6 -52.1 -41.3 -46.6 -47.0 4Q11 5.5 -4.5 40.6 11.1 21.6 -2.9 1Q12 2.5 2.9 -10.0 8.9 6.4 10.7 2Q12 -16.9 -17.7 -18.8 -16.6 -5.2 -11.8 3Q12 4.3 -11.7 -0.9 3.9 15.9 -2.7 Oct 12 4.4 7.1 13.1 14.3 2.1 5.6 Source: Bloomberg, grouped by Daiwa

- 10 - China Thermal Coal Sector 19 November 2012

We forecast China‘s stock of coal inventory to be What is the most important reduced from 31 days in 2012 to 28 days in 2013 as we share-price driver? expect accelerated demand growth in 2013, and believe this fundamental change supports our positive industry We conducted a correlation analysis between share-price outlook in the near term. performances in recent years and: 1) port inventory (measured by Qinhuangdao), 2) power plant inventory,  Forecasts of total inventory trend (Mil tonnes) (Days) and 3) spot coal prices (measured by Qinhuangdao 5,500 350 35 kcal). We found that the relationship between the share- price performances and power plant inventory days is the 300 30 strongest (correlation co-efficiency of negative 0.56x for 250 25 power plant inventory). 200 20 150 15  Correlation between share-price performance and power plant 100 10 inventory days 50 5 (Days) (HKD bn) 0 0 35 Correlation = -0.56 1,600 2008A 2009A 2010A 2011A 2012E 2013E 2014E 2015E 30 1,400 Total system inventory Inventory days (RHS)

25 1,200 Source: CCTD, Bloomberg 20 1,000 15 800 Demand, supply and prices 10 600

5 400 In our bottom-up demand/supply analysis, we look for

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- a weaker seller‘s market in 2H12 and expect China‘s

Jun Jun Jun Jun Jun

Mar Mar Mar Mar Mar

Sep Dec Sep Dec Sep Dec Dec Sep Sep spot coal prices (Qinhuangdao 5,500 kcal FOB price) to IPP inventory days (LHS) Total market cap (RHS) edge up slowly to CNY660/t by year-end. On an Source: CCTD, Bloomberg annualized basis, this rise in spot coal in 2H12 would  Correlation between share-price performance and port inventory still represent a 13.7% YoY fall in average spot coal ('000 tonne) (HKD bn) prices during 2012. 10,000 1,600 Correlation = -0.14 9,000 1,400 Compared with 1H12 (production and consumption 8,000 1,200 growth of 5.6% YoY and 2.8% YoY, with an ex-import 7,000 oversupply of 102m tonnes), we expect a much better 1,000 6,000 demand-supply balance in 2H12 (production and 800 5,000 consumption growth of 0.3% YoY and 3.9% YoY, with an 4,000 600 ex-import supply shortage of 72m tonnes). We forecast

3,000 400 system inventory to have increased by 27% YoY to 321m

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- tonnes (or 31 days of demand) by the end of 2012.

Jun Jun Jun Jun Jun

Mar Mar Mar Mar Mar

Sep Dec Sep Dec Sep Dec Sep Sep Dec Qinghuangdao inventory (LHS) Total market cap (RHS) However, on our forecasts, the balance would continue Source: CCTD, Bloomberg to improve in 2013 with demand growth (4.9% YoY)

 Correlation between share-price performance and coal prices outpacing supply growth (2.5% YoY). With a steady rise in imported coal (up 1.8% YoY for 2013E), we expect (CNY/tonne) (HKD bn) Correlation = 0.14 1,600 system inventory to destock by 3 days to 28 days (or 1,050 1,400 303m tonnes). As a result, we expect the spot coal price 950 to see a further 1% increase, although remaining below 1,200 850 the current price cap (CNY800/tonne) throughout the 1,000 whole year. 750 800 650 600 Our forecast for slower production growth in 2013 is

550 400 based on: 1) pressure from the government for

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09 09 11 11 12 08 08 10 10

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- destocking to continue in the industry (as quoted by

Jun Jun Jun Jun Jun

Mar Mar Mar Mar Mar

Sep Dec Sep Dec Sep Dec Sep Dec Sep the local press), 2) small mines that were shut down QHD 5,500kcal coal FOB price (LHS) Total market cap (RHS) recently due to safety measures may not fully resume

Source: CCTD, Bloomberg until after the National People‘s Congress in March

- 11 - China Thermal Coal Sector 19 November 2012

2013, based on our industry research, 3) a number of  Unit cost of sales trend of listed coal producers large coal mines are barely profitable (according to (CNY/t) government data, about 17.8% of scalable state-owned 400 coal producers recorded losses in 8M12), and we 350 estimate the large coal mines accounted for 2/3 of 300 market share in terms of production in 2011, and 4) a 250 continuing rise in coal production costs, which would 200 push up the price floor. 150 100 Cash production costs have increased by a high single- 50 digit percentage per year over the past 10 years, and 0 2007 2008 2009 2010 2011 even the well-managed listed companies (such as the Shenhua China Coal Yanzhou three listed producers) have seen a similar trend. Many costs are on an unavoidable upward trend, like labour Source: Companies costs (true for both China and key producing countries), raw-material costs (tyres, diesel and explosives), and  China: spot coal price (Qinhuangdao) forecasts government taxes (such as China‘s changing resources (CNY/t) tax and Australia‘s carbon tax). 1,100 1,000 Price cap If we take a theoretical cost rise of 10% in 2013 with 900 800 recovering demand, we estimate the theoretical price floor 700 would exceed the CNY615 floor seen in 2012, especially if 600 supply (as prices and profitability could recovery slowly) 500 were to increase at a slower rate than demand. 400 2012's low 300  Selected production costs in China 200 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Average cost (CNY/t) 214.38 216.61 211.76 228.60 241.87 295.73 Shanxi premium blend 5500kcal YoY (%) 7.67 10.25 12.45 9.75 12.82 36.53 3Q08 4Q08 1Q09 2Q09 3Q09 2Q10 Source: SX Coal, Daiwa forecasts Average cost (CNY/t) 239.93 283.34 264.41 268.48 263.10 293.98 YoY (%) 13.30 23.93 9.33 -9.21 9.66 9.50

Source: SX Coal

Note: not all quarters are available and the data ceased publication in 2010

 China coal demand-supply forecasts (mt) 2008 2009 2010 2011 2012E 2013E 2014E 2015E 1H11 2H11 1H12 2H12E 1. Raw coal production 2,716 3,050 3,240 3,638 3,747 3,840 3,975 4,114 1,705 1,933 1,863 1,884 Production addition 193 334 190 398 109 93 134 139 158 -49

Production growth (%) 7.7% 12.3% 6.2% 12.3% 3.0% 2.5% 3.5% 3.5% 9.3% -2.5%

Key SOEs 1,379 1,561

Local SOEs 424 490

Village & Township 914 999

2. Commercial coal production 2,802 2,973 3,235 3,520 3,626 3,716 3,846 3,980 1,809 1,711 1,910 1,716 Production growth (%) 4.1% 6.1% 8.8% 8.8% 3.0% 2.5% 3.5% 3.5% 5.6% 0.3%

3. Domestic Consumption 2,758 3,092 3,331 3,659 3,764 3,947 4,135 4,294 1,916 1,743 1,970 1,812 Consumption growth (%) 2.7% 12.1% 7.7% 9.8% 2.8% 4.9% 4.8% 3.8% 2.8% 3.9%

Demand-supply gap (=2-3) 44 -119 -96 -139 -138 -231 -289 -313 -212 190 -107 72 4. Export 45 22 18 14 12 9 9 9 8 6 6 6 Export Growth (%) -14.7% -50.6% -19.5% -22.7% -14.4% -25.1% 0.0% 0.0% -29.5% 6.2%

5. Import 40 125 166 183 218 222 236 283 71 112 140 78 Import Growth (%) -21.5% 213.6% 33.2% 10.2% 19.0% 1.8% 6.3% 20.0% 98.0% -30.6%

- Met coal 7 34 47 45 52 56 61 61 19 25 25 27 - Others (steam, lignite) 33 91 119 138 166 166 175 175 52 88 115 51 6. Net Export (Import) 6 -102 -148 -169 -206 -213 -227 -274 -63 -107 -134 -72 Net Export growth (%) 129% -1958% 45% 14% 22% 3% 7% 21% 114.4% -32.7%

Inventory (total EOY) 188 172 223 253 321 303 241 202

Inventory change 39 -17 52 30 68 -18 -62 -39

Inventory days 25 20 24 25 31 28 21 17

Coal prices (average)

Qinhuangdao 5500kcal price (CNY/t) 739 610 747 818 706 713 717 717

US$/t 106 89 110 127 110 110 111 111

YoY CNY price 58.0% -17.4% 22.4% 9.6% -13.7% 0.9% 0.5% 0.0%

Source: SX Coal, CEIC, Daiwa forecasts - 12 - China Thermal Coal Sector 19 November 2012

 Coal inventory levels at power plants and inland coal price Perfect storm should ease in 2H12 (Days) (CNY/t) 700 As we discussed in our introduction, three major 27 650 factors occurred coincidentally in 1H12, which created a perfect storm scenario, weighing on thermal coal 22 600 prices in China (Qinhuangdao 5,500 kcal down by 21% 550 17 from CNY790/tonne in early April to CNY615/tonne in 500 mid-July before edging up recently). Qinhuangdao 12 inventory (the largest coal port in China) experienced a 450 sharp inventory build-up within a matter of 40 days 7 400 (up 83% from 5.2m tonnes in late April to 9.5m tonnes Apr-10 Aug-10 Dec-10 Apr-11 Aug-11 Dec-11 Apr-12 Sep-12 IPP inventory days (LHS) Datong mine-mouth (RHS) by mid-June). Source: CCTD However, inventory has started to ease recently to 5.4m tonnes as of mid-October after the destocking in 3Q12 In the following section, we examine how each variable and completion of the Daqing railway maintenance. caused the price collapse in 1H12 and where we could Following the maintenance, inventory has rebounded see improvement in 2H12. to close to 6m tonnes in mid-November, which is much higher than the level at the same time in 2011. 1) Slightly higher demand growth in 2H12 However, as October power output suggests a small The slowdown in demand growth was first detected demand recovery, we expect a sequential coal demand through the disappointing manufacturing PMI and improvement starting in 4Q12. power consumption numbers in April 2012. While the market widely expected these to have bottomed out in  China: Qinhuangdao port inventory and spot coal prices July, the August number slipped again, especially with ('000 tonne) (CNY/t) the manufacturing PMI dropping below 50 for the first 9,500 950 time since November 2011. However, the PMI 900 improved back to above 50 in October. Meanwhile, 8,000 850 power output also beat the usual seasonality of 800 6,500 September and October (-0.2% MoM for October vs. 750 the historical mean of -2.7% MoM), suggesting a small 5,000 700 demand recovery. 650 3,500 600  China: manufacturing PMI vs. power output growth Apr-10 Aug-10 Dec-10 Apr-11 Aug-11 Dec-11 Apr-12 Aug-12 (%) (%) QHD coal inventory (LHS) QHD FOB Shanx i Blend (RHS) PMI is leading indicator ahead 65 of power demand 50 QHD FOB Datong Blend (RHS) 60 40 Source: SX Coal 55 30 50 20 Meanwhile, inventory at the power plant level also 45 10 came down from the 28-day peak in June to 24 days as 40 0 of early September before edging up again throughout 35 (10)

September and October. Based on our industry 30 (20)

06 07 08 10 11 12 09

06 07 08 10 11 12 09

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research, the rise in inventory through September and -

Jul Jul Jul Jul Jul Jul Jul

Apr Oct Apr Oct Apr Oct Apr Oct Apr Oct Apr Oct Apr Oct

Jan Jan Jan Jan Jan Jan October at the power plant level was due to pre- Jan emptive re-stocking activity ahead of: 1) the Golden PMI YoY (LHS) Power gen YoY (RHS)

Week holiday at the beginning of October, 2) Source: CEIC maintenance carried out on the Daqin railway from 8- 22 October, and 3) restocking ahead of the winter peak What could cause a swing in demand would be physical demand. production for the steel industry, which consumed 11% of power usage for the first 7 months of 2012 and 15% While the overall inventory level remains high of total coal consumption (mainly coking coal) in 1H12. compared with the past few years, we believe it should Given the increasing number of loss-making steel gradually come down in the next few quarters, with a companies in China, daily average production of crude more favourable demand-supply situation. steel declined in September, but has rebounded since

- 13 - China Thermal Coal Sector 19 November 2012

October. The rebound supports what we discovered on  China: power consumption breakdown by industry (7M12) our latest trip in China. Steel 10.6% In her report published on 26 September 2012, Non-ferrous 7.6% Penetrating China’s steel heart, Daiwa steel analyst Joey Chen believes that after experiencing weakening Chemical demand growth and steel prices YTD, steel mills and 7.6% steel traders have already turned prudent about their Construction production and inventory levels since 1H12. They see materials limited downside to steel prices and demand from 5.8% Others current levels. Joey expects demand to improve slightly 68.4% in 2H12 due to seasonal factors and on the back of a slow pick-up in infrastructure construction, which would translate into a rebound in steel prices in the Source: CEIC next few months. China has recently approved a series of infrastructure In addition, the low inventory level for steel traders is projects amounting to more than CNY800bn. Although likely to be positive for steel prices. The steel traders many of these projects have some overlap with the and mills Joey visited said they were seeing a shortage projects announced by local governments, we see it as of different steel products, as buying interest has confidence booster. The biggest challenge, however, is picked up driven by a recovery in steel prices. More not a lack of FAI, but rather how to fund these traders have started restocking, in anticipation of investments. higher steel prices ahead. They also indicated that they are likely to stock up on some products ahead of spring Daiwa‘s Chi Sun believes that China is encouraging and Lunar New Year in 2013. more diversified sources of funding to manage banking system risks to avoid a build-up of bad loans. Daiwa With traders currently accounting for about 65-70% of forecasts China‘s FAI growth to remain at decent levels domestic sales volume, Joey believes their sentiment going forward (20.5% YoY for 2012 and 18.0% YoY for and behaviour will determine steel prices in the short 2013). term. Given traders‘ current restocking from low  China: FAI and new loan growth inventory and our anticipation of some demand recovery, Joey continues to expect steel prices to rise in (YoY) 120% the next few months. Daiwa‘s house view is that 100% China‘s total crude steel production will only increase 80% by 5.4% YoY to 720m tonnes for 2012, following 9% 60% YoY growth in 2011. 40%

20%  China: daily average crude steel production 0% (Kilo tonne) (20%) 13,000 (40%) 12,000 2003 2004 2005 2006 2007 2008 2009 2010 2011 11,000 FAI New loan 10,000 Source: CEIC 9,000 8,000 7,000 We project the consumption of coal for power usage in 6,000 China to increase by 2% YoY for 2012, followed by 7% 5,000 YoY growth for 2013 and 6% YoY for 2014, given the Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 relationship between power consumption and 2011 2012 economic output, and normalizing hydro power output

Source: China Iron and Steel Association after 2012.

We forecast the consumption of coal for construction (cement) usage to rise by 7% YoY for 2012, followed by 6% YoY growth for 2013 and 5% YoY for 2014, while we expect no growth for chemical usage. As a result, we forecast total commercial coal consumption growth of - 14 - China Thermal Coal Sector 19 November 2012

2.8% YoY for 2012, followed by accelerated growth of  China: commercial coal consumption breakdown (2012E) 4.9% and 4.8% YoY for 2013 and 2014, respectively. In Others our 2012 forecasts, power, steel, construction and 16.1% chemical usage account for 51%, 17%, 13% and 3% of total consumption. Chemical 2.5%

 China: monthly steel/cement/fertilizer production (YoY) Construction Power (%) 13.4% 51.2% 40

30

20 Steel 10 16.7% 0 Source: Daiwa forecasts

(10) 2) Imported coal likely to come off in 2H12

(20)

12 11

11 11 11 11 12 12

11 12

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- China has become a net coal importer since 2009 with

Jul Jul

Apr Apr

Oct

Jan Jun Jan Jun

Feb Mar Feb Mar

Aug Sep Nov Dec Aug Sep May May total imported volume increasing every year, driven by: Crude steel Cement Fertilizer 1) continuing domestic railway bottlenecks, 2) pressure Source: China Iron and Steel Association, SX Coal for coastal provinces to achieve energy efficiency and environmental targets (outsourcing mining process,  Commercial coal consumption forecasts by driver which creates pollution and consumer energy), and 3) 2009 2010 2011 2012E 2013E 2014E 2015E price arbitrage opportunities. (The last reason has been Domestic Consumption (mt) 3,092 3,331 3,567 3,764 3,947 4,135 4,294 Consumption growth (%) 12.1% 7.7% 7.1% 2.8% 4.9% 4.8% 3.8% especially prevailing this year.) - Power 1,461 1,615 1,869 1,912 2,048 2,175 2,276 - Steel 533 578 617 630 648 681 717 In 1H12, China imported total raw coal of 140mt (98% - Construction 375 429 475 505 536 562 585 YoY growth), mostly driven by price arbitrage between - Chemical 92 89 91 96 96 96 96 - Others 631 620 515 620 620 620 620 domestic and import coal prices. However, driven by Breakdown (%) the earlier recovery of regional coal prices than China

- Power 47% 48% 52% 51% 52% 53% 53% domestic prices, coal imports were only 63mt in 3Q12, - Steel 17% 17% 17% 17% 16% 16% 17% up just 19% YoY. - Construction 12% 13% 13% 13% 14% 14% 14% - Chemical 3% 3% 3% 3% 2% 2% 2% - Others 20% 19% 14% 16% 16% 15% 14% Based on our own calculations, taking the Newcastle Growth (%) (6,000 kcal) FOB price adjusted for freight and VAT,

- Power 7% 11% 16% 2% 7% 6% 5% imported coal was cheaper than the Qinhuangdao price - Steel 16% 9% 7% 2% 3% 5% 5% adjusted for Guangzhou CFR from March to July 2012. - Construction 17% 14% 11% 7% 6% 5% 4% - Chemical 3% -3% 2% 5% 0% 0% 0% However, the arrival price (CFR) in the Guangzhou - Others 21% -2% -17% 2% 0% 0% 0% port of high-ash Indonesia Kalimantan has not Underlying drivers meaningfully recovered, which leaves price arbitrage

- Coal-fired power consumption 2,983 3,325 3,898 3,988 4,271 4,537 4,747 open. (TWh) - Crude steel production (mt) 566 626 684 712 732 770 810 - Cement production (mt) 1,629 1,868 2,063 2,197 2,330 2,435 2,529 However, during the regional price recovery from - Fertilizer production (mt) 67 66 60 63 63 63 63 August-September (8% for Newcastle, 8% for Richards Growth (%) Bay and 10% for ARA in Europe), import volume was - Coal-fired power consumption 6% 11% 17% 2% 7% 6% 5% (TWh) under pressure as price arbitrage became less - Crude steel production (mt) 14% 11% 9% 4% 3% 5% 5% profitable. Despite the FOB price weakness in - Cement production (mt) 17% 15% 10% 7% 6% 5% 4% exporting ports in October, the arbitrage gaps are still - Fertilizer production (mt) 14% -1% -9% 5% 0% 0% 0% very small considering freight rates are rebounding. Source: CEIC, Daiwa forecasts

- 15 - China Thermal Coal Sector 19 November 2012

 China: total monthly raw coal imports and growth rate  Guangzhou port CFR price difference with Indonesia imported (mn tonne) (%) coal 30 600 (CNY/tonne) (mn tonne) 25 500 300 30 400 20 200 20 300 15 100 10 200 10 0 0 100 5 0 (100) (10)

0 (100) (200) (20)

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04 05 06 08 09 11 10

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05 10 07

04 09 09 04

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Feb Feb Feb Feb

Aug Nov Aug Nov Nov Aug Aug

May May May May Monthly net imports QHD premium to Indonesia (LHS) Source: CCTD Source: CCTD, Daiwa  Guangzhou port CFR price difference with Australian imported coal  Regional coal prices (Newcastle, Richards Bay, ARA) (CNY/tonne) (mn tonne) (USD/tonne) 250 30 220 200 20 150 180 10 160 50 0 140 (50) 120 (10) 100 (150) (20) 80 60

(250) (30) 40

09 10 11 12

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10 11 09 12

09 11 12 10

- - - -

- - - -

- - - -

- - - -

08 09 11 12 10

09 10 11 12

08 08 09 09 10 11 11 12 10

- - - - -

- - - -

------

Jul Jul Jul Jul

Apr Oct Apr Oct Apr Oct Apr Oct

Jan Jan Jan Jan

Feb Feb Feb Feb

Aug Nov Aug Nov Nov Aug Nov Aug Aug

May May May May May Monthly net import (RHS) QHD premium to Newcastle (LHS) Newcastle Richards Bay ARA Ports

Source: CCTD, Daiwa Source: SX Coal

Last, based on cost curves projected by E.ON. in its presentation materials, we calculate that assuming no major changes throughout 1H12, current FOB prices could lead to the high-cash-cost producers in Australia and Indonesia being phased out, which is another reason for the recent support of regional coal prices.

- 16 - China Thermal Coal Sector 19 November 2012

 Cash cost curve of coal exporting countries and current FOB coal prices

FOB cash cost (US$/t)

high high

high high

high high

- -

120 - USA USA

CIF ARA 6,000kcal - US$87.70/mt mid

- mid mid FOB Newcastle 6,300kcal - US$86.50/mt -

100 mid

-

Australia (QLD) Australia (QLD)

Australia (NSW) Australia (NSW)

Canada Canada

low low

high high

mid / New Zealand mid /

-

low

-

low

-

-

-

high high

Australia (QLD) (QLD) Australia high high

80 Yanzhou Coal - US$48.5/mt -

-

mid

USA

-

low Russia

FOB Richards Bay 6,000kcal - US$83.75/mt mid

-

-

mid mid

Australia (NSW)

Canada Canada

Venezuela

low

-

-

high high

low

low

USA

Russia

Indonesia Indonesia

-

-

mid

-

Columbia Columbia

Australia (QLD) Australia (QLD) -

60 (NSW) Australia

low

Columbia Columbia

-

Indonesia Indonesia

Russia

Columbia Columbia

Indonesia Indonesia South Africa South

40 Africa South South Africa South

20 FOB Kalimantan 4,200kcal - US$40.05/mt China Coal - US$35.2/mt

China Shenhua - US$15.8/mt 0 100 200 300 400 500 600 700 800 Cumulative capacity (mtpa) Source: E.ON., SX Coal

Daiwa‘s house forecast suggests total imported coal of  China: historical rainfall trend 218m tonnes for 2012 (166m tonnes of thermal coal (mm) and 52m tonnes of metallurgical or coking coal). As 700 China imported a total of 140mt of coal in 1H12, 680 660 implied growth for 2H12 would be a 30% YoY (44% 640 HoH) drop. 620 600 3) Low hydro season and winter re- 580 560 stocking should boost coal purchases in 540 4Q12 520

Following a year of serious droughts in 2011 (c.50% 500

1961 1967 1970 1976 1979 1982 1985 1988 1991 1994 1997 2000 2006 2009 1964 1973 2003

YoY decline in rainfall), hydro power has recovered 2012E since 2Q12 with China‘s rainfall normalizing. In the Source: China Environment Public first 10 months, hydro power output increased by Note: 2012 forecast is based on news research 24.2% YoY compared with a 1.6% YoY decline for thermal power. Given China‘s higher dispatch priority  China: monthly hydro power output trend for hydro (16% of total power output in the first 10 (Bn KWh) months of total output), thermal power has been under 100 pressure as a result of direct competition. 80

60

40

20

0 Jan-Feb Apr Jun Aug Oct Dec 2007 2008 2009 2010 2011 2012 Source: CEIC

- 17 - China Thermal Coal Sector 19 November 2012

 China: monthly thermal power output trend Also, northern China has experienced an earlier-than- (Bn KWh) expected winter this year, with most cities starting the 650 heating season 1-2 weeks earlier than usual. As heat is 550 generated from both central heating facilities and co- generation power plants (mostly based on coal fuel), we 450 expect the winter effect to increase the demand for 350 coal-fired power generation as a whole.

