120730_50591_China Metals and Mining_F:Normal Cover 2011 7/30/2012 4:11 PM Page 1
Natural Resources & Energy China Equity July 2012
Simon Francis* Metals & Mining Head of Metals & Mining Research, Asia Pacific The Hongkong and Shanghai Banking Corporation Limited +852 2996 6620 [email protected]
Simon Francis joined HSBC as Regional Sector Head of Metals & Mining in March 2012. He is a Chartered Accountant (UK ACA) with Metals & Mining a degree in mathematics from the University of London. Simon’s equity research experience in Asia spans almost 20 years, virtually all of it covering the Metals & Mining sector. He has lived in various countries in Asia and worked for various financial institutions. From 2003 to 2012, he was regional sector head at prominent securities firms in Hong Kong, achieving significant recognition in the Greenwich Asia, Greenwich Europe, and Greenwich US surveys. Back to reality – launching coverage in China, Taiwan and Mongolia Thomas Zhu* Analyst, Metals & Mining, Asia Pacific The Hongkong and Shanghai Banking Corporation Limited +852 2822 4325 [email protected]
Thomas Zhu joined HSBC in March 2012 as Metals & Mining Analyst for the Asia-Pacific region. He holds a Master’s degree in Business from Tsinghua University, Beijing. Following completion of a rigorous graduate training programme at a global investment bank, Thomas worked with Simon Francis as a metals analyst from 2009 to 2012.
Chris Chen* Analyst, Metals & Mining, Asia Pacific The Hongkong and Shanghai Banking Corporation Limited
+852 2822 4277 China Equity [email protected] We forecast a return to normalized demand growth and prices. Commodities markets are not Chris Chen holds a first class honours degree in accounting and finance from the Hong Kong University of Science & Technology. tight enough to drive up prices, though downside risks are largely cost-curve limited. We Before joining HSBC’s Metals & Mining team as Associate Analyst in 2012, she worked for a global assurance, tax and advisory services firm as an audit associate and with Simon Francis as a research associate. believe China is roughly a decade away from peak consumption levels
Amit Pansari, CFA* Analyst Stock valuations are at trough levels. Commodities prices should recover somewhat in 2H12 HSBC Bank plc +91 80 3001 3760 although risks to demand remain. We see the investment opportunities as being poor in steel [email protected] and aluminium, better in copper, thermal and metallurgical coal, and good in gold Amit Pansari joined HSBC in June 2007 as a part of the Metals & Mining Research team. Prior to joining HSBC, he worked as a research analyst with a global analytical company and as a business analyst with an Indian fast-moving consumer good company. Amit is a Chartered Accountant and a CFA charter holder. We initiate/resume coverage of 14 stocks. Our top picks are China Shenhua, Mongolian Mining, Zijin Mining, Shougang Fushan Resources and China Metal Recycling
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations. By Simon Francis and team
July 2012 Disclosures and Disclaimer This report must be read with the disclosures and analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it Natural Resources & Energy China Equity abc July 2012
Summary We launch coverage of 14 stocks in the China, Mongolia and Taiwan metals and mining space.
We argue that commodities markets are entering a period of slower yet more sustainable demand growth driven by industrialization and urbanization. We believe that the drivers of the last upcycle – loose Chinese monetary policy, increasing Western debt, and China’s fiscal stimulus in 2009 – are simply not prevalent today and that the incredible growth rates of 2003-11, are thus a thing of the past.
China remains a decade away from peak consumption levels in our view. For much of the past decade or more, China’s development has been focused on the coastal areas. Substantial parts of central and western China remain relatively undeveloped; urbanization levels are still quite low overall.
With slower growth, we think the supply-side will more easily be able to keep up with demand. As a result, the chances of extraordinary price outcomes – as seen in the last cycle – are less likely.
Commodities prices have been a key driver of share price performance since 2003 and more benign prices may make investing in the sector trickier. Yet, even in an environment of ‘normalized’ prices some companies will make healthy margins through the cycle.
Overall, our approach is neither ‘risk on’ nor ‘risk off’. We simply look for fundamentally sound companies with good earnings prospects driven by stronger prices, industry structural changes or volume growth or stocks that are simply undervalued.
Our top picks are China Shenhua, Mongolian Mining, Zijin Mining, Shougang Fushan Resources and China Metal Recycling.
To vote for HSBC in Asiamoney 2012 – www.asiamoney.com/survey/takesurvey/en/BP12/ Click here for more information on HSBC’s HK/China Research Team 1 Natural Resources & Energy China Equity abc July 2012
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Contents
Ratings and valuations 8 Company profiles 85 Aluminum Corp of China (Chalco) (2600 HK) 87
A return to normalised growth, Angang Steel (347 HK) 103 and prices 17 Baoshan Iron & Steel (600019 CH) 115
China economic outlook 30 China Coal Energy (1898 HK) 127
China Metal Recycling (773 HK) 141 Aluminium – structural oversupply to persist 33 China Shenhua Energy (1088 HK) 153 China Steel Corp (2002 TT) 167 Copper – fundamentally fine 42 Jiangxi Copper (358 HK) 179 Gold – higher in a time of Maanshan Iron & Steel (323 HK) 195 crisis 47 Mongolian Mining Corp (975 HK) 207 Steel – likely to stay tough out Shougang Fushan Resources (639 HK) 219 there 55 Yanzhou Coal (1171 HK) 229
Zhaojin Mining (1818 HK) 247 Metallurgical coal – supply side issues abating 67 Zijin Mining (2899 HK) 261
Thermal coal – taking the heat Disclosure appendix 274 out of the market 74 Disclaimer 277
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HSBC Metals & Mining sector valuation summary Bloomberg HSBC Mkt cap Target Current Potential ______PE ______EV/EBITDA______PB ______code rating USDbn price price return* 2011 2012e 2013e 2011 2012e 2013e 2011 2012e Coal China Coal Energy 1898 HK N(V) 14.1 7.48 6.48 19% 7.2 8.2 7.7 3.6 4.0 3.6 0.9 0.8 China Shenhua 1088 HK OW 67.9 34.00 27.15 29% 9.7 9.8 9.4 5.2 5.3 4.9 2.0 1.8 Shougang Fushan 639 HK OW(V) 1.3 3.00 1.97 61% 4.7 4.9 4.9 1.6 1.4 1.1 0.6 0.5 Mongolia Mining 975 HK OW(V) 1.9 7.15 4.03 77% 16.2 10.0 6.5 13.6 8.0 5.5 2.5 2.0 Yanzhou Coal 1171 HK N(V) 11.4 12.80 11.10 19% 5.0 7.7 7.8 3.9 5.5 5.5 1.1 1.0
Steel Angang Steel 347 HK N(V) 4.0 4.14 3.49 19% n.a. n.a. 21.7 10.1 8.6 5.7 0.4 0.4 Baoshan 600019 CH N 11.3 4.50 4.11 15% 9.8 7.3 11.1 5.4 4.0 5.0 0.7 0.6 CH Metal Recycling 773 HK OW(V) 0.8 12.25 5.58 125% 3.4 3.5 3.1 4.8 4.2 3.2 1.0 0.8 China Steel 2002 TT UW 13.2 24.75 26.50 -2% 20.3 42.9 25.3 13.7 20.5 16.0 1.4 1.6 Maanshan I&S 323 HK N(V) 2.2 1.75 1.49 17% 135.8 n.a. 12.8 5.0 6.5 4.5 0.4 0.4
Non-ferrous metals Chalco 2600 HK UW(V) 10.6 2.50 3.04 -18% 142.3 n.a. 84.2 10.6 15.1 10.3 0.7 0.7 Jiangxi Copper 358 HK N(V) 10.0 19.40 16.50 20% 7.1 7.3 8.1 5.9 5.2 4.2 1.2 1.1
Gold Zhaojin Mining 1818 HK OW(V) 3.3 14.30 8.82 66% 12.7 10.2 9.6 8.1 6.9 6.2 3.2 2.7 Zijin Mining 2899 HK OW(V) 10.9 3.70 2.29 66% 7.2 6.8 6.4 4.1 4.1 3.7 1.6 1.4
*Potential return equals the percentage difference between the current share price and the target price, plus the forecast dividend yield. Source: Bloomberg, HSBC Note: Priced as of 25 July 2012
HSBC Metals & Mining key financials summary Bloomberg ___ Revenue growth ______EBITDA margin ______EPS growth ______RoE ______Net debt to equity__ Div code yield 2012e 2013e 2014e 2012e 2013e 2014e 2012e 2013e 2014e 2012e 2013e 2014e 2012e 2013e 2014e 2012e Coal China Coal Energy 1898 HK 5% 9% 6% 20% 20% 20% -12% 6% 3% 10% 10% 10% 5% 2% -3% 4% China Shenhua 1088 HK 17% 6% 6% 36% 35% 36% 0% 4% 9% 19% 18% 17% 7% 2% -3% 4% Shougang Fushan 639 HK -5% 4% -2% 51% 49% 47% -6% 2% -7% 11% 10% 9% -25% -28% -30% 9% Mongolia Mining 975 HK 91% 36% 10% 29% 32% 36% 62% 53% 22% 22% 27% 25% 50% 44% 38% 0% Yanzhou Coal 1171 HK 8% 6% 9% 23% 23% 24% -35% 0% 19% 13% 12% 13% 44% 46% 38% 3%
Steel Angang Steel 347 HK -4% 6% -2% 7% 9% 11% nm nm 132% -3% 2% 4% 58% 52% 43% 0% Baoshan 600019 CH -12% 0% 1% 14% 10% 12% 35% -35% 40% 9% 6% 8% 32% 25% 14% 6% CH Metal Recycling 773 HK 6% 6% 17% 4% 4% 4% -3% 12% 16% 25% 23% 23% 40% 21% 13% 6% China Steel 2002 TT -8% 6% 1% 12% 14% 17% -53% 70% 20% 3% 6% 7% 54% 52% 45% 5% Maanshan I&S 323 HK -1% 7% -2% 5% 7% 8% -633% nm 93% -1% 3% 5% 73% 67% 59% 0%
Non-ferrous metals Chalco 2600 HK 7% 6% 3% 5% 6% 6% -878% nm 104% -4% 1% 2% 133% 133% 132% 0% Jiangxi Copper 358 HK -3% -16% 5% 8% 10% 10% -2% -10% 14% 15% 12% 13% 0% -16% -24% 2%
Gold Zhaojin Mining 1818 HK 30% 11% 12% 46% 45% 43% 25% 6% 10% 28% 25% 24% 30% 15% 0% 3% Zijin Mining 2899 HK 16% 2% 7% 24% 26% 27% 6% 7% 16% 22% 21% 21% 14% 8% -4% 4%
Source: Company data, HSBC estimates
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Share price performance (priced at close of 25 July) Bloomberg Current 52-week 52-week ______Absolute performance______Relative performance______code price low high 1W 1M 3M 1 YR 1W 1M 3M 1 YR Coal China Coal Energy 1898 HK 6.48 6.08 11.66 -2% 3% -24% -44% -1% 5% -9% -18% China Shenhua Energy 1088 HK 27.15 24.15 40.20 -3% 6% -19% -32% -2% 7% -5% -6% Shougang Fushan 639 HK 1.97 1.93 4.77 -1% -12% -24% -58% 0% -11% -9% -32% Mongolia Mining 975 HK 4.03 4.00 9.88 -6% -14% -36% -58% -5% -13% -21% -32% Yanzhou Coal 1171 HK 11.10 11.04 30.90 -2% -8% -32% -62% -2% -7% -17% -37%
Steel Angang Steel 347 HK 3.49 3.44 8.49 -13% -17% -34% -58% -13% -16% -20% -32% Baoshan 600019 CH 4.11 4.11 5.82 -2% -6% -18% -29% 0% -2% -7% -8% China Metal Recycling 773 HK 5.58 5.58 10.88 -5% -9% -36% -44% -5% -8% -21% -18% China Steel 2002 TT 26.50 26.50 31.50 -2% -4% -8% -12% 1% -3% -1% 8% Maanshan Iron & Steel 323 HK 1.49 1.44 3.49 -9% -16% -35% -56% -8% -14% -21% -30%
Non-ferrous metals Aluminum Corp of China 2600 HK 3.04 2.98 6.83 -1% -5% -19% -51% -1% -3% -4% -25% Jiangxi Copper 358 HK 16.50 11.30 28.45 -5% 0% -9% -40% -4% 1% 6% -14%
Gold Zijin Mining 2899 HK 2.29 1.95 4.46 -7% -11% -21% -47% -6% -9% -7% -21% Zhaojin Mining 1818 HK 8.82 8.00 18.70 -9% -11% -23% -41% -8% -9% -8% -15%
Note: Hong Kong shares relative to HSCEI, China Steel relative to Taiex, Baoshan relative to SHCOMP Source: Bloomberg
HSBC commodity price forecasts ______y-o-y______Unit 2010 2011 2012e 2013e 2014e Long run 2010 2011 2012e 2013e 2014e Coal Thermal coal Australia contract (6700kcal/ kg, fob) USD/t 91 122 119 104 100 82 9% 34% -3% -13% -4% Australia spot (6700kcal/ kg, fob) USD/t 99 121 99 99 101 82 37% 22% -18% 0% 2% Shanxi mixed (5500kcal/kg, fob, inc VAT) RMB/t 746 818 712 683 713 540 24% 10% -13% -4% 4% Datong premium (5800kcal/kg fob, inc VAT) RMB/t 789 872 778 745 763 570 25% 10% -11% -4% 2% Metallurgical coal Hard coking coal USD/t 191 289 220 228 208 120 11% 51% -24% 3% -9% Semi-soft coking coal USD/t 141 206 151 143 131 76 14% 46% -27% -5% -9% ULV PCI USD/t 163 223 160 166 151 88 26% 37% -28% 3% -9% Fushan No 4, f.o.r (inc VAT) RMB/t 1,482 1,675 1,622 1,644 1,600 1,200 17% 13% -3% 1% -3% Shanxi 1/3 coking (inc VAT) RMB/t 1,322 1,486 1,504 1,512 1,472 1,104 17% 12% 1% 1% -3%
Base metals LME aluminium USD/t 2,175 2,401 2,110 2,200 2,400 2,315 30% 10% -12% 4% 9% SHFE aluminium (in VAT) RMB/t 15,847 16,830 16,166 16,826 17,202 16,600 13% 6% -4% 4% 2% LME copper USD/t 7,551 8,821 8,000 7,500 8,000 6,200 47% 17% -9% -6% 7% SHFE copper (VAT) RMB/t 59,044 65,944 58,500 53,791 57,377 44,500 40% 12% -11% -8% 7% LME nickel USD/t 21,838 22,885 18,030 18,500 20,000 18,700 48% 5% -21% 3% 8% LME zinc USD/t 2,163 2,193 2,019 2,205 2,443 1,742 30% 1% -8% 9% 11%
Precious metals Gold USD/oz 1,225 1,570 1,760 1,775 1,750 1,500 26% 28% 12% 1% -1% Silver USD/oz 20 3531 32 28 25 38% 75% -12% 3%-13%
Bulks and steel Alumina USD/t 326 360 317 330 360 312 45% 10% -12% 4% 9% Iron ore-fines (Australia) USD/t 112 163 130 135 135 80 61% 45% -20% 4% 0% China HRC (inc VAT) USD/t 558 640 601 625 610 450 17% 15% -6% 4% -2%
Source: Thomson Reuters Datastream, SXCoal, CUSteel, HSBC forecasts
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HSBC metals and mining “six cells” Bloomberg code Rating Valuation Consensus Angang 347 HK N(V) 0.5x PB. Poor outlook for returns, previous trough points 2012e: bigger loss TP HKD4.14, 2013e: 20% above Potential return: 19% TP: 22% below. Baoshan 600019 CH N 0.7x PB. Poor outlook for returns, previous trough points 2012e: 12% below TP HKD4.50, 2013e: 29% below Potential return: 15% TP: 26% below
Chalco 2600 HK UW(V) DCF valuation. Earnings weak and volatile. 2012e: in line TP HKD2.50 2013e: n.a.: no consensus Potential return: -18% TP: 19% below
China Coal 1898 HK N(V) 50:50 blend of a PE-based valuation of HKD8.18 based on 10.0x 2012e: 15% below TP HKD7.48 2012e PE, and a DCF valuation of HKD6.78 2013e: 20% below Potential return: 19% TP: 15% below
China Shenhua 1088 HK OW 50:50 blend of a PE-based valuation of HKD33.75 (based on 12x 2012e: 6% below TP HKD34.00, 2012e PE) and a DCF valuation of HKD34.30 2013e: 11% below Potential return: 29% TP: 5% below
China Steel 2002 TT UW 1.5x PB. Poor outlook for returns, previous trough points 2012e: 33% below TP TWD24.75, 2013e: 21% below Potential return: -2% TP: in line
CMR 773 HK OW(V), 50:50 blend of a PE-based valuation of HKD9.50 based on 6.0x 2012e: 6% below TP HKD12.25, 2012e PE, and a DCF valuation of HKD15.00 2013e: 18% below Potential return: 125% TP: 13% above
Jiangxi Copper 358 HK N(V) 50:50 blend of a PE-based valuation of HKD18.50 (based on 7.9x 2012e: in line TP HKD19.40 2012e PE) and a DCF valuation of HKD20.30 2013e: 10% below Potential return: 20% TP: in line
Maanshan 323 HK N(V) 0.4x PB. Poor outlook for returns, previous trough points 2012e: Loss TP HKD1.75, 2013e: 13% below Potential return: 17% TP: 28% below.
Mongolia Mining 975 HK OW(V) DCF valuation 2012e: 27% below TP HKD7.15 2013e: 23% below Potential return: 77% TP: 7% below
Shougang Fushan 639 HK OW(V) 50:50 blend of a PE-based valuation of HKD2.70 (based on 6.7x 2012e: 5% above TP HKD3.00 2012e PE) and a DCF valuation of HKD3.30 2013e: 7% above Potential return: 61% TP: in line
Yanzhou Coal 1171 HK N(V) 50:50 blend of PE-based valuation of HKD13.25 (based on 9.0x 2012e: 22% below TP HKD12.80 2012e PE) and a DCF valuation of HKD12.35. 2013e: 27% below Potential return: 19% TP: 10% below
Zhaojin Mining 1818 HK OW(V) 50:50 blend of a PE-based valuation of HKD13.30 (based on 2012e: 1% below TP HKD14.30 15.0x 2012e PE) and a DCF valuation of HKD15.20. 2013e: 6% below Potential return: 66% TP: 4% below
Zijin Mining 2899 HK OW(V) 50:50 blend of a PE-based valuation of HKD3.30 (based on 9.5x 2012e: 3% below TP HKD3.70 2012e PE) and a DCF valuation of HKD4.00. 2013e: 7% below Potential return: 66% TP: in line
Note: Potential return equals the percentage difference between the current share price and the target price, plus the forecast dividend yield. Source: Bloomberg, HSBC
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HSBC metals and mining “six cells” Business overview Thesis Potential catalysts Angang One of China’s largest steel makers with a crude Tough outlook with weak demand, excess capacity Steel and iron ore prices, earnings reports. steel capacity of 21.6mtpa and little supply-side discipline. Margins are returns Potential catalysts could include industry expected to remain suppressed. restructuring, upstream integration. Baoshan One of China’s largest steel makers with a capacity Tough sector outlook. Margins higher than other Steel and iron ore prices, earnings reports, of c26.0mtpa of crude steel Chinese producers because of scale, location and plant reorganisation. Also, industry niche products, but still under pressure. restructuring, upstream integration.
Chalco China’s largest producer of aluminium and alumina High cost producer only likely to achieve healthy Aluminium, alumina and power prices. returns in tight aluminium markets. Restructuring to Future restructuring to lower costs. reduce costs likely to be expensive and long-winded.
China Coal China’s second largest coal producer with coal With a high proportion of spot market sales and Chinese thermal coal prices and the spot- resources of 19.6bt based on PRC standards weaker coal prices, China Coal faces a tougher contract sales split. Volume growth through outlook this year. asset injections or greenfield projects.
China Shenhua China’s largest coal producer with c9.3bn tonnes of The group’s blend of coal and power businesses Chinese thermal coal prices and the spot- marketable reserves under JORC standard makes earnings relatively insulated from the current contract sales split. Expansion of the coal weakness in coal prices and power businesses.
China Steel Taiwan’s largest steel maker with a controlled crude Competition from China and a lack of raw materials Steel and iron ore prices, earnings reports. steel capacity of 13.4m tpa integration has forced down margins and the dividend Expansion at Dragon Steel. yield
CMR China’s largest metals recycling company Strong growth prospects driven by consolidation of Higher rates of scrap usage in China. the Chinese scrap industry and increasing scrap Industry consolidation, improving margins penetration rates once sufficient market share is gained
Jiangxi Copper China’s largest copper producer Biggest beneficiary of higher copper prices in 2H12e, Higher copper prices. Greater visibility on though upside to copper prices looks limited projects in Afghanistan and Peru
Maanshan One of China’s leading steel makers with a crude Tough outlook with weak demand, excess capacity Steel and iron ore prices, earnings reports. steel capacity of c19mtpa. and little supply-side discipline. Margins are returns Potential catalysts could include industry expected to remain suppressed. restructuring, upstream integration.
Mongolia Mining Coking coal miner in Mongolia, substantial exporter Excellent growth prospects as mines ramp-up. Rapid Coking coal prices, development of to China EPS growth over next two years. infrastructure to reduce transportation costs, mine volume growth.
Shougang Fushan China’s second largest producer of hard coking coal Stable output of high quality coal means strong cash Coking coal prices, potential acquisitions flows and a high dividend yield. Little to no immediate and the approval of the Lianshan Project. growth prospects.
Yanzhou Coal A significant coal miner with operations in China and Aiming to increase capacity to 150m tpa by 2015. Chinese and international thermal and Australia Expansion is ‘back-end loaded’ meaning little coking coal prices. Development of new contribution to earnings in next two years. projects, potential acquisitions.
Zhaojin Mining China’s fourth largest gold producer Biggest beneficiary of higher gold prices in 2H12e Gold prices. Resources growth through with excellent resources growth prospects and a acquisitions or exploration forecast gold volume CAGR of c12% in 2011-2014e
Zijin Mining China’s largest gold producer and second-largest Beneficiary of higher gold and copper prices in 2H12e Gold and copper prices, the resumption of mined copper producer and copper volume CAGR of c21% in 2011-14e. Re- mining at Zijinshan and potential future rating expected once Zijinshan resumes in 2H12. acquisitions.
Source: HSBC
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Ratings and valuations
Valuations are once again at trough levels. Commodities prices should recover somewhat in 2H12 but risks to demand remain We see the investment opportunities as being poor in steel and aluminium, better in copper, thermal and metallurgical coal, and good in gold Our top picks are China Shenhua, Mongolian Mining, Fushan Resources, Zijin Mining and China Metal Recycling
Stock ratings There is a great expectation that demand growth Simon Francis* in China will accelerate in 2H12 (and certainly Head of Metals & Mining Our most bullish call is on gold Research, Asia Pacific 2H12 is expected to look a lot better in y-o-y The Hongkong and Shanghai We initiate or re-initiate coverage of 14 stocks in Banking Corporation Limited terms because 2H11 was so weak) but we +852 2996 6620 the metals and mining sector. question how significantly this will drive up [email protected] prices in well-supplied commodities markets. Thomas Zhu* We argue that slower economic growth in China Analyst and China’s gradual shift away from fixed asset The Hongkong and Shanghai Comparing current prices with our average price Banking Corporation Limited investment led growth will lead to a ‘normalising’ forecasts for 2H12, our most bullish call is on +852 2822 4325 [email protected] of commodities demand growth. We believe the gold which is trading 17% below our forecast for Chris Chen* supply side will be better able to meet this slower 2H12e. For most other commodities, we expect Analyst demand growth and that, as a result, we are less The Hongkong and Shanghai average prices in 2H12 to be within 10% of Banking Corporation Limited likely to witness the sometimes extraordinary current prices. +852 2822 4277 commodities price outcomes that we saw in the [email protected] last upcycle. Across the 14 stocks in our universe, our 2012e Amit Pansari* Analyst earnings forecasts range from being 5% above HSBC Bank plc Most commodities prices are already returning consensus to 33% below consensus and we +91 80 3001 3760 [email protected] towards the top end of the cost curve. forecast bigger losses than consensus for the *Employed by a non-US affiliate For many metals and mining companies, the Chinese steel companies. Our forecasts suggest of HSBC Securities (USA) Inc, and is not registered/ qualified underlying commodity prices have been a key the sector is due for another round of earnings pursuant to FINRA regulations driver over the past decade. From that perspective, downgrades, probably once the interim results are our forecasts that price outcomes will be more released in August. benign than in the last upcycle makes investing in We see the biggest risks to earnings as being in the sector trickier. the Chinese steel companies (where some analysts still forecast healthy profits in 2012e) and in China Steel (UW). We also see downgrades risks
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in some of the coal companies – Mongolian Our top picks are… Mining (OW(V)), China Coal (N(V)) and China Metal Recycling (347 HK, OW(V)) – Yanzhou Coal (N(V)) – where selling prices have industry restructuring, volume growth come off sharply and analysts have yet to fully adjust forecasts. China Shenhua (1088 HK, OW) – excellent long-run growth prospects Even so, we do think that valuations look cheap. Most of the stocks we cover are now back to the Mongolia Mining (975 HK, OW(V)) – trough levels reached in October 2008 and again strong volume growth over next two years, in October 2011. It is difficult to conclude, we most rapid EPS growth in that period think, that prospects in the sector are worse now Shougang Fushan Resources (639 HK, than they seemed at those times. OW(V)) – dividend yield
Our valuation approach Zijin Mining (2899 HK, OW(V)) – exposure Generally speaking we value mining stocks using a to gold, corporate image recovery, volume blend of PE and DCF valuations aiming to capture growth both the short-term outlook as well as the long-term Steelmakers face a period of low value. We tend to use relatively recent trading margins and poor returns histories as a guide for target PE multiples simply because the macro conditions that drove the sector Chinese steel companies face a difficult in the last upcycle (2003-2008) – ie loose monetary environment characterised by slower demand policy in China and the accumulation of Western growth, surplus capacity, a lack of supply-side consumer debt – no longer exist. discipline and consequently poor margins and returns. Where mining operations are starting up there is usually a period of very rapid growth in While the outlook for 2H12 maybe for better production yet earnings remain low. Multiples are growth in y-o-y terms, this reflects the weaker high because investors are paying for future rather 2H11 base, rather than strong underlying demand. than present earnings. In these cases – eg Steelmakers are simply not in a position to force Mongolia Mining – we rely on DCF valuations. up prices – which will continue to be ‘cost-push, rather than ‘demand-pull’ – nor margins. We value the steel companies using PB valuations because earnings are weak and difficult to forecast. The de-rating of the steel stocks, especially since Our target PB multiples are based on expected iron ore prices were ‘floated’ in April 2010, is ROEs and relatively recent trading histories. entirely justified in our view by weaker ROEs. ROEs are expected to remain weak over the next Overall, the focus of our stock recommendations few years. is neither ‘risk-on’ nor ‘risk-off’. We look for fundamentally sound companies with good earnings prospects driven either by stronger commodities prices (gold), strong volume growth or industry structural changes (recycling) or stocks that are simply undervalued.
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PB for Angang, Maanshan, Baoshan and China Steel Recycling are likely to emerge with both more
3.0 assured growth prospects and better margins.
2.5 China Metal Recycling, sales volume 2.0 5000 1.5 Tonnes 4000 000s 1.0 3000 0.5 2000 2003 2004 2005 2006 2007 2008 2009 2010 2011 Maanshan Angang 1000 Baoshan China Steel 0
Source: Company data, HSBC 2009 2010 2011E 2012E 2013E 2014E
Steel scrap Non-ferrous scrap ROEs for Angang, Maanshan, Baoshan and China Steel Source: Company data, HSBC 40%
30% China Metal Recycling share prices vs copper prices
20% 12.0 11.0 R2 = 0.4328 10% 10.0 0% 9.0 8.0 -10% 2003 2004 2005 2006 2007 2008 2009 2010 2011 7.0 Maanshan Angang 6.0 Baoshan China Steel 5.0
China Metal Recycling, HK$ Source: Company data, HSBC 6,000 7,000 8,000 9,000 10,000 11,000
LME copper prices, US$/t Generally speaking we think suppliers of steel raw Source: Bloomberg, HSBC materials – steel scrap, coking coal and iron ore – look better placed than the steel companies. Coking coal – great growth in These companies have better earnings Mongolia prospects and greater visibility and some trade at Mongolian Mining (OW(V)) is another Top Pick attractive valuations. The company offers the fastest EPS growth in our China Metal Recycling is one of our Top Pick universe over the next two years (up 62% in The recycling industry is important because 2012e and 53% in 2013e) driven by the ramp up recycling is significantly more energy efficient than in production at its Ukhaa Khudag (UHG) mine mining and processing ores. The Chinese and initial production output at Baruun Naran. government has started to restructure the industry, The Mongolian government’s approval of the and over the next few years we expect smaller railway project bodes well for cheaper ‘mom and pop’ type businesses to be squeezed out. transportation costs in the future. Environmental regulations will become stricter and We also rate Shougang Fushan Resources this will favour larger, more efficient businesses OW(V), though for entirely different reasons with proper scrap handling facilities. We believe Fushan is cashed-up – holding roughly half its that large enterprises such as China Metal market capitalisation in cash – and has poor
10 Natural Resources & Energy China Equity abc July 2012
growth prospects. The much hoped-for Lianshan plans to bring on new mines by the end of the mining project seems to be a pipe-dream to us and 12th Five Year Plan – ie by 2015. This probably management is now looking for overseas means there is upside potential to our DCF acquisitions. This means the cash pile is unlikely valuations, but this will not help earnings in the to be returned wholesale to shareholders. Despite near term. this, the combination of a sell-off in the shares China Shenhua (OW) looks cheap to us and a c45% payout ratio means the stock is We see the most value in China Shenhua, our only expected to yield c9% pa in the next three years. Overweight rating amongst the three stocks. Fushan is by far the highest dividend yielding Shenhua is a low beta stock; it is the most stocks in our universe. defensive stock within our coverage universe. Fushan’s annual dividend yields Despite the current uncertain macro environment,
10% earnings visibility remains relatively high mainly 9% because of the power business. As a result, we see 8% the least risk of consensus earnings downgrades 7% for Shenhua after the 1H12 results. We view the 6% 5% current sell-off as a buying opportunity. 4% Consensus earnings downgrade y-t-d (1 Jan 2012 = 100) 3% 2% 120
110 2009 2010 2011 2012E 2013E 2014E Source: Bloomberg, company data, HSBC 100
90 Thermal coal – anaemic near-term outlook, yet excellent long-run growth 80 Jul-12
Chinese and international coal prices declined Apr-12 Jan-12 Jun-12 Feb-12 Mar-12 May-12 sharply from April to July 2012, though they are Shenhua China Coal Yanzhou Coal now stabilising. As a result, earnings will be Source: Thomson Reuters Datastream, HSBC weaker than generally expected earlier in the year. We forecast China Coal’s earnings to decline by Neutral and Underweight base 12% y-o-y in 2012e and Yanzhou Coal’s earnings metals, but… to decline by 35% y-o-y. Shenhua looks relatively Copper rebound in 2H12e to be restricted by resilient by virtue of its substantial power business. high Chinese inventories – we rate Jiangxi The decline in coal prices has led to shares being Copper Neutral (V) sold-off aggressively with valuations now trading While we expect copper prices to rise from the close to their October 2008 and October 2011 trough current level in 2H12e, we think the upside will levels. This, combined with the fact we expect coal be limited by high copper inventories in China. In prices to recover somewhat through 2H12e suggests short, we would need to see a stronger-than- that further valuation downside is limited. expected recovery in demand from key downstream sectors or lower copper inventories to All three stocks are focussed on volume growth, revisit our forecasts and recommendation. though much of this is ‘back-end loaded’ with
11 Natural Resources & Energy China Equity abc July 2012
Jiangxi Copper (N(V)) offers the highest earnings We do forecast aluminium prices to rise in 2H12e leverage to copper among major Chinese and perhaps there is a risk that Chalco shares rise companies. For a 10% increase in copper prices, with aluminium prices. We would sell into a rally we expect Jiangxi Copper’s earnings will increase given the poor outlook for earnings and returns. by c13% in 2012e and 2013e. More positive on gold The company does plan to increase its copper Gold producers should benefit from higher concentrates self-sufficiency ratio, from 21% in gold prices 2011 to 40% by 2016e, by increasing output in James Steel, our gold commodities analyst, Afghanistan and Peru and through further believes that a combination of monetary and acquisitions. We have not factored these financial influences, geopolitical concerns, and projects into our model; greater visibility on the heightened investor anxiety will spur gold prices timing and cost of these assets could also make us to move above USD1,900/oz by the end of 2012. more positive. This implies more than 20% upside from the
Jiangxi Copper share price vs copper prices, 2010-present current level.
30.00 Zijin Mining (OW(V)) is one of our Top Picks R2 = 0.8469 We like Zijin for three main reasons. First, we 25.00 have a positive view on gold and Zijin’s earnings
20.00 are sensitive to gold prices. Second, the company offers robust mined copper volume CAGR of 15.00 c21% in 2011-14e. Third, we think the stock Jiangxi Copper, HK$/shr 10.00 should be re-rated following the recent conclusion 6,000 7,000 8,000 9,000 10,000 of the CSRC investigation and the Zijinshan China spot copper prices, US$/t copper mine resumption in 2H12e. Management
Source: Bloomberg, HSBC is planning a reverse roadshow to the Zijinshan copper mine in 2H12e. We think this will be a Aluminium looks structurally challenged catalyst for the re-rating. Although we see reasonable aluminium demand We also rate Zhaojin Mining OW(V). Although growth, there is plenty of supply, lots of planned the street has greater upside to the consensus capacity and high inventories. These factors will target price for Zhaojin, our preference is for keep aluminium prices in check, in our view. Zijin. First, Zhaojin accumulated inventories in We initiate on Aluminum Corp of China (Chalco) 1Q12 and as a result, 1Q12 earnings represented with an Underweight (V) rating. In our view, only 10% of the current full year consensus Chalco lacks the level of vertical integration estimate. We see greater risk of consensus necessary to achieve meaningful returns in earnings downgrades for Zhaojin. Second, we anything other than tight aluminium markets. believe Zijin has been more heavily shorted Management is trying to restructure the business recently suggesting a greater chance of a ‘short to lower costs but this is like to be a lengthy and squeeze’ as the corporate image recovers. expensive process. Realising that the outlook in aluminium is weak, Chalco moved into trading in 2010 and into coal in 2012.
12 Natural Resources & Energy China Equity abc July 2012
Daily PE of Zijin
24.0
19.0
14.0
9.0
4.0 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12
Daily P/E
Source: Bloomberg, HSBC
Zhaojin Mining is even more highly leveraged to gold prices Zhaojin offers the highest earnings leverage to gold among major Chinese companies with earnings 1.6x sensitive to gold prices in both 2012e and 2013e. We also expect to see decent volume growth with self-produced gold volumes expected to rise by a CAGR of c12% in 2011-14e. Further acquisitions are another potential share price catalyst.
Zhaojin earnings sensitivity to gold prices in 2012e Gold prices, USD/oz 1,426 1,584 1,760 1,936 2,130 Net income, RMBm 1,453 1,754 2,089 2,424 2,793
Source: HSBC
13 Natural Resources & Energy China Equity abc July 2012
Commodities prices outlook We also see smaller rebounds in base metals, for 2H12 thermal coal and Chinese hot-rolled coil (HRC) prices. Copper should benefit from further power Our sense is that our commodity price forecasts grid investment and a recovery in white goods give somewhat contradictory signals for metals sales. Thermal coal prices should be driven by the and mining stocks in 2H12. seasonally strong demand in 4Q12e. On a positive note, we do expect most commodity These rebounds in prices are already incorporated prices to rebound from currently weak levels in into our earnings models. 2H12 as economic activity recovers. The risks are two-fold. First, in h-o-h and y-o-y We are most bullish on gold, where James Steel, terms, commodities prices in 2H12e are expected our gold commodity analyst, expects gold prices to be much weaker. This will be apparent in to rise above USD1,900/oz by year end, indicating company earnings; we are set for a series of weak more than c20% upside from the current level and comparables and another round of downgrades c17% upside from current levels to our forecast after the August reporting season. for the 2H12 average price. The second risk is that economic growth in 2H12 may be slower than expected. In that case commodities prices may not rise as much as we forecast, with negative implications for earnings.
Commodities prices forecasts (priced as of 25 July 2012) Unit Now FY12e 1H12 2H12e h-o-h y-o-y 2H upside from Now Coal Thermal Coal Australia Spot (6700kcal/ kg, fob) USD/t 81 99 103 95 -8% -19% 17% Shanxi Mixed (5500kcal/kg, fob, inc VAT) RMB/t 620 712 776 648 -16% -23% 5% Datong Premium (5800kcal/kg fob, inc VAT) RMB/t 705 778 830 726 -13% -19% 3% Metallurgical Coal Hard Coking Coal USD/t 225 220 223 217 -3% -28% -4% Semi-soft Coking Coal USD/t 147 151 163 139 -15% -29% -5% ULV PCI USD/t 164 160 162 158 -2% -28% -4% Base metals LME Aluminium USD/t 1,840 2,110 2,084 2,136 2% -5% 16% SHFE Aluminium (inc VAT) RMB/t 15,340 16,166 15,972 16,360 2% -3% 7% LME Copper USD/t 7,440 8,000 8,097 7,903 -2% -4% 6% SHFE Copper (inc VAT) RMB/t 54,330 58,500 58,065 58,935 1% -4% 8% LME Nickel USD/t 15,825 18,030 18,430 17,630 -4% -13% 11% LME Zinc USD/t 1,792 2,019 1,984 2,054 4% -1% 15% Precious Metals Gold USD/oz 1,601 1,760 1,649 1,871 13% 11% 17% Silver USD/oz 27 31 31 31 0% -12% 14% Bulks and Steel Alumina USD/t 325 317312 322 3%-4% -1% Iron Ore-Fines (Australia fob) USD/t 111 130 133 127 -5% -16% 15% China HRC (ex VAT) USD/t 554 601 597 605 1% -4% 9%
Source: Bloomberg, Brook Hunt, SXCoal, HSBC
14 Natural Resources & Energy China Equity abc July 2012
Stocks are back to trough We calculate that all stocks except Jiangxi Copper valuations are currently trading below the 20-day average trough valuation in October 2011. Actually all Given the recent sell-off in commodities, we stocks except Jiangxi Copper and Zijin Mining are examine which stocks are trading at or close to trading at or below the absolute trough reached in previous trough valuations. We use PB valuations, October 2011. as earnings in the sector are largely driven by commodity prices which are volatile, even at the When compared with 2008 troughs, 7 stocks – best of times. We look at two trough periods; the China Coal, Shougang Fushan, Angang, Euro crisis in October 2011 and the global financial Maanshan, Baosteel, Chalco and Zijin – are crisis in October 2008. We look at both the trading at a 10% premium or less to the 20-day absolute trough points and also a 20-day period average trough valuation with Baoshan and Zijin average around the trough in order to remove one- trading below the absolute trough point. day share price anomalies. (We exclude Mongolian We think it is hard to conclude that prospects in Mining from this analysis because the stock was the sector are worse now than they seemed at only listed in October 2010). these trough points, suggesting to us that stock prices already factor in the weak commodities prices outlook.
Metals and mining PB multiples - now versus 2008 and 2011 troughs (based on daily one-year forward valuations) ______2008 trough______2011 trough______Now Trough 20 days Downside to Downside to 20 Trough 20 days Downside to Downside to 20 average trough days average average trough days average Coal China Coal 0.78 0.54 0.84 -31% 8% 0.83 0.97 7% 25% China Shenhua 1.65 0.89 1.46 -46% -11% 1.82 2.08 10% 26% Yanzhou 0.93 0.46 0.68 -51% -27% 1.24 1.56 33% 67% Fushan 0.48 0.41 0.51 -15% 6% 0.53 0.71 10% 46%
Steel Angang 0.42 0.35 0.53 -16% 27% 0.42 0.53 0% 26% Maanshan 0.35 0.25 0.37 -29% 6% 0.35 0.42 1% 20% Baoshan 0.63 0.80 0.92 27% 46% 0.79 0.82 26% 30% China Steel 1.57 0.96 1.13 -39% -28% 1.67 1.70 6% 8% CMR 0.73 n.a. n.a. n.a. n.a. 0.90 1.12 23% 54%
Non-ferrous Chalco 0.67 0.51 0.71 -25% 5% 0.74 0.82 10% 21% Jiangxi Copper 1.00 0.34 0.50 -66% -50% 0.70 0.90 -30% -10%
Gold Zhaojin 2.30 0.61 0.84 -73% -63% 3.00 3.50 30% 52% Zijin 1.20 1.30 1.90 8% 58% 1.10 1.40 -8% 17%
Source: Company data, Datastream, HSBC
15 Natural Resources & Energy China Equity abc July 2012
HSBC vs consensus China Coal shares actually rose by 1% to 3% despite the earnings downgrades, probably Our earnings forecasts for 2012e range from being suggesting that the market expects further 5% above to 33% below consensus for most earnings downside to be limited for these stocks. stocks and we forecast larger losses than consensus for the steel companies. Given the Over the past three months, earnings have been weakness in commodities prices recently – most downgraded for most stocks (by 3% to 391%) notably in thermal coal – we would expect to see with share prices down by 6% to 36%. Only a round of earnings downgrades once the interim Baosteel had earnings upgraded by 17%, though results are released. the share price has still declined by 16%.
Over the past one month, most company earnings were downgraded by 1% to 425% with share prices down by 3% to 17%. China Shenhua and
Consensus earnings changes vs. share price changes over last one month
10% 5% 0% -5% -10% -15% -20% -25% -30% -35% -40% -425%-164% -49% Zijin JXC CSC CMR MMC Chalco Zhaojin Angang Fushan Baosteel Shenhua Yanzhou M aanshan China coalChina Earnings change Price Change
Source: Thomson Reuters Datastream, HSBC
Consensus earnings changes vs. share price changes over last three month
20% 10% 0% -10% -20% -30% -40% -50% -60% -212% -391% -77% Zijin JXC CSC CMR MMC Chalco Zhaojin Angang Fushan Baosteel Shenhua Yanzhou Maanshan China coalChina Earnings change Price Change
Source: Thomson Reuters Datastream, HSBC
16 Natural Resources & Energy China Equity abc July 2012
A return to normalised growth, and prices
We forecast a period of sustained yet slower demand growth; China remains a decade away from peak consumption levels Commodities markets are not tight enough to drive up prices though downside risks are largely cost-curve limited We forecast relatively benign commodity price outcomes
A period of sustained, but Last upcycle drivers slower growth We believe the commodities upcycle of 2003-08 –
In this section we outline our big picture view of the a period when supply struggled to keep up with commodities markets. We also compare China to demand and prices reached record highs – was other Asian economies to try and assess when driven by surging private sector debt in the US China’s commodities demand may mature. We and loose Chinese monetary policy. Private sector argue that markets are entering a period of slower, debt in the US rose from 183% of GDP in 2003 to yet more sustainable, growth driven by the a peak of 214% in 2007. Chinese M2 growth traditional forces of industrialisation and average c18% during the period. urbanisation. We believe that the incredible demand After the financial crisis in 2008, the cycle was growth rates seen in 2003-2011 are a thing of the further extended by the Chinese governments’ past. With slower growth, we think the supply side RMB4trn fiscal stimulus. Notably, Chinese M2 will much more easily be able to keep up with growth shot up to 30% in November 2009. demand. As a result, we view the chances of extraordinary price outcomes – as seen in the last Over the next few years, we expect a return to upcycle – as much less likely. normalised growth rates, without the drivers of debt accumulation in the West, loose monetary China’s role in all of this is vitally important. policy in China or the massive fiscal stimulus China represents typically 40-55% of global provided by China from 2009. We also expect demand for commodities, and often 40-100% of China to continue to develop its economy towards annual incremental demand. Slowing Chinese consumption, gradually departing from its historical GDP growth and the government’s gradual shift model of growth led by fixed asset investment. away from a fixed asset investment led economy will have an important bearing on commodities.
17 Natural Resources & Energy China Equity abc July 2012
Commodity cycle drivers and role of China
US private sector debt as a % of GDP China M2 growth (y-o-y)
220% 30%
210% 25%
200% 20%
15% 190%
10% 180% Jan-03 Jan- 04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 2003 2004 2005 2006 2007 2008 2009 20 10 2011 Source: World Bank, HSBC Source: Bloomberg, HSBC
China share of global commodities demand China share of commodity demand growth (2007 to 2011)
60% 250% 209% 50% 200% 40% 30% 150% 124% 107% 103% 98% 20% 100% 10% 50% 0% Aluminium Copper Iron ore Steel Coal 0% 2007 2011 Aluminium Copper Iron ore Steel Coal
Source: Brook Hunt, World Steel Association, BP, HSBC Source: Brook Hunt, World Steel Association, BP, HSBC
China commodity demand growth (CAGR) Global commodity demand growth (CAGR)
30% 10%
25% 8% 20% 6% 15% 10% 4%
5% 2% 0% 0% 2003-2007 2007-2011 2011-2015e 2003-2007 2007-2011 2011-2015e Aluminium Copper Iron ore Aluminium Copper Iron ore Steel Coal Steel Coal
Source: Brook Hunt, World Steel Association, HSBC Source: Brook Hunt, World Steel Association, BP, HSBC
18 Natural Resources & Energy China Equity abc July 2012
Estimating the point of economic Is 1970 too early for Taiwan? We don’t think so. ‘take-off’ GDP per capita reached USD2,500 (1990 dollars) The starting point for our analysis is an estimate in 1970 and steel consumption per capita rose by of the point of ‘take-off’ for each economy. That 3.6x in the following four years. is the level of income per capita at which China has seen phenomenal demand materials consumption starts to accelerate. In growth… Asia, we find this is around GDP levels of Metals consumption in China has grown rapidly in USD2,500/capita measured in constant 1990 the years since economic ‘take-off’. In fact, dollars. We take these ‘take-off’ points as 1952 demand growth in China has been much faster than for Japan, 1970 for Taiwan, 1972 for Korea and in other Asian economies at similar stages of their 1999 for China. development. For instance, our analysis of steel We accept this is not an exact science. demand per capita suggests that, ten years after Consumption patterns are driven by various ‘take-off’, Chinese cumulative consumption was factors including income levels, savings rates, 1.7x that of Japan and 1.6x that of South Korea. building habits, geology, topology, the availability of credit, tax rates and others, and thus may differ across different economies.
Steel demand per capita (kg) took off when per capita Cumulative steel demand per capita (tonnes) income levels reached USD2,500 4.0 3.5 400
3.0 300 2. 1 2.3 2.0 1.9 2.0 1.5 200 1. 2 1.3 1.0 100 0.0 0 10 y rs from take off 13 y rs from take off 2,000 3,000 4,000 5,000 6,000 7,000 China Taiw an Japan S. Korea Japan S Korea Taiwan China
Source: World Steel Association, HSBC Source: World Steel Association, HSBC
Average GDP per capita for each five year period (1990 constant USD) and cumulative steel demand per capita for each five year period (tonnes) ______Japan ______China______S Korea ______Taiwan ______GDP/capita y-o-y Steel/capita y-o-y GDP/capita y-o-y Steel/capita y-o-y GDP/capita y-o-y Steel/capita y-o-y GDP/capita y-o-y Steel/capita y-o-y 1950-54 2,288 0.31 400 934 1,025 55-59 3,139 37% 0.59 89% 496 1,200 28% 1,254 22% 60-64 4,797 53% 1.25 113% 464 1,285 7% 1,487 19% 65-69 7,290 52% 2.18 74% 548 1,700 32% 2,063 39% 70-74 10,613 46% 3.26 49% 626 0.15 2,559 50% 0.33 3,065 49% 0.46 75-79 12,165 15% 2.74 -16% 717 15% 0.18 26% 3,754 47% 0.77 136% 4,278 40% 1.05 127% 80-84 14,068 16% 3.00 10% 930 30% 0.23 23% 4,671 24% 1.01 31% 5,768 35% 1.52 45% 85-89 16,478 17% 3.24 8% 1,318 42% 0.31 39% 6,899 48% 1.71 70% 8,255 43% 2.47 62% 90-94 19,311 17% 3.54 9% 1,671 27% 0.40 26% 9,924 44% 2.89 69% 11,307 37% 4.94 100% 95-99 20,196 5% 3.14 -11% 2,310 38% 0.47 18% 12,996 31% 3.82 32% 14,615 29% 5.45 10% 2000-04 20,824 3% 3.02 -4% 3,318 44% 0.82 75% 16,289 25% 4.63 21% 17,205 18% 5.35 -2% 05-09 22,195 7% 3.08 2% 5,617 69% 1.67 104% 19,658 21% 5.50 19% 20,810 21% 4.49 -16%
Source: Conference Board Total Economy Database, World Steel Association, HSBC
19 Natural Resources & Energy China Equity abc July 2012
…driven by rapid GDP growth and We estimate that in 1999 to 2007, the 8 years after high metal intensity economic take-off, China consumed an average of Income levels in China have grown more quickly 5.2 tonnes of steel per million dollars of GDP than in other Asian nations in the period following (again based on constant 1990 dollars). This ‘take-off’. Whereas in Japan, South Korea and consumption level is far higher than the other Taiwan it took 17-18 years for GDP per capita to Asian nations we have examined where steel rise from cUSD2,500 to cUSD8,000, in China this intensity was typically c2 tonnes per million growth took just 13 years. dollars of GDP at take-off and averaged c4 tonnes over the next decade. GDP per capita from take off year (1990 constant USD) We see a similar trend in aluminium. China’s 12,000 average aluminium consumption per million 10,000 dollars of GDP was 114 kg in 1999 to 2007. This 8,000 compares to an average of Japan, South Korea and 6,000 Taiwan of 55 kg.
4,000 For both steel and aluminium, China has had ready 2,000 access to the key raw materials – iron ore and coking 1 3 5 7 9 1113151719 coal for steel and bauxite/alumina for aluminium – Japan Taiwan S Korea China and has had no issues raising consumption. The
Source: The Conference Board Total Economy Database, HSBC trend is slightly different for copper.
In copper, China’s consumption has grown Further, China’s economic growth has been more broadly in line with the patterns seen in other metals intensive. That is, China has consumed more countries, except perhaps in 2006-07 when metal per unit of GDP than Japan, South Korea or Chinese consumption seemed low. We attribute Taiwan. We attribute this to the high proportion of this to incredibly high prices at the time. China is fixed asset investment in Chinese GDP. short of copper – copper imports in the form of China Urban FAI as a % of nominal GDP concentrates and scrap represent a substantial 70% portion of total demand – and the demand trend is 60% slightly different as a result. 50% 40% 30% 20% 10% 0%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Thomson Reuters Datastream, CEIC, HSBC
20 Natural Resources & Energy China Equity abc July 2012
Higher GDP growth and metal intensity has led to higher per capita metals consumption
Steel consumption per unit of GDP from take-off year Steel consumption per capita from take-off year (tonnes per USDm)
8.0 800
6.0 600
4.0 400
2.0 200 Steel/capita (kg)
0.0 0 135791113151719 1 3 5 7 9 1113151719
Japan Taiwan S Korea Year from take off China Forecast China Japan S. Korea Taiwan
Source: The Conference Board Total Economy Database, World Steel Association, HSBC Source: World Steel Association, HSBC
Aluminium consumption per unit of GDP from take-off year Aluminium consumption per capita from take-off year (kg per USDm)
200 15
150 10 100 5 50
0 Aluminium/ (kg) capita 0 13 57 91113151719 1 3 5 7 9 11 13 15 17 19 Japan Taiwan S Korea Year from take off China Forecast China Japan S. Korea Taiwan
Source: The Conference Board Total Economy Database, Brook Hunt, HSBC Source: Brook Hunt, HSBC
Copper consumption per unit of GDP from take-off year (kg Copper consumption per capita from take-off year per USDm)
200 20
150 15
100 10
50 5 Copper/ capita (kg) 0 0 13 57 91113151719 1 3 5 7 9 1113151719 Japan Taiwan S Korea Year from take off China Forecast China Japan S. Korea Taiwan
Source: The Conference Board Total Economy Database, Brook Hunt, HSBC Source: Brook Hunt, HSBC
21 Natural Resources & Energy China Equity abc July 2012
Unwinding of these factors will likely Secondly, we believe that Chinese economic lead to slower demand growth growth will become less metal intensive as the We forecast slower demand growth across the government gradually shifts the economy away commodities spectrum than we saw over the past from fixed asset investment and towards higher decade with a notable slow down in Chinese consumption levels. growth rates. These two factors together will lead to slower but Firstly, we expect slower Chinese real GDP more sustained metals demand growth in China, growth. Chinese real GDP grew at an average of in our view. With slower demand growth, China’s 10.5% p.a. in 2003 to 2011. Growth slowed to contribution to world growth is expected to 8.1% in 1Q12 and further to 7.6% in 2Q12. The decline. We expect Chinese demand growth to HSBC economics team forecasts GDP at 8.4% in broadly converge with global demand growth 2012e and 8.8% in 2013e, still slower than during over the next four years. the last upcycle. China has embraced a policy of slower and more sustainable economic growth and targets a 7% GDP growth in the 12th Five Year Plan (2011-2015).