250 The cold weather arriving earlier this year in the 150 northern China regions has made people wonder if this Jan-Feb Apr Jun Aug Oct Dec winter will be colder than in the past. According to 2007 2008 2009 forecasts from the Hong Kong Observatory, winter 2010 2011 2012 should arrive earlier this year in Hong Kong, last longer Source: CEIC and be colder because global warming is causing the icebergs to melt in the Arctic, which absorbs heat from The off-season impact on hydro power has emerged the environment. Mr. Shun Chi-ming, the Hong Kong later than we expected. Tracking water outflow velocity Observatory Director, warned that there could be more of China‘s largest hydro dam, the Three Gorges dam, extreme weather going forward, with cold spells we note there was a rebound in early October coming more often and lasting longer. compared with a historically downward slope. However, the water level upstream from the dam itself His view is shared by Mr. Zhu Congwen, a research has tracked historical seasonal inflow, which means analyst at Chinese Academy of Meteorological Sciences. with less rain going into 4Q12, water outflow (or driver Mr. Zhu believes the accelerating melting of the of electricity) should also ease soon. icebergs would increase the atmospheric pressure in the North Pole, which could push the cold air to the  Three Gorges dam: water outflow velocity lower latitude zones and cause abnormal temperature (m³/s) declines in China. However, some researchers think it 40,000 is still too early to forecast the winter temperature, as it 35,000 could be affected by many other factors such as the 30,000 average Pacific Ocean sea surface temperature near the 25,000 equator, which is not easy to forecast at the moment. 20,000 15,000 10,000  Average temperatures in Beijing 5,000 (℃)

0 25

12

12 12 12 12

12 12

12 12

12 12 12

12 12

12 12

-

- - - -

- -

- -

- - -

- -

- -

Jul Jul

Apr

Oct

Jan Jan Jun

Feb Mar Mar

Aug Sep Sep Nov May May 20 2010 2011 2012 15 Source: China Yangtze Power

10  Three Gorges dam: upstream water level (m) 5 200 0 190 1-Oct-2012 15-Oct-2012 29-Oct-2012 12-Nov-2012 180 2012 2011 Historical average (2008-2011) 170 Source: Bloomberg 160 150 4) Better-than-expected supply discipline 140 Coal producers in key provinces have been under

130 pressure since July to cut production, even in the top-3

Jul

Jul

-

-

Apr Oct

Jan

Jan Jun

Mar

Mar

Feb

Sep

Aug Sep Nov

- -

-

May

- -

May

-

-

-

-

8

- - -

-

-

1

4

9 29

6 producing provinces, Shanxi, Inner Mongolia and

15 21

22 17

25

12

19 30 11 27 2010 2011 2012 Shaanxi (where notable cuts took place in September). We believe the production cuts are to stop the losses Source: China Yangtze Power and due to the temporary shutdown of mines for safety measures.

- 18 - China Thermal Coal Sector 19 November 2012

In terms of listed companies, we have seen a similar  Raw coal production MoM of Shenhua and China Coal trend for Shenhua in recent months, but for China (% ) Coal, monthly output in July and September 25 outperformed the key provinces on a MoM basis. 20 Shenhua‘s key production base is Inner Mongolia, and 15 China Coal‘s is mostly in Shanxi. 10 5 According to local press reports, in the first 8 months 0 of 2012, 16 large state-owned coal producers recorded a (5) net loss, making 17.8% of scalable coal producers loss- (10) making. This is also another angle from which to look (15) at the floor for coal prices, and with production costs Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Shenhua China Coal rising over time, the floor price should also be higher with self-corrective market decisions based on loss Source: SX Coal ratios. Going forward, the three companies we cover are likely  Loss ratio of state-owned coal producers to come under less pressure to cut production as a (%) result of them having tightened up their safety 25 standards as required by the government. All three companies, especially Yanzhou (zero fatalities for 5 20 consecutive years from 2007-11) have kept annual 15 fatality rates (measured by number of deaths per million tonnes) at much lower levels than the national 10 average.

5 The biggest question now is whether the small mines

0 that have been recently shut down will resume

06 07 08 09 11 12 10

06 09 10 11 12 07 08

06 07 08 09 10 11 12

------

------

- production after November 2012. Based on our

------

Jan Jan Jan Jan Jan Jan Jan

Sep Sep Sep Sep Sep Sep Sep

May May May May May May May industry research, some industry experts do not believe Source: CEIC full production will resume until the 18th National People‘s Congress commences in March 2013 when  Raw coal production MoM by province long-term safety measures are likely to be introduced, 10 7.5 which could lead to a sustained destocking trend 4.9 5 throughout 1Q13. As demand returns steadily, production at the mines could resume, especially with 0 small mines accounting for a meaningful market share (5) -3.3 -3.8 (we estimate one-third of the market in 2011). -5.2 -5.3 (10) (15)  Fatality rates Fatality rate/m tonnes 2007 2008 2009 2010 2011 (20) -17.8 Shenhua 0.0060 0.0000 0.0170 0.0123 0.0196 (25) -22.8 -22.6 China Coal 0.0220 0.0200 0.0090 0.0410 0.0080 Inner Mongolia Shanxi Shaanxi (%) Yanzhou 0.0000 0.0000 0.0000 0.0000 0.0000 July August September China 1.4850 1.1820 0.8920 0.7490 0.5640 Vs. country

Source: SX Coal Shenhua -100% -100% -98% -98% -97% China Coal -99% -98% -99% -95% -99% Yanzhou -100% -100% -100% -100% -100% Source: Company, NDRC

- 19 - China Thermal Coal Sector 19 November 2012

 Production cuts prior to the 18th National Congress of the CPC growth. That said, India‘s appetite for thermal coal Province Status imports is hard to forecast, making it a variable factor All local mines have been shut down, with resumption of production not expected before December 2012. Only Longmay Mining Group's for our outlook of seaborne trade supply/demand. Heilongjiang production has not been affected. Jilin In the Baishan area, only 2-3 local mines are still operating. Industry publications say that state-owned Coal India Almost all local mines have been shut, and only a few large mines are still Qinhai in operation. (COAL IN, INR351.15, Buy [1]) has decided to import All small mines have been shut. Large mines are still operating but safety roughly 15% of the domestic demand volume in order Gansu inspections are conducted every day. to meet its obligation to supply coal to domestic In the Yulin area, one-third of the coal mines have been shut. Small mines customers (electric power companies). This would with annual production under 300 kilo tonnes will not resume production Shaanxi until the end of the year. come to an import of nearly 20mt. However, we will In the Lvliang area, small private mines have been shut. In the Lishi area, need to decide whether to change our import volume all mines have been shut. In the Datong area, all mines will be shut until the end of November were they except those under Datong Coal Mine forecast for 2012 after gauging whether the firm will Shanxi Group. In the Yangyuan Pingding area, most mines have been shut down. actually carry out the import plan. Some underground mines have been shut but open-pit mines have not Inner Mongolia been not been affected. For 2013, we envisage a supply glut of 15mt. The Small mines with annual production under 300 kilo tonnes would be shut Shandong from early November this year. oversupply will likely contract YoY, but we think About 10% of Huaibei's production has been cut, but Huainan was not supply/demand will remain very loose. We forecast Anhui affected by and large. thermal coal output to increase by 4.6% YoY to 852mt, Henan Small mines continued to be closed since last inspection in August. In Panzhihua area, only Panmei Company is still operating, and all else while demand looks set to rise by 3.5% to 837mt. Sichuan were shut. Supply volumes of thermal coal in the seaborne trade Chongqin Only SOE mines are still operating, and small local mines were shut. market are likely to lose a considerable amount of Source: SX Coal, Daiwa momentum YoY. In our view, the combination of erosion in supply/demand and plummeting prices will force some high-cost manufacturers to stop producing Regional coal-price outlook thermal coal, while the main suppliers probably will not seek to aggressively increase output. Thermal coal Based on forecasts by our Japan Resources Team, the Price trend thermal coal seaborne trade market will be saddled We forecast Japan-Australia contract prices (Australia with a supply glut of 5mt in 2012. Supply volumes of FOB) to fall by 22% YoY to USD90/t in FY13 and remain thermal coal look set to rise by 5% YoY to 814mt, while flat at USD90/t in FY14. The FY12 contract price has demand volumes will be up 4% YoY to 809mt. We been settled at USD115/ t. We forecast thermal coal spot forecast output in major coal-producing countries such prices to remain in the USD80-100/t range for the next as Indonesia, Australia, Colombia and South Africa to six months. A sharp improvement in supply/demand increase by 3-7% YoY, with steady exports overall. conditions in the seaborne trade market is hard to For Indonesia, the world‘s largest thermal coal picture. However, an unexpectedly steep price decline supplier, we forecast coal exports (incl. coking coal) to since spring has pushed recent spot prices down to the rise by 6% YoY for 2012. We also assume thermal coal level of production costs at major suppliers in Australia export volume growth of 6% YoY growth for Australia and elsewhere. This indicates that spot prices are likely and 3% YoY for South Africa. However, we forecast to stay steady and low for the time being. Colombia‘s exports to increase by 7% YoY, as a major supplier plans to add capacity, but coal railway workers We have kept our outlook for long-term thermal coal went on strike at end-July. prices at USD90/t because production costs are around that level for new suppliers such as Australia, which is a Our forecast for China‘s import volumes of thermal marginal producer. Recent spot prices have been coal currently calls for 159mt, 15% above the year- trending below that line, but we see no need to revise earlier level. Total import volumes for Jan-Jul 2012 our long-term forecast at this juncture. At current spot were up 57% YoY to 102mt. However, the rapid prices, Australian thermal coal suppliers are above cash increase in 1H12 led to an inventory glut, so import cost, but many seem to be in the red or at the break-even volumes are likely to lose a lot of momentum in 2H12. point on a total cost basis. Sales at contract prices Meanwhile, our forecast for India‘s import volumes of (USD15/t for FY12) account for over half of the total at thermal coal is 59mt, up 10% YoY. many Australian suppliers, so we have seen no decisive moves to curtail production or close mines yet. August announcements showed that FY11 imports Nevertheless, some suppliers have been reducing jumped by 33% to 66mt. We expect gains in import contractor jobs and/or cutting headcount, so they could volume to narrow in FY12 along with slowing economic start closing mines if thermal coal prices remain soft.

- 20 - China Thermal Coal Sector 19 November 2012

Meanwhile, some US coal suppliers are cutting back  Mine-mouth coal prices production. On 21 June, Arch Coal announced plans to (CNY/tonne) close three mines in the Appalachia region, and Consol 750 Energy decided to idle its Fola complex in West 650 Virginia early in July. 550 450  Regional thermal coal imports/exports forecasts (m tonne) 350 2008 2009 2010 2011 2012E 2013E 2014E 250 Imports 150

Japan 105 92 102 101 103 104 105

08 09 10 12 11

08 09 10 12 11

10 11 08 09 12

09 10 12 08 11

- - - - -

- - - - -

- - - - -

- - - -

- yoy 4.1% -12.5% 10.5% -0.4% 2.0% 1.0% 1.0% -

Jul Jul Jul Jul Jul

Oct Apr Oct Apr Oct Apr Oct Apr Apr Oct

Jan Jan Jan Jan Korea 74 80 88 94 93 93 95 Jan Shanxi Datong Nanjiao 5500kcal Inner Mongolia Ordos 5500kcal - yoy 12.8% 8.8% 9.1% 7.6% -2.0% 1.0% 2.0% Taiwan 53 49 53 55 58 60 62 Shaanxi Yulin 5500kcal

- yoy -11.9% -8.5% 9.5% 4.0% 4.0% 4.0% 3.0% Source: SX Coal EU15* 158 146 148 145 141 144 147 - yoy -1.0% -7.9% 2.0% -2.0% -3.0% 2.0% 2.0% China 34 92 119 139 159 164 172 History suggests a strong correlation over time between - yoy -26.0% 171.2% 29.1% 16.4% 15.0% 3.0% 5.0% mine-mouth and coastal prices (we take an average of India 34 49 48 53 59 67 76 mine-mouth prices from Shanxi, Inner Mongolia and - yoy 21.3% 45.0% -0.6% 10.0% 10.0% 15.0% 13.0% Shaanxi to compare with the Circum-Bohai Sea Price Subtotal 458 508 559 588 612 633 658 - yoy -0.3% 10.9% 10.1% 5.3% 4.1% 3.4% 3.9% Index). From time to time, there have been small time Total Imports 665 677 748 775 809 837 868 lags. However, given that seaborne coal accounts for - yoy 1.9% 1.8% 10.5% 3.7% 4.3% 3.5% 3.7% about 40% of total coal demand in China, we believe that Exports mine-mouth prices should follow trends in coastal prices Indonesia* 201 234 291 323 343 360 374 - yoy 2.6% 16.5% 24.3% 11.1% 6.0% 5.0% 4.0% eventually, given some time lags. Australia 126 139 141 148 156 163 169 - yoy 12.5% 10.2% 1.5% 4.5% 6.0% 4.0% 4.0%  Mine-mouth vs. seaborne coal prices South Africa* 69 67 70 72 74 75 78 900 600 - yoy 2.0% -3.0% 5.0% 1.7% 3.0% 2.0% 3.0% 850 Colombia 58 60 62 68 73 79 83 550 - yoy -8.0% 3.0% 4.0% 10.0% 7.0% 8.0% 5.0% 800 500 China 42 22 18 11 9 8 7 750 - yoy -17.1% -48.2% -17.8% -39.0% -20.0% -10.0% -5.0% 700 450 Russia 84 92 99 95 98 102 106 650 400 - yoy -1.0% 9.4% 7.5% -3.2% 3.0% 4.0% 4.0% 600 US 35 20 23 34 37 40 43 350 550 - yoy 45.6% -44.0% 16.7% 47.9% 8.0% 8.0% 7.0% 500 300

Sub-total 615 633 704 751 790 827 860

11 12

10 11

11 12

10 11 11 12 12

11 12

- -

- - - -

------

- yoy 2.8% 2.9% 11.2% 6.7% 5.1% 4.6% 4.1% -

Apr Apr

Oct Oct Oct

Jun Jun

Feb Feb

Aug Dec Aug others 49 43 43 24 24 25 26 Dec - yoy -8.4% -12.0% -0.2% -44.5% 0.0% 4.0% 3.0% BSPI Index (LHS) Average mine-mouth price 5,500kcal (RHS) Total Exports 665 677 748 775 814 852 886 - yoy 1.9% 1.8% 10.5% 3.7% 5.0% 4.6% 4.0% Source: SX Coal, calculated by Daiwa Source: TEX Report, AME, Daiwa Note: *Incl. metallurgical coal Looking at the locations of producing mines of the three coal produces, the following maps illustrate that Shenhua is more focused in Inner Mongolia (especially Mine-mouth coal prices on the west side where rail transport is available), whereas most of China Coal‘s reserves are in Shanxi Despite the bottoming of coastal coal prices, there have Province. Yanzhou‘s key production in China is in been mixed signals for mine-mouth coal prices. For Shandong but has expanded to Shanxi, Henan and example, the Shanxi Datong Nanjiao (5,500 kcal) Inner Mongolia; the Australia business is run mine-mouth price saw a bit leg down adjustment in throughout its subsidiary, Yancoal Australia (Not mid-August (from CNY500/t to CNY440/t), while rated), which has recently expanded further following Inner Mongolia Ordos (5,500kcal) and Shaanxi Yulin the acquisition of Gloucester (GCL) (Not listed). (5,500kcal) have seen small rebounds in recent weeks.

- 21 - China Thermal Coal Sector 19 November 2012

 Coal mine locations 2010 level amid inflation, and at a 5% maximum increase in 2012 given the fast deteriorating profitability

Heilongjiang of power plants. Meanwhile, the NDRC has capped spot- China coal prices twice, introducing a cap at the final price of Jilin

Liaoning 19 June in 2008 (range of CNY840-860/tonne) and, Xinjiang Inner Mongolia Beijing Gansu most recently, CNY800/tonne (Circum-Bohai coastal Hebei Ningxia Shanxi Shandong prices at 5,500kcal) throughout 2012. Qinghai Jiangsu Shaanxi Henan Tibet (Xizang) Shanghai Hubei Anhui Sichuan  Government intervention since the reform Jiangxi Zhejiang Hunan Contract Spot Fujian Guizhou Taiwan 2005 Provided guidance of 8% cap n.a. Yunan Guangdong Guangxi 2008 n.a. Capped at 19 June prices Australia 2011 Cap at 0% n.a. Hainan 2012 Cap at 5% Capped at CNY800/t

China Shenhua Source: Various sources China Coal Yanzhou Coal During 1H12, following reduced gap between spot and contract prices, the NDRC launched a study of Source: Companies contract-spot convergence. Based on our industry research, the study was suggested by coal users, Near-term opportunity: especially power plants, and did not receive a lot of support from coal producers. convergence of spot and contract prices Recent press reports suggest there could be two different versions of the proposal. The first version Contract coal has played an important role throughout suggests contract coal sales run for periods of 2-5 years China‘s transition from a planned economy to a quasi- and the contract price be based on a benchmark plus market economy. Before the 1980s, all coal was priced an adjustment-variable formula with the benchmark by the central government, with the total contract price decided by the NDRC, which means the volume planned by the government. After the 1980s, government would be able to limit volatility. The the planned proportion accounted for about 50% and second version is free price-setting by the buyers and in 2012 was reduced further. Coal-price adjustments in sellers for contract coal, which would mean it was free 1958, 1965, and 1979 were due to low profitability of from government intervention. Besides coal-price the coal producers. changes, there could also be policies on power prices linked to changes in coal prices and railway quota  China: raw-coal price adjustments before 1992 allocations. However, there has not been an official Coal price Coal costs Net profit Net margin document on the details and it remains speculation at Year (CNY/tonne) (CNY/tonne) (CNY/tonne) (%) this time. Before After Before After Before After Before After 1958 11.0 13.4 9.3 10.2 1.7 3.2 15.6 24.1 Reasons why full convergence is difficult 1965 15.4 17.3 14.3 15.8 1.1 1.6 7.0 9.0 1979 15.9 21.0 13.5 17.8 2.4 3.2 14.9 15.2 Based on our recent discussions with industry experts 1985 23.8 26.9 17.8 23.4 6.0 3.5 25.2 13.0 and listed companies, many believe that these Source: Various sources measures do not represent substantial reforms compared with the previous pricing mechanism. There From 1979-92, the country began to introduce a market are also difficulties linking a market-based coal price mechanism by allowing market pricing outside the with a market-based power price, which has been the planned quota. In 1993, it extended the reform with key conflict over the past decade. market pricing becoming the main standard. The government issued guidance prices for contract coal In China, electricity prices are fully regulated by the until 2002, when guidance was formally suspended NDRC at both the on-grid (tariffs paid by the power grid and pricing was left to the buyers and sellers. However, companies to the power plants) and end-user (tariffs coal pricing has not been 100% market-based due to paid by the users to the power grids) levels. In the past government intervention. decade, there have been a few times when inflation has been the key impediment to electricity price hikes For instance, following a failure in negotiations in 2004, (especially after 2006), resulting in volatile profitability the NDRC provided a guidance cap of an 8% increase. In for the power producers. With the relatively soft 2011, the government capped the contract price at the economic growth currently, if China were to link fully

- 22 - China Thermal Coal Sector 19 November 2012

fuel prices with electricity prices, a sudden sharp rise in  Major China coal producers: contract and spot prices coal prices could squeeze further the already weak (CNY/tonne) 2008 2009 2010 2011 2012E margins of industrial users such as steel mills and Shenhua Spot 438 421 457 508 467 aluminium smelters (industrial users account for more Contract 336 362 362 338 355 than 70% of total power consumption currently). Difference 30% 16% 26% 50% 32% China Coal Another important issue is the railway transport quota, Spot 612 417 521 562 517 Contract 365 402 410 425 468 which has been used to guarantee the transportation of Difference 68% 4% 27% 32% 11% key contract coal supplies in the past. If China opens its Source: Companies coal market fully, it could become increasingly difficult for coal companies to secure railway transport,  Shenhua: breakdown of contract and spot prices by delivery especially ahead of periods of peak demand. In our method (CNY/t) view, until China resolves fully the issues of the market Spot 2007 2008 2009 2010 2011 9M12 pricing of electricity and transportation bottlenecks, Total 265 438 421 457 508 472 Mine mouth 102 163 178 142 171 138 any reform of coal pricing would continue to be only Direct arrival (rail) 289 387 401 406 473 416 partial. In fact, the NDRC reduced the proportion of Seaborne 399 614 473 590 630 568 contract coal in the market by cutting railway quotas Contract for cross-provincial transportation for 2012, while the Total 311 336 362 362 338 349 Mine mouth 0 79 105 163 162 184 target shipments for 2012 were 11% YoY lower at 834m Direct arrival (rail) 229 261 278 263 251 253 tonnes, which accounts for 36% of our forecast 2012 Seaborne 360 409 441 462 451 481 total rail-shipment forecast for coal. Difference Total -15% 30% 16% 26% 50% 35%  PRC Government: target shipments by rail (m tonnes) Mine mouth - 106% 70% -13% 5% -25% Direct arrival (rail) 26% 48% 44% 55% 88% 64% Cross-provincial Actual total rail Year target YoY (%) shipment YoY (%) % of key target Seaborne 11% 50% 7% 28% 40% 18% 2008 785 1,691 46.4 Source: Company 2009 846 7.8 1,751 3.5 48.3 2010 907 7.2 2,000 14.3 45.3 However, if there is a convergence of contract and spot 2011 932 2.8 2,270 13.5 41.1 2012E 834 -10.5 2,350 3.5 35.5 coal pricing, we still see China Coal as a bigger Source: NDRC beneficiary in terms of net profit as the company‘s earnings are the most sensitive to changes in contract- Any market-based contract pricing is coal prices. We estimate that every 1% rise in the positive for coal producers contract price on top of our 3% YoY contract price increase assumption for 2012 leads to about a 2% rise As we expect the spot-coal price to remain higher than in our 2013 EPS forecast. This is due to the company‘s the contract price, we expect the proportion of contract higher gross margin and large non-coal business. sales to total sales to fall further in the future. We forecast a 3% YoY increase in the contract-coal price  2013E EPS sensitivity to changes in thermal-coal prices (%) for 2012. However, any move towards a more market- Every 1% increase in Contract Spot based system could benefit the listed coal producers we Shenhua +0.3 +0.9 cover much more, as gap between contract and spot- China Coal +1.9 +2.5 coal prices is generally larger than 3% currently. Yanzhou +0.7 +9.4 Source: Daiwa estimates Note: For domestic thermal coal only, Yanzhou is also sensitive to changes in Australia In the above discussion, we exclude Yanzhou as the coal prices and domestic coking-coal prices company sells most of its coal in China in the sport market. Based on the disclosed prices and our forecasts Key risk is a flat contract price (for 2012), the gap between Shenhua‘s average spot As mentioned, the issue of market-based contract and contract prices gap is the largest. The difference pricing has yet to be finalised and there are still between Shenhua‘s and China Coal‘s average contract numerous uncertainties going into the year-end prices is the result of the former‘s larger contract sales negotiations. If the contract price is not allowed to through what Shenhua calls ‗direct arrival‘ (transported change for 2013, as was the case in 2011, there could be directly to customers by rail) and the mine mouth, with risk to the Bloomberg-consensus EPS forecasts for only about 46% (2011) shipped by sea to customers. 2013, especially for China Coal. Seaborne prices are generally higher due to the higher transportation costs. However, looking at different channels, Shenhua still sells contract coal at a big discount to spot coal, especially for direct arrival and the seaborne market.

- 23 - China Thermal Coal Sector 19 November 2012

 2013E EPS downside if there is no change in contract price complete value chain (coal mines, power plants, % Earnings downside railway lines, ports, and ships) than the latter (coal Shenhua -0.9 mines and power plants: we forecast a self-sufficiency China Coal -5.7 Yanzhou -2.1 ratio in coal of 30% for 2012). Source: Daiwa estimates Based on 2011 numbers, our back-of-the-envelope To mitigate its high sensitivity to contract-coal pricing, calculation (assuming internal costs were similar to China Coal has been selling more coal on the spot outsourced levels) shows that Shenhua achieved a cost- market over the past few years (48% for 2011 compared of-sales saving of 12% in its coal-mining business as a with 13% for 2006). In our forecasts, we assume a slow result of using its own railway lines, ports, and ships, shift into more spot coal (59% by 2014E). As can be and a cost-of-sales saving of 21% in its power business seen from the following table, in 2011, the frozen as a result of using its own coal. Meanwhile, the contract price led to a YoY decline in China Coal‘s transportation businesses have positive gross-profit contract coal sales. Compared with Shenhua‘s much margins except for the shipping business, which is larger output of contract coal (we believe China Coal currently facing margin pressure. For the coal business, has been more flexible in the past in being able to take the largest cost saving comes from the operation of the advantage of price differences in different cycles), Shuohuang railway line (53% owned by Shenhua with China Coal‘s growth rate of the realised contract price the remainder mostly owned by Daqing Railway has been larger. Given this, we estimate the potential Group), China‘s second-largest coal-transportation rail earnings downside to our 2013 EPS forecast would be line in terms of volume after the Daqing line. less than 5.7%. Lastly, Shenhua‘s 9M12 prices suggest a premium of mine-mouth contract prices over spot  Shenhua: savings from vertical integration prices, which could be a potential risk when Coal (CNYm) 2009 2010 2011 2012E 2013E 2014E convergence takes place. On the positive side, most of Total revenue 84,606 106,103 140,112 152,409 166,190 178,817 Total COGS 43,838 63,786 92,847 104,809 113,640 122,561 China Coal‘s sales go to the seaborne market, reducing Total transport costs 27,017 29,565 35,824 39,732 42,499 45,394 such risks. Total internal COGS 19,414 22,128 24,992 30,087 34,942 39,744 As a % 72% 75% 70% 76% 82% 88%  China Coal: contract/spot sales split Cost savings attributable to internal transport 9,144 10,121 10,942 13,013 15,467 17,941 m tonnes 2006 2007 2008 2009 2010 2011 2012E 2013E 2014E As a % 21% 16% 12% 12% 14% 15% Total 44.8 59.4 65.6 76.2 87.3 98.5 105.8 120.8 135.7 Power (CNYm) Contract 38.9 52.2 54.8 55.6 61.5 51.6 55.4 55.2 55.2 Total revenue 32,680 44,195 57,791 68,966 74,240 80,392 Spot 5.9 7.2 10.8 20.6 25.8 47.0 50.0 65.1 80.0 Total COGS 24,727 35,331 46,715 52,085 55,805 60,219 Breakdown Total fuel cost 16,834 25,690 34,825 38,094 40,927 44,282 Total 100% 100% 100% 100% 100% 100% 100% 100% 100% Total internal fuel cost 14,142 22,875 29,600 31,357 33,875 36,545 Contract 87% 88% 84% 73% 70% 52% 52% 46% 41% As a % 84% 89% 85% 82% 83% 83% Spot 13% 12% 16% 27% 30% 48% 47% 54% 59% Cost saving attributable to Source: Company, Daiwa forecasts internal fuel 6,771 8,802 9,680 9,793 10,712 11,497 As a % 27% 25% 21% 19% 19% 19%  ASP coal-price changes over the past few years Source: Company, Daiwa forecasts Shenhua 2008 2009 2010 2011 Spot -4% 9% 11% -10% China Coal also operates non-coal assets such as a coal- Contract 8% 0% -7% 5% China Coal mining machinery business, but internal sales are Spot -32% 25% 8% -8% small, resulting in limited cost savings. However, the Contract 10% 2% 4% 10% company is the market leader in manufacturing coal- Source: Company mining equipment in China and stable sales growth in this area provides diversification benefits.

The benefits of vertical Yanzhou Coal operates a small, 200km rail line integration connecting its coal mines in Shandong Province, but the level of integration is minimal. Meanwhile, most of In recent years, vertical integration has been a trend the company‘s power business serves its coal-chemical among companies seeking earnings stability. The most assets. common choice is coal-power integration, which can involve power plants acquiring captive coal mines or coal producers securing demand through their own power plants. The two best examples in the listed universe are Shenhua and China Resources Power (836 HK, HKD16.86, Buy [1]). Shenhua owns a more

- 24 - China Thermal Coal Sector 19 November 2012

Shenhua‘s much lower raw-material costs are likely Near-term risk: rising costs due to more ideal exploration conditions at its mines (and thus lower exploration costs), and the attractive A trend globally that China has not been immune to is acquisition costs for the Shendong coal mines rising coal-production and selling costs. Over the past (underground mine blocks that have achieved similar five years, Shenhua‘s unit production costs have cash costs as comparable open-pit mines). China Coal increased at a CAGR of 5%, lower than the 7% for and Yanzhou have much higher production costs due to China Coal and 10% for Yanzhou. It is important to less-perfect mine conditions and much high acquisition note that Shenhua‘s materials costs, labour costs, and costs (higher non-cash depreciation unit costs). Thus, depreciation costs are significantly lower than those of the construction of coal mines tends to have a decisive China Coal and Yanzhou on a per-tonne basis. For impact on the level of commodity and equipment costs. 1H12, Shenhua saw a similar YoY rise in unit costs (10%) as China Coal (8%) and Yanzhou (11%). Shenhua also operates a very large coal-trading business in third-party coal so the unit transportation  China Thermal Coal Sector: unit cost of sales of self-produced costs shown in the preceding table include the coal coal volume from this. However, given the company‘s (Rmb/tonne) unique vertically integrated model of railway lines, 400 ports and shipping business, excluding internal 350 transportation costs the unit costs of external 300 transportation are significantly lower than those of 250 China Coal. Railway lines account for the majority of 200 the transportation costs and the profitability of the 150 lines is impressively high (48% for 2011), so the costs of 100 50 running an internal transportation operation are lower 0 than using outside contractors. Yanzhou sells coal 2007 2008 2009 2010 2011 mostly in Shandong, and therefore enjoys much lower Shenhua China Coal Yanzhou transportation costs, but it is interesting to note that it has substantially higher staff costs per unit of coal sales Source: Companies than its peers, which could be explained by the tonnage  China Thermal Coal Sector: unit cost of sales breakdown production per employee (self-produced coal divided Shenhua 2007 2008 2009 2010 2011 by the total number of employees). Yanzhou‘s Materials costs 18.2 23.1 21.6 21.5 22.8 productivity could improve in the future with output Staff costs 10.2 12.0 11.3 13.9 14.6 from Australia mines growing at a faster rate than Depreciation and amortisation 16.9 18.0 20.2 20.9 20.8 those in China, but this is unlikely to lead to a fall in Repair and maintenance 9.4 8.9 8.5 9.6 7.5 Other production costs 20.3 33.4 39.1 43.5 53.0 unit labour costs given the much higher labour costs in Cost of transportation (assuming same as third parties) 105.9 99.9 106.2 94.4 92.5 Australia and potential labour-shortage issues. Other costs (including third parties) 1.5 2.6 4.0 10.3 7.5 Self-produced coal 182.3 197.8 210.9 214.0 218.8  China Thermal Coal Sector: production per employees China Coal 2007 2008 2009 2010 2011 ’000 tonnes/head 2007 2008 2009 2010 2011 Materials costs 81.2 98.8 73.0 73.2 80.6 Shenhua 2.7 3.1 3.4 3.8 3.4 Staff costs 19.5 24.2 28.2 31.2 29.8 China Coal 1.3 1.5 1.4 1.6 1.8 Depreciation and amortisation 13.4 13.5 24.0 32.2 35.0 Yanzhou 0.8 0.7 0.7 0.9 0.9 Repair and maintenance 6.1 7.9 6.1 8.0 11.6 Source: Companies Transportation costs 85.8 88.4 84.0 89.4 91.2 Coal sustainable development fund (reserve) - - - 16.5 19.1 Outsourcing mining engineering fee - - - 21.0 24.1 Sales taxes and surcharges - - - 11.1 12.0 Other costs 52.7 59.7 73.5 37.2 41.4 Self-produced coal 258.6 292.5 288.6 319.8 344.7 Yanzhou 2007 2008 2009 2010 2011 Materials and electricity 49.1 57.8 58.1 49.2 60.1 Staff costs 71.9 77.3 96.1 103.1 114.8 Depreciation and amortisation 34.6 31.8 42.9 42.7 44.2 Repairs and Maintenance 13.3 0.0 0.0 0.0 0.0 Land restoration and related 25.0 96.6 50.9 33.9 33.8 Transportation 19.7 18.8 14.4 27.2 26.0 Business tax and surcharges 0.0 11.5 12.3 11.1 11.4 Resources tax 0.0 0.0 0.0 0.0 0.0 Other cost of coal sales 23.2 27.3 15.7 40.4 52.0 Self-produced coal 236.8 321.1 290.3 307.6 342.3 Source: Companies

- 25 - China Thermal Coal Sector 19 November 2012

 China Thermal Coal Sector: unit transportation costs of coal Labour costs, which accounted for one of the largest sales absolute cost increases in the past, may continue to rise (Rmb/tonne) due to continuing wage inflation in China. Australia‘s 120 average labour cost over the past few years increased 100 by about 3-6% a year from January 2007-May 2012, 80 lower than that in China. However, the mining industry in Australia has faced a serious labour shortage, and 60 therefore much greater wage inflation (5-9% a year 40 over the same period). Construction and mining 20 labourers rank behind engineering and legal

0 professionals in terms of the average wage for major 2007 2008 2009 2010 2011 occupations. BIS Shrapnel forecasts Australia‘s all- Shenhua total Shenhua external China Coal Yanzhou industry labour cost to rise by an average of 4.2% for the seven years from FY12-18. With more people Source: Companies retiring, the supply of labour is likely to increase at a

 China Thermal Coal Sector: gross margin of coal-sales slower rate over the coming decade. BIS Shrapnel division expects this to lead not only to a shortage of skilled (%) labour, but of every type of labour. Meanwhile, the 50 demand for labour should continue to rise — particularly in periods of strong investment and 40 economic growth. A sustained shortage of labour is

30 likely to result in a long-term upward rise in wage- inflation pressures. 20  China: unit GDP labour costs 10 (Rmb) 0.15 0 0.140 2009 2010 2011 0.14 Shenhua China Coal Yanzhou 0.14 0.130 0.129 0.129 Source: Companies 0.13 0.127 0.127 0.127 0.125 0.125 0.124 0.124 0.13 0.122

Likely cost trends 0.12

Although some of the raw-material costs (such as steel 0.12 products and parts) have softened as a result of the

global economic slowdown and oversupply, other costs 0.11

2000 2001 2002 2004 2006 2008 2009 2010 2011 2005 2007 such as diesel fuel (crude oil), electricity, tyres 2003 (rubber), and explosives (ammonium) have been more Source: CEIC stable in recent years.  Australia: labour cost vs. inflation  Prices of steel, crude oil, rubber, and ammonium (Rebased to 100) 130 (Rebased to 100) 400 125 350 120 300 115 250 200 110 150 105

100 100

07 08 09 10 11 12

07 08 09 10 12 11

07 07 08 09 09 10 11 11 08 10

- - - - -

50 -

------

------

Feb Feb Feb Feb Feb Feb

Aug Nov Aug Aug Nov Aug Aug Nov Nov Nov

May May May May May 0 May Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Labour cost index CPI Steel Crude oil Natrual rubber Ammonia Source: Australian Bureau of Statistics, Daiwa Note: Using 2007 as the base year Source: Bloomberg

- 26 - China Thermal Coal Sector 19 November 2012

 Australia: average wage by occupation Resources Tax, and set the resources tax rate for crude Engineering professionals oil and natural gas at 5-10% of sales income. As coal Legal professionals accounts for a much greater proportion in China‘s Construction and mining labourers energy mix (70% of primary energy consumption for Accountants, auditors and company… 2011) than oil and gas, the government has been very All occupations cautious about reforming the coal-resource tax. On 29 August 2012, China‘s finance minister, Xie Xuren, Truck drivers noted in a report to the National People‘s Congress Miscellaneous clerical and administrative… Standing Committee that resources-tax reform should Miscellaneous factory process workers be deepened, and a price-based tax levy should be Storepersons applied to mineral products including coal. Farm, forestry and garden workers (AUD per week)  Comparison of current and expected new resource-tax rate 0 200 400 600 800 1,0001,2001,4001,6001,8002,000 Current tax rate Expected new tax rate Source: Australian Bureau of Statistics (May 2010) Types of coal Province (CNY/tonne) (% of mine-mouth price)

 Australia: average wage – mining industry vs. all industries Coking coal All 8-20 5-10% Thermal coal and others Anhui 2.0 (AUD per week) Gansu 3.0 2,500 Guizhou 2.5 Hebei 3.0 Heilongjiang 2.3 2,000 Henan 4.0 Hunan 2.5 1,500 Inner Mongolia 3.2 5-10% Jilin 2.5

Liaoning 2.8 1,000 Ningxia 2.3

Shaanxi 3.2 500

Shandong 3.6

08 09 10 11 12

07

07 08 09 10 11

07 08 09 10 11

07 09 11 08 10 12

------

------

- - - - -

- Shanxi 3.2

Feb Feb Feb Feb Feb Feb

Aug Nov Aug Nov Aug Nov Aug Nov Aug Nov

May May May May May May Sichuan 2.5 Mining industry All industries Xinjiang 3.0

Source: Australian Bureau of Statistics Yunnan 3.0 Source: NDRC, Daiwa Australia carbon tax In the event that a price-based tax levy is applied, Another cost that could rise in Australia is the newly Yanzhou would face much greater cost pressure than imposed (July 2012) carbon tax on fugitive greenhouse its peers as the company sells more coking coal than gas emissions (those resulting from leaks and other thermal coal, thus would see higher absolute charges. unintended or irregular releases of gas). Our We calculate that a tax of 5% of mine-mouth prices calculation suggests this could elevate Yanzhou‘s (simply derived by subtracting unit transportation average production cost in Australia by 2-3%, based on costs from the unit realised ASP), would result in an industry experts‘ expectations, but mines with large gas 8% rise in costs for Yanzhou and a 17% rise based on a emissions could see a significant rise in charges. The tax of 10% on mine-mouth prices. Shenhua and China carbon tax per tonne (AUD23) is fixed until 2015, and Coal would see a similar impact. so investors will have to face uncertainties in market pricing after that. Shenhua and China Coal currently  China Thermal Coal Sector: impact on unit selling cost in 2013 have no operations in Australia, so are not subject to CNY/t Average ASP Transportation Ex-transportation At 5% At 10% these Australia-specific risks. We provide more Shenhua 425 92 333 17 33 detailed analysis in Yanzhou‘s company section. China Coal 508 105 403 20 40 Yanzhou 546 26 520 26 52 Cost increase (at 5%) Cost increase (at 10%) Scenarios for resources-tax reform Shenhua +5% +11% China has long delayed the reform of resource taxes, China Coal +5% +10% which could lead to a big rise in costs in the future. Yanzhou +8% +17%

Currently, the resources tax for thermal coal is levied Source: Company, Daiwa forecasts on the sales volume (CNY2-4/tonne), representing less According to a report by China Business Journal in than 1% of the mine-mouth price. The government has September 2012, there were more than 20 kinds of been trying to change the volume-based tax levy to a taxes and fees levied on coal production, amounting to price-based one for many years. In October 2011, the about CNY140/tonne. There are also other non-official central government issued the Decision of the State charges, such as tipping fees for railway transportation, Council on Amending the Provisional Regulation on which we estimate amount to about CNY60/tonne. If

- 27 - China Thermal Coal Sector 19 November 2012

such taxes and fees are reduced or cancelled, we believe the impact of any resources-tax reform would be much Long-term risk #1: transportation smaller. In addition, coal producers could try to bottleneck transfer some of the cost pressure to their downstream customers. Different provinces have different fees; for In March 2012, China announced its 12th Five-Year example, the coal sustainable-development fund (a fee Plan (2011-15) targets for the coal industry, including levied by Shanxi government) is unique to Shanxi the 2015 targets for production, transport, and (where China Coal has the most exposure) and other environmental issues. The key figures for 2015 are: provinces mostly charge coal-price adjustment fund. annual capacity of 4.1bn tpa (tonnes per annum), annual production volume of 3.9bn tpa, total railway  A list of major taxes and fees capacity of 2.8-3.0bn tpa (actual volume of 2.6bn tpa), (CNY/tonne) Shanxi Inner Mongolia Shaanxi Coal price-adjustment fund n.a. Lignite: 8 Raw coal: 15 and total seaborne transported capacity of 800m tpa Anthracite: 20 Clean coal: 25 (actual volume of 750m tpa). The production target is Others: 15 Coking coal:25 consistent with our forecast by 2015 (3.98bn tpa). Coal sustainable Thermal coal: <= 18 n.a. n.a. Anthracite: <= 23 development fund th Coking coal: <=23  Targets based on the 12 Five-Year Plan Ecological and 10 based on area 3 Matrices Targets in 2015 environmental restoration Production and treatment deposit Capacity Annual capacity of 4.1bn tpa by 2015: large coal mines: 2.6bn tpa (63% share), Coal mine transformation 5 n.a. n.a. mines with capacity >0.3m tonnes account for 900m tonnes (22% of all) and fund and environmental rest at 600m tonnes (15% share) restoration fund Production By 2015, coal production controlled at about 3.9bn tpa Coal mine maintenance 8.5 9.5 10.5 New capacity During the 12th FYP, build carry-forward capacity of 360m tonnes/year, newly fee build 740m tonnes/year, and complete 750m tonnes/year Water resources Raw coal: 2 based on water used based on water used Companies Have 10 producers with production of 1bn tonnes/year, 10 with 50m compensation fees Clean coal: 3 tonnes/year, both of which account for 60% of the total share Coking coal: 4 Technology Mechanisation to reach >75%: large mines (>95%), mines with capacity >0.3m Mining resources 1% of sales income 1% of sales income 1% of sales income tonnes (>70%), other mines (>55%) compensation charges Safety By 2015, fatal accidents and major coal accidents to drop by 12.5% and 15% Exploration rights usage based on area based on area based on area compared with 2010; death rate to drop to below 28% fee (CNY100-500/sq km) (CNY100-500/sq km) (CNY100-500/sq km) Utilisation Coal-bed methane (CBM) reserves to increase by 1tn cm and CBM production Mining rights usage fee based on area based on area based on area to be up to 30bn cm/year (CNY1,000/sq km) (CNY1,000/sq km) (CNY1,000/sq km) Environment Land reclamation rate to exceed 60% Safety production fee Open-cut mine: 5 Open-cut mine: 5 Open-cut mine: 5 Resources Energy saving up to 95m tonnes of standard coal Others: 15-30 Others: 15-30 Others: 15-30 saving Source: NDRC, Daiwa Transportation Net exports Net exports from coal-exporting provinces to amount to 1.66bn tonnes/year In the nutshell, China Coal‘s unit sales-cost base is (1.58bn from Shanxi, Shaanxi, Inner Mongolia and Gansu) with the main destinations eastern China, Beijing-Tianjin-Hebei area, central east and more sensitive to raw-material cost changes while northeast, and a small amount of volume to the Sichuan-Chongqing area; from Yanzhou is most sensitive to changes in labour costs Xinjiang (300m tonnes) to Western Gansu, Qinghai, the Sichuan-Chongqing (both in China and Australia) and resources-tax area; Yunnan and Guizhou (500m tonnes) to Guangdong, Guangxi and Hunan Net imports Total net importing volume to amount to 1.62bn tonnes/year: 16.2bn for eastern changes. Shenhua is most sensitive to transportation China, the Beijing-Tianjin-Hebei area, central east and northeast, and 400m costs, but close to half of it is from internal railway and tonnes for Sichuan-Chongqing shipping, which would reduce half of the impact at net Railway To raise railway transportation volume to 2.6bn tonnes with total capacity of 2.8-3bn tonnes/year; for Shanxi, Shaanxi, and Inner Mongolia, outbound rail profit level. If certain fees are reduced or temporarily output and capacity of 1.43bn tonnes and 2bn tonnes, respectively; Lanxin line waived, such as the coal-development fund, China Coal reconstruction and Lanyu line to support Xinjiang outbound transport Seaborne North-south seaborne transport system: Jinzhou, Qinhuangdao, Tianjin, would benefit more. Tangshan, Huanghua, Qingdao, Rizhao, Lianyungang - offload at ports in Jiangsu, Shanghai, Zhejiang, Fujian, Guangdong, Guangxi and Hainan; by  China Thermal Coal Sector: total unit cost sensitivity to 2015, seaborne volume to reach 750m tonnes/year from northern ports with a changes in cost items capacity of 800m tonnes/year Sensitivity Shenhua China Coal Yangzhou Source: NDRC 10% change in raw-material costs 0.6% 2.3% 1.8% 10% change in labour costs 0.9% 0.9% 3.4% Based on the plans: 1) 67% of coal would be 10% change in transportation costs 4.2% 2.6% 0.8% transported by rail from the ‗Three West‘ region Resources tax (at 5% scenario) 5.0% 5.0% 8.0% (Shanxi, Shaanxi, and Western Inner Mongolia), Source: Daiwa estimates Xinjiang, Yunnan, and Guizhou to eastern China, the  China Thermal Coal Sector: 2013E EPS sensitivity to change Beijing-Tianjin-Hebei area, the central east and in costs northeast, and 2) 19% of coal would be shipped from Sensitivity 1% increase in costs northern sea ports to southern sea ports. Shenhua 1.2% China Coal 3.8% Yanzhou 10.0% Source: Daiwa estimates - 28 - China Thermal Coal Sector 19 November 2012

 China: coal supply flow during the 12th FYP  Market share by provincial production (1996-2011) 1996 Share 2005 Share 2011 Share Shanxi 25.8% Shanxi 24.2% Inner Mongolia 25.5% Henan 7.9% Inner Mongolia 11.9% Shanxi 22.7% Chongqing 7.6% Henan 10.7% Shaanxi 10.6% Shandong 6.4% Shandong 7.7% Henan 5.1% Heilongjiang 5.9% Guizhou 6.1% Guizhou 4.4% Source: CCTD

 China: medium-to-long term railway plan (2008)

Source: 12th Five-Year Plan for the coal industry

Based on these targets, rail volume would account for 19% of total production by 2015, from 18% for 2011, and seaborne volume would account for 67% by 2015, from 65% for 2011, which suggests that transportation capacity would only increase marginally faster than total coal production.

 Railway and seaborne shipments of coal Source: NDRC (%) 66.7 70 64.5 We have conducted an SOTP analysis of each of the 60 new rail lines due to be opened over the next few years. Most of the new capacity will be in the ‗Three West‘ 50 region, and total rail capacity could improve 40 meaningfully in 2015. We forecast total coal-loading 30 rail capacity to rise by 6% YoY for 2013, mostly due to 17.6 19.2 20 capacity expansion of Shuohuang line (from 191m tpa 10 to 244m tpa: we expect this to reach 350m tpa by 2015) and the Houyue line (from 99m tpa to 109m tpa: we 0 2011 2015E look for 129m tpa after 2015). We also forecast a 6% Rail-backed Seaborne YoY capacity increase for 2014, followed by a 13% YoY

Source: 12-th five-year plan for coal industry rise for 2015. Compared with our total commercial coal-demand and production-growth forecasts of 4% Rail transport has been the major transportation YoY and 3% YoY, respectively, for 2013, the railway bottleneck as production has become more capacity bottleneck should ease only slightly over the concentrated. In 2011, Shanxi, Inner Mongolia, and next few years. Shaanxi produced 59% of China‘s raw coal, while the top-three coal-producing provinces produced 41% and Therefore, it is fair to conclude that the railway 47% of total coal production in 1996 and 2005, bottleneck (especially for coal coming from the Three respectively. Shanxi has always been the largest West region) will not be meaningfully alleviated until producer, while Inner Mongolia and Shaanxi have 2015. It thus seems that average transportation costs become among the top-three producers following are unlikely to decline over the near term (through a increases in transportation capacity. reduced reliance on trucking costs, which are higher than rail-transportation costs). Thus, we believe it is still too early to see a reduced cost spread between mine-mouth and seaborne coal prices.