China real GDP growth (y-o-y) China nominal FAI growth (y-o-y)
15% 32% 14% 30% 13% 28% 12% 26% 11% 24%
10% 22% 9% 20% 8% 18% 2003 2004 2005 2006 2007 2008 2009 2010 2011 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012e 2013e 2012e 2013e
Source: CEIC, HSBC Source: CEIC, HSBC
China share of global demand growth China and global commodity demand growth*
250% 209% 20% 200% 15% 150% 124% 110% 107% 103% 98% 10% 100% 65% 52% 51% 54% 50% 5%
0% 0% Aluminium Copper Iron ore Steel Coal 2003-2007 2007-2011 2011-2015e 2007-2011 2011-2015e China Wo rl d
*Simple averages of aluminium, copper, iron ore, steel and coal CAGR Source: Brook Hunt, World Steel Association, BP, HSBC Source: Brook Hunt, World Steel Association, BP, HSBC
22 Natural Resources & Energy China Equity abc July 2012
How long until China peaks? consumption or income levels, nor the urbanisation levels suggest to us that consumption We often hear the view that China is ‘peaking out’ rates are peaking. and that commodities consumption growth is bound to slow in the near future. We try to Based on the experience of other countries, quantify this using the above income and commodities consumption levels tend to peak consumption per capita analysis. when GDP reaches USD11,000-13,000 per capita. Demand then tends to stabilise, though it may We examine the intensity of materials consumption remain at or around peak levels for years to come. in China compared with other countries at similar Assuming a real GDP growth rate of 8% until stages of development. We conclude that China is 2015e, and 5% thereafter, and population growth broadly following a development path already of 1% p.a., we estimate China will reach this level travelled by other Asian nations and is roughly a of income in 2020-21 – ie, eight to nine years decade away from its peak. from now. While we accept that some areas of China are This would be consistent with other Asian maturing in terms of commodities consumption economies where peak consumption levels were per capita – eg, Shanghai, Beijing and Tianjin – reached 21-24 years after take-off. most of China is not. Neither the per capita
GDP per capita at peak demand levels (1990 constant USD) Steel consumption per capita vs GDP per capita
14,000 1,500 12,000 10,000 1,000 8,000 500 6,000 4,000 Demand per Capita per Capita (kg) Demand 0 2,000 0 5,000 10,000 15,000 20,000 25,000 0 Income per Capita (PPP) Korea Taiw an Japan China Japan S.Korea Taiw an
Source: The Conference Board Total Economy Database, HSBC Source: World Steel Association, GGDC, HSBC
Aluminium consumption per capita vs GDP per capita Copper consumption per capita vs GDP per capita
30 30 25 25 20 20 15 15 10 10
5 5
Demand per Capita (kg) Capita per Demand 0 (kg) Capita per Demand 0 0 5,000 10,000 15,000 20,000 25,000 0 5,000 10,000 15,000 20,000 25,000 Income per Capita (PPP) Income per Capita (PPP) China Japan S. Kor ea Taiwan China Japan S. Kor ea Taiwan
Source: Brook Hunt, GGDC, HSBC Source: Brook Hunt, GGDC, HSBC
23 Natural Resources & Energy China Equity abc July 2012
Chinese urbanisation levels remain This analysis that Chinese commodity intensity will low … not peak until the early 2020s is consistent with Despite the phenomenal pace of development HSBC’s earlier work in this area. See our global over the past few years, China still has a metals and mining sector report of 20 September substantial rural population. We expect to see 2011, The structural vs. cyclical metals debate: Will urbanisation continue over the next few years. China offset a Western slowdown? This is important because urbanisation drives metals demand.
China urban and rural population (m people) China household steel intensity (kg)
Source: Rio Tinto presentation Source: Rio Tinto presentation
Steel intensity increases with urbanization (kg per sq m) Global rural and urban population (bn people)
Source: BHP Billiton presentation Source: BHP Billiton presentation
24 Natural Resources & Energy China Equity abc July 2012
…and western China still has a way China GDP per capita by province (2010 nominal USD) to go Early economic development in China was focused in the coastal regions. As a result, we estimate that the western regions are on average about five years behind the coastal regions in terms of income per capita. In some provinces, the difference could be as much as 10 years. These differences in income levels are a key reason why the Chinese government has now set about balancing growth across China by developing these poorer regions. Source: BHP Billiton presentation
Western areas of China five years behind eastern ones
60 Real GDP per capita (Rmb'000/person), 2000 price 50
40
30
20
10
0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
East (ex cl. Shanghai) West Jiangsu Gansu Guizhou
Source: CEIC, HSBC
Chinese regional steel intensity (urban population), steel use per capita 2011 (kg)
Source: Rio Tinto presentation; Note: bubble size represents population
25 Natural Resources & Energy China Equity abc July 2012
Prices normalising too Limited downside risk to prices given cost support… As a result of this slower demand growth, we expect the supply-side to be more easily able to We see limited downside to prices given that match demand, thus reducing the likelihood of commodities are typically closer to the top end of extraordinary price outcomes. We have already the cost curve now and also given our expectation seen some commodities prices returning to the that economic activity will pick-up through the levels of the top end of the cost curve. second half of the year.
The coal market has been a good testament to this over the past few months. Better weather in Australia and Indonesia, the greater availability of hydro-power in China and the low gas prices in the US have meant that the coal market is no longer structurally tight. International coal prices have collapsed back toward the top of the cost curve.
Global aluminium 90th percentile cash cost vs. price Global iron ore cost curve 3, 500 140 Iron ore spot price USD/t (fob, 62% Fe) 3, 000 120 Low Quality Chinese ore 2, 500 100 80 2, 000 60 1, 500 40 C1 cash cost (USD/t) 1, 000 (USD/t) cost cash C1 20 0
2000 2002 2004 2006 2008 2010 2012 0 600 1,200 1,800 90th percentile C1 cost LME Aluminium Cumulative Costed Production (mt)
Source: Brook Hunt, HSBC Source: AME, HSBC
Global thermal coal 90th percentile cash cost vs. price Global metallurgical coal 90th percentile cash cost vs. price
Source: Brook Hunt, HSBC Source: Brook Hunt, HSBC
26 Natural Resources & Energy China Equity abc July 2012
…yet limited upside risks as the markets remain well supplied We expect commodities markets to remain well supplied over the medium term. The pinch point charts highlight that most commodities markets are far from being tight. This is true for aluminium, nickel and zinc where market fundamentals are more relevant. For copper, we believe that the market remains somewhat tight compared with historical standards. This, along with significant investment demand has enabled it to trade above the cash cost.
Please see our Metals Quarterly for full details of our price forecasts.
Aluminium price vs stock consumption days Copper price vs stock consumption days
5, 000 10,000 4, 000 8,000 3, 000 6,000 2, 000 4,000 1, 000 2,000 LME Prices (USD/LME t) Prices 0 L M E Pr ices(US D/ t) 0 0 10203040 0102030 Days of inventory Days of inventory All data 1Q00-4Q03 All data 1Q00-4Q03 1Q04-2Q08 2Q12 1Q04-2Q08 2Q12
Source: Thomson Reuters Datastream, Brook Hunt, HSBC Source: Thomson Reuters Datastream, Brook Hunt, HSBC
Nickel price vs stock consumption days Zinc price vs stock consumption days
60,000 3,500 3,000 40,000 2,500 2,000 20,000 1,500 1,000 L M E Pr ices(USD/ t) 0
LM E Prices (USD/t) LM Prices E 500 0 10203040 0
Days of inventory 0 204060 Days of inventory All data 1Q00-4Q03 All data 1Q 0 0 -4 Q 0 3 1Q04-2Q08 2Q12 1Q04-2Q08 2Q 1 2
Source: Thomson Reuters Datastream, Brook Hunt, HSBC Source: Thomson Reuters Datastream, Brook Hunt, HSBC
27 Natural Resources & Energy China Equity abc July 2012
Price outcomes and risk Relative strength in the US dollar – which is Short-term prices can be driven by the being seen as a relative safe haven in the perception of risk current (mainly Eurozone) crisis – should be Although the markets perception of the level of negative for commodities. risk, as measured by the VIX index is lower than Cost support, while valid over the medium it was in say October 2011, changes in the term, did not serve as a fundamental support perception of risk will still drive commodities level during the 2008-2009 crisis. prices. In particular:
Increasing market risk is generally bad for commodities prices. Prices can trade below their ‘fundamental’ level if the risk perception is high enough.
Daily VIX & LME 3-month aluminium LME and SHFE 3-month aluminium prices
2,800 50 3,500 2,600 40 3,000 2,400 2,500 30 US$/t 2,200 US$/t 2,000 20 2,000 1,500 1,800 10 1,000 Jul-11 Jul-12 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Apr-11 Oct-11 Apr-12 Jan-11 Jan-12 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
3-month LME Aluminium VIX (RHS) 3-month LM E Aluminium SHFE 3m (ex-VAT)
Source: Bloomberg Source: Bloomberg, HSBC
Daily VIX & LME 3-month copper LME and SHFE 3-month copper prices
10,500 10,500 50 9,500 40 8,500 8,500 30 6,500 US$/t US$/t 7,500 20 4,500
6,500 10 2,500 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Jul-11 Jul-12 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Apr-11 Oct-11 Apr-12 Jan-11 Jan-12
3-month LM E copper VIX (RHS) LME 3 month SHFE 3 month (ex -VAT)
Source: Bloomberg Source: Bloomberg, HSBC
28 Natural Resources & Energy China Equity abc July 2012
We expect benign commodity price outcomes
LME Aluminium (USD/t) LME Copper (USD/t)
2,800 10,000
2,600 9,000 2,400 8,000 2,200 2,000 7,000 1,800 6,000 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Spot prices Average spot Spot prices Av erage spot Estimated average Estim ated average
Source: Bloomberg, Thomson Reuters Datastream, HSBC Source: Bloomberg, Thomson Reuters Datastream, HSBC
Thermal Coal spot (Australia export fob, USD/t) Coking Coal contract (Australia export HCC fob, USD/t)
140 350 130 300 120 110 250 100 200 90 80 150 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Spot prices Average spot Spot prices Average spot Estimated average Estimated average
Source: Bloomberg, Thomson Reuters Datastream, HSBC Source: Bloomberg, Thomson Reuters Datastream, HSBC
Iron ore (China cif, 62% Fe, USD/t) China HRC (including VAT, USD/t)
200 700
180 650
160 600
140 550
120 500 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Spot prices Average spot Spot prices Average spot Estimated average Estimated average
Source: Bloomberg, Thomson Reuters Datastream, HSBC Source: Bloomberg, Thomson Reuters Datastream, HSBC
29 Natural Resources & Energy China Equity abc July 2012
China economic outlook
Beijing is stepping up easing on the monetary, fiscal and regulation fronts Once this filters through, growth will likely recover to over 8.5% And there’s still enough fiscal ammunition left to support growth if the Eurozone recession deepens further
China’s economic outlook low in June (9.5% y-o-y) and hard numbers such Qu Hongbin Economist as electricity production was only flat y-o-y. Reserve requirement ratio (RRR) cuts, two drops The Hongkong and Shanghai Banking Corporation Limited in interest rates, faster approvals for infrastructure Industrial output growth is slowing… (HK) +852 2822 2025 projects, tax incentives to buy energy-efficient (%y r,3mma) [email protected] 25 60 home appliances, lower regulatory barriers for Sun Junwei 20 investment – the list of easing moves goes on and 55 China Economist 15 The Hongkong and Shanghai on. Beijing has clearly started to take more 50 Banking Corporation Limited 10 decisive action to fuel growth in domestic demand +86 10 5999 8234 5 45 [email protected] to offset the impact of the global slowdown. 0 40 For the rest of the year, we expect another 200bp 05 06 07 08 09 10 11 12 of reserve ratio cuts, additional fiscal spending on IP (Lhs ) HSBC China manufacturing PMI *(Rhs, lead by 2m) public works, tax cuts and tax incentives to buy consumer goods as well as lower regulatory Source: Markit, CEIC, HSBC barriers for private investment. This strong mix of The slowdown is likely to have continued into monetary, fiscal and regulatory easing, once it July, as indicated by the weaker reading of July’s filters through, should lift domestic investment HSBC flash manufacturing PMI. As the first growth while keeping consumption steady in the available leading indicator, it remained below 50 coming quarters. Despite weakening global despite mild m-o-m recovery from the second demand, our China economist Qu Hongbin lowest level in 39 months. expects China’s growth should recover from 7.8% in 2Q to over 8.5% in 2H12. …but has probably bottomed China has slowed… Beijing has already started to take more decisive action to fuel growth in domestic demand to offset China has slowed faster than expected, implying the impact of the global slowdown. It has cut that growth in 2Q may have dropped below banks’ required reserve ratios (RRR), announced Beijing policy makers’ comfort zone. Industrial two drops in interest rates and is speeding up production (IP) growth was close to a three-year approvals for infrastructure projects as well as
30 Natural Resources & Energy China Equity abc July 2012
introducing tax incentives to buy energy-efficient Credit easing will likely lift investment growth home appliances and lowering regulatory barriers 40 (%y r, 3mma) (%yr, 3mma) 40 for investment. 35 35 30 Rate cuts as inflation falls fast 30 25 25 10 20 8 20 15 6 15 10 4 05 06 07 08 09 10 11 12 2 0 Fix ed asset inv estment (Lhs) Loans (Rhs) -2 01 02 03 04 05 06 07 08 09 10 11 12 -4 Source: CEIC, HSBC
1-y ear lending rate 1-y ear deposit rate CPI Additional ammunition if needed Our forecast that growth will be above 8.5% in Source: CEIC, HSBC 2H assumes the Eurozone will have a shallow Our China economist expects additional monetary recession of around -0.6%, in line with HSBC’s easing, mainly through the use of quantitative European economists’ forecast. But what if the tools (open market operations and an additional Eurozone slips into a much deeper recession (say 200bp in RRR cuts before year-end). The -5% or -6%) and Greece leaves? possibility of further interest rate cuts is still open Without more aggressive easing, a deep Eurozone should inflation falls faster than expected. recession would create a real risk that China’s This strong mix of monetary, fiscal and regulatory growth would drop to below 6% in 2H from the easing, once it filters through, should lift domestic current level of around 7.5% in 2Q, according to investment growth while keeping consumption our China economist. That would be too big a risk steady in the coming quarters. Despite weakening for Beijing. Historical experience shows that GDP global demand, China’s growth should recover growth of below 8% invites the risk of high levels from 7.8% in 2Q to over 8.5% in 2H12, in our of unemployment. Social stability is of paramount China economist’s estimation. importance this year, given that Beijing policy makers want to secure a smooth leadership change later this year.
31 Natural Resources & Energy China Equity abc July 2012
Below 8% GDP growth invites the risk of high levels of the 2008-09 slowdown China cut interest rates unemployment by 216bps in three months. The current-year (%y r) (%) 14 4.4 lending rate stands at 6.00% (after the rate 4.3 12 cuts), still higher than the average of 5.84% 4.2 over the past decade. The significant negative 10 output gap should allow more aggressive rate 4.1 8 cuts to bring the benchmark interest rate below 4.0 its long-term level. 6 3.9 05 06 07 08 09 10 11 12 Opening more sectors to private capital: This requires little government spending but could GDP (LHS) Urban unemployment rate (RHS) spur investment in the higher added value Source: CEIC, HSBC service sectors from which private investment We are confident that should things turn really is currently excluded. There are still ugly in the Eurozone, China would still have restrictions for investing in areas such as enough fiscal ammunition left to support growth education, financial services and media. at around 8%. Here are the main options: Services sectors: higher value-added (breakdown)
A stronger dose of fiscal stimulus: China’s 0.6 overall fiscal position remains strong. Apart 0.5 0.4 from RMB3trn in cash deposits that provide a 0.3 strong buffer to a slowdown, Beijing could 0.2 issue RMB1-2trn of special infrastructure 0.1 bonds to invest mainly in public housing. The 0 target of building 36m public housing units Manufacturing Serv ices during the 12th Five-Year plan (2011-15) Employee Compensation Net Taxes should cover the lowest income group in the Depreciation Operating Surplus
cities. Besides the 10m units begun last year Source: NBS, HSBC and another 7m to be started this year (implying around 20% growth for ongoing Cutting taxes more aggressively, especially projects), that still leaves nearly 20m units to for SMEs: The VAT reforms that took place be built in the coming three years. Beijing can in 2009 are estimated to have reduced the front-load the construction, which involves corporate tax burden by RMB120bn. If the investment of approximately RMB2,500bn VAT pilot scheme in Shanghai is rolled (or 5.3% of 2011 GDP). This not only across the whole nation it is likely to cut taxes provides a strong cushion against an by a further RMB100-150bn. investment slowdown in the short term, but would also boost consumption when the units are finished and also reduce the incentives for precautionary savings in the medium and long term.
Cutting rates by another c70bps to cushion the investment downturn: As a reference, during
32 Natural Resources & Energy China Equity abc July 2012
Aluminium – structural oversupply to persist
Global market set to remain in surplus, with strong Chinese output growth and slow Western production cuts China will remain self-sufficient with opportunistic imports only dashing the hopes of Western producers We forecast LME aluminium prices at USD2,110/tonne in 2012e and USD2,200/tonne in 2013e
Prices now at cost support Our forecasts are that the global market will levels remain in surplus, though the annual surpluses are expected to decline over the next few years. London Metal Exchange (LME) aluminium prices have fallen sharply from their somewhat euphoric So far this year, LME spot prices have traded at highs of mid-2011 and are now trading well USD1,800-2,300/t, averaging USD2,077/t. We below the top end of the cost curve. With falling see USD1,900/t as a good support level for global demand growth, plenty of supply – aluminium prices unless there is a full blown especially from China – and increasing global recession which we do not expect. inventories, it seems unlikely that prices will rebound significantly anytime soon.
HSBC LME aluminium price forecast LME and SHFE (ex VAT) spot aluminium prices (USD/t equivalent)
1,200 1. 20 2, 800 1,000 1. 10 2, 600 800 1. 00 2, 400 600 0. 90 2, 200 400 0. 80 2, 000 200 0. 70 1, 800 0 0. 60 1, 600 2009 2010 2011 Jul-10 Jul-11 Jul-12 Apr-10 Oct- 10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 2012e 2013e 2014e 2015e Global surplus (kt) - LHS Prices (U SD/ lb) - RHS SHFE LME
Source: Bloomberg, Brook Hunt, China Metals, HSBC Source: Bloomberg, HSBC
33 Natural Resources & Energy China Equity abc July 2012
Global aluminium cost curve (2012) World ex-China aluminium cost curve (2012)
2,900 2,900 2,700 2,700 2,500 2,500 2,300 2,300 2,100 2,100 1,900 1,900 1,700
C1 costs (U SD/t) 1,700 1,500 C1 costs (USD/t) 1,500 1,300 1,300 0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100% Cumulative production C um ul ative pr od u cti on
Source: Brook Hunt, HSBC Source: Brook Hunt, HSBC
We expect LME aluminium prices to average Global market to remain in USD2,110/t in 2012e, USD2,200/t in 2013e and surplus USD2,400/t in 2014e with prices rising as the We expect the global aluminium market to remain annual surplus declines. in surplus over the next few years as demand Shanghai Futures Exchange (SHFE) prices have growth fails to keep pace with rising supply. We been less volatile than LME prices over the past see strong supply growth in regions that have 18 months. There is a 15% duty on aluminium witnessed rapid recent capacity additions exports from China and typically SHFE prices including China and the Middle East. trade at a discount to LME prices. HSBC aluminium supply and demand model (kt) We forecast SHFE prices (including VAT) of 2011 2012e 2013e 2014e 2015e RMB16,166/t in 2012e (RMB15,970/t in 1H12), World capacity 53,016 54,801 56,816 59,198 61,056 y-o-y 7.8% 3.4% 3.7% 4.2% 3.1% RMB16,830/t in 2013e and RMB17,200/t in 2014e. Capacity utilisation 83% 85% 87% 88% 89%
We estimate that at current prices of cUSD1,900/t, World production 44,237 46,344 49,285 51,850 54,295 y-o-y 7.6% 4.8% 6.3% 5.2% 4.7% c59% of global production is loss-making. Adding the cUSD200/t physical premium to the LME World consumption 43,039 45,182 48,265 51,027 53,847 y-o-y 7.8% 5.0% 6.8% 5.7% 5.5% price, c37% of production is loss-making. World balance 1,199 1,161 1,019 823 448 Looking at the aluminium cost curve for the world World ex China balance 999 661 694 598 223 ex-China, we estimate that c36% of capacity is Total global stocks 6,844 8,005 9,025 9,848 10,296 Stock (weeks) 8.3 9.2 9.7 10.0 9.9 loss-making at USD1,900/t and c20% is loss- Source: Brook Hunt, IAI, HSBC making at USD2,100 (considering the USD200/t premium). No wonder then that we are now Demand growth to slow seeing production cuts, not only in China, but in We expect aluminium demand growth to slow the West as well. across most of the major regions in line with the Our price forecast of USD2,110/t for 2012 slowdown in global economic growth. represents the 80th percentile of the ex-China HSBC economics team expects global IP growth aluminium cost curve. to slowdown to 3.8% in 2012 from 4.9% in 2011, with developed world slowing to 1.4% (2.7%) and
34 Natural Resources & Energy China Equity abc July 2012
emerging world to 6.5% (7.4%). Similarly, we World aluminium production (kt) expect global aluminium demand growth to slow Jan-June 12 Jan-June 11 y-o-y% to 5% y-o-y in 2012 from 8% in 2011, mainly Africa 789 884 -11% North America 2,398 2,430 -1% supported by China where we expect demand to Latin America 1,035 1,095 -5% increase by c8%. We expect ex-China demand Middle East 1,823 1,681 8% Asia ex China and ME 1,271 1,277 0% growth to slow to 3% in 2012 (from 5% in 2011) West Europe 1,826 1,994 -8% reflecting the weak demand environment in C&E Europe 2,174 2,128 2% Oceania 1,122 1,140 -2% Europe and North America. Est. unreported 300 288 4% World ex-China 12,738 12,917 -1% China 9,522 8,559 11% HSBC aluminium demand growth estimates World 22,260 21,476 4%
15% Source: IAI, CNIA, HSBC
10% World annualised monthly aluminium production (mt)
5% 46
0% 44
-5% 42 2010 2011 2012e 2013e 2014e 2015e 40 N America Europe China Wo r ld
Source: Brook Hunt, China Metals, HSBC 38
Jul-10 Jul-11 Apr-10 Oct-10 Apr -11 Oct-11 Apr-12 Supply remains at elevated levels Jan-10 Jan-11 Jan-12
Global aluminium production increased by 4% Source: IAI, HSBC y-o-y in January to June 2012, according to International Aluminium Institute (IAI), mainly Output cuts not sufficient driven by China where production increased by While we have seen slowing production in the 11% y-o-y. World ex-China production was down world ex-China, we not do believe it is sufficient to just 1% in the same period, as increased output in balance the market anytime soon. At the start of the the Middle East and emerging Europe largely year, we believe Western producers were optimistic offset cuts in other regions. that announced capacity cuts would balance the market. According to Brook Hunt, some 1.6mtpa of We believe that the trend of lower production in capacity – representing c3% of global capacity – is the world ex-China is as much due to unforeseen in various stages of being closed, though not all of it disruptions as producer restraint. African smoothly. So far, the level of production cuts has production, for instance, was down 11% because been slower than anticipated. of a major unplanned outage at South Africa’s largest smelter, Hillside, owned by BHP Billiton. We expect world ex-China output to increase as and when labour and power issues at some of the smelters are resolved.
35 Natural Resources & Energy China Equity abc July 2012
Aluminium capacity cuts Country Company Smelter Cuts (ktpa) Date Comments Price related Netherlands Klesch Group Vlissingen 230 Dec 11 Bankruptcy - assets for sale Australia Hydro Kurri Kurri 60 Mar 12 Possibility of more cuts Australia Hydro Kurri Kurri 120 Jun 12 Under review Spain Alcoa Aviles 47 Jun 12 Implementation by mid-2012 Spain Alcoa La Coruna 43 Jun 12 Implementation by mid-2012 Sub Total 500 Labour and power issues Canada Rio Tinto Alma 290 Jan 12 On-going labour issue Canada Rio Tinto Shawinigan 0 Jan 12 Cut being restored UK Rio Tinto Lynemouth 178 Mar 12 Permanent shutdown brought forward New Zealand Rio Tinto NZAS 50 May 12 Due to high spot power price (operating at 85-90% of capacity) Italy Alcoa Pt. Vesme 150 Nov 12 Closure deferred due to stiff opposition from labour and government Russia Rusal Multiple 450 2012-2013 Under review, 300-600kt of permanent closure over 18 months period Sub Total 1,118
Total 1,618
Source: Brook Hunt, HSBC
Inventories remain high as financing inventories are tied up in these deals. Financing deals are still profitable deals work on the principle that the contango (that Global inventories, including both exchange and is, the amount by which the forward price is non exchange inventories, have remained at c7m greater than the spot price) is bigger than the tonnes since the beginning of the year equating to associated costs, which are interest, insurance and c60 days of consumption and more than double metal storage costs. These costs have been low, the levels seen before the financial crisis in 2008. because interest rates are low and also because The picture looks even more grim if we account warehouses have been offering incentives. As the for the off-exchange inventories which Alcoa aluminium market remains in contango, we expect estimates to be c2.3m tonnes outside China and financing deals to continue and for metal to c1.0m tonnes in China, taking the inventory count remain locked up in warehouses. to over 10m tonnes. LME 3-15month spread as a % of 3-month price
Global aluminium inventory (kt) 8%
8,000 65 6% 6,000 60 4% 4,000 55
2,000 50 2%
0 45 0% Jul-10 Jul-11 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 Jul-10 Jul-11 Jul-12 LME IA I Jan- 10 Apr-10 Oct -10 Jan-11 Apr -11 Oct-11 Jan- 12 Apr-12 Japan SHF E Stock day s (RHS) Source: Thomson Reuters Datastream, HSBC
Source: IAI, Bloomberg, HSBC
The high level of inventories mainly reflects the fact that a lot of metal is tied up in financing deals. Rusal estimates that roughly 65% of global
36 Natural Resources & Energy China Equity abc July 2012
Warehousing has also reduced spot months to take this cancelled stock out and will availability of metal continue to appear in the LME inventory figures. The warehousing business has become another Aluminium cancelled warrants (kt) prominent feature of the aluminium market where the queues to get the metal out of the LME 2,000 warehouses are very long, in some cases as long as 1,500 one year. This puts warehouses in a very profitable 1,000 position, as they continue to earn while the warrant holder waits for the metal to be delivered. 500
This has encouraged warehouses to enter the 0 market directly and buy even more metal by Jul-10 Jul-11 Apr-10 Oct-10 Apr-11 Oct -11 Apr -12 Jan-10 Jan-11 Jan-12 offering upfront incentives to producers, Detroit Netherlands Others sometimes equivalent to the physical premium Source: Bloomberg, HSBC paid by consumers. As a recent testimony to this practice, Glencore has signed a multi-year deal to In our view, the practice clearly distorts the buy 14.5m tonnes of aluminium from Rusal. aluminium market. Yet it seems unlikely to change Glencore holds aluminium at its warehouses in all the time that interest rates remain low. Vlissingen (Netherlands) which has the second largest stockpile of the metal globally after This has caused spot premiums to surge Detroit. These two locations together hold c60% The above two factors, namely financing deals and of LME aluminium inventory. the warehousing business, have reduced the availability of the material in the spot physical LME aluminium inventory by location (kt) market. Warehouse companies are competing
6,000 aggressively with consumers and have created a 5,000 situation where aluminium premiums are rising, 4,000 even as consumption slows and inventory is built up. 3,000 2,000 These high levels of premiums are providing price 1,000 support to smelters. Premiums in US hit an all- 0 time high of USD222/t in June with premiums in Europe at similar levels. Asian markets, which Jul-10 Jul-11 Apr-10 Oct-10 Apr-11 Oc t -11 Ap r -12 Jan-10 Jan-11 Jan-12 enjoyed lower premiums compared with the West Detroit Netherlands Others over the last two years, were recently jolted when Source: Bloomberg, HSBC Rio Tinto proposed to Japanese buyers to increase quarterly contract premiums from USD121/t in A quick glance at the cancelled warrants reveals 2Q to all-time high of USD200/t for July to the extent of the warehouse problem that the September shipments. According to Reuters, the aluminium market is facing. Cancelled warrants in Japan 3Q premium has been settled at USD200- aluminium are at their all-time highs at c36% of 210/t in early June. inventory with the largest cancellation in Detroit and Netherlands, at c50% of the stocks in their respective locations. Despite the increase in the minimum load out rates it will take several
37 Natural Resources & Energy China Equity abc July 2012
Aluminium premiums by region (USD/t) RMB0.6/kWh driving the average smelting cost in
240 the region to RMB16,800/t. These production cuts 220 are likely to be offset by increasing output in 200 other regions. 180 160 HSBC China aluminium and alumina demand and supply 140 estimates (kt) 120 2011 2012e 2013e 2014e 2015e 100 Aluminium Capacity 24,000 25,000 26,000 27,000 28,000 Jul-10 Jul-11 Apr-10 Oc t -10 Ap r -11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 Production 17,788 19,567 21,328 23,034 24,877 W. Europe (duty paid) US M id West y-o-y % 10% 10% 9% 8% 8% Japan contract Net exports 433 400 300 200 200 Source: Brook Hunt, HSBC Change in stocks (233) 100 25 25 25 Apparent consumption 17,588 19,067 21,003 22,809 24,652 y-o-y % 13% 8% 10% 9% 8%
Chinese aluminium outlook Alumina Capacity 46,440 48,500 50,000 50,000 50,000 We expect to see continued robust growth in both Production 34,003 37,403 40,770 44,439 48,438 production and consumption in China over the next y-o-y % 17% 10% 9% 9% 9% Net imports 1,805 2,200 2,200 2,000 2,000 few years driven by big picture trends such as Total available alumina 35,808 39,603 42,970 46,439 50,438 Change in stocks (est) (132) 62 (124) (103) 163 urbanisation and industrialisation. There is plenty Apparent consumption 35,940 39,541 43,093 46,542 50,275 of capacity growth in China. We expect production Used in aluminium 34,687 38,155 41,589 44,916 48,510 production to easily keep pace with demand and for China to Alumina: Aluminium 1.95 1.95 1.95 1.95 1.95 Non-metallurgical 1,253 1,386 1,504 1,625 1,765 remain a net exporter. While China is a net exporter applications, est of aluminium, it is and will remain a substantial net Source: China Metals, HSBC importer of both alumina and bauxite. In addition, some local governments are giving Output growth to remain strong additional energy subsidies to aluminium smelters We expect Chinese demand growth to slow but to help them stay in production. still outpace the rest of the world. We estimate Chinese demand will grow by 8% in 2012e and by China primary aluminium production (kt) a further 10% in 2013e, broadly in line with the 22 domestic GDP growth. 20 Chinese aluminium output growth has remained strong so far this year with January to June 2012 18 production increasing by 11% y-o-y. Recently, 16 some talks regarding output cuts in China have surfaced as prices continue to hover around the 14 average production cost. Henan Nonferrous Metals Jul-10 Jul-11 Apr-10 Oct-10 Apr -11 Oct-11 Apr -12 Jan-10 Jan-11 Jan-12 Industry Association deputy chairman, Wen Xianjun, has announced that Henan province has Source: IAI, HSBC idled c700ktpa of smelting capacity which could rise to 1.2mtpa by the end of the year if prices do not recover. Henan is one of the highest cost producing regions with power prices of
38 Natural Resources & Energy China Equity abc July 2012
Chinese imports are declining Indonesia – rising resource Chinese primary aluminium imports surged in the nationalism beginning of the year supported by a favourable In May 2012, Indonesia imposed an export tax of SHFE-LME arbitrage and the importing of metal 20% and a conditional ban on exports of 65 for use as collateral for short term financing different types of unprocessed mineral ores. The because of the tight credit market. These factors export ban is slated to commence from 2014. The have reversed now; the SHFE is trading at a new rules are aimed at increasing the level of discount to the LME and the credit market has been investment and employment in the mining sector. helped by RRR cuts, resulting in declining imports. There are exceptions to the rules for companies China primary aluminium trade (kt) holding the older Contract of Work type mining
80 permits. In order to continue exporting, 60 companies in Indonesia now need export permits; 40 Indonesia’s trade ministry had awarded 13 such 20 permits by June 22. 0 -20 How the new rules are implemented could have a -40 -60 potentially significant impact on some sectors. Indonesia is the top exporter of refined tin and Jul-10 Jul-11 Apr-10 Oc t -10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 thermal coal. It produced 14% of the world’s Imports Ex ports N e t Im po rt s (E x p ort s ) nickel ore in 2011, 15% of the world’s bauxite
Source: CEIC, HSBC and 3% of the world’s copper. Most of this ore is
processed overseas. Inventories have risen sharply China relies heavily on Indonesian SHFE inventories have risen sharply in recent bauxite months, though prices have remained largely stable since the start of the year. One threat is to the Chinese alumina and aluminium sectors. In 2011, China imported some SHFE aluminium inventory and price 45.2m tonnes of bauxite, an increase of 49% 500 19,000 y-o-y. About 80% of this material came from 400 18,000 Indonesia with the remainder mostly from 300 17,000 Australia and India. Assuming a bauxite to 200 16,000 aluminium ratio of roughly 4:1, bauxite imports 100 15,000 from Indonesia accounted for about 9m tonnes or 51% of Chinese aluminium production last year. 0 14,000 We see two main impacts from the new rules on Jul-10 Jul-11 Jan-10 Apr-10 Oct-10 Jan-11 Apr-11 Oct-11 Jan-12 Apr-12 the aluminium market. Stock -kt (LHS) Price - RM B/t (RHS)
Source: Bloomberg, HSBC A rush to stock-up before May Changes in tax rates often cause short-term dislocations in the commodities markets in China, and Indonesia’s imposition of a 20% tax on bauxite exports was no exception as Chinese companies rushed to buy before the tax became
39 Natural Resources & Energy China Equity abc July 2012
effective. Chinese imports of Indonesian bauxite Impact on Chinese aluminium costs leapt 63% m-o-m in May to 5.6m tonnes and are According to the May trade figures, China paid up 55% in the year-to-date at 20.7m tonnes. It is USD43.06/t for Indonesian bauxite and USD55.63/t likely the level of imports will decline in June for Australian bauxite. (The figures may not be after the export tax took effect. Imports will directly comparable because of differing alumina hardly collapse though, because at present, China and silica contents). The worst case scenario, at has little choice but to import from Indonesia. least for now, appears to be that Indonesian export taxes apply to all exports. That would boost the China bauxite imports (kt) 7,000 prices (based on May data) to USD51.67/t, in line with the cost of Australian material. It would add 6,000 cUSD36/t (RMB225/t) to the cost of producing 5,000 aluminium which based on a cash production cost 4,000 of say RMB13,000/t represents a 2% increase. 3,000 Given that China has some of the highest cost 2,000 aluminium producers, it is possible that more 1,000 capacity will have to be shut down. Jan-10 Jan-11 Jan-12 Sep- 10 Sep-11 May-10 May-11 May-12 It is also possible, of course, that Indonesia’s Source: China Metals, HSBC mining industry will bear some of the additional cost, perhaps splitting the additional burden with China has two choices to deal with this problem in their Chinese customers. This would limit the our view. Firstly, it can increase its imports from impact on Chinese costs. Australia, but this will be contingent on Australia’s ability to meet Chinese demand. Secondly, China Building refineries in Indonesia or seek other can increase its alumina imports. China was a big sources? importer of alumina during 2000-2005 but started Indonesia’s ban on exports is designed to to substitute it with bauxite from 2006 as the encourage processing of ores in Indonesia, thus country ramped up its refining capacity. We have creating both investment and employment. Our already seen a sharp increase in alumina imports sense is that with no current plans in place, it is over the last 3-4 months as the threat of the highly unlikely that there will be 15mtpa refining Indonesian export tax became more immediate. capacity built over the next two years. Thus, it seems likely that either Indonesia will kill the China alumina and bauxite imports in term of contained aluminium (kt) bauxite mining industry, or once again change the
500 1, 500 rules. Time will tell. Overall, Indonesia needs to 400 1, 200 find a balance between existing exports, 300 900 employment and tax take, and what it wants to
200 600 achieve in terms of future growth. Our sense is the 100 300 current rules have not found the right balance.
0 0 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
Alumina (LHS) Baux ite (RHS) Source: China Metals, HSBC
40 Natural Resources & Energy China Equity abc July 2012
HSBC Global aluminium demand and supply by region (kt) 2006 2007 20082009 2010 2011 2012e 2013e 2014e2015e Consumption by region North America 7,219 6,721 6,073 4,724 5,285 5,545 5,686 5,766 5,847 5,929 Europe 8,713 9,120 8,858 7,121 7,970 8,419 8,401 8,662 8,826 8,994 W Europe 6,476 6,835 6,545 5,211 5,873 6,128 6,037 6,233 6,331 6,431 C&E Europe 2,237 2,285 2,313 1,910 2,097 2,290 2,364 2,428 2,495 2,563 Asia 14,889 18,434 18,543 20,287 22,272 24,513 26,278 28,677 30,906 33,172 China 8,627 12,271 12,384 14,410 15,599 17,588 19,067 21,003 22,809 24,652 Japan 2,323 2,197 2,250 1,711 1,793 1,741 1,755 1,825 1,866 1,891 Other Asia 3,939 3,966 3,909 4,166 4,879 5,184 5,456 5,849 6,231 6,630 Australasia 422 444 462 438 468 464 496 511 526 540 Africa 466 492 468 424 531 548 573 604 636 669 Middle East 1,238 1,352 1,389 1,305 1,543 1,697 1,776 1,892 2,015 2,147 Latin America 1,373 1,509 1,692 1,587 1,849 1,853 1,972 2,154 2,272 2,397 World 34,318 38,071 37,485 35,886 39,918 43,039 45,182 48,265 51,027 53,847
Y-o-y% N America 1% -7% -10% -22% 12% 5% 3% 1% 1% 1% Europe 5% 5% -3% -20% 12% 6% 0% 3% 2% 2% W Europe 4% 6% -4% -20% 13% 4% -1% 3% 2% 2% C&E Europe 7% 2% 1% -17% 10% 9% 3% 3% 3% 3% Asia 14% 24% 1% 9% 10% 10% 7% 9% 8% 7% China 22% 42% 1% 16% 8% 13% 8% 10% 9% 8% Japan 2% -5% 2% -24% 5% -3% 1% 4% 2% 1% Other Asia 5% 1% -1% 7% 17% 6% 5% 7% 7% 6% Australasia -6% 5% 4% -5% 7% -1% 7% 3% 3% 3% Africa 9% 6% -5% -9% 25% 3% 5% 5% 5% 5% Middle East 1% 9% 3% -6% 18% 10% 5% 7% 7% 7% Latin America 2% 10% 12% -6% 17% 0% 6% 9% 5% 5% World 7% 11% -2% -4% 11% 8% 5% 7% 6%6%
Production by region North America 5,333 5,643 5,785 4,759 4,689 4,978 5,105 5,176 5,249 5,323 Europe 9,298 9,691 10,313 8,639 8,953 9,234 9,340 9,616 9,831 10,051 Western Europe 4,174 4,321 4,625 3,722 3,801 4,062 4,002 4,132 4,197 4,263 C&E Europe 5,124 5,369 5,688 4,917 5,152 5,172 5,338 5,484 5,634 5,789 Asia 10,686 14,095 14,688 14,718 18,068 19,835 21,986 23,921 25,796 27,816 China 9,300 12,606 13,130 12,963 16,133 17,788 19,567 21,328 23,034 24,877 Other Asia 1,386 1,489 1,558 1,756 1,935 2,047 2,419 2,593 2,762 2,939 Australasia 2,274 2,316 2,296 2,212 2,278 2,303 2,335 2,404 2,473 2,541 Africa 1,865 1,816 1,715 1,682 1,746 1,802 1,872 1,973 2,077 2,184 Middle East 1,909 2,025 2,111 2,449 3,077 3,873 4,155 4,427 4,715 5,023 Latin America 2,493 2,559 2,660 2,507 2,307 2,213 2,351 2,568 2,709 2,857 Production adjustment -800 -800 -1,000 -1,500 World 33,858 38,145 39,569 36,967 41,118 44,237 46,344 49,285 51,850 54,295 World ex China 24,558 25,539 26,439 24,004 24,985 26,449 26,777 27,957 28,816 29,418
Y-o-y% 400 300 200 200 North America -0.9% 5.8% 2.5% -17.7% -1.5% 6.2% 2.6% 1.4% 1.4% 1.4% Europe -0.9% 4.2% 6.4% -16.2% 3.6% 3.1% 1.1% 3.0% 2.2% 2.2% Western Europe -3.9% 3.5% 7.0% -19.5% 2.1% 6.9% -1.5% 3.2% 1.6% 1.6% C&E Europe 1.7% 4.8% 5.9% -13.6% 4.8% 0.4% 3.2% 2.7% 2.7% 2.7% Asia 19.0% 31.9% 4.2% 0.2% 22.8% 9.8% 10.8% 8.8% 7.8% 7.8% China 20.1% 35.5% 4.2% -1.3% 24.5% 10.3% 10.0% 9.0% 8.0% 8.0% Other Asia 12.3% 7.4% 4.6% 12.7% 10.2% 5.8% 18.2% 7.2% 6.5% 6.4% Australasia 1.0% 1.8% -0.8% -3.7% 3.0% 1.1% 1.4% 2.9% 2.9% 2.8% Africa 6.4% -2.6% -5.6% -1.9% 3.8% 3.2% 3.9% 5.4% 5.2% 5.1% Middle East 8.1% 6.1% 4.2% 16.0% 25.6% 25.9% 7.3% 6.5% 6.5% 6.5% Latin America 4.3% 2.7% 4.0% -5.8% -8.0% -4.1% 6.2% 9.2% 5.5% 5.5% World 6.1% 12.7% 3.7% -6.6% 11.2% 7.6% 4.8% 6.3% 5.2% 4.7% World ex China 1.6% 4.0% 3.5% -9.2% 4.1% 5.9% 1.2% 4.4% 3.1% 2.1%
Source: IAI, Brook Hunt, HSBC
41 Natural Resources & Energy China Equity abc July 2012
Copper – fundamentally fine
Copper was a victim of risk selling in 2Q. Exchange inventories actually fell 20% in 2Q, but prices also fell 9% We think there is upside to spot prices in 2H12e but expect macro sentiment to continue to dominate fundamentals We expect LME copper prices to average USD8,000/t in 2012e, USD7,500/t in 2013e and USD8,000/t in 2014e
Prices to remain at high levels Our commodities team expects the copper market to remain well supplied in 2013e as mine supply We expect the copper market to remain relatively growth peaks. We forecast an LME copper price of tight in 2012 posting a small surplus of 148k USD8,000/t in 2012, declining to USD7,500 in tonnes. Exchange inventories have declined year- 2013e on increasing market surplus, and rising to-date indicating that there has neither been a back to USD8,000/t in 2014e. SHFE copper prices significant negative shock to demand nor a should be in line with LME prices and we expect pronounced destocking cycle. This is despite SHFE prices of RMB58,500/t in 2012e, deceleration in Chinese economic growth and RMB53,791/t in 2013e and RMB57,377/t in 2014e. demand contraction in South Europe and is certainly bullish for the copper market. LME spot and SHFE cash month copper prices (USD/t equivalent) HSBC Global copper supply and demand model summary (kt) 10,000 2011 2012e 2013e 2014e 2015e 9,000 Concentrate Supply 12,840 13,185 14,273 15,123 16,302 SXEW cathode 3,401 3,681 3,769 3,847 3,813 8,000 Scrap Supply 4,182 4,300 4,505 4570 4720 Total 20,423 21,165 22,547 23,541 24,835 7,000 y-o-y% 2% 4% 7% 4% 5% Refined Production 19,544 20,278 21,578 22,430 23,740 y-o-y% 3% 4% 6% 4% 6% 6,000 Refined Consumption 19,620 20,130 21,237 22,193 23,125 y-o-y% 4% 3% 5% 4% 4% Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Refined Balance -76 148 341 237 615 Jan-10 Jan-11 Jan-12 LME SHFE Total Stocks 1,752 1,900 2,241 2,478 3,093 Stocks (Days of demand) 33 34 39 41 49 Source: Bloomberg, HSBC Source: Brook Hunt, HSBC
42 Natural Resources & Energy China Equity abc July 2012
Global demand growth has slowed… 1Q12 copper output was down due to unplanned We expect global copper demand growth to slow maintenance outage and lower grades at its to 3% in 2012 due to weakness in markets such as Chuquicamata smelter. Production was down at Europe. We continue to see a cyclical recovery in Freeport Candelaria mine and Antofagasta’s demand growth in 2013 to an above-trend rate of Michilla mines due to lower head grades. This 5%, and a reversion to structural growth rates of was partially offset by anticipated production 4-4.5% thereafter. increases at Los Bronces and Esperanza
Global copper demand growth Chile monthly copper production (kt)
10% 550
8% 500
6% 450
4% 400
2% 350 Jul Oct Apr Jun Jan Dec Aug Sep 0% Feb Mar Nov May 2010 2011 2012 2010 2011 2012e 2013e 2014e 2015e Source: Thomson Reuters Datastream, HSBC Source: Brook Hunt, HSBC
…so has supply Peru’s production was up just 1% y-o-y over January to April 2012. Output was lower at Cerro Copper supply in 1Q12 has surprised on the due to lower head grades and at Tintaya due to downside with several of the major copper miners rainfall. This was offset by increases at Antamina announcing flat to negative output growth. (capacity expansion) and Toquepala and Cuajone Copper production from major miners (kt) mines (higher ore grades and recoveries). 1Q11 4Q11 1Q12 q-o-q y-o-y Peru monthly copper production (kt) Codelco 414 485 373 -23% -10% Freeport 431 373 378 1% -12% 130 BHP 274 280 281 0% 3% Xstrata 210 231 171 -26% -18% 120 Antofagasta 130 187 163 -13% 26% Southern Copper 124 161 154 -4% 24% 110 Anglo American 139 170 168 -1% 21% KGHM 140 144 134 -7% -4% 100 Rio Tinto 146 137 120 -13% -18% Norilsk Nickel 94 98 88 -10% -6% 90 Vale 70 85 73 -14% 4% Kazakhmys 74 74 65 -11% -12% 80 First Quantum 75 67 66 -2% -12% Jul Apr Oct Jan Jun Feb Mar Aug Sep Dec Nov Teck Resources 57 69 63 -9% 11% May Total 2,378 2,562 2,297 -10% -3% 2010 2011 2012 Source: Company data, HSBC estimates Source: Thomson Reuters Datastream, HSBC
Chile copper production was down 2% over Despite the weak start, we expect 2012 production January to May 2012. The country’s copper growth of 4% dominated by some relatively output has continued to suffer due to unplanned certain year-on-year gains from the re-expansion maintenance outage and lower grades. Codelco’s of Escondida (+250k tonnes), a full year of
43 Natural Resources & Energy China Equity abc July 2012
expansion at Los Bronces (+250k tonnes), the Contract concentrate delayed ramp-up at Esperanza (+70k tonnes) and treatment and refining higher production at Antamina (+110k tonnes). charges to remain elevated
Output likely to accelerate in 2013 Chinese copper smelters and global miner BHP We expect the ramp-up of Esperanza, Escondida Billiton settled 2012 term copper concentrate and Antapaccay to continue into 2013. In treatment and refining charges (TC/RC) at addition, we should see growth from a recovery at USD60/t and USD6c/lb, 25% lower than average Grasberg (+170k tonnes) and first commercial of USD81/USD8.1c they achieved last year. In production at Oyu Tolgio (+100k tonnes), plus 2011, Chinese smelters and BHP failed to set further growth at Xstrata’s Southern Peru assets yearly TC/RC for term concentrate deliveries and (+75k tonnes). Unscheduled maintenance outages, instead set TC/RC in half-year charges for the lower ore grades and labour disruptions has first time, agreeing to charges set at become a regular feature of the copper market and USD72/USD7.2c for 1H11 and USD90/USD9.0c we have already incorporated a high disruption for 2H11. BHP’s settlement for 2012 is 5.5% rate of 7% in our estimates and see ‘post lower than the USD63.5/US6.35c Freeport agreed disruption supply growth’ of +7% in 2013. with China’s Jiangxi Copper and Japan’s Pan Pacific Copper. 2013 is the peak, but late decade is looking questionable Spot treatment charges remain weak in the range of 10% 500 USD20-25/t reflecting limited activity in the spot 8% 400 6% market as Chinese smelters have secured an 300 4% increasing proportion of their concentrate 200 2% requirements under long-term contracts this year. 100 0% We note here that because of the low volumes, spot -2% 0 TC/RC are a very poor reflection of the contract
1996 1999 2002 2005 2008 2011 market and expect TC/RC to remain stable at high 2014E Global Mine Output grow th Cu Price c/lb levels as mine supply continue to increase.
Source: Brook Hunt, HSBC Copper treatment charges (USD/t)
120 100 80 60 USD/t 40 20 0 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Spot TC Contract TC
Source: Brook Hunt, HSBC
44 Natural Resources & Energy China Equity abc July 2012
China copper market outlook China investment in power grid, RMBbn
We expect China’s copper consumption growth to 400 350 slowdown over the next few years as China’s 300 GDP growth slows to a more sustainable level. 250 We forecast China’s real copper demand to reach 200 c7.7m tonnes in 2012e, up c5% y-o-y. We expect 150 the growth to be primarily driven by power 100 industry investment and white goods 50 0 consumption. 2008 2009 2010 2011 2012e 1H12 We expect China’s refined copper production to Source: CEIC, NDRC, CEC grow by c10% in 2012e, broadly in line with the smelting/refining capacities growth. … and the property market bottoms China should continue to rely heavily on copper We forecast white goods (primarily air imports, both for raw materials and refined conditioners, fridges and freezers) should copper. We expect refined copper net imports to represent c16% of China’s copper demand in be c2.7m tonnes in 2012e, flat y-o-y. 2012e and we expect copper consumption in the sector to grow by 10% y-o-y in 2012e. HSBC China copper supply and demand model (kt) 2009 2010 2011 2012e 2013e Historically, property sales in China have been a Production 4,162 4,623 5,197 5,717 6,288 leading indicator for Chinese home appliances y-o-y 10% 11% 12% 10% 10% Net (imports)/exports (3,112) (2,882) (2,679) (2,700) (2,400) production. Chinese property GFA sales have Change in inventories 80 37 (45) 100 (40) rebounded from -14% y-o-y in January to -3% Apparent consumption 7,194 7,469 7,921 8,317 8,728 y-o-y 40% 4% 6% 5% 5% y-o-y in June and our property team expects a
Real consumption 6,100 6,800 7,330 7,679 8,089 further pick-up in transaction volume in 2H12. If y-o-y 20% 11% 8% 5% 5% the Chinese property market bottoms as our Source: Antaike, SHFE, HSBC property team expects, we should see copper demand from white goods pick up in 2H12. Demand to pick up in 2H12 as power grid investment rebounds … We expect the power industry to remain the biggest driver for Chinese copper demand and we expect the sector to represent c45% of China’s copper consumption in 2012e. China plans to invest cRMB375bn in power grids in 2012e, up 2% y-o-y, though grid investment was only cRMB139bn in 1H12, representing only 37% of the full year target. It seems unlikely to us that the Chinese government will significantly reduce its investment target for the full year suggesting that copper demand from the power industry should pick up strongly in 2H12.
45 Natural Resources & Energy China Equity abc July 2012
Property sales and white goods production SHFE/LME cash month copper price ratio
100% 1.05
50% 1.00
0% 0.95
0.90 -50% Jul-12 Apr-12 Jan-12 Jun-12 Feb-12 Mar-12 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 May-12 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
Floor space sold y oy % SHFE/LME cash month Total home appliances produced y oy %
Source: CEIC, HSBC Source: Bloomberg, HSBC
SHFE/LME ratio has improved … …but high inventories are likely to The SHFE/LME cash month copper prices ratio weigh on prices has picked up from a recent low of 0.92 in late According to CRU, copper cathodes inventories at April to about 1.00 recently. We think the Shanghai bonded warehouses were c500,000 improvement in SHFE/LME ratio shows that tonnes in late-June, down from the recent peak of copper demand in China is gradually recovering, c650,000 tonnes in mid-May but still at very although the magnitude is not yet big enough to elevated level. Similarly, inventories at the push copper prices substantially higher. Shanghai Futures Exchange have declined to 160,973 tonnes from the recent peak of c230,000 We expect the ratio to trade slightly below 1.00 tonnes but are still high compared with historical over the next few months until better demand in levels. In total, these inventories represent c30 days downstream sectors filters through to copper or of China’s real copper demand in 2012e, which we until China lowers its inventories to a more think will likely cap price gains, if any, in the reasonable level. China copper market.
Copper inventory at SHFE, tonnes Copper inventory at Shanghai bonded warehouse (kt)
250,000 700 600 200,000 500 400 300 150,000 200 100 100,000 0
50,000 Jul-11 Apr-11 Oct-11 Apr-12 Jan-11 Jan-12 Jul-11 Jul-12 mid-June-12 Apr-11 Oct-11 Apr-12 Jan-11 Jan-12
Source: Bloomberg Source: CRU
46 Natural Resources & Energy China Equity abc July 2012
Gold – higher in a time of crisis
Expect gold prices to rally to over USD1,900/oz by year-end on likely impact of easy monetary policies and fiscal policy concerns Government efforts to manage large debt burdens, geopolitical uncertainties, and central banks’ growing appetite for gold also argue for higher prices Currency movements, notably in EUR/USD, should play an important role in determining gold prices this year
Moving above USD1,900/oz Gold: HSBC forecasts of average annual prices James Steel Analyst (USD/oz) 2012 2013 2014 Long term* Our precious metals analyst believe that a HSBC Securities (USA) Inc Gold 1,760 1,775 1,750 1,500 +1 212 525 3117 combination of monetary and financial influences, [email protected] Source: HSBC * Long term = Five years geopolitical concerns, and heightened investor anxiety will spur higher gold prices to move just Fed rules above USD1,900/oz by the end of 2012. Sluggish underlying physical supply/demand balances are Gold prices have been strongly influenced by likely to keep gold from challenging the monetary policy and expectations for it. Western USD2,000/oz level, in our view. To the downside, central banks have pursued highly accommodative we believe, a break of USD1,500/oz would monetary policies in an effort to prevent their stimulate increased physical demand and raise the economies from slipping back into recession, and possibility of a reduction in mine output, and this in the Eurozone, to help combat the sovereign should help set a floor for prices at around debt crisis. These include unconventional policies, USD1,450/oz. We maintain our forecast of the including a huge increase in bond purchases via average bullion price at USD1,760/oz for 2012. an expansion of central banks’ balance sheets. Concerns about the long-run inflationary consequences of these policies stimulated investor demand for gold from 2007-2011.