- 29 - China Thermal Coal Sector 19 November 2012

 Rail transported coal as a % of total coal production

(m tonne) (%) 3,000 70

2,500 65

2,000 60

1,500 55

1,000 50

500 45

0 40

2003 2005 2006 2008 2009 2010 2011 2004 2007

2012E 2013E 2014E 2015E Coal transported by railway (LHS) % of transported coal (RHS)

Source: SX Coal, Daiwa forecasts

 Railway capacity forecasts

Throughput capacity (m tonnes) Expected Long-term Coal production base Line From To completion 2011 2012E 2013E 2014E 2015E target North lines

Daqin Datong, Shanxi Qinhuangdao, Hebei n.a. 440 450 450 450 450 450 Shuohuang Shuozhou, Shanxi Huanghua, Hebei 2015 164 191 244 297 350 400 Fengshada Datong, Shanxi Fengtai, Beijing 2015 30 35 40 45 65 70 Jingyuan Yuanping, Shanxi Shijingshan, Beijing n.a. 15 16 17 18 20 50 Jitong Jining, Inner Mongolia Tongliao, Inner Mongolia 2015 10 12 14 30 35 50 Middle lines Shitai Taiyuan, Shanxi Shijiazhuang, Heibei n.a. 75 76 77 78 78 90 Hanchang Changzhi, Shanxi Handan, Heibei 2015 15 27 39 51 62 130 Shanxi, Shaanxi, South lines Western Inner Mongolia Houyue Houyue, Shanxi Yueshan, Henan 2015 89 99 109 119 129 150 Taijiao Taiyuan, Shanxi Jiaozuo, Henan n.a. 40 42 44 46 49 85 Longhai Lanzhou, Gansu Lianyungang, Jiangsu 2015 11 18 25 32 40 50 Xikang 2012 15 20 50 50 50 100 Ningxi 2015 13 13 30 50 70 70 New lines Zhangtang Ordos, Inner Mongolia Caofedian, Hebei late 2014 120 200 Mengxi - Huazhong Western Inner Mongolia Hubei, Hunan, Jiangxi 2017 200 Central & Southern Shanxi Lvliang, Shanxi Rizhao, Shandong Sep-14 20 90 200 Sub-total 917 999 1,139 1,286 1,608 2,295 Xinjiang Lanxin Urumqi, Xinjiang Lanzhou, Gansu n.a. 20 20 20 20 20 20 Lanxin No.2 Urumqi, Xinjiang Lanzhou, Gansu end of 2014 10 30 300 Sub-total 20 20 20 30 50 320 Others 1,333 1,335 1,337 1,339 1,342 1,342 Country total 2,270 2,354 2,496 2,655 3,000 3,957 Annual addition 270 84 142 159 345 957 Total YoY 14% 4% 6% 6% 13% Source: Daiwa forecasts, NDRC

recent growth in US gas production and reserves, Long-term risk #2: threat from helping to push up total gas production in the country shale gas to its highest levels since 2007. The Henry Hub gas price is currently close to USD3/MMBtu, which is The development of shale-gas resources represents the about 80% lower than the peak in 2008. There have most significant advance in the oil and gas industry for been increasing industry concerns about whether US many decades, particularly in the US, which is leading shale gas will have an impact on global energy prices the world in shale gas and oil development. Although once exports start after the completion of export the US has been producing oil and gas from shale facilities such as LNG ports. formations for decades, it was not until hydraulic fracturing and horizontal drilling technologies were combined that shale activity really took off in the early 2000s. Shale gas has been the primary source of the

- 30 - China Thermal Coal Sector 19 November 2012

 Henry Hub gas price in the US  Comparing shale-gas production: PRC Government targets vs. Daiwa forecasts (USD/short ton) (USD/MMBtu) (bcf/year) 160 25 2,824 140 3,000 20 120 2,500 100 15 80 2,000 60 10 40 1,500 5 20 1,000

0 0 530

04 05 09 10

01 06 11

04 09

02 07 12 03

08 353

- - - -

- - -

- -

- - - -

- 500 230

Jul Jul Jul

Jan Jan

Mar Mar

Nov Sep Nov Sep

May May May 0 Central Appalachian coal price (LHS) Henry Hub gas price (RHS) 2015E 2020E

Chinese govt targets Daiwa forecasts Source: Bloomberg Source: Reuters, Daiwa forecasts About 66m tpa of LNG capacity is planned to come Note: Daiwa forecasts are combined shale gas and CBM production online in North America between 2015 and 2020, but only one field (Cheniere at 14m tpa) has received all the As China‘s economy moves from hyper-growth to required government approvals. Daiwa‘s Regional Head stabile economic growth, we expect total energy of Oil & Gas, Adrian Loh, believes that about 20m tpa consumption to normalise to mid-single-digit could make its way into Asia by 2020 out of the 66m tpa percentage growth. Total primary energy consumption – and there is upside potential to this rather than increased at a 9% CAGR from 2001-11 while average downside. We note that quite a few Asia oil companies GDP growth was 10.4% a year. However, as China are involved in this project (Kogas, PetroChina, Petronas, promotes energy efficiency (currently targeting unit and Mitsubishi) so the implication is that they want to GDP energy consumption to decline by 16% for 2015 supply this gas to their home markets, or at least Asia, from the 2010 level), we expect the multiple to (energy rather than serve Europe. consumption divided by GDP) decline from 0.58x for 2010 to 0.49x for 2015. As other energy sources such as Potential impact on long-term coal demand natural gas (including unconventional gas, eg, coal-bed in China methane and shale gas) and alternative energy (including hydro, nuclear, wind, biomass, and solar Another worrying issue is China‘s own shale gas. The power and waste-energy) are supported by strong US Energy Information Administration (EIA) estimates policy incentives, we forecast a CAGR of 19% from that the country‘s total technically recoverable shale 2011-15 and total energy consumption to only increase gas resources are currently 1,275tcf, 13x that of its by 4% a year over the same period. conventional gas resources. However, Adrian expressed a cautious view about long-term shale gas development Given mounting environmental concerns, we forecast in China in his report, China shale: a long-term coal‘s contribution to China‘s total energy mix to fall paradigm shift, published in April 2012. from 69% for 2011 to 62% for 2015 and the consumption CAGR to decline from 8.8% over the past China‘s shale-gas production targets appear very decade to only 1.2% from 2011-15. For some years in ambitious to us, with 6.5bcm (230bcf) targeted for the following decade, there could even be some YoY 2015 and 60- 100bcm for 2020, compared with declines. The impact could be larger from 2016-20, for Daiwa‘s forecasts of 10bcm (353bcf) and 15bcm which we forecast a CAGR of only 0.4% in coal (530bcf), respectively. Although the country appears to consumption due to lower overall energy consumption have a large shale resource base, our cautious view is growth and more sustainable usage growth in oil, predicated on the belief that much exploration and alternative energy, and natural gas. We note that we evaluation work needs to be done to prove the forecast a 12% CAGR in natural-gas consumption over productivity and commerciality of its shale basins. 2016-20, and estimate that each 5pp rise in this would Given our forecast for China‘s gas demand to more reduce coal demand by about 1pp a year over the than triple to 387bcm by 2030 (a 6.6% CAGR from period. 2010-30), any incremental shale-gas production should displace gas imports, in our view.

- 31 - China Thermal Coal Sector 19 November 2012

 Primary energy growth by fuel  Public bidding results of the first batch of shale gas (2011) Natural Blocks Rank Competitors Exploration investment (CNYm) Expected wells Total Alternative energy Oil Coal gas Yuqin Nanchuan 1 Sinopec 591 11 CAGR (1986-2001) 4.2 7.5 5.9 3.5 4.5 2 CUCBM 219 5 CAGR (2001-2011) 8.7 9.4 7.0 8.8 16.1 3 CNPC 150 11 Average (2011-15E) 4.0 13.5 3.7 1.4 19.2 Yuqin Xiangxiu 1 Henan CBM 248 10 Average (2016-20E) 2.9 8.1 3.0 0.4 11.8 2 CUCBM 165 6 Average (2021-30E) 2.0 5.5 2.5 -1.5 8.0 3 Yanchang Oil 193 5 Source: CEIC, NDRC, Daiwa forecasts Guizhou Suiyang Auction failure Guizhou Fenggang Auction failure  Primary energy contribution by fuel Source: Ministry of Land and Resources of the PRC Total Alternative energy Oil Coal Natural gas 2001 100.0 7.5 21.8 68.3 2.4  China: locations of shale gas blocs in 2012 2011 100.0 8.0 18.6 68.8 4.6 2015E 100.0 11.4 18.4 62.3 8.0 2020E 100.0 14.5 18.5 55.0 12.0 2030E 100.0 20.4 19.4 38.9 21.3 Source: CEIC, NDRC, Daiwa forecasts

 China: primary energy growth (%) 30

20

10

0

(10)

Source: NDRC

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

2014E 2016E 2018E 2020E 2022E 2024E 2026E 2028E 2012E Total Alternativenergy Oil Therefore, coal producers that now heavily rely on Coal Natural Gas profits from coal mining should also prepare for a shift Source: Daiwa in long-term strategy to areas with more sustainability.

Prepare for rainy days This is partially why Yanzhou has been actively investing in overseas markets such as Australia (coal) Although not included at the listed company level, and Canada (potash). Shenhua‘s parent company, Shenhua Group (Not listed), has been investing aggressively in renewable energy How much more the company can diversify over the (mostly wind power) through Shenhua Guohua Energy near term depends on the robustness of its balance (Not listed). For 2011, Shenhua Guohua Energy‘s total sheet. Among the China thermal-coal companies, we installed wind power capacity was 3.44GW, the fifth- see Shenhua as the best-positioned in terms of its highest in China. Also, we believe that the thermal coal balance sheet given its net-cash position, followed by companies could consider entering the shale-gas China Coal, which has a reasonable net-gearing ratio producing chain. In May 2012, Mainland news reported that we do not expect to rise significantly over the next that Shenhua Group had hired a number of shale-gas few years. We are concerned about Yanzhou‘s balance experts to work on shale-gas exploration and sheet, especially given a falling gross margin and ROE. development. In the second batch of public tenders, which were opened recently, Shenhua Group will be qualified to participate as the tenders are open to all China-registered companies (the first batch was on an invitation-only basis). Compared with only four blocks offered (two failed to attract bids) in first batch, a total of 20 blocks will be up for auction this time.

- 32 - China Thermal Coal Sector 19 November 2012

 China coal producers: net gearing (%) 60

40

20

0

(20)

(40)

(60) 2007 2008 2009 2010 2011 2012E 2013E 2014E

Shenhua China Coal Yanzhou Source: Bloomberg, Daiwa forecasts

 China coal producers: FCF projections (CNYm) 40,000

30,000

20,000

10,000

0

(10,000)

(20,000) 2012E 2013E 2014E

Shenhua China Coal Yanzhou Source: Bloomberg, Daiwa forecasts

Investments need to be value-added In terms of ROI (calculated by dividing the change in the amount of EBIT by the average capex spent), we expect those of Shenhua and China Coal to remain mostly positive over the next few years but be below their past-five-year averages. We expect Yanzhou‘s one-year ROI to turn negative for 2012 with possible losses in Australia and more low-margin mines contributing to output growth in the PRC. This is another lesson that not all investments are good.

 China coal producers: ROI (%) 100

50

0

(50)

(100) 2007 2008 2009 2010 2011 2012E 2013E 2014E

Shenhua China Coal Yanzhou Source: Bloomberg, Daiwa forecasts

- 33 - China Thermal Coal Sector 19 November 2012

Mongolia, Anhui, Sichuan, Qinghai, Shanghai, and Appendix: the top players in the Shaanxi provinces. industry Hebei Jizhong Energy Group Shenhua Group The group was founded in 2008 and is directly The parent group of the listed company, China controlled by Hebei Province SASAC. It was the fifth- Shenhua Energy (1088 HK), has been the largest coal largest raw-coal producer in China in 2011, and has producer in China for a number of years. It is directly coal mines in Hebei and Shanxi provinces. Three of its controlled by central government‘s State-owned Assets subsidiaries are listed domestic: Jizhong Energy Supervision and Administration Commission (SASAC). Resources (000937 CH), North China Pharmaceutical Group (600812 CH), and Hebei Jinniu Chemical China National Coal Corp Industry (600722 CH).

The parent group of the listed company, China Coal Shanxi Lu’an Mining Industry Group Energy (1899 HK), is one of the key state-owned enterprises (SOE) controlled by Shanxi Province The group is the one of the top-five coal players in SASAC. It was the second-largest raw-coal producer in Shanxi Province and one of the top-10 raw-coal China in 2011. China National Coal‘s major businesses producers in China. It was restructured in 2000 and is include coal production and trading, coal-mining directly held by Shanxi Province SASAC. The group has equipment manufacturing, coal chemicals, pit-mouth five developed coal mines –Lu‘an, Wuxia, Lu‘ning, power generation, as well as coal-mine construction. Lu‘meng, and Lu‘xin – in Shanxi province. It is the parent group of the listed vehicle, Lu‘an Huanneng Shanxi Coking Coal Group (601699 CH).

The group was established in 2001 and is owned solely Anhui Huainan Mining Group by Shanxi Province SASAC. It manages one of the 14 large-scale coal-production bases designated by the The group was restructured in 1998 and is directly central government and is the parent of the listed controlled by Anhui Province SASAC. It was one of the Xishan Coal Electricity Group (000983 CH) and top-10 raw-coal producers in China in 2011. The group Shanxi Coking Group Company (600740 CH). The owns 74% of the coal resources of Anhui Province and group ranked top and fourth in coking-coal and raw- 50% of those in the eastern China region. Its key asset, coal production, respectively, for 2011. Huainan mine, is one of the five major coal mines in China. Shanxi Datong Coal Mine Group Hebei Kailuan Group Restructured in 2000, the group is the third-largest player in China in terms of 2011 raw-coal production. Hebwi Kailuan Group was the top-10 raw-coal Its owns 73 coal mines in Shanxi province and Inner producers in China in 2011 and is directly owned by Mongolia. The group‘s subsidiary, Datong Coal Hebei Province SASAC. It owns more than 10 Industry (601001 CH), was listed on the A-share productive coal mines in China. It is the parent of market in 2006. The group is directly controlled by Kailuan Energy Chemical (600997 CH) listed on the A- Shanxi Province SASAC. share market.

Shaanxi Coal and Chemical Industry Group Shandong Yankuang Group The group is directly owned by Shaanxi Province The parent group of the listed company, Yanzho Coal SASAC. It was the sixth-largest raw-coal producer in Mining Company (1711 HK). Following restructuring in China in 2011. Its coal resources are mainly located in 2006, the group became solely owned by Shandong the Yulin, Yanan, Xianyang, Weinan, and Tongchuan Province SASAC. It is one of the top-10 raw-coal regions of Shaanxi Province. producers in China in 2011 and has three industrial parks in Shandong Lunan, Yanzhou, and Zoucheng. Henan Coal Chemical Industry Group Outside Shandong province, it owns and operates five production bases in Shaanxi, Inner Mongolia, Guizhou, Based in Zhengzhou, the group is one of the top-10 Xinjiang, and Australia. raw-coal producers in China, the largest methanol producer in central China, and largest coal-gas supplier in Asia. It is directly owned by Henan Province SASAC and has businesses in Henan, Guizhou, Xinjiang, Inner

- 34 - China Thermal Coal Sector 19 November 2012

 Top-20 coal producers: annual coal production and capacity expansion plans 2012-15E (m tonnes) No. Company Name in Chinese 2008 2009 2010 2011 2012E 2013E 2014E 2015E 1 Shenhua Group 神华集团有限责任公司 281 328 357 400 460 520 580 640 2 China National Coal Group 中煤能源集团有限公司 114 125 154 164 193 222 251 280 3 Shanxi Coking Coal Group 山西焦煤集团有限责任公司 80 81 102 110 133 155 178 200 4 Shanxi Datong Coal Mine Group 山西大同煤矿集团有限责任公司 69 75 101 115 136 158 179 200 5 Shaanxi Coal and Chemical Industry Group 陕西煤业化工集团有限责任公司 60 71 100 100 120 140 170 200 6 Henan Coal Chemical Industry Group 河南煤业化工集团有限责任公司 45 57 74 85 101 118 134 150 7 Hebei Jizhong Energy Group 冀中能源集团有限责任公司 36 42 73 102 124 132 140 150 8 Shanxi Lu’an Mining Industry Group 山西潞安矿业（集团）有限责任公司 42 55 71 80 95 110 125 140 9 Anhui Huainan Mining Group 淮南矿业（集团）有限责任公司 57 67 66 70 90 108 125 140 10 Hebei Kailuan Group 开滦（集团）有限责任公司 33 40 61 70 78 85 93 100 11 Shandong Yankuang Group 兖矿集团有限公司 40 50 60 70 85 95 105 110 12 CPI Mengdong Energy Group 中电投蒙东能源集团有限责任公司 37 43 53 67 72 81 90 100 13 Shanxi Yangquan Coal Industry Group 山西阳泉煤业（集团）有限责任公司 37 44 52 58 64 82 100 130 14 Inner Mongolia Yitai Group 内蒙古伊泰集团有限公司 26 37 51 60 66 76 86 100 15 Heilongjiang Longmay Mining Holding Group 黑龙江龙煤矿业控股集团有限责任公司 55 55 50 53 65 77 88 100 16 China Pingmei Shenma Energy and Chemical Group 中国平煤神马能源化工集团有限责任公司 41 46 50 43 57 72 86 100 17 Shanxi Jincheng Anthracite Mining Group 山西晋城无烟煤矿业集团有限责任公司 37 43 46 53 65 77 88 100 18 Inner Mongolia Yidong Investment Group 内蒙古伊东投资集团有限公司 16 21 40 30 35 40 45 50 19 Henan Yima Coal Industry Group 河南义马煤业集团股份有限公司 22 23 31 40 50 60 70 80 20 Anhui Huaibei Mining Group 安徽淮北矿业（集团）有限责任公司 27 27 31 34 46 57 69 80 Top 20 total 1,161 1,339 1,623 1,804 2,134 2,462 2,800 3,150 Top 20 YoY 15% 21% 11% 18% 15% 14% 12% Source: China National Coal Association, CCTD, SX Coal, Daiwa forecasts

- 35 -

Energy / China 1088 HK Energy / China 19 November 2012

China Shenhua Energy

China Shenhua Energy Target (HKD): 34.90 g 38.00 Upside: 23.6% 1088 HK 16 Nov price (HKD): 30.75

A premium for earnings stability 1 Buy (unchanged)  Shenhua is our top pick as we expect sustainable earnings 2 Outperform visibility, supported by its deepening vertical integration 3 Hold  Not the biggest beneficiary of coal-price recovery, but earnings 4 Underperform structure should be the most defensive against rising costs 5 Sell

 Earnings upside could largely come from expanding power and rail businesses; ROE and dividend yield should remain superior

How do we justify our view?

given Shenhua‘s more stable coal  How we differ supply and favourable coal prices. Our 2013-14E EPS are 5-8% above consensus as we are more bullish on Putting the synergies it benefits from a coal-price recovery in 2013.

into perspective, in 2011 Shenhua Forecast revisions (%) Dave Dai, CFA saved 12% on the cost of sales for its Year to 31 Dec 12E 13E 14E (852) 2848 4068 coal-mining business through internal Revenue change (2.7) (6.7) (8.6) [email protected] sales to its railway, ports and shipping Net profit change 0.3 2.7 0.5 Core EPS (FD) change 0.3 2.7 0.5 businesses, and 21% on the cost of Gary Zhou sales for its power business on the Source: Daiwa forecasts (852) 2773 8535 back of internal coal sales. [email protected] Share price performance

Although any upside in spot and (HKD) (%) contract-coal prices may not result 37 105  What's new 33 96 Shenhua‘s vertical integration has in greater earnings upside given its 30 88 given it greater earnings stability already fat profit margin, we think 27 79 than its peers. We expect the Shenhua is at a sweet ‗low-cost‘ spot 24 70 company to be a leader in terms of as it has the lowest cash cost among Nov-11 Feb-12 May-12 Aug-12 Nov-12 its peers, which we expect to cap any Ch Shenhua (LHS) Relative to HSI (RHS) profit margins, with the highest ROE/ROI among its peers going margin erosion going forward. We forward. This report marks the believe the expansion of its power 12-month range 24.70-36.05 transfer of coverage to Dave Dai. and transport businesses would Market cap (USDbn) 78.90 create more cost synergies and 3m avg daily turnover (USDm) 57.90 Shares outstanding (m) 19,890  What's the impact earnings growth. Major shareholder Shenhua Group (73.0%)

While Shenhua‘s shipping business  What we recommend is likely to be loss-making this year, Financial summary (CNY) we believe the downside should be We raise our NAV-based six-month Year to 31 Dec 12E 13E 14E minimal as we expect its power, target price to HKD38 and reiterate Revenue (m) 231,882 251,734 271,386 railway and port operations to our Buy (1) rating to incorporate Operating profit (m) 71,914 78,757 85,078 remain profitable. One may argue further long-term benefits that we Net profit (m) 47,205 52,588 56,636 see from vertical integration. The Core EPS (fully-diluted) 2.373 2.644 2.847 the stock is expensive compared EPS change (%) 3.3 11.4 7.7 with its industry peers. However, a 2013E PER of 9.4x is undemanding, Daiwa vs Cons. EPS (%) (0.1) 5.0 7.5 breakdown of its profit returns for as it is 30% lower than the stock‘s PER (x) 10.4 9.4 8.7 the past five years shows that past-five-year trading mean. A 4% Dividend yield (%) 3.8 4.3 4.6 dividend yield (based on our 2013 DPS 0.949 1.058 1.139 Shenhua‘s coal and railway PBR (x) 1.9 1.7 1.5 businesses are more profitable. We forecasts) is also the best among its EV/EBITDA (x) 7.3 6.5 5.8 also expect the power business to peers. ROE (%) 19.7 19.5 18.7 trade at a market-leader premium Source: FactSet, Daiwa forecasts

See important disclosures, including any required research certifications, beginning on page 69 China Thermal Coal Sector 19 November 2012

1 Buy (unchanged) How do we justify our view? 2 Outperform

3 Hold  Growth outlook

4 Underperform  Valuation

5 Sell  Earnings revisions

 Growth outlook  China Shenhua: net profit and YoY We forecast Shenhua‘s earnings growth to slow, from a (CNYm) (%) 60,000 56,636 35.0 CAGR of 20% for 2008-11 to a CAGR of 10% for 2012- 52,588 47,205 14. We believe the stock is still attractive given its 50,000 29.4 45,677 30.0 superior earnings stability. 38,834 25.0 40,000 31,706 22.5 19.0 20.0 30,000 26,641 17.6 15.0 20,000 11.4 10.0 7.7 10,000 5.0 3.3 0 0.0 2008 2009 2010 2011 2012E 2013E 2014E Net profit (LHS) YoY growth (RHS) Source: Company, Daiwa forecasts

 Valuation  Shenhua : one-year-forward PER history

The stock is trading at an undemanding 2013E PER of (x) 9.4x, which is 30% lower than its past-five-year average 35

12-month-forward PER of 13.4x. This is also almost 1SD 30 below its past five-year average. 25 24.1x Avg+2SD

20 18.8x Avg+1SD 15 13.4x Avg 10 8.1x Avg-1SD 5 2.7x Avg-2SD 0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: Bloomberg, Daiwa

 Earnings revisions  Shenhua: consensus EPS forecast revisions

The 2012-13 Bloomberg-consensus EPS forecasts for (Rebased to 100) Shenhua have been revised down by 9-14% YTD, due, in 105 our view, to declining average spot-coal prices. 100 However, the magnitude of the cuts is much less than those for its peers (24-49% YTD downward revisions). 95 90 85 80

75

12

12 12 12

12

12 12

12 12

12

12

-

-

- -

-

- -

- -

-

-

Jul

Apr

Oct

Jan Jun

Feb Mar

Nov

Aug Sep May 2012E 2013E Source: Bloomberg, Daiwa

- 37 - China Thermal Coal Sector 19 November 2012

Financial summary

 Key assumptions Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Coal production (m tonnes) 158 186 210 246 282 302 322 344 Coal sales (m tonnes) 209 233 254 313 387 432 462 493 Coal avg selling price (Rmb/tonne) n.a. n.a. 409 436 426 433 436 436

 Profit and loss (CNYm) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Coal revenues 55,741 74,572 84,618 106,080 140,090 152,409 166,190 178,817 Power revenues 23,922 29,393 33,157 44,800 58,348 68,966 74,240 80,392 Other Revenue 2,444 3,168 3,537 6,782 9,759 10,507 11,304 12,178 Total Revenue 82,107 107,133 121,312 157,662 208,197 231,882 251,734 271,386 Other income 0 0 0 0 0 0 0 0 COGS (43,773) (59,378) (65,492) (90,142) (128,092) (147,190) (159,895) (173,192) SG&A (5,144) (6,961) (8,055) (9,219) (10,973) (11,778) (12,082) (12,115) Other op.expenses (693) (1,119) (657) (776) (827) (1,000) (1,000) (1,000) Operating profit 32,497 39,675 47,108 57,525 68,305 71,914 78,757 85,078 Net-interest inc./(exp.) (2,383) (3,393) (2,038) (2,248) (2,136) (1,731) (1,543) (814) Assoc/forex/extraord./others 665 693 742 665 291 291 291 291 Pre-tax profit 30,779 36,975 45,812 55,942 66,460 70,474 77,505 84,555 Tax (6,742) (7,076) (9,626) (11,473) (13,951) (16,209) (17,051) (19,448) Min. int./pref. div./others (3,456) (3,258) (4,480) (5,635) (6,832) (7,060) (7,866) (8,471) Net profit (reported) 20,581 26,641 31,706 38,834 45,677 47,205 52,588 56,636 Net profit (adjusted) 20,581 26,641 31,706 38,834 45,677 47,205 52,588 56,636 EPS (reported)(CNY) 1.138 1.440 1.594 1.952 2.296 2.373 2.644 2.847 EPS (adjusted)(CNY) 1.138 1.440 1.594 1.952 2.296 2.373 2.644 2.847 EPS (adjusted fully-diluted)(CNY) 1.138 1.440 1.594 1.952 2.296 2.373 2.644 2.847 DPS (CNY) 0.504 0.460 0.530 0.750 0.900 0.949 1.058 1.139 EBIT 32,497 39,675 47,108 57,525 68,305 71,914 78,757 85,078 EBITDA 32,497 39,675 47,108 57,525 68,305 71,914 78,757 85,078

 Cash flow (CNYm) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Profit before tax 30,779 36,975 45,812 55,942 66,460 70,474 77,505 84,555 Depreciation and amortisation 8,140 9,893 11,252 13,334 15,571 18,138 19,663 20,852 Tax paid (6,742) (7,076) (9,626) (11,473) (13,951) (16,209) (17,051) (19,448) Change in working capital 1,612 1,056 8,512 9,821 7,922 (8,249) (823) (800) Other operational CF items 43,536 (2,830) (9,847) 4,710 (17,696) (409) (409) (409) Cash flow from operations 77,325 38,018 46,103 72,334 58,306 63,745 78,885 84,750 Capex (32,991) (36,019) (30,165) (38,113) (48,843) (36,640) (34,000) (34,000) Net (acquisitions)/disposals 0 0 0 0 0 0 0 0 Other investing CF items 89 (91) (432) 519 (111) (290) (290) (290) Cash flow from investing (32,902) (36,110) (30,597) (37,594) (48,954) (36,930) (34,290) (34,290) Change in debt 2,548 12,891 1,925 (8,555) (7,226) (4,401) (7,922) (6,338) Net share issues/(repurchases) 0 0 0 0 0 0 0 0 Dividends paid (9,325) (9,149) (10,541) (14,917) (17,901) (18,882) (21,035) (22,655) Other financing CF items 0 0 0 0 0 0 0 0 Cash flow from financing (6,777) 3,742 (8,616) (23,472) (25,127) (23,283) (28,958) (28,992) Forex effect/others 0 0 0 0 0 0 0 0 Change in cash 37,646 5,650 6,890 11,268 (15,775) 3,532 15,637 21,467 Free cash flow 44,334 1,999 15,938 34,221 9,463 27,105 44,885 50,750 Source: FactSet, Daiwa forecasts

- 38 - China Thermal Coal Sector 19 November 2012

Financial summary continued …

 Balance sheet (CNYm) As at 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Cash & short-term investment 53,404 59,054 65,944 77,212 61,437 64,969 80,606 102,074 Inventory 6,337 7,842 7,727 11,574 12,628 15,425 17,111 18,842 Accounts receivable 6,562 8,034 8,690 11,424 13,365 14,065 15,269 16,461 Other current assets 3,883 2,976 10,198 19,251 20,507 20,507 20,507 20,507 Total current assets 70,186 77,906 92,559 119,461 107,937 114,966 133,493 157,883 Fixed assets 131,059 145,253 163,645 188,061 219,904 238,815 253,561 267,118 Goodwill & intangibles 1,162 2,435 2,928 3,248 3,596 3,596 3,596 3,596 Other non-current assets 36,120 49,946 52,645 61,361 69,640 69,930 70,220 70,510 Total assets 238,527 275,540 311,777 372,131 401,077 427,306 460,870 499,107 Short-term debt 11,649 18,213 22,252 15,317 16,389 16,389 16,389 16,389 Accounts payable 8,545 9,098 13,227 19,661 23,668 18,916 20,983 23,105 Other current liabilities 13,177 15,345 20,305 41,948 47,492 47,492 47,492 47,492 Total current liabilities 33,371 42,656 55,784 76,926 87,549 82,797 84,864 86,986 Long-term debt 49,718 56,045 53,931 52,311 44,013 39,612 31,689 25,351 Other non-current liabilities 5,634 5,096 4,644 5,467 5,201 5,201 5,201 5,201 Total liabilities 88,723 103,797 114,359 134,704 136,763 127,609 121,754 117,538 Share capital 19,890 19,890 19,890 19,890 19,890 19,890 19,890 19,890 Reserves/R.E./others 109,898 127,542 150,771 185,223 205,932 234,255 265,808 299,789 Shareholders' equity 129,788 147,432 170,661 205,113 225,822 254,145 285,698 319,679 Minority interests 20,016 24,311 26,757 32,314 38,492 45,552 53,418 61,889 Total equity & liabilities 238,527 275,540 311,777 372,131 401,077 427,306 460,870 499,107 EV 517,217 528,462 525,485 511,904 526,384 525,222 509,238 489,614 Net debt/(cash) 7,963 15,204 10,239 (9,584) (1,035) (8,968) (32,528) (60,333) BVPS (CNY) 7.175 7.970 8.580 10.312 11.354 12.778 14.364 16.072

 Key ratios (%) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Sales (YoY) 26.0 30.5 13.2 30.0 32.1 11.4 8.6 7.8 EBITDA (YoY) 18.2 22.1 18.7 22.1 18.7 5.3 9.5 8.0 Operating profit (YoY) 18.2 22.1 18.7 22.1 18.7 5.3 9.5 8.0 Net profit (YoY) 16.6 29.4 19.0 22.5 17.6 3.3 11.4 7.7 Core EPS (fully-diluted) (YoY) 7.5 26.6 10.7 22.5 17.6 3.3 11.4 7.7 Gross-profit margin 46.7 44.6 46.0 42.8 38.5 36.5 36.5 36.2 EBITDA margin 39.6 37.0 38.8 36.5 32.8 31.0 31.3 31.3 Operating-profit margin 39.6 37.0 38.8 36.5 32.8 31.0 31.3 31.3 ROAE 20.6 19.2 19.9 20.7 21.2 19.7 19.5 18.7 ROAA 10.0 10.4 10.8 11.4 11.8 11.4 11.8 11.8 ROCE 18.1 17.4 18.1 19.9 21.7 21.1 21.2 21.0 ROIC 17.5 18.6 18.9 21.0 22.0 20.0 20.6 20.9 Net debt to equity 6.1 10.3 6.0 n.a. n.a. n.a. n.a. n.a. Effective tax rate 21.9 19.1 21.0 20.5 21.0 23.0 22.0 23.0 Accounts receivable (days) 26.0 24.9 25.2 23.3 21.7 21.6 21.3 21.3 Current ratio (x) 2.1 1.8 1.7 1.6 1.2 1.4 1.6 1.8 Net interest cover (x) 13.6 11.7 23.1 25.6 32.0 41.6 51.0 104.5 Net dividend payout 44.3 31.9 33.2 38.4 39.2 40.0 40.0 40.0 Source: FactSet, Daiwa forecasts

 Company profile China Shenhua Energy is the largest coal producer in China with a fully integrated operation from coal mining to transportation to power generation. The majority of the company's coal sales, as well as its assets, are within China. The company produces mainly bituminous coal for consumption in thermal power plants within China.

- 39 - China Thermal Coal Sector 19 November 2012

company‘s output plans and a meaningful hedge A premium for against coal-price fluctuations. Third, as the railways usually lead to the ports, Shenhua‘s stake in the earnings stability country‘s coal port and shipping businesses also should ensure its throughput quotas for its railway business.

Earnings growth sustainability from Of course, the company‘s ancillary supporting business deepening vertical integration lines (railway, port & shipping) are not without commercial benefit, as the cost of operating railways and ports is still significantly lower than paying for A long-term value investment third-party services. Based on the company‘s 2011 numbers, our rough calculation takes into account cost Shenhua is well known for its vertically integrated savings (assuming similar levels of internal costs as business model. Coal, power generation, railway those outsourced) and shows that Shenhua saved 12% transportation and port transportation account for on the cost of sales for its coal-mining business by 74%, 15%, 10% and 1% of the company‘s one-year using its internal railways, ports and shipping services, forward NAV, according to our estimates. In 2011, 19% and 21% on the cost of sales for its power business of the company‘s commercial coal output was through internal sales of coal. These synergies are consumed internally by its power segment. Some 77% especially valid as the company‘s transportation of all the coal the company transported in 2011 was business offers a positive gross-profit margin except for through its own railways, while 58% of the seaborne its shipping business, which is currently under coal it produced that year was shipped from its self- pressure. For the coal business, the largest cost synergy owned ports. comes from operating the Shuohuang Railway (53% owned by Shenhua and the remainder mostly owned by  Shenhua: revenue breakdown Daqing Railway Group [Not rated]), China‘s second- CNYm 2010 2011 2012E 2013E 2014E largest coal-transportation railway after the Daqing Coal 106,103 140,112 152,409 166,190 178,817 Power 44,195 57,791 68,966 74,240 80,392 Railway. Railway 2,285 2,745 3,338 3,866 4,446 Port 152 147 164 176 189  Shenhua: vertical-integration synergy Shipping 902 2,961 2,564 2,820 3,102 Coal (CNYm) 2009 2010 2011 2012E 2013E 2014E Others 4,025 4,441 4,441 4,441 4,441 Total revenue 84,606 106,103 140,112 152,409 166,190 178,817 Total 157,662 208,197 231,882 251,734 271,386 Total COGS 43,838 63,786 92,847 104,809 113,640 122,561 Source: Company, Daiwa forecasts Total transport costs 27,017 29,565 35,824 39,732 42,499 45,394 Total internal COGS 19,414 22,128 24,992 30,087 34,942 39,744  Shenhua: gross-margin breakdown As a % 72% 75% 70% 76% 82% 88% Cost savings attributable to CNYm 2010 2011 2012E 2013E 2014E internal transport 9,144 10,121 10,942 13,013 15,467 17,941 30% 27% 26% 25% Coal 33% As a % 21% 16% 12% 12% 14% 15% Power 20% 19% 24% 24% 25% Power (CNYm) Railway 49% 48% 48% 48% 48% Total revenue 32,680 44,195 57,791 68,966 74,240 80,392 Port 29% 35% 41% 45% 45% Total COGS 24,727 35,331 46,715 52,085 55,805 60,219 Shipping 13% 14% -7% 2% 11% Total fuel cost 16,834 25,690 34,825 38,094 40,927 44,282 Total 43% 38% 37% 36% 36% Total internal fuel cost 14,142 22,875 29,600 31,357 33,875 36,545 Source: Company, Daiwa forecasts As a % 84% 89% 85% 82% 83% 83% Cost saving attributable to Rationale behind its integration strategy internal fuel 6,771 8,802 9,680 9,793 10,712 11,497 As a % 27% 25% 21% 19% 19% 19% We believe Shenhua‘s integration strategy is simple for Source: Company, Daiwa forecasts three reasons. First, it has access to coal resources from distant areas like Inner Mongolia through its extensive The advantage of vertical integration has supported self-owned railway network. Although it has alleviated Shenhua‘s sustainably high gross-profit margin trend a nation-wide transportation bottleneck in recent compared with that of its peers, despite operating in a years, on the back of an increase in capacity build-out commodity business. Based on the following chart, and slowing coal demand, we do not expect a full Shenhua has shown a better quarterly gross margin breakthrough until after 2014, pending the completion than its peers for most of the time over the past five of Zhangtang Railway and several other major railway years, and the difference became apparent during the lines that focus on coal transportation. Second, on the economic downturns in 2009 and 2012. demand side, Shenhua‘s sizeable coal-fired power- generation business (still growing rapidly in terms of capacity) has provided sustainable demand for the

- 40 - China Thermal Coal Sector 19 November 2012

 China Thermal Coal Sector: quarterly gross-margin  Shenhua: one-year-forward EV/reserve history comparison (PRC GAAP) (x) (%) 20 70 18 60 16 50 14 12 12.4x Avg+2SD 40 10 9.5x Avg+1SD 30 8 6.7x Avg 6 20 4 3.8x Avg-1SD 10 2 0.9x Avg-2SD

0

2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 1Q10 2Q10 3Q10 4Q10 1Q11 3Q11 4Q11 1Q12 2Q12 3Q12 1Q08 4Q09 2Q11 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Shenhua Yanzhou China Coal Source: Bloomberg, Daiwa forecasts Source: Companies One could say that Shenhua‘s vertical integration is not attractive from a valuation perspective, as the 2013E Valuation supported by PER for the whole company is higher than that for each deepening vertical integration standalone business. However, we believe some of Shenhua‘s operations deserve to trade at a premium The stock is trading currently at a 9.4x 2013E PER, valuation compared with the peer average. For which is 30% below its past five-year trading average. example, the listed IPPs that we cover are trading at We are raising our six-month target price from similar one-year forward PERs, but at a lower average HKD34.9 to HKD38.0 as we believe Shenhua will PBR than Shenhua. However, as it sees a stable fuel continue to benefit from deepening vertical integration. cost due to its internal coal supplies, we think the standalone power business deserves to trade at a  Shenhua: one-year forward PER valuation history valuation that is similar to that of the valuation leader, (x) which is China Resources Power. We therefore believe 35 a 1.5x one-year forward PBR, on the back of an expected high ROE, is reasonable for the power 30 division. 25 24.1x Avg+2SD 20 For the railway business, the company‘s only peer 18.8x Avg+1SD (Daqin Railway) is trading currently at a single-digit 15 13.4x Avg PER, with single-digit 2012-14 EPS growth, according 10 to the Bloomberg consensus. However, we believe 8.1x Avg-1SD 5 Shenhua‘s railway business has more promising 2.7x Avg-2SD expansion plans than Daqin‘s, with its Shuohuang line 0 expanding to a second phase, with total capacity Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 improving by more than 40% in three years‘ time. Also, Source: Bloomberg, Daiwa forecasts historically Shenhua‘s Shuohuang Railway has had a  Shenhua: one-year-forward PBR valuation history better gross-profit margin than Daqin‘s, which should justify a premium over Daqin‘s PER on a one-year (x) 6.0 forward basis. Shuohuang also could be less affected by demand weakness, due to Shenhua‘s internal sales. On 5.0 a PBR basis, we think Shenhua‘s railway asset also 4.4x Avg+2SD 4.0 deserves a premium valuation to that of Daqin as its 3.4x Avg+1SD calculated segment profit/segment equity is the highest 3.0 among all of Shenhua‘s business segments. 2.5x Avg 2.0 1.6x Avg-1SD  Shenhua: segmental profit/calculation of segmental equity 1.0 ROE 2008 2009 2010 2011 0.6x Avg-2SD Coal 78% 83% 54% 45% 0.0 Power 12% 16% 16% 16% Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Rail 35% 40% 33% 30% Source: Bloomberg, Daiwa forecasts Port 0% 1% 5% 8% Shipping - - 9% 20% Source: Company, calculated by Daiwa

- 41 - China Thermal Coal Sector 19 November 2012

 Gross margin comparison  Power segment: capacity expansion % 2007 2008 2009 2010 2011 (MW) (%) Daqing railway 50.1 46.4 37.5 40.4 39.3 40,000 35 Shenhua's Shuohuang railway 57.2 48.2 49.1 49.0 48.1 35,000 30 Source: Company 30,000 25 25,000  Shenhua: one-year forward NAV breakdown 20 20,000 Ports 15 Railway 15,000 9.8% 1.3% 10,000 10 5,000 5 Power 0 0 14.5% 2007 2008 2009 2010 2011 Consolidated installed capacity (LHS) YoY growth rate (RHS)

Source: Company

Extending transport business Coal 74.4% Shenhua is the largest shareholder in Shenhuang Railway, the second-largest west-east coal channel in Source: Daiwa forecasts China. Shenhua expects to expand the capacity of the Shuohuang Railway (the second section of the  Shenhua: NAV forecasts Shenhuang Railway) to 350m tonnes in 2015. This Business Valuation Target multiple Total asset % value (HKDm) would support Shenhua‘s coal-production expansion th Coal DCF 10.3% WACC, 1% terminal 565,685 74% during the 12 Five-Year Plan period. Power PBR 1.5x 2013E PBR 110,332 15% Railway Book value 1.5x 2013E PBR 74,621 10%  Shenhuang Railway Ports Book value 1x 2013E PBR 10,056 1% Current capacity Capacity target for Total 760,695 100% Shenhua's (m tonnes per 2015E (m tonnes per Shares 19,890 Section Origin Destination ownership year) year) NAV/share (HKD) 38.0 Shenmu, Shuozhou, Target price (HKD) 38.0 1st section Shaanxi Shanxi 100% 200 200 Source: Daiwa forecasts Shuozhou, Huanghua 2st section Shanxi Port, Hebei 52.7% 190 350 Source: Company Expanding the power business Downstream, Shenhua‘s power-generation capacity has Construction of the Bazhun Railway (200m tonnes per grown by more than 20% YoY over the past five years, year), the Baoshen Railway expansion (100m tonnes providing a good hedge when coal prices decline. In the per year), the Dazhun Railway (200m tonnes per year), past, most of Shenhua‘s capacity addition has come and the Zhunchi Railway (200m tonnes per year) from its parent injecting assets with attractive should be finished before 2015, and would significantly valuations. improve the company‘s ability to transport coal from production bases through the its railway networks. Going forward, management is guiding for 2GW in annual capacity additions, which implies 5-7% YoY growth. Although the pace of growth is likely to slow over the next few years, we believe Shenhua‘s power segment still will be big enough to provide downside protection for the company‘s main coal-mining business.

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 The railway transportation segment under the 12th Five-Year Plan

Source: Company

Shenhua currently owns two ports (the Huanghua Port and Shenhua Tianjin Coal Dock), from which 48% of its seaborne coal was shipped in 9M12. We expect the capacity expansion of Phase III of the Huanghua Port to be completed before the end of 2012, increasing the port‘s capacity by 50m tonnes to 150m tonnes. To enhance the company‘s ability to receive seaborne coal shipments from North China and overseas, Shenhua is also speeding up the construction of the Zhuhai Gaolan Port (40m tonnes) and carrying out preparatory work for Fujian Luoyuan Bay and Zhejiang Zhoushan Port.

 Shenhua: port turnover volume forecast Million tonnes 2010 2011 2012E 2013E 2014E Huanghua Port 87.2 95.7 102.2 107.5 113.2 Shenhua Tianjin Coal Dock 22.5 25.5 27.2 28.7 30.2 Source: Company, Daiwa forecasts

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 The port transportation segment under the 12th Five-Year Plan A long-term portfolio choice

Shenhua and its close peers are categorised as ‗energy‘ stocks in the main industry indices. Shenhua‘s main competitors for index weights are usually CNOOC, PetroChina, Sinopec, Kunlun Energy and its coal peers. Year-to-date, the Bloomberg consensus has been revising downs its 2012-13 earnings forecasts substantially for Sinopec, Yanzhou and China Coal, while Shenhua, PetroChina and CNOOC have been more resilient. Of course, there could be upside revisions to earnings forecasts if the cycle returns for heavily overdone names but, regardless, we believe Shenhua deserves to trade at a premium valuation to its peers as we expect continued strong earnings visibility.

 The most famous names in the energy sector Stock Code CNOOC 838 HK PetroChina 857 HK Sinopec 386 HK Shenhua 1088 HK Kunlun Energy 135 HK China Coal 1898 HK Inner Mongolia Yitai 900948 CN Yanzhou 1171 HK China Oilfield Services 2883 HK Source: Company Source: Daiwa

A fifth round of asset injections by the parent, Shenhua  China Energy Sector: Bloomberg-consensus 2012 EPS- Group, would go to Shenhua Coal Liquefaction and forecast revisions Chemical Co, and supporting coal mines. Shenhua has (Rebased to 100) a good track record when it comes to parent injections, 110 but this time we are concerned that the group‘s coal- 100 chemical business might not be as profitable as 90 Shenhua‘s existing business. However, we are still waiting for the group‘s and Shenhua‘s final decision on 80 the valuation of the assets that would be injected this 70

time round. 60

12

12

12 12

12

12 12

12 12 12

12

-

-

- -

-

- -

- - -

-

Jul

Apr Oct

Jan Jun

Mar

Feb

Aug Sep Nov  China and international dry-bulk indexes May Shenhua China Coal Yanzhou (Units) (Units) Petrochina Sinopec CNOOC 3,000 5,000 Source: Bloomberg 2,500 4,000 2,000 3,000 1,500 2,000 1,000

500 1,000

0 0

10 11 12 09

09 10 11 12

10 11 09 12

09 11 12 10

- - - -

- - - -

- - - -

- - - -

Jul Jul Jul Jul

Apr Oct Oct Apr Oct Apr Oct Apr

Jan Jan Jan Jan China Coastal Bulk (Coal) Freight Index Baltic Dry Index

Source: SX Coal

- 44 - China Thermal Coal Sector 19 November 2012

 Peer group valuations EPS CAGR Company name Stock code Rating Market cap P/E ratio (x) P/B ratio (x) ROE (%) Div yield (%) (%) US$mil 2012E 2013E 2012E 2013E 2012E 2013E 2012E 2013E 12-14E Coal Shenhua 1088 HK Buy 78,900 10.4 9.4 1.9 1.7 19.7 19.5 3.8 4.3 9.5 China Coal 1898 HK Buy 12,640 9.1 8.0 0.9 0.8 10.2 10.7 3.2 3.6 9.0 Yanzhou Coal 1171 HK Hold 7,140 8.6 12.6 1.0 0.9 11.6 7.4 3.6 2.0 -19.9 Simple average 32,893 9.4 10.0 1.3 1.1 13.8 12.5 3.5 3.3 -0.5 Oil Petrochina 857 HK Outperform 239,410 10.6 8.7 1.4 1.3 13.5 15.0 3.8 4.6 21.1 Sinopec 386 HK Underperform 87,800 9.1 7.7 1.1 1.0 12.1 13.0 2.5 2.9 11.2 CNOOC 883 HK Buy 92,080 9.1 8.3 1.8 1.6 21.9 20.2 2.2 2.4 9.2 Simple average 142,297 9.7 8.2 1.4 1.3 15.8 16.1 2.8 3.3 13.8 IPPs China Resources Power 836 HK Buy 10,351 11.5 9.7 1.5 1.4 13.8 14.9 2.7 3.2 13.4 Huaneng Power International 902 HK Underperform 13,505 13.4 11.7 1.3 1.3 10.3 11.0 3.7 4.3 11.1 Datang International Power 991 HK Hold 7,614 11.7 10.8 0.9 0.8 8.0 8.1 2.1 2.3 17.1 Simple average 10,490 12.2 10.7 1.3 1.2 10.7 11.3 2.9 3.3 13.9 Port (dry bulk) Tianjin Port Development 3382 HK Not rated 742 7.3 6.7 0.6 0.5 7.0 8.4 5.0 5.4 5.3 Jiangsu Lianyungang Port 601008 CH Not rated 423 14.2 11.5 n.a. n.a. n.a. n.a. n.a. n.a. 22.4 Rizhao Port 600017 CH Not rated 1,329 11.4 10.9 0.9 0.8 8.0 8.0 n.a. n.a. 10.9 Simple average 831 11.0 9.7 0.7 0.7 7.5 8.2 5.0 5.4 12.8 Railway (operation) Daqin Railway 601006 CH Not rated 14,555 7.8 7.1 1.3 1.2 16.9 16.7 6.6 7.4 8.3 Source: Bloomberg, Daiwa Note: Prices are updated as of November 16, 2012

 Coal Thermal Coal Sector: unit cash cost comparison (2011)

Well-positioned at the low end of (CNY/tonne) the cost curve 350 300 Most of Shenhua‘s coal mines are located in Inner 250 Mongolia, where exploration costs are relatively lower 200 than in inland provinces such as Shanxi and Shaanxi. 150 On a unit-production-cash-cost basis, Shenhua has 100 significantly lower costs than its peers. 50

0  China Thermal Coal Sector: mine locations Shenhua China Coal Yanzhou Materials & electricity Wages Repair and maintenance Others (taxes, fees, etc.) Heilongjiang China Source: Companies Jilin Liaoning Xinjiang We forecast Shenhua‘s saleable coal production to Inner Mongolia Beijing Gansu Hebei increase by 6-7% YoY on average for 2013-15, which Ningxia Shanxi Shandong Qinghai Jiangsu would be slower than the double-digit-percentage Shaanxi Henan

Tibet (Xizang) Shanghai Hubei Anhui annual growth for the past five years. Sichuan Jiangxi Zhejiang Hunan Fujian Guizhou Taiwan  Shenhua: coal production and sales

Yunan Guangdong Guangxi Million tonnes 2010 2011 2012E 2013E 2014E Australia Raw production (m tonnes) 272.9 313.2 335.9 358.2 382.1 Hainan Saleable production (m tonnes) 245.6 281.9 302.3 322.4 343.9

China Shenhua Total coal sales (m tonnes) 313.1 387.3 431.9 461.9 493.4 China Coal Yanzhou Coal Export (m tonnes) 10.3 5.6 8.0 10.0 12.0 Source: Company, Daiwa forecasts

Source: Companies

- 45 - China Thermal Coal Sector 19 November 2012

 Shenhua: domestic coal sales volume Million tonnes 2010 2011 2012E 2013E 2014E Risks By contract Long-term contract 169.0 171.7 169.5 180.8 192.6 Spot market 133.8 210.0 254.3 271.2 288.8 The key risk to our call would be worse-than-expected By transport coal demand. If the recovery in coal prices in 2013 Mine-mouth 31.3 52.0 57.7 61.6 65.6 turns out to be weaker than expected, there could also Direct arrival 111.3 125.2 139.0 148.2 157.9 be downside to our target price. Seaborne 160.2 204.5 227.1 242.1 257.9 Source: Company, Daiwa forecasts Other risk factors include lower-than-expected power

 Shenhua: coal-price forecasts demand and railway turnover. As power demand CNY/tonne 2010 2011 2012E 2013E 2014E growth in China has been weak since April this year Long-term contract 362.1 337.8 354.7 365.3 365.3 (until a rebound in October), we think there could be Spot market 457.0 507.7 467.3 472.0 476.7 risk to our power output assumptions if we see lower- - Mine mouth 142.2 171.0 162.5 164.1 165.7 than-expected power demand next year due to a weak - Direct arrival (rail) 406.2 473.0 425.7 430.0 434.3 - Seaborne 590.0 629.7 535.2 540.6 546.0 economy. Railway turnover for Shenhua has been Export 566.5 747.7 598.2 604.1 610.2 stable in the past as the company mainly serves its own Source: Company, Daiwa forecasts coal transportation needs. However, if coal demand next year is much worse than expected, this could also In terms of exposure to different costs, Shenhua is put pressure on railway turnover. more exposed to transportation costs than its peers for its coal segment but such exposure is largely reduced as it has its own railways and ports. The company‘s defensive nature will also mean that its earnings would be less negatively affected by an unexpected increases in raw-material costs, labour costs and the coal resource tax.