47 Natural Resources & Energy China Equity abc July 2012
Fed easing intentions are an important issue for Political polarization and extremism are the gold market. In US Monetary Policy: Shifting traditionally positive for gold. Gold tends to gears?, 7 June 2012, HSBC US economist Kevin prosper in times of political uncertainty and Logan said the balance of Fed opinion may be conflict as financial markets turn increasingly tilting in favour of providing more monetary volatile and investors seek the safety of hard accommodation. He suggested that additional assets. The possibility of sovereign default also is easing could be partly a pre-emptive response to traditionally gold-bullish, as investors may flee the financial crisis in Europe and partly a reaction sovereign paper for hard assets such as bullion. to signs that employment growth is faltering. If Financial repression and gold the Fed follows this path, we anticipate stronger gold prices. If the Fed maintains current policies, One of the legacies of the economic crisis is the gold prices could come under renewed pressure. enormous levels of sovereign debt left in its wake. That said, price declines may be limited, as Fed How governments cope with near-record policy is already highly accommodative by peacetime debt levels may have important historical benchmarks. implications for gold prices, in our view. Global risk factors are growing In The liquidation of government debt (2011) by Carmen M. Reinhart and M. Belen Sbrancia, Repeat of history may boost gold National Bureau of Economic Research, the In Ghosts from the 1930s have returned to haunt us, authors point out that periods of high indebtedness 10 May 2012, HSBC Chief Economist Stephen have typically been associated with rising King pointed out that although the world has incidents of default or restructuring of public and avoided a Great Depression, political extremism is private debts. A subtle type of this debt on the rise in some countries. Furthermore, he restructuring is known as “financial repression,” a wrote, nationalist backlashes are growing in many term used to describe a variety of measures that countries against creditors, particularly foreign governments employ to channel funds to them creditors. This could have important bullish that they might not otherwise attract – for ramifications for gold prices, we believe. example, US government bond yields are historically low due partly to government policy.
Timeline of gold 1, 800 USD/oz June 7: April 24: 1, 750 Bernanke Te stimony to JEC FOMC statemen t
1, 700 June 1: May US payrolls 1, 650 Feb 29: report Bernank e Te stimony 1, 600 to JEC Jan 24: 1, 550 FOMC statem ent
1, 500 Jan-12 Feb-12 Mar-12 Apr-12 May -1 2 Ju n-12
Source: Bloomberg, HSBC
48 Natural Resources & Energy China Equity abc July 2012
Faced with historically high public and private Gold and commodities index domestic debt, financial repression policies – with 300 2, 000 the main goal of keeping interest rates low – will 250 1, 500 probably be a favoured policy response for a long 200 time to come, the NBER study said. Prolonged 1, 000 150 periods of low negative real interest rates are 100 500 gold-friendly, and we expect policies geared to Ja n-0 8 J an-09 J an-10 Jan-11 Jan -12 financial repression to be an important element in higher gold prices this year and next. Bloomberg Commodity Index (LHS ) Food, fuel, and gold Go ld pr i ces (U SD /oz ) (R HS)
Soaring commodity prices were a notable feature Source: Bloomberg, HSBC of the global economic boom from 2003-2008. As Fiscal cliff could buoy gold a commodity, gold is affected by the direction of the overall commodity sector. Gold rallies and In US Economics: The Fiscal Cliffhanger, 17 May price weakness are usually accompanied by 2012, our US economist Kevin Logan, wrote that higher and lower commodity prices, respectively. if US taxes increase and spending declines as scheduled later this year and in early 2013, The behaviour of commodity prices is likely to aggregate spending in the economy could drop off continue to influence gold prices, in our view. a “cliff.” This “fiscal cliff” is very likely to reduce Commodity-related geopolitical instability and growth, Mr. Logan said; we believe it could also commodity-related inflation scares are likely to affect gold. trigger increased investor demand for gold, we believe. According to the IMF, fundamentals Gold and US federal debt arguing for higher commodity prices are 2, 000 150% 1, 500 essentially intact, although near-term demand 100% 1, 000 levels are uncertain. Thus, while commodities 50% 500 might not be a positive near-term influence on 0 0% gold due to uncertain near-term demand, it appears that higher commodity prices in the Jun-71 Jun-76 Jun-81 J un-86 Jun-91 J un-96 Jun-01 Jun-06 Jun-11 medium to longer term are likely lend support to gold prices. Gold prices (USD/oz) (LHS) Gros s Fe deral De bt as a % of GDP (RHS)
Source: US Congressional Budget Office, HSBC
Mr. Logan said the rational course of action would be for Congress to seek compromise and make progress on smaller deficits and stabilization of the federal debt-to-GDP ratio. If this were viewed as a likely course, gold prices would probably come under pressure, in our view. But the experience of the deficit standoff last summer should remind investors that the political
49 Natural Resources & Energy China Equity abc July 2012
process in Washington can create budgetary the team argues, should foster a EUR rally and stalemate and unexpected financial risks, Mr. undermine safe-haven demand for the USD. Logan said. These risks, we believe, are gold- In another important factor for gold, the team friendly and likely to help propel gold higher in suggested that the focus of financial markets will the second half of this year and into 2013. shift to the US. A greater focus on the weak state Gold’s role as surrogate of US government finances in the run-up to the currency US elections in November could lead a reassessment of the USD, according to the team. As a surrogate currency, gold is sensitive to movements in foreign exchange markets. Gold’s Investment demand inverse correlation to the USD is among the most The official sector buys stable and enduring relationships in the bullion After nearly two decades as substantial sellers of market. This is largely because gold prices are gold, central banks turned buyers in 2010, typically denominated in US dollars, which purchasing a net 77 tonnes. The pace of central implies that exposure from buying and selling banks’ gold purchases accelerated sharply in gold is strongly influenced by moves in the 2011, with the official sector acquiring a net 456 exchange rate for USD. Because the USD is tonnes, according to the Bank for International widely regarded as the world’s principal reserve Settlements (BIS). This represented the greatest currency and gold as the world’s principal hard accumulation of gold by central banks in more asset, it is logical that the two would be inversely than 40 years. correlated. This relationship has broken down periodically, most notably during the recent The financial crisis rekindled central banks’ economic crisis, but in the long run, the traditional appetite for gold. Although the scale of purchases relationship has always been re-established. appears to have moderated this year, compared to
Gold’s performance vs currencies and platinum, 2011-present 2011, the official sector remains a strong buyer of gold. According to the most recent data from BIS, 20% 20% central banks purchased a net 118.9 tonnes of gold 10% 10% from January-April this year. The major buyers 0% 0% were Turkey, 45 tonnes; the Philippines, 35 -1 0% -1 0% tonnes; Mexico, 20 tonnes; Russia, 16.6 tonnes; -2 0% -2 0% Kazakhstan, 16 tonnes; Belarus, 4 tonnes; and -3 0% -3 0% Ukraine, 3tonnes. China also might have JP Y SEK ZAR BRL GBP EU R NO K AUD CH F SGD GOLD accumulated gold from domestic sources, but this PLATINUM Source: Bloomberg has not been reported to the BIS. Light sellers included Sri Lanka and Germany. Despite the decline in EUR/USD this year, the HSBC currency team retains the view that the EUR will finish 2012 substantially higher. It bases this on its view that Greece will stay in the Eurozone. The team also believes that European policymakers will adopt measures to support the other peripheral European Union members. This,
50 Natural Resources & Energy China Equity abc July 2012
Gold held in central banks, as a percentage of total reserves Historically low net long positions imply plenty of
10,000 80% room for investors to rebuild long positions and 8,000 60% for gold prices to trade higher. 6,000 40% 4,000 ETFs: Barely higher and more volatile 20% 2,000 A notable feature of the gold market has been the 0 0% popularity of gold exchange-traded funds (ETFs) US IMF Italy with investors. That said, following several years China Japan Russia France
Germany of near-robust growth, ETF demand is moderating
Switzerland Netherlands notably and holdings have been subject to Gold (tonnes) % of res erv es increasing volatility in the past 30 months, with
Source: World Gold Council, HSBC changes in risk sentiment resulting in periodic Traders: How low can you go? liquidations. Despite this, the overall trajectory of Commitments of Traders reports issued by the demand remains slightly positive. Commodity Futures Trading Commission (CFTC) We anticipate that demand for allocated gold and have been a reliable barometer of investor other sources of bullion may limit any increase in attitudes toward the metal. Speculators have been gold ETF off-take to c125 tonnes this year and net long gold on the Comex since the genesis of c100 tonnes in 2013. Other forms of physical gold the bull market in 2001. These positions, demand include bars and coins. Combined bar and however, are often subject to considerable coin demand in 1Q12 rose 13% to 389 tonnes volatility and fluctuations, which can visibly from a year earlier, according to Thomson Reuters affect gold prices. We believe this helps explain GFMS data compiled for the World Gold the volatility of gold prices. Council’s most recent “Gold Demand Trends.” Gold and net speculative positions, 2010-present Physical demand for bullion products appears to 2, 200 40 moz have fallen sharply since 1Q, with the US Mint 30 1, 800 reporting c50% lower demand for its gold coins in 20 April and May, compared with the same period in 1, 400 10 2011. We expect lower prices, combined with
1, 000 0 continuing investor concerns, to stimulate Jan -10 Jul-10 Jan-11 Jul-11 Ja n-12 physical demand for coins and bars in the second half of this year. This should also help put a floor Spec p osition in COMEX (RHS) under gold price declines. The following chart Gold Pri ce U SD/ oz (LHS ) shows monthly sales of US gold coins.
Source: CFTC, HSBC
According to the latest CFTC data, net long speculative positions total c15.6m oz, up from the year-to-date low of c13.0m oz set in the last week of May. Net long speculative positions also are about 15.28m oz below the record high of 30.8m oz set at the beginning of December 2008, when gold prices were trading around USD1,200/oz.
51 Natural Resources & Energy China Equity abc July 2012
Gold prices, gold ETF, and net speculative positions According to data collected by Thomson Reuters
2, 300 150 GFMS for the World Gold Council, global moz 1, 800 jewellery demand in 1Q this year was c511 100 tonnes, a 10% drop compared with 1Q11 demand 1, 300 50 of c570 tonnes. Some of this decline can be 800 explained by the price increase between the two 300 0 periods; gold prices were 20% higher on average Jun -04 J un-06 Jun -08 Jun-10 Jun-12 in 1Q12 than a year earlier. Jewellery demand Gold in ETFs (RHS) remains sluggish globally but is above the near- Spe c position in COMEX (RHS) Gold Price USD/oz (LHS) disastrous levels during the worst periods of the financial crisis in 2008 and 2009, when Source: Gold Bullion, ETF Securities, CFTC, HSBC consumers cut back on expenditures on luxury
Fabrication demand goods, including gold jewellery. Indian troubles and Chinese strength Indian demand for gold jewellery is down considerably so far this year. Demand fell sharply Jewellery consumption is the largest component of in response to near-closure of the Indian retail fabrication demand. This makes jewellery jewellery segment from mid-March to the end of consumption arguably the single most important April in response to proposed government determinant of price. A notable feature of the gold increases on bullion imports and other bullion jewellery market is its decline as a share of total taxes. In addition, domestic Indian demand has demand in recent years. In 2011, gold jewellery been severely crimped by a weak INR, which accounted for barely 45% of total gold demand, noticeably increased the gold price in local terms. down from c75% in 2005. For 2012, we forecast that High local prices also triggered a boom in Indian jewellery will remain below 50% of total fabrication scrap recycling. demand. The decline in jewellery’s share of demand is also a reflection of the increased importance of Indian gold jewellery demand and the INR investment demand, as well as outright declines in 250 58 tonnes physical jewellery consumption. 200 53 150 Global demand for gold jewellery (tonnes) 48 100 3,000 50 43 2,500 0 38 J an- Jan- Jan- Jan- Jan- Jan- Jan- 2,000 06 07 08 09 10 11 12 1,500 Ind ia Je wellery De mand (LHS) 1,000 U SD-IN R (RH S)
500 Source: World Gold Council, Bloomberg, HSBC
0 Chinese demand, meanwhile, has been generally 2004 2005 2006 2007 2008 2009 2010 2012f 2011e strong for most of this year. Although the pace of Source: Thomson Reuters GFMS, WGC, HSBC growth in Chinese gold jewellery demand appears to have slowed in the first quarter, it remains strong. More recently, any big jump in gold
52 Natural Resources & Energy China Equity abc July 2012
imports from Hong Kong supports the notion that Global gold mine production (tonnes)
Chinese jewellery demand has increased recently. 3, 200 2, 000
Even so, some of the gold may have been re- 3, 000 1, 500 exported and some was for investment, so the 2, 800 broad import figure does not entirely represent 1, 000 2, 600 jewellery demand. Taking these factors into 500 2, 400 account, we believe that gold jewellery demand in China is on a strong footing. By comparison, 2, 200 0 2005 2006 2007 2008 2009 2010 2011
advanced markets such as the US and Europe 201 2f 2013f recorded declines in jewellery purchases in 1Q, Mine pro duction - LHS Gold (USD/oz) - RHS compared with the same period in 2011. Source: Thomson Reuters GFMS, WGC, HSBC
China: Gold imports from Hong Kong Although costs are rising rapidly, at current prices 120 the vast bulk of producers still have significant Tonn es financial incentive to increase output wherever 100 possible. Regardless of price, producers face a 80 range of obstacles and challenges to raising 60 output, including declining ore grades, reserves 40 that are difficult to access, increased government regulations, rising costs, and a shortage of skilled 20 and technical manpower. Despite this, the output 0 trajectory for at least the next three years appears to be higher. Nov-08 Nov-09 Nov-10 Nov-11 May-09 May-10 Ma y-11 Source: Hong Kong Census and Statistics Department Scrap supply
Not strapped Gold mine supply Recycled scrap supplies have replaced official More but harder to get sector sales as the largest source of gold supply Gold production is rising in response to high after mine output. The scrap market grew from prices and investments made earlier in the mining c600 tonnes in 2000 to c1,661 tonnes in 2011, but cycle. Output gains are modest, however, the latter was down from 1,718 tonnes in 2010, compared to the steep increases in recent years. according to data compiled for the World Gold Gold prices have risen every year since 2000, and Council by Thomson Reuters GFMS. The likely despite a more than fourfold price increase since dearth of any further significant official sector then, it was not until 2010 that production sales leaves the gold market highly dependent on surpassed that in the banner year of 2001. recycled flows for new supply. According to the World Gold Council’s latest “Demand Trends,” compiled by Thomson Reuters GFMS, scrap supplies in the first quarter of 2012 totalled 392 tonnes, up c11% from the 1Q11 levels but very close to the 1Q07 to 1Q11 average of 395 tonnes.
53 Natural Resources & Energy China Equity abc July 2012
Gold: Supply/demand balance (tonnes) 2005 2006 2007 2008 2009 2010 2011 2012f 2013f Mine production 2,550 2481 2,476 2,409 2,589 2,741 2,818 2,890 2,980 Official sector net sales 662 367 484 236 33.6 -77 -456.4 -450 -425 Old gold scrap 886 1,107 956 1,217 1,695 1,719 1,661 1,786 1,650 Producer hedging -86 -373 -444 -349 -236.4 -107.8 5 20 20 Total supply 4,012 3,582 3,472 3,513 4,081 4,275 4,028 4,246 4,225 Jewellery 2,707 2,283 2,405 2,187 1,814 2,017 1,973 1,848 1,950 Electronics 280.4 306.1 310.6 292.7 274.9 326 320 323 325 Dentistry 62.4 60.7 57.8 55.9 52.7 48.7 43.4 43 42 Other industrial uses 87.8 91.2 93.2 86.9 82.2 90.9 89.4 90 90 Other fabrication 430.6 458 461.6 435.5 409.8 465.6 452.7 456 457 Total fabrications 3,138 2,741 2,867 2,623 2,223 2,482 2,426 2,304 2,407
Bar hoarding 237.6 210.4 222.5 605.2 483.1 908.7 1,191 1,100 1,150 Official coins 110.9 129.1 137 187.3 234.1 213.1 245.5 175 225 Medals 37 59.4 72.6 69.6 58.9 88.3 87.8 89 88 Exchange-traded funds 208.1 260.2 253.3 320.9 617.1 367.7 162 125 100 Total investment demand 594 659 685 1,183 1,393 1,578 1,686 1,489 1,563 Total demand 3,731 3,400 3,552 3,806 3,617 4,060 4,112 3,793 3,970 Balance = net investment 281 182 -80 -293 464 214 -84 453 255 Gold price (USD/oz) 445 605 697 872 974 1,227 1,573 1,760 1,775
Source: WGC, Thomson Reuters GFMS, HSBC
Based in part on our outlook for higher gold prices later this year, a slight reduction in recycling from Western markets, and continued high recycling levels from India, we anticipate a c125 tonnes increase in scrap supply to a record c1,786 tonnes for 2012, or c60% of our estimate of mine supply. For 2013, we expect a reduction Indian scrap levels, which should reduce them to near 1,650 tonnes.
54 Natural Resources & Energy China Equity abc July 2012
Steel – likely to stay tough out there
Companies face a challenging environment with slowing demand growth, surplus capacity and a lack of supply-side discipline Recovering demand in 2H12 driven by stimulus and base effects is likely to be offset by increasing production Steel prices expected to remain cost-driven. Chinese HRC prices are forecast to fall by 6% in 2012e and rise by 4% in 2013e
Tough now, tough later Shougang, Angang and others have cut prices for July and August deliveries. Steelmakers in China The outlook for Chinese steel companies is tough believe the outlook is weak. now and likely to remain so for the foreseeable future, in our view. The industry has excess Chinese HRC and rebar prices capacity and a distinct lack of supply-side 700 USD/t discipline. No steel maker we know of will make 660 meaningful cuts in production for fear of losing 620 market share to competitors. Steel prices will 580 fluctuate with demand seasonality and the buying 540 and selling patterns of Chinese steel traders, but 500 ultimately will continue to be determined by iron 460 ore and coking coal prices. We see margins Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 remaining suppressed over the medium term. Jan-10 Jan-11 Jan-12 Rebar HR C
The outlook for prices Source: CISA, HSBC
So far this year, steel prices have been weak. We In y-o-y terms, average Chinese HRC prices for saw a much weaker seasonal demand-led pick-up 1H12 fell USD52/t or 8%. 3Q is normally a in steel prices in January-April compared to slower period and we would expect prices to drift previous years and prices fell sharply in May as further. We do expect to see prices recover in usual, as traders destocked into the summer 4Q12 as demand picks-up but low utilisation rates slowdown. suggest there will be a ready supply-side response Over the past few weeks, major producers restricting any increase. including Boashan, Wuhan Iron and Steel,
55 Natural Resources & Energy China Equity abc July 2012
All in all, we expect Chinese HRC prices to fall Our forecasts are for marginally slower growth by USD39/t or 6% y-o-y in 2012e and to rise by than anticipated by the World Steel Association USD24/t or 4% in 2013e. which expects growth of 3.6% in 2012e and 4.5% in 2013e. Chinese HRC prices forecasts
680 Growth still emerging market driven 660 USD/t Global steel demand growth will continue to be 640 620 driven by emerging markets. We forecast Chinese 600 consumption growth at 5.1% in 2012e and 4.9% 580 560 in 2013e and expect China to account for c70% of 540 incremental global growth in 2012e, declining to 520 c58% in 2013e. 500 We calculate that China accounted for c76% of 1Q10 4Q10 3Q11 2Q12 1Q13 4Q13 3Q14 the growth in world steel consumption in 2001- Source: CISA, HSBC 2011, as loose monetary policy and rapid fixed Global demand growth to slow asset investment in China effectively masked sharply in 2012 demand weaknesses in other parts of the world. We expect world steel consumption to slow In future, we believe the development of other sharply in 2012 driven primarily by slower growth economies, such as India, and a shift in in China, stagnating demand in the US and a economic growth patterns in China away from decline in Europe. We forecast global growth of investment and towards consumption, will mean 3.3% in 2012e and 3.9% in 2013e, down from that world growth will become geographically growth of 6.7% in 2011. more broad-based.
We forecast Indian steel demand to grow by 6.5% in 2012e and 8.7% in 2013e and expect India to
account for increasingly large share of global HSBC global finished steel demand estimates (mt) demand growth. India accounted for c7% of the 2011 2012e 2013e 2014e 2015e growth in world steel consumption over 2001- Finished steel consumption (mt) Europe 186 184 186 191 196 2011, but we expect its share of incremental CIS 54 54 56 60 64 demand to grow to 11% in the 2011-2015e period. N. America 127 130 132 136 140 C&S America 46 49 52 55 59 Asia Pacific 895 935 977 1,022 1,069 We expect demand in the BRIC nations (Brazil, Middle East/ Africa 71 74 77 80 84 Russia, India and China) to grow by 5-6% over 2012 World 1,379 1,424 1,480 1,544 1,612 China 618 649 681 715 751 to 2015e. BRICs accounted for 87% of demand World ex China 761 775 799 829 862 growth between 2001 and 2011, but we expect its Change y-o-y contribution to slow to 74% over 2011-2015e on a Europe 6.5% -0.9% 1.0% 2.6% 2.7% CIS 12.0% -0.8% 4.3% 6.8% 7.4% rising share of growth from other emerging N. America 9.7% 2.0% 2.2% 2.6% 2.7% C&S America 2.0% 5.4% 6.9% 6.9% 6.9% economies, such as Middle East and Africa. Asia Pacific 7.0% 4.4% 4.5% 4.6% 4.6% Middle East/ Africa -1.2% 4.0% 4.2% 4.8% 4.8% World 6.7% 3.3% 3.9% 4.4% 4.4% China 8.4% 5.1% 4.9% 5.0% 5.0% World ex China 5.4% 1.8% 3.0% 3.8% 3.9%
Source: World Steel Association, HSBC
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Global demand growth to become more broad based, share Global output returning to trend of incremental demand growth We expect global crude steel output growth to 80% 70% normalize to 3-4% p.a. over the medium term. 60% 58% 53% 52% This compares to a post-crisis rebound of 15% 42% 47% 48% growth in 2010 and 7% growth in 2011. 40% 30% Quarterly global crude steel production has returned to trend 20% (mt)
400 0% 2012e 2013e 2014e 2015e 350 China World ex China 300 Source: World Steel Association, HSBC 250
In contrast to China, we forecast world ex-China 200 demand growth of just 1.8% in 2012e and 3.0% in 150 2013e. Our forecasts are lower than the World Steel
Association estimates of 3.2% for 2012e and 4.8% 1Q98 4Q99 3Q01 2Q03 1Q05 4Q06 3Q08 2Q10 1Q12 for 2013e. We note the World Steel Association has Source: World Steel Association, HSBC cut its ex-China demand forecasts for 2012 in each of its previous reviews and we believe there remains Global steel production reached an all-time high of further downside risk to its estimates. 1.579btpa (annualised) in April 2012, but declined by 1.2% y-o-y to 1.560mtpa in June 2012. That said, The World Steel Association alludes to this in its world production in January-June 2012 remained short-range outlook published in April 2012, stating flat, as Asian production grew by just 1% y-o-y, and that “although the global impact of the euro zone North American growth was offset by declines in debt crisis has been limited so far, uncertainties Europe and South America. continue to exist and this remains the key downside risk to our current outlook. High oil prices and Importantly, global utilization rates have been geopolitical tensions in the oil producing regions are hovering between 71% and 83% since early 2010. also important downside risk factors”. With a slower growth outlook, it seems unlikely to us that utilisation rates will rise significantly in
World Steel Association’s world ex-China demand forecast World crude steel production growth has remained flat y-o-y for 2012 has been continuously revised down over Jan-June2012
7% 8% 6% 6% 5% 4% 2% 4% 0% 3% -2% 2% -4% 1% C.I. S World Africa
0% Europe
Apr 2011 Oct 2011 Apr 2012 PacificAsia Middle East North America North AmSouth erica Source: World Steel Association, HSBC Source: World Steel Association, HSBC
57 Natural Resources & Energy China Equity abc July 2012
the near term. That will make it difficult, we Chinese steel outlook believe, for steel makers to be able to force China’s apparent crude steel demand reached up margins. 648m tonnes in 2011, up 8% y-o-y. Crude steel Global crude steel capacity utilization has failed to reach its production reached 684m tonnes, up 9% y-o-y. pre-crisis level
95% We forecast growth in apparent demand at c5% p.a. in 2012e and 2013e. This is slower than our 85% China economist Qu Hongbin’s forecast of real GDP growth of 8.4% in 2012e and 8.8% in 2013e. 75% While this is unusual in an emerging economy, we 65% expect to see continued economic restructuring away from investment and for monetary policy to 55% remain reasonably ‘tight’. Our China economist expects Chinese FAI growth to ease from 24% in Jul-08 Jul-09 Jul-10 Jul-11 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 2011 to 19% this year. He also does not expect Source: World Steel Association, HSBC substantial fiscal stimulus of the magnitude seen in 2009. Our forecasts imply c5% p.a. growth in output in 2012e and 2013e.
Although production levels have continued to rise over the past few months, reaching a peak output of an annualised 737m tonnes in April, growth rates are now much slower than they were in the first 10 months of 2011.
HSBC China supply and demand estimates (mt) 2009 20102011 2012e 2013e 2014e 2015e Crude steel production 567 627 684 719 748 783 821 Change y-o-y 13% 11% 9.2% 5.1% 3.9% 4.8% 4.8%
Net imports/(exports) semis 5 1 1 1 1 1 1 Change y-o-y % -407% -88% 34% -2% 43% 0% 0%
Imports finished steel 18 17 16 16 20 20 20 Change y-o-y 15% -7% -5% 0% 27% 0% 0%
Exports finished steel 25 43 49 49 50 50 50 Change y-o-y -59% 73% 15% 0% 2% 0% 0%
Net imports/(exports) finished steel (7) (26) (33) (35) (30) (30) (30) Change y-o-y % -85% 286% 28% 6% -14% 0% 0%
Apparent consumption - crude steel basis 564 598 648 681 715 751 789 Change y-o-y 25% 6% 8% 5.1% 5.0% 5.0% 5.0%
Apparent consumption - finished products basis 536 570 618 649 681 715 751 Change y-o-y 25% 6% 8% 5.1% 4.9% 5% 5%
Source: China Metals, HSBC
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China annualised monthly crude steel production and US-China HRC prices and Chinese exports growth (mt) 6.0 400 Tonnes m US$/t 750 30% 5.5 350 5.0 300 700 20% 4.5 250 4.0 200 650 10% 3.5 150 600 3.0 100 2.5 50 0% 550 2.0 - 500 -10% Jul-10 Jul-11 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12
Chinese steel exports US-China HRC prices gap Jul-10 Jul-11 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12
Annualised crude prodn Change YoY (RHS) Source: China Metals, Bloomberg, HSBC Source: China Metals, HSBC
Inventory levels normal We expect Chinese net exports of finished steel to Markets remain overly concerned about the remain roughly flat at 30-35m tonnes over 2012e Chinese steel inventories but we believe that they to 2015e. Net exports have been running at are at reasonable levels. Traders’ inventories are annualised rates of 43-46m tonnes in March-May. treading the well chalked out path, though the China imports, exports and net trade (mt) pace of de-stocking has been a bit slow. 2 Inventories have declined by 19% since reaching its peak in February, at a little slower than in 2011 0 where inventories declined by c26% from its peak -2 by the third week of July. -4 China traders’ steel inventory
-6 20 Jul-10 Jul-11 Apr -10 Oct-10 Apr -11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 18 Imports Ex po rt s N e t Im po rt s (E x po rts ) 16 Source: China Metals, HSBC
14 The level of Chinese steel exports is mainly driven by the ‘export price gap’, the difference 12 Jul Ap r Oc t Jun Jan Aug Sep Feb Mar Dec Nov between Chinese and overseas steel prices. May 2010 2011 2012
Source: Mysteel, HSBC
2H12 base effects, but … We understand the view that “the second half of the year will definitely be better”, yet we do not believe this will result in significantly higher selling prices or better margins.
59 Natural Resources & Energy China Equity abc July 2012
While our forecast is for annual growth of c5% this The property sector, which represents the biggest year, we expect a marked split between growth in chunk of steel demand, has suffered from the 1H12 and 2H12. China’s credit tightening was government engineered slowdown aimed at particularly acute in 4Q11. As a result, steel avoiding an asset bubble in the residential production and consumption rates were much property market. Growth in real estate weaker than usual towards the back-end of last year. investments in residential building has slowed to As a result, we forecast consumption of 0% y-o-y in 12% y-t-d in June compared to over 30% levels in 1H12 and 11% y-o-y in 2H12. 2010 and 2011. Similarly growth of floor space under construction has declined to its lowest level We expect a pickup in demand in 2H driven by since January 2010. The Real Estate Climate stimulus measures, including a further monetary Index, a gauge of the present situation and future easing via an additional 200bp reserve requirement trend of the real estate market in China, has ratio (RRR) cuts through the rest of this year, and continued to decline. Fixed asset investment in fiscal stimulus through additional tax cuts, VAT infrastructure has also decelerated as government reforms and speedy spending on public works. shifts its focus towards consumption led economic Annualized quarterly crude steel consumption growth. Both auto and appliances production
170 25% growth has remained flat y-t-d. Tonnes m 20% 160 Too much capacity, too little discipline 15% 150 10% The Chinese Iron and Steel Association’s (CISA) 140 5% official estimate is that Chinese crude steel 0% 130 capacity will be c840mtpa this year. This seems -5% low to us, which probably results from data for 120 -10% capacity additions made by smaller steel mills not
1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q 11 4Q11 1Q12 being readily available and thus not included in Annualised consumption YoY growth (RHS) the CISA estimate. Other estimates – including Source: China Metals, HSBC from the NDRC – are as high as 900mtpa.
… underlying demand is still weak Assuming the 900mtpa to be accurate, the One of the main issues facing the industry is that Chinese steel makers would operate at an average underlying demand from several key sectors utilisation rate of c80% this year. Further, remains weak. assuming no net capacity additions over the next few years, utilisation rates could reach 83% in China steel demand by end use (2011) 2013e, 87% in 2014e and 91% in 2015e. By Machinery 2015e, utilisation rates could reach the levels 22% Auto where the steel market may become ‘tight’. This, 8% of course, is predicated on the assumption that Infrastructure Shipbuilding there is no further capacity growth, something 23% 4% Appliances which in China seems highly unlikely. 2% Other It also suggests that the market will not tighten 3% significantly over the next couple of years. Property 38% Source: Brook Hunt, HSBC
60 Natural Resources & Energy China Equity abc July 2012
Two new projects approved The first reason is, as stated above, the In June 2012, the NDRC finally approved two government hopes to close some older plants. steel projects in southern China that it had held up Second, these new mills will focus on producing for several years. Both projects are part of the higher-end steel products for the auto, home broader restructuring of the industry and were appliance and machinery industries which the approved on the basis that other more outdated capacity would be closed. older mills are incapable of.
Baoshan Group’s Guangdong Zhanjiang project Third, being coastal plants in southern China they has a proposed crude steel capacity of 10mtpa and will be able to import iron ore more cheaply than was approved on the basis that Guangdong would either inland or northern China plants. close 16.1mtpa existing capacity. Fourth, China is shifting its excess capacity from Wuhan Steel’s Fangchenggang project has a inland to the coast. Essentially, the NDRC plans proposed crude steel capacity of 9.2mtpa and was to transfer surplus capacity to export market – an approved on the basis that Guangxi province ominous warning for foreign steel makers. would close 10.7mtpa outdated capacity.
Given the overcapacity in the industry it is worth asking why the NDRC approved these projects at all.
China Real Estate Climate Index FAI infrastructure growth y-t-d 109 50%
106 40% 30% 103 20% 100 10% 97 0%
94 -10% Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
Source: CEIC, NBS, HSBC Source: CEIC, NBS, HSBC
Auto production growth y-t-d China home appliances growth y-t-d
150% 50% 40% 100% 30% 20% 10% 50% 0% -10% 0% -20% -30% -50% -40% Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
Source: CEIC, NBS, HSBC Source: CEIC, NBS, HSBC
61 Natural Resources & Energy China Equity abc July 2012
What does China’s 12th Five-Year China’s claimed 48.6% production share for the Plan really mean for steel? top 10 firms in 2010 included groups that had not China’s 12th Five-Year Plan for the steel industry in fact merged at all. was officially released by the NDRC in November Anben, for instance, is claimed to be the third- 2011. Instead of signalling a new emphasis on largest steel maker in China. Yet, Angang and restructuring, the plan reiterated broad targets for Bengang Steel have not merged. Shandong Iron industry development that were first published in and Steel was claimed to be the 7th largest steel 2009. We see little in the plan that can boost maker in China in 2010, but Laiwu Iron and Steel companies’ returns over the next 2-3 years. and Jigang Steel, the two companies in Shandong Province, only received final approval to merge Steel sector consolidation has been a failure their listed entities late last year. Even in groups One of the government’s targets has been to such as Hebei Iron and Steel, which were formed consolidate the sector in the hope that this would from the merger of a myriad of smaller companies, lead to more efficient operations. China’s plan is little real restructuring of production assets has to increase the production share of the top 10 taken place. companies from a claimed 48.6% in 2010 to 60% by 2015. In our view, these figures are wishful It is not relevant what China claims the top 10 thinking by Chinese government officials and have production share is, but rather what real little bearing of the realities of the sector. restructuring is taking place and on that measure the industry has made very little progress over the past few years.
China steel industrial layout along coastal region
Source: Mysteel.net
62 Natural Resources & Energy China Equity abc July 2012
Plans to close blast furnaces to have minimum The outlook for iron ore impact We expect the iron ore market to remain tight Part of the plan involves the closure of all blast over medium term as supply ex-China is delayed furnaces with capacity less than 400 cu m. Smaller and Chinese iron ore grades remain challenging. blast furnaces are generally less energy-efficient, We expect global ore production to increase by so closing them fits in with the government’s plan 5% y-o-y in 2012e and by 3% y-o-y in 2013e, to improve the energy efficiency of the industry. broadly in line with our steel output growth The issue is that there are hardly any blast furnaces forecast of 3-4%. Given the slow output growth of left operating that are that small. the world ex-China, Chinese production will be The plans to close smaller furnaces have been required to keep the market in balance. well publicized by the government – the original Spot iron ore prices have declined recently on the plan was to close furnaces smaller than 300 cu m back of weaker-than-expected demand growth in by 2010 – and steel enterprises have had years to China, but have found support from the top end of adjust. This has meant building larger furnaces. the China iron ore cost curve. We expect iron ore According to data from the China Iron and Steel prices to average USD130/t (fob) in 2012e and Association, the number of furnaces with remain in USD130-140/t range over the next capacity of 1,000-2,000 cu m grew from 31 in three years. 2003 to 112 by 2009. The bottom line is that plans to close smaller furnaces have already been China imported iron ore price has fallen since May on weaker than expected demand growth ( 62% Fe, USD/t) implemented by the industry and will have little 200 impact on production levels, utilization rates, costs or selling prices. 175
Similar to plans in the cement industry, it looks as 150 though projects in Xinjiang will be approved. It is 125 unclear at this stage how much new capacity will be approved during the 12th Five-Year Plan 100 period, but we can be confident that China will not Jul-11 Jul -12 Apr-11 Oct-11 Apr-12 want to become a major net importer of steel. Jan-11 Jan-12
The plan unlikely to reduce volatility in Source: The Steel Index, Bloomberg, HSBC Chinese steel prices The high degree of volatility in Chinese steel prices stems from the fact that most steel in China is distributed through steel traders. These traders often aim to ‘call the market’ by anticipating short-term changes in demand. In order to take advantage of these trends, the traders often build or reduce inventories quickly and these mini- stocking or destocking cycles cause prices to be highly volatile. Nothing in the proposed plans will change this.
63 Natural Resources & Energy China Equity abc July 2012
China iron ore cost provides a floor Chin iron ore annualised monthly production on a grade adjusted basis (mt) Iron ore prices have continued to find support 550 120% from the high end of the Chinese cost curve. Production costs in China are much higher than 450 80% that in Australia or Brazil, as mines are small in 350 40% scale and often located underground which 250 0% increases the mining cost substantially. We believe the market will continue to be balanced by 150 -40% high cost Chinese iron ore supply. As such, Jul-10 Jul-11 Apr -10 Oct-10 Apr-11 Oc t -11 Apr -12 Chinese marginal cost of production, which is in Jan-10 Jan-11 Jan-12 Iron ore supply (LHS) YoY% (RHS) the range of USD120-140/t, will continue to provide a floor to price in our view. Source: CEIC, HSBC
Global iron ore cost curve …and falling Indian iron ore exports
Low Quality We expect the ban on Indian iron ore exports to 140 C hinese remove 30-35m tonnes of ore from the market in 120 2012, having already taken c25m tonnes out of the 100 market in 2011. We do not expect this material to 80 come back into the market any time soon.
60 P Arecelor Mittal Arecelor o FM G BH 40 Ri
Va l e Chinese iron ore imports from India has continued to decline (mt) C1 cost cash (USD/t) 20 14 0 0 600 1,200 1,800 12 Cumulative Costed Production (mt) 10 8 Source: AME, HSBC 6 Supply has remained tight as Chinese 4 2 production has declined… 0 We estimate that Chinese domestic iron ore supply Jul-10 Jul-11 on a grade adjusted basis has fallen over Jan to Jan- 10 Apr-10 Oct-10 Jan-11 Apr-11 Oct -11 Jan-12 Apr-12
June 2012 compared with last year. China iron ore Source: China Customs, HSBC output is sensitive to prices in our view. Output remained strong over January to August 2011, Chinese import dependency is high when iron ore prices were in the range of USD170- and rising 190/t but started to decline from October 2011 as Chinese steel industry has been largely reliant on iron ore prices fell to USD140-150/t levels. imported iron ore as domestic production has been insufficient to meet the rising demand from steel mills. Chinese pig iron production grew at a CAGR of 16% over 2001-2011 but domestic iron ore supply (on a grade adjusted basis) has grown at 10%. While the gross ore production growth has been impressive at 20%, iron ore grades have
64 Natural Resources & Energy China Equity abc July 2012
continued to fall, halving from the high-30s% in content). As the steel industry gradually produces early 2000’s to just 17% by 2011. We expect higher-quality steels, it will demand better quality gross iron ore production to rise 7% y-o-y in iron ore. This is likely to have to be imported. 2012e and remain flat over the next two years. Based on the NDRC’s forecast of crude steel China gross iron ore production and grades (mt) consumption of 750m tonnes in 2015e (a forecast
1,500 60% we think is too low) and assuming no net 1,200 50% imports/exports and allowing for some increase in the use of steel scrap, Chinese iron ore demand is 900 40% likely to reach c1.05bn tonnes at typical imported 600 30% grades of c62% Fe content. 300 20% 0 10% To meet the NDRC’s plan, China will need to produce c470m tonnes at 62% Fe content or 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012e 2013e 2014e 2015e roughly 1.7bn tonnes at an average Chinese grade Gross production Iron ore grade (RHS) of c17% Fe content (our estimate). This represents Source: CEIC, HSBC an increase over peak production levels of c10%
and will be possible only if: 1) Chinese ore grades Chinese iron ore imports have continued to rise to do not deteriorate further; and 2) iron ore prices fill the domestic demand-supply gap with imports stay above the Chinese cost of production which is now representing c70% of supply. We expect cUSD120-130/t for much of production and nearer Chinese imports to continue to increase, as USD150-160/t for some marginal production. domestic production growth flattens, and for imports to account for over 75% of domestic China continues to seek non- demand by 2015e. traditional sources of iron ore China is relying more and more on ‘non- China iron ore consumption and share of imports (mt Fe units) traditional’ sources of iron ore. Imports from
900 80% South Africa were up 19% y-o-y to 10.2m tonnes 750 70% in 1Q12, imports from North America rose 68% 600 60% to 6.9m tonnes, imports from Ukraine rose 39% to 450 50% 4.0m tonnes, and imports from Indonesia rose 300 40% 150 30% 45% to 3.9m tonnes. Most of this material is not 0 20% reflected in the spot iron ore indexes. This could explain why spot trading appeared to be so thin in 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012e 2013e 2014e 2015e 1Q12, even though China’s steel mills were Imported Fe Units Dom estic Fe Units Imo r ts s ha re (RHS) clearly importing more material.
Source: CEIC, HSBC India exported 26.5m tonnes of iron ore to China in China’s NDRC actually hopes to raise its 1Q11, but with higher export taxes and bans on domestic iron ore supply to 45% of total demand mining in some areas, this had fallen to 11.8m (from c33% so far this year). The main issue is tonnes in 3Q11 and to 11.6m tonnes in 4Q11. The that Chinese iron ore is typically very low grade data for 1Q12, shows something of a recovery with (with many smaller iron concentrate producers imports from India reaching 14.1m tonnes, up c22% using feedstock with as low as 10-15% Fe q-o-q though still down substantially (47%) in y-o-y
65 Natural Resources & Energy China Equity abc July 2012
terms. Of this amount, we think India is supplying Spread between 62% Fe and 58% Fe iron ore prices very little high-quality iron ore, with import grades 60% in 1Q12 at 50-55% average Fe content. 50% Of the other major suppliers, imports from 40% Australia were 83.0m tonnes, up 22% y-o-y (last 30% year Australia was hit by bad weather) and 20% imports from Brazil were 41.6m tonnes, up just 10% 3% y-o-y as Vale shipments were impacted by 0% rains in 1Q12. Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 China share of imports from non traditional sources (ie excluding Australia, Brazil and India) Source: Bloomberg, HSBC
30% Since iron ore prices were effectively ‘floated’ in 25% April 2010 – one factor behind the destruction of Chinese steel making margins – steel makers have 20% tried to reduce costs by using a greater proportion of lower-grade iron ore. Demand for lower-grade 15% ores has strengthened relative to demand for 10% higher-grade ores, resulting in a narrowing of the ‘grades spread’. The Steel Index’s 58% Fe content Jul-10 Jul-11
Jan-10 Apr-10 Oct-10 Jan-11 Apr-11 Oct-11 Jan-12 Apr-12 iron ore index includes material with 55-60% Fe content, with a maximum of 8% silica and 5% Source: Bloomberg, HSBC alumina, regardless of origin. It includes, for
instance, most mid-grade Australian iron ores China iron ore imports by region (mt) such as BHP’s Yandi fines (57.5% Fe content, Total Australia Brazil India S Africa Others 5.5-6.0% silica). What the indices do not show is 1Q11 177 68 40 26 9 34 2Q11 157 65 29 23 9 31 that most Indian iron ore supplied into China this 3Q11 174 81 36 12 9 36 year has been 50-55% Fe content material. 4Q11 178 82 38 12 10 37 1Q12 187 83 42 14 10 38 This is too poor a quality to be included in the 2Q12 180 83 35 14 10 38 iron ore price indices – but not too poor to be used Source: China Customs, HSBC by many Chinese steel makers.
Narrowing spreads between grades It is worth noting that the Platts indices for One interesting trend is that the spread between the differing ore grades sometimes show different price for 62% Fe content iron ore and the lower trends. One reason for this is the Platts index grade 58% Fe content ore has declined since mid- excludes much of the mid-grade Australian ores 2010. The average price premium of 62% material because of a silica content cut-off of 5% but does include Indian ore from producers such as Sesa over 58% material was 26% in 2010, 15% in 2011 Goa and Fomento, who sell less than 55% Fe and 9% so far this year. It reached an all-time low of content material. Australian ores tend to attract a just 4.4% on May 11, 2012 with 62% material premium to Indian mid-grade material. As a trading at USD141.3/t cost and freight (cfr) China result, The Steel Index indices tend to narrow and 58% material trading at USD133.9/t. more than the Platts indices when times are tough.
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Metallurgical coal – supply side issues abating
Market now well-supplied given Australian recovery and rising supply from Mongolia, Mozambique and Russia Demand environment will remain benign as global crude steel production growth moderates Prices have come off. We forecast hard coking coal prices at USD220/t in 2012e and USD228/t in 2013
A more benign outlook predominantly hard coals) and prices declining, we expect the discount for semi-soft coals relative We see a more benign outlook for coking coal to harder grades to expand. We are already seeing prices driven by slower growth in global pig iron this in recent settlements. We forecast semi-soft production and the continued easing of supply- coking coal prices at USD151/t in 2012e, side issues. While the coking coal market will USD143/t in 2013e and USD131/t in 2014e with remain vulnerable to bad weather (which pushed forward prices at c63% of our hard coking coal up prices in 2011) and labour strikes, we expect prices. We see more limited supply growth in prices to ease as exports from Australia, Mongolia low-volatile pulverised coal injection (PCI) coals and Mozambique increase. suggesting prices may be better supported than for We forecast hard coking coal prices (calendar semi-soft grades. year, fob Australia) at USD220/t in 2012e, We retain our long-run forecast of USD120/t for USD228/t in 2013e and USD208/t in 2014e. hard coking coal (2012e prices), based on prices With hard coking coal supplies increasing trading at the top end of the cost curve. We (Australia, Mongolia and Mozambique all supply introduce long-run forecasts for semi-soft coking
HSBC coking coal price forecasts ______Annual ______Quarterly ______Ccy 2011a 2012e 2013e2014e L run 1Q12a 2Q12a 3Q12a 4Q12e 1Q13e 2Q13e 3Q13e 4Q13e Hard Coking Coal USD/t 289 220 228 208 120 235 210 225 210 220 240 230 220 Semi-soft Coking USD/t 206 151 143 131 76 179 147 147 132 139 151 145 139 ULV PCI USD/t 223 160 166 151 88 171 153 164 153 161 175 168 161 Fushan No 4, f.o.r (inc VAT) RMB/t 1,675 1,622 1,644 1,600 1,200 1,643 1,594 1,600 1,650 1,625 1,675 1,650 1,625 Shanxi 1/3 coking (inc VAT) RMB/t 1,486 1,504 1,512 1,472 1,104 1,530 1,494 1,472 1,518 1,495 1,541 1,518 1,495
Source: HSBC
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HSBC internationally traded coal supply and demand model (mt) 2009 2010 2011 2012e2013e 2014e 2015e 2016e Change 2011-2016e Coking Coal Imports Asia 146 184 185 194 201 210 219 229 44 China 35 47 45 48 50 54 58 61 16 India 28 35 33 37 39 40 41 44 11 Japan 52 60 60 63 66 68 70 72 12 South Korea 21 28 31 31 32 33 35 36 5 Taiwan 6 8 10 9 9 10 10 10 1 Other Asia 5 6 6 56556 0 CIS 10 12 10 10 10 9 10 11 1 Europe 46 52 51 53 55 57 59 61 10 North America 4 6 6 66677 1 Brazil 12 13 14 14 15 16 17 18 4 Others 7 18 13 12 12 12 13 13 0 Total 224 285 278 289 299 311 324 338 60
Coking Coal Exports Australia 134 159 133 138 143 148 154 160 27 Mongolia 4 15 19 20 21 22 23 26 7 Russia 11 13 13 14 14 16 19 21 8 Indonesia 5 7 7 889910 2 Mozambique 0 0 0 346911 11 Canada 22 27 28 30 32 33 32 33 5 USA 34 51 63 60 58 57 58 57 -6 Others 14 13 15 17 18 20 20 21 6 Total 224 285 278 289 299 311 324 338 60
Source: AME, McCloskey, ABARE, China Customs, HSBC
coal of USD76/t and ULV PCI of USD88/t on a We expect this growth in demand – 60m tonnes similar basis. over the next five years – to be comfortably met Moderating demand outlook by increasing mine output and an easing of and… infrastructure bottlenecks. …supply-side issues abating We expect demand for internationally traded coking coal to grow at c4% p.a. over 2012e to The biggest issue impacting coking coal prices has 2016e, implying growth of 11-14mtpa. Asia is been the abatement of weather-related issues in expected to continue to be the biggest importer of Australia that impacted the market in 2011. In early coking coal, accounting for c73% of incremental 2011, adverse weather in Queensland, Australia imports over the next five years. damaged mines and rail infrastructure causing export volumes to plummet. The Queensland Global coking coal imports by region (mt) Resources Council, an industry body, estimated that
400 as much as 40m tonnes of coal production was lost as a result of flooding in the year to June 2011. 300
200 Australia exports fell from 159m tonne in 2010 to 133m tonne in 2011, though this was compensated 100 for by increased exports (at high prices) from the 0 US, and to a lesser degree, Mongolia. 2011 2016e China In di a Japan S Korea Others
Source: AME, McCloskey, ABARE, China Customs, HSBC
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Over the next couple of years we expect a We expect Australian exports to rise c4% y-o-y to recovery in Australian exports and growth in 138m tonnes in 2012 and grow steadily thereafter supply from Mongolia and Mozambique to keep at 3-4% pa, reaching 160m tonnes by 2016e. We the international market adequately supplied. estimate Australia will contribute 44% of the global traded supply growth in the next five years. Share of global traded coking coal supply growth over 2011 to 2016e Australia will continue to be the major player, 50% accounting for roughly 50% of the global export 40% 30% market, in our view. This is mainly attributable to 20% its relatively close proximity to Asian steel mills, 10% and its ability to readily export significant 0% -10% volumes of high-quality hard coking coal. -20% Australian coal exports by type (2012e) USA Others Russia Canada Australia Mongolia Se m i- s o ft Mozam bique coking Source: AME, HSBC 23% Hard Australian production normalising coking 62% Although Australian production has been recently impacted by industrial action at BHP’s mines LVPCI (which helped push up the price settlements for 15% 3Q12) overall Australian coking coal exports are Source: AME, HSBC returning to normal after last years flooding. The wet season in Queensland was relatively mild this Mongolia has established itself as a year compared to last year. According to data from new frontier McCloskey, Australian coking coal exports rose by Coking coal supply from Mongolia has 22% y-o-y in the first four months of 2012. increased exponentially over the last two years Australia monthly coking coal exports from just over 4m tonnes in 2009 to c19m tonnes 16 in 2011, a CAGR of 107%. Mongolia accounted for 27% of the global coking coal exports growth 14 over this period. 12 We expect Mongolian coking coal exports to 10 increase by 7% in 2012 to 20m tonnes and by
8 5-10% per annum thereafter, reaching 26m tonnes
Jul by 2016e. We estimate Mongolia will contribute Apr Oct Jan Jun Dec Feb Mar Aug Sep Nov May 2010 2011 2012 c12% of the global supply growth over the next five years. Source: McCloskey, HSBC
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Mongolia coking coal exports (mt) China coking coal imports from Mongolia (mt) and share of total coking coal imports 30 25 50% 25 20 40% 20 15 30% 15 10 10 20% 5 5 10% 0 0 0% 2009 2010 2011 2009 2010 2011 2012e 2013e 2014e 2015e 2016e China coking coal imports from Mongolia Share of imports (RHS) Source: AME, HSBC
Source: McCloskey, HSBC
Mongolian coal exports are mainly hard coking (54%) or semi soft coking (43%), with PCI coal So far, Mongolia has exported largely unwashed accounting for just 3%. Australian exports are and raw coal but we expect it to start exporting also predominantly hard coking (62%). more processed coal with the commissioning of coal handling processing plants at major Mongolian coal exports by type (2012e) Mongolian coal producers such as Mongolia
Mining. This will help to increase the quality and desirability of coking coals from Mongolia. Se m i- s of t coking Mozambique – new kid on the block 43% Hard Mozambique looks a lot like Mongolia did in coking 2008-09. The country has one of the world’s most 54% significant unexplored coal reserves. Shipments of coal have just commenced and the growth plans LVPCI are substantial. 3% Source: AME, HSBC Mozambique major coal projects
Ownership USDm Capacity China is the single largest export destination for Moatize Vale 1,900 c11mtpa when fully Mongolian coal and Mongolia has increasingly ramped up overtaken Australia as the main supplier of coking Moatize II Vale 2,068 c11mtpa when fully ramped up coal into China. In 2011, Mongolia coals Benga Rio Tinto 65%, 516 initial capacity of Tata Steel 35% c2.4mtpa by 2013, represented 45% of Chinese coking coal imports, plans to expand the compared with 23% from Australia. Mongolia project capacity to c10mtpa by 2015 currently has limited infrastructure to transport Minas Moatize Beacon Hill 166 2mtpa saleable coal Revuboe Talbot Group na initial capacity of c5- coal to destinations other than China. (58.9%), Nippon 6mtpa and is scalable Steel (23.3%), up to 17mtpa
Source: Companies, HSBC
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Mozambique coal projects hard coking coal, shipped June 25) were to India. Beacon Hill Resources (BHR LN, not rated) has an agreement to sell 600,000tpa (out of a planned production of 2.0mtpa) to Global Coke, an India coke producer.
Mozambique coal exports are predominantly hard coking. We expect coking coal exports from Mozambique to reach 2.5m tonnes in 2012e and 4.0m tonnes in 2013e mainly from Vale’s Moatize and Rio Tinto’s Benga project. Exports could reach 10.6m tonnes by 2016e as additional new projects such as Revuboe, Songa and Zambeze come on stream and coal transportation infrastructure is improved. We estimate Mozambique will contribute c17% of the global traded supply growth between 2011 and 2016e.
Source: Beacon Hill Resources Mozambique coking coal exports (mt)
12 Overview of Tete basin and the upcoming projects 10 8 6 4 2 0
2011 Source: Beacon Hill Resources 2012e 2013e 2014e 2015e 2016e Source: AME, HSBC
Perhaps one important difference between Mozambique and Mongolia is that most coal Moatize project is owned and operated by Vale. projects in Mozambique are owned and operated Total capex for the project is estimated to be by major international mining companies. The USD1.9bn and the project is expected to have a presence of companies such as Vale and Rio Tinto nominal capacity of c11mtpa when fully ramped has done much to boost confidence in the country, up, comprising 8.5mtpa of hard coking coal (70% transforming the perception of Mozambique from premium, 30% standard) and 2.5mtpa of thermal a ‘frontier country’ to a major world coal basin. coal. Mining operations started at Moatize in 3Q11 with the first export shipment made in For steel companies in India, Mozambique is now September 2011. Moatize produced c275k tonnes the closest supply basin; much of Mozambique’s of coking coal in 4Q11 and the output increased coal will be shipped to India. We note that so far by c83% q-o-q to c501k tonnes (2mtpa) in 1Q12 many of Vale’s shipments of coal from its as the mine is currently in the ramp-up stage. Moatize mine and also Rio Tinto’s initial shipment from Benga (34,000 tonnes of premium
71 Natural Resources & Energy China Equity abc July 2012
Vale is planning to further expand the capacity at with a target capacity of 2mtpa saleable coal and Moatize project, Moatize II, and has announced a the first coking coal due to be produced this year. budget of USD2,068m for phase two, which will The company will supply Indian coke producer increase its capacity by a further 11mtpa (70% GlobalCoke with 600ktpa of coal and has a coking, 30% thermal). Geological research studies marketing deal with giant Dutch trader Vitol in this for the expansion are under progress and the project regard. Beacon Hill has target to produce 100k is expected to come on stream by 2H14. tonnes of coking coal in 2012 from this project.
Vale has also been investing in necessary Revuboe project is currently owned by a infrastructure in Mozambique to be able to export consortium of Talbot Group (58.9%), Nippon the increasing volumes from its Moatize project. Steel (23.3%), Nippon Steel Trading (10%) and POSCO (7.8%) though there are plans for Anglo Benga project is also located in the Moatize American to buy the mine. It is located in the basin and is a JV between Rio Tinto (65%) and Moatize basin and is bordered by Rio Tinto’s Tata Steel (35%). Project capex is cUSD516m Benga and Zambeze projects and Vale’s Moatize and is expected to have an initial capacity of project. The project will have an initial capacity of c2.4mtpa by 2013, comprising 1.5mtpa of hard c5-6mtpa and is scalable up to 17mtpa. We expect coking coal and 0.8mtpa of thermal coal. The first supply from the project in 2015. company plans to expand the project capacity to c10mtpa by 2015 (60% coking, 40% thermal). Russian exports are shifting to Asia
The mining operations started at Benga in 1Q12 We forecast coal exports from Russia to grow by with first export shipment of hard coking coal 5.9% in 2012e and by 3.0% in 2013e to reach amounting to 34k tonnes made in late June 2012. 14.2m tonnes. This is supported by expansion at Rio Tinto has guided for c1m tonne of coking coal SUEK’s operations in the Kuzbass and ramp-up at and 0.5m tonne of thermal coal to be shipped in Raspadskaya. We expect exports to further grow 2012 from this project. Coal infrastructure to 21m tonnes by 2016e as other brownfield and remains a major challenge and the company is greenfield projects come on stream, contributing working along with the Mozambique government 13% to the global supply growth between 2011 to secure the development of efficient coal and 2016e. transportation infrastructure. Coking coal exports from Russia into the Asian Zambeze project is owned by Rio Tinto and is market have been increasing, reflecting strong located adjacent to its Benga project. The project demand from developing Asia and subdued is scheduled to come on stream in 2015. demand from Europe. We expect this trend to Exploration licences have already been granted, continue as necessary infrastructure is being put in feasibility studies are well underway and infill place to export Russian coal to Chinese and other drilling has started. Asian markets.
Minas Moatize project is located in the Tete Russia’s primary rail transportation, the Trans- province and is owned by Beacon Hill Resources. Siberian Railway, operates at close to full It has coal reserves of 42.65m tonnes including capacity which has constrained the ability of 23.46m tonnes saleable coal at a yield of 55%. The eastern producers to transport coal to the Chinese project cost is estimated to be USD166m. The market. Development of the rail infrastructure company is ramping up coal output at this project connecting to the new Vanino Port will allow
72 Natural Resources & Energy China Equity abc July 2012
eastern Russian coking coal operations to easily access China and the rest of Asia.
China, Japan and India coking coal imports from Russia (mt) and share of Russian exports
8 60%
6 50%
4 40%
2 30%
0 20% 2008 2009 2010 2011
China, Japan and S Korea imports from Russia Share of Russia exports (R HS)
Source: AME, McCloskey, HSBC
US continues to gain Asian market share The US has significantly gained Asian market share over the last two years, encouraged by strong Asian demand and high coking coal prices. US exports surged in 2011 to 63m tonnes (up 51% y-o-y) when adverse weather conditions in Australia and Canada resulted in a tight market causing hard coking coal contract prices to spike to USD330/t. We expect US coal exports to decline by 6% y-o-y to 60m tonnes as Asian supply improves and remain flat at c57-58m tonnes over 2013-2016e.
US share of exports to China, India, Japan and South Korea
35% 30% 28% 30% 23% 25%
20% 14% 15% 10% 10% 3% 5% 0% 2007 2008 2009 2010 2011 Jan-Apr 2012
Source: McCloskey, HSBC
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Thermal coal – taking the heat out of the market
A easing in supply has balanced the market, forcing down prices Long-run outlook remains positive supported by urbanisation in countries such as China and India We forecast prices to stabilise with benchmark spot Australian coals at USD99/t in 2012e and 2013e
Prices have collapsed Qinhuangdao 5,500kcal/kg coal vs. Australian coal prices
Thermal coal prices have collapsed over the past 1000 900 few months, hit by a rapid easing in supply 800 constraints. Factors contributing to more readily 700
Rmb/t 600 available supplies include greater hydro 500 availability in China, a milder wet season in 400 Indonesia and Australia and lower gas prices in Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 the US. We do expect prices to recover through Jan-10 Jan-11 Jan-12 Australia ex ports, adj to 5500 kcal/kg, cfr China the back half of the year but note that this hinges Shanx i premium blend, 5500 kcal/kg, QHD on increasing demand from China (peak season, economic stimulus) and a supply-side response. Source: Bloomberg, SXCoal, HSBC
Australia coal export prices (6,700 kcal/kg, fob) have declined c32% so far this year from above USD130/t at the start of the year to USD85/t now. The weekly price for Shanxi coal (5,500 kcal/kg, including VAT) has declined by 24% from RMB805/t including VAT at the start of the year to RMB615/t now.
HSBC Thermal coal prices forecasts ______Annual______Quarterly ______Ccy 2011a 2012e 2013e 2014e L run 1Q12a 2Q12a 3Q12a 4Q12e 1Q13e 2Q13e 3Q13e 4Q13e Australia spot (fob) USD/t 121 99 99 101 82 112 94 92 98 100 95 100 102 Australia contract (fob) USD/t 122 119 104 100 82 130 115 115 115 115 100 100 100 Shanxi mixed (inc VAT) RMB/t 818 712 683 713 540 780 772 635 660 680 670 680 700 Datong premium (inc VAT) RMB/t 872 778 745 763 570 835 826 715 735 750 735 740 755
Source: HSBC
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International coal prices are now around the level Two things suggest to us that prices are now of the top end of the cost curve, suggesting there bottoming. Firstly, we have begun to see prices is probably little further downside risk without bounce back very slightly. Spot trades for more substantial demand destruction, which we Newcastle coals were at cUSD83/t a couple of do not expect. weeks ago, and now we are seeing some trades at USD88-89/t. It is not a huge increase, but it is a We forecast spot Australian export prices (6,700 sign that prices are no longer falling. kcal/kg, fob, calendar years) at USD99/t in 2012e, USD99/t in 2013e and USD101/t in 2014e. Secondly, some Chinese provincial governments – including Shandong and Hebei – have said that We introduce price forecasts for two Chinese they will make ‘structural adjustments’ in the coals; the Datong Coal premium blend (5,800 sector if prices keep declining. We take this to kcal/kg) and the Shanxi blend (5,500 kcal/kg) essentially mean they will ask coal producers in both fob Qinhuangdao. their provinces to curtail production. We are China coal price forecasts already seeing signs that some higher cost Coal prices in China have collapsed over the past producers in Inner Mongolia are cutting output. few weeks and months. The price of Shanxi While prices look like they have bottomed, three mixed blend 5,500 kcal/kg coal has plummeted factors suggest to us that we will not see a sharp from RMB805/t at the start of the year to recovery. First, underlying demand is still weak. RMB615/t now, a fall of 24% in about six Although the government has made several months. The price of Datong premium blend, interest rate and RRR cuts so far this year, coal 5,800 kcal/kg coal has fallen by 19% from companies in China tell us the market is ‘loose’, RMB860/t to RMB700/t in the same timeframe. that demand – especially industrial demand – is We do think coal prices are bottoming out at weak, and that customers are becoming more around current levels and that prices should demanding (because they can). gradually recover through the rest of the year Secondly, power companies still have ample and into 2013. We do not, however, expect a inventories and these will have to be worked off V-shaped recovery. before prices can rebound significantly. The
China Shanxi mixed blend (5,500 kcal/kg) and Datong inventories at the major Chinese power companies premium blend (5,800 kcal/kg) coal prices (RMB/t, inc VAT) are now around 26 days. It is quite possible that
900 over the next 3-4 months, coal inventories go 850 from being ‘plentiful’ to ‘normal’ rather than from 800 ‘normal’ to ‘tight’, and coal prices rise less than 750 expected as a result. 700 650 Thirdly, there has been ample hydro power supply 600 this year. Typically, this will last into October, taking the pressure off of coal supply. 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12e 4Q12e 1Q13e 2Q13e 3Q13e 4Q13e 1Q14e 2Q14e 3Q14e 4Q14e Shanxi m ix ed blend Datong premium blend
Source: Bloomberg, SXCoal, HSBC
75 Natural Resources & Energy China Equity abc July 2012
What does this mean for our coal price high prices in 1H12). This year we expect prices forecasts? in 2H12 to fall by 17% h-o-h – this is going to We expect the price of 5,500 kcal/kg coal to impact coal company earnings in the second half recover from RMB615t now to RMB680/t by of this year. In 1H13, although we expect prices to 1Q13 and further to RMB700/t by 4Q13. While be recovering sequentially, we forecast a decline we do forecast a recovery it is worth noting that of 13% y-o-y. 2012 average prices are forecast to decline by Demand is holding up, but … 13% y-o-y. Also, 2013 average prices are expected to decline by a further 4% y-o-y Overall demand for internationally traded thermal (because the average 2012 price is distorted by coal in Asia has been reasonably strong so far this year. China, Japan and S Korea combined imports
increased by 25% y-o-y over January-May 2012. China Shanxi mixed blend (5,500 kcal/kg) and Datong premium blend (5,800 kcal/kg) coal prices (RMB/t, inc VAT) China, Japan and S Korea thermal coal imports (mt) Shanxi mixed Datong premium 40 Annual 2010 746 789 2011 818 872 35 2012e 712 778 2013e 683 745 30 2014e 713 763 y-o-y Change 25 2011 10% 10% 2012e -13% -11% 20 2013e -4% -4%
2014e 4% 2% Jul Apr Oct Jan Feb Mar Jun Aug Sep Dec Nov May Half Yearly 2010 2011 2012 1H12 776 831 2H12e 648 725 Source: McCloskey, HSBC 1H13e 675 743 2H13e 690 748 h-o-h Change We expect Asia to remain the primary demand 1H12 -7% -7% 2H12e -17% -13% driver over the next five years, accounting for 1H13e 4% 2% c91% of incremental demand. We forecast Asian 2H13e 2% 1% y-o-y Change imports to rise by 7% y-o-y to 615m tonnes in 2012 1H12 -3% -2% and by a further 7% to 656m tonnes in 2013e. 2H12e -23% -19% 1H13e -13% -11% 2H13e 7% 3% Chinese import demand remains Quarterly 1Q12 780 835 strong … 2Q12 772 826 With plummeting coal prices and slower Chinese 3Q12e 635 715 4Q12e 660 735 economic growth, it would be easy to expect 1Q13e 680 750 2Q13e 670 735 Chinese thermal coal imports had weakened. In 3Q13e 680 740 fact, the opposite is true. Chinese thermal coal 4Q13e 700 755 q-o-q Change imports (including anthracite) reached an 1Q12 -7% -7% 2Q12 -1% -1% annualized rate of 196mtpa in May 2012, its 3Q12e -18% -13% second highest record level. In the first five 4Q12e 4% 3% 1Q13e 3% 2% months of the year, Chinese thermal coal imports 2Q13e -1% -2% 3Q13e 1% 1% rose by 69% y-o-y to 69.7m tonnes. 4Q13e 3% 2%
Source: Bloomberg, SXCoal, HSBC
76 Natural Resources & Energy China Equity abc July 2012
HSBC internationally traded thermal coal supply and demand model (mt) 2009 2010 2011 2012e2013e 2014e 2015e 2016e Change 2011-2016e Thermal Coal Imports Asia 461 533 574 615 656 696 732 762 188 China 92 119 139 152 166 181 193 203 63 India 60 75 93 106 120 136 151 166 73 Japan 124 125 124 128 131 134 136 135 10 South Korea 82 91 91 100 103 105 107 110 19 Taiwan 49 58 59 61 64 67 69 71 13 Other Asia 54 65 68 68 72 74 75 77 10 CIS 28 23 24 24 25 26 27 27 4 Europe 179 188 187 191 192 192 193 192 6 United States 19 16 17 17 18 19 19 19 3 C&S America 9 10 11 12 13 14 15 15 4 Others 27 28 29 29 29 29 31 31 2 Total 724 798 841 889 933 976 1,016 1,047 206
Thermal Coal Exports Australia 139 141 148 166 170 181 193 204 57 China 22 18 11 11 10 10 9 9 -2 Indonesia 233 291 323 342 362 381 397 411 88 Mongolia 1 2 4 6 8 10 13 15 10 Vietnam 25 21 16 1312975 -11 Mozambique 0 0 0 12455 5 South Africa 66 68 68 70 72 75 78 81 13 Russia 92 95 100 103 112 118 120 122 22 Colombia 67 68 79 86 90 94 97 99 20 United States 20 23 32 35 36 37 36 36 4 Others 61 65 57 57 57 56 59 60 3 Total 726 792 838 888 932 976 1,015 1,046 208
Source: AME, McCloskey, China Customs, HSBC
So far this year, Chinese coal prices have imports as domestic mining capacity is lagging generally been higher than international prices behind. Indian thermal coal imports in January- leading power companies to source more coal February were up 9% y-o-y and we expect full from overseas suppliers. year imports to increase by 14% to 106m tonnes.
Notably, China Resource Power (836 HK, OW, India thermal coal imports (mt)
TP HKD19.30) said earlier this year it planned to 12 import 36% of its coal needs in 2012, up from just 5% in 2011. About half of the company’s plants 10 enjoy coastal locations and can benefit from lower 8 cost of imported coal. 6 … and so does Indian demand 4 Indian thermal coal imports have remained strong Jul Jan Apr Jun Oct Feb Mar Aug Sep Dec Nov over the past one year as India’s largest state May 2010 2011 2012 owned coal miner Coal India (COAL IN, OW, TP INR400) has not been able to meet rising demand Source: McCloskey, HSBC from domestic power producers. Indian power Indian imports are being helped by a combination capacity is largely coal based and any increase in of low coal prices and cheap freight, which has the power capacity directly translates into coal helped trigger a surge in buying, mainly from demand and by extension increased need for Indian cement producers. In addition, the
77 Natural Resources & Energy China Equity abc July 2012
suspension of a 5% import duty on thermal coal availability of hydro power which combined with imports (for a two-year period) introduced in slowing economic growth has meant a much March this year is also helping imports. looser coal market.
Further, electricity generation in India is on an Hydro output vs. coal price uptrend, having already risen by c5% y-o-y in 100 900 bn kwh Rmb/t January to May 2012, and will continue to require 80 800 imported coal. 60 700 40 India monthly electricity generation (bn kWh) 20 600 80 - 500
75 Jul-09 Jul-10 Jul-11 Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-09 Jan-10 Jan-11 Jan-12
70 Hy dro pow er production Shanx i premium blend, 5500 kcal/kg, QHD
65 Source: Bloomberg, SXCoal, HSBC
60 … higher inventories
Jul-10 Jul-11 As a result, power companies were able to build Jan- 10 Apr-10 Oct-10 Jan-11 Apr-11 Oct -11 Jan-12 Apr-12 inventories (which reached 28 days in early-June Source: India Central Electricity Authority, HSBC from 17 days in mid-March), thus taking the heat … supply has eased out of the market.
Several factors have contributed to easing supplies China’s key power plant coal inventory including greater hydro availability in China, a 100 30 Tonnes m Days milder wet season in Indonesia and Australia and 90 25 lower gas prices in the US. 80 70 20 China – greater hydro availability 60 15 and … 50 There are two peak seasons in coal in China. We 40 10 think of them as the household or ‘mini’ peak in the Jul-11 Jul-12 Apr-11 Oct-11 Apr-12 Jan-11 Jan-12 summer when the weather is hot and air- Coal inventory at key plower plants conditioning use is high, and an industrial, or ‘major’ Days of inventory peak in the winter months when economic activity Source: China Coal Resources peaks towards the end of the year. Power companies typically try to build coal inventories in the lead up Indonesia and Australia – milder to these peak seasons and when the coal market is weather tight this can lead to higher coal prices. In addition to easier supplies in China we have also seen recovering supply from Australia. The drought in southern China in early 2011 made Australian exports were impacted by bad weather this summer inventory-building more difficult. A conditions in the early part of the last year but has shortage of hydro-electric power put additional continued to recover. January-April 2012 exports stress on coal demand, forcing up prices. This year, there has been more rainfall and greater
78 Natural Resources & Energy China Equity abc July 2012
were up by 21% y-o-y; exports to China were up US – the impact of cheaper gas by 276% and that to Japan by 14%. We think in the long run, it is hard to accurately
Australia monthly thermal coal exports (mt) quantify the impact of increasing gas supplies for a number of reasons including infrastructure costs 16 and the gas-coal economics. Over the past few 14 months though, the impact has been dramatic.
12 We have seen higher cost US coal mines exit the industry and increasing supplies of US coal 10 entering the seaborne market, helping to suppress 8 international coal prices. According to data from Jul Apr Oc t Jan Jun
Feb Mar Aug Sep Dec the US Energy Information Administration (EIA) May Nov 2010 2011 2012 US coal production was (an annualised) 860m
Source: McCloskey, HSBC tonnes in May 2012, 13% below the level in 2011 (992m tonnes). April 2012 production of an At the same time, a milder wet season in annualised 817m tonnes was the lowest monthly Indonesia resulted in fewer disruptions in coal production level for more than 15 years. production and monthly export levels have been Unlike most Chinese power companies, which are maintained at above 25m tonnes over the last one predominantly coal-fired, US power companies year. We expect Indonesian export to grow by 5- have more flexibility to switch their fuel sources 6% annually for the next five years and account between coal and gas depending upon the relative for 42% of the incremental global export supply cost benefits. With gas prices now back to cheap over this period. levels, the US power industry has shunned coal; Indonesia monthly thermal coal exports (mt) we are seeing a reversal in a long-run trend of
35 increasing US coal burn.
30 Peabody Energy (BTU US, not rated) is one of the largest coal companies in the world. In its March 25 2012 quarterly report, Peabody noted that in March
20 this year, on an annualised basis c140m tonnes of US coal production had already been curtailed. 15 Peabody also estimated that US coal-fuelled Jul Apr Oct Jan Feb Mar Jun Aug Sep Dec Nov May electricity demand could decline in excess of 100m 2010 2011 2012 tonnes in 2012, with net US coal exports increasing
Source: McCloskey, HSBC c15m tonnes to more than 110m tonnes.
79 Natural Resources & Energy China Equity abc July 2012
US coal production and consumption US coal consumption by electric power sector
100 1,000 Tonnes m Tonnes m 900 90 800 80 700 70 600
60 500 400 50 300 200 Jul-10 Jul-11 Apr-10 Oct-10 Apr-11 Oc t-11 Apr-12 Jan-10 Jan-11 Jan-12 Production Consumption 1973 1976 1979 1982 1985 1988 1995 1998 2001 2004 2007 2010
Source: U.S. Energy Information Administration Source: U.S. Energy Information Administration
US monthly electric power sector coal consumption US monthly steam coal exports (mt)
90 Tonnes m 6 85 5 80 75 4 70 3 65
60 2 55 1 50 0 Jul Apr Oct Jan Jun Mar Feb Aug Sep Nov Dec May Jul Apr Oct Jan Jun Feb Mar Aug Sep Dec May 2010 2011 2012 Nov 2010 2011 2012
Source: U.S. Energy Information Administration Source: McCloskey, HSBC
80 Natural Resources & Energy China Equity abc July 2012
Long-term demand outlook Urbanisation rates are a key driver of power remains strong demand and urbanisation levels in China and India are comparatively low. Although coal prices have come off sharply over the past few months, in the longer run, we do see China’s urbanization rate the market being well supported by robust demand growth. There are substantial coal-fired 90 capacity plans in China, India and other emerging 80 70 markets, and urbanisation rates in these countries 60 remain low. Increased coal use in these countries 50 is likely to mean a substantial increase in the level 40 of internationally traded coal. 30 20 Growth in coal-fired generating 2007 2010 2015e 2020e capacity China Japan U.S./Korea
Peabody estimates that world coal-fired power Source: Peabody generating capacity will increase by 385GW by
2016e, and further, that this new capacity will require an additional 1.3bn tonnes per annum of coal. Peabody expects Chinese coal-fired capacity to increase by 240GW by 2016e, Indian capacity to increase by 70GW and other countries’ capacity to increase by 75GW.
New coal-fuelled generation capacity 2011-2016
400 Gigawatts 350 300 250 200 150 100 50 0
Rest of World India China
Source: Peabody
81 Natural Resources & Energy China Equity abc July 2012
China demand outlook ambitious; or 2) widespread under-reporting of coal output towards the end of 2015. China consumed nearly 3.7bn tonnes of coal in 2011. We forecast demand to rise by 4-5% p.a. in The power, cement and construction, and steel 2012e-2016e and we believe that the level of and metallurgy sectors accounted for 82% of annual demand will rise by c880mtpa over the Chinese coal demand in 2011. next five years. Our forecasts call for markedly China coal consumption breakdown, 2011 slower growth than in the past decade, Cement & reflecting slower economic growth, a more c ons truction energy-efficient economy and China’s aim to be 14% less dependent on coal. Steel & The Chinese government specified in its five-year Power metallurgy 17% plan for the coal industry that it aims to cap total 51% domestic coal consumption at c3.9bn tonnes by Chemicals 2015. This implies an annual growth rate of only 4% 1.5% over the next four years. This goal will be Others 14% difficult to achieve unless the economy slows substantially or there is significant achievement Source: SXCoal, HSBC on energy efficiency. We expect either 1) the government to acknowledge its target is too
China coal consumption by sector, tonnes m 2009 2010 2011 2012e 2013e 2014e 2015e 2016e Total domestic consumption 3,213 3,394 3,673 3,851 4,026 4,197 4,390 4,554 Power 1,564 1,674 1,869 2,000 2,132 2,257 2,399 2,513 Cement & construction 445 480 516 531 547 564 581 598 Steel & metallurgy 502 547 617 642 662 686 713 738 Chemicals 141 148 158 164 171 178 185 192 Others 561 545 513 513 513 513 513 513
Consumption growth, y-o-y 16% 6% 8% 5% 5% 4% 5% 4% Consumption growth, y-o-y, tonnes m 450 181 279 178 174 172 193 163
Power Power generation, kWh bn 3,664 4,228 4,721 5,118 5,568 6,013 6,494 6,911 Growth, y-o-y 5% 15% 12% 8% 9% 8% 8% 6% Thermal power generation, kWh bn 3,012 3,330 3,773 4,094 4,426 4,751 5,098 5,390 Growth, y-o-y 8% 11% 13% 9% 8% 7% 7% 6% Thermal as a % of total 82% 79% 80% 80% 80% 79% 79% 78% Coal consumption growth, y-o-y -3% 7% 12% 7% 7% 6% 6% 5%
Cement and construction Cement production, tonnes m 1,617 1,867 2,085 2,195 2,300 2,369 2,440 2,513 Growth, y-o-y 14% 15% 12% 5% 5% 3% 3% 3% Coal consumption growth, y-o-y 25% 8% 8% 3% 3% 3% 3% 3%
Steel and metallurgy Crude steel production, tonnes m 567 627 684 719 748 783 821 858 Growth, y-o-y 13% 11% 9% 5% 4% 5% 5% 5% Coal consumption growth, y-o-y 20% 9% 13% 4% 3% 4% 4% 4%
Chemicals, consumption growth, y-o-y -4% 5% 7% 4% 4% 4% 4% 4% Others, consumption growth, y-o-y 144% -3% -6% 0% 0% 0% 0% 0%
Source: Coalworld, HSBC
82 Natural Resources & Energy China Equity abc July 2012
Thermal power demand years, coal usage by the sector has only grown by The power sector accounted for c1.87bn tonnes of an average of 8% p.a. Chinese coal demand in 2011, accounting for 52% We expect coal usage by the cement and of total demand. Coal usage by the Chinese construction sectors to grow by 3% p.a. in 2012e- thermal power sector grew at an average rate of 2016e, as we forecast a sharp slowdown in cement c11% p.a. over the past decade. output growth. China thermal power generation Are these forecasts too conservative? 7,500 18% kwH bn China’s National Reform and Development 6,500 16% 14% Commission (NDRC) plans to limit China’s coal 5,500 12% 4,500 10% usage to 3.9bn tpa by 2015 which is the end of the th 3,500 8% 12 Five-Year Plan. Our forecast is for 6% 2,500 4% consumption to reach 4.4bn tonnes by 2015e and 1,500 2% Peabody Energy forecasts consumption to reach 500 0% 5.0bn tonnes by then. Our forecast is for average 2002 2004 2006 2008 2010
2012e 2014e 2016e annual growth in coal consumption of 4.6% over Power generation Chg YoY (RHS) the next four years, whereas Peabody’s
Source: CEIC, HSBC assumption is for average annual growth of 8%.
We estimate demand from the power sector will Historically the NDRC’s coal consumption rise by 7% p.a. in 2012e-2013e and slow to 6% in plans have not been a good guide to actual 2014e-2015e based on two main assumptions. consumption levels.
First, we expect Chinese power generation to China annual coal use for last year of plan grow in line with Chinese GDP growth, meaning 6 Target Actual that one unit of GDP growth absorbs one unit of Tonnes bn 5 additional power output. This assumes the 4 Chinese economy will become more power efficient – the power-to-GDP multiplier has been 3 mostly above 1.0x over the past decade. In the 2 longer-term, we expect China’s energy efficiency 1 will further improve. 0 2001-2005 10th 5- 2006-2010 11th 5- 2011-2015 12th 5- Second, we assume that power producers continue year plan year plan year plan to use less coal per unit of power output. Source: Peabody
Cement and construction
The cement and construction sectors consumed 516m tonnes of coal in 2011, or c14% of total Chinese coal demand. Over the past few years, there has been a remarkable energy efficiency improvement by the cement and construction industries. Whereas Chinese cement output has risen at an average of 11% over the past five
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84 Natural Resources & Energy China Equity abc July 2012
Company profiles
85 Natural Resources & Energy China Equity abc July 2012
Financials & valuation: Aluminum Corp of China Underweight (V)
Financial statements Key forecast drivers Year to 12/2011a 12/2012e 12/2013e 12/2014e Year to 12/2011a 12/2012e 12/2013e 12/2014e Profit & loss summary (RMBm) Alumina production (kt) 12,202 12,537 13,107 13,535 Alumina external ASP (RMB/t) 2,493 2,347 2,436 2,495 Revenue 145,874 155,749 164,618 170,148 Alumina cash cost (RMB/t) 2,000 1,938 1,900 1,935 EBITDA 9,884 7,233 10,587 10,877 Aluminium production (kt) 3,915 4,332 4,332 4,332 Depreciation & amortisation -5,748 -6,411 -6,388 -6,021 Aluminium ASP (RMB/t) 14,469 13,817 14,381 14,703 Operating profit/EBIT 4,136 822 4,199 4,856 Aluminium cash cost (RMB/t) 13,509 13,685 14,049 14,372 Net interest -3,318 -3,492 -3,603 -3,640 PBT 818 -2,670 596 1,216 HSBC PBT 818 -2,670 596 1,216 Taxation -127 614 -149 -304 Valuation data Net profit 238 -1,850 402 821 Year to 12/2011a 12/2012e 12/2013e 12/2014e HSBC net profit 238 -1,850 402 821 EV/sales 0.7 0.7 0.7 0.6 Cash flow summary (RMBm) EV/EBITDA 10.6 15.1 10.3 10.1 Cash flow from operations 2,490 3,129 6,000 6,128 EV/IC 0.9 0.9 0.9 0.9 Capex -8,553 -6,200 -6,200 -6,200 PE* 142.3 84.2 41.3 Cash flow from investment -9,715 -7,455 -6,439 -6,752 P/Book value 0.7 0.7 0.7 0.7 Dividends -154 0 0 -101 FCF yield (%) -25.6 -9.7 -0.5 0.1 Change in net debt 11,114 4,166 341 626 Dividend yield (%) 0.0 0.0 0.3 0.6 FCF equity -8,673 -3,277 -155 19 *Based on HSBC EPS (diluted)
Balance sheet summary (RMBm) Intangible fixed assets 6,707 6,574 6,440 6,307 Issuer information
- 1 7 Tangible fixed assets 93,775 93,698 93,643 93,956 . Share price (HKD)3.04 Target price (HKD)2.50 8 Current assets 49,970 54,005 56,396 58,128 Cash & others 11,645 11,956 12,577 12,964 Reuters (Equity) 2600.HK Bloomberg (Equity) 2600 HK Total assets 157,134 162,213 164,655 167,118 Market cap (USDm) 10,558 Market cap (HKDm) 82,356 Operating liabilities 16,269 18,565 19,545 20,176 Free float (%) 58 Enterprise value (RMBm) 109,088 Gross debt 82,706 87,184 88,146 89,159 Country China Sector Metals & Mining Net debt 71,062 75,228 75,569 76,196 Analyst Simon Francis Contact +852 2996 6620 Shareholders funds 51,826 49,976 50,378 51,098
Invested capital 122,539 123,755 124,357 125,250 Price relative
12 12 Ratio, growth and per share analysis 11 11 10 10 Year to 12/2011a 12/2012e 12/2013e 12/2014e 9 9 8 8 Y-o-y % change 7 7 6 6 Revenue 20.6 6.8 5.7 3.4 5 5 EBITDA -0.7 -26.8 46.4 2.7 4 4 Operating profit 7.0 -80.1 410.7 15.6 3 3 PBT -40.7 -426.4 104.1 2 2 HSBC EPS -69.4 -877.5 104.1 2010 2011 2012 2013 Aluminum Corp of China Rel to HANG SENG CHINA ENTERPRISES INDEX Ratios (%) Source: HSBC Revenue/IC (x) 1.2 1.3 1.3 1.4
ROIC 3.0 0.5 2.5 2.9 ROE 0.5 -3.6 0.8 1.6 Note: price at close of 25 Jul 2012 ROA 2.4 0.5 2.0 2.3 EBITDA margin 6.8 4.6 6.4 6.4 Operating profit margin 2.8 0.5 2.6 2.9 EBITDA/net interest (x) 3.0 2.1 2.9 3.0 Net debt/equity 122.2 133.2 132.7 131.9 Net debt/EBITDA (x) 7.2 10.4 7.1 7.0 CF from operations/net debt 3.5 4.2 7.9 8.0 Per share data (RMB) EPS Rep (diluted) 0.02 -0.14 0.03 0.06 HSBC EPS (diluted) 0.02 -0.14 0.03 0.06 DPS 0.00 0.00 0.01 0.02 Book value 3.83 3.70 3.72 3.78
86 Natural Resources & Energy China Equity abc July 2012
Aluminum Corp of China (Chalco) (2600 HK)
Chalco is a high-cost producer that is likely to continue to struggle to post meaningful returns given the tough outlook for aluminium The necessary restructuring to reduce costs is likely to be both expensive and long-winded We initiate coverage of Chalco with an UW(V) rating and a DCF- based share target price of HKD2.50
Initiating at Underweight (V) end of the cost curve, we see Chalco continuing to Simon Francis* Head of Metals & Mining struggle to post decent profits. Aluminum Corp of China (Chalco) is the largest Research, Asia Pacific The Hongkong and Shanghai producer of alumina, primary aluminium and Global aluminium cost curve (2012) Banking Corporation Limited +852 2996 6620 aluminium fabrication products in China. It is also 3,000 [email protected]
the largest alumina producer and fourth largest
2,500 Chris Chen* Chalco
Analyst
aluminium producer globally.
2,000
The Hongkong and Shanghai
Banking Corporation Limited
1,500
We initiate coverage of Chalco with an +852 2822 4277 Underweight (V) rating and a DCF-based target 1,000 [email protected]
500 C1 cash cost (USD/t) price of HKD2.50. Amit Pansari* Analyst
0 HSBC Bank plc We forecast aluminium prices to rise in 2H12e 0 1020304050 +91 80 3001 3760 [email protected] and perhaps there is a risk that Chalco shares rise Cumulative production (mt) with aluminium prices. We would sell into a rally *Employed by a non-US affiliate Source: Brookhunt, HSBC of HSBC Securities (USA) Inc, given the poor outlook for earnings and returns. and is not registered/ qualified pursuant to FINRA regulations A high-cost producer; not well- We believe Chalco’s high-cost position reflects positioned for tough times three main issues. Firstly, with a variety of different locations, Chalco’s alumina and aluminium Our most important concern is that Chalco is a businesses are not truly integrated. We estimate relatively high cost producer and in our view is that only 15% of Chalco’s aluminium capacity is poorly positioned to make meaningful returns integrated with alumina production on site. The except in very tight aluminium markets. In the remaining 85% have to purchase alumina from current environment, in which aluminium prices either Chalco alumina refineries in other locations are likely to continue to struggle to clear the top or from third parties. In 2011, Chalco used c7.5m
87 Natural Resources & Energy China Equity abc July 2012
tonnes of alumina for its aluminium production, all We estimate Chalco’s aluminium cash production of which was supplied by its own refineries. Chalco costs at cRMB13,685/tonne in 2012e and sold c4.5m tonnes of metallurgical grade alumina RMB14,049/tonne in 2013e. According to into the market in 2011. management, the range of costs at different locations is roughly +/- RMB1,000/tonne around Secondly, Chinese bauxite (the principal raw this average level. material for alumina) is of a form that requires more energy in the refining process. In addition, Based on these figures, we expect Chalco to much of it has relatively low alumina-to-silica achieve a gross margin in aluminium of just 6-7% ratios. This also increases the refining costs, as in 2012e-13e. more caustic soda is required to eliminate the silica. Increasing reliance on low-margin Thirdly, Chalco’s energy costs are high. Chalco trading uses coal in the refining process and also as a fuel, Over the past two years, we have seen a rapid yet is not integrated into coal. Power costs increase in the level of Chalco’s trading activities. represent c48% of the aluminium cash costs of Trading revenues have risen from RMB9.3bn in production. Chalco’s power costs are 2009 to RMB47.3bn in 2010 and to RMB63.3bn in RMB0.49/kWh. While lower cost aluminium 2011, a rise of 6.8x in just two years. Last year, smelters around the world may benefit from trading represented c43% of consolidated revenues. cheaper power sources (eg, hydro), Chalco has no such benefits. The company is increasing its reliance on trading to offset the poor profitability in the aluminium Chalco 2012e aluminium production cash cost break-up and alumina businesses. Similarly, the company Carbon has attempted to shift into coal to boost earnings. 9% Chalco trading revenues (RMBbn) Others Power 10% 70 50% 48% 60 50 40% 40 30% Al umi na 30 33% 20 20% 10 0 10% Source: HSBC estimates 2009 2010 2011 Trading rev enues % of total (RHS) Our view is that it would take a major restructuring of the company in order to address Source: Company data, HSBC estimates these issues and that any such restructuring would be both expensive and long-winded. Chalco We believe the increasing reliance on trading has would need to acquire coal mines and build power two main implications. Firstly, trading is a plants in order to lower its electricity costs. relatively low-margin business, suggesting that Ideally, it would seek sources of higher quality Chalco’s margins will remain suppressed. bauxite, enabling it to lower its refining costs. Secondly, it suggests Chalco has little confidence that earnings in the core aluminium and alumina business will improve anytime soon.
88 Natural Resources & Energy China Equity abc July 2012
Poor outlook for earnings and returns The SouthGobi deal is now being held up by the We forecast Chalco’s ROEs at between -4% and Mongolian government. Although at the time the +2% in 2012e-14e. We expect Chalco to post a deal was announced Mongolia did not have rules loss in 2012e (1Q12 net loss was RMB1.1bn) and preventing it, a new foreign investment law was to make a small profit in 2013e. We do not see passed by the National Diet in May 2012. It was profitability returning to the levels enjoyed in the widely known that the Mongolian government 2003-08 commodities upcycle anytime soon. was drafting such a law. Also Mongolia is known to be sensitive to the acquisition of resources by Chalco net income (RMBbn) China, as this could put both the demand and
15 supply side in the hands of Chinese state-owned companies. 10 Balance sheet increasingly stretched 5 We expect Chalco’s balance sheet to remain
0 stretched and estimate that its net debt-to-equity will reach 133% by the end of 2012. We forecast -5 gearing to remain stable at these levels over the next two years. 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012F 2013F 2014F Source: Company data, HSBC estimates Chalco net debt (RMBbn) and gearing
80 160% Investment strategy not aluminium focused 60 120%
In our view, the investment strategy has not been 40 80% aluminium-focused and has done little to integrate 20 40% the aluminium business to bring down costs. 0 0% Chalco’s first major investment outside of 2003 2004 2005 2006 2007 2008 2009 2010 2011 aluminium was the Simandou iron ore project in 2012F 2013F 2014F Guinea, a joint venture with Rio Tinto. Chalco Net Debt Net Debt/ Equity (RHS) invested USD880m in the project for a 29% stake Source: Company data, HSBC estimates in 2012. The project is now subject to the Guinean government taking a 35% stake, including 15% Plans to issue A shares for free, which will dilute Chalco. With net debt-to-equity reaching 122% at the end of 2011, management would like to shore up the In April 2012, Chalco agreed to purchase 56-60% balance sheet by issuing A-shares. The proposed of SouthGobi Resources (1878 HK, not rated) issue has been approved twice already but on each from Ivanhoe. Chalco also agreed to buy a 29.9% occasion Chalco was unable to sell the shares at stake in Winsway Coking Coal (1733 HK, not an agreeable price. Management is now seeking rated). These companies are predominantly its third approval for the issue. coking coal-focused and as such do not seem to help Chalco integrate its business. Rather the aim The plan is to issue up to 1.25bn A shares at a appears to be generating some coal off-take for discount of up to 10%. The issue would enlarge the trading division. Chalco’s outstanding shares in issue by c9.2%. In
89 Natural Resources & Energy China Equity abc July 2012
previous efforts, Chalco did not plan a public Low PB multiple justified sales but rather a private placement to a maximum Chalco’s shares have been substantially de-rated of ten shareholders. since early 2010 (when confidence in the global Based on the current A share price of RMB6.01, economic recovery was high) from a PB of above the issue would be at a minimum price of 2.0x to the current valuation of 0.7x. We believe RMB5.41. This represents a substantial 122% this de-rating is justified by the poor returns and premium to the current H share price of expect further downside in the share price.
HKD3.04. While on that basis, the issue may not Chalco’s daily PB be bad for H-share investors we do question both 2.5 whether the issue can be executed and whether the company needs to undertake further expansion. It 2.0 would also likely be earnings dilutive in 2012e and 2013e. 1.5
Valuation 1.0
Target price of HKD2.50 0.5 While we normally value the mining stocks using Jul-10 Jul-11 Jul-12 Apr-10 Oc t-10 Apr-11 Oc t-11 Apr-12 Jan-10 Jan-11 Jan-12 a blend of PE and DCF valuations, in Chalco’s Source: Company data, Datastream, HSBC case, earnings are thin and thus highly volatile. We value Chalco using DCF.
Our DCF-based target price of HKD2.50 is based on the following assumptions:
A cost of capital of 9%.
Adjusted beta of 1.18 measured against the HSCEI index
Borrowings representing 30% of EV. This is much lower than Chalco’s current gearing level which was 122% at the end of 2011
Long-run production of 12.8m tpa alumina (excluding chemicals) and 4.3m tpa aluminium
Chinese aluminium price forecasts of RMB16,166/tonne (including VAT) in 2012e and RMB16,830/tonne in 2013e and a long- run forecast of RMB16,600/tonne
Long-run trading revenues representing 40% of consolidated revenues at a gross margin of 1.4%
90 Natural Resources & Energy China Equity abc July 2012
Estimate of replacement cost which is below the Neutral band. On this basis, we We estimate that in China, aluminium capacity rate Chalco Underweight (V). Potential return costs cRMB12,000 per tonne and alumina capacity equals the percentage difference between the costs cRMB5,000 per tonne. China is a major net current share price and the target price, including importer of bauxite and alumina and only a small the forecast dividend yield when indicated. net exporter of aluminium. At our target price of Risks HKD2.50, we estimate Chalco would trade at a We expect aluminium prices to rise in 2H12. There 31% discount to replacement cost. is a risk that Chalco’s share price would rise with Chalco replacement cost valuation the aluminium price. Generally, we expect Attributable Cost Cost Chalco’s restructuring efforts, aimed at reducing Capacity kt RMB/t RMBm production costs, to be both expensive and time- Aluminium 3,561 12,000 42,732 consuming. The upside risk to our view is that they Alumina 14,513 5,000 72,565 are not. Chalco may be able to secure coal and
Replacement cost 115,297 power assets and integrate these with its aluminium Net debt – 2012e 75,228 Net replacement cost 40,069 business more quickly than we forecast, thus Shares in issue 13,524 resulting in lower-than-expected production costs Replacement cost/ share, RMB 2.96 Replacement cost/ share, HKD 3.61 and higher-than-expected profitability.
Source: Company data, HSBC estimates Anaemic earnings outlook HSBC ratings bands We forecast Chalco will achieve a net loss of For volatile stocks, the band for a Neutral rating, RMB1.9bn in 2012e, post a small income of N(V), is 10ppt above and below our hurdle rate, RMB0.4bn in 2013e and RMB0.8bn in 2014e. which for China is 10%. Our target price implies a Our forecasts incorporate a substantial amount of potential return of -18% (excluding dividend yield), trading revenues. Even so, the anaemic outlook
DCF valuation Year to Dec (RMBm) 2011 2012e 2013e 2014e 2015e 2016e 2017e 2018e 2019e 2020e 2021e Terminal Free cash flow calculation Revenue 145,874 155,749 164,618 170,148 179,819 184,920 188,316 193,585 199,012 204,601 210,359 216,289 Y-o-y 21% 7% 6% 3% 6% 3% 2% 3% 3% 3% 3% 3% EBIT 4,136 822 4,199 4,856 7,427 8,013 8,223 9,289 10,407 11,728 13,107 14,545 EBIT margin 3% 1% 3% 3% 4% 4% 4% 5% 5% 6% 6% 7% NOPAT 3,492 633 3,149 3,642 5,570 6,010 6,167 6,967 7,805 8,796 9,830 10,909 Capex, net (9,128) (6,200) (6,200) (6,200) (6,200) (6,200) (6,000) (6,000) (6,000) (6,000) (6,000) (6,000) Depreciation 5,748 6,411 6,388 6,021 5,809 6,038 5,936 5,974 6,000 6,015 6,017 6,007 Change in working capital (5,428) (1,432) (790) (714) (996) (656) (465) (593) (605) (591) (603) (615) Free operating CF (FoCF) (5,316) (588) 2,547 2,749 4,183 5,192 5,638 6,348 7,200 8,219 9,244 10,301 DCF Parameters Interest-bearing liabilities as a % of EV 30% Common parameters WACC 9.0% Terminal FCF growth 3.0% NPV of FoCF 105,734 Risk-free rate 3.0% + Net cash (debt), current (75,228) Market risk 7.0% Beta 1.18 - Minorities (Market value) (3,244) Cost of debt (pre-tax) 5.0% +/- Other items - = Equity value 27,262 / Number of shares 13,525 / HKD:RMB exchange rate 0.80 = NPV per share (HKD) 2.52
Source: Company data, HSBC estimates
91 Natural Resources & Energy China Equity abc July 2012
we expect for aluminium prices suggests earnings SHFE aluminium prices (RMB/t, ex VAT) are unlikely to stage a significant recovery 15,000 anytime soon. In 2012e-14e, we forecast Chalco’s 14,500 ROE at just -4% to +2%. 14,000 Essentially, we regard Chalco as a high-cost producer operating in a market that has sufficient 13,500 excess capacity to keep margins suppressed. 13,000
Production and sales volumes 12,500 We expect Chalco to produce 12.5m tonnes of 2010 2011 2012F 2013F 2014F alumina in 2012e, including 1.2m tonnes of Source: Bloomberg, HSBC estimates alumina chemicals. About c7.3m tonnes (of the non-chemical alumina) will be smelted into Earnings sensitivity aluminium and a 4.0m tonnes are expected to be As is common with companies achieving only sold to third parties. thin margins, Chalco’s earnings are highly Alumina production is expected to rise to 13.1m sensitive to changes in commodity prices. We tonnes by 2013e (including 1.3m tonnes of estimate that a 1% increase in aluminium prices (a alumina chemicals). This increase in production change of about USD22/tonne) compared to our of 7% over two years will mainly come from the estimates would reduce our net loss forecasts by new Chongqing and Zunyi refineries, which RMB492m or 27% in 2012e and increase our net commenced operations in 2011. income forecast by cRMB510m or 125% in 2013e. In our view, this makes Chalco’s earnings We expect aluminium production to reach 4.3m highly unpredictable. tonnes in 2012 and remain at this level over the next two years. What’s the consensus? The wide range of earnings estimates for Chalco Aluminium prices suggests there is no real consensus on the We forecast SHFE aluminium prices at earnings outlook. This probably reflects: 1) the RMB13,817/tonne (ex-VAT) in 2012e, down 5% high degree of earnings sensitivity to changes in y-o-y, RMB14,381/tonne in 2013e, up 4% y-o-y commodity prices and 2) the difficulty in and at RMB14,703/tonne in 2014e, up another 2% forecasting trading incomes. y-o-y. Costs are also expected to rise. As a result of these changes, we expect the aluminium gross HSBC versus consensus earnings estimates margin to fall from c10% in 2011 to c6-7% in Year to Dec (RMBm) 2012e 2013e 2014e (1,881) 86 966 2012e-14e. Consensus - High end estimate 137 2,858 3,884 - Low end estimate (3,697) (2,911) (3,336)
HSBC estimate (1,850) 402 821
Source: Bloomberg, HSBC estimates
92 Natural Resources & Energy China Equity abc July 2012
What is Aluminum Corp of Chalco 2011 EBITDA breakdown by segment (excluding China? corporate and before intersegment elimination)
Alum inium Fabrication Aluminum Corp of China (Chalco) is the largest 49% 4% producer of alumina, primary aluminium and Trading aluminium fabrication products in China. It is also 8% the largest alumina producer and fourth largest aluminium producer globally. In 2011, Chalco produced 11.0m tonnes of alumina (excluding alumina chemicals), 3.9m tonnes of primary aluminium and 662k tonnes of aluminium Alumina 39% fabricated products representing 32%, 23% and Source: Company data, HSBC estimates 3%, respectively, of the total output in China. Chalco had total alumina production capacity of Alumina c14.2mtpa, primary aluminium capacity of Alumina segment includes the mining and 4.3mtpa and fabrication capacity of 1.7mtpa at the purchasing of bauxite and other raw materials, and end of 2011. production and sale of alumina as well as alumina- Chalco also has a presence in iron ore through its related products, such as alumina hydrate, alumina- joint venture with Rio Tinto for Simandou iron based chemical products and gallium. ore project in Guinea. It has recently made its Alumina is produced from bauxite through a foray into coal mining with its intention to acquire chemical refining process. Chalco uses various a 29.9% stake in Winsway Coking Coal and 56- refining processes depending upon the mineral 60% stake in SouthGobi Resources. composition of the ore. Most of the bauxite Chalco operates through four business segments: reserves in China contain diasporic bauxite having alumina, aluminium, aluminium fabrication, and low alumina-to-silica ratios and cannot be refined trading. Aluminium segment was the largest profit using a simple Bayer process. Chalco processes contributor in 2011 with EBITDA share of c49%, these ores using a sintering process or a hybrid followed by Alumina division at 39%. Fabrication Bayer-sintering process. Gallium is produced as a business has contributed 4% to EBITDA in 2011, by-product while producing alumina through but has been a drag on Chalco’s bottom line since Bayer process. its acquisition from its parent in 2008. The trading Chalco operates nine alumina facilities and one division, while accounting for c51% of the research institute with a total designed annual revenues in 2011, contributed only 8% to production capacity of c14.2mtpa at the end of EBITDA, as the segment has very thin profit 2011. Four of these alumina refineries are margins (EBITDA margins of less than 1%). integrated with primary aluminium smelters. In Chalco has significantly increased its trading 2011, Chalco produced c11.0m tonnes of alumina, business since 2010 in an attempt to cushion c1.2m tonnes of alumina chemical products and earnings decline from the aluminium business. c35.9 tonnes of gallium and supplied c7.5m tonnes or 64.3% of its total alumina production to its own smelters, meeting 100% of the smelter’s requirements. Chalco’s Shanxi branch and Henan
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branch are currently undergoing remoulding and ranged from 2.0 to 2.4 over the last five years. upgrading, which is expected to be completed by Bauxite deposits have been mostly discovered in the end of 2012 and will increase their capacity by the southern and northern parts of central China. 530k tonnes and 160k tonnes, respectively. The largest bauxite deposit in China lies in Chalco alumina assets as at end 2011 Shanxi Province. Most Chinese bauxite is Production Alumina Chemicals Utilization Al2O3.H2O mineral, which is uncommon in other capacity output output (kt) rate (ktpa) (kt) parts of the world. Shanxi branch 2,217 1,772 17 90.5% The refining process is mostly determined by the Henan branch 2,250 1,965 75 88.8% Shandong branch 1,770 1,870 674 90.2% alumina-to-silica ratio of the bauxite. Most of the Guizhou branch 1,200 1,066 6 100.0% Zhongzhou branch 2,980 1,615 221 98.4% bauxite reserves in China have low alumina-to- Guangxi branch 2,210 1,942 183 100.0% silica ratios. The average alumina-to-silica ratio of Zunyi Alumina** 800 742 - 100.0% Chongqing branch 800 49 1 50.0% Chalco’s proven and probable reserves is 6.41:1 Guangxi Huayin* 530 646 - 100.0% Research Institute 20 - 15 - and varies in a wide range between 4:1 and 10:1. Total 14,777 11,667 1,192 94.2% Chalco uses a sintering process to process these * Chalco holds 33% equity interest, indicated production capacity represents Chalco’s pro rata share, ** Chalco has 67% interest, indicated production capacity is shown on a 100% types of ores. basis Source: Company data, HSBC estimates Chalco sources its bauxite from either its owned mines or other small independent mines in China or Alumina inputs and costs sometimes international suppliers. Chalco also The principal inputs for alumina are bauxite and purchases higher-grade ore from other suppliers, energy in the form electricity, coal and fuel oil. which is blended with its own lower grade bauxite Bauxite supplies: Bauxite is the principal raw for processing. The company consumed 27.8m material in alumina production. Chalco used c2.4 tonnes of bauxite for alumina production in 2011, tonnes of bauxite to produce 1 tonne of alumina in out of which c13.6m tonnes was supplied by its own 2011. Chalco’s bauxite-to-alumina ratio has mines representing a self sufficiency ratio of c49%.
Chalco Bauxite mining assets as at end 2011 Mine Location Mining method Capacity Production Reserves Alumina Silica A/S ratio (kt) (kt) (mt) grade (%) grade (%) Pingguo mine Guangxi Zhuang Open pit 5,080 5,124 93.4 54.8 5.1 10.81 Guizhou No. 1 mine Guizhou Province Open pit/ underground 1,400 1,062 1.9 66.2 11.6 5.7 Guizhou No. 2 mine Guizhou Province Open pit/ underground 22.3 64.9 8.5 7.59 Zunyi mine Guizhou Province Open pit/ underground - 165 4.3 59.0 8.5 6.91 Xiaoyi mine Shanxi Province Open pit 2,750 2,907 23.8 63.5 12.6 5.03 Shanxi Other Mines Shanxi Province Open pit/ underground 1,300 970 12.3 61.3 9.5 6.46 Mianchi mine Henan Province Open pit/ underground 400 310 2.2 63.5 10.2 6.19 Luoyang mine Henan Province Open pit/ underground 700 735 5.4 60.0 9.8 6.13 Xiaoguan mine Henan Province Open pit/ underground 730 476 14.5 63.9 14.5 4.42 Gongyi mine Henan Province Open pit/ underground 820 211 3.3 63.9 13.8 4.62 Dengfeng mine Henan Province Open pit/ underground 350 368 0.4 60.0 8.8 6.81 Sanmenxia mine Henan Province Underground - 54 33.4 64.8 11.3 5.73 Xuchang mine Henan Province Open pit/ underground 400 65 0.3 62.2 16.3 3.81 Jiaozuo mine Henan Province Open pit/ underground 400 304 1.3 57.8 14.4 4.01 Pingdingshan mine Henan province Open pit/ underground 500 316 3.2 63.3 13.5 4.68 Yangquan mine Shanxi Province Open pit 200 180 5.4 55.2 13.2 4.19 Nanchuan mine Chongqing City Underground 1,650 318 34.7 61.3 13.4 4.57 Total (average) 16,680 13,565 261.9 60.0 9.4 6.41 Proved 143.8 60.8 10.3 5.89 Probable 118.1 59.0 8.2 7.2
Source: Company data, HSBC estimates
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As of December 31 2011, Chalco owned and Aluminium operated 17 mines that had c262m tonnes of This segment includes the production and sale of bauxite reserves and had an annual production primary aluminium and aluminium-related capacity of 16.7m tonnes. products, such as carbon products. The company’s The average per tonne purchase price of bauxite principal aluminium product is ingots, which from joint operations and other suppliers was accounted for c77.7% of production in 2011. RMB354/tonne in 2011. This compares to a cost Chalco internally produce substantially all the from Chalco’s own mines of RMB176/tonne. carbon products used at smelters and sell remaining carbon products to external customers. Chalco’s source of bauxite supply (kt) 2006 2007 2008 2009 2010 2011 Primary aluminium is produced from alumina through electrolytic reduction. All of Chalco’s Owned mines 4,115 4,770 6,885 10,657 12,730 13,565 Joint operated 4,710 3,752 1,404 440 40 4 primary aluminium capacity uses a pre-bake Others 10,343 15,016 13,992 6,293 13,005 14,210 Total 19,169 23,538 22,281 17,390 25,775 27,778 reduction process, which is used by most modern Share aluminium production facilities. Owned mines 21.5% 20.3% 30.9% 61.3% 49.4% 48.8% Joint operated 24.6% 15.9% 6.3% 2.5% 0.2% 0.0% Others 54.0% 63.8% 62.8% 36.2% 50.5% 51.2% Chalco operates sixteen primary aluminium Total 100% 100% 100% 100% 100% 100% production facilities and one research institute Source: Company data, HSBC estimates with a total designed annual production capacity of c4.3mtpa at the end of 2011. Four of these Other alumina inputs: Electricity, coal, alkali, smelters are integrated with alumina refineries, and heavy oil are other principal materials that are c15% of total capacity, and do not need to source used in alumina production. Electricity is a major alumina externally. In 2011, the company cost component in the refining process. Chalco produced approximately 3.9mtpa of primary generates its own electricity at some of its aluminium and the average utilization rate for production facilities and also purchases it from smelters was 92.6%. Fushun Aluminum is regional power grids. Power prices in China can currently undergoing remoulding and upgrading, vary substantially across the regions, depending which is expected to be complete by the end of on the regional demand and power production 2012 and will increase its capacity by 90k tonne. costs, resulting in different electricity costs at various alumina refineries.