 Total unit cost sensitivity to changes in cost items Sensitivity Shenhua China Coal Yangzhou 10% change in raw-material costs 0.6% 2.3% 1.8% 10% change in labour costs 0.9% 0.9% 3.4% 10% change in transportation costs* 4.2% 2.6% 0.8% Resources tax (5% scenario) 5% 5% 8% Source: Daiwa estimates

- 46 - China Thermal Coal Sector 19 November 2012

 Shenhua: business and locations

Source: Company

- 47 -

Energy / China 1898 HK Energy / China 19 November 2012

China Coal Energy

China Coal Energy Target (HKD): 7.00 g 9.00 Upside: 20.2% 1898 HK 19 Nov price (HKD): 7.49

Favourable odds in play 1 Buy (from Hold)  We think China Coal offers a favourable risk-adjusted reward 2 Outperform profile as a better play on a coal demand recovery than Yanzhou 3 Hold  Unlike Yanzhou, China Coal does not face profitability issues 4 Underperform from organic expansion and enjoys a lower threat on costs 5 Sell

 Raise target price to HKD9.00 and upgrade to Buy; a cyclical momentum play

How do we justify our view?

less affected by rising labour costs and higher than other brokers‘ latest risks of changing resources tax (which forecasts due to our more optimistic should be implemented in steps). For view on coal price and costs. 2013, we project YoY earnings decline

for Yanzhou but positive growth for Forecast revisions (%) Dave Dai, CFA China Coal, driven by self-production Year to 31 Dec 12E 13E 14E (852) 2848 4068 growth of 14% YoY, on the back of two Revenue change (3.8) (0.6) 4.0 [email protected] new mines. Our modest EPS revisions Net profit change (4.0) 2.9 1.7 Core EPS (FD) change (4.0) 2.9 1.7 for 2012-14E reflect our more positive Gary Zhou view on a coal price recovery. Source: Daiwa forecasts (852) 2773 8535 [email protected] As China Coal has historically realised Share price performance

better contract prices than Shenhua, it (HKD) (%) 10.5 100  What's new has more positive earnings leverage if the contract coal price moves towards 9.4 89 Having underperformed the HSCEI 8.3 78 market prices going forward, Index for three consecutive years, we 7.1 66 especially in the seaborne coal market see a favourable risk-reward profile 6.0 55 for China Coal in the near term. This where the contract price remains Nov-11 Feb-12 May-12 Aug-12 lower than spot prices. The parent report marks the transfer of China Coal (LHS) Relative to HSI (RHS) company‘s declared aim to increase its coverage to Dave Dai. stake by up to 2.5% between October 12-month range 6.09-10.38  What's the impact 2012 and October 2013 is not Market cap (USDbn) 12.81 The company‘s strong cost substantial, but suggests some insight 3m avg daily turnover (USDm) 30.03 Shares outstanding (m) 13,259 management was a surprise to us in on an undervalued business. Major shareholder China National Coal Group (57.5%) 3Q12 although cost escalation in 4Q in  What we recommend prior years has been a seasonal case. We raise our DCF-based six-month Financial summary (CNY) What we like about its current cost target price to HKD9.00 (from Year to 31 Dec 12E 13E 14E structure is that it is less exposed to Revenue (m) 90,142 100,742 111,291 HKD7.00), due mostly to changes in Operating profit (m) 12,140 13,506 14,300 some imminent cost inflation factors our long-term assumptions for the such as labour costs. Its closest peer, Net profit (m) 8,667 9,800 10,297 spot/contract coal mix. Its valuation Core EPS (fully-diluted) 0.654 0.739 0.777 Yanzhou, has great earnings risk if looks appealing to us, trading below EPS change (%) (11.6) 13.1 5.1 labour costs rise more than expected; book, at a 12-month forward PER that Daiwa vs Cons. EPS (%) 0.3 7.6 3.7 PER (x) 9.2 8.2 7.8 hence we project a lower rise in is 56% below its past-5-year mean, operating costs (4% YoY) for China Dividend yield (%) 3.2 3.6 3.7 with an ROE of 11% over 2013-14E. DPS 0.190 0.215 0.226 Coal in 2013. China Coal‘s earnings PBR (x) 0.9 0.8 0.8 visibility is more straightforward with:  How we differ EV/EBITDA (x) 8.0 7.7 7.2 1) no margin erosion from overseas Our 2012-14E EPS are slightly higher ROE (%) 10.2 10.7 10.5 operations, 2) a cost structure that is than the consensus mean but much Source: FactSet, Daiwa forecasts

See important disclosures, including any required research certifications, beginning on page 69 China Thermal Coal Sector 19 November 2012

1 Buy (from Hold) How do we justify our view? 2 Outperform

3 Hold  Growth outlook

4 Underperform  Valuation

5 Sell  Earnings revisions

 Growth outlook  China Coal: net profit and YoY growth rates (2008-14E) We forecast China Coal‘s net profit to decline by 12% (CNYm) (% ) 12,000 40.0 YoY for 2012 as a result of a falling spot coal price and 10,297 9,802 9,800 the company‘s high sensitivity to coal price changes. 31.3 10,000 8,667 30.0 However, we expect its earnings to pick up again 7,131 7,409 7,466 starting from 2013, driven primarily by a coal price 8,000 18.5 20.0 13.1 recovery, and forecast growth of 13% YoY for 2013 and 6,000 10.0 3.9 5.1 5% YoY for 2014. 0.8 4,000 0.0 2,000 -11.6 -10.0 0 -20.0 2008 2009 2010 2011 2012E 2013E 2014E Net profit (LHS) YoY growth (RHS) Source: Company, Daiwa forecasts

 Valuation  China Coal: 12-month forward PER trend

The stock is trading currently at a PER of 8.0x based on (x ) our 2013 EPS forecast, substantially below its past-5- 50 year average 12-month forward PER of 14.2x, and not 45 much higher than its trough PER of 5.7x at the end of 40 2008. China Coal‘s 2013E PER also stands almost 1SD 35 30 below its past-five-year average. We believe its current 26.6 Avg+2SD valuation looks attractive in view of the favourable 25 20.4x Avg+1SD earnings-growth outlook we see for the company. 20 15 14.2x Avg 10 8.1x Avg-1SD 5 0 1.9x Avg-2SD Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: Bloomberg, Daiwa estimates

 Earnings revisions  China Coal: consensus EPS forecast revisions (2012-13E)

The 2012-13 Bloomberg-consensus EPS forecasts for (Rebased to 100) China Coal have been revised down by 24-33% YTD, 105 which we consider reasonable and believe can be 100 95 explained by the larger-than-expected decline in the 90 spot coal price. 85 80 75 70 65

60

12

12

12 12

12

12 12

12

12 12

12

-

-

- -

-

- -

- - -

-

Jul

Apr Oct

Jan Jun

Mar

Feb

Aug Sep Nov May 2012E 2013E Source: Bloomberg

- 49 - China Thermal Coal Sector 19 November 2012

Financial summary

 Key assumptions Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Coal production (m tonnes) n.a. n.a. 81 94 103 110 126 142 Coal sales (m tonnes) 85 89 97 117 135 142 157 173 Coal avg selling price (CNY/tonne) 310 421 421 476 532 518 526 530

 Profit and loss (CNYm) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Coal 26,362 37,352 40,909 55,839 71,741 73,642 82,837 91,464 Coke 3,738 6,653 3,590 4,888 5,274 4,497 4,459 4,596 Other Revenue 5,541 7,747 8,688 9,576 10,758 12,003 13,446 15,232 Total Revenue 35,641 51,753 53,187 70,303 87,773 90,142 100,742 111,291 Other income 0 0 0 0 0 0 0 0 COGS (26,483) (38,188) (41,156) (55,825) (69,466) (72,801) (81,581) (90,816) SG&A (2,251) (2,867) (2,936) (3,749) (4,574) (5,200) (5,655) (6,175) Other op.expenses 0 0 0 0 0 0 0 0 Operating profit 6,906 10,698 9,095 10,729 13,733 12,140 13,506 14,300 Net-interest inc./(exp.) (747) (1,006) 452 (109) (177) (554) (608) (711) Assoc/forex/extraord./others 2,197 806 768 379 486 691 691 691 Pre-tax profit 8,356 10,498 10,316 10,999 14,042 12,277 13,589 14,279 Tax (1,950) (2,494) (2,395) (2,848) (3,383) (2,958) (3,274) (3,440) Min. int./pref. div./others (386) (873) (511) (685) (857) (652) (516) (542) Net profit (reported) 6,020 7,131 7,409 7,466 9,802 8,667 9,800 10,297 Net profit (adjusted) 6,020 7,131 7,409 7,466 9,802 8,667 9,800 10,297 EPS (reported)(CNY) 0.513 0.543 0.559 0.563 0.739 0.654 0.739 0.777 EPS (adjusted)(CNY) 0.513 0.543 0.559 0.563 0.739 0.654 0.739 0.777 EPS (adjusted fully-diluted)(CNY) 0.513 0.543 0.559 0.563 0.739 0.654 0.739 0.777 DPS (CNY) 0.160 0.154 0.150 0.156 0.215 0.190 0.215 0.226 EBIT 6,906 10,698 9,095 10,729 13,733 12,140 13,506 14,300 EBITDA 6,906 10,698 9,095 10,729 13,733 12,140 13,506 14,300

 Cash flow (CNYm) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Profit before tax 8,356 10,498 10,316 10,999 14,042 12,277 13,589 14,279 Depreciation and amortisation 1,355 1,528 2,232 3,039 4,136 5,366 7,293 8,515 Tax paid (1,950) (2,494) (2,395) (2,848) (3,383) (2,958) (3,274) (3,440) Change in working capital (6,757) 1,400 2,629 (1,633) 6,082 (1,447) (656) (632) Other operational CF items (2,104) (23,395) 13,212 17,134 (7,612) (695) (823) (844) Cash flow from operations (1,100) (12,462) 25,993 26,691 13,265 12,543 16,131 17,878 Capex (11,082) (8,966) (24,891) (14,667) (28,069) (27,000) (21,000) (14,000) Net (acquisitions)/disposals (817) (492) (544) (1,980) (3,215) (500) (500) (500) Other investing CF items (242) (213) (377) (283) 1 0 0 0 Cash flow from investing (12,142) (9,671) (25,812) (16,929) (31,284) (27,500) (21,500) (14,500) Change in debt (721) 1,171 1,196 (138) 16,896 15,000 10,000 0 Net share issues/(repurchases) 0 25,320 0 53 0 0 0 0 Dividends paid (1,874) (2,044) (1,987) (2,073) (2,851) (2,521) (2,851) (2,995) Other financing CF items 1,890 1,296 5,350 2,690 1,930 652 516 542 Cash flow from financing (705) 25,743 4,559 532 15,975 13,131 7,665 (2,453) Forex effect/others 0 0 0 0 0 0 0 0 Change in cash (13,946) 3,610 4,740 10,294 (2,044) (1,826) 2,296 925 Free cash flow (12,182) (21,428) 1,102 12,024 (14,805) (14,457) (4,869) 3,878 Source: FactSet, Daiwa forecasts

- 50 - China Thermal Coal Sector 19 November 2012

Financial summary continued …

 Balance sheet (CNYm) As at 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Cash & short-term investment 10,666 37,393 37,286 30,041 35,347 33,563 36,166 37,392 Inventory 3,316 4,240 4,978 6,215 7,319 7,978 8,940 9,952 Accounts receivable 4,281 5,635 4,964 7,006 7,803 8,644 9,660 10,672 Other current assets 4,869 3,918 3,645 5,439 5,643 5,643 5,643 5,643 Total current assets 23,132 51,185 50,873 48,700 56,111 55,829 60,410 63,660 Fixed assets 22,003 29,010 38,121 46,418 60,224 81,858 95,565 101,050 Goodwill & intangibles 45 41 43 43 110 110 110 110 Other non-current assets 8,016 8,275 22,063 27,776 43,487 43,987 44,487 44,987 Total assets 53,195 88,512 111,100 122,936 159,933 181,784 200,572 209,808 Short-term debt 981 887 990 1,422 2,623 2,623 2,623 2,623 Accounts payable 4,651 6,814 6,801 9,254 10,917 10,970 12,293 13,685 Other current liabilities 4,728 5,292 7,728 8,715 15,239 15,239 15,239 15,239 Total current liabilities 10,360 12,993 15,519 19,391 28,779 28,832 30,155 31,547 Long-term debt 8,928 10,194 11,287 10,716 26,411 41,411 51,411 51,411 Other non-current liabilities 2,902 2,498 6,098 6,491 8,778 8,778 8,778 8,778 Total liabilities 22,190 25,685 32,904 36,598 63,968 79,022 90,345 91,736 Share capital 18,459 43,779 43,779 43,832 43,832 43,832 43,832 43,832 Reserves/R.E./others 9,591 14,798 24,816 30,216 37,913 44,058 51,007 58,309 Shareholders' equity 28,050 58,577 68,595 74,049 81,745 87,891 94,840 102,142 Minority interests 2,954 4,250 9,600 12,290 14,220 14,872 15,388 15,930 Total equity & liabilities 53,195 88,512 111,100 122,936 159,933 181,784 200,572 209,808 EV 80,675 55,924 62,033 69,850 80,154 97,090 104,503 103,319 Net debt/(cash) (757) (26,312) (25,010) (17,903) (6,313) 10,471 17,868 16,642 BVPS (CNY) 2.391 4.462 5.174 5.585 6.165 6.629 7.153 7.704

 Key ratios (%) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Sales (YoY) 17.9 45.2 2.8 32.2 24.9 2.7 11.8 10.5 EBITDA (YoY) 45.9 54.9 (15.0) 18.0 28.0 (11.6) 11.3 5.9 Operating profit (YoY) 45.9 54.9 (15.0) 18.0 28.0 (11.6) 11.3 5.9 Net profit (YoY) 89.8 18.5 3.9 0.8 31.3 (11.6) 13.1 5.1 Core EPS (fully-diluted) (YoY) 31.2 5.9 2.9 0.8 31.3 (11.6) 13.1 5.1 Gross-profit margin 25.7 26.2 22.6 20.6 20.9 19.2 19.0 18.4 EBITDA margin 19.4 20.7 17.1 15.3 15.6 13.5 13.4 12.8 Operating-profit margin 19.4 20.7 17.1 15.3 15.6 13.5 13.4 12.8 ROAE 24.3 16.5 11.7 10.5 12.6 10.2 10.7 10.5 ROAA 12.2 10.1 7.4 6.4 6.9 5.1 5.1 5.0 ROCE 18.6 18.6 11.1 11.4 12.3 8.9 8.7 8.5 ROIC 23.5 24.4 15.6 13.1 13.2 9.1 8.5 8.3 Net debt to equity n.a. n.a. n.a. n.a. n.a. 11.9 18.8 16.3 Effective tax rate 23.3 23.8 23.2 25.9 24.1 24.1 24.1 24.1 Accounts receivable (days) 36.0 35.0 36.4 31.1 30.8 33.3 33.2 33.3 Current ratio (x) 2.2 3.9 3.3 2.5 1.9 1.9 2.0 2.0 Net interest cover (x) 9.2 10.6 n.a. 98.5 77.7 21.9 22.2 20.1 Net dividend payout 31.2 28.4 26.8 27.8 29.1 29.1 29.1 29.1 Source: FactSet, Daiwa forecasts

 Company profile State-owned China Coal is a leading coal miner in China producing and selling mainly thermal coal. The company also manufactures coal mining equipment and offers coal mine design services.

- 51 - China Thermal Coal Sector 19 November 2012

 China Coal: gross margin trend and forecasts (%) 2011 2011 2012E 2013E 2014E Coal 22% 22% 20% 20% 19% Coking -1% 2% -2% 0% 0% Coal-mining equipment 19% 19% 19% 19% 19% Other businesses 7% 7% 7% 7% 7% Inter-segment deductions -19% -14% -3% 2% 1% Favourable odds in Total 21% 21% 19% 19% 18% Source: Company, Daiwa forecasts play In terms of coal sales, we forecast China Coal to record 14% YoY growth in self-produced commercial output for 2013 on the back of its planned opening of two new We upgrade our rating on China Coal to mines next year, Wangjialing and Hecaogou. We Buy (1) from Hold (3) forecast the company‘s total sales volume of commercial coal to increase by 11% YoY for 2013, as we believe the scope of its coal-trading business should be A pure thermal coal story in limited by its own organic output growth.

China  China coal: coal production and sales-volume trend (m tonnes) 2010 2011 2012E 2013E 2014E Among China‘s three listed coal companies, we believe Raw coal production 122.5 129.2 138.0 157.5 177.0 China Coal offers a much purer play on China‘s Commercial coal production 94.4 102.8 110.4 126.0 141.6 domestic market. A large part of Yanzhou‘s future Sales volume of commercial coal 117.3 134.7 142.3 157.5 172.7 Self-produced commercial coal 89.8 100.2 107.6 122.8 138.0 earnings growth is likely to come from its operations in Coke production volume 2.2 2.1 2.2 2.3 2.4 Australia. Shenhua does not have a big overseas Sales volume of coke 2.6 2.6 2.7 2.8 2.9 business but its business model of full vertical Source: Company, Daiwa forecasts integration also means that coal is only 74% of the group‘s NAV, based on our forecasts. China Coal runs  China Coal: coal sales volume trend non-coal businesses such as coal-mining equipment, (m tonnes) 2010 2011 2012E 2013E 2014E 1. Self-produced commercial coal 89.8 100.2 107.6 122.8 138.0 power plants and aluminium smelting. However, its (I) Thermal coal 88.7 99.3 106.6 121.7 136.8 coal-related business will represent close to 90% of its 1. Domestic sale 87.3 98.5 105.8 120.8 135.7 2012 gross profit based on our forecast, so the - Long-term contract 61.5 51.6 55.4 55.2 55.2 company‘s level of vertical integration is much smaller - Spot trading 25.8 47.0 50.0 65.1 80.0 than that of Shenhua. 2. Exports 1.4 0.7 0.8 0.9 1.0 (II) Coking coal 1.1 0.9 0.9 1.1 1.2 2. Proprietary coal trading - total 23.9 30.9 31.0 31.0 31.0  China Coal: revenue breakdown 3. Import and export agency - total 3.6 3.7 3.7 3.7 3.7 (CNYm) 2010 2011 2012E 2013E 2014E Total sales volume 117.3 134.7 142.3 157.5 172.7 Coal 55,839 71,708 73,642 83,376 92,715 Source: Company, Daiwa forecasts Coking 4,888 5,274 4,497 4,459 4,596 Coal-mining equipment 7,071 8,129 9,348 10,751 12,363  China Coal: coal price trend Other businesses 4,170 4,400 4,620 4,759 4,901

Inter-segment deductions -1,665 -1,738 -1,965 -2,063 -2,033 (CNY/tonne) 2,010 2,011 2012E 2013E 2014E Total 70,303 87,773 90,142 100,743 112,291 I. Self-produced commercial coal 456 500 496 508 513 Source: Company, Daiwa forecasts (I) Thermal coal 446 493 454 458 463 1. Domestic sale 443 490 451 455 460  China Coal: gross profit breakdown - Long-term contract 410 425 468 482 482 (CNYm) 2010 2011 2012E 2013E 2014E - Spot trading 521 562 517 522 527 Coal 12,560 16,126 14,775 16,544 17,937 2. Export 662 795 676 683 689 Coking -70 84 -90 0 0 (II) Coking coal 1,267 1,382 1,064 1,011 1,011 Coal-mining equipment 1,376 1,554 1,730 1,989 2,288 II. Proprietary coal trading - total 621 699 594 600 606 Other businesses 291 298 323 333 343 III. Import and export agency - total 13 15 14 14 14 Inter-segment deductions 321 245 49 -47 -18 Average coal price 476 532 518 526 530 Total 14,478 18,307 16,787 18,819 20,550 Source: Company, Daiwa forecasts Source: Company, Daiwa forecasts More exposure to seaborne prices We estimate that China Coal generates a much higher proportion of its coal sales at coastal ports (ie, exposed to the seaborne market) than Shenhua and Yanzhou, with more mine-mouth and direct arrivals. This also means that China Coal should be able to realise a higher coal price recovery on average than its peers in - 52 - China Thermal Coal Sector 19 November 2012

2013 given the much stronger supply forces (with  China Coal and Yanzhou: operating margin comparison easing inventory and imports declining from the high (% ) base in 1H12) in the seaborne market. 35 30 Solid market position in mining equipment 25 Accounting for close to 10% of its total revenue for 20 2012 on our forecasts, China Coal‘s coal-mining- 15 equipment division is the largest market player in the 10 PRC, ranking ahead of Zhengzhou Coal Mining Machinery, Tiandi, Sanyi, ERA Mining Machinery and 5 International Mining Machinery (IMM) (all not rated). 0 2010 2011 2012E 2013E 2014E Having recorded a sales CAGR of 23% for the past 5 China Coal Yanzhou years, we expect this business line to maintain mid- teens revenue growth with stable operating margin Source: Company, Daiwa forecasts growth over the next few years.  China Coal and Yanzhou: ROE comparison Given what we consider as the sustainable growth of (% ) this business, we forecast an increase in the share of 30 divisional sales to external customers (from 87% for 25

2012E to 90% by 2014E). Also, China Coal has 20 promising prospects overseas, in our view, with previous sales made to Russia, Vietnam and India in 15 recent years. 10

5  Sales of major Chinese coal-mining-equipment makers 0 (CNYbn) 2010 2011 2012E 2013E 2014E 10 China Coal Yanzhou

8 Source: Company, Daiwa forecasts

6 Acquired by Caterpillar Acquired by in Nov 2011 Joy Global 4 in Jul 2011 Positive cost surprise in 3Q12 2 For 3Q12, China Coal reported a surprise drop in its 0 unit production cost (excluding transportation costs) of China Coal ZMJ Tiandi SANYI ERA IMM (1898 HK) (601717 CH) (600582 CH) (631 HK) (8043 HK) (1683 HK) 22% QoQ under PRC GAAP. Management‘s official 2010 2011 explanation was strengthened cost management. Looking at the historical trend, however, the unit cost Source: Companies tends to fluctuate with weak seasonal patterns, but over the past few years it has tended to peak in the fourth Crossing swords with Yanzhou quarter of the year, with an average cost increase of 26% QoQ. Even if we assume a large QoQ unit cost hike A few years ago, it would have been far-fetched to think in 4Q12, we still believe that the company‘s overall unit that China Coal could one day surpass Yanzhou in cost increase for 2012 should be manageable, at around terms of profitability. However, this has now 6% YoY. materialised, with Yanzhou‘s profitability dragged down since mid-2012 by its less profitable expansion in China and Australia. We expect China Coal to beat Yanzhou in terms of both operating margins and ROE starting in 2012 despite falling slightly behind in gross margins onwards of 2012.