Substantial quantities of coal are used as a reducing agent and also as a fuel to produce steam and gas in the alumina refining process. Alkali is used as a supplemental material in alumina refining. The sintering process and the hybrid Bayer-sintering process require soda ash while caustic soda is used in the Bayer process. Heavy oil, natural gas and coal gas are used as fuel to refine alumina. Chalco purchases these raw materials from external suppliers under negotiated supply contracts.
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Chalco aluminium assets as at end 2011 historically supplied all or substantially all of the Stake Production Aluminium Utilization alumina required from their own integrated capacity output (kt) rate (ktpa) refineries. Other aluminium plants (3.7mtpa Baotou Aluminum 100% 388 401 100% capacity, 85% of total) obtain alumina either from Fushun Aluminum 100% 240 212 100% other non-integrated Chalco refineries or from Gansu Hualu 51% 230 220 100% Guangxi branch 100% 140 108 60% third parties. In 2011, Chalco produced 3.9m Guizhou branch 100% 404 413 95% tonnes of aluminium and consumed 7.5m tonnes Henan branch 100% 56 - - Jiaozuo Wanfang 24% 412 417 100% of alumina, all of which was received from its Lanzhou branch 100% 388 418 100% Qinghai branch 100% 367 386 100% own refineries. Research Institute 100% 18 4 - Shandong Huayu 55% 200 220 100% Chalco generates electricity at three of its smelters Shandong branch 100% 55 50 100% Shanxi Huasheng 51% 220 224 100% and purchases its remaining electric power Shanxi Huaze 60% 350 347 100% requirement. The company has entered into direct Zunyi Aluminum 100% 235 209 88% Liancheng branch 100% 613 275 77% purchase agreements with power generation Longmen Aluminum 55% 17 11 62% Total (100% basis) 4,332 3,915 93% enterprises for two of its smelters and it purchases Attributable 3,561 3,138 the remaining electricity from the regional power Source: Company data, HSBC estimates grids at prices set by the government.
Aluminium inputs and costs Electricity costs have fluctuated in recent years Alumina and electricity are the two principal cost due to periodic shortages of electricity in China, components in making aluminium and accounted cyclical demand and government policies. for c36.5% and c41.6%, respectively, of Electricity prices in China sometimes vary aluminium production cost in 2011. Other than substantially across regions. There is a common these, carbon anodes, carbon cathodes and sodium electricity tariff schedule for industrial users fluoride are also used for smelting operations. within each region though electricity purchased Chalco used c1.9 tonnes of alumina and c14,109 from different power grids is subject to different kWh of electricity to produce 1 tonne of tariff levels. aluminium in 2011. In 2011, the average electricity cost of Chalco’s Chalco aluminium production cost breakup (2011) smelters was RMB0.4597/kWh and a total of 55.2 billion kWh of electricity was consumed for the Electricity 41% aluminium production. Chalco’s average electricity cost has increased substantially in
Others recent years. 22%
Alumina 37%
Source: Company data, HSBC estimates
Chalco’s Shandong, Henan, Guizhou, and Guangxi branches (combined capacity of 654ktpa, 15% of total) are fully integrated having
96 Natural Resources & Energy China Equity abc July 2012
Chalco average electricity cost (RMB/kWh) Chalco aluminium fabrication assets as at end 2011
0. 50 15% Production Fabrication Utilization capacity output (kt) rate (ktpa) 0. 45 10% Northwest Aluminum 135 55 41% Chalco Ruimin 370 148 40% 0. 40 5% Huaxi Aluminum 22 23 105% Chalco Southwest Aluminum 350 232 66% 0. 35 0% Chalco Southwest Aluminum 250 33 13% Cold Rolling 0. 30 -5% Henan Aluminum 355 125 35% Shandong branch 10 8 80% 2006 2007 2008 2009 2010 2011 Chalco Qingdao 120 9 8% Chalco Nanhai 110 29 26% Unit cost (LHS) YoY% (RHS) Total 1,722 662 38%
Source: Company data, HSBC estimates Source: Company data, HSBC estimates
We view high power costs in China as a key Aluminium fabrication inputs and costs factor that puts Chinese aluminium producers Primary aluminium is the main raw material used towards the top end of the global cost curve. in aluminium fabrication operations. Other metal Unlike some other producers around the world, raw materials are also used depending on the type Chalco does not enjoy the benefit of cheaper of products. Primary aluminium used in hydro-power or subsidised electricity. aluminium fabrication operations is mainly supplied by Chalco’s own aluminium smelters. In Carbon anodes and cathodes are two other key addition, Chalco Qingdao and Chalco Nanhai use raw materials in the smelting process. Chalco recycled aluminium materials. obtains all of its carbon cathodes from its Guizhou branch and produces all other carbon products at Trading its own smelters. The Guizhou branch also sells The trading segment includes sales of alumina, carbon cathodes to third-party smelters in China. primary aluminium, aluminium fabrication products, other non-ferrous metal products and Aluminium fabrication raw and ancillary materials in bulk both This segment includes the production and sale of manufactured by the company and sourced from aluminium fabrication products. The company’s external suppliers domestically and abroad. fabrication products include casts, planks, screens, extrusions, forges, powder, and die-castings and In 2011, Chalco Trading also entered into a long- are widely used in the construction, power term coking coal trading agreement in respect of generation, automobile, packaging, machinery and the coal from the Tavan Tolgoi mine with Erdenes durable goods industries. MGL LLC, which is a Mongolian state-owned company engaging in development and operations Chalco currently operates nine aluminium of mining deposits in Mongolia. Chalco’s trading fabrication facilities in China with a total designed business was established as a separate segment in capacity of 1.7mtpa. In 2011, the company July 2010 as a result of the operational produced c662k tonnes of aluminium fabrication restructuring by the company. products and the average utilization rate of the fabrication plants was 38.4%.
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Other assets the equity interest at no cost. This could Simandou Iron Ore Project potentially dilute Chalco’s stake in the project if Chalco has a presence in iron ore through its JV the Guinean government exercises its option. with Rio Tinto for Simandou iron ore project in Winsway Coking Coal (1733 HK) Guinea. Chalco planned to expand into iron ore Chalco has entered into an agreement with operations in an attempt to diversify its product Winsway to acquire 29.9% of the issued share offering, but the earnings from this project is too capital of the company for a total cash far away, in our view. consideration of HKD2.4bn. Following the Simandou project is a premium open-pit iron ore successful completion of acquisition, Chalco will mine located in Guinea, West Africa, with become the single largest shareholder of estimated resources of 2.25bn tonnes having an Winsway. average Fe grade of 66% to 67%. The projected Winsway is one of the leading suppliers of production capacity of the mine is 95mtpa on full imported coking coal and one of the largest off ramp-up and the capex cost for the projects is takers of Mongolian coking coal into China. Its estimated to be USD6.0bn. principal business includes procurement, Chalco acquired a 29% effective interest in the transportation, storage, processing and marketing project this year for USD880m (RMB5,544m). It of coking coal. holds its interest in Simnadou through its 65% SouthGobi Resources (1878 HK, not rated) equity interest in Chalco Iron Ore, which owns Chalco has entered into an agreement with 47% interest in Simfer Jersey Ltd, which owns Ivanhoe Mines, the controlling shareholder of 95% stake in the Simandou project. SouthGobi resources, to acquire 56% to 60% of
Simandou project stake holding the issued share of the company for a total Rio Tinto (through Simfer) 50% consideration ranging from CAD863.7m Chalco 29% (HKD6.7bn) to CAD925.4m (HKD7.2bn). Other Chinese investors 16% International finance corporation 5% Total 100% SouthGobi is an integrated coal mining,
Source: Company data, HSBC estimates development, and exploration company with
metallurgical and thermal coal mines in Chalco established Chalco Iron Ore along with the Mongolia’s South Gobi region. China-Africa Development Fund and three leading PRC enterprises in the steel, port building and railway construction industries to serve as an investment vehicle for investing in the Simandou project. Chalco holds 65% and the other investors collectively hold 35% of the equity interest in Chalco Iron Ore.
In April 2011, Rio Tinto and the Government of Guinea entered into a settlement agreement, pursuant to which the Government of Guinea has the right to acquire up to 35% of the equity interest in the Simandou project, including 15% of
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Chalco: Income statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Net Revenues 120,995 145,874 155,749 164,618 170,148 y-o-y change (%) 72% 21% 7% 6% 3%
Cost of sales 113,350 138,111 150,532 156,054 160,755
Gross profit 7,645 7,763 5,217 8,564 9,392 y-o-y change (%) 543% 2% -33% 64% 10% Gross profit margin (%) 6% 5% 3% 5% 6%
Operating expenses 4,361 4,620 4,984 5,268 5,445 Selling and distribution 1,573 1,623 1,869 1,975 2,042 General and administration 2,624 2,779 2,959 3,128 3,233 Research and development 164 218 156 165 170
Income from operations 3,284 3,143 233 3,297 3,948 Operating profit margin (%) 3% 2% 0% 2% 2%
Other income/ (expense) net 581 993 589 902 908
EBIT 3,865 4,136 822 4,199 4,856 EBIT margin (%) 3% 3% 1% 3% 3%
Net finance income/ (expense) (2,485) (3,318) (3,492) (3,603) (3,640) Interest expenses (2,576) (3,457) (3,610) (3,726) (3,768) Interest income 91 139 118 123 128
PBT 1,380 818(2,670) 596 1,216 PBT margin (%) 1% 1% -2% 0% 1%
Taxation (411) (127)614 (149) (304) Effective tax rate (%) 30% 16% 23% 25% 25%
Minority interests (191) (453) 206 (45) (91)
Net income 778 238 (1,850) 402 821 y-o-y change (%) nm -69% -878% nm 104% Net income margin (%) 0.6% 0.2% -1.2% 0.2% 0.5%
EPS (RMB) 0.06 0.02 (0.14) 0.03 0.06 DPS (RMB) 0.01 - - 0.01 0.02 Payout ratio 20% 0% 0% 25% 25%
EBITDA 9,949 9,884 7,233 10,587 10,877 EBITDA margin (%) 8% 7% 5% 6% 6%
Source: Company data, HSBC estimates
99 Natural Resources & Energy China Equity abc July 2012
Chalco: Balance sheet summary (RMBm) 2010a 2011a2012e 2013e 2014e Assets Current assets 41,325 49,970 54,005 56,396 58,128 Cash and cash equivalents 8,983 10,591 10,902 11,523 11,910 Time deposits 50 40 40 40 40 Pledged bank balances 463 1,013 1,013 1,013 1,013 Notes receivable 1,982 4,137 3,414 3,608 3,729 Due from related parties 367 399 399 399 399 Bills and accounts receivable 922 1,096 1,280 1,353 1,398 Inventories 21,780 24,124 28,869 29,928 30,830 Prepaid income tax 304 306 300 300 300 Other current assets 6,475 8,263 7,787 8,231 8,507
Fixed assets 90,779 93,775 93,698 93,643 93,956 Property, plant and equipment, net 72,722 77,579 79,502 81,447 81,760 Construction in progress 18,057 16,196 14,196 12,196 12,196
Other assets 9,219 13,389 14,510 14,616 15,035 Long-term investments 1,298 2,537 4,479 4,719 5,271 Investments in joint ventures 991 1,457 1,457 1,457 1,457 Goodwill, mining rights& computer software 3,034 3,067 2,994 2,920 2,847 Mineral exploration rights - 1,081 1,081 1,081 1,081 Land use rights 2,181 2,558 2,498 2,438 2,378 Deferred tax assets 1,411 1,517 1,600 1,600 1,600 Others 304 1,170 400 400 400
Total assets 141,322 157,134 162,213 164,655 167,118
Liabilities Current liabilities 55,734 62,360 57,148 54,153 55,190 Short-term loans 31,462 42,573 30,514 26,444 26,748 Current portion of long-term loans 10,258 4,164 8,718 8,815 8,916 Accounts and notes payable 6,010 8,002 9,486 9,834 10,130 Due to related parties 367 399 427 451 466 Taxation payable 96 51 (246) 60 122 Other payables and accruals 7,542 7,171 8,248 8,551 8,809
Non-current liabilities 28,402 36,619 48,601 53,538 54,146 Long-term loans 27,724 35,969 47,951 52,888 53,496 Others 678 650650 650 650
Total liabilities 84,135 98,979 105,749 107,691 109,335
Shareholders’ equity 51,581 51,826 49,976 50,378 51,098 Share capital 13,524 13,524 13,524 13,524 13,524 Share premium 12,848 12,847 12,847 12,847 12,847 Retained earnings 18,503 18,587 16,921 17,283 17,921 Reserves 6,706 6,868 6,683 6,723 6,805
Minority interests 5,606 6,329 6,489 6,586 6,685
Total liabilities and shareholders’ equity 141,322 157,134 162,213 164,655 167,118
Gearing Gross debts 69,444 82,706 87,184 88,146 89,159 Cash and ST investments 9,496 11,645 11,956 12,577 12,964 Net debts 59,948 71,062 75,228 75,569 76,196
Shareholders equity including minorities 57,187 58,155 56,464 56,964 57,782 Net debt-to-equity 105% 122% 133% 133% 132%
Source: Company data, HSBC estimates
100 Natural Resources & Energy China Equity abc July 2012
Chalco: Cash flow statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Cash flow from operating activities Profit before tax 1,380 818 (2,670) 596 1,216 Depreciation and Amortisation 6,084 5,860 6,411 6,388 6,021 Changes in working capital (2,359) (6,559) (1,432) (790) (714) Others 2,299 6,688 3,698 3,558 3,549 Interest received/(paid) - (4,040) (3,492) (3,603) (3,640) Income Tax Paid (300) (278) 614 (149) (304) Operating cash flow 7,104 2,490 3,129 6,000 6,128
Cash flow from investing activities Additions of fixed assets (8,326) (8,553) (6,200) (6,200) (6,200) Other Asset Changes (10) (188) 0 0 0 Proceeds from assets disposal 392 81 - - - Acquisitions & investment (333) (1,134) (1,942) (239) (552) Others 17 80687 - - Investing cash flow (8,260) (9,715) (7,455) (6,439) (6,752)
Cash flow from financing activities Dividend paid - (154) - - (101) Changes in capital structure (30) (21) - - - New loans and borrowings 46,836 74,211 4,477 962 1,013 Loans and borrowing repayment (41,195) (61,078) - - - Others (2,893) (4,116) 159 98 99 Financing cash flow 2,718 8,842 4,637 1,060 1,011
Net increase/ (decrease) in cash 1,561 1,618 311 621 387 Net exchange adjustment 20 (9) - - - Net cash movement 1,581 1,609 311 621 387
Source: Company data, HSBC estimates
101 Natural Resources & Energy China Equity abc July 2012
Financials & valuation: Angang Steel Neutral (V) Financial statements Key forecast drivers Year to 12/2011a 12/2012e 12/2013e 12/2014e Year to 12/2011a 12/2012e 12/2013e 12/2014e Profit & loss summary (RMBm) Crude steel production (kt) 19,783 20,769 21,653 21,647 Finished steel sales (kt) 18,838 19,938 20,787 20,781 Revenue 90,207 87,010 92,309 90,648 Average selling price (RMB/t) 4,588 4,211 4,285 4,209 EBITDA 5,215 5,837 8,440 10,312 Iron ore price (RMB/t) 1,152 968 923 816 Depreciation & amortisation -7,055 -6,927 -6,178 -6,418 Coking coal price (RMB/t) 1,401 1,350 1,380 1,340 Operating profit/EBIT -1,840 -1,091 2,263 3,895 RMB:USD 6.46 6.25 6.13 6.12 Net interest -1,464 -1,434 -1,224 -1,169
PBT -3,304 -2,525 1,038 2,726 HSBC PBT -3,304 -2,525 1,038 2,726 Taxation 955 631 -260 -681 Valuation data Net profit -2,163 -1,714 959 2,224 Year to 12/2011a 12/2012e 12/2013e 12/2014e HSBC net profit -2,163 -1,714 959 2,224 EV/sales 0.6 0.6 0.5 0.5 Cash flow summary (RMBm) EV/EBITDA 10.1 8.6 5.7 4.3 Cash flow from operations 3,030 6,620 6,533 8,794 EV/IC 0.7 0.7 0.7 0.6 Capex -5,495 -4,000 -4,000 -4,000 PE* 21.7 9.3 Cash flow from investment -5,589 -4,586 -4,400 -4,400 PB 0.4 0.4 0.4 0.4 Dividends -1,085 0 0 -479 FCF yield (%) -3.6 11.3 10.9 21.3 Change in net debt 3,203 -2,214 -2,313 -4,094 Dividend yield (%) 0.0 0.0 2.3 5.3 FCF equity -782 2,440 2,353 4,614 *Based on HSBC EPS (diluted)
Balance sheet summary (RMBm) Intangible fixed assets 3 3 3 3 Issuer information
1 8 . Tangible fixed assets 69,655 66,728 64,550 62,133 Share price (HKD)3.49 Target price (HKD)4.14 6 Current assets 30,342 28,960 30,063 29,267 Cash & others 2,341 3,045 3,231 3,173 Reuters (Equity) 0347.HK Bloomberg (Equity) 347 HK Total assets 104,915 101,006 100,332 97,518 Market cap (USDm) 4,021 Market cap (HKDm) 31,363 Operating liabilities 18,656 17,790 18,104 17,517 Free float (%) 40 Enterprise value (RMBm) 51,066 Gross debt 33,966 32,457 30,330 26,177 Country China Sector Metals & Mining Net debt 31,625 29,411 27,099 23,005 Analyst Simon Francis Contact +852 2996 6620 Shareholders funds 50,739 49,025 49,984 51,729
Invested capital 79,003 74,856 73,282 70,713 Price relative 21 21 Ratio, growth and per share analysis 19 19 17 17 Year to 12/2011a 12/2012e 12/2013e 12/2014e 15 15 13 13 Y-o-y % change 11 11 9 9 Revenue -2.2 -3.5 6.1 -1.8 7 7 EBITDA -51.9 11.9 44.6 22.2 5 5 Operating profit -150.3 72.1 3 3 PBT -238.9 162.5 1 1 HSBC EPS -205.3 132.0 2010 2011 2012 2013 Angang Steel Rel to HANG SENG CHINA ENTERPRISES INDEX Ratios (%) Source: HSBC Revenue/IC (x) 1.1 1.1 1.2 1.3
ROIC -1.6 -1.1 2.3 4.1 ROE -4.1 -3.4 1.9 4.4 Note: price at close of 25 Jul 2012 ROA -1.2 -0.8 1.7 3.0 EBITDA margin 5.8 6.7 9.1 11.4 Operating profit margin -2.0 -1.3 2.5 4.3 EBITDA/net interest (x) 3.6 4.1 6.9 8.8 Net debt/equity 60.5 57.9 52.2 42.7 Net debt/EBITDA (x) 6.1 5.0 3.2 2.2 CF from operations/net debt 9.6 22.5 24.1 38.2 Per share data (RMB) EPS Rep (diluted) -0.30 -0.24 0.13 0.31 HSBC EPS (diluted) -0.30 -0.24 0.13 0.31 DPS 0.00 0.00 0.07 0.15 Book value 7.01 6.78 6.91 7.15
102 Natural Resources & Energy China Equity abc July 2012
Angang Steel (347 HK)
Chinese steelmakers, including Angang, face a tough outlook with weak demand, excess capacity and little supply-side discipline We recognise the high-beta nature of the stock but expect margins and returns to remain suppressed We resume coverage on Angang with a Neutral (V) rating and a target price of HKD4.14 based on a 0.5x 2012e PB
Resume coverage with governments and is a significant employer; Simon Francis* Head of Metals & Mining Neutral (V) closures have been difficult to achieve. Research, Asia Pacific The Hongkong and Shanghai Angang Steel (Angang) is one of China’s largest What ‘consolidation’ has taken place tends to be Banking Corporation Limited +852 2996 6620 steel makers with a capacity of 21.6mtpa of crude merely a change in ownership; we are not yet seeing [email protected] steel. We resume coverage with a Neutral (V) widespread consolidation of production lines. Chris Chen* rating and a target price of HKD4.14 based on Analyst Overall, we believe this situation is likely to The Hongkong and Shanghai Angang trading at a 2012e PB of 0.5x. Banking Corporation Limited persist until either the Chinese steel sector +852 2822 4277 Tough environment for Chinese steel becomes more consolidated or global demand [email protected] Amit Pansari* makers… improves to such a degree that utilization rates Analyst Angang, and other steel makers in China, face rise significantly. Neither of these seems likely HSBC Bank plc +91 80 3001 3760 issues that we believe are both structural and over the medium term. [email protected] substantial. One issue is the market remains *Employed by a non-US affiliate Furthermore, the demand outlook is weaker now. of HSBC Securities (USA) Inc, highly fragmented with competition based largely We forecast average annual demand growth of 5% and is not registered/ qualified on selling prices. Another concern is the pursuant to FINRA regulations over the next three years. This compares to industry’s excess production capacity and the average growth of 14% p.a. in 2003-11. weak supply-side discipline among producers. Yet another issue, at least at the list-co level, is that We expect Chinese steel prices to continue to be most companies have very little upstream driven by costs with the industry as a whole making integration into raw materials and therefore poor margins. Angang is no exception to this. almost no control over production costs. …and a poor outlook for earnings and Whilst the Chinese government has aimed to close returns outdated steel capacity and to consolidate the As a result of these issues, the outlook for sector, this is taking far longer than expected. The Angang’s earnings and returns is poor, in our steel industry is largely controlled by local view. We forecast the company’s ROEs at between -3% and +4% in 2012e-14e. We expect
103 Natural Resources & Energy China Equity abc July 2012
Angang to post a loss in 2012e (1Q12 net loss was It does seem to us that the market expects RMB1.9bn and 1H12 net loss was RMB2.0bn Angang’s share price to sky-rocket each time the after retrospectively adjusting for the new iron ore Chinese government looks to stimulate the pricing scheme) and to make a small profit in economy. We would make the following cautions: 2013e. Our net income forecasts represent a profit Our China economist does not expect fiscal per tonne sold of just USD8 in 2013e and USD17 stimulus of the magnitude seen in 2009 in 2014e. We do not see profitability returning to the levels enjoyed in the 2003-08 commodities The Chinese government is stimulating upcycle anytime soon. because underlying demand is weak
Angang net income (RMBbn) Even if demand can be stimulated, Angang’s
8 earnings outlook is unlikely to improve because of the structural issues in the industry 6 mentioned above 4 2 All in all, we would view owning the shares as a 0 ‘trade’ rather than ‘investment’ and would sell (2) into a rally. (4) Balance sheet
2003 2004 2005 2006 2007 2008 2009 2010 2011 We estimate the company’s net-debt-to-equity 2012F 2013F 2014F Source: Company data, HSBC estimates ratio at 58% at the end of 2012e. We expect the balance sheet to gradually improve over the next Is there a risk of a stimulus-driven two years with net-debt-to-equity declining to rally? 43% by the end of 2014e.
Angang is a high-beta stock (beta of 1.27 Angang net debt (cash) (RMBbn) and gearing measured against the HSCEI) and historically 40 80% there has been a close correlation between 30 60% Chinese money supply growth and the share price. 20 40%
Angang share price vs. China M2 money supply growth 10 20%
20 40% 0 0% -10 -20% 15 30% 2003 2004 2005 200 6 2007 2008 2009 2010 2011
10 20% 2012F 2013F 2014F N et Debt (Cash) Net Debt (Cash)/ Equity (RHS) 5 10% Source: Company data, HSBC estimates 0 0% We forecast capex at RMB4bn pa over the next Jul-09 Jul-10 Jul-11 Jan-09 Jan- 10 Jan-11 Jan-12 three years. There are no major projects currently Angang H (LHS) M2 yoy (RHS) underway and we do not expect any to be Source: Thomson Reuters Datastream, HSBC announced this year.
104 Natural Resources & Energy China Equity abc July 2012
Valuations We also calculate daily EV/EBITDA and EV per PB-based target price tonne of capacity valuations on a one-year forward basis. Since iron ore prices were floated We value the Chinese steel stocks using PB in April 2010, Angang has traded at an average valuations because margins are thin and earnings EV/tonne of USD588. The stock reached a peak are both weak and volatile. We determine the valuation of USD2,082/tonne in October 2007 at target PB primarily by reference to our ROE the height of the China stock bubble and a trough forecasts as well as historical trends. of USD347/tonne in October 2008 when the We value Angang using a target PB of 0.5x. This bubble burst. looks reasonable to us in the context of the poor We calculate that at our target price of HKD4.14, outlook for returns and given previous trough the stock would trade at an EV/tonne of USD400. points. We forecast Angang’s ROEs at between This represents a 50% discount to estimated -3% and +4% over the next three years. replacement cost of USD800/tonne, which appears During the ‘relief rally’ of 4Q11, the stock rose appropriate to us, again, given the returns outlook. from a low 0.42x PB in October 2011 to a high of 0.80x in January 2012.
Angang’s daily PB Angang’s ROE and PB
2.5 2.5 30% 25% 2.0 2.0 20% 1.5 15% 1.5 10% 1.0 5% 1.0 0% 0.5 -5% 0.5 - -10%
- 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 P/BV ROE (RHS)
Jul-09 Jul-10 Jul-11 Jul-12 Jan-09 Jan-10 Jan-11 Jan-12
Source: Company data, Datastream, HSBC Source: Company data, HSBC
Angang’s daily EV/EBITDA Angang’s daily EV/t
22 1,100 20 1,000 US$/t 18 900 800 16 700 14 600 12 500 10 400 8 300 6 200 Jul-09 Jul-10 Jul-11 Jul-12 Jul-09 Jul-10 Jul-11 Jul-12 Jan-09 Jan-10 Jan-11 Jan-12 Jan-09 Jan-10 Jan-11 Jan-12
Source: Company data, Datastream, HSBC Source: Company data, Datastream, HSBC
105 Natural Resources & Energy China Equity abc July 2012
HSBC ratings bands Historical and forecast ROEs For volatile stocks, the band for a Neutral rating, 25%
N(V), is 10ppt above and below our hurdle rate, 20% which for China is 10%. Our target price together 15% with the expected dividend yield where indicated implies a potential return of 19%, which is within 10% the Neutral band. On this basis, we rate Angang 5% Neutral (V). Potential return equals the percentage 0% difference between the current share price and the 2004 2005 2006 2007 2008 2009 2010 2011
-5% 2012e 2013e 2014e target price, including the forecast dividend yield when indicated. Source: Company data, HSBC estimates
Risks We expect Angang to achieve a net loss per tonne The main upside risk to our view is that Chinese of RMB83 (USD13) in 2012e and a net income steel prices are stronger than expected. This could per tonne of just RMB44 (USD7) in 2013e. arise from stronger-than-expected demand or from Net income and cash net income per tonne structural changes in the industry resulting in a reduction of the amount of excess capacity. The 600 Rmb/t 500 company may be able to develop more niche 400 market products that attract better margins. The 300 company may be able to reduce production costs 200 below our forecasts. 100 - (100) 2008 2009 2010 2011 2012e 2013e The main downside risk, in our view, is that steel (200) prices are lower than expected resulting in lower Net income per tonne Cash net income per tonne earnings and a lower valuation.
Source: Company data, HSBC estimates Earnings outlook is poor
We expect Angang to make a net loss of Sales volume RMB1.7bn in 2012e, a net income of RMB959m Angang produced 19.8m tonnes of crude steel in in 2013e and RMB2.2bn in 2014e. We would 2011, down c9% y-o-y, as some production caution that there is very little visibility to these facilities were suspended for repairs and forecasts given the low margin nature of the maintenance amid weakening demand and falling business and the highly volatile nature of the main steel prices. Output this year is expected to rise by drivers: steel, iron ore and coking coal prices. 5% y-o-y to 20.8m tonnes.
We estimate Angang will achieve an average We forecast sales volume of 19.9m tonnes in ROE of just 1% over the next three years. 2012e, up 6% y-o-y and 20.8m tonnes in 2013e, up 4% y-o-y.
106 Natural Resources & Energy China Equity abc July 2012
Selling prices USD177/tonne in 1H11 and USD159/tonne in We expect Angang’s average selling prices to fall 2H11. We estimate Angang’s average iron ore cost 8% y-o-y to RMB4,211/tonne in 2012e and edge will fall 16% y-o-y to RMB968/tonne in 2012e and up 2% y-o-y to RMB4,285/tonne in 2013e. another 5% y-o-y to RMB923/tonne in 2013e.
Selling prices should be marginally higher in Iron ore prices, 62% Fe cfr China 2Q12e than in 1Q12e. We expect 3Q12e prices 200 US$/t will be seasonally weaker than in 2Q12e. After 175 cutting its June prices, Angang cut its July delivery prices by RMB130/tonne for hot-rolled 150 coil (HRC) products and by RMB200-300/tonne 125 for cold-rolled coil (CRC) products and made further cuts for August deliveries of RMB150/t 100 for HRC and RMB50/t for CRC. Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 Production costs Iron ore fines import prices, cfr Tianjin port
We forecast production costs to decrease in y-o-y Source: Bloomberg terms in 2012e on lower iron ore and coking coal Angang sources virtually all of its coking coal prices as well as the change of pricing scheme for from China. The average price of Liulin No.4 iron ore purchased from the parent company. coking coal fell by 4% y-o-y and 3% q-o-q in Angang sources 50% of its iron ore from its 2Q12. We expect Angang’s coal costs to fall 4% parent in the form of iron concentrates. Under the y-o-y in 2012e and edge up 2% y-o-y in 2013e. previous agreement, prices for these purchases Chinese coking coal prices were based on the average imported iron 1,800 concentrates in the preceding half year. That is, Rmb/t 1,700 Angang’s 1H12 iron concentrates would have 1,600 been based on average imported price in 2H11. 1,500 1,400 On 28 June, Angang’s shareholders passed a 1,300 resolution to change the price of iron ore 1,200 purchased from its parent to the average price in Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 the month falling two months before the month of Jan-10 Jan-11 Jan-12 No.4 Coking Coal: Lvliang: Liulin the transaction (T-2). That is, Angang’s 1H12 iron 1/3 Coking Coal: Linfen: Puxian concentrates costs are now based on average Source: SXCoal imported prices from November 2011 to April 2012. We calculate that the new pricing scheme would have reduced Angang’s costs of iron ore from its parent by USD18/tonne in 1H12. Based on 1Q sales volume of 4.5m tonnes, we estimate this would have reduced Angang’s 1Q12 pre-tax loss by cRMB500m.
The average price of 62% Fe content iron ore cfr China declined to USD141/tonne in 1H12 from
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Earnings sensitivity production has stabilized over the last three years Given the weak earnings, our forecasts are highly at c20-22mtpa as there has been no capacity sensitive to changes in the main earnings drivers: growth since the commissioning of Bayuquan steel prices, and iron ore and coking coal costs. facility in 2008.
We estimate that a 1% rise in average steel prices Angang mainly produces flat products, including would reduce Angang’s loss by 37% in 2012e and HRC, CRC, coated sheet and plates and also a increase Angang’s earnings by 72% in 2013e. small portion of some longs and tubes products. It produced c19m tonnes of finished steel in 2011 We estimate that 1% increase in iron ore costs with flat steel accounting for c90%. would increase Angang’s losses by 14% in 2012e and decrease Angang’s earnings by 26% in 2013e. Angang crude steel production (mt) 25 What’s the consensus? Bayuquan commissioned 20 This high degree of earnings sensitivity – and thus uncertainty – is born out in consensus estimates. 15 Asset acquisition from pare nt The consensus forecast for 2012 (taking recent 10 estimates only) is for a net loss of RMB780m. 5 Recent estimates vary from a low of a loss of RMB3.1bn to a high of a profit of RMB1.8bn. 0
HSBC versus consensus earnings estimates 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 RMBm 2012e 2013e 2014e Source: Company data, HSBC estimates
Consensus (780) 801 1,671 High end estimate 1,795 2,286 2,813 Sales Low end estimate (3,074) (1,958) 640 Angang sold c19m tonnes of finished products in HSBC estimate (1,714) 959 2,224 2011 (down 8% y-o-y) with flat products Source: Bloomberg, HSBC estimates accounting for c90% of sales volume. Exports What is Anshan Iron & steel? accounted for c9% of sales volume in 2011. Angang 2011 finished steel sales by products Anshan Iron & Steel (Angang) is the second largest steel producer in China and is the largest Hot rolled strip steel mill in Northeast China. The company had a Lon g 35% crude steel capacity of c22mtpa as at the end of products 2011 with c17mtpa at its works in Anshan and 10% c5mtpa at its Bayuquan facility. Angang is a state- owned company and is majority owned (67%) by Plates Cold rolled Angang Iron & Steel Group. 17% products Production 38% Angang produced c20m tonnes of crude steel in Source: Company data, HSBC estimates 2011, down 9% y-o-y as some production facilities were suspended for repairs and In 2011, Angang had a c5-6% domestic market maintenance amid weakening demand and falling share in HRC and CRC, and a 13-15% domestic steel prices in the fourth quarter. Angang’s steel
108 Natural Resources & Energy China Equity abc July 2012
market share for more specialized products, such as heavy rails and silicon steel.
Angang market share of major products
Heav y rails 15%
Silicon Steel 13%
Med ium & Thick plate s 6%
CRC 6%
HRC 5%
Galv aniz ed Sheets 4%
Se am le ss s teel p ipe s 2%
Wire rods 1%
Source: Company data, HSBC estimates
Raw materials Angang does not have any direct upstream integration with respect to its two major raw materials requirement, namely iron ore and coking coal. Angang purchases iron ore from its parent, which currently meets c50% of the company’s requirement, in our view. Angang purchases all its coking coal requirements domestically.
109 Natural Resources & Energy China Equity abc July 2012
Angang: Income statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Net Revenues 92,212 90,207 87,010 92,309 90,648 y-o-y change (%) 32% -2% -4% 6% -2%
Cost of sales 85,694 89,327 85,802 87,568 84,272
Gross Profit 6,518 880 1,208 4,741 6,377 y-o-y change (%) 57% -86% 37% 293% 34% Gross profit margin (%) 7% 1% 1% 5% 7%
Operating Expenses 3,466 3,306 2,958 3,138 3,082 Delivery and selling costs 1,622 1,549 1,392 1,477 1,450 General and administrative 1,844 1,757 1,566 1,662 1,632
Income from Operations 3,052 (2,426) (1,751) 1,603 3,295 Operating profit margin (%) 3% -3% -2% 2% 4%
Other income/ (expense) net 603 586 660 660 600
EBIT 3,655 (1,840) (1,091) 2,263 3,895 EBIT margin (%) 4% -2% -1% 2% 4%
Net finance income/ (expense) (1,277) (1,464) (1,434) (1,224) (1,169) Interest expenses (1,303) (1,492) (1,461) (1,256) (1,201) Interest income 26 28 27 31 32
PBT 2,378 (3,304) (2,525) 1,038 2,726 PBT margin (%) 3% -4% -3% 1% 3%
Taxation (413) 955631 (260) (681) Effective tax rate (%) 17% 29% 25% 25% 25%
Minority interest 89 186 180 180 180
Net income 2,054 (2,163) (1,714) 959 2,224 y-o-y change (%) 173% -205% nm nm 132% Net income margin (%) 2% -2% -2% 1% 2%
EPS (RMB) 0.28 (0.30) (0.24) 0.13 0.31 DPS (RMB) 0.15 - - 0.07 0.15 Payout ratio 50% n.a. n.a. 50% 50%
EBITDA 10,831 5,215 5,837 8,440 10,312 EBITDA margin (%) 12% 6% 7% 9% 11%
Source: Company data, HSBC estimates
110 Natural Resources & Energy China Equity abc July 2012
Angang: Balance sheet summary (RMBm) 2010a 2011a2012e 2013e 2014e Assets Current assets 33,026 30,342 28,960 30,063 29,267 Cash in hand and at banks 3,651 2,341 3,045 3,231 3,173 Trade/bill receivables 4,856 6,586 5,960 6,323 6,209 Current tax assets 24 94 - - - Inventories 13,134 14,242 14,104 14,395 13,853 Amount due from related companies 7,357 4,647 1,500 1,500 1,500 Prepayment, deposits and other receivables 4,004 2,432 4,350 4,615 4,532
Fixed assets 70,550 69,655 66,728 64,550 62,133 Property, plant and equipment 64,226 60,387 57,460 55,282 52,865 Construction in progress 6,324 9,268 9,268 9,268 9,268
Other assets 3,543 4,918 5,318 5,718 6,118 Intangible assets 8 3333 Investment in associate 1,733 2,125 2,525 2,925 3,325 Other investment 434 450 450 450 450 Deferred tax assets 1,368 2,340 2,340 2,340 2,340
Total assets 107,119 104,915 101,006 100,332 97,518
Liabilities Current liabilities 38,482 38,801 36,764 32,769 30,106 Bank loan 16,356 14,831 19,474 15,165 13,089 Short-term debentures 3,000 6,000 - - - Trade payables 9,357 9,900 9,403 9,596 9,235 Deferred income 23 5 10 10 10 Amount due to related parties 2,392 1,979 2,000 2,000 2,000 Other payables 7,354 6,086 5,877 5,998 5,772
Non-current liabilities 13,308 13,821 13,483 15,665 13,589 Bank loans 12,717 13,135 12,983 15,165 13,089 Deferred tax liabilities and others 591 686 500 500 500
Total liabilities 41,855 49,469 51,790 52,622 50,246
Shareholders’ equity 54,052 50,739 49,025 49,984 51,729 Share capital 7,235 7,235 7,235 7,235 7,235 Share premium 31,414 31,414 31,414 31,414 31,414 Reserves 3,713 3,625 3,454 3,550 3,772 Retained profits 11,690 8,465 6,923 7,786 9,308
Minority interests 1,277 1,554 1,734 1,914 2,094
Total liabilities and shareholders’ equity 107,119 104,915 101,006 100,332 97,518
Gearing Gross debts 32,073 33,966 32,457 30,330 26,177 Cash and ST investments 3,651 2,341 3,045 3,231 3,173 Net debts/(cash) 28,422 31,625 29,411 27,099 23,005
Shareholders equity including minorities 55,329 52,293 50,759 51,898 53,823 Net debt-to-equity 51% 60% 58% 52% 43%
Source: Company data, HSBC estimates
111 Natural Resources & Energy China Equity abc July 2012
Angang: Cash flow statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Cash flow from operating activities Profit Before Tax 2,378 (3,304) (2,525) 1,038 2,726 Depreciation 7,176 7,055 6,927 6,178 6,418 Change in working capital (1,207) 7 1,406 (604) 152 Interest received/(paid) (1,653) (1,734) (1,434) (1,224) (1,169) Income Tax Paid (568) (57) 631 (260) (681) Others 1,324 1,063 1,614 1,404 1,349 Net cash from operating activities 7,450 3,030 6,620 6,533 8,794
Cash flow from investing activities Capital expenditure (4,851) (5,495) (4,000) (4,000) (4,000) Asset Disposal 5 3 - - - Acquisitions/investment (25) (103) (400) (400) (400) Others 76 6 (186) - - Investing cash flows (4,795) (5,589) (4,586) (4,400) (4,400)
Cash flow from financing activities Dividend paid (434) (1,085) - - (479) Net new borrowings (812) 1,871 (1,509) (2,127) (4,152) Others - 463 180 180 180 Financing cash flows (1,246) 1,249 (1,329) (1,947) (4,452)
Net increase/ (decrease) in cash 1,409 (1,310) 704 185 (58)
Source: Company data, HSBC estimates
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Financials & valuation: Baoshan Iron & Steel Neutral
Financial statements Key forecast drivers Year to 12/2011a 12/2012e 12/2013e 12/2014e Year to 12/2011a 12/2012e 12/2013e 12/2014e Profit & loss summary (RMBm) Crude steel production (kt) 26,641 25,517 25,952 26,988 Finished steel sales (kt) 25,803 24,630 25,050 26,050 Revenue 222,505 195,339 195,284 197,721 Average selling prices (RMB/t) 6,137 5,353 5,261 5,152 EBITDA 23,885 27,212 20,312 23,943 Iron ore prices (RMB/t) 1,118 938 920 796 Depreciation & amortisation -13,143 -12,132 -10,778 -11,259 Coking coal prices (RMB/t) 1,592 1,538 1,564 1,521 Operating profit/EBIT 10,742 15,080 9,534 12,684 RMB:USD 6.46 6.25 6.13 6.12 Net interest -1,482 -1,505 -1,010 -707
PBT 9,260 13,574 8,524 11,977 HSBC PBT 9,260 13,574 8,524 11,977 Taxation -1,524 -3,122 -1,705 -2,395 Valuation data Net profit 7,362 9,909 6,479 9,102 Year to 12/2011a 12/2012e 12/2013e 12/2014e HSBC net profit 7,362 9,909 6,479 9,102 EV/sales 0.6 0.6 0.5 0.5 Cash flow summary (RMBm) EV/EBITDA 5.4 4.0 5.0 3.7 Cash flow from operations 12,142 13,118 22,314 24,951 EV/IC 0.8 0.8 0.7 0.7 Capex -15,068 -12,493 -10,000 -10,000 PE* 9.8 7.3 11.1 7.9 Cash flow from investment -16,130 10,775 -10,000 -10,000 PB 0.7 0.6 0.6 0.6 Dividends -6,912 -3,502 -3,964 -2,591 FCF yield (%) -3.1 18.4 17.6 21.4 Change in net debt 12,542 -19,932 -7,986 -11,996 Dividend yield (%) 4.9 5.5 3.6 5.1 FCF equity -2,256 13,221 12,654 15,429 *Based on HSBC EPS (diluted)
Balance sheet summary (RMBm) Intangible fixed assets 8,126 7,720 7,334 6,967 Issuer information
1 0 . Tangible fixed assets 132,460 97,616 97,224 96,332 Share price (RMB)4.11 Target price (RMB)4.50 7 Current assets 79,234 116,583 95,351 90,951 Cash & others 14,379 35,161 19,528 19,772 Reuters (Equity) 600019.SS Bloomberg (Equity) 600019 CH Total assets 231,100 232,621 210,611 204,952 Market cap (USDm) 11,266 Market cap (RMBm) 71,975 Operating liabilities 45,382 41,903 40,996 40,578 Free float (%) 25 Enterprise value (RMBm) 109,593 Gross debt 71,930 72,780 49,161 37,409 Country China Sector Metals & Mining Net debt 57,551 37,619 29,632 17,637 Analyst Simon Francis Contact +852 2996 6620 Shareholders funds 106,495 113,136 115,651 122,162
Invested capital 160,058 144,855 139,384 133,900 Price relative
11 11 Ratio, growth and per share analysis 10 10 Year to 12/2011a 12/2012e 12/2013e 12/2014e 9 9 8 8 Y-o-y % change 7 7 Revenue 10.1 -12.2 0.0 1.2 6 6 EBITDA -24.3 13.9 -25.4 17.9 5 5 Operating profit -42.0 40.4 -36.8 33.0 4 4 PBT -45.8 46.6 -37.2 40.5 3 3 HSBC EPS -42.9 34.6 -34.6 40.5 2010 2011 2012 2013 Baoshan Iron & Steel Rel to SSE COMPOSITE INDEX Ratios (%) Source: HSBC Revenue/IC (x) 1.5 1.3 1.4 1.4
ROIC 5.9 7.6 5.4 7.4 ROE 7.0 9.0 5.7 7.7 Note: price at close of 25 Jul 2012 ROA 4.2 5.3 3.8 5.2 EBITDA margin 10.7 13.9 10.4 12.1 Operating profit margin 4.8 7.7 4.9 6.4 EBITDA/net interest (x) 16.1 18.1 20.1 33.9 Net debt/equity 50.7 32.0 24.7 13.9 Net debt/EBITDA (x) 2.4 1.4 1.5 0.7 CF from operations/net debt 21.1 34.9 75.3 141.5 Per share data (RMB) EPS Rep (diluted) 0.42 0.57 0.37 0.52 HSBC EPS (diluted) 0.42 0.57 0.37 0.52 DPS 0.20 0.23 0.15 0.21 Book value 6.08 6.46 6.60 6.98
114 Natural Resources & Energy China Equity abc July 2012
Baoshan Iron & Steel (600019 CH)
Baoshan’s strategy of product differentiation has enabled it to sustain superior margins over the past few years though margins have still declined In common with other Chinese steel companies, lower ROEs have led to the shares being substantially de-rated We resume coverage of Baoshan with a Neutral rating and a target price of RMB4.50 based on 0.7x 2012e PB
Resume coverage with Neutral Furthermore, the demand outlook is weak. We Simon Francis* Head of Metals & Mining forecast average annual demand growth of 5% Baoshan is one of China’s largest steel makers Research, Asia Pacific over the next three years. This compares to The Hongkong and Shanghai with a capacity of c26.0mtpa of crude steel. We Banking Corporation Limited average growth of 14% p.a. in 2003-11. +852 2996 6620 resume coverage with a Neutral rating and a target [email protected] price of RMB4.50 based on a 2012e PB of 0.7x. We expect Chinese steel prices to continue to be Chris Chen* driven by costs with the industry as a whole making Analyst Tough outlook for Chinese steel The Hongkong and Shanghai poor margins. Baoshan is no exception to this. Banking Corporation Limited makers +852 2822 4277 [email protected] Like Angang, and other steel producers in China, Outlook for earnings and returns weakening, but superior to peers Amit Pansari* Baoshan faces issues that we believe are both Analyst structural and substantial. The market remains While Baoshan has sustained higher returns than HSBC Bank plc +91 80 3001 3760 highly fragmented with competition based largely many Chinese steel producers over the past few [email protected] on selling price. The industry has excess years, earnings have deteriorated recently with *Employed by a non-US affiliate of HSBC Securities (USA) Inc, production capacity and there is little to no earnings declining in y-o-y terms in four out of and is not registered/ qualified supply-side discipline among producers. At the the past five years. pursuant to FINRA regulations list-co level, companies have very little upstream We forecast the company’s ROEs at between 3% integration into raw materials and therefore and 8% in 2012e-14e. almost no control over production costs. Our net income forecasts represent a profit per So far the Chinese government has not been tonne sold of just USD18 in 2012e (excluding successful in addressing these issues. one-off gains) and USD42 in 2013e. We do not
115 Natural Resources & Energy China Equity abc July 2012
see profitability returning to the levels enjoyed in Baoshan’s domestic market share the 2003-08 commodities upcycle anytime soon. 60% 50% Baoshan net income (RMBbn) 40% 14 30% 20% 12 10% 10 0%
et e teel ube lat 8 s she tube t p o sheet y n t er Tin plate n ilicon steelHRW pipeShip Au ances Boiler S 6 ackaging steel machi P Oil exploratio gth me appli 4 tren Ho gh-s 2 Hi
Source: Company data 2003 2004 2005 2006 2007 2008 2009 2010 2011
2012e 2013e 2014e
*excluding one-off gain in 2012e Source: Company data, HSBC estimates Yet, margins and returns have not been immune ‘Number one, only one’, a strategy of While Baoshan’s strategy, together with large- differentiation scale, modern coastal located plants have enabled Baoshan’s primary strategy is to differentiate its the company to achieve higher returns than other products in order to achieve reasonable margins major listed Chinese steel makers, Baoshan’s and returns. The target is that 50% of production margins have still come under pressure over the will be ‘number one, only one’ products within the past few years. next five years, which means some 13-14mtpa of Gross margins of Baoshan and Maanshan differentiated products by that time. As the name implies, ‘number one, only one’ refers to 30% 25% Baoshan’s strategy of being the largest producer of, 20% or the only producer of, its key products. Baoshan 15% believes that there are good import substitution 10% opportunities for most of these products. 5% This strategy is apparent in Baoshan’s market 0% shares, which we believe are higher than for other 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012e 2013e 2014e Chinese steel companies. Mostly notably, Baoshan Maanshan Baoshan has a market share of c50% in the cold- Source: Company data, HSBC estimates rolled auto sheet market for passenger cars and c70-80% market share in the market for exposed Disposal of stainless and special steel auto sheets. Within Baoshan’s auto sheet sales of business 4.55m tonnes in 2011, roughly half was sales of Baoshan completed the disposal of the stainless ‘number one, only one’ products. and special steel business to its parent company in April 2012. The sale generated proceeds of RMB45.2bn, including RMB22.7bn in cash and RMB22.5bn to be paid in instalments (over the next five years). The sales generated a profit of
116 Natural Resources & Energy China Equity abc July 2012
RMB9.6bn (including RMB7.5bn in land Corex facilities to an area where coal is cheap and appreciation) that will be recognized in the 2Q12 where the off-gases can be used more efficiently. results. Strong balance sheet The stainless and special steel products were Baoshan has retained a strong balance sheet over produced from an integrated line, meaning that the past few years with net debt-to-equity some carbon steel capacity was sold as well. In reaching 51% at the end of last year. We expect total, Baoshan sold 4.0mtpa of steel capacity. gearing to decline to 32% by the end of this year The sale should improve profitability in two ways. and to 14% by the end of 2014e.
First the sold assets were loss-making, generating Baoshan’s net debt (cash) (RMBbn) and gearing a loss of RMB1.54bn in 2011. Adding back this 60 60% loss would have boosted Baoshan’s profit by 21% 50 50% in 2011. Second, cash from the sale will be put to 40 40% reducing Baoshan’s borrowings, meaning lower 30 30% interest costs. Management expects interest costs 20 to come down by RMB1.4bn p.a. 10 20% - 10% Is there further restructuring ahead? 2003 2004 2005 2006 2007 2008 2009 2010 2011 One part of the business that is coming in for 2012e 2013e 2014e closer management scrutiny is the 3.0mtpa Corex Net Debt (Cash) Net Debt (Cash)/ Equity (RHS) facilities in Shanghai. Corex is a steel making Source: Company data, HSBC estimates technology that differs from conventional blast furnace technology in that non-coking coal can be Valuation used. It has two environmental advantages over PB-based target price the conventional steel making process. First, as We value the Chinese steel stocks using PB coke ovens are not needed, the problems of valuations because margins are thin and earnings benzene and other coal tar by-products are are both weak and volatile. We determine the eliminated. Second, the dust issues associated target PB primarily by reference to our ROE with blast furnaces are also eliminated because the forecasts as well as historical trends. off-gas is used as fuel. Baoshan shares have been substantially de-rated Baoshan is finding that the production costs in the over the past couple of years from a PB of more Corex process are higher than expected. One than 1.5x at the start of 2010 to around 0.65x now. factor is that China has over-capacity in coke. We expect the company’s returns to remain under This means that the cost of coke is not pressure over the next few years. substantially higher than the cost of coking coal and this makes the conventional blast furnace Our target price of RMB4.50 is based on Baoshan steel making route relatively more cost-efficient. trading at 0.7x 2012e PB. We think this is Second, Baoshan has been unable to take full reasonable in the context of the weak earnings advantage of the gas by-products, which would outlook and given previous trough points. We also reduce effective costs. think Baoshan’s ROEs at just 3-8% each year for the next three years (excluding the pre-tax gain of Management is now examining the strategic RMB9.6bn from disposal of stainless and special options. One option might be to relocate the
117 Natural Resources & Energy China Equity abc July 2012
steel business in 2012e) justify the discount to Baoshan’s daily EV/EBITDA book value. 8.5 8.0 Baoshan’s ROE and PB 7.5 3.0 30% 7.0 6.5 2.5 25% 6.0 2.0 20% 5.5 1.5 5.0 15% 4.5 1.0 4.0 0.5 10%
- 5% Jul-09 Jul-10 Jul-11 Jul-12 Jan-09 Jan-10 Jan-11 Jan-12
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Company data, Datastream, HSBC
P/BV ROE (RHS) Baoshan’s daily EV/t Source: Company data, HSBC 1,300 US$/t Baoshan’s daily PB 1,200 1,100 1.9 1,000 1.7 900 1.5 800 1.3 700 1.1 600 0.9 0.7 Jul-09 Jul-10 Jul-11 Jul-12 Jan-09 Jan-10 Jan-11 Jan-12 0.5 Source: Company data, Datastream, HSBC
Jul-09 Jul-10 Jul-11 Jul-12 Jan-09 Jan-10 Jan-11 Jan-12 HSBC ratings bands Source: Company data, Datastream, HSBC For non-volatile stocks, the band for a Neutral We also calculate daily EV/EBITDA and EV per rating (N) is 5ppt above and below our hurdle tonne of capacity valuations on a one-year rate, which for China is 10%. Our target price forward basis. Since iron ore prices were floated together with the expected dividend yield where in April 2010, Baoshan has traded at an average indicated implies a potential return of 15%, which EV/t of USD872/t. is within the Neutral band. On this basis, we rate Baoshan Neutral. Potential return equals the We calculate that at our target price of RMB4.50, percentage difference between the current share the stock would trade at an EV/t of USD700. This price and the target price, including the forecast represents a 13% discount to estimated dividend yield when indicated. replacement cost of USD800/t which appears appropriate to us, again given the returns outlook. Risks
The main upside risk to our view is that Chinese steel prices are stronger than expected. This could arise from stronger-than-expected demand or from structural changes in the industry resulting in a reduction of the amount of excess capacity.
118 Natural Resources & Energy China Equity abc July 2012
Baoshan may be successful in developing more The company disposed of the stainless and ‘number one, only one’ products which may attract speciality steel business in April 2012, which will higher niche product margins. Cost cutting efforts reduce output by c1.7m tonnes in 2012e. The lost at the company – including the potential relocation output is expected to be partly offset by output of the Corex production facilities in future – may from Meishan expansion project. Meishan Steel be more successful than we anticipate. previously had an annual capacity of 3mtpa for HRC products. The new production line of hot- The main downside risk, in our view, is that steel rolled and pickled high strength steel was prices are lower than expected resulting in lower completed and commissioned in October 2011, earnings and a lower valuation. adding another 1mtpa of capacity.
Weak earnings outlook We forecast sales volume of 24.6m tonnes in We expect Baoshan to make net income of 2012e, down 5% y-o-y and 25.1m tonnes in RMB9.9bn in 2012e, RMB6.5bn in 2013e and 2013e, up 2% y-o-y. RMB9.1bn in 2014e. The 2012e net income Selling prices includes a pre-tax gain of RMB9.6bn from the We expect Baoshan’s average selling prices to disposal of stainless and special steel business. decline by 13% y-o-y to RMB5,353/t in 2012e We are cautious that there is little visibility to and by a further 2% y-o-y to RMB5,261/t in these forecasts given the low margin nature of the 2013e. We forecast Baoshan’s average carbon business and the highly volatile nature of the main steel prices will fall by 6% y-o-y to RMB5,187/t drivers – steel, iron ore and coking coal prices. and slightly recover by 1% y-o-y to RMB5,261/t Stripping out the gain from disposal in 2012e, we in 2013e. estimate Baoshan will achieve an average ROE of We do not think steel prices will pick up just 5% over the next three years. meaningfully in 3Q12. Baoshan cut its July Historical and forecast ROEs delivery prices by RMB200/t for hot-rolled coil
25% (HRC) and cold-rolled coil (CRC) products and cut prices by a further RMB200/t for HRC and 20% RMB260/t for CRC for August deliveries. These 15% cuts came after prices were kept flat in April-June. 10% Production costs 5% We expect Baoshan’s production costs to decline y-o-y driven by lower raw material costs. 0%
2004 2005 2006 2007 2008 2009 2010 2011 Baoshan imports almost its entire iron ore 2012e 2013e 2014e Source: Company data, HSBC estimates requirement. The average price of 62% Fe content iron ore, cfr China has declined to USD141/t in Sales volume 1H12 from USD177/t in 1H11 and USD159/t in Baoshan sold 25.8m tonnes of steel products in 2H11. We estimate Baoshan’s average cost of 2011, up 2% y-o-y, of which 23.5m tonnes were iron ore will decline by 16% y-o-y in 2012e and carbon steel and the remaining 2.3m tonnes being by a further 2% y-o-y in 2013e. stainless steel and specialty steel.
119 Natural Resources & Energy China Equity abc July 2012
Iron ore prices, 62% Fe, cfr China Earnings sensitivity 200 Given the low level of earnings, our earnings US$/t forecasts are very sensitive to changes in the main 175 earnings drivers – steel prices and iron ore and 150 coking costs.
125 We estimate that a 1% increase in average steel prices would increase Baoshan’s earnings by 9% 100 in 2012e and by 15% in 2013e. Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 Iron ore fines import prices, cfr Tianjin port We estimate that a 1% increase in iron ore costs would reduce Baoshan’s earnings by 3% in 2012e Source: Bloomberg and by 4% in 2013e. Baoshan purchases its coking coal requirement What’s the consensus? mostly from domestic market. The average prices This high degree of earnings sensitivity – and thus of Liulin No.4 coking coal prices have fallen by uncertainty – is born out in the current consensus 4% y-o-y and 3% q-o-q in 2Q12. We forecast estimates. The consensus forecast for 2012 (taking Baoshan’s coal costs to fall by 3% y-o-y in 2012e recent estimates only) is for net income of and slightly increase by 2% y-o-y in 2013e. RMB11.3bn. Recent estimates vary from a low of Chinese coking coal prices RMB6.5bn to a high of RMB16.3bn.
1,800 Rmb/t HSBC versus consensus earnings estimates 1,700 2012e 2013e 2014e 1,600 1,500 Consensus 11,263 9,171 11,015 - High end estimate 16,293 10,729 15,503 1,400 - Low end estimate 6,535 7,079 8,135 1,300 Range as % of consensus 58 -145% 77 - 117% 74 - 141% 1,200 HSBC estimate 9,909 6,479 9,102 HSBC as % of consensus 88% 71% 83% Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 Source: Bloomberg, HSBC estimates No.4 Coking Coal: Lvliang: Liulin
1/3 Coking Coal: Linfen: Puxian
Source: SXCoal
Overall Baoshan uses c20% steel scrap in its crude steel production, including steel scrap used in converter as well as scrap used in electric arc furnaces. Baoshan generates c2m tonnes of scrap internally and purchases the remaining requirement from third parties. We forecast Baoshan’s scrap costs will decline by 7% in 2012e and stay flat in 2013e in accordance with the steel prices movement.
120 Natural Resources & Energy China Equity abc July 2012
What is Baoshan Iron & Baoshan crude steel production (mt)
Steel? 30 CAGR 2006-2011: 4% Baoshan Iron & Steel is the largest listed steel 25 CAGR 2001-2006: 20% producer in China with crude steel capacity of 20 c26mtpa as at end 2011. It is a state-owned 15 company and is majorly owned (75%) by Baoshan 10 Iron & Steel group. 5
Production facilities 0 Baoshan utilises blast furnaces, EAFs and COREX 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 technology in its steelmaking. Blast furnaces Source: Company data, HSBC estimates account for c79% of the total capacity with COREX accounting for 12% and EAF 9%. The company’s Baoshan 2011 finished steel production by type of products steel production units are mainly located in Shanghai and thus have a natural cost advantage Longs over the more inland-located steel makers. 7% Tubes Baoshan disposed off its stainless steel and special 6% steel division to its parent in 1H12 to eliminate Flats Stainless losses from these businesses. 78% 5% Special Baoshan has added c5.5m tonnes of steel capacity 4% over the last five years. It established a 1.5mtpa
COREX plant in 2007 and another plant with as similar capacity in 2011. In addition, Baoshan’s Source: Company data, HSBC estimates
77% owned steel subsidiary Shanghai Meishan Within the flat products segment, HRC accounted Iron & Steel Co (Meisteel) successfully for the highest share of output at 36%, followed commissioned its No 4 Blast Furnace with a crude by CRC at 27%. steel capacity of c2.5mtpa at the end of 2009. Baoshan 2011 flat steel production by product type Baoshan’s crude steel capacity additions over 2006 to 2011
Year Capacity (mtpa) CRC Galvanized 20% No. 1 COREX 2007 1.5 27% No. 4 Blast furnace 2009 2.5 No. 2 COREX 2011 1.5 Total 5.5 Coated Source: Company data, HSBC estimates 10%
Electric The company’s crude steel production growth has steel slowed substantially over the last five years. HR C 7% Baoshan’s crude steel production grew at a CAGR 36% of 20% over 2001 to 2006, roughly in line with Source: Company data, HSBC estimates Chinese production growth of 23%. This was helped by significant capacity additions in 2005 The company has continued to optimize its and 2006. product mix and has strived to steadily move
121 Natural Resources & Energy China Equity abc July 2012
towards high-end products. The HRC share of the Raw materials sales mix declined from 41% in 2006 to 33% in Baoshan does not have any upstream integration 2011. At the same time, the CRC share increased with respect to its two major raw materials from 29% to 36%. requirement, namely iron ore and coking coal. It
Baoshan 2011 finished steel sales by products imports all its iron ore requirements, mainly from Australia and Brazil and procures more than 90% of CRC Plates its coal requirements domestically. In addition, it 36% 9% Tubes also uses carbon steel scrap (to produce steel through 6% EAF) which is procured domestically. Other Longs materials used in the production are limestone, 7% Stainlesss ferroalloys, stainless steel scrap and nickel. 5%
Special HRC 4% 33%
Source: Company data, HSBC estimates
The company enjoys a leading position in the domestic market for many of its product categories. It has c50% of market share for cold- rolled auto sheet and 29% of the share in home appliances sheet, which are the two most important end-user markets for flat steel products.
Baoshan market share of major products
60% 50% 50% 40% 29% 26% 30% 22% 19% 20% 10% 10% 0% Tin plate Tin sheet sheet sheets boiler tube boiler Cold-rolled auto Cold-rolled Home appliance Home NGO silicon steel silicon NGO Industrial stainless Industrial High-pressure alloy High-pressure Source: Company data, HSBC estimates
122 Natural Resources & Energy China Equity abc July 2012
Baoshan: Income statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Net Revenues 202,149 222,505 195,339 195,284 197,721 y-o-y change (%) 36% 10% -12% 0% 1%
Cost of sales 178,342 203,482 184,580 179,643 178,035
Gross Profit 23,807 19,023 10,759 15,641 19,685 y-o-y change (%) 77% -20% -43% 45% 26% Gross profit margin (%) 12% 9% 6% 8% 10%
Operating Expenses 7,089 10,533 7,130 7,577 7,672 Delivery and selling costs 1,785 1,950 1,660 1,719 1,740 General and administrative 5,304 8,584 5,470 5,859 5,932
Income from Operations 16,718 8,490 3,630 8,064 12,014 Operating profit margin (%) 8% 4% 2% 4% 6%
Other income/ (expense) net 1,806 2,253 11,450 1,470 670
EBIT 18,525 10,742 15,080 9,534 12,684 EBIT margin (%) 9% 5% 8% 5% 6%
Net finance income/ (expense) (1,448) (1,482) (1,505) (1,010) (707) Interest expenses (1,759) (2,008) (2,496) (2,103) (1,493) Interest income 311 526 991 1,094 786
PBT 17,076 9,260 13,574 8,524 11,977 PBT margin (%) 8% 4% 7% 4% 6%
Taxation (3,715) (1,524) (3,122) (1,705) (2,395) Effective tax rate (%) 22% 16% 23% 20% 20%
Minority interest (472) (374) (543) (341) (479)
Net income 12,889 7,362 9,909 6,479 9,102 y-o-y change (%) 122% -43% 35% -35% 40% Net income margin ( %) 6% 3% 5% 3% 5%
EPS (RMB) 0.74 0.42 0.57 0.37 0.52 DPS (RMB) 0.30 0.20 0.23 0.15 0.21 Payout ratio 41% 48% 40% 40% 40%
EBITDA 31,550 23,885 27,212 20,312 23,943 EBITDA margin (%) 16% 11% 14% 10% 12%
Source: Company data, HSBC estimates
123 Natural Resources & Energy China Equity abc July 2012
Baoshan: Balance sheet summary (RMBm) 2010a 2011a2012e 2013e 2014e Assets Current assets 68,864 79,234 116,583 95,351 90,951 Cash and cash equivalents 9,201 14,379 35,161 19,528 19,772 ST investments 297 353 350 350 350 Notes receivables 7,880 12,860 10,704 10,701 10,834 Accounts receivables 6,729 6,984 6,422 6,420 6,500 Prepayments 5,464 5,298 5,537 5,389 5,341 Inventories 38,027 37,390 35,399 34,452 34,144 Others 1,266 1,970 23,010 18,510 14,010
Fixed assets 128,004 132,460 97,616 97,224 96,332 Property, plant and equipment 117,737 115,371 75,684 75,292 74,399 Project materials 504 806 800 800 800 Construction in progress 9,763 16,283 21,132 21,132 21,132
Other assets 19,197 19,406 18,422 18,036 17,669 LT equity investment 5,686 6,003 6,000 6,000 6,000 Deferred taxes 1,135 1,189 700 700 700 Intangible assets 8,149 8,126 7,720 7,334 6,967 Others 4,226 4,087 4,002 4,002 4,002
Total assets 216,065 231,100 232,621 210,611 204,952
Liabilities Current liabilities 73,176 98,838 76,738 64,385 58,455 Short-term loans 23,611 38,876 29,112 19,664 14,964 Current portion of long term debt 3,537 16,810 7,278 4,916 3,741 Notes payables 2,222 2,678 7,500 7,500 7,500 Accounts payables 19,164 19,271 20,228 19,687 19,511 Customers’ advanced payments 11,796 10,790 9,767 9,764 9,886 Wages payables 1,641 1,553 1,553 1,553 1,553 Dividend and interest payables 304 334 300 300 300 Taxes payables 1,123 (988)--- Others 9,778 9,514 1,000 1,000 1,000
Non-current liabilities 31,547 18,792 38,245 26,072 19,832 Long-term borrowings 8,587 7,326 36,390 24,580 18,704 Bond payable 18,475 8,919 - - - Long-term payables 2,542 ---- Deferred tax 396 317 300 300 300 Special payables 458 911 500 400 300 Other LT payables 1,088 1,319 1,055 791 528
Total liabilities 104,723 117,630 114,983 90,457 78,287
Shareholders’ equity 104,747 106,495 113,136 115,651 122,162 Share capital 17,512 17,512 17,512 17,512 17,512 Capital reserves 37,566 37,331 37,331 37,331 37,331 Retained earnings 29,674 30,754 35,774 37,382 42,618 Others 19,995 20,898 22,520 23,427 24,701
Minorities 6,596 6,975 4,502 4,503 4,504
Total liabilities and shareholders’ equity 216,065 231,100 232,621 210,611 204,952
Gearing Gross debt 54,210 71,930 72,780 49,161 37,409 Cash and ST investment 9,201 14,379 35,161 19,528 19,772 Net debt 45,009 57,551 37,619 29,632 17,637
Shareholders equity including minorities 111,343 113,470 117,638 120,154 126,666 Net debt-to-equity 40% 51% 32% 25% 14%
Source: Company data, HSBC estimates
124 Natural Resources & Energy China Equity abc July 2012
Baoshan: Cash flow statement summary (RMBm) 2010a 2011a 2012e 2013e 2014e Cash flow from operating activities Profit before tax 17,076 9,260 13,574 8,524 11,977 Depreciation & Amortisation 13,025 13,143 12,132 10,778 11,259 Change in working capital (9,958) (8,067) 3,129 5,056 4,589 Net interest charges (1,448) (1,482) (1,505) (1,010) (707) Tax (3,715) (1,524) (3,122) (1,705) (2,395) Others 3,876 813(11,090) 670 229 Operating cash flows 18,856 12,142 13,118 22,314 24,951
Cash flow from investing activities Proceeds from assets disposal 124 32 22,690 - - Proceeds from business and investments 6,531 3,231 - - - Capital expenditure (13,246) (15,068) (12,493) (10,000) (10,000) Acquisition and investments (6,019) (4,338) (86) - - Others - 13664 (0) - Investing cash flows (12,610) (16,130) 10,775 (10,000) (10,000)
Cash flow from financing activities Dividends (4,524) (6,912) (3,502) (3,964) (2,591) Changes in capital structure 223 212 - - - Loans 4,002 18,862 849 (23,619) (11,752) Others (2,869) (2,869) (458) (364) (364) Financing cash flows (3,167) 9,293 (3,111) (27,946) (14,707)
Net increase/ (decrease) in cash 3,078 5,305 20,782 (15,633) 244 Exchange difference 36 (62)--- Net cash movement 3,114 5,242 20,782 (15,633) 244
Source: Company data, HSBC estimates
125 Natural Resources & Energy China Equity abc July 2012
Financials & valuation: China Coal Energy Co Neutral (V)
Financial statements Key forecast drivers Year to 12/2011a 12/2012e 12/2013e 12/2014e Year to 12/2011a 12/2012e 12/2013e 12/2014e Profit & loss summary (RMBm) Saleable coal production (mt) 103 111 122 129 Self produced coal ASP (RMB/t) 500 501 516 528 Revenue 87,773 92,300 100,183 106,435 Unit cost (RMB/t) 345 368 384 395 EBITDA 18,958 18,776 20,511 21,756 Coal trading volume (mt) 31 30 30 30 Depreciation & amortisation -4,740 -5,777 -6,477 -6,997 Coal trading gross margin (%) 2.4 2.0 2.0 2.0 Operating profit/EBIT 14,219 12,999 14,034 14,759 RMB:USD 6.46 6.25 6.13 6.12 Net interest -177 -435 -700 -1,010
PBT 14,042 12,564 13,334 13,749 HSBC PBT 14,042 12,564 13,334 13,749 Taxation -3,383 -3,141 -3,334 -3,437 Valuation data Net profit 9,802 8,669 9,201 9,487 Year to 12/2011a 12/2012e 12/2013e 12/2014e HSBC net profit 9,802 8,669 9,201 9,487 EV/sales 0.8 0.8 0.7 0.6 Cash flow summary (RMBm) EV/EBITDA 3.6 4.0 3.6 3.1 Cash flow from operations 14,698 8,333 14,598 19,903 EV/IC 0.8 0.8 0.7 0.6 Capex -19,911 -14,129 -12,000 -8,000 PE* 7.2 8.2 7.7 7.5 Cash flow from investment -35,178 -11,942 -12,000 -8,000 PB 0.9 0.8 0.8 0.7 Dividends -2,073 -2,851 -2,601 -2,760 FCF yield (%) -7.0 -7.1 4.8 17.8 Change in net debt 12,268 8,093 -2,256 -5,915 Dividend yield (%) 4.0 3.7 3.9 4.0 FCF equity -4,998 -5,043 3,398 12,728 *Based on HSBC EPS (diluted)
Balance sheet summary (RMBm) Intangible fixed assets 31,345 32,635 33,886 35,096 Issuer information
1 5 . Tangible fixed assets 60,224 67,286 71,558 71,351 Share price (HKD)6.48 Target price (HKD)7.48 4 Current assets 56,111 54,633 59,090 58,378 Cash & others 32,174 28,613 31,057 28,738 Reuters (Equity) 1898.HK Bloomberg (Equity) 1898 HK Total assets 159,933 164,619 174,599 174,890 Market cap (USDm) 14,132 Market cap (HKDm) 110,227 Operating liabilities 26,720 25,897 28,092 29,861 Free float (%) 43 Enterprise value (RMBm) 76,311 Gross debt 29,034 33,567 33,754 25,520 Country China Sector Metals & Mining Net debt -3,139 4,954 2,698 -3,218 Analyst Simon Francis Contact +852 2996 6620 Shareholders funds 81,745 87,563 94,163 100,890
Invested capital 88,787 100,044 105,386 106,226 Price relative
18 18 Ratio, growth and per share analysis 16 16 Year to 12/2011a 12/2012e 12/2013e 12/2014e 14 14 Y-o-y % change 12 12 10 10 Revenue 24.9 5.2 8.5 6.2 8 8 EBITDA 29.5 -1.0 9.2 6.1 Operating profit 28.0 -8.6 8.0 5.2 6 6 PBT 27.7 -10.5 6.1 3.1 4 4 HSBC EPS 31.3 -11.6 6.1 3.1 2010 2011 2012 2013 China Coal Energy Co Rel to HANG SENG CHINA ENTERPRISES INDEX Ratios (%) Source: HSBC Revenue/IC (x) 1.1 1.0 1.0 1.0
ROIC 13.6 10.3 10.2 10.5 ROE 12.6 10.2 10.1 9.7 Note: price at close of 25 Jul 2012 ROA 8.0 6.3 6.5 6.5 EBITDA margin 21.6 20.3 20.5 20.4 Operating profit margin 16.2 14.1 14.0 13.9 EBITDA/net interest (x) 107.3 43.2 29.3 21.5 Net debt/equity -3.3 4.8 2.4 -2.7 Net debt/EBITDA (x) -0.2 0.3 0.1 -0.1 CF from operations/net debt 168.2 541.1 Per share data (RMB) EPS Rep (diluted) 0.74 0.65 0.69 0.72 HSBC EPS (diluted) 0.74 0.65 0.69 0.72 DPS 0.22 0.20 0.21 0.21 Book value 6.17 6.60 7.10 7.61
126 Natural Resources & Energy China Equity abc July 2012
China Coal Energy (1898 HK)
With a high proportion of spot market sales and weaker coal prices, we believe China Coal faces a tougher outlook this year Even so, the company has strong long-term growth prospects, and valuations have already fallen significantly Resume coverage with Neutral (V) and a target price of HKD7.48 based on a blended PE and DCF valuation
Resume coverage with China Coal does not plan to boost sales volume to Simon Francis* Head of Metals & Mining Neutral (V) try and offset falling prices. According to Research, Asia Pacific management, 5% production volume guidance is The Hongkong and Shanghai China Coal Energy is one of the largest coal mining Banking Corporation Limited ‘not too conservative’. Production volume rose by +852 2996 6620 companies in China. It had 19.6bn of coal resources 11% y-o-y in 1Q12, but is expected to slow through [email protected] as of the end of 2011. In addition to the coal the rest of the year. Chris Chen* business, China Coal is one of the largest non-steel Analyst The Hongkong and Shanghai integrated coke producers in China and also a China Coal’s monthly operating data highlights a Banking Corporation Limited +852 2822 4277 leading coal mining equipment supplier. slowdown in 2Q12. Commercial coal production [email protected] volume fell by 8% q-o-q from 28.8m tonnes in We resume coverage of China Coal with a Neutral Amit Pansari* 1Q12 to 26.5m tonnes in 2Q12. Domestic sales of Analyst (V) rating and a target price of HKD7.48 based on HSBC Bank plc self-produced coal (ie excluding trading) fell by +91 80 3001 3760 a 50:50 blended PE and DCF valuation. Our PE 11% from 28.2m tonnes in 1Q12 to 25.1m tonnes [email protected] valuation is HKD8.18, based on 10.0x 2012e PE, in 2Q12. *Employed by a non-US affiliate and our DCF valuation is HKD6.78. of HSBC Securities (USA) Inc, and is not registered/ qualified Tougher outlook this year pursuant to FINRA regulations We expect China Coal’s earnings to decline by 12% y-o-y in 2012e driven by slower production volume growth and essentially flat selling prices. We note that China Coal’s high spot market proportion in 1Q12 makes 2Q12 earnings vulnerable to disappointments. The spot sales proportion was 59% in 1Q12, a level that we believe is unsustainably high. Plummeting Chinese coal prices from April through June 2012 suggest much weaker earnings in q-o-q terms in 2Q12e.
127 Natural Resources & Energy China Equity abc July 2012
Monthly domestic sales of self-produced coal Sep 2011. The mine has a designed capacity of
10 20mtpa and is expected to reach full capacity by Tonnes m the end of 2013e. 9 Wangjialing mine has a designed capacity of 8 6mtpa. Construction is expected to be finished in 2H12. We expect the mine to reach full capacity 7 in 2014e. 6 China Coal is also constructing a few greenfield projects in the Inner Mongolia-Shaanxi Mining Apr-12 Jun-12 Jan-12 Feb-12 Mar-12 May-12 Base. The Hecaogou coking coal mine in Shaanxi Source: Company data has a capacity of 3mtpa which should contribute Note that coal sales volume rose sharply q-o-q in volume in 2012. Two mines in Ordos, Inner 2Q12 but this reflects a big increase in low- Mongolia, Muduchaideng Coal mine and Nalin margin third-party traded coals. River No.2 Coal mine, have capacity of 6mtpa and 8mtpa, respectively, and are currently waiting Our net income forecasts are 15% below for government approval. consensus in 2012e; we expect another round of downgrades after the 1H12 results in August. Asset injections plans China Coal said in March that it would acquire Long-term volume growth Tangshangou Coal mine (1.2mtpa) from its parent Despite the currently tougher environment, China this year. The purchase will bring China Coal Coal has a plan of expanding its self-produced another 70.6m tonnes of thermal coal resources. raw coal production to 200mtpa by 2015e. In In 2011, Tangshangou produced 1.5m tonnes of 2011, the company produced 129m tonnes of raw coal. The company is currently waiting for coal. The volume growth should mainly come government approval on the asset injection. from the Pingshuo East coal mine, Wangjialing, and other greenfield projects in Shaanxi and Inner The parent is consolidating local coal mines in Mongolia. We expect most of the volume increase Shanxi and potential asset injections could be a to come on stream in 2014-15e. catalyst in the next two years.
Construction of Pingshuo East has already been completed and the mine commenced operation in
China Coal’s coal expansion projects Project Region Project Capex Spent* % Capacity Capex/t Status start (RMBm) (RMBm) spent (mtpa) (RMB) Pingshuo East Shanxi Jan-09 10,570 9,588 91% 20.0 529 Major work completed Wangjialing Mine Shanxi Apr-07 5,021 3,975 79% 6.0 837 Major work completed Kongzhuang Mine renovation and Jiangsu Nov-07 532 482 91% 1.8 296 Major work completed expansion Hecaogou Coal Mine Shanxi Sep-10 2,180 1,258 58% 3.0 727 Under progress No.106 Coal Mine Xinjiang Mar-10 677 312 46% 1.8 376 Under progress Muduchaideng Coal Mine Ordos Not started 6,021 na na 6.0 1,004 Undergoing approval procedures Nalin River No.2 Coal Mine Ordos Not started 6,890 na na 8.0 861
*Amount spent until 31 Dec 2011 Source: Company data, HSBC estimates
128 Natural Resources & Energy China Equity abc July 2012
Valuations Target price of HKD7.48 Substantially de-rated in terms of We set a target price of HKD7.48 based on a earnings-based valuations blended PE and DCF valuation. We apply a 50:50 China Coal has been substantially de-rated in blend of a PE valuation of HKD8.18, based on terms of PE and EV/EBITDA multiples over the 10.0x 2012e PE, and a DCF valuation of HKD6.78. past two and a half years. Calculated on a daily one-year forward basis, the PE valuation has Our DCF valuation of HKD6.78 is based on the declined from above 20x in early 2010 – a time following assumptions: when hopes of a global economy recovery were A cost of capital of 11.1%. high – to around 8x now. Similarly, we calculate the daily, one-year forward EV/EBITDA multiple Adjusted beta of 1.16 measured against the has declined from above 10x in early 2010 to HSCEI index. below 4x now. The company remaining in a net cash position in the long run.
Our valuation is sensitive to discount rate. We calculate that if China Coal was 30% financed by borrowings, our DCF target price would rise by 34% to HKD9.06 per share.
A long-run commercial coal output of 135mtpa.
DCF Valuation Year to Dec (RMBm) 2011 2012e 2013e 2014e 2015e 2016e 2017e 2018e 2019e 2020e 2021e 2022e …… Terminal Free cash flow calculation Revenue 87,773 92,300 100,183 106,435 107,131 107,996 109,615 111,597 113,621 115,687 117,797 119,113 182,339 Y-o-y 25% 5% 9% 6% 1% 1% 1% 2% 2% 2% 2% 1% 2% EBIT 14,219 12,999 14,034 14,759 13,536 12,607 12,152 11,925 11,679 11,944 12,215 11,904 19,423 EBIT margin 16% 14% 14% 14% 13% 12% 11% 11% 10% 10% 10% 10% 11% NOPAT 10,664 9,749 10,525 11,069 10,152 9,455 9,114 8,944 8,759 8,958 9,161 8,928 19,423 Capex, net (20,609) (12,000) (10,000) (6,000) (5,000) (5,000) (5,000) (5,000) (5,000) (5,000) (5,000) (5,000) (2,500) Depreciation 4,740 5,777 6,477 6,997 6,278 6,558 6,590 6,602 6,594 6,556 6,340 6,100 2,547 Change in working capital 6,082 (3,314) 181 162 272 224 168 141 147 50 50 124 85 Free operating CF (FoCF) 877 212 7,184 12,229 11,701 11,236 10,872 10,687 10,500 10,564 10,550 10,153 19,555 DCF Inputs WACC inputs Interest-bearing liabilities as a % of EV 0% Terminal FCF growth 0.0% WACC 11.1% Risk-free rate 3.0% NPV of free cash flows 93,472 Market risk 7.0% Add net cash/(debt) (4,954) Beta 1.16 Less market value of minorities (16,462) Cost of debt (pre-tax) 6.0% = Equity value 72,056 / Number of shares 13,259 / HKD:RMB exchange rate 0.80 = NPV per share (HKD) 6.78
Source: Company data, HSBC estimates
129 Natural Resources & Energy China Equity abc July 2012
Daily PE of China Coal with the expected dividend yield where indicated,
25.0 implies a potential return of 19%, which is within the Neutral band. On this basis we rate China 20.0 Coal Neutral (V). Potential return equals the
15.0 percentage difference between the current share price and the target price, including the forecast 10.0 dividend yield when indicated.
5.0 Jul-10 Jul-11 Jul-12 Jan-10 Jan-11 Jan-12
Source: Company data, Datastream, HSBC
Daily EV/EBITDA of China Coal 12.0
10.0
8.0
6.0
4.0
2.0 Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 Source: Company data, Datastream, HSBC
Given the fairly steady decline in the rating over the past two and a half years, there is no established trading range for the stock and no appropriate ‘average’ multiple. We set our target PE at 10.0x 2012e, which is higher than the current multiple.
We do expect coal prices to recover through 2H12e (though we do not expect a dramatic recovery) which supports the notion that the earnings multiples have bottomed.
At our target PE multiple, China Coal would trade at a 17% discount to Shenhua in 2012e, broadly in line with the average so far this year. HSBC ratings bands For volatile stocks, the band for a Neutral rating, N(V), is 10ppt above and below our hurdle rate, which for China is 10%. Our target price, together
130 Natural Resources & Energy China Equity abc July 2012
Risks Quarterly commercial coal output 30.0 We see the following upside risks: China Coal’s Tonnes m earnings are predominantly driven by Chinese coal 28.0 prices which may be higher than we anticipate 26.0 resulting in better-than-expected earnings. The 24.0 company may make further acquisitions and existing projects may be developed more quickly 22.0 than we currently forecast. Production costs may 20.0 be lower than we expect.
1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 Downside risks include lower-than-expected coal Source: Company data prices and slower or more costly development of current projects compared to our expectations. We expect China Coal’s commercial coal Earnings outlook production to increase by c13mtpa or 13% in 2012 with growth mostly from Pingshuo East, We think China Coal faces a poor earnings outlook Wangjialing Mine and Hecaogou mine. At the this year due to deteriorated coal prices and rising beginning of this year, management guided for production costs, partly offset by small volume 5% growth in output. In our view, this target is far increases from the Pingshuo East and Wangjialing from conservative given the current poor market. mines. We forecast China Coal will achieve net income of RMB8.7bn in 2012e, RMB9.2bn in The Pingshuo East coal mine produced 2m tonnes 2013e, and RMB9.5bn in 2014e, down 12% y-o-y, of raw coal in 2011. We expect output from this up 6% y-o-y and up 3% y-o-y respectively. mine to reach 8m tonnes in 2012e and 15m tonnes in 2013e. Mine output We estimate the Wangjialing mine will contribute China Coal produced 10.5m tonnes of commercial c1.5m tonnes of raw coal output in 2012e and 6m coal in March 2012 and 28.8m tonnes in 1Q12, tonnes in 2013e. which is equivalent to an annualized output of 115m tonnes, up 12% y-o-y. The company has Sales volume historically ‘over-produced’ in the first quarter as China Coal sold 100m tonnes of self-produced it tends to have better railway access as other commercial coal in 2011, of which spot sales producers lower output either because of the accounted for 48% of domestic thermal coal sales. Chinese New Year holiday or for safety We expect sales volume to rise by 11% y-o-y to inspections. In June 2012, China Coal produced 111m tonnes in 2012e and by 10% y-o-y to 122m just 8.6m tonnes of commercial coal. tonnes in 2013e.
131 Natural Resources & Energy China Equity abc July 2012
Self-produced coal sales volume 2013e, with contract prices up by another 5%
140.0 y-o-y and spot prices unchanged y-o-y. 130.0 Tonnes m 120.0 China Coal’s domestic contract/ spot prices 110.0 650 100.0 Rmb/t 90.0 80.0 550 70.0 60.0 450 50.0 40.0 350 2008 2009 2010 2011
2012E 2013E 2014E 250
Source: Company data, HSBC estimates
2006 2007 2008 2009 2010 2011 2012E 2013E Contract Spot We forecast the proportion of spot sales will rise Source: Company data, HSBC estimates from 48% in 2011 to 55% in 2012e and 2013e. In 1Q12, China Coal increased its thermal coal spot Production costs sales by 64% y-o-y to 16.7m tonnes, accounting for 59% of its self-produced coal sales. We expect We expect China Coal’s unit coal cash production spot sales for the rest of the year to come down as costs to increase by 7% in 2012e and by 4% in prices of 5,500 kcal/kg Shanxi premium blend 2013e to RMB332/t and RMB347/t, respectively, coal have plummeted by 28% to RMB615/t in mainly on higher material costs and staff costs. mid-July from a peak of RMB860/t in Nov 2011. Earnings sensitivity At the current price level, spot prices are only We estimate a 1% increase in average coal selling cRMB10/t higher than contract coal prices. prices would raise our net profit forecasts for Spot sales as % of domestic thermal coal sales China Coal by 4% in both 2012e and 2013e. 60%
50%
40%
30%
20%
10% 2006 2007 2008 2009 2010 2011
2012E 2013E Source: Company data, HSBC estimates
Selling prices We forecast a 5% y-o-y increase for domestic contract prices and 10% decline for spot prices in 2012e. As a result, we forecast China Coal’s average selling prices to stay flat y-o-y at RMB501/t in 2012e. We expect average selling prices to increase by 3% y-o-y to RMB516/t in
132 Natural Resources & Energy China Equity abc July 2012
What is China Coal Energy? of total production. The company produced c107.6m tonnes of saleable coal in 2011, out of which c98.1m China Coal Energy (China Coal) is the second tonnes (91%) were produced from self-produced raw largest coal producer in China. Based on PRC coal at an average yield of 76% as Pingshuo had a standards, it had coal resources of c19.6bn tonnes very low yield of 73%. by the end of 2011. The company has three main business segments: coal, coke and coal mining China Coal 2011 coal production summary (mt) equipment. The coal segment comprises coal Raw % Saleable % Yield mining (self produced coal sales) and coal trading coal share coal share (purchase of coal for sales). This segmentation is Pingshuo 109.2 85% 80.2 75% 73% Datun 7.3 7% important because the trading business has low Liliu 1.5 1% Dongpo 7.2 7% margins, which can distort the overall profitability Nanliang 1.9 2% of the business. Owned mine 129.2 98.1 91% 76% Shuozong CPP 6.1 6% Dazhong CPP 3.4 3% Coal business Purchased raw coal 9.5 9% Total 129.2 107.6 100% The coal segment accounted for c82% of the Source: Company data, HSBC estimates company’s revenues in 2011 with coal mining accounting for 57% and coal trading for 25%. The Coal sales coal segment contributed 90% of consolidated China Coal sold c134.7m tonnes of coal in 2011, gross profit in 2011 with coal mining accounting out of which c74% was self produced coal and the for 87% and coal trading just 3%. rest was through proprietary trading and agency Coal production sales. The company has substantially increased its China Coal operates in five mining areas, namely coal trading business over the last four years with Pingshuo, Datun, Liliu, Dongpo and Nanliang. The share of trading increasing from c6% in 2008 to company has grown rapidly over the past few years, c23% by 2011. The company is also engaged in with raw coal production increasing at a CAGR of coal import and export agency services in a small 17% over 2005 to 2011. China Coal produced way and this segment accounted for c3% of its c129.2m tonnes of raw coal from its own coal mines 2011 sales volume. in 2011. Pingshuo is the largest producing area with an output of c109.2m tonnes, accounting for c85%
Revenue break-up by business (2011) Gross profit break-up by business (2011)
Coal trading 25% Coal mining Coke 87% 6% Machinery Machinery 8% Coal 8% mining Others Coal trading, 3% 57% 4% Others, 2%
Source: Company reports, HSBC Source: Company reports, HSBC
133 Natural Resources & Energy China Equity abc July 2012
Commercial coal sales volume breakup (2011) China Coal self produced coal contract and spot ASP (RMB/t)
700 650 Proprietary 600 c oal trading 550 23% 500
Self 450 Import and produced 400 ex port 350 74% agency 2008 2009 2010 2011 3% Contract Spot
Source: Company data, HSBC estimates Source: Company data, HSBC estimates
China Coal primarily produces and sells thermal Coal mining equipment business coal in the domestic market. Thermal coal This division contributed c8% to the company’s accounted for c99% of total sales in 2011 and the revenues and gross profit in 2011. China Coal domestic market accounted for 99% of self- supplies underground mining equipment, such as produced coal sales. The company self-produced armoured face conveyors, hydraulic roof supports, coal on both contract and spot basis and it has been road headers and shearer with domestic market successful in increasing its spot coal sales volume shares of 65%, 19%, 30%, 68% and 10%, to 48% of sales by 2011 from 17% in 2008. respectively. The total value of equipment produced
China Coal self-produced coal sales volume by pricing increased by 14% y-o-y in 2011 to RMB8.2bn with conveyor equipment accounting for c39% of 100% 17 % production value. At the same time, machinery 27% 30% 80% 48% production volume increased by c39% y-o-y to 359k 60% tonnes in 2011. 83 % 40% 73% 70% China Coal’s mining equipment production value in 2011 (RMBm) 52% 20% Suppo rt 0% equipment 32% 2008 2009 2010 2011 Roadheader Contract Spot 10%
Source: Company data, HSBC estimates She ar er 9% This shift to spot pricing has enabled company to Conveyor Electric maintain its profit margins at high levels, as spot Equipment mining 38% motor coal prices have generally been at a premium to 11% contract prices. Source: Company data, HSBC estimates
134 Natural Resources & Energy China Equity abc July 2012
Coke business Coal resources The coke and coal chemical product division The company has coal resources of 19.6bn tonnes contributed c6% of revenues but negligible profits in five provinces with Shanxi and Inner Mongolia in 2011. In 2011 the company sold c2.6m tonnes together accounting for c90% of resources. of coke, c2m tonnes of which were produced from Thermal coal accounts for c86% of its resources its own mines. and coking coal accounts for the balance of 14%.
Sales volume of coke (2011) Coal resources (2011) Volume mt By base bn tonnes Share of total Self-produced 2.10 Shanxi 7.97 41% Metallurgical coke 1.77 InnerMongolia-Shaanxi 9.67 49% Foundry coke .33 Jiangsu 1.17 6% Proprietary and agency .48 Xinjiang 0.62 3% Total 2.58 Heilongjiang 0.21 1% By coal type Source: Company reports, HSBC Thermal coal 16.92 86% Coking coal 2.72 14% Total 19.64 100% Source: Company reports, HSBC
135 Natural Resources & Energy China Equity abc July 2012
China Coal: Income statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Net Revenues 70,303 87,773 92,300 100,183 106,435 y-o-y change (%) 32% 25% 5% 9% 6%
Cost of sales 55,825 69,466 74,901 81,339 86,542
Gross Profit 14,478 18,307 17,399 18,843 19,893 y-o-y change (%) 16% 26% -5% 8% 6% Gross profit margin (%) 21% 21% 19% 19% 19%
Selling, general and admin exp 3,749 4,574 4,800 5,210 5,535 Operating exp as % revenues 5% 5% 5% 5% 5%
Income from Operations 10,729 13,733 12,599 13,634 14,359 Operating profit margin (%) 15% 16% 14% 14% 13%
Other income/ (expense) net 379 486 400 400 400
EBIT 11,108 14,219 12,999 14,034 14,759 EBIT margin (%) 16% 16% 14% 14% 14%
Net finance income/ (expense) (109) (177) (435) (700) (1,010) Interest expenses (593) (799) (1,099) (1,346) (1,334) Interest income 484 622 665 647 324
PBT 10,999 14,042 12,564 13,334 13,749 PBT margin (%) 16% 16% 14% 13% 13%
Taxation 2,848 3,383 3,141 3,334 3,437 Effective tax rate (%) 26% 24% 25% 25% 25%
Minority interests (685) (857) (754) (800) (825)
Net income 7,466 9,802 8,669 9,201 9,487 y-o-y change (%) -5% 31% -12% 6% 3% Net income margin (%) 11% 11% 9% 9% 9%
EPS (RMB) 0.56 0.74 0.65 0.69 0.72 DPS (RMB) 0.16 0.22 0.20 0.21 0.21 Payout ratio 28% 29% 30% 30% 30%
EBITDA 14,635 18,958 18,776 20,511 21,756 EBITDA margin (%) 21% 22% 20% 20% 20%
Source: Company data, HSBC estimates
136 Natural Resources & Energy China Equity abc July 2012
China Coal: Balance sheet summary (RMBm) 2010a 2011a2012e 2013e 2014e Assets Current assets 48,700 56,111 54,633 59,090 58,378 Cash and bank balances 22,922 20,879 13,845 15,027 15,965 Time deposits w/ initial term > 3mths 4,624 11,295 14,768 16,029 12,772 Restricted bank deposits 2,495 3,173 2,500 2,500 2,500 Inventories 6,215 7,319 8,208 8,914 9,484 Trade receivables 7,006 7,803 8,851 9,607 10,206 Prepayments and other receivables 5,439 5,643 6,461 7,013 7,450
Fixed assets 46,418 60,224 67,286 71,558 71,351
Other assets 27,818 43,598 42,700 43,951 45,161 Investment properties 31 30 30 30 30 Land use rights 2,564 2,815 2,746 2,676 2,606 Mining rights 18,611 28,420 29,791 31,123 32,415 Intangible assets 43 110 98 86 74 Investment in associates 3,995 7,059 4,800 4,800 4,800 Other non-current assets 2,575 5,164 5,235 5,235 5,235
Total assets 122,936 159,933 164,619 174,599 174,890
Liabilities Current liabilities 19,391 28,779 28,954 31,167 32,113 Trade and notes payable 9,254 10,917 12,518 13,594 14,463 Accruals and other payables 6,997 11,676 10,260 11,142 11,855 Taxes payable 1,651 3,534 2,769 3,005 3,193 Short-term borrowings 396 1,825 1,343 1,350 1,021 Current portion of long-term borrowings 1,026 798 2,014 2,025 1,531 Others 66 2850 50 50
Non-current liabilities 17,207 35,189 31,640 31,809 24,398 Long-term borrowings 10,716 26,411 30,210 30,379 22,968 Others 6,491 8,778 1,430 1,430 1,430
Total liabilities 36,598 63,968 60,594 62,976 56,511
Shareholders’ equity 74,049 81,745 87,563 94,163 100,890 Share capital 13,259 13,259 13,259 13,259 13,259 Reserves 42,818 43,944 44,811 45,731 46,680 Retained earnings 17,972 24,542 29,493 35,173 40,951
Minority interests 12,290 14,220 16,462 17,460 17,489
Total liabilities and shareholders’ equity 122,936 159,933 164,619 174,599 174,890
Gearing Gross debt 12,138 29,034 33,567 33,754 25,520 Cash and ST investment 27,546 32,174 28,613 31,057 28,738 Net debt/ (cash) (15,408) (3,139) 4,954 2,698 (3,218)
Shareholders equity 86,339 95,965 104,025 111,623 118,379 Net debt-to-equity -18% -3% 5% 2% -3%
Source: Company data, HSBC estimates
137 Natural Resources & Energy China Equity abc July 2012
China Coal: Cash flow statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Cash flow from operating activities Profit before tax 10,999 14,042 12,564 13,334 13,749 Depreciation and amortisation 3,527 4,669 5,777 6,477 6,997 Change in Working capital (2,351) (486) (6,114) (1,080) 3,419 Net Interest Paid 126 (342) (435) (700) (1,010) Tax Paid (2,066) (3,213) (3,141) (3,334) (3,437) Other 449 27(319) (100) 185 Operating cash flow 10,683 14,698 8,333 14,598 19,903
Cash flow from investing activities Proceeds of PPE & intangible assets 52 42 - - - Capex (12,295) (19,911) (14,129) (12,000) (8,000) Acquisitions & Inv (2,981) (6,359) 2,427 - - Other 16,690 (8,950) (239) - - Investing cash flows 1,466 (35,178) (11,942) (12,000) (8,000)
Cash flow from financing activities Dividends Paid (1,987) (2,073) (2,851) (2,601) (2,760) Equity Movements - - - - - Debt Movements (267) 20,276 4,533 188 (8,234) Other 400 240(5,106) 998 29 Financing cash flows (1,853) 18,443 (3,425) (1,415) (10,966)
Net increase/ (decrease) in Cash 10,296 (2,037) (7,034) 1,182 938 Net exchange differences (2) (7) - - - Net cash movement 10,294 (2,044) (7,034) 1,182 938
Source: Company data, HSBC estimates
138 Natural Resources & Energy China Equity abc July 2012
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139 Natural Resources & Energy China Equity abc July 2012
Financials & valuation: China Metal Recycling Overweight (V)
Financial statements Key forecast drivers Year to 12/2011a 12/2012e 12/2013e 12/2014e Year to 12/2011a 12/2012e 12/2013e 12/2014e Profit & loss summary (HKDm) Total scrap sales volume (kt) 2,518 3,150 3,900 4,850 Steel scrap (kt) 1,850 2,400 3,100 4,000 Revenue 52,141 55,110 58,182 67,867 Non-ferrous scrap (kt) 668 750 800 850 EBITDA 1,815 2,280 2,586 3,006 Steel scrap ASP (HKD/t) 4,291 4,185 4,108 4,231 Depreciation & amortisation -44 -54 -66 -75 Non-ferrous scrap ASP (HKD/t) 60,678 55,021 51,811 55,229 Operating profit/EBIT 1,771 2,226 2,520 2,931 Gross margin (%) 4.0 4.8 5.0 5.0 Net interest -222 -320 -327 -319 PBT 1,965 1,936 2,224 2,643 HSBC PBT 1,965 1,936 2,224 2,643 Taxation -92 -116 -178 -264 Valuation data Net profit 1,862 1,801 2,024 2,352 Year to 12/2011a 12/2012e 12/2013e 12/2014e HSBC net profit 1,862 1,801 2,024 2,352 EV/sales 0.2 0.2 0.1 0.1 Cash flow summary (HKDm) EV/EBITDA 4.8 4.2 3.2 2.7 Cash flow from operations -1,088 24 1,607 890 EV/IC 1.1 0.9 0.8 0.6 Capex -61 -200 -150 -100 PE* 3.4 3.5 3.1 2.7 Cash flow from investment -209 -20 -12 -78 PB 1.0 0.8 0.7 0.6 Dividends -182 -365 -360 -405 FCF yield (%) -26.3 -2.9 22.1 12.0 Change in net debt 1,778 830 -1,235 -407 Dividend yield (%) 5.7 5.7 6.4 7.4 FCF equity -1,719 -187 1,449 786 *Based on HSBC EPS (diluted)
Balance sheet summary (HKDm) Intangible fixed assets 0 0 0 0 Issuer information
1 1 9 Tangible fixed assets 454 607 698 731 . Share price (HKD)5.58 Target price (HKD)12.25 5 Current assets 16,315 18,147 20,174 23,102 Cash & others 3,278 2,796 4,031 4,438 Reuters (Equity) 0773.HK Bloomberg (Equity) 773 HK Total assets 17,580 19,397 21,393 24,350 Market cap (USDm) 844 Market cap (HKDm) 6,546 Operating liabilities 5,466 5,481 5,790 6,774 Free float (%) 43 Enterprise value (HKDm) 9,751 Gross debt 5,653 6,000 6,000 6,000 Country Hong Kong Sector Metals & Mining Net debt 2,375 3,204 1,969 1,562 Analyst Simon Francis Contact +852 2996 6620 Shareholders funds 6,352 7,788 9,451 11,399
Invested capital 8,025 10,478 11,051 12,621 Price relative
14 14 Ratio, growth and per share analysis 13 13 12 12 Year to 12/2011a 12/2012e 12/2013e 12/2014e 11 11 10 10 Y-o-y % change 9 9 8 8 Revenue 131.7 5.7 5.6 16.6 7 7 EBITDA 69.0 25.6 13.4 16.2 6 6 Operating profit 69.9 25.7 13.2 16.3 5 5 PBT 108.0 -1.5 14.8 18.8 4 4 HSBC EPS 94.0 -3.3 12.4 16.2 2010 2011 2012 2013 China Metal Recycling Rel to HANG SENG CHINA ENTERPRISES INDEX Ratios (%) Source: HSBC Revenue/IC (x) 8.1 6.0 5.4 5.7
ROIC 26.3 22.6 21.5 22.3 ROE 34.1 25.5 23.5 22.6 Note: price at close of 25 Jul 2012 ROA 13.5 11.6 11.7 11.8 EBITDA margin 3.5 4.1 4.4 4.4 Operating profit margin 3.4 4.0 4.3 4.3 EBITDA/net interest (x) 8.2 7.1 7.9 9.4 Net debt/equity 36.8 40.5 20.5 13.5 Net debt/EBITDA (x) 1.3 1.4 0.8 0.5 CF from operations/net debt 0.7 81.6 57.0 Per share data (HKD) EPS Rep (diluted) 1.63 1.58 1.77 2.06 HSBC EPS (diluted) 1.63 1.58 1.77 2.06 DPS 0.32 0.32 0.35 0.41 Book value 5.57 6.83 8.29 9.99
140 Natural Resources & Energy China Equity abc July 2012
China Metal Recycling (773 HK)
The Chinese scrap market is highly fragmented and offers phenomenal opportunities for growth. China Metal Recycling is at the forefront of a consolidation process that has just begun Trading at PEs of 3.5x in 2012e and 3.1x in 2013e, we view the stock as compellingly cheap Initiating with an Overweight (V) rating and a blended PE and DCF-based target price of HKD12.25
Initiating at Overweight (V) steel scrap represents 10-20% of the iron inputs in Simon Francis* Head of Metals & Mining blast furnace steel making. (This is different from China Metal Recycling (CMR) is the largest Research, Asia Pacific producing steel in an electric arc furnace (EAF) The Hongkong and Shanghai metals recycling company in China measured by Banking Corporation Limited where scrap steel is the main input). In China, the +852 2996 6620 revenues. By the end of this year, the company vast majority of steel production comes from blast [email protected] will have a capacity of 6.2mtpa and operations in furnaces. As a result, we expect steel scrap Chris Chen* nine different locations in China. Analyst demand to rise broadly in line with crude steel The Hongkong and Shanghai Banking Corporation Limited We initiate coverage of China Metal Recycling production. +852 2822 4277 with an Overweight (V) rating and a target price [email protected] …and penetration rates remain low of HKD12.25 based on a 50:50 blend of PE and Amit Pansari* Although China is already the largest consumer of Analyst DCF valuations. Our PE valuation is HKD9.50, HSBC Bank plc steel scrap, the rate of scrap penetration – the +91 80 3001 3760 based on 6.0x 2012e PE, and our DCF valuation is consumption of steel scrap per tonne of crude steel [email protected] HKD15.00. produced – remains low by global standards. This *Employed by a non-US affiliate of HSBC Securities (USA) Inc, Excellent long-term prospects is normal in relatively early stage economies and is not registered/ qualified pursuant to FINRA regulations We think the company has excellent long-term which are yet to develop a substantial pool of growth prospects driven by increasing scrap domestically available scrap that can be recycled penetration rates in China and the consolidation of using electric arc furnace (EAF) steel making what is currently a very fragmented industry. technology. In 2011, Chinese steel mills consumed 91m tonnes of steel scrap and produced 696m Scrap is cost effective… tonnes of crude steel resulting in an effective scrap Steel scrap is used to improve blast furnace rate of 13%. By comparison, in the US, scrap efficiency by reducing the use of coke. Typically, accounts for more than 60% of steel produced.
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In fact, the rate of scrap penetration in China has sophisticated businesses. We also see increased been declining over the past few years – it was 16% imports. China is short of copper ore and is big in 2006 – as the growth in crude steel production net importer of copper. has outstripped that of scrap consumption. China copper scrap imports, tonnes 000s
China steel scrap consumption and scrap rate 6,000 30% 5,500 20% 100 17 % 5,000 10% 80 16 % 4,500 0% 60 15 % 4,000 -10% 40 14 % 3,500 -20% 20 13 % 3,000 -30%
0 12 %
2006 2007 2008 2009 2010 2011 2003 2004 2005 2006 2007 2008 2009 2010 2011
BOF EA F Total scrap rate Scrap import YoY (RHS)
Source: SBB, HSBC Source: China Metals
Notably in China, even where steel makers do use Strong competitive position EAFs, they typically use high proportions of pig The Chinese scrap industry is in its infancy. There iron in the input mix, partly because of cost and are around 500 scrap dealers, the vast majority of partly because of the lack of availability of good which provide only simple sorting services and quality scrap. which often do not abide by environmental best- practices. There are only a few relatively large- Wide regional variations in scrap usage Surprisingly perhaps, the steel mills in northern scale businesses that can provide more China, including Hebei Iron and Steel, use very sophisticated processing. We estimate that China little scrap, reflecting the tightness of scrap Metal Recycling, the largest recycler by revenue, supplies in the region. In this area, steel mills tend has a market share in ferrous scrap of under 3%. to use ‘home produced’ scrap – ie, scrap We believe China Metal Recycling has a strong generated at the mill when steel is formed or cut – competitive position derived from: and supplement this with pig iron. Some of the subsidiaries of Hebei Iron and Steel have scrap Its large scale, multiple locations and rates as low as 2%. proximity to customers
This is in marked contrast to some areas around The ability to perform more sophisticated the Yangzte River Delta (Jiangsu, Shanghai) scrap processing where the metals processing industries provide a Access to cheap (water-based) transportation greater scrap supply. Close relationships with suppliers and Huge potential in non-ferrous scrap as well customers There is also huge potential for the development of the non-ferrous scrap market in China in our First mover advantages which make view. We see the domestic scrap market replicating the business relatively expensive developing away from the current ‘mom and pop’ and time-consuming type businesses towards larger-scale, more
142 Natural Resources & Energy China Equity abc July 2012
Barriers to entry suppliers quickly (often in cash) whilst having to We see three main barriers to entry. Arguably the allow customers generous credit terms. Simply two biggest of these are: 1) the acquisition of put, the major steel companies have greater suitable land which should be close to good bargaining power than their scrap suppliers. transportation links and customers, and 2) the Over the long run, we forecast China Metal securing of government approvals which can Recycling’s bills and accounts receivable at 76 include scrap metal import licenses, construction days, inventories at 20 days and payables days at permits, land title certificates, harbour operations 36 days. That is a working capital cycle of 60 days. permits and environmental approvals. In addition, relationships with suppliers and customers have to This is important because a greater working be built and maintained. capital requirement would mean lower free cash flows and this would impact our valuation. In March 2009, the State Council published Decree #551, Government Policy Affecting the Secure financing Metal Recycling Industry. The decree aims to One of the issues over the past year or so has been regulate the collection and recycling of electrical that as China has tightened credit, it has become and electronics products, to promote the recycling more difficult for smaller companies to secure industry and to enforce stricter environmental debt financing. The market was concerned rules. The decree became effective in January throughout much of 2011 that this tightening 2011 and is currently being rolled out by would negatively impact the company. provincial governments. These measures should In fact, China Metal Recycling has been able to be positive for companies such as China Metal secure some HKD10bn in credit facilities Recycling, as the qualification system for (roughly half of which has been drawn down), recyclers should help drive out many of the putting it at a major advantage over smaller smaller producers. competitors. In entering the market in Baotou last Scrap recycling is a low-margin year and also in securing the Tianjin JV, China business… Metal Recycling was effectively ‘the banker’ Scrap recycling is about volume, integration and bringing much needed working capital to the deals. efficiency; it is a low-margin business. In 2011, Valuations the company achieved a gross margin of 4.6% (adjusting for hedging gains/losses) and a net Target price of HKD12.25 income margin of 4%. We set a target price of HKD12.25 based on a 50:50 blend of PE and DCF valuations. Our PE Margins have declined over the past 2-3 years as valuation is HKD9.50, based on 6.0x 2012e PE, the company has entered new markets and has had and our DCF valuation is HKD15.00. to secure market share by giving away margin. Management views it as essential to gain the Our DCF valuation of HKD15.00 is based on the market share early in the consolidation process. following assumptions: …and working capital intensive A long-term scrap recycling throughput of Scrap recycling is working capital intensive. Scrap 5.85mtpa. By installing further equipment, we dealers typically have to finance the working think the current land bank could support a capital gap created by having to pay small
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DCF Valuation Year to Dec (HKD m) 2011 2012e 2013e 2014e 2015e 2016e 2017e 2018e 2019e 2020e 2021e 2022e 2023e 2024e 2025e 2026e Free cash flow calculation Revenue 52,141 55,110 58,182 67,867 67,767 67,518 68,352 69,639 70,951 72,290 73,656 75,049 76,470 77,920 79,398 80,906 Y-o-y 132% 6% 6% 17% 0% 0% 1% 2% 2% 2% 2% 2% 2% 2% 2% 2% EBIT 1,771 2,226 2,520 2,931 2,925 2,777 2,812 2,865 2,919 2,975 3,034 3,092 3,150 3,210 3,176 3,236 EBIT margin 3% 4% 4% 4% 4% 4% 4% 4% 4% 4% 4% 4% 4% 4% 4% 4% NOPAT 1,688 2,093 2,319 2,638 2,574 2,361 2,109 2,149 2,189 2,231 2,276 2,319 2,363 2,408 3,176 3,236 Capex, net (50) (200) (150) (100) (100) (100) (100) (100) (100) (100) (100) (100) (100) (100) (100) (100) Depreciation 37 47 59 68 75 82 82 89 91 94 97 99 101 102 103 102 Change in working capital (3,159) (1,831) (482) (1,537) 35 61 (42) (202) (206) (211) (214) (219) (223) (228) (241) (237) Free operating CF (FoCF) (1,483) 109 1,745 1,069 2,584 2,404 2,049 1,935 1,974 2,014 2,058 2,099 2,140 2,182 2,939 3,001 Tax rate (%) 5.0 5.6 4.7 6.0 8.0 10.0 12.0 15.0 25.0 25.0 25.0 25.0 25.0 25.0 25.0 25.0
DCF Inputs WACC inputs Interest-bearing liabilities as a % of EV 0% Risk-free rate 3.0% WACC 10.7% Market risk 7.0% NPV of free cash flows 20,426 Beta 1.10 Add net cash/(debt) (3,204) Cost of debt (pre-tax) 6.0% Less market value of minorities 129 Terminal FCF growth 0.0% = Equity value 17,093 / Number of shares 1,138 = NPV per share (HKD) 15.02
Source: HSBC estimates
much larger operation. We have not factored our DCF valuation would fall by 21% to further growth into our model. HKD11.86 per share.