- 53 - China Thermal Coal Sector 19 November 2012

 China Coal: quarterly unit selling cost trend (CNY/tonne) More upside from possible 290 contract-spot price convergence 270 250 As discussed in the industry section of this report, the 230 PRC Government has initiated talks with China‘s power 210 and coal producers to converge spot prices with 190 contract prices for coal. Although we see a full convergence as unlikely this year, any linkage between 170 spot and contract pricing should be positive for coal 150 1Q 2Q 3Q 4Q producers exposed to the seaborne market, especially 2009 2010 2011 2012 China Coal, whose average contract price is lower than its spot price. Source: Company, calculated by Daiwa As we expect the spot coal price to remain at a  China Coal: quarterly gross margin trend premium to the contract price for the rest of this year (CNY/tonne) and in 2013, we project the contract sales proportion of 45 China Coal and Shenhua‘s total coal sales volume to 43 decline further going forward. We forecast a 3% YoY 41 39 increase in the contract coal price for 2012, as contract 37 coal prices are currently at a discount to average spot 35 coal prices for the major coal producers. However, any 33 move towards more market-based conversion could 31 29 benefit the listed coal producers in our coverage much 27 more, as the gap is generally larger than 3%. 25 1Q 2Q 3Q 4Q We have excluded Yanzhou from this illustration, as 2009 2010 2011 2012 the company sells most of its coal in China in the spot Source: Company market. Based on the disclosed prices and our forecasts (for 2012), Shenhua seems to have a much bigger gap Less exposure to labour and policy risks vs. between its average spot and contract prices than peers China Coal. The difference between Shenhua and China As discussed in the industry section of this sector Coal‘s average contract prices results from Shenhua‘s report, China Coal has much smaller exposure to larger contract sales via direct arrivals and mine-mouth labour costs and resources taxes than its peers. sales, and only about 46% (2011) to the seaborne market. Seaborne prices are generally higher due to  Total unit cost sensitivity to changes in cost items higher transportation costs. However, looking at the Sensitivity Shenhua China Coal Yangzhou different channels, Shenhua still sells contract coal at a 10% change in raw-material costs 0.6% 2.3% 1.8% big discount to China Coal, especially for direct arrivals 10% change in labour costs 0.9% 0.9% 3.4% and the seaborne market. 10% change in transportation costs 4.2% 2.6% 0.8% Resources tax (at 5% scenario) 5% 5% 8%  Contract-spot prices of major coal producers Source: Daiwa estimates 2008 2009 2010 2011 2012E Shenhua  2013E EPS sensitivity to change in costs Spot 438 421 457 508 456 Company 1% increase in costs Contract 336 362 362 338 355 Shenhua 1.2% Difference 30% 16% 26% 50% 28% China Coal 3.8% China Coal Yanzhou 10.0% Spot 612 417 521 562 517 Source: Daiwa estimates Contract 365 402 410 425 468 Difference 68% 4% 27% 32% 11%

Source: Companies, Daiwa forecasts

- 54 - China Thermal Coal Sector 19 November 2012

 Shenhua: contract/spot price breakdown by delivery (CNY/t) EPS forecast for China Coal of 5.7%. Lastly, Shenhua‘s Spot 2007 2008 2009 2010 2011 9M12 9M12 prices suggest a premium of mine-mouth Total 265 438 421 457 508 472 contract prices over spot prices, which could be a Mine mouth 102 163 178 142 171 138 Direct arrival (rail) 289 387 401 406 473 416 potential risk when convergence takes place. On the Seaborne 399 614 473 590 630 568 positive side, most of China Coal‘s sales go to the Contract seaborne market, reducing such risks. Total 311 336 362 362 338 349 Mine mouth 0 79 105 163 162 184  China Coal: contract/spot sales volume split Direct arrival (rail) 229 261 278 263 251 253 (m tonnes) 2006 2007 2008 2009 2010 2011 2012E 2013E 2014E Seaborne 360 409 441 462 451 481 Total 44.8 59.4 65.6 76.2 87.3 98.5 105.8 120.8 135.7 Difference Contract 38.9 52.2 54.8 55.6 61.5 51.6 55.4 55.2 55.2 Total -15% 30% 16% 26% 50% 35% Spot 5.9 7.2 10.8 20.6 25.8 47.0 50.0 65.1 80.0 Mine mouth - 106% 70% -13% 5% -25% Breakdown Direct arrival (rail) 26% 48% 44% 55% 88% 64% Total 100% 100% 100% 100% 100% 100% 100% 100% 100% Seaborne 11% 50% 7% 28% 40% 18% Contract 87% 88% 84% 73% 70% 52% 52% 46% 41% Source: Company Spot 13% 12% 16% 27% 30% 48% 47% 54% 59%

Source: Company, Daiwa forecasts China Coal‘s earnings are the most sensitive of the three coal producers to changes in contract coal prices.  Realised changes in coal prices (YoY) We calculate that every 1% increase in the contract Shenhua 2008 2009 2010 2011 price on top of our 3% assumption would lead to about Spot -4% 9% 11% -10% a 2% boost to our 2013 EPS forecast. Contract 8% 0% -7% 5% China Coal Spot -32% 25% 8% -8%  2013E EPS sensitivity to changes in thermal coal prices (%) Contract 10% 2% 4% 10% Every 1% increase in: Contract price Spot price Source: Company Shenhua +0.3 +0.9 China Coal +1.9 +2.5 Yanzhou +0.7 +9.4 Source: Daiwa forecasts Valuation looks attractive Note: Yanzhou’s spot coal includes both China and Australian coal prices Given the company‘s slightly better-than-expected Key risk would be a flat contract price operations for 3Q12 and following a transfer of As discussed in further detail earlier in this report, any coverage, we are making modest revisions to our 2012- reform of the coal price mechanism is still under 14 earnings forecasts for China Coal. The stock is now discussion and there are still various uncertainties trading significantly below its past-5-year averages in going into the year-end negotiations. If the contract terms of both forward PER and PBR. We are raising price is not allowed to change for 2013 in the way that our DCF-based six-month target price from to happened in 2011, we would see downside to our HKD9.00 (from HKD7.00), reflecting mainly a lower- earnings forecasts for 2013, especially for China Coal. than-expected unit cost for 3Q12 and our assumption of a gradual long-term shift towards more spot coal  2013E EPS downside in case of no change in contract price sales, implying higher long-term average selling prices % EPS downside than our previous forecasts. Shenhua -0.9 China Coal -5.7  China Coal: 12-month forward PER trend Yanzhou -2.1 (x ) Source: Daiwa forecasts 50 In this case, a natural counter-strategy for China Coal 45 would be to sell more in the spot market. In our current 40 forecasts, we already assume a slow shift into more 35 30 spot coal. In 2011, the frozen contract price led to a YoY 26.6 Avg+2SD 25 decline in China Coal‘s contract coal sales. Compared 20 20.4x Avg+1SD with Shenhua‘s much larger output (and perhaps more 15 14.2x Avg social responsibility for contract coal), we believe that 10 8.1x Avg-1SD China Coal has historically been more flexible to take 5 advantage of price differences in different cycles, and 0 1.9x Avg-2SD that compared with Shenhua the growth rate of its Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 realised contract price has been larger. In the event of Source: Bloomberg, Daiwa forecasts no change in the contract price in 2013, we calculate that there would be downside potential to our 2013

- 55 - China Thermal Coal Sector 19 November 2012

 China Coal: 12-month forward PBR trend  China Coal: 12-month forward EV/reserve trend (x ) (x ) 6.0 5.0 4.5 5.0 4.0 4.0 3.5 3.4x Avg+2SD 3.5x Avg+2SD 3.0 2.7x Avg+1SD 3.0 2.5 2.6x Avg+1SD 2.0 1.9x Avg 2.0 1.7x Avg 1.5 1.2x Avg-1SD 1.0 1.0 0.8x Avg-1SD 0.5 0.4x Avg-2SD 0.0 0.0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

Source: Bloomberg, Daiwa forecasts Source: Bloomberg, Daiwa forecasts

 China Coal: DCF valuation (in CNYm) 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E Risk-free rate 3.5% Market risk premium 6.0% Beta 1.0

Cost of equity 9.5% Cost of debt 6.5%

% of equity capital 80% % of debt capital 20%

WACC 8.9% Growth 2.0%

EBIT (1-t) 9,216 10,252 10,855 12,831 13,543 14,102 14,663 14,708 14,756 Plus deprecation 5,366 7,293 8,515 9,003 9,270 9,335 9,395 9,449 9,498 Change in working capital (1,447) (656) (632) (924) (380) (304) (306) (48) (50) Less interest (554) (608) (711) (711) (711) (612) (359) (52) 256 Capital expenditure + investments (27,000) (21,000) (14,000) (12,000) (10,000) (10,000) (10,000) (10,000) (10,000) Free cash flow (14,420) (4,718) 4,026 8,199 11,722 12,521 13,392 14,057 14,460 Discounted FCF (14,420) (4,332) 3,395 6,349 8,335 8,175 8,030 7,739 7,310 Terminal 71% 108,065 Firm value 153,066 Less: net debt 17,868 Equity value 135,197 Less: minority interests 15,388 Shareholders’ equity 119,810 No. of shares (m) 13,259 Target price (HKD) 9.0 Source: Daiwa estimates and forecasts

- 56 -

Energy / China 1171 HK Energy / China 19 November 2012

Yanzhou Coal Mining

Yanzhou Coal Mining Target (HKD): 12.60 g 11.30 Upside: 0.4% 1171 HK 19 Nov price (HKD): 11.26

Value-destructive expansion 1 Buy  Yanzhou‘s aggressive expansion strategy is coming at the 2 Outperform expense of rapidly eroding margins and a depressed ROE 3 Hold (unchanged)  Despite high earnings sensitivity to spot-coal prices, risk-reward 4 Underperform profile looks unfavourable given considerable cost pressure 5 Sell

 The stock is much more expensive than its peers on a PER basis; reiterate Hold (3) rating

How do we justify our view?

prices, as well as potential consensus as we are less optimistic compensation to shareholders of about the Australia operation. Also, Yancoal Australia by the end of the consensus forecasts may not 2013. We now forecast Yanzhou‘s fully reflect Yanzhou‘s 3Q12 net loss.

overall gross margin to fall from Forecast revisions (%) Dave Dai, CFA 40% for 2011 to 18% for 2014 (32% Year to 31 Dec 12E 13E 14E (852) 2848 4068 previously) and a compound annual Revenue change 7.0 12.4 13.2 [email protected] decline in EPS of 20% for 2012-14 (a Net profit change (20.2) (53.1) (58.9) Core EPS (FD) change (20.0) (53.0) (58.8) 12% increase previously). Gary Zhou Source: Daiwa forecasts (852) 2773 8535 The company‘s earnings are the [email protected] Share price performance most sensitive among its peers to changes in spot-coal prices, as we (HKD) (%) estimate there would be 9% upside 20 100  What's new 18 88 We continue to see few catalysts for to 2013 EPS for every 1% rise in the 15 75 the stock following Yanzhou‘s spot price. However, Yanzhou‘s 13 63 disappointing 3Q12 results. Our earnings sensitivity to changes in 10 50 forecasts now incorporate the newly unit production costs is also high, at Nov-11 Feb-12 May-12 Aug-12 10%, with large exposure to labour Yzhou Coal (LHS) Relative to HSI (RHS) acquired Gloucester (GCL) of Australia. This report marks the costs and resource taxes. We are transfer of coverage to Dave Dai. cutting our 2012-14 EPS forecasts by 12-month range 10.32-20.60 20-59% due to the worse-than- Market cap (USDbn) 7.14  What's the impact expected 3Q12 results and 3m avg daily turnover (USDm) 43.87 continuing cost pressures. Shares outstanding (m) 4,918 Yanzhou once had the best gross Major shareholder Yankuang Group (52.9%) margin in the sector, supported by  What we recommend the profitability of its Shandong Financial summary (CNY) operations. However, this is no We are lowering our DCF-based six- Year to 31 Dec 12E 13E 14E longer the case given its aggressive month target price to HKD11.30. Revenue (m) 52,427 60,044 65,216 expansion into low-margin mines in The stock‘s valuation now appears Operating profit (m) 5,925 4,658 4,429 China and Australia. stretched, with the 2013E PER near Net profit (m) 5,137 3,513 3,299 its past-five-year mean. The main Core EPS (fully-diluted) 1.047 0.716 0.672 EPS change (%) (42.5) (31.6) (6.1) While the merger of GCL with risks to our call would be stronger- Daiwa vs Cons. EPS (%) (12.6) (33.3) (43.3) Yanzhou‘s 78%-owned Australian than-expected coal-price rises and PER (x) 8.6 12.6 13.5 subsidiary, Yancoal Australia (Not lower-than-expected cost increases. Dividend yield (%) 3.6 2.0 1.9 DPS 0.329 0.179 0.168 rated), offers wider access to port  How we differ PBR (x) 1.0 0.9 0.9 throughput, the coal-mine assets EV/EBITDA (x) 11.2 15.0 16.0 could burden the overall Australia Our 2012-14 EPS forecasts are 13- ROE (%) 11.6 7.4 6.6 business with high costs and low 43% below those of the Bloomberg Source: FactSet, Daiwa forecasts

See important disclosures, including any required research certifications, beginning on page 69 China Thermal Coal Sector 19 November 2012

1 Buy How do we justify our view? 2 Outperform

3 Hold (unchanged)  Growth outlook

4 Underperform  Valuation

5 Sell  Earnings revisions

 Growth outlook  Yanzhou: profitability

We forecast Yanzhou‘s gross margin to fall from 40% for (%) 2011 to a range of 18-25% over 2012-14, due to rapid 50 44 cost hikes, especially for the company‘s Australia 40 40 business. Meanwhile, we forecast Yanzhou‘s EBIT 29 27 margin to fall from 26% in 2011 to 7-11% over 2012-14 30 26 25 and its net margin to fall from 19% in 2011 to 5-10% 19 20 18 over 2012-14. 20 11 10 8 10 6 7 5

0 2010A 2011A 2012E 2013E 2014E Gross margin EBIT margin Net margin

Source: Company, Daiwa forecasts

 Valuation  Yanzhou: forward PER history

The stock is trading currently at a PER of 12.6x on our (x) 2013 EPS forecast, in line with its past-five-year average 35

12-month forward PER of 12.6x. We believe it is not 30 attractive at this level given the company‘s deteriorating 26.7x Avg+2SD earnings outlook. 25 20 19.6x Avg+1SD

15 12.6x Avg 10

5 5.5x Avg-1SD

0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: Company, Daiwa forecasts

 Earnings revisions  Yanzhou: consensus EPS-forecast revisions (2012-14E)

The 2012-13 Bloomberg-consensus EPS forecasts for (Rebased to 100) Yanzhou have been cut sharply YTD, by 38-49%. The 110 latest large revisions were seen after the company‘s 100 3Q12 net loss. 90 80 70 60 50

40

12

12 12 12

12

12 12

12 12

12

12

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- - -

-

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-

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Jul

Apr

Oct

Jan Jun

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Aug Sep Nov May 2012E 2013E

Source: Bloomberg, Daiwa

- 58 - China Thermal Coal Sector 19 November 2012

Financial summary

 Key assumptions Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Coal production (m tonnes) 33 34 34 46 51 57 68 78 Coal sales (m tonnes) 35 38 38 50 64 81 94 104 Coal avg selling price (CNY/t) 409 640 529 663 708 638 658 654

 Profit and loss (CNYm) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Coal mining 14,907 24,933 19,948 32,591 45,181 50,484 57,972 63,049 Railway transportation 204 256 267 513 477 477 501 501 Other Revenue 0 98 462 840 1,408 1,466 1,571 1,666 Total Revenue 15,110 25,287 20,677 33,944 47,066 52,427 60,044 65,216 Other income 0 0 0 0 0 0 0 0 COGS (7,882) (12,836) (11,547) (18,887) (28,280) (39,487) (48,311) (53,573) SG&A (2,855) (3,832) (3,820) (5,094) (6,570) (7,016) (7,074) (7,213) Other op.expenses 0 0 0 0 0 0 0 0 Operating profit 4,374 8,619 5,310 9,964 12,216 5,925 4,658 4,429 Net-interest inc./(exp.) (27) (38) (45) (603) (839) (1,153) (1,235) (1,267) Assoc/forex/extraord./others 196 284 421 3,117 1,145 1,988 1,379 1,347 Pre-tax profit 4,543 8,865 5,686 12,477 12,521 6,760 4,802 4,510 Tax (1,316) (2,386) (1,553) (3,171) (3,545) (1,352) (1,105) (1,037) Min. int./pref. div./others 3 9 (15) (25) (48) (270) (185) (174) Net profit (reported) 3,230 6,489 4,117 9,281 8,928 5,137 3,513 3,299 Net profit (adjusted) 3,230 6,489 4,117 9,281 8,928 5,137 3,513 3,299 EPS (reported)(CNY) 0.660 1.320 0.840 1.890 1.820 1.047 0.716 0.672 EPS (adjusted)(CNY) 0.660 1.320 0.840 1.890 1.820 1.047 0.716 0.672 EPS (adjusted fully-diluted)(CNY) 0.660 1.320 0.840 1.890 1.820 1.047 0.716 0.672 DPS (CNY) 0.170 0.400 0.250 0.590 0.570 0.329 0.179 0.168 EBIT 4,374 8,619 5,310 9,964 12,216 5,925 4,658 4,429 EBITDA 4,374 8,619 5,310 9,964 12,216 5,925 4,658 4,429

 Cash flow (CNYm) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Profit before tax 4,543 8,865 5,686 12,477 12,521 6,760 4,802 4,510 Depreciation and amortisation 1,253 1,176 1,838 2,777 2,987 3,848 4,636 5,244 Tax paid (1,316) (2,386) (1,553) (3,171) (3,545) (1,352) (1,105) (1,037) Change in working capital (35) (47) 1,028 (6,342) 7,697 (496) (918) (645) Other operational CF items 1,430 2,902 1,850 5,670 4,343 2,134 2,449 2,645 Cash flow from operations 5,876 10,511 8,848 11,412 24,003 10,894 9,864 10,716 Capex (2,689) (2,485) (25,399) (4,432) (21,628) (11,000) (10,000) (8,000) Net (acquisitions)/disposals (898) 67 (111) (134) (628) (55) (105) (105) Other investing CF items (313) 270 (155) 71 (148) 0 0 0 Cash flow from investing (3,900) (2,148) (25,665) (4,496) (22,404) (11,055) (10,105) (8,105) Change in debt (58) (80) 22,251 506 11,439 3,131 2,000 0 Net share issues/(repurchases) 52 (0) 0 0 0 0 0 0 Dividends paid (836) (1,967) (1,230) (2,902) (2,803) (1,613) (878) (825) Other financing CF items (14) (49) (208) (3,979) 1,597 0 0 0 Cash flow from financing (857) (2,097) 20,813 (6,375) 10,232 1,518 1,122 (825) Forex effect/others 0 0 0 0 0 0 0 0 Change in cash 1,119 6,266 3,996 541 11,831 1,356 881 1,786 Free cash flow 3,187 8,026 (16,551) 6,979 2,374 (106) (136) 2,716 Source: FactSet, Daiwa forecasts

- 59 - China Thermal Coal Sector 19 November 2012

Financial summary continued …

 Balance sheet (CNYm) As at 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Cash & short-term investment 5,731 9,612 12,054 9,424 17,710 16,932 15,364 14,505 Inventory 440 820 886 1,646 1,391 1,943 2,377 2,636 Accounts receivable 2,753 2,977 4,724 10,017 7,312 8,145 9,328 10,132 Other current assets 984 1,586 2,337 3,194 4,018 4,018 4,018 4,018 Total current assets 9,908 14,994 20,001 24,281 30,431 31,038 31,087 31,291 Fixed assets 13,525 14,149 18,877 19,875 31,274 39,146 45,232 48,709 Goodwill & intangibles 655 1,338 20,172 20,830 28,072 27,351 26,630 25,909 Other non-current assets 2,100 1,856 3,382 7,770 7,375 7,430 7,535 7,640 Total assets 26,187 32,339 62,433 72,756 97,152 104,965 110,484 113,548 Short-term debt 72 82 1,604 621 19,592 19,592 19,592 19,592 Accounts payable 658 910 1,367 1,554 2,241 3,129 3,828 4,245 Other current liabilities 3,370 4,305 7,439 7,958 12,889 12,889 12,889 12,889 Total current liabilities 4,099 5,297 10,410 10,134 34,721 35,609 36,309 36,726 Long-term debt 258 176 20,912 22,401 14,869 18,000 20,000 20,000 Other non-current liabilities 341 49 1,856 2,783 4,236 4,236 4,236 4,236 Total liabilities 4,699 5,522 33,178 35,317 53,827 57,845 60,544 60,961 Share capital 4,918 4,918 4,918 4,918 4,918 4,918 4,918 4,918 Reserves/R.E./others 16,499 21,837 24,233 32,413 37,716 41,240 43,875 46,349 Shareholders' equity 21,418 26,755 29,152 37,332 42,634 46,159 48,793 51,267 Minority interests 71 61 102 107 691 961 1,146 1,319 Total equity & liabilities 26,187 32,339 62,433 72,756 97,152 104,965 110,484 113,548 EV 39,219 35,256 55,113 58,253 61,991 66,169 69,922 70,954 Net debt/(cash) (5,401) (9,354) 10,462 13,598 16,751 20,660 24,228 25,086 BVPS (CNY) 4.355 5.440 5.927 7.590 8.668 9.385 9.921 10.424

 Key ratios (%) Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E Sales (YoY) 16.7 67.4 (18.2) 64.2 38.7 11.4 14.5 8.6 EBITDA (YoY) 21.9 97.1 (38.4) 87.6 22.6 (51.5) (21.4) (4.9) Operating profit (YoY) 21.9 97.1 (38.4) 87.6 22.6 (51.5) (21.4) (4.9) Net profit (YoY) 36.1 100.9 (36.5) 125.4 (3.8) (42.5) (31.6) (6.1) Core EPS (fully-diluted) (YoY) 37.5 100.0 (36.4) 125.0 (3.7) (42.5) (31.6) (6.1) Gross-profit margin 47.8 49.2 44.2 44.4 39.9 24.7 19.5 17.9 EBITDA margin 28.9 34.1 25.7 29.4 26.0 11.3 7.8 6.8 Operating-profit margin 28.9 34.1 25.7 29.4 26.0 11.3 7.8 6.8 ROAE 16.0 26.9 14.7 27.9 22.3 11.6 7.4 6.6 ROAA 13.0 22.2 8.7 13.7 10.5 5.1 3.3 2.9 ROCE 21.2 35.3 13.5 17.8 17.7 7.3 5.3 4.9 ROIC 21.1 37.6 13.5 16.4 15.8 7.4 5.1 4.5 Net debt to equity n.a. n.a. 35.9 36.4 39.3 44.8 49.7 48.9 Effective tax rate 29.0 26.9 27.3 25.4 28.3 20.0 23.0 23.0 Accounts receivable (days) 60.0 41.4 68.0 79.3 67.2 53.8 53.1 54.5 Current ratio (x) 2.4 2.8 1.9 2.4 0.9 0.9 0.9 0.9 Net interest cover (x) 160.7 224.7 117.7 16.5 14.6 5.1 3.8 3.5 Net dividend payout 25.8 30.3 29.8 31.2 31.3 31.4 25.0 25.0 Source: FactSet, Daiwa forecasts

 Company profile Yanzhou Coal is a leading state-owned coal miner with its primary assets in China and Australia. The company also processes coal into chemicals.

- 60 - China Thermal Coal Sector 19 November 2012

Port Waratah Coal Services (PWCS), to support its current production and planned production-growth activity. In Queensland, through its near 50% ownership in Middlemount Coal, GCL has port allocation at Abbot Point Coal Terminal (APCT) and (until 2014) Dalrymple Bay Coal Terminal (DBCT), and Value-destructive through Middlemount Coal‘s interests in the North Queensland Coal Terminal Pty Ltd (NQCT) is seeking expansion additional allocation of up to 1m tpa (on a 100% basis) at APCT. Reiterate Hold rating  GCL: asset locations

Australia business a drag

Although Yanzhou made impressive overseas acquisitions in the past, the recent operational environment in Australia and the newly added GCL assets (the merger was finalised in June this year) have, in our view, put significant pressure on the company‘s overall profitability.