A net cash position in the long run. This A beta of 1.1. seems reasonable to us given the low No terminal growth beyond 2025. equipment costs and the prospects for strong operating cash flows. Global peer valuation comparison
We calculate the shares could be worth as China Metal Recycling looks cheap to us much as HKD18.90 if the company could compared to its global recycling peers. raise gearing to a level 30% net-debt-to- Our sample of five global recycling companies is equity. This could most easily be achieved by trading at simple average PEs of 12.6x on 2012e raising the dividend payouts to shareholders. and 6.6x on 2013e. Sims Metal Management This seems unlikely in the short term. (SGM AU, not rated) the largest company in our A gross margin of 5% in the long run. sample is trading at PEs of 23.0x on 2012e and 7.7x on 2013e. Based on these figures, we A working capital cycle of 60 days. This calculate China Metal Recycling is trading at a comprises bills and trade receivables of 76 72% discount to our sample and an 85% discount days, inventories of 20 days and bills and to Sims on 2012e estimates and at a 52% discount trade payables of 36 days. The DCF valuation to our sample and a 59% discount to Sims on is sensitive to the amount of working capital 2013e estimates. required to sustain the business; a bigger working capital requirement would mean less free cash flow. We calculate that if the working capital requirement increases from 60 days in our current forecasts to 80 days,
144 Natural Resources & Energy China Equity abc July 2012
Peer group valuation comparison Company Bloomberg Price Mkt cap ______PE ______EV/EBITDA______PB ______ROE ______USD bn 2011 2012e 2013e 2011 2012e 2013e 2011 2012e 2013e 2011 2012e 2013e China Metal Recycling 773 HK 5.58 0.8 3.4 3.5 3.1 4.8 4.2 3.2 1.0 0.8 0.7 34% 25% 23% Chiho-Tiande 976 HK 3.96 0.5 26.4 7.5 5.2 20.6 5.9 4.8 2.0 1.5 1.1 8% 23% 24% Commercial Metals CMC US 11.81 1.4 23.5 9.7 7.0 7.9 5.3 4.0 1.2 1.1 1.0 5% 12% 15% Schnitzer Steel SCHN US 26.04 0.7 7.2 19.2 9.8 4.8 7.1 4.9 0.6 0.6 0.6 9% 3% 6% Sims Group SGM AU 8.05 1.7 n.a. 23.0 7.7 5.9 6.7 4.3 0.6 0.7 0.7 -15% 3% 9% Simple average 15.1 12.6 6.6 8.8 5.8 4.2 1.1 0.9 0.8 8% 13% 16%
Source: Bloomberg, HSBC estimates for China Metal Recycling
HSBC ratings bands Sales volume For volatile stocks, the band for a Neutral rating, We forecast sales volume at 3.2m tonnes in 2012e N(V), is 10ppt above and below our hurdle rate, and expect volumes to rise by 24% to 3.9m tonnes which for China is 10%. Our target price, together in 2013e and by a further 24% y-o-y to 4.9m with the expected dividend yield where indicated, tonnes in 2014e. Of these amounts, we expect implies a potential return of 125% which is above ferrous scrap sales volume to reach 2.4m tonnes in the Neutral band. On this basis we rate China 2012e and 3.1m tonnes in 2013e. We forecast Metal Recycling Overweight (V). Potential return non-ferrous scrap volume at 750,000 tonnes in equals the percentage difference between the 2012e and 800,000 tonnes in 2013e. Beyond current share price and the target price, including 2013e, we assume roughly a c10% increase each the forecast dividend yield when indicated. year in utilization rates until sales volume reaches 5.9m tonnes in 2016. Risks Ferrous and non ferrous scrap sales volume and capacity Our investment thesis hinges upon the company utilization being able to achieve robust volume growth over 6,000 100% the next few years whilst maintaining its margins at 5,000 90% reasonable levels. While we believe that in the 4,000 80% context of increasing regulation and consolidation 3,000 70% 2,000 60% of the sector, this is achievable, there is a risk that 1,000 50% the sector consolidates more slowly than we 0 40% anticipate and that margins are lower than we 2011 forecast. The company’s earnings are sensitive to 2012e 2013e 2014e 2015e 2016e Non Ferrous Scrap sales volumes and margins and this could result in Ferrous Scrap Capac ity Util izati on (R HS) lower-than-expected earnings and a lower valuation. Source: Company data, HSBC estimates Earnings outlook
We expect China Metal Recycling to achieve net Sales mix income of HKD1.8bn in 2012e, down 3.3% y-o-y, The amount of non-ferrous scrap sold is an and HKD2.0bn in 2013e, up 12.4% y-o-y. Four important driver of both earnings and the balance main factors drive earnings: sales volume, sales sheet, because non-ferrous scrap prices are several mix, selling price and gross margins. times higher than steel scrap prices. The non- ferrous scrap sales proportion is likely to be c24% this year. The higher the proportion of non-ferrous
145 Natural Resources & Energy China Equity abc July 2012
scrap sold, the greater the revenues and the greater China Metal Recycling scrap sales volume (kt) the working capital requirement. 3,000 2,500 Selling prices 2,000 We forecast selling prices based on our forecasts 1,500 for steel and other metals prices. In China, steel 1,000 scrap prices are closely correlated to pig iron and 500 rebar prices. The market is spot-based and prices 0 tend to move together. This should bring a greater 2007 2008 2009 2010 2011 degree of stability to margins in our view. Steel scrap Non ferrous scrap
Source: Company data, HSBC estimates Non-ferrous scrap sales are roughly 90% copper scrap and 10% aluminium scrap. Hence, copper Production facilities prices are another important driver. CMR segments its production facilities by Gross margins geographic region and has recycling facilities in We forecast a gross margin of 4.8% in 2012e and Southern, Eastern, Northern and Central China.
5.0% in both 2013e and 2014e. Earnings are CMR 2012 Capacity highly sensitive to our margin forecasts. An Regions Interest Capacity Attributable % of total increase in the margin of 1ppt from our current Southern China 1,800 1,675 30% forecast of 4.8% in 2012e to 5.8% would raise our Guangzhou Asia Steel 75% 500 375 7% Guangzhou Yatong 100% 500 500 9% earnings forecasts by 30%. Hong Kong 100% 200 200 4% Zhongshan 100% 600 600 11% What is China Metal Eastern China 2,400 2,400 43% Jiangyan Port 100% 1,400 1,400 25% Recycling? Yangzhou & Ningbo 100% 1,000 1,000 18% Central China 1,000 700 13% China Metal Recycling (CMR) is the largest scrap Wuhan 70% 1,000 700 13% Northern China 1,000 775 14% recycler in China. It collects scrap both locally Tianjin Yatong 100% 500 500 9% and through imports, sorts and cuts it according to Baotou 55% 500 275 5% Total 6,200 5,550 100% metal and grade and sells it on. The main value Source: Company data, HSBC estimates add comes from buying scrap in an unusable form and processing it into convenient bundles for use Products by steel, copper and other metal producing Steel scrap products include companies. CMR is able to process scrap using No.1 heavy melting steel, wrought iron and/or both magnetic and eddy current separation steel scrap, ¼ inch or more in thickness equipment. The company had a production capacity 4.9mtpa as at the end of 2011 which is No.2 heavy melting steel, wrought iron and expected to increase to 6.2mt by 2012e. steel scrap, black and galvanised, 1/8 inch or more in thickness CMR has continued to increase its sales volume over the last five years supported by increased Shredded scrap, homogeneous iron and steel capacity at its various plants. Its sales volume scrap, magnetically separated and mainly reached 2.5m tonnes (up 31% y-o-y) in 2011, with prepared from automobiles steel scrap accounting for 73% of the total sales.
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Non-ferrous metals scrap Japan where sellers of certain products have The company sells copper, aluminium and to contribute to a fund for the product to be stainless steel scrap. Copper scrap is divided into eventually recycled). the following categories: Recyclers will be encouraged to establish Barley No.1 copper wire, bare, uncoated, cooperative arrangements with electrical and unalloyed copper wire electronic product companies. This should substantially reduce the number of scrap Berry No.1 copper wire, clean, un-tinned, recyclers and the number of collection points. uncoated, unalloyed copper and cable A qualifying system will be introduced for Candy No.1 heavy copper, clean, unalloyed, recyclers with a focus on the necessary uncoated copper clippings, punching, bus equipment and manpower, and also the ability bars, commutator segments to deal with non-metal scrap in an Birch No.2 copper wire, miscellaneous, environmentally friendly way. unalloyed copper wire having a nominal 96% Local governments will be asked to put copper content recycling infrastructure into their urban Cliff No.2 copper, miscellaneous, unalloyed planning and they will be in charge of copper scrap having a nominal 96% copper examining qualification applications. content We think the measures should be a big positive Apart from those mentioned above, the company for companies such as China Metal Recycling. also sells Zorba Shredded Nonferrous Scrap One factor is that the qualification system for (predominantly aluminium) and Sabot Stainless recyclers should help drive out many of the Steel Scrap (clean stainless steel clips and solids smaller producers. Another is that the containing a minimum of 7% nickel and 16% encouragement of cooperation agreements with chrome). electrical and electronic products companies should help ensure a steady stream of scrap More on the regulations supply and reduce the number of collection Decree #551 was a landmark for the industry points. Decree #551, published by the State Council in March 2009, aims to regulate the collection and Subsidies for recycling electrical appliances recycling of electrical and electronics products, to In June 2012, six of the Ministries under the State promote the recycling industry and to enforce Council announced the “Policy related to the stricter environmental rules. Collection and Management of Funding for Waste Electrical and Electronic (‘E&E’) Products While at the time, the precise implementation of Processing”. The new policy came into effect the decree had yet to be finalized, some of the from 1 July 2012. Essentially, the policy provides broader measures included the following: that recyclers will be subsidised for each piece of The government plans to establish a recycling electrical appliance that is processed. fund to subsidize the collection and recycling of these products. Manufacturers and scrap importers will both be required to contribute to the fund. (This is similar to the practice in
147 Natural Resources & Energy China Equity abc July 2012
China electrical appliances recycling subsidy (RMB/unit) Suppliers: 1) Will benefit from the JVs processing Appliance Subsidy (RMB/unit) capabilities; 2) Avoid competition with each TVs 85 other; and 3) Overcome the capital hurdles Refrigerators 80 Washing machines 35 associated with expansion. Air-conditioners 35 Personal Computers 85 The deal was structured with a large degree of Source: Company data, HSBC estimates exclusivity for the shareholders. That is, the
suppliers are not allowed to supply parties in Tianjin joint venture China other than the JV. Tianjin Pipe is not In November 2010, China Metal Recycling allowed to purchase scrap from other parties (as formed a new recycling joint venture with Tianjin long as the JV can fulfil its requirements). CMR is Pipe and 11 local scrap recycling enterprises. not allowed to target the northern China market, except through the JV. CMR contributed RMB200m in cash for its 33% equity stake. Hong Kong IPO
Tianjin Pipe is a state-owned company and the The company undertook its IPO on the Hong largest seamless pipe maker in China with a Kong stock exchange in June 2009, issuing 345m production capacity of 3.5mtpa. It uses scrap as its new shares (including green shoe) at HKD5.18 primary raw material and has annual requirements per share, thereby raising cHKD1,787m of 2.5mtpa of steel scrap and 200,000tpa of (USD231m) in new equity. About 40% of the copper scrap. proceeds were immediately deployed to repay borrowings. The remainder was used for working Tianjin Pipe will be the single largest shareholder capital and expansion. in the joint venture with a 37.5% stake. We understand that the government entity being the biggest shareholder was a factor behind the swift granting of government approval for the deal.
CMR will appoint two of the seven directors including the chairman. Tianjin Pipe will appoint three directors and the local scrap suppliers the other two.
We see the main benefits to each party involved in the deal as follows:
CMR: 1) Gains access to the north China market; 2) At a cheap price; 3) Has formed a JV with a government company, something that could help in future transactions and 4) Has a significant stake in a platform that looks set to continue consolidating the market in north China.
Tianjin Pipe: 1) Gains more stable scrap supply; 2) At a reasonable price.
148 Natural Resources & Energy China Equity abc July 2012
China Metal Recycling: Income statement summary (HKD m) 2010a 2011a2012e 2013e 2014e Net Revenues 22,508 52,141 55,110 58,182 67,867 y-o-y change (%) 148% 132% 6% 6% 17%
Cost of sales 21,273 50,057 52,492 55,273 64,474
Gross Profit 1,235 2,083 2,618 2,909 3,393 y-o-y change (%) 56% 69% 26% 11% 17% Gross profit margin (%) 5% 4% 5% 5% 5%
Operating expenses 191 307 441 465 543 Operating expenses as % revenues 1% 1% 1% 1% 1%
Income from Operations 1,044 1,777 2,177 2,444 2,850 Operating profit margin (%) 5% 3% 4% 4% 4%
Other income/ (expense) net (2) (6) 49 77 81
EBIT 1,042 1,771 2,226 2,520 2,931 EBIT margin (%) 5% 3% 4% 4% 4%
Net financial Income/ (expense) (98) 194 (290) (297) (289) Interest income 18 32 29 33 41 Interest expenses (95) (254) (350) (360) (360) Others (21) 41630 30 30
PBT 945 1,965 1,936 2,224 2,643 PBT margin (%) 4% 4% 4% 4% 4%
Taxation 53 92116 178 264 Effective tax rate (%) 6% 5% 6% 8% 10%
Minority Interest 5 11 19 22 26
Net Income 887 1,862 1,801 2,024 2,352 y-o-y change (%) 85% 110% -3% 12% 16% Net income margin (%) 4% 4% 3% 3% 3%
EPS (HKD) 0.85 1.63 1.58 1.77 2.06 DPS (HKD) 0.16 0.32 0.32 0.35 0.41 Payout ratio 21% 20% 20% 20% 20%
EBITDA 1,074 1,815 2,280 2,586 3,006 EBITDA margin (%) 5% 3% 4% 4% 4%
Source: Company data, HSBC estimates
149 Natural Resources & Energy China Equity abc July 2012
China Metal Recycling: Balance sheet summary (HKD m) 2010a 2011a2012e 2013e 2014e Assets Current assets 12,864 16,315 18,147 20,174 23,102 Cash and bank 1,089 1,519 1,506 2,741 3,148 Restricted and pledged cash 1,883 1,664 1,200 1,200 1,200 Bills receivable 717 2,304 2,416 2,550 2,975 Accounts receivable 6,304 6,910 9,059 9,564 11,156 Inventories 1,747 2,640 2,876 3,029 3,533 Others 1,125 1,278 1,090 1,090 1,090
Fixed assets 427 454 607 698 731
Other assets 440 811 643 520 517 Prepaid lease payment 195 200 197 194 191 Investment in associate 97 305 326 326 326 Others 149 306120 - -
Total Assets 13,731 17,580 19,397 21,393 24,350
Liabilities Current Liabilities 8,749 10,753 11,481 11,790 12,774 Short-term bank loans and discounted bills 3,282 5,287 6,000 6,000 6,000 Bills payable 1,110 2,418 2,301 2,423 2,826 Accounts payable 3,762 2,441 2,876 3,029 3,533 Accruals and other payables 410 400 262 276 322 Others 186 20741 62 93
Non-current liabilities 353 366 - - - Long-term bank loans 353 366 - - - Others 0 -- - -
Total liabilities 9,103 11,119 11,481 11,790 12,774
Shareholders’ equity 4,557 6,352 7,788 9,451 11,399 Share capital and share premium 2,626 2,652 2,652 2,652 2,652 Retained earnings 1,639 3,319 4,755 6,418 8,365 Reserves 291 381381 381 381
Minority Interest 71 109 129 151 177
Total liabilities and shareholders’ equity 13,731 17,580 19,397 21,393 24,350
Gearing Gross debts 3,634 5,653 6,000 6,000 6,000 Cash and ST investments 3,038 3,278 2,796 4,031 4,438 Net debts 597 2,375 3,204 1,969 1,562
Shareholders equity including minorities 4,628 6,461 7,917 9,602 11,576 Net debt-to-equity 13% 37% 40% 21% 13%
Source: Company data, HSBC estimates
150 Natural Resources & Energy China Equity abc July 2012
China Metal Recycling: Cash flow statement summary (HKD m) 2010a 2011a2012e 2013e 2014e Cash flow from operating activities Profit before taxation 945 1,965 1,936 2,224 2,643 Depreciation and depreciation 32 48 54 66 75 Changes in operating assets and liabilities (2,063) (3,159) (1,831) (482) (1,537) Loss(gain) on assets disposal (1) 1 - - - Net interest (paid) / received 77 222 (320) (327) (319) Taxes paid (32) (73) (116) (178) (264) Others 104 (91) 301 305 292 Operating cash flow (938) (1,088) 24 1,607 890
Cash flow from investing activities Additions of non-current assets (126) (61) (200) (150) (100) Proceeds from assets disposal 2 17 - - - Acquisitions & investment (251) (212) - - - Others (1,715) 47180 138 22 Investing cash flow (2,091) (209) (20) (12) (78)
Cash flow from financing activities Dividend paid (125) (182) (365) (360) (405) Changes in capital structure 718 19 - - - Debt movements 2,878 1,371 347 - - Others 72 4790 - - Financing cash flow 3,543 1,687 (17) (360) (405)
Net increase/ (decrease) in cash 514 390 (13) 1,235 407 Net exchange adjustment 20 40 - - - Net cash movement 534 430 (13) 1,235 407
Source: Company data, HSBC estimates
151 Natural Resources & Energy China Equity abc July 2012
Financials & valuation: China Shenhua Energy Overweight
Financial statements Key forecast drivers Year to 12/2011a 12/2012e 12/2013e 12/2014e Year to 12/2011a 12/2012e 12/2013e 12/2014e Profit & loss summary (RMBm) Coal sales volume (mt) 387 463 480 489 Average selling price (RMB/t) 436 420 428 443 Revenue 208,197 243,563 258,776 273,647 Cash production costs (RMB/t) 98 102 106 109 EBITDA 84,194 87,586 91,685 97,982 Power dispatches (GWh) 165,300 194,854 214,804 226,204 Depreciation & amortisation -15,571 -17,137 -18,357 -18,239 Average tariff (RMB/MWh) 341 348 353 360 Operating profit/EBIT 68,623 70,449 73,328 79,743 RMB:USD 6.46 6.30 6.30 6.30 Net interest -2,163 -2,524 -2,739 -2,549 PBT 66,460 67,925 70,589 77,195 HSBC PBT 66,460 67,925 70,589 77,195 Taxation -13,951 -15,623 -16,235 -17,755 Valuation data Net profit 45,677 45,503 47,287 51,713 Year to 12/2011a 12/2012e 12/2013e 12/2014e HSBC net profit 45,677 45,503 47,287 51,713 EV/sales 2.1 1.9 1.8 1.6 Cash flow summary (RMBm) EV/EBITDA 5.2 5.3 4.9 4.5 Cash flow from operations 70,665 44,900 79,670 78,489 EV/IC 2.0 1.7 1.5 1.4 Capex -44,713 -55,000 -45,000 -40,000 PE* 9.7 9.8 9.4 8.6 Cash flow from investment -54,850 -57,529 -48,264 -43,616 PB 2.0 1.8 1.6 1.4 Dividends -14,917 -17,901 -18,201 -18,915 FCF yield (%) 5.4 -2.2 7.8 8.7 Change in net debt 2,080 27,981 -13,254 -16,079 Dividend yield (%) 4.0 4.1 4.3 4.7 FCF equity 24,056 -9,748 35,013 38,827 *Based on HSBC EPS (diluted)
Balance sheet summary (RMBm) Intangible fixed assets 3,596 3,444 3,402 3,363 Issuer information
2 5 . Tangible fixed assets 254,073 292,288 319,273 341,373 Share price (HKD)27.15 Target price (HKD)34.00 2 Current assets 107,937 94,031 103,812 121,614 Cash & others 69,060 47,677 60,931 77,010 Reuters (Equity) 1088.HK Bloomberg (Equity) 1088 HK Total assets 401,077 425,137 461,765 501,532 Market cap (USDm) 67,858 Market cap (HKDm) 529,295 Operating liabilities 72,825 59,129 62,888 65,583 Free float (%) 27 Enterprise value (RMBm) 467,426 Gross debt 60,402 67,000 67,000 67,000 Country China Sector Metals & Mining Net debt -8,658 19,323 6,069 -10,010 Analyst Simon Francis Contact +852 2996 6620 Shareholders funds 225,822 253,424 282,510 315,308
Invested capital 223,721 282,956 302,668 323,758 Price relative
52 52 Ratio, growth and per share analysis 47 47 Year to 12/2011a 12/2012e 12/2013e 12/2014e 42 42 Y-o-y % change 37 37 Revenue 36.9 17.0 6.2 5.7 32 32 EBITDA 20.1 4.0 4.7 6.9 27 27 Operating profit 20.9 2.7 4.1 8.7 PBT 21.4 2.2 3.9 9.4 22 22 HSBC EPS 19.8 -0.4 3.9 9.4 2010 2011 2012 2013 China Shenhua Energy Rel to HANG SENG CHINA ENTERPRISES INDEX Ratios (%) Source: HSBC Revenue/IC (x) 1.0 1.0 0.9 0.9
ROIC 25.8 21.4 19.3 19.6 ROE 21.5 19.0 17.6 17.3 Note: price at close of 25 Jul 2012 ROA 14.8 13.3 12.9 12.9 EBITDA margin 40.4 36.0 35.4 35.8 Operating profit margin 33.0 28.9 28.3 29.1 EBITDA/net interest (x) 38.9 34.7 33.5 38.4 Net debt/equity -3.3 6.5 1.8 -2.7 Net debt/EBITDA (x) -0.1 0.2 0.1 -0.1 CF from operations/net debt 232.4 1312.7 Per share data (RMB) EPS Rep (diluted) 2.30 2.29 2.38 2.60 HSBC EPS (diluted) 2.30 2.29 2.38 2.60 DPS 0.90 0.92 0.95 1.04 Book value 11.35 12.74 14.20 15.85
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China Shenhua Energy (1088 HK)
Shenhua has compelling long-term growth prospects, in our view, and the ability to grow its coal business without resorting to potentially expensive and risky international M&A The group’s blend of coal and power businesses should mean that earnings are relatively insulated from the current weakness in coal prices Resume coverage with Overweight and a target price of HKD34.00 based on a blended PE and DCF-based valuation
Resume coverage with HKD33.75, based on 12x 2012e PE, and a DCF Simon Francis* Head of Metals & Mining Overweight valuation of HKD34.30. Research, Asia Pacific The Hongkong and Shanghai China Shenhua Energy is the leading coal A compelling position – as bankable Banking Corporation Limited +852 2996 6620 producer in China, with commercial coal as it gets in this sector [email protected] production of 282m tonnes and coal sales of 387m Shenhua is a large market cap stock, the ‘poster Chris Chen* tonnes in 2011. Shenhua has c9.3bn tonnes of Analyst child’ of the industry and an important power The Hongkong and Shanghai marketable reserves under JORC standard, producer, which has as near to ‘bankable’ Banking Corporation Limited +852 2822 4277 making it one of the largest coal companies in the earnings that a stock in this sector is likely to [email protected] world in terms of reserves. The company owns a offer. With further expansion at Zhunge’er and Amit Pansari* dedicated coal transportation network, comprising Analyst Ha’erwusu over the next few years, and the Xinjie HSBC Bank plc both rail lines and port facilities. It also has a project longer term, we believe the company has +91 80 3001 3760 [email protected] substantial power generating business with some compelling long-run growth prospects. 36.3GW of generating capacity. In 2011, the *Employed by a non-US affiliate of HSBC Securities (USA) Inc, power business accounted for c28% of It is highly unlikely, in our view, that other coal and is not registered/ qualified pursuant to FINRA regulations consolidated operating profits. companies can boast such excellent growth prospects without having to resort to usually We resume coverage of Shenhua with an expensive and risky cross-border M&A Overweight rating and a target price of HKD34.00 transactions. In that sense, Shenhua is based on a blended PE and DCF valuation. We distinctively placed. apply a 50:50 blend between a PE-based target of
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Margins relatively insulated from coal Expansion at Zhunge’er and Ha’erwusu – price fluctuations railway dependent Two factors about Shenhua’s business model In 2011, the Zhunge’er and Ha’erwusu mine make its margins relatively more stable compared produced a combined 54.3m tonnes of coal. to other Chinese coal companies. First, Shenhua’s Shenhua plans to raise combined output to power business consumes a substantial portion of 100mtpa. Based on the 2011 figures, this the company’s coal production. The price at expansion would boost Shenhua coal production which this coal is sold among the business by 16%. segments does not impact the overall profitability The main issue with expanding these mines at of the group. In 2011, sales of coal to the power present is the lack of suitable railway capacity to division accounted for 17% of total coal sales bring the coals to market. Shenhua currently uses (64m tonnes out of 387m tonnes). the Daqin Railway which is already operating at Second, Shenhua purchases a lot of third party close to full capacity and is unable to handle coals that it uses for blending and to more fully another 40-50mtpa of Shenhua coals. utilise its infrastructure network. The price of this As a result, Shenhua plans a major expansion of coal typically moves broadly in line with selling its own railway network. This comprises: prices, thus insulating the overall margin. In 2011, coals acquired from third parties accounted for Expansion of the Dazhun Railway from 27% of total coal sales, and we expect this to rise 80mtpa now to 130mtpa by 2013e to 32% of total coal sales in 2012e. Expansion of the Shuohuang railway from As a result of these factors, Shenhua’s margins 200mtpa now to 400mtpa by 2015e. Shenhua and earnings are more stable than China Coal or expects to put about 350mtpa of its own coal Yanzhou Coal. These, and other factors, are along this line. reflected in Shenhua’s lower beta. Using weekly Construction of the new Bazhun Railway data over the past two years, Shenhua has an which should be completed in 2013e adjusted beta measured against the HSCEI of 0.96, versus 1.16 for China Coal and 1.17 for Construction of the new Zhunchi Railway Yanzhou Coal. which will run north-south from Waixigou to Shenchi and should be completed in 2014e Plenty of growth still to come in coal… Xinjie: big, but when? Although Shenhua has grown rapidly over the The Xinjie mine project is expected to be another past decade, we continue to see solid long-term long-run driver of growth in the coal segment. The prospects for volume growth, both in coal and project has been approved by the NDRC. Mine also in power. planning is currently underway, and Shenhua has not yet applied for mining rights. The Xinjie project We see two main drivers of long-term volume contains some 13.0bn tonnes of coal resources and is growth in the coal segment. Firstly, further expected to have an eventual capacity of 100mtpa. expansion at Shenhua’s existing Zhunge’er and Capex is estimated at RMB50bn. Ha’erwusu mines. Secondly, the Xinjie mine project. All these assets are in Inner Mongolia.
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Shenhua owns a 70% stake in the project, with the Total controlled power capacity
State-Owned Assets Investment Management Co 40.0 GW of Erdos City owning the remaining 30%. 35.0 30.0 The coal at Xinjie is typically greater than 5,500 25.0 kcal/kg, with some seams greater than 6,000 20.0 kcal/kg. This compares to the Shendong coals, 15.0 which are typically 5,000-5,500 kcal/kg coals. 10.0 5.0 Generally speaking, the geology at Xinjie is - considered to be good. The coal seams are thick 2005 2006 2007 2008 2009 2010 2011 and there is less overburden than at Shendong. 2012E
Xinjie lends itself to using modern, efficient long Source: Company data, HSBC estimates wall mining techniques. Shenhua remains committed to growing its power The next stages are to apply for exploration rights business. We expect organic growth in the and to undertake a feasibility study. We expect segment of 2-3GW pa, as well as further first production from Xinjie in 2015e. acquisitions. We understand that Shenhua is We have already incorporated the project into our discussing potential acquisitions with provincial model; by our estimates it is worth HKD3.30 per governments in Jiangxi, Fujian and other Shenhua share, 9.6% of our target price. southeast China provinces where the power markets are relatively ‘tight’. Obviously, in incorporating these mines there is a degree of project risk. The mines could be delayed Whereas power assets in China have been for several reasons and costs maybe higher than relatively easy to acquire in the past because of anticipated. That said, we do note that Shenhua high coal prices and poor power margins, asking increased mine output at Shendong from 47m prices are now rising. We forecast segment tonnes in 2002 to 111m tonnes in 2008 – a 2.5- capacity growth of 2GW pa in each of the next fold increase in six years. With that experience, four years (8GW in total) though further we believe Shenhua is arguably the best placed of acquisitions could raise these figures. any of the Chinese companies to undertake these We estimate that these acquisitions will contribute projects. 1% to total power dispatches in 2012e, rising to …and in the power business 11% in 2013e and 15% in 2014e. Over the past few years, Shenhua’s power business We expect revenues growth to be primarily volume has grown more quickly than the coal business. In driven with average tariffs in the power business fact, the power business has roughly doubled in size rising by 1-2% pa over the next three years. over the past 3-4 years. We calculate that controlled We expect power revenues to rise by 20% y-o-y power capacity has risen from 18.0GW in 2008 to to RMB71.1bn in 2012e, driven by the capacity 36.4GW in 2011 and equity capacity (Shenhua’s increases in 2011 and by a further 12% y-o-y to effective equity stake) has risen from 10.8GW to RMB79.6bn in 2013e. 22.8GW in the same timeframe.
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Yet near-term earnings outlook Our DCF valuation of HKD34.30 is based on the anaemic following assumptions:
While Shenhua’s earnings can be regarded as A cost of capital of 10.4% relatively ‘predictable’, at least compared to many companies in the sector, we are not forecasting Adjusted beta of 1.05 measured against the strong earnings growth over the next couple of HSCEI index years. In fact, we forecast flat earnings in y-o-y The company remaining in a net cash position terms in 2012e, and growth of just 4% y-o-y in in the long run 2013e. Our valuation is sensitive to the discount rate; Strong balance sheet we calculate that if China Shenhua was 30% Shenhua has retained a strong balance sheet over financed by borrowings, our target price the past few years with net cash reaching would rise by 27% to HKD43.8 per share RMB8.7bn as at the end of last year. We expect a Long-term raw coal production volume of net-to-equity of 7% by the end of this year but for 393m tpa and power generation of 256k GWh the company to be in a net cash position by the end of 2014e.
Shenhua’s net debt (cash) (RMBbn) and gearing
20. 0 10%
10. 0 5% - 0% (10.0)
(20.0) -5% 2007 2008 2009 2010 2011 2012E 2013E 2014E Net debt (Cash) Net debt-to-equity
Source: Company data, HSBC estimates
Management expects consolidated capex to be RMB40-45bn each year for the next two to three years. Valuation Target price of HKD34.00 We set a target price of HKD34.00 based on a blended PE and DCF valuation. We apply a 50:50 blend between a PE-based target of HKD33.75, based on 12x 2012e PE, and a DCF valuation of HKD34.30.
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DCF Valuation Year to Dec (RMBm) 2011 2012e 2013e 2014e 2015e 2016e 2017e 2018e 2019e 2020e …… 2045e Free cash flow calculation Revenue 208,197 243,563 258,776 273,647 280,896 292,605 304,980 313,170 326,615 340,479 558,598 Y-o-y 37% 17% 6% 6% 3% 4% 4% 3% 4% 4% 1% EBIT 68,623 70,449 73,328 79,743 82,754 86,017 89,469 91,246 93,597 98,901 109,602 EBIT margin 33% 29% 28% 29% 29% 29% 29% 29% 29% 29% 20% NOPAT 54,218 54,245 56,462 61,402 63,721 64,513 67,102 68,434 70,198 74,176 82,201 Capex, net (38,017) (55,200) (45,300) (40,300) (30,300) (20,300) (18,300) (18,300) (18,300) (18,300) (13,300) Depreciation 15,571 17,137 18,357 18,239 19,698 19,663 18,921 18,768 19,414 16,770 13,279 Change in working capital 17,910 (21,811) 7,303 1,148 579 1,715 1,322 967 1,675 1,228 662 Free operating CF (FoCF) 49,682 (5,628) 36,822 40,489 53,697 65,591 69,045 69,870 72,986 73,873 82,843 DCF Inputs WACC inputs Interest-bearing liabilities as a % of EV 0% Terminal FCF growth 0.0% WACC 10.4% Risk-free rate 3.0% NPV of free cash flows 609,005 Market risk 7.0% Add net cash/(debt) (19,323) Beta 1.05 Less market value of minorities (42,514) Cost of debt (pre-tax) 6.0% = Equity value (RMBm) 547,168 / Number of shares 19,890 / HKD:RMB exchange rate 0.80 = NPV per share (HKD) 34.33
Source: Company data, HSBC estimates
Earnings-based valuation Daily PE of China Shenhua China Shenhua has been de-rated in terms of PE 20.0 and EV/EBITDA multiples over the past two and 18.0 a half years. Calculated on a daily one-year 16.0 forward basis, the PE valuation has declined from 14.0 above 18x in early 2010 – a time when hopes of a 12.0 global economy recovery were high – to around 10.0 10x now. Similarly we calculate the daily, one- 8.0 year forward EV/EBITDA multiple has declined Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 from around 10x in early 2010 to about 5x now. Jan-10 Jan-11 Jan-12
Source: Company data, Datastream, HSBC We do expect coal prices in China to recover through 2H12e, although we do not expect a dramatic recovery. This suggests to us the PE multiple has already bottomed and should rebound as prices rise.
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Daily EV/EBITDA of China Shenhua projects – including the Xinjie project which
11.0 represents 9.6% of our DCF valuation – may be 10.0 developed more slower than we currently forecast 9.0 or at higher cost. This could have a negative 8.0 impact on future earnings and our valuation. 7.0 6.0 Earnings in the power business could be lower 5.0 than expected as a result of lower power tariffs, or 4.0 higher coal or other costs. Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 Earnings outlook
Source: Company data, Datastream, HSBC We forecast China Shenhua will achieve net
income of RMB45.5bn in 2012e, RMB47.3bn in Whereas China Coal shares have been steadily de- 2013e, and RMB51.7bn in 2014e. We expect rated over this past two and a half year period, earnings to marginally decrease in 2012e on Shenhua shares have not. Rather, Shenhua has substantially lower coal prices partly offset by been sold off recently, since coal prices started to coal output from new mines and power dispatched plummet. That makes it more difficult, in our from new power plants. view, to establish an appropriate target multiple for the stock. Coal production We expect Shenhua to produce 313m tonnes We set our target PE multiple at 12x 2012e. This commercial coal in 2012e, up 11% y-o-y. The is lower than Shenhua’s historical trading range company produced 156m tonnes in 1H12, up but roughly equal to the average multiple over the 15% y-o-y. June production was an annualised past 18 months. 309m tonnes. HSBC ratings bands Several of Shenhua’s mines are being ramped up For non-volatile stocks, the band for a Neutral over this year and next. This year, we expect rating (N) is 5ppt above and below our hurdle y-o-y production increases of 6m tonnes at rate, which for China is 10%. Our target price, Shenbao, 5m tonnes at Shengli, 3m tonnes at together with the expected dividend yield where Baotou and 2m tonnes at Huangyuchan – a total indicated, implies a potential return of 29% which y-o-y production increase of 16m tonnes. is above the Neutral band. On this basis we rate China Shenhua Overweight. Potential return Purchases of third-party coals equals the percentage difference between the Shenhua buys third-party coal, both to blend with current share price and the target price, including its own coal when customer specifications the forecast dividend yield when indicated. demand it and also to better utilize its rail and port Risks capacity. Buying coal in this way is a low (almost nil) margin business, meaning that the greater the We see the following downside risks to our view: proportion of third-party coal being sold, China Shenhua’s earnings are predominantly generally the lower the margin. driven by Chinese coal prices, which may be lower than we anticipate resulting in lower-than- This proportion of third-party coal to own coal expected earnings. The company’s coal mining production has increased steadily over the past few years.
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Third-party coal as % of own production slightly increase by 1% y-o-y in 2013e as we
45% assume a higher proportion of third-party 40% purchases in the next three years as a result of the 35% company seeking to expand its market share. 30% Volume guidance looks conservative 25% We believe that Shenhua’s guidance, given in 20% March 2012, for its production and sales volume 15% for 2012e was too conservative, probably reflecting 10% the uncertainties in the Chinese economy. At its 2003 2004 2005 2006 2007 2008 2009 2010 2011 1H12 March analysts’ meeting, Shenhua guided for coal Source: Company data production volumes of 300m tonnes and sales of
400m tonnes, the difference being the amount of
coal acquired from third parties. According to Shenhua’s monthly operating data Selling prices releases, the company purchased 66m tonnes of We forecast a 5% y-o-y increase in contract prices third-party coal in 1H12, a rise of 29% y-o-y. In and 10% decline in spot prices. We also expect June, purchases were running at an annualized the proportion of spot sales to external customers rate of 117mtpa. Over the past three months to increase from 66% in 2011 to 70% in 2012e. (April to June) third-party coal purchases were As a result, we forecast China Shenhua’s average 48% of Shenhua’s own commercial coal selling prices to fall by 4% y-o-y at RMB420/t in production. Given the negative margins on coal 2012e. We expect average selling prices to rise by purchased from third parties, this increase in coal 2% to RMB428/t in 2013e, with contract prices up purchases will tend to be a drag on the headline by another 5% y-o-y and spot prices remaining margins of the coal segment. flat y-o-y. We believe that if coal prices remain depressed Production costs through 2H12, Shenhua will look to reduce its purchases of third-party coals in order to We expect China Shenhua’s coal cash production boost margins. costs to increase by 4% each year in both 2012e and 2013e to RMB102/t and RMB106/t, Sales volume respectively, mainly on higher material costs and China Shenhua sold 387m tonnes of commercial staff costs. coal in 2011, of which 282m tonnes were self- Earnings sensitivity produced coal and the remaining 105m tonnes were purchased from third parties. We expect We estimate a 1% increase in average coal selling total sales volume to rise by 19% y-o-y in 2012e prices would raise our net profit by 1% in both and by 4% y-o-y inn 2013e. 2012e and 2013e.
We forecast the company’s self-produced coal will increase by 11% y-o-y to 313m tonnes in 2012e and by a further 5% to 329m tonnes in 2013e. Coal purchased from third parties will climb by 43% y-o-y to 150m tonnes in 2012e and
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What is China Shenhua Coal business Energy? Production China Shenhua Energy (China Shenhua) is the China Shenhua coal business comprises four mines largest coal producer in China. It mainly operates in Shaanxi and Inner Mongolia, namely the through three main business segments – namely Shendong, Zhunge’er, Shengli and Baorixile coal, power and railways – and has a very small port (Shenbao) mines. These four mines together and shipping operations. contributed c98% of the company’s total commercial coal production of 282m tonnes in 2011 The coal segment accounted for c69% of revenues (233m tonnes on an attributable basis), out of which and 69% of EBIT in 2011, while the power segment Shendong mines alone produced c172.5m tonnes accounted for c23% of revenues and 15% of profit. accounting for 61% of the total production. China The company has continued to build its power Shenhua has recorded a very impressive growth with business along with its coal business, with the power coal production growing at a CAGR of 15% over division consistently contributing c25-30% of the 2005 to 2011, most of which has been organic or revenues over the last 10 years. through asset acquisition from parent.
Railways accounted for only 1% of revenue in China Shenhua 2011 commercial coal production summary (mt) 2011 as most of it is consumed internally, but Stake Output % share Attributable contributed c14% to the company’s EBIT. China Shendong mines 100% 155.4 55% 155.4 Shenhua owns a vast network of rail Shendong - Jinjie mines 70% 17.1 6% 12.0 Zhunge’er mines 58% 54.3 19% 31.4 transportation, which gives it a competitive edge Shengli mines 63% 24.4 9% 15.3 Baorixile mines 57% 26.2 9% 14.8 over other miners as China’s existing rail Baotou mines 100% 3.0 1% 3.0 infrastructure is not sufficient to meet the growing Chaijiagou Mining 95% 1.0 0% 1.0 Indonesia Coal Power 70% 0.5 0% 0.4 demand for coal transport. China faces a Total production 83% 281.9 100% 233.2 significant regional supply-demand mismatch in Source: Company data, HSBC coal as supply is largely concentrated in the northwest while power plants are mainly located near the coastal region in the south eastern part of the country. This necessitates coal transportation by rails to address the regional gap.
China Shenhua 2011 coal revenues by segment China Shenhua 2011 EBIT by segment
Power Power 28% 15%
Railway 1% Railway Coal Coal 14% 69% 69% Others Others 2% 2%
Source: Company data, HSBC Source: Company data, HSBC
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Coal sales China Shenhua coal reserves and resources (end-2011) China Shenhua sold 387m tonnes of commercial Recoverable Marketable Resources reserve (bnt)* reserve (bnt)# (bnt)* coal in 2011, out of which self produced coal was Shendong mines 8.3 8.3 4.7 c282m tonnes (73%) and purchased coal was Zhunge’er mines 3.5 3.5 2.2 c105m tonnes (27%). Shenhua’s trading activity Shengli mines 1.4 1.4 0.8 Baorixile mines 1.3 1.3 1.4 has consistently accounted for c20-25% of sales Baotou mines (inc Lijiahao) 0.7 0.7 0.3 volume over the last five years. Other mines 0.05 0.0 0.0 Total 15.3 9.3 25.4
*PRC standard, #JORC standard The company sold c74m tonnes (c19%) of coal to Source: Company reports, HSBC its own power plants, c308m tonnes (c80%) to domestic customers and exported c6m tonnes Power segment (1%). Shenhua mainly sells thermal coal, which Shenhua’s power business mainly operates coal- accounted for c82% of total domestic sales in fired power plants and also some wind power and 2011. It sells coal on both a contract and spot gas-fired power generation businesses. It has total basis and its share of spot sales have increased installed capacity of c37GW and equity installed substantially accounting for 55% of total sales capacity of c23GW (63%) at the end of 2011. in 2011. Gross power generation was 180bn kWh and power
China Shenhua coal sales volume by pricing and coal sales output despatch amounted to 168bn kWh. Power ASP (RMB/t) segment consumed 80m tonnes of coal in 2011, of 100% 550 which c64m tonnes was sourced internally from
80% 500 own mines. 450 60% Power plants (2011) 400 40% Power plants Location Installed Equity 350 capacity MW installed 20% 300 capacity MW 0% 250 Huanghua Power Hebei 2,520 1,285 2006 2007 2008 2009 2010 2011 Sanhe Power Hebei 1,300 715 Dingzhou Power Hebei 2,520 1,021 Spot % Contract % Panshan Power Tianjin 1,030 469 Spot ASP (RHS) Contract ASP (RHS) Zhunge’er Power Inner Mongolia 1,060 613 Shendong Power Inner Mongolia 3,467 2,957 Source: Company data, HSBC Guohua Zhunge’er Inner Mongolia 1,320 858 Guohua Hudian Inner Mongolia 1,200 960 Beijing Thermal Beijing 400 280 Reserves and resources Suizhong Power Liaoning 3,600 1,800 The company had coal resources and recoverable Ninghai Power Zhejiang 4,400 2,640 Jinjie Energy Shaanxi 2,400 1,680 coal reserves (under PRC standard) of 25.4bn Shenmu Power Shaanxi 220 112 Taishan Power Guangdong 5,000 4,000 tonnes and 15.3bn tonnes, respectively, and Huizhou Thermal Guangdong 660 660 marketable coal reserves of 9.3bn tonnes as per Mengjin Power Henan 1,200 612 Indonesia Coal Power Indonesia 300 210 JORC standards by the end of 2011. Chenjiagang Power Jiangsu 1,320 726 Shenwan Energy Anhui 2,440 1,244 Coal - power plant total 36,357 22,842 Other power plants Zhuhai Wind Energy Guangdong 16 12 Yuyao Power(3) Zhejiang 780 624 Total 37,153 23,478
Source: Company reports, HSBC
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Railway segment Shenhua owns a series of transportation assets that enable the company to overcome its relatively poor location. It owns four railways namely, Shuohuang-Huangwan, Shenshuo, Dazhun and Baoshen. These networks help the company to transport coal across China and to its ports. The transportation turnover of its self-owned railway was 162.3bn tkm which accounted for c76% of its coal transport requirement. Port segment The company owns and operates Huanghua Port and Shenhua Tianjin Coal Dock which are the major transhipment hubs of the company for coal sales to domestic coastal and overseas markets. The seaborne coal volume of the company amounted to 210.1m tonnes in 2011, out of which its self-operated ports handled c121.2m tonnes or 60% of volume. Shipping segment The company operates its shipping business through Shenhua Zhonghai Shipping Company. It shipped c81m tonnes of cargo in 2011.
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China Shenhua: Income statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Net revenues 152,063 208,197 243,563 258,776 273,647 y-o-y change (%) 25% 37% 17% 6% 6%
Cost of sales 86,838 128,092 160,262 171,774 179,427
Gross Profit 65,225 80,105 83,301 87,002 94,220 y-o-y change (%) 17% 23% 4% 4% 8% Gross profit margin (%) 43% 38% 34% 34% 34%
Operating expenses 8,774 11,800 13,152 13,974 14,777 Selling, general and admin costs 8,143 10,973 12,178 12,939 13,682 Others 631 827974 1,035 1,095
Income from operations 56,451 68,305 70,149 73,028 79,443 Operating profit margin (%) 37% 33% 29% 28% 29%
Other income/ (expense) net 299 318 300 300 300
EBIT 56,750 68,623 70,449 73,328 79,743 EBIT margin (%) 37% 33% 29% 28% 29%
Net finance income/ (expense) (1,997) (2,163) (2,524) (2,739) (2,549) Interest income 1,174 968 759 706 897 Interest expenses (3,171) (3,131) (3,282) (3,445) (3,445)
PBT 54,753 66,460 67,925 70,589 77,195 PBT margin (%) 36% 32% 28% 27% 28%
Taxation (11,184) (13,951) (15,623) (16,235) (17,755) Effective tax rate (%) 20% 21% 23% 23% 23%
Minority interests (5,437) (6,832) (6,799) (7,066) (7,727)
Net income 38,132 45,677 45,503 47,287 51,713 y-o-y change (%) 20% 20% 0% 4% 9% Net income margin (%) 25% 22% 19% 18% 19%
EPS (RMB) 1.92 2.30 2.29 2.38 2.60 DPS (RMB) 0.75 0.90 0.92 0.95 1.04 Payout ratio (%) 39% 39% 40% 40% 40%
EBITDA 70,079 84,194 87,586 91,685 97,982 EBITDA margin (%) 46% 40% 36% 35% 36%
Source: Company data, HSBC estimates
163 Natural Resources & Energy China Equity abc July 2012
China Shenhua: Balance sheet summary (RMBm) 2010a 2011a2012e 2013e 2014e Assets Current assets 103,995 107,937 94,031 103,812 121,614 Cash and cash equivalents 73,345 61,437 37,677 50,931 67,010 Time deposits 2,021 7,623 10,000 10,000 10,000 Bills receivable 2,054 973- - - Accounts receivable, net 8,591 12,392 17,350 18,433 19,493 Inventories 11,167 12,628 16,015 11,295 11,798 Prepayments and other assets 6,817 12,884 12,988 13,153 13,313
Fixed assets 210,623 254,073 292,288 319,273 341,373 Property, plant and equipment 179,434 219,904 238,119 260,104 277,204 Construction in progress 31,189 34,169 54,169 59,169 64,169
Other assets 26,242 39,067 38,819 38,680 38,545 Intangible assets 3,228 3,596 3,444 3,402 3,363 Interests in associates 3,285 3,065 3,365 3,665 3,965 Investments 950 835835 835 835 Lease prepayments 8,409 11,892 11,496 11,099 10,703 Deferred tax assets 686 933 933 933 933 Other non-current assets 9,684 18,746 18,746 18,746 18,746
Total assets 340,860 401,077 425,137 461,765 501,532
Liabilities Current liabilities 58,900 87,549 73,826 77,656 80,527 Bank loans 8,201 5,011 5,000 5,000 5,000 Current portion of LT borrowings 7,697 11,378 12,000 12,000 12,000 Current portion of LT payable 393 271 200 200 200 Trade payables 18,264 23,604 32,052 34,355 35,885 Others 24,345 47,285 24,573 26,101 27,442
Non-current liabilities 53,172 49,214 55,374 55,423 55,544 Bank loans and other borrowings 48,730 44,013 50,000 50,000 50,000 Long term payable, less current portion 1,777 2,346 2,400 2,400 2,400 Accrued reclamation obligations 1,577 1,724 1,724 1,724 1,724 Deferred tax liabilities 1,088 1,131 1,250 1,299 1,420
Total liabilities 112,072 136,763 129,199 133,079 136,071
Shareholders’ equity 198,325 225,822 253,424 282,510 315,308 Share capital 19,890 19,890 19,890 19,890 19,890 Share premium 85,001 85,001 85,001 85,001 85,001 Retained profits 77,713 107,052 129,424 153,075 179,928 Reserves 15,721 13,879 19,109 24,545 30,489
Minority interest 30,463 38,492 42,514 46,177 50,153
Total liabilities and shareholders’ equity 340,860 401,077 425,137 461,765 501,532
Gearing Gross debts 64,628 60,402 67,000 67,000 67,000 Cash and cash equivalent 75,366 69,060 47,677 60,931 77,010 Net debts/(cash) (10,738) (8,658) 19,323 6,069 (10,010)
Shareholders equity including minorities 228,788 264,314 295,938 328,687 365,461 Net debt-to-equity -5% -3% 7% 2% -3%
Source: Company data, HSBC estimates
164 Natural Resources & Energy China Equity abc July 2012
China Shenhua: Cash flow statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Cash flow from operating activities Profit before tax 54,753 66,460 67,925 70,589 77,195 Depreciation and amortisation 13,329 15,571 17,137 18,357 18,239 Impairment loss 304 138 - - - Loss(gain) on assets disposal 85 167 - - - Change in working capital (1,095) 689 (24,188) 7,303 1,148 Net interest paid (2,392) (2,251) (2,524) (2,739) (2,549) Tax paid (9,472) (11,740) (15,623) (16,235) (17,755) Others 1,697 1,631 2,172 2,397 2,210 Operating cash flow 57,209 70,665 44,900 79,670 78,489
Cash flow from investing activities Additions of PPE and assets under construction (26,147) (44,713) (55,000) (45,000) (40,000) Additions of non-current assets (1,387) (259) 248 139 135 Proceeds from assets disposal 100 50 - - - Acquisitions & investment (82) (10,458) (2,778) (3,403) (3,750) Others 3,087 530- - - Investing cash flow (24,429) (54,850) (57,529) (48,264) (43,616)
Cash flow from financing activities Dividend paid (10,541) (14,917) (17,901) (18,201) (18,915) New loans and borrowings 29,638 4,671 6,598 - - Loans and borrowing repayment (42,097) (20,814) - - - Others (2,377) (523) 173 49 122 Financing cash flow (25,377) (31,583) (11,130) (18,152) (18,793)
Net change in cash 7,403 (15,768) (23,760) 13,254 16,079 Net exchange adjustment (2) (7) - - - Net cash movement 7,401 (15,775) (23,760) 13,254 16,079
Source: Company data, HSBC estimates
165 Natural Resources & Energy China Equity abc July 2012
Financials & valuation: China Steel Corp Underweight Financial statements Key forecast drivers Year to 12/2011a 12/2012e 12/2013e 12/2014e Year to 12/2011a 12/2012e 12/2013e 12/2014e Profit & loss summary (TWDm) Finished steel sales (kt) 9,167 9,330 9,630 10,030 Average selling price (TWD/t) 24,962 23,213 23,263 22,507 Revenue 240,376 221,578 234,018 235,745 Iron ore price (TWD/t) 5,598 5,130 5,017 4,481 EBITDA 35,781 26,341 33,741 39,704 Coking coal price (TWD/t) 8,019 7,901 8,016 7,657 Depreciation & amortisation -14,848 -15,344 -15,675 -16,006 TWD:USD 29.32 29.65 29.00 28.50 Operating profit/EBIT 20,932 10,996 18,065 23,697 Net interest -648 -1,117 -1,312 -1,233 PBT 20,285 9,879 16,754 22,464 HSBC PBT 20,285 9,879 16,754 22,464 Taxation -791 -494 -838 -3,370 Valuation data Net profit 19,436 9,326 15,856 19,033 Year to 12/2011a 12/2012e 12/2013e 12/2014e HSBC net profit 19,436 9,326 15,856 19,033 EV/sales 2.0 2.4 2.3 2.2 Cash flow summary (TWDm) EV/EBITDA 13.7 20.5 16.0 13.1 Cash flow from operations -31,481 18,192 23,623 23,640 EV/IC 2.1 2.4 2.5 2.5 Capex -16,250 -15,000 -10,000 -10,000 PE* 20.3 42.9 25.3 21.1 Cash flow from investment -24,906 -34,798 -23,000 -10,000 PB 1.4 1.6 1.5 1.5 Dividends -26,921 -18,808 -7,039 -11,937 FCF yield (%) -3.5 6.1 5.2 6.4 Change in net debt 21,589 43,987 -679 -15,153 Dividend yield (%) 7.5 4.7 1.7 3.0 FCF equity -13,951 24,310 20,662 25,577 *Based on HSBC EPS (diluted)
Balance sheet summary (TWDm) Intangible fixed assets 0 0 0 0 Issuer information
- 6 . Tangible fixed assets 187,141 186,887 181,302 175,388 Share price (TWD)26.50 Target price (TWD)24.75 6 Current assets 87,240 70,670 72,464 71,834 Cash & others 2,914 4,446 4,571 4,588 Reuters (Equity) 2002.TW Bloomberg (Equity) 2002 TT Total assets 421,935 424,767 433,885 427,249 Market cap (USDm) 13,227 Market cap (TWDm) 398,725 Operating liabilities 36,610 30,151 30,946 32,289 Free float (%) 79 Enterprise value (TWDm) 536,090 Gross debt 96,292 141,811 141,257 126,121 Country Taiwan Sector Metals & Mining Net debt 93,378 137,365 136,686 121,533 Analyst Simon Francis Contact +852 2996 6620 Shareholders funds 288,587 252,359 261,236 268,393
Invested capital 234,857 222,960 218,249 210,345 Price relative 37 37 Ratio, growth and per share analysis 35 35 Year to 12/2011a 12/2012e 12/2013e 12/2014e 33 33 Y-o-y % change 31 31 Revenue 0.5 -7.8 5.6 0.7 29 29 EBITDA -39.3 -26.4 28.1 17.7 27 27 Operating profit -53.1 -47.5 64.3 31.2 PBT -54.0 -51.3 69.6 34.1 25 25 HSBC EPS -53.6 -52.6 69.6 20.0 2010 2011 2012 2013 China Steel Corp Rel to TAIWAN WEIGHTED INDEX Ratios (%) Source: HSBC Revenue/IC (x) 1.1 1.0 1.1 1.1
ROIC 9.3 4.6 7.8 9.4 ROE 7.0 3.4 6.2 7.2 Note: price at close of 25 Jul 2012 ROA 5.0 2.5 4.0 4.7 EBITDA margin 14.9 11.9 14.4 16.8 Operating profit margin 8.7 5.0 7.7 10.1 EBITDA/net interest (x) 55.2 23.6 25.7 32.2 Net debt/equity 32.4 54.4 52.3 45.3 Net debt/EBITDA (x) 2.6 5.2 4.1 3.1 CF from operations/net debt 13.2 17.3 19.5 Per share data (TWD) EPS Rep (diluted) 1.30 0.62 1.05 1.25 HSBC EPS (diluted) 1.30 0.62 1.05 1.25 DPS 1.99 1.25 0.46 0.78 Book value 19.18 16.52 17.11 17.57
166 Natural Resources & Energy China Equity abc July 2012
China Steel Corp (2002 TT)
Competition from China and a lack of raw materials integration has forced down margins and the dividend yield. We believe China Steel’s status as a ‘dividend play’ may be ending We recognise the low-beta nature of the stock but believe that earnings downgrades and the weaker DPS will lead to a weaker share price We initiate coverage on China Steel with an Underweight rating and a target price of TWD24.75 based on a 1.5x 2012e PB
Initiate with Underweight little upstream integration into raw materials and Simon Francis* therefore little control over its production costs. Head of Metals & Mining China Steel is the largest steel maker in Taiwan Research, Asia Pacific The Hongkong and Shanghai with a controlled crude steel capacity of 13.4mtpa Consequently, margins have fallen substantially Banking Corporation Limited +852 2996 6620 at the end of 2011. We initiate coverage of China over the past decade. Given the structural issues in [email protected] Steel with an Underweight rating and a share the Chinese market, we see little hope for China Chris Chen* target price of TWD24.75 based on China Steel Steel’s margins to improve meaningfully over the Analyst The Hongkong and Shanghai trading at a 2012e PB of 1.5x. next few years. Banking Corporation Limited +852 2822 4277 Tough environment… China Steel gross profit margin [email protected] Amit Pansari* Like other steel makers in Asia, China Steel faces 40% Analyst a challenging environment. In China, the steel 35% HSBC Bank plc 30% +91 80 3001 3760 market remains very highly fragmented and [email protected] 25% competition is based largely on selling price. The 20% *Employed by a non-US affiliate of HSBC Securities (USA) Inc, industry has excess production capacity and there 15% and is not registered/ qualified is little to no supply-side discipline among 10% pursuant to FINRA regulations producers. As a result, prices have tended to settle 5% at broadly the break-even level for many 0%
producers. 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012e 2013e 2014e Source: Company data, HSBC estimates China Steel’s customers increasingly have options to buy from Chinese steel makers and, as a result, price competition in China has impacted China Steel’s selling prices. In addition, China Steel has
167 Natural Resources & Energy China Equity abc July 2012
…and a weaker outlook for earnings against the Taiex index. In contrast, Angang’s and returns yield, measured against the HSCEI is 1.3. We forecast China Steel’s ROEs at between 3% China Steel and Angang H share price performance (index and 7% in 2012e-14e. This is down from an Jan 2010 = 100) average of 18% in 2003-11. 120 100 We forecast China Steel’s net income at 80 TWD9.4bn in 2012e and TWD15.9bn in 2013e. 60 In the first six months of the year, China Steel had 40 made a pre-tax profit of just TWD2.9bn. 20 0 Our earnings forecasts are 33% below consensus in 2012e and 21% below in 2013e. Jan-10 Sep-10 Jan-11 Sep-11 Jan-12 May-10 May-11 May-12
Chin Steel net income (TWDbn) Angang H China Steel
Source: Thomson Reuters Datastream, HSBC 60 50 We believe the current structural issues in the 40 Chinese steel industry may mark the end of China 30 Steel’s ‘dividend play’ status. We believe that 20 over the next few years, lower margins and 10 earnings will mean lower dividends per share. 0 This is likely to lead to a de-rating in the stock, in our view. 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012e 2013e 2014e We estimate that China Steel is trading at a dividend Source: Company data, HSBC estimates yield of 4.7% in 2012e and 1.7% in 2013e.