 Yancoal Australia: share price vs. local index and other Australia materials stocks

(Rebased to 100) 140 130 120 110 100 90 80 70 60 50 28-Jun-12 19-Jul-12 9-Aug-12 30-Aug-12 20-Sep-12 Yancoal Australia BHP Rio Tinto Source: GCL Anglo American Xstrata Glencore ASX Index Rationale behind the merger Source: Bloomberg According to Yancoal Australia (Not rated), the merger GCL is an Australian entity involved in coal production, with GCL provides a business-growth plan supported exploration, and mining operations in the Gloucester by large and diversified coal-reserve and coal-resource Basin and Hunter Valley in New South Wales and in bases of 697m tonnes and 3.5bn tonnes, respectively the Bowen Basin, Queensland. The company produces (on an equity basis). The merged entity has substantial metallurgical and thermal coal for export, with two port and rail capacity and allocations in place to open-cut operational mines in the Gloucester Basin support the production-growth plans of the combined (Stratford and Duralie) and Donaldson Coal in the operations. It also has substantial New South Wales Hunter Valley, which consists of two underground port allocations, with a 27% interest in NCIG and mines (Tasman and Abel), and one open-cut mine significant PWCS capacity allocations. Combined New (Donaldson). In Queensland, GCL has joint control and South Wales port capacity is about 18.6m tpa for 2012 holds a near 50% interest in the Middlemount Coal and should increase to about 27.2m tpa in 2016. open-cut mine located in the Bowen Basin. We believe opportunities exist for Yancoal Australia to The company has large coal-reserve and resources leverage on future projects to utilise excess New South bases, with reserves of 293m tonnes and resources of Wales port capacity. The merged company also has 1.8bn tonnes (on an equity basis). In New South Wales, port capacity in Queensland at APCT, DBCT (until GCL has an 11.6% interest in Newcastle Coal 2014), and at RG Tanna and Wiggins Island (capacity Infrastructure Group (NCIG) and port allocations at allocation only) to support production from Middlemount mine and Yarrabee mine. - 61 - China Thermal Coal Sector 19 November 2012

But at what cost...  Yancoal Australia: financials AUDm 1H11 1H12 The following shows the pro-forma projections based Revenue 743 601 on the listing document. It appears that GCL in FY11 Other income 154 235 could generate a positive net profit of AUD27m and Change in inventories -41 -42 Yancoal AUD288m. Raw materials -86 -87 Employee benefits expenses -77 -96  Pro-forma financials of the Yancoal Australia and GCL (FY11) Depreciation -60 -66 Transportation -80 -79 AUDm GCL Yancoal Combined Contractual services -81 -116 Current assets 244 1,385 914 Government royalty -52 -42 Non-current assets 2,179 3,973 7,166 Changes in overburden 5 6 Total assets 2,423 5,357 8,080 Transaction costs 0 -45 Current liabilities 867 1,175 1,043 Other expenses -27 -27 Non-current liabilities 871 2,420 4,653 Finance costs -36 -19 Total liabilities 1,738 3,595 5,696 Profit before tax 361 223 Total equity 684 1,763 2,384 Income tax -108 192 Revenue 396 1,462 1,858 EBITDA 85 602 687 Net profit 254 414 EBIT 48 475 523 Revenue adjusted for one-off items 714 587 Profit before tax 35 420 - Profit before tax adjusted for one-off items 181 -24 Net profit 27 288 - Source: Company Source: Yancoal Australia The MRRT is a tax on 30% of the ‗super profits‘ However, GCL recorded a loss for the period from July (defined as assessable receipts minus deductible to December 2011. The company explained that the expenditure including an MRRT allowance) from first quarter of the period saw a gradual softening of mining of iron ore and coal in Australia. Effective from overseas demand for export coal, in particular 1 July 2012, we expect the MRRT to increase the tax metallurgical coal. The situation deteriorated in the burden on Yancoal Australia. second quarter. Coal prices during the period were volatile, more so in the metallurgical coal market. Future deductible expenditure includes a starting base Thermal coal prices were subdued at times. However, allowance to be based on the value of the mining assets movements in prices, in most cases, coincided with as at 1 May 2010 plus capital expenditure to 30 June changes in the value of the Australia Dollar. 2012, depreciated over the life of the mines. Projects Movements in metallurgical coal prices were more are also eligible for the 25% extraction allowance that aligned with slowing of product demand from overseas reduces the effective statutory tax rate to 22.5% of the users and general global economic conditions, affecting super profits. State royalties are creditable for MRRT non-premium coking-coal products and low-volatile purposes, and MRRT payments are deductible for pulverised coal injection products in particular. company income-tax purposes.

 GCL: financial information Cost burden from carbon tax from July AUDm 6 months to Dec 2011 12 months to June 2011 2012 Revenue 227 307 EBITDAT 35 90 Another future increase in costs for the whole Australia Depreciation and amortisation -26 -19 business is associated with the carbon-tax scheme EBITT 9 72 there. The Government‘s Clean Energy Bills contain a Transaction cost -41 -9 EBIT -33 62 mechanism for pricing carbon emissions and came into Finance cost -24 14 effect on 1 July 2012. The carbon-pricing mechanism Profit before tax -57 77 affects an entity differently depending on whether it is Income tax 20 -22 directly liable under the scheme (liable entity) or is Net profit -37 55 indirectly affected (eg, by purchasing goods from a Source: GCL liable entity). Before the merger with GCL, in 1H12, Yancoal Australia‘s profitability deteriorated, with recurring In the utilities industry, there was a listed player, CLP earnings declining substantially. One-off items (2 HK, HKD66.2, Hold [3]), that was directly affected included in 1H12 were: 1) foreign-currency gains of by the scheme as a local user. In 2011, the company AUD14m grouped as part of revenue, 2) foreign- booked a HKD1.9bn provision after assessing the currency gains of AUD15m grouped as part of other impact of the scheme. For coal mines, the carbon tax is income, 3) an acquisition gain of AUD218m, and 4) a charged on fugitive greenhouse gas emissions. positive tax charge of AUD192m. The tax charge is related to the Minerals Resource Rent Tax (MRRT). - 62 - China Thermal Coal Sector 19 November 2012

According to KPMG, the government estimates that a carbon price of AUD23 would translate into about Deteriorating operations AUD1.4/tonne for ‗average non-gassy mines‘ but could rise to AUD7.4/tonne for ‗average gassy mines‘ and We expect Yanzhou to increase its coal sales over the AUD25 for ‗coal for the gassiest‘ mines. To alleviate next few years in three areas: 1) in China (mostly from such cost pressure, an assistance package of AUD1.3bn new mines in Heze City (Shandong Province) and over six years is available for existing but not new Ordos City (Inner Mongolia), 2) in Australia (largely mines. from GCL), and 3) coal trading. The above changes in the sales mix will have a negative impact on overall Most industry experts believe that 18 mines in New profitability as: 1) Yanzhou‘s Shandong operations are South Wales and seven in Queensland will be eligible. the most profitable (a gross margin of close to 50%) but These mines must have a fugitive emissions intensity of capacity is not growing any longer, 2) GCL is likely to 0.1 tonne of CO2-e per tonne of saleable coal, based on see a negative gross margin based on our price and cost 2008-09 data. Assistance will be provided on up to forecasts, and 3) externally purchased coal should 80% of the fugitive emission above 0.1 tonne of CO2-e remain a business on which margins are thin. We per tonne of saleable coal. This assistance will be forecast the overall unit cost of sales to rise by 6% (or capped based on the higher of the 2007-08 or 2008-09 7% for its China operations) YoY for 2013 (higher than production levels. This means that most of Yanzhou‘s for its peers), driven by both changes in locations and mines in Australia are not eligible for assistance under the sensitivity of the company‘s to rising labour costs. the scheme based on the years of production. Open-cut mines should have less fugitive emissions than  Yanzhou: coal sales mix underground mines and Yanzhou seems to have a ’000 tonnes 2010 2011 2012E 2013E 2014E China (self-produced) 36,234 40,882 43,602 48,438 55,025 balanced portfolio between the two in Australia. Australia (self-produced) 8,022 10,060 13,795 19,470 23,053 External purchase 5,378 13,308 23,954 26,350 26,350  Operational years of Yanzhou’s Australian mines Source: Company, Daiwa forecasts GCL Operation Type Duralie Mar-03 Open cut  Yanzhou: coal sales mix Stradford Since 1995 Open cut ’000 tonnes 2010 2011 2012E 2013E 2014E Abel Feasibility Open-cut/underground 1. Total for the Company 33,657 33,276 33,276 33,276 33,276 Tasman Feasibility Open-cut/underground 2. Shanxi Neng Hua 1,498 1,223 1,285 1,285 1,285 Donaldson To cease in 2013 3. Heze Neng Hua 1,079 2,004 2,338 2,672 3,006 Middlemount Nov-11 Open cut 4. Ordos Neng Hua 0 4,379 6,703 11,205 17,458 Monash Exploration Underground 5. Yancoal Australia 8,022 10,060 12,021 13,780 15,466 Yancoal Operation Type 6. External 5,378 13,308 23,954 26,350 26,350 Austra >60 years ago Underground 7. GCL - - 1,774 5,690 7,586 Yarrabee Since 1994 Open-cut/underground Total 49,634 64,250 81,352 94,258 104,428 Ashton Early 2011 Open-cut/underground Source: Company, Daiwa forecasts Moolarben May-10 Open cut Cambry Down Late 2010 Open cut Westfarm Premier Late 2011 Open cut  Yanzhou: coal selling-price forecasts CNY/tonne 2010 2011 2012E 2013E 2014E Source: Company 1. Total for the company 634 686 611 618 624 2. Shanxi Neng Hua 382 468 421 428 435 While we do not have the emission data for individual 3. Heze Neng Hua 772 913 798 853 848 mines to calculate the associated tax, the Australia 4. Ordos Neng Hua 0 291 291 280 284 Climate Change Minister, Greg Combet, said t0 the 5. Yancoal Australia 774 930 744 744 751 domestic press that under the carbon tax companies 6. External 742 722 665 671 685 7. GCL 815 1,004 746 670 641 would incur an average additional cost of only AUD2 Total 663 708 624 618 607 for every tonne of coal produced, which we estimate Source: Company, Daiwa forecasts would then account for 2.4% and 2% of Yancoal‘s and GCL‘s 2011 sales costs, respectively. However, a Wood  Yanzhou: unit cost of sales forecasts Mackenzie report published earlier this year noted that CNY /tonne 2010 2011 2012E 2013E 2014E under a carbon permit price of AUD23/tonne, the 1. Total for the company 259 289 335 359 378 weighted-average cost per marketable tonne was about 2. Shanxi Neng Hua 250 333 350 375 395 3. Heze Neng Hua 660 649 590 633 665 AUD3, but if the carbon price reaches AUD40/tonne 4. Ordos Neng Hua 0 159 200 215 225 after 2015, the cost impact becomes AUD4.6 per 5. Yancoal Australia 393 426 533 570 587 marketable tonne. Given the range, we believe it is 6. External 736 718 660 673 673 reasonable to assume the combined company will see a 7. GCL 614 732 746 784 784 Total 365 427 465 494 496 2-3% unit cost increase for 2013. Source: Company, Daiwa forecasts

- 63 - China Thermal Coal Sector 19 November 2012

 Yanzhou: gross margin by mines  Yanzhou: net gearing ratio 2010 2011 2012E 2013E 2014E (% ) 1. Total for the company 59.1 57.9 45.2 41.8 39.4 60 2. Shanxi Neng Hua 34.7 28.9 16.8 12.4 9.4 49.7 48.9 3. Heze Neng Hua 14.5 28.9 26.1 25.8 21.5 50 44.8 4. Ordos Neng Hua - - 27.3 23.4 20.7 39.3 5. Yancoal Australia (ex GCL) - 31.0 28.4 23.3 21.8 40 36.4 6. External 0.9 0.7 0.7 -0.3 1.6 7. GCL 24.7 27.1 -0.1 -17.0 -22.3 30 Total 44.4 39.3 25.0 19.6 17.9 Source: Company, Daiwa forecasts 20

Deteriorating gross margins could directly depress the 10 EBIT margin and net margin as well as the ROE. We 0 2010 2011 2012E 2013E 2014E forecast Yanzhou‘s net gearing ratio to reach 46% for 2013, which is the highest among its peers. Source: Company, Daiwa forecasts

 Yanzhou: profitability (% ) Potash operations are non-core 50 44 40 In July 2011, Yanzhou proposed acquiring Canadian 40 potash exploration permits for USD260m. The permits 29 27 30 26 25 cover a total area of about 5,364 sq km in Canada‘s 19 20 18 Saskatchewan province. The company needs to conduct 20 further exploration to produce a formal reserves 11 10 8 10 6 7 5 estimate. Mining giants such as BHP Billiton (Not rated) and Potash Corp (Not listed) operate in the same 0 province. In the announcement, Yanzhou‘s view was: 2010 2011 2012E 2013E 2014E ‗The company, through the transaction, will be able to Gross margin EBIT margin Net margin fully leverage its mining expertise and to enhance Source: Company, Daiwa forecasts commercial benefits. The company will consistently adhere to market-focused business principles and  Yanzhou: ROE localised operating approaches in overseas investment, (% ) to carry out the follow-up exploration activities and 30 27.9 other operations with respect to the relevant Canadian potash resources accordingly‘. 25 22.3 20 Potash, a potassium nutrient used to shield crops from dryness and disease, has seen very volatile spot prices 15 11.6 in recent years. Besides volatile pricing, we are not sure

10 7.4 whether potash, a non-core and unfamiliar business for 6.6 Yanzhou as a coal company, could create value for the 5 overall business, despite the profitability of

0 experienced potash miners. We have not incorporated 2010 2011 2012E 2013E 2014E any impact from the potential purchase of this business

Source: Company, Daiwa forecasts into our earnings forecasts.

- 64 - China Thermal Coal Sector 19 November 2012

 Potassium chloride (muriate of potash) FOB Vancouver price GCL‘s shareholders. The CVR shares are to be (USD/tonne) repurchased following implementation of the merger 1,000 proposal at a ‗repurchase price‘ equal to the amount by 900 800 which the price of Yancoal Australia ordinary shares on 700 Australian Stock Exchange is less than AUD6.96, based 600 on the 90 day volume-weighted average price 18 500 months after the merger proposal is implemented, 400 subject to a cap of AUD3.00 per CVR share and other 300 200 conditions. This could result in a maximum payment of 100 AUD263m for Yancoal Australia by the end of 2013,

0 which we see as an additional risk to Yanzhou Coal.

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Apr Apr Apr Apr Apr Apr

Oct Oct Oct Oct Oct

Jan Jan Jan Jan Jan Jan  Yanzhou: Daiwa earnings- forecast revisions Source: Bloomberg New forecasts Previous forecasts % change 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E Output (m tonnes)* 56 62 70 59 63 68 -5% -1% 3% Lowering DCF-based target price ASP (CNY/tonne)* 627 651 642 614 626 621 2% 4% 3% Unit cost of sales to HKD11.30 (CNY/tonne)* 336 371 379 324 326 334 4% 14% 14% Source: Daiwa forecasts Note: *Exclude coal trading We are cutting our 2012-14 earnings forecasts sharply on the back of recent market changes in output and  Yanzhou: forward PER valuation history prices, as well as disappointing operations in 3Q12. The (x) stock now looks expensive to us, with a 12-month 35 forward PER multiple, at 13x, close to its past-five-year average, while its peers are trading below their past- 30 26.7x Avg+2SD five-year averages. Yanzhou‘s 12-month forward PBR 25 multiple is also below the stock‘s past-five-year average 20 19.6x Avg+1SD mean, highlighting our concern about the ROE. We are 15 not sure whether an EV/reserve measure is an effective 12.6x Avg tool with which to value Yanzhou given that the 10 profitability of mines tends to vary substantially, but 5 5.5x Avg-1SD even on this basis Yanzhou‘s valuation looks far from 0 attractive. Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: Bloomberg, Daiwa forecasts We are revising down Yanzhou‘s coal-output forecasts for 2012-14, by 1-5%. We are revising up our average  Yanzhou: forward PBR valuation history coal-selling price forecasts by 2-4% on the back of a (x) higher expected revenue contribution from the 3.0 Australian coal business, which has a higher ASP. The 2.8 Avg+2SD 2.5 major reason for the cuts to our 2012-14 earnings 2.2x Avg+1SD forecasts is the unit-cost rise that we see (we are 2.0 increasing our unit-cost forecasts for the period by 4- 1.6x Avg 14%, mainly because we see higher cost pressure from 1.5 the Australian business over the next few years). 1.0 1.1x Avg-1SD

Given the 0.4% upside potential to our new target 0.5 0.5x Avg-2SD price, we maintain our Hold (3) rating. The key risks to 0.0 our call would be stronger-than-expected coal-price Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 rises and lower-than-expected cost increases. As we Source: Bloomberg, Daiwa forecasts mentioned previously, Yanzhou‘s earnings are highly sensitive to coal-price rises and unit-cost hikes. These could be the two main share-price swing factors.

In addition, based on the share swap agreement signed during the acquisition of GCL, Yancoal Australia has issued 87.6m contingent value rights (CVR shares) to

- 65 - China Thermal Coal Sector 19 November 2012

 Yanzhou: forward EV/reserve history

(x) 12 10.7x Avg+2SD 10

8 8.4x Avg+1SD

6 6.0x Avg

4 3.7x Avg-1SD

2 1.4x Avg-2SD 0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: Bloomberg, Daiwa forecasts

 Yanzhou: DCF valuation (in CNYm) 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E Risk free rate 3.5% market risk premium 6.0% Beta 1.0

Cost of equity 9.5% Cost of debt 5.0%

% of equity capital 60% % of debt capital 40%

WACC 7.7% Growth 3.0%

Free cash flows EBIT (1-t) 4,740 3,586 3,411 4,293 5,254 5,267 5,328 5,384 5,440 Plus deprecation 3,848 4,636 5,244 5,592 5,905 6,086 6,250 6,397 6,529 Change in working capital (496) (918) (645) (716) (668) (32) (140) (127) (127) Capital expenditure + investments (11,000) (10,000) (8,000) (8,000) (7,000) (7,000) (7,000) (7,000) (7,000) Free Cash flow (2,908) (2,696) 9 1,169 3,491 4,322 4,438 4,653 4,842 Discounted FCF (2,908) (2,503) 8 936 2,595 2,983 2,844 2,769 2,675 Terminal 83% 58,617 Firm value 70,921 Net debt 24,228 Equity value 46,694 Less: Minority interest 1,146 Equity value after minority interest 45,548 No. of shares (m) 4,906 Target price (HKD) 11.3 Source: Daiwa estimates

- 66 - China Thermal Coal Sector 19 November 2012

Daiwa’s Asia Pacific Research Directory

HONG KONG SOUTH KOREA Nagahisa MIYABE (852) 2848 4971 [email protected] Chang H LEE (82) 2 787 9177 [email protected] Regional Research Head Head of Korea Research; Strategy; Banking/Finance John HETHERINGTON (852) 2773 8787 [email protected] Sung Yop CHUNG (82) 2 787 9157 [email protected] Regional Deputy Head of Asia Pacific Research; Regional Head of Product Management Pan-Asia Co-head/Regional Head of Automobiles and Components; Automobiles; Pranab Kumar SARMAH (852) 2848 4441 [email protected] Shipbuilding; Steel Regional Head of Research Promotion Anderson CHA (82) 2 787 9185 [email protected] Mingchun SUN (852) 2773 8751 [email protected] Banking/Finance Head of China Research; Chief Economist (Regional) Mike OH (82) 2 787 9179 [email protected] Dave DAI (852) 2848 4068 [email protected] Capital Goods (Construction and Machinery) Deputy Head of Hong Kong and China Research; Pan-Asia/Regional Head of Clean Sang Hee PARK (82) 2 787 9165 [email protected] Energy and Utilities; Utilities; Power Equipment; Renewables (Hong Kong, China) Consumer/Retail Kevin LAI (852) 2848 4926 [email protected] Jae H LEE (82) 2 787 9173 [email protected] Deputy Head of Regional Economics; Macro Economics (Regional) IT/Electronics (Tech Hardware and Memory Chips) Chi SUN (852) 2848 4427 [email protected] Thomas Y KWON (82) 2 787 9181 [email protected] Macro Economics (China) Pan-Asia Head of Internet & Telecommunications; Software (Korea) – Internet/On-line Game Jonas KAN (852) 2848 4439 [email protected] Shannen PARK (82) 2 787 9184 [email protected] Head of Hong Kong Research; Head of Hong Kong and China Property; Regional Custom Products Group Property Coordinator; Property Developers (Hong Kong) Jeff CHUNG (852) 2773 8783 [email protected] TAIWAN Automobiles and Components (China) Mark CHANG (886) 2 8758 6245 [email protected] Grace WU (852) 2532 4383 [email protected] Head of Research; Regional Head of Small/Medium Cap; Small/Medium Cap (Regional) Head of Greater China FIG; Banking (Hong Kong, China) Birdy LU (886) 2 8758 6248 [email protected] Jerry YANG (852) 2773 8842 [email protected] IT/Technology Hardware (Handsets and Components) Banking/Diversified Financials (Taiwan) Christine WANG (886) 2 8758 6249 [email protected] Leon QI (852) 2532 4381 [email protected] IT/Technology Hardware (PC Hardware) Banking (Hong Kong, China) Chris LIN (886) 2 8758 6251 [email protected] Joseph HO (852) 2848 4443 [email protected] IT/Technology Hardware (Panels) Head of Industrials and Machineries (Hong Kong, China); Capital Goods –Electronics Equipments and Machinery (Hong Kong, China) Bing ZHOU (852) 2773 8782 [email protected] INDIA Consumer/Retail (Hong Kong, China) Punit SRIVASTAVA (91) 22 6622 1013 [email protected] Hongxia ZHU (852) 2848 4460 [email protected] Head of Research; Strategy; Banking/Finance Consumer, Pharmaceuticals and Healthcare (China) Navin MATTA (91) 22 6622 8411 [email protected] Eric CHEN (852) 2773 8702 [email protected] Automobiles and Components Pan-Asia/Regional Head of IT/Electronics; Semiconductor/IC Design (Regional) Saurabh MEHTA (91) 22 6622 1009 [email protected] Felix LAM (852) 2532 4341 [email protected] Capital Goods; Utilities Head of Materials (Hong Kong, China); Cement and Building Materials (China, Mihir SHAH (91) 22 6622 1020 [email protected] Taiwan); Property (China) FMCG/Consumer John CHOI (852) 2773 8730 [email protected] Deepak PODDAR (91) 22 6622 1016 [email protected] Head of Multi-Industries (Hong Kong, China); Small/Mid Cap (Regional); Materials Internet (China) Nirmal RAGHAVAN (91) 22 6622 1018 [email protected] Kelvin LAU (852) 2848 4467 [email protected] Oil and Gas; Utilities Head of Transportation (Hong Kong, China); Hong Kong and China Research

Coordinator; Transportation (Regional) SINGAPORE Jibo MA (852) 2848 4489 [email protected] Head of Custom Products Group; Custom Products Group Adrian LOH (65) 6499 6548 [email protected] Head of Singapore Research, Regional Head of Oil and Gas; Oil and Gas (ASEAN and Thomas HO (852) 2773 8716 [email protected] China); Capital Goods (Singapore) Custom Products Group Srikanth VADLAMANI (65) 6499 6570 [email protected]

Banking (ASEAN) PHILIPPINES David LUM (65) 6329 2102 [email protected] Rommel RODRIGO (63) 2 813 7344 [email protected] Property and REITs ext 302 Ramakrishna MARUVADA (65) 6499 6543 [email protected] Head of Philippines Research; Strategy; Capital Goods; Materials Head of ASEAN & India Telecommunications; Telecommunications (ASEAN & India) Danielo PICACHE (63) 2 813 7344 [email protected]

ext 293

Property; Banking; Transportation – Port

- 67 - China Thermal Coal Sector 19 November 2012

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- 68 - China Thermal Coal Sector 19 November 2012

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- 69 - China Thermal Coal Sector 19 November 2012

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Japan - additional notification items pursuant to Article 37 of the Financial Instruments and Exchange Law (This Notification is only applicable where report is distributed by Daiwa Securities Co. Ltd.)

If you decide to enter into a business arrangement with us based on the information described in materials presented along with this document, we ask you to pay close attention to the following items.  In addition to the purchase price of a financial instrument, we will collect a trading commission* for each transaction as agreed beforehand with you. Since commissions may be included in the purchase price or may not be charged for certain transactions, we recommend that you confirm the commission for each transaction.  In some cases, we may also charge a maximum of ¥ 2 million (including tax) per year as a standing proxy fee for our deposit of your securities, if you are a non-resident of Japan.  For derivative and margin transactions etc., we may require collateral or margin requirements in accordance with an agreement made beforehand with you. Ordinarily in such cases, the amount of the transaction will be in excess of the required collateral or margin requirements.  There is a risk that you will incur losses on your transactions due to changes in the market price of financial instruments based on fluctuations in interest rates, exchange rates, stock prices, real estate prices, commodity prices, and others. In addition, depending on the content of the transaction, the loss could exceed the amount of the collateral or margin requirements.  There may be a difference between bid price etc. and ask price etc. of OTC derivatives handled by us.  Before engaging in any trading, please thoroughly confirm accounting and tax treatments regarding your trading in financial instruments with such experts as certified public accountants. *The amount of the trading commission cannot be stated here in advance because it will be determined between our company and you based on current market conditions and the content of each transaction etc.

When making an actual transaction, please be sure to carefully read the materials presented to you prior to the execution of agreement, and to take responsibility for your own decisions regarding the signing of the agreement with us.

Corporate Name: Daiwa Securities Co. Ltd. Financial instruments firm: chief of Kanto Local Finance Bureau (Kin-sho) No.108 Memberships: Japan Securities Dealers Association, Financial Futures Association of Japan Japan Securities Investment Advisers Association Type II Financial Instruments Firms Association

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