‘Dividend play’ status probably China Steel’s annual dividend yields coming to an end 7% China Steel has historically paid generous 6% dividends. In 2003-11, the company maintained a 5% cash dividend payout ratio of 67-78% and paid an average yield (based on annual average share 4% prices) of 7.7%. We believe this is the most 3% generous dividend payout ratio in the sector. 2%
In March 2012, China Steel announced a dividend 1%
of TWD1.25 per share, representing a 96% payout 2009 2010 2011 2012e 2013e 2014e from 2011 net income. Source: Company data, HSBC
Largely as a result of this high yield, we believe, China Steel has enjoyed a solid reputation as a ‘dividend play’. This has manifested itself in the share price being relatively defensive. Notably, China Steel has a beta of just 0.5 measured
168 Natural Resources & Energy China Equity abc July 2012
Expansion in Taiwan looks expensive China Steel net debt/ (cash) (TWDbn) and gearing China Steel is in the midst of a major capacity 150 60% expansion that will take crude steel 100 40% production capacity from 11.9mtpa in 2009 to 16.3mtpa in 2013e. 50 20%
The expansion comprises a 5mtpa two-stage 0 0% expansion at Dragon Steel (a 100%-held -50 -20% subsidiary) – the first phase of which is already 2003 2004 2005 2006 2007 2008 2009 2010 2011 completed – and a refurbishment of the electric 2012e 2013e 2014e Net Debt (Cash) Net Debt (Cash)/ Equity arc furnace (EAF) capacity, also at Dragon Steel. Source: Company data, HSBC estimates The second phase of the Dragon Steel expansion, comprising another 2.5mtpa blast furnace and an Valuation expansion in the hot-rolled facility from 3mtpa to PB-based target price 4mtpa is expected to be completed by the end of We value the Greater China steel stocks using a this year. PB valuation methodology, mainly because We think the project is expensive. Management Chinese steel company’s margins are thin and estimates the total cost of the Dragon Steel earnings are both weak and volatile. We expansion at TWD204bn. This comprises determine the target PB primarily by reference to TWD110bn for phase 1 (TWD78bn for the steel our ROE forecasts. making plant and TWD32bn for the rolling mill) We apply a PB multiple of 1.5x to China Steel and a further TWD94bn for phase 2 (a second blast furnace and the expansion of the hot strip which is equal to the 10-year historical average. This is notably higher than the Chinese companies mill from 3mtpa to 4mtpa). which reflects China Steel’s higher payout ratio. Based on an operating capacity of 2.5mtpa, the As a result of this higher payout ratio, China cost per tonne of capacity for Phase 1 is Steel’s book value per share had risen by just 54% cUSD1,470/t. The overall per tonne capacity cost in the ten years up to the end of 2011. For for the project, based on 5mtpa operating comparison, Angang’s book value per share had capacity, is cUSD1,365/t. risen almost three-fold in the same timeframe.
Given the tough environment that this capacity is being commissioned into, we expect the financial returns for the project to be poor. Gearing has risen as the company has expanded We expect China Steel’s net-debt-to-equity ratio to increase to 54% by the end of 2012, from 32% last year.
169 Natural Resources & Energy China Equity abc July 2012
China Steel’s ROE and PB China Steel’s daily PE
2.2 30% 50 45 2.0 25% 40 1.8 35 20% 1.6 30 15% 25 1.4 20 1.2 10% 15 10 1.0 5% 5
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 -
P/BV ROE (RHS ) Jul-09 Jul-10 Jul-11 Jul-12 Apr-09 Oct-09 Apr-10 Oc t-10 Apr-11 Oct-11 Apr-12 Jan-09 Jan-10 Jan-11 Jan-12
Source: Company data, HSBC Source: Company data, Datastream, HSBC
Looks expensive in terms of earnings- China Steel’s daily EV/EBITDA based valuations 24 In addition to PB, we also calculate daily PE, 22 EV/EBITDA and EV per tonne of capacity 20 valuations on a one-year forward basis. In terms 18 16 of these valuations, China Steel looks 14 expensive to us, although valuations have come 12 off their highs recently. 10 8 The significant increases in valuations over the 6 Jul-09 Jul-10 Jul-11 Jul-12
past two and half years reflect falling earnings Jan-09 Jan-10 Jan-11 Jan-12 being much more than a weaker share price – the Source: Company data, Datastream, HSBC shares have been remarkably stable. We do not see how these valuations can continue to be Since iron ore prices were floated in April 2010, justified given the poor outlook, in our view. China Steel has traded at an average EV/t of USD1,300/t. The stock reached a peak valuation China Steel’s daily PB of USD1,562/t in April 2011 and a trough of 2.0 USD958/t in June 2010. 1.8 We calculate that at our share target price of 1.6 TWD24.75, the stock would trade at an EV/t 1.4 of USD890. 1.2 1.0 0.8 Jul-09 Jul-10 Jul-11 Jul-12 Jan-09 Jan-10 Jan-11 Jan-12
Source: Company data, Datastream, HSBC
170 Natural Resources & Energy China Equity abc July 2012
China Steel’s daily EV/t volatile nature of the main drivers – steel, iron ore
1,600 and coking coal prices. US$/t 1,400 We estimate China Steel will achieve an average 1,200 ROE of just 6% over the next three years. 1,000 Historical and forecast ROEs 800 35% 600 30% 400 25%
Jul-09 Jul-10 Jul-11 Jul-12 20% Jan-09 Jan-10 Jan-11 Jan-12 15% Source: Company data, Datastream, HSBC 10% HSBC ratings bands 5% 0% For non-volatile stocks, the band for a Neutral 2004 2005 2006 2007 2008 2009 2010 2011 rating (N) is 5ppt above and below our hurdle 2012e 2013e 2014e rate, which for Taiwan is 9.5%. Our target price Source: Company data, HSBC estimates together with the expected dividend yield where indicated implies a potential return of -2% which Sales volume is below the Neutral band. On this basis, we rate China Steel sold 9.2m tonnes of finished steel in China Steel Underweight. Potential return equals 2011. We forecast sales volume of 9.3m tonnes in the percentage difference between the current 2012e, up 2% y-o-y and 9.6m tonnes in 2013e, up share price and the target price, including the 3% y-o-y. In China Steel, we expect to see a forecast dividend yield where indicated. continued focus on cold-rolled steel products as hot-rolled production is shifted to Dragon Steel. Risks Cold-rolled accounted for 33% of China Steel’s The main upside risk to our view is that steel sales volume in 2011, up from 29% in 2010. prices are stronger than expected. This could arise from stronger-than-expected demand or from Selling prices structural changes in the industry in China, We expect China Steel’s average selling prices to resulting in a reduction of the level of competition drop by 7% y-o-y from TWD24,962/t in 2011 to which China Steel faces. The development of the TWD23,213/t in 2012e and marginally increase to Dragon Steel may cost less than we forecast. It TWD23,263/t in 2013e. may be more profitable than we anticipate. The Production costs company’s production costs may be lower than we forecast. China Steel’s average delivered iron ore costs should decline by 8% y-o-y to TWD5,130/t in Poor earnings outlook 2012e and by further 2% y-o-y to TWD5,017/t in We expect China Steel to make a net income of 2013e. We estimate the company’s coking coal TWD9.4bn in 2012e, TWD15.9bn in 2013e and prices at TWD7,901/t in 2012e (up 1% y-o-y) and RMB19.1bn in 2014e. We are cautious that there TWD8,016/t in 2013e (down 1% y-o-y). is very little visibility to these forecasts given the low-margin nature of the business and the highly
171 Natural Resources & Energy China Equity abc July 2012
What is China Steel there has been no major capacity expansion at its Corporation? Kaohsiung works.
China Steel Corporation (CSC) is the largest steel CSC crude steel production (mt) manufacturer in Taiwan and is a listed steel unit 12 of the CSC group. CSC group had a crude steel 10 capacity of 13.4mtpa at the end of 2011 with 8 9.9mtpa at CSC and 3.5mtpa at Dragon steel. The 6 group has additional rolling facilities through its subsidiary Chung Hung Steel. CSC accounts for 4 Dragon Steel and Chung Hung Steel as associates 2 in its financial statements and thus does not 0 include them in its production or sales numbers. 2004 2005 2006 2007 2008 2009 2010 2011 The Taiwan government is the single largest Source: Company data, HSBC shareholder owning c21% stake in CSC. Production Sales CSC mainly produces steel using the blast furnace CSC mainly produces and sells HRC, CRC, (BF) process with 9.9mtpa BF capacity at its coated products, plates, bars and wire rod. It sold Kaohsiung works. Dragon steel currently has a BF c9.2m tonnes of finished products in 2011 (-7% y- capacity of c2.5mtpa and EAF capacity of 1mtpa o-y) with flat steel accounting for c75%. CSC and another 2.5mtpa BF plant and 0.4mpa EAF exported 2.79m tonnes of steel in 2011 accounting plant will be commissioned next year taking the for 30% of its sales volume, historically company CSC group capacity to 16.3mtpa by 2013e, has exported anywhere between 20-25% of its 14.9mtpa BF and 1.4mtpa EAF. sales volume. The company’s major export markets are China (29.3% of 2011 sales volumes), China Steel Group capacity (mtpa) Japan (25.3%) and South East Asia (28.3%). 20 CSC 2011 finished steel sales by products 15 5.0 Plate Bar/Rod 2.0 2.5 2.5 12% 25% 10 0.9 1.0 1.0 1.0 1. 4
5 9.99.99.99.99.9 Semis Coated 0. 3% 0 17% 2009 2010 2011 2012e 2013e
CSC Dragon EAF Dragon BF HR C CRC Source: Company data, HSBC estimates 30% 16%
CSC produced c8.76m tonnes of crude steel in Source: Company data, HSBC
2011, down 10% y-o-y due to weak market environment. The company’s production has stabilized over the last eight years at c8-10mtpa as
172 Natural Resources & Energy China Equity abc July 2012
In the domestic market, CSC mainly sells its Raw materials products directly to end-users with traders CSC does not have any direct upstream accounting for just 3% of sales volume in 2011. It integration with respect to iron ore and coking sold c20.2% to coil centres, c20% to direct users coal and have secured supply through long-term and c18% to bolts and nuts manufacturers in contract with the miners. The company imports all 2011. of its iron ore and coking coal requirements and a
CSC 2011 domestic sales volume by end markets majority of it is from Australia. CSC imported Others c16.9m tonnes of iron ore and c8.5m tonnes of 0.4% Wire-rod 0.9% coking coal in 2011, of which Australia accounted Hand tools 2.0% Trader 3.0% for c67% and c73%, respectively. Ship-building 3.5% Veh icles 6.9% CSC aims to secure at least 30% of major raw Piping 7.3% Steel structure 7.6% materials through investments in mines. At Re-rolling 10.3% Bolts-nuts 17. 8% present, CSC has 1% stake in NAMISA (iron Direct users 19.9% ore), 2.5% stake in Roy Hill project (iron ore) and Coil center 20.2% 5% stake in Sonoma coal project (coking coal). It 0% 5% 10% 15% 20% 25% also owns 5% in Dongbu Metal, Korea’s largest
Source: Company data, HSBC ferroalloys producer and has acquired 39.04% in Hsin Hsin Cement for lime stone supply. CSC being the largest domestic producer enjoys significant domestic market share across its product categories. Last year, it had 80% share in electric steel, 69% in plates, 67% in CRC, 59% in rod and wire and 29% in HRC. CSC group had a much higher share of 80% in CRC and 87% in HRC.
CSC group market share of major products
21% 13%
37% 80 % 67% 68% 59% 49% 29% 27% HDG Plat e HRC CRC Bar/rod Elec Galv Elec Elec St e el CSC Dragon Chung Hung
Source: Company data, HSBC
173 Natural Resources & Energy China Equity abc July 2012
China Steel: Income statement summary (TWD m) 2010a 2011a2012e 2013e 2014e Net Revenues 239,187 240,376 221,578 234,018 235,745 y-o-y change (%) 45% 0% -8% 6% 1%
Cost of sales 196,236 218,782 207,734 213,615 210,658
Gross Profit 42,951 21,594 13,844 20,403 25,087 y-o-y change (%) 192% -50% -36% 47% 23% Gross profit margin (%) 18% 9% 6% 9% 11%
Operating Expenses 6,950 7,057 6,647 7,138 7,190 Sales and marketing 2,615 2,414 2,216 2,340 2,357 Administration 2,954 3,205 3,102 3,159 3,183 Research and development 1,380 1,438 1,329 1,638 1,650
Income from Operations 36,001 14,537 7,196 13,265 17,897 Operating profit margin (%) 15% 6% 3% 6% 8%
Other income/ (expense) net 8,661 6,395 3,800 4,800 5,800 - of which income from associates 8,248 5,151 3,000 4,000 5,000
EBIT 44,662 20,932 10,996 18,065 23,697 EBIT margin (%) 19% 9% 5% 8% 10%
Net financial /(expense) (568) (648) (1,117) (1,312) (1,233) Interest expenses (660) (769) (1,161) (1,380) (1,303) Interest income 92 121 43 68 70
PBT 44,094 20,285 9,879 16,754 22,464 PBT margin (%) 18% 8% 4% 7% 10%
Taxation (6,507) (791) (494) (838) (3,370) Effective tax rate (%) 15% 4% 5% 5% 15%
Net income 37,587 19,493 9,385 15,916 19,094 Preferred share dividends 57 58 59 60 61 Adjusted net income 37,530 19,436 9,326 15,856 19,033 y-o-y change (%) 92% -48% -52% 70% 20% Adjusted net income margin (%) 16% 8% 4% 7% 8%
Basic EPS (TWD) 2.83 1.30 0.61 1.04 1.25 Diluted EPS (TWD) 2.80 1.30 0.62 1.05 1.25 DPS paid (TWD) 1.01 1.99 1.25 0.46 0.78 Payout ratio (based on previous year 67% 72% 96% 75% 75% income)
EBITDA 58,973 35,781 26,341 33,741 39,704 EBITDA margin (%) 25% 15% 12% 14% 17%
Source: Company data, HSBC estimates
174 Natural Resources & Energy China Equity abc July 2012
China Steel: Balance sheet summary (TWD m) 2010a 2011a2012e 2013e 2014e Assets Current assets 63,885 87,240 70,670 72,464 71,834 Cash at bank and in hand 2,171 684 2,216 2,340 2,357 Marketable securities 2,068 2,231 2,231 2,231 2,231 Notes receivable 1,243 1,335 1,335 1,335 1,335 Accounts receivable 2,487 3,318 4,249 4,488 4,521 Other receivables 1,122 1,162 1,093 1,154 1,163 Inventories 46,958 67,341 48,377 49,746 49,057 Other current assets 7,836 11,170 11,170 11,170 11,170
Fixed assets 180,960 187,141 186,887 181,302 175,388
Other assets 137,543 147,554 167,210 180,119 180,027 Available for sale financial assets 3,136 3,260 3,260 3,260 3,260 Financial assets carried at cost 3,247 7,421 7,421 7,421 7,421 Bond investments 3,686 3,906 3,906 3,906 3,906 Investments accounted for using equity method 123,129 127,253 147,000 160,000 160,000 Other financial assets 753 2,209 2,209 2,209 2,209 Other assets 3,591 3,504 3,414 3,323 3,231
Total assets 382,387 421,935 424,767 433,885 427,249
Liabilities Current liabilities 47,970 49,454 53,451 54,108 51,667 Short term debt 1,342 6,468 9,927 9,888 8,828 Bonds payable 13,698 11,295 14,181 14,126 12,612 Current portion of long term debt - 3,682 5,672 5,650 5,045 Bills issued 3,726 3,603 5,672 5,650 5,045 Trade payables 5,940 5,517 5,691 5,852 5,771 Accrued expenses 10,733 8,306 8,537 8,779 8,657 Others 12,531 10,583 3,770 4,163 5,708
Non-current liabilities 68,467 83,893 118,957 118,541 107,189 Long debt bank borrowings 23,182 21,285 28,362 28,251 25,224 Long term bonds & notes payable 4,497 11,989 22,690 22,601 20,179 Bonds payable 29,580 37,969 55,306 55,090 49,187 Others 11,208 12,650 12,598 12,598 12,598
Total liabilities 116,437 133,348 172,408 172,649 158,856
Shareholders’ equity 265,950 288,587 252,359 261,236 268,393 Share capital 135,279 150,462 152,725 152,725 152,725 Preferred stock 383 383 383 383 383 Capital reserve 20,072 36,248 36,248 36,248 36,248 Retained earnings 37,652 19,607 5,924 13,863 19,429 Others 72,564 81,888 57,079 58,018 59,609
Total liabilities and shareholders’ equity 382,387 421,935 424,767 433,885 427,249
Gearing Gross debt 76,028 96,292 141,811 141,257 126,121 Cash and ST investment 4,239 2,914 4,446 4,571 4,588 Net debt/ (cash) 71,789 93,378 137,365 136,686 121,533
Shareholders equity including minorities 265,950 288,587 252,359 261,236 268,393 Net debt-to-equity 27% 32% 54% 52% 45%
Source: Company data, HSBC estimates
175 Natural Resources & Energy China Equity abc July 2012
China Steel: Cash flow statement summary (TWD m) 2010a 2011a2012e 2013e 2014e Cash flow from operating activities EBIT 44,662 20,932 10,996 18,065 23,697 Depreciation and amortisation 14,311 14,848 15,344 15,675 16,006 Changes in operating assets and liabilities 21,912 (32,043) 14,580 (929) 476 Net interest (paid) / received (720) (568) (648) (1,117) (1,312) Tax paid (557) (6,507) (791) (494) (838) Others (23,399) (28,143) (21,291) (7,577) (14,390) Operating cash flow 56,210 (31,481) 18,192 23,623 23,640
Cash flow from investing activities Capex (39,111) (16,250) (15,000) (10,000) (10,000) Additions of non-current assets (19,738) (10,100) (19,746) (13,000) 0 Others (160) 1,445 (51) - - Investing cash flow (59,008) (24,906) (34,798) (23,000) (10,000)
Cash flow from financing activities Dividend paid (13,225) (26,921) (18,808) (7,039) (11,937) Changes in capital structure 4,334 15,183 2,263 - - Loans movement (5,630) 22,667 42,633 (499) (13,622) Others 11,496 48,660 (7,950) 7,039 11,937 Financing cash flow (3,026) 59,590 18,138 (499) (13,622)
Net increase/ (decrease) in cash (5,824) 3,203 1,532 124 17
Source: Company data, HSBC estimates
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177 Natural Resources & Energy China Equity abc July 2012
Financials & valuation: Jiangxi Copper Co Ltd Neutral (V) Financial statements Key forecast drivers Year to 12/2011a 12/2012e 12/2013e 12/2014e Year to 12/2011a 12/2012e 12/2013e 12/2014e Profit & loss summary (RMBm) Copper concentrates prodn (t) 202,000 212,700 229,700 233,300 Copper cathodes prodn (t) 940,000 1,090,000 1,100,000 1,100,000 Revenue 117,119 113,718 95,851 100,363 Copper prices (USD/t) 8,816 8,000 7,500 8,000 EBITDA 8,643 9,091 9,152 10,085 Gold prices (USD/oz) 1,571 1,760 1,775 1,750 Depreciation & amortisation -1,178 -1,142 -1,239 -1,257 Copper TC (USD/t) 81 64 60 60 Operating profit/EBIT 7,465 7,948 7,913 8,829 Copper concs costs (USD/t) 3,508 3,734 3,922 4,039 Net interest -174 -458 -276 -74 PBT 7,709 7,685 7,832 8,950 HSBC PBT 7,709 7,685 7,832 8,950 Taxation -1,060 -1,153 -1,958 -2,238 Valuation data Net profit 6,587 6,467 5,815 6,645 Year to 12/2011a 12/2012e 12/2013e 12/2014e HSBC net profit 6,587 6,467 5,815 6,645 EV/sales 0.4 0.4 0.4 0.3 Cash flow summary (RMBm) EV/EBITDA 5.9 5.2 4.2 3.3 Cash flow from operations 6,632 8,413 11,253 6,398 EV/IC 1.2 1.1 1.0 0.8 Capex -2,462 -2,540 -2,540 -1,140 PE* 7.1 7.3 8.1 7.1 Cash flow from investment -4,973 -2,395 -2,502 -1,102 P/Book 1.2 1.1 0.9 0.8 Dividends -1,385 -2,424 -970 -872 FCF yield (%) 6.8 10.5 19.2 12.6 Change in net debt -1,299 -4,212 -8,383 -5,117 Dividend yield (%) 5.2 2.1 1.9 2.1 FCF equity 3,204 4,936 9,060 5,919 *Based on HSBC EPS (diluted)
Balance sheet summary (RMBm) Intangible fixed assets 847 851 853 855 Issuer information
1 7 . Tangible fixed assets 18,092 19,487 20,786 20,667 Share price (HKD)16.50 Target price (HKD)19.40 6 Current assets 46,202 52,180 54,198 60,253 Cash & others 11,082 15,829 24,212 29,329 Reuters (Equity) 0358.HK Bloomberg (Equity) 358 HK Total assets 68,150 75,418 78,737 84,675 Market cap (USDm) 9,958 Market cap (HKDm) 77,672 Operating liabilities 12,795 13,989 12,307 12,529 Free float (%) 61 Enterprise value (RMBm) 47,198 Gross debt 15,405 15,940 15,940 15,940 Country China Sector Metals & Mining Net debt 4,323 111 -8,272 -13,389 Analyst Thomas J Zhu Contact +852 2822 4325 Shareholders’ funds 39,303 44,800 49,743 55,392
Invested capital 41,264 42,699 39,318 39,917 Price relative 34 34 Ratio, growth and per share analysis 29 29 Year to 12/2011a 12/2012e 12/2013e 12/2014e 24 24 Y-o-y % change 19 19 Revenue 53.8 -2.9 -15.7 4.7 EBITDA 15.6 5.2 0.7 10.2 14 14 Operating profit 15.4 6.5 -0.4 11.6 PBT 27.2 -0.3 1.9 14.3 9 9 HSBC EPS 19.6 -1.8 -10.1 14.3 2010 2011 2012 2013 Jiangxi Copper Co Ltd Rel to HANG SENG CHINA ENTERPRISES INDEX Ratios (%) Source: HSBC Revenue/IC (x) 3.0 2.7 2.3 2.5
ROIC 16.3 16.1 14.5 16.7 ROE 17.9 15.4 12.3 12.6 Note: price at close of 25 Jul 2012 ROA 11.8 10.1 8.5 9.0 EBITDA margin 7.4 8.0 9.5 10.0 Operating profit margin 6.4 7.0 8.3 8.8 EBITDA/net interest (x) 49.6 19.8 33.1 137.0 Net debt/equity 10.9 0.2 -16.4 -23.9 Net debt/EBITDA (x) 0.5 0.0 -0.9 -1.3 CF from operations/net debt 153.4 7575.3 - - Per share data (RMB) EPS Rep (diluted) 1.90 1.87 1.68 1.92 HSBC EPS (diluted) 1.90 1.87 1.68 1.92 DPS 0.70 0.28 0.25 0.29 Book value 11.35 12.94 14.37 16.00
178 Natural Resources & Energy China Equity abc July 2012
Jiangxi Copper (358 HK)
Jiangxi Copper offers the highest earnings leverage to copper among major Chinese companies We think its shares will be primarily driven by copper prices; higher by-products prices, including higher gold and sulphuric acid prices, could also push up earnings and thus share prices Initiate coverage with a Neutral (V) rating and target price of HKD19.40 based on blended PE and DCF valuations
Initiating with Neutral (V) Yunnan Copper (000878 CH, Not Rated) and Thomas Zhu* Analyst 48,500 tonnes by Tongling Nonferrous (000630 Jiangxi Copper, based in Jiangxi province, is the The Hongkong and Shanghai CH, Not Rated). The company had c15.0m tonnes Banking Corporation Limited largest copper producer in China. We initiate +852 2822 4325 of copper resources by the end of 2011, representing [email protected] coverage of the company with a Neutral (V) a very long mine life of about 70 years. Simon Francis* rating and a target price of HKD19.40 based on a Head of Metals & Mining 50:50 blend of PE and DCF valuations. Our PE China investment in power grid, RMBbn Research, Asia Pacific The Hongkong and Shanghai valuation is HKD18.50 based on a 7.9x 2012e PE, 400 Banking Corporation Limited +852 2996 6620 and a DCF valuation is HKD20.30. 350 [email protected] 300 We like Jiangxi Copper as it offers the highest Amit Pansari* 250 Analyst earnings leverage to copper among major Chinese 200 HSBC Bank plc +91 80 3001 3760 companies. We expect copper prices to rise in 150 [email protected] 100 2H12e, although the rebound is unlikely to be *Employed by a non-US affiliate strong due to high copper inventories in China. A 50 of HSBC Securities (USA) Inc, 0 and is not registered/ qualified strong demand recovery in downstream sectors or pursuant to FINRA regulations 2008 2009 2010 2011 2012e 1H12 lower copper inventories would lead us to re-visit our rating. Source: CEIC, NDRC, CEC
Leading market position Jiangxi Copper is the largest copper producer in China and has the largest copper resources among Chinese companies. The company produced 202,000 tonnes of mined copper in 2011, much more than the 85,468 tonnes produced by Zijin Mining (2899 HK, OW(V)), 66,324 tonnes by
179 Natural Resources & Energy China Equity abc July 2012
Purest Hong Kong-listed copper play Historically, property sales in China have been a Jiangxi Copper has the highest percentage of leading indicator for Chinese home appliances revenues from copper among major peers. In production. The momentum in Chinese property 2011, revenues from copper represented c85% of GFA sales has improved from -14% y-o-y in total revenues. Gross profit from copper January to -3% y-o-y in June and our property represented c57% of total gross profit. We expect team expects a further pick-up in transaction revenue and profit contributions to remain at volume in 2H12e. If the Chinese property market similar level over the next few years. bottoms out as our property team expects, we should see copper demand from white goods pick Copper demand to pick up in 2H12 on up in 2H12e. rebound in power grid investments… Property sales and white goods production We expect the power industry to remain the biggest driver of Chinese copper demand and the 100% sector to represent c45% of China’s copper 50% consumption in 2012e. China plans to invest RMB375bn in power grids in 2012e, up 2% y-o-y. 0% However, power grid investment came to only cRMB139bn in 1H12, representing only 37% of -50% the full-year target. It seems unlikely to us that the Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Chinese government will significantly reduce its Floor space sold yoy% investment target for the full year, suggesting that Total home appliances produced yoy% copper demand from the power industry should Source: CEIC, HSBC pick up strongly in 2H12.
…and bottoming property market We forecast white goods (primarily air conditioners, fridges and freezers) should represent c16% of China’s copper demand in 2012e, and we expect copper consumption in the sector to grow by 10% y-o-y in 2012e.
Revenue split in 2011 Gross profit split in 2011
Chemical Others Precious products 6% metals 11% 10%
Copper Chemical related products Copper Precious 85% 2% related metals 57% Others 26% 3%
Source: Company data Source: Company data
180 Natural Resources & Energy China Equity abc July 2012
But high inventories likely to limit Net debt/(cash), RMBm prices gains 10,000 20%
According to CRU, copper cathodes inventories at 5,000 10% Shanghai bonded warehouses were c500,000 0 0% tonnes in late June, down from the recent peak of (5,000) 2010 2011 2012e 2013e 2014e -10% c650,000 tonnes in mid-May but still at a very elevated level. Similarly, inventories at the (10,000) -20% Shanghai Futures Exchange declined to 160,973 (15,000) -30% tonnes from the recent peak of c230,000 tonnes but are still high compared to its history. In total, Net debt/(cash) Net debt-to-equity (RHS) these inventories are estimated to account for c30 Source: Company data, HSBC estimates days of China’s real copper demand in 2012e, which we think will likely cap price gains, if any, Experienced management in the China market. Chairman Li Yihuang has 31 years of experience Earnings sensitive to copper prices in the copper industry. He is a senior engineer and is also a deputy of the 11th National People’s We estimate that for a 10% increase in copper Congress. We think management’s professional prices, Jiangxi Copper’s earnings should increase experience will benefit Jiangxi Copper in terms of by 13% in 2012e and 2013e. This is the highest operations and future acquisitions. sensitivity to copper prices among major Chinese companies. Valuation and risks Strong balance sheet Target price of HKD19.40 We expect Jiangxi Copper to be in net debt of We set a target price of HKD19.40 based on a RMB111m by the end of 2012e. We expect the 50:50 blend of PE and DCF valuations. Our PE company to remain in net cash in 2013-14e. valuation is HKD18.50, based on a 7.9x 2012e PE, and our DCF valuation is HKD20.30.
Our PE valuation is based on a 10% discount to its average PE over the past two years. We think our target PE is justified as it reflects: 1) the
Copper inventory at SHFE, tonnes Copper inventory at Shanghai bonded warehouse, tonnes 000s
250,000 700 600 200,000 500 400 300 150,000 200 100 100,000 0
50,000 Jul-11 Apr-11 Oc t-11 Apr-12 Jan-11 Jan-12 mid-June-12 Jul-11 Jul-12 Apr-11 Oct-11 Apr-12 Jan-11 Jan-12
Source: Bloomberg Source: CRU
181 Natural Resources & Energy China Equity abc July 2012
relatively long-term trading multiple of the Risks company; 2) the company’s lower EPS growth We see the following upside risks: Jiangxi and margins in 2012-13e compared to 2010-11; Copper’s earnings are predominantly driven by and 3) the high volatility of the stock. copper prices, which may be higher than we
Jiangxi Copper’s daily PE anticipate, resulting in better-than-expected earnings. The projects in Afghanistan and Peru 15.0 may come on stream sooner than we expect. Production costs may be lower than we expect. 10.0 Downside risks include lower-than-expected 5.0 copper prices and cost rising faster than we expect.
- Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12
Daily P/E
Source: Bloomberg, HSBC
Our DCF valuation is based on the following assumptions:
A cost of capital of 12.5%
Adjusted beta of 1.38 measured against the HSCEI index
Borrowings representing 0% of EV
Copper resources of c15.0m tonnes
Long-run production of c233,300 tpa of mined copper
Copper prices forecasts of USD8,000/tonne in 2012e, USD7,500/ tonnes in 2013e and long- run forecast of USD6,200/ tonnes
Gold prices forecasts of USD1,760/oz in 2012e, USD1,775/oz in 2013e and long-run forecast of USD1,500/oz
Terminal growth rate of 0%
182 Natural Resources & Energy China Equity abc July 2012
DCF valuation Terminal year Year to Dec (RMBm) 2011 2012e 2013e 2014e 2015e 2016e 2017e 2018e 2019e 2020e 2021e …… 2046e Free cash flow calculation Revenues 117,119 113,718 95,851 100,363 92,509 90,518 93,233 96,030 98,911 101,879 104,935 219,710 EBIT 7,465 7,948 7,913 8,829 7,548 7,142 7,425 7,715 8,012 8,316 8,629 18,116 Tax rate 14% 15% 25% 25% 25% 25% 25% 25% 25% 25% 25% 25% NOPAT 6,438 6,756 5,935 6,621 5,661 5,357 5,569 5,786 6,009 6,237 6,472 13,587 Capex, net (1,873) (2,540) (2,540) (1,140) (1,140) (1,140) (1,140) (890) (890) (890) (885) (140) D&A 1,178 1,142 1,239 1,257 1,245 1,229 1,210 1,184 1,152 1,116 1,078 111 Changes in working capital (1,743) (4) 4,682 (716) 1,282 316 (462) (476) (490) (505) (520) (1,099) Free operating CF 4,000 5,355 9,316 6,023 7,048 5,762 5,178 5,605 5,780 5,959 6,145 12,459 DCF inputs WACC inputs Interest-bearing debt as % of EV 0% Terminal FCF growth 0.0% WACC 12.7% Risk-free rate 3.0% NPV of free cash flows 56,949 Market risk premium 7.0% Less net debt/(cash) 111 Beta 1.38 Less minority interests 568 Cost of debt (pre-tax) 5.0% HKD/RMB 1.25 Equity value (HKD m) 70,224 Shares outstanding 3,463 NPV per share (HKD) 20.28
Source: Company data, HSBC estimates
HSBC ratings bands tonnes of copper cathodes (up 16% y-o-y) as the For volatile stocks, the band for a Neutral rating, company expands its smelting capacities. is 10ppt above and below our hurdle rate, which We forecast that Jiangxi Copper will produce for China is 10%. Our target price, together with 229,700 tonnes of copper in concentrates in the expected dividend yield, implies a potential 2013e, up 8% y-o-y. The growth should continue return of 20%, which is within the Neutral band. to be driven by the Dexing mine expansion. We On this basis we rate Jiangxi Copper Neutral (V). forecast copper cathodes production to be flat at Potential return equals the percentage difference 1,100,000 tonnes in 2013e. between the current share price and the target price, including the forecast dividend yield We expect both copper concentrates and copper when indicated. cathodes production to be flat from 2013e onwards. Earnings outlook We have not factored in the potential volume We forecast Jiangxi Copper to achieve net income contribution from the mines in Peru and of RMB6.5bn in 2012e, RMB5.8bn in 2013e and Afghanistan, as we think there is much RMB6.6bn in 2014e. The earnings decline in uncertainty on the timing and final capacities of 2013e will be driven by the decline in copper those mines. prices as forecasted by our commodities team in Metals Quarterly – Q3 2012, 17 July 2012. Copper and gold prices Production and sales volumes Our commodities team expects LME copper prices to average USD8,000/tonne in 2012e, We expect Jiangxi Copper to produce 212,700 USD7,500/tonne in 2013e, down 6% y-o-y, and tonnes of copper in concentrates in 2012e, up 5% USD8,000/tonne in 2014e, up 7% y-o-y. y-o-y. We expect the growth to be driven by the capacity expansion at the Dexing mine. We Our precious metals analyst forecasts London PM forecast Jiangxi Copper to produce 1,090,000 gold prices to average USD1,760/oz in 2012e and
183 Natural Resources & Energy China Equity abc July 2012
to stay almost flat at USD1,775/oz in 2013e and USD1,750/oz in 2014e.
Gold and copper prices 2010 2011 2012e 2013e 2014e Copper prices 7,556 8,820 8,000 7,500 8,000 y-o-y 46% 17% -9% -6% 7% Gold prices 1,225 1,571 1,760 1,775 1,750 y-o-y 26% 28% 12% 1% -1%
Source: Bloomberg, HSBC estimates
Earnings sensitivity Jiangxi’s earnings are highly sensitive to copper prices. For a 10% change in copper prices, Jiangxi Copper’s earnings would change by c13% in 2012e and 2013e.
Earnings sensitivities in 2012e Copper prices, USD/t 6,480 7,200 8,000 8,800 9,680 Net income, RMBm 4,842 5,612 6,467 7,322 8,263 EPS, RMB 1.40 1.62 1.87 2.11 2.39
Source: HSBC estimates
Earnings sensitivities in 2013e Copper prices, USD/t 6,075 6,750 7,500 8,250 9,075 Net income, RMBm 4,368 5,053 5,815 6,578 7,416 EPS, RMB 1.26 1.46 1.68 1.90 2.14
Source: HSBC estimates
184 Natural Resources & Energy China Equity abc July 2012
What is Jiangxi Copper? Resources at the end of 2011 100% interest(t) Attributable in JVs (t) Total Jiangxi Copper is the largest copper producer in Copper 10,890,000 4,070,000 14,960,000 China. The company has six operating mines in Gold 343 42 385 China and seven copper products-processing Silver 9,669 9,669 Molybdenum 265,000 265,000 plants. The company has also acquired a 40% stake Sulphur etc. 106,910,000 106,910,000 in the Northern Peru project and a 25% stake in the Source: Company data, HSBC
Aynak project in Afghanistan. Its Guixi Smelter is the largest copper smelter in China. Production and sales
Jiangxi Copper increased its copper cathode Copper cathodes and copper processing products are capacity from 400ktpa in 2005 to 900ktpa in the main products of Jiangxi copper. The rest of the 2011. It produced c940k tonnes of copper products are by-products of copper refining process. cathode, c578k tonnes of copper products, c25 Jiangxi produced 940k tonnes of copper cathode and tonnes of gold, and c526 tonnes of silver in 2011. 578k tonnes of copper processing products in 2011. About 85% of its revenues came from the copper During 2005 to 2011, copper cathode production segment while precious metals accounted for grew at a CAGR of 14%.
10%, chemicals for 2% and rare metals and others Production volume 2011 for 3%. Copper (c87%) and precious metals Category (t) (c9%) were also the two major contributors in Copper cathodes 940,000 Jiangxi’s 2011 gross profits. Copper processing products 578,000 Gold 25.4 Silver 526.4 Jiangxi has one of the largest copper resources Sulphuric acid 2,370,000 among Chinese companies. Jiangxi’s total proven Pyrite concentrates 1,700,000 Molybdenum concentrates 5,566 copper resources stood at c15m tonnes at the end of Selenium products 283 Ammonium rhenate 3 2011. However, the company’s copper resources Tellurium concentrates 50 have been declining since 2009. In line with this, Bismuth concentrates 801 gold and silver resources have depleted steadily too Source: Company data, HSBC in recent years.
2011 Sales mix 2011 Gross profit mix
Raremetals Raremetals others & others & 3% 3% Chemicals Chemicals Copper Copper 2% 85% 1% Precious 87% Precious metals metals 9% 10%
Source: Company data, HSBC Source: Company data, HSBC
185 Natural Resources & Energy China Equity abc July 2012
Copper production growth outpacing resource growth
Copper resources grew at CAGR 11% (2005-11) Mined copper production grew at CAGR 6% (2005-11)
16,000 90% 220 18%
195 14% 13,000 50% 170 9% 10,000 10% 145 5%
7,000 -30% 120 0% 2005 2006 2007 2008 2009 2010 2011 2005 2006 2007 2008 20 09 201 0 2011
Copper resource (kt) YoY- RHS M ined copper production (k t) YoY- R HS
Source: Company data, HSBC Source: Company data, HSBC
Gold resources grew at CAGR 10% (2005-11) Gold production grew at CAGR 13% (2005-11)
500 60% 30 30%
410 40% 25 23%
320 20% 20 15%
230 0% 15 8%
140 -20% 10 0% 2005 2006 2007 2008 2009 2 010 2011 2005 2006 2007 2008 2009 2010 2011
Gold Resource (t) YoY- RHS Gold Production (t) YoY - RHS
Source: Company data, HSBC Source: Company data, HSBC
Silver resources grew at CAGR 11% (2005-11) Silver production grew at CAGR 8% (2005-11)
12,000 60% 600 16%
10,000 40% 525 12%
8,000 20% 450 8%
6,000 0% 375 4%
4,000 -2 0% 300 0% 2005 2006 20 07 2008 2009 2010 2011 2005 2006 2007 2008 2009 2010 2011
Silv er resources (t) YoY-RHS Silv er Production (t) YoY- R HS
Source: Company data, HSBC Source: Company data, HSBC
186 Natural Resources & Energy China Equity abc July 2012
Raw material supply We estimate 2012 output from the mine to be c156k tonnes. Jiangxi Copper sources raw materials from various sources. For producing copper cathodes, Yongping mine the company primarily sources raw materials from The Yongping mine is also located in northwest its captive mines, imported copper concentrates, Jiangxi. In 2011, the mine produced c20k tonnes domestic copper concentrates, and scrap copper. of copper concentrates, which account for c10% For copper-processing products, Jiangxi uses of the overall mined copper production of Jiangxi. copper cathodes produced by itself and copper At the end of 2010, the mine had c935k tonnes of cathodes sourced from third party manufacturers. copper resources at an average grade of c0.59%. Mine details Resource also contains silver and sulphur.
Jiangxi Copper has six major copper mines in We estimate 2012 production from the mine to be China: Dexing mine (along with the copper factory c20k tonnes. mining area, Fujiawu mining area, and Zhushahong mining area), Chengmenshan mine (along with the Wushan mine Jinjiwo mine), Yongping mine, Dongxiang mine, The mine produced c11k tonnes of copper Wushan mine, and Yinshan mine. The company concentrates in 2011, accounting for c5% of sends all copper concentrates produced from its own copper produced from Jiangxi’s own mines. The mines to the Guixi Smelter for smelting. mine had copper resources of c1.1m tonnes at an average grade of c0.41% at the end of 2010. Dexing mine
The Dexing mine is an open-pit copper mine in Copper production breakdown by mines (HSBC 2011e) northwest Jiangxi. It is Jiangxi’s largest mine and also one of the largest across China. In 2011, the Yon gping mine produced c148k tonnes of copper 10% concentrates, which represents c73% of copper Chengmen produced from Jiangxi’s own mines. Dexing 73% shan Dexing has copper resources of c6.4m tonnes at 9% Wushan an average grade of c0.45% by the end of 2010. 5% There is also 139 tonnes of gold in the mine along Yi nsha n Dongx iang with some silver and sulphur. 2% 1%
Source: Company data, HSBC estimates
Resource profile (as of 2010) Location Main products Resources (as of 2010)(m Production (2011) (k tonnes) tonnes) Dexing mine North-eastern Jiangxi Copper 6.4 148 Yongping mine North-eastern Jiangxi Copper 0.9 20 Wushan mine Jiangxi Province Copper 1.1 11 Chengmenshan mine Jiangxi Province Copper 1.5 18 Yinshan mine Jiangxi Province Copper 0.8 3.5 Dongxiang mine Jiangxi Province Copper 0.2 1
Source: Company data, HSBC
187 Natural Resources & Energy China Equity abc July 2012
We estimate 2012 output from the mine to be c12k. copper cathodes from the smelter in 2011, and we expect 2012 production at 1,090k tonnes. Chengmenshan mine The mine produced c18k tonnes of copper Assets are primarily located in Jiangxi province concentrates in 2011, accounting for c9% of copper produced from Jiangxi’s own mines. The mine had copper resources of c1.5m tonnes at an average grade of 0.99% as at the end of 2010.
We estimate 2012 output from the mine to be c19k tonnes. Yinshan Mine The mine produced c3.5k tonnes of copper concentrates in 2011, accounting for c2% of copper produced from Jiangxi’s own mines. The Source: Company data, HSBC mine had copper resources of c809k tonnes at an average grade of 0.5% as at the end of 2010. In Management Profile 2011, the company completed Yinshan Mining’s Mr. Li Yihuang is currently the Chairman and 50k tonnes production expansion. General Manager of the company. He is also a deputy of the 11th National People’s Congress, We estimate 2012 output from the mine to be c4k member of the 11th Jiangxi Provincial Party tonnes. Committee and the 5th Outstanding Youthful Dongxiang Mine Entrepreneur of Jiangxi Province. The mine produced c1k tonnes of copper Mr. Li Baomin is the Vice Chairman and concentrates in 2011, accounting for c1% of executive Director of the Company. copper produced from Jiangxi’s own mines. The mine had copper resources of c160k tonnes at an Major shareholders average grade of 0.49% as at the end of 2010. Jiangxi Copper Corporation is the company’s We estimate 2012 output from the mine to be largest shareholder, with a c39% stake. JCC is c1k tonnes. a wholly state-owned company under the Jiangxi government. Guixi Smelter HKSCC Nominees Ltd holds a c38% stake in Guixi Smelter is one of the largest copper Jiangxi Copper and is the second largest smelters and refineries in the world. The company shareholder in the company. uses Guixi for processing both copper concentrates and scrap copper. IPO and secondary listing
This smelter has a capacity to produce 900k Jiangxi Copper listed on the Hong Kong Stock tonnes of copper cathodes per annum. During Exchange in 1997. It issued c656m new shares at 2011, the company completed Guixi Smelter’s HKD2.55/share and raised net proceeds of additional 50k tonnes anode copper technology cHKD1.6bn (USD202m). transformation. Jiangxi produced 940k tonnes of
188 Natural Resources & Energy China Equity abc July 2012
Later, during December 2001, the company was listed on the Shanghai Stock Exchange. Jiangxi issued 230m new shares at RMB2.27/share and raised net proceeds of cRMB494m (USD59m).
Production process chart Concentrating Tailing
Copper ore Copper ore Pyrite Copper ore Crushing Milling Flotation deposit mining Concentrate
Copper concentrate Sm elting
Air steam Flash furnace Pre-drying drying
Copp er matte Sulfur Dioxide Slag gas
Sulfuric Acid Converting Slag cleaning making furnace furnace
Blister Copper Water quenching Sulfuric Acid copper matte slag
Anode Con vert er Slag Fu rn ace slag flotation
E lectrolytic Anode slime Copper re fin ing Tailing concentrate Hydro-metallurgical Product processing Copper Process cathode Facility Refining Silver Go ld
P rec ious me ta l Source: Company data, HSBC
189 Natural Resources & Energy China Equity abc July 2012
Jiangxi Copper: Income statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Net Revenues 76,139 117,119 113,718 95,851 100,363 y-o-y change (%) 48% 54% -3% -16% 5%
Cost of sales 68,092 107,348 104,234 86,596 90,129
Gross profit 8,047 9,771 9,484 9,255 10,234 y-o-y change (%) 62% 21% -3% -2% 11% Gross margin 11% 8% 8% 10% 10%
Operating expenses 1,576 2,306 1,535 1,342 1,405 Selling & distribution expenses 346 437 398 383 401 Admin expenses 1,230 1,869 1,137 959 1,004
Income from Operations 6,471 7,465 7,948 7,913 8,829 Operating profit margin (%) 8% 6% 7% 8% 9%
Other income/(expenses) (409) 243 (263) (81) 121 Interest income 74 557 404 601 803 Interest expenses (444) (731) (862) (877) (877) Share of profit/(loss) from associates/JV (13) 56 (5) (5) (5) Others (27) 362200 200 200
PBT 6,061 7,709 7,685 7,832 8,950 PBT margin (%) 8% 7% 7% 8% 9%
Taxation (1,015) (1,060) (1,153) (1,958) (2,238) Effective tax rate (%) 17% 14% 15% 25% 25%
Minority interests 59 61 65 59 67
Net income 4,988 6,587 6,467 5,815 6,645 y-o-y change (%) 109% 32% -2% -10% 14% Net income margin (%) 7% 6% 6% 6% 7%
EPS (RMB) 1.59 1.90 1.87 1.68 1.92 DPS (RMB) 0.20 0.70 0.28 0.25 0.29 Payout ratio 14% 37% 15% 15% 15%
EBITDA 7,477 8,643 9,091 9,152 10,085 EBITDA margin (%) 10% 7% 8% 10% 10%
Source: Company data, HSBC estimates
190 Natural Resources & Energy China Equity abc July 2012
Jiangxi Copper: Balance sheet summary (RMBm) 2010a 2011a2012e 2013e 2014e Assets Current assets 34,875 46,202 52,180 54,198 60,253 Cash 3,864 11,082 15,829 24,212 29,329 Trade & bills receivable 5,169 7,597 7,789 6,565 6,874 Inventories 18,270 14,097 18,562 15,421 16,050 Prepayments & other receivables 4,044 4,973 3,500 3,500 3,500 Pledged deposit 2,439 4,764 3,000 3,000 3,000 Investments & others 1,088 3,689 3,500 1,500 1,500
Fixed assets 16,704 18,092 19,487 20,786 20,667
Other assets 3,267 3,856 3,751 3,753 3,755 Intangible assets 875 847 851 853 855 Exploration and evaluation assets 203 206 200 200 200 Interests in associates/JV 968 1,557 1,500 1,500 1,500 Land lease prepayments 326 428 400 400 400 Deferred assets 185 306 300 300 300 Others 710 510500 500 500
Total assets 54,845 68,150 75,418 78,737 84,675
Liabilities Current liabilities 14,104 22,020 23,439 21,757 21,979 Trade & bills payables 5,105 5,576 7,139 5,457 5,679 Other payables & accruals 1,909 3,234 3,000 3,000 3,000 Derivative financial instruments 1,221 152 - - - S-T borrowings 3,596 9,809 10,000 10,000 10,000 Taxes payable & others 675 886 800 800 800 Others 1,598 2,363 2,500 2,500 2,500
Non-current liabilities 6,203 6,323 6,610 6,610 6,610 L-T borrowings 713 174 440 440 440 Bonds payable 5,178 5,422 5,500 5,500 5,500 Others 312 727670 670 670
Total liabilities 20,307 28,344 30,049 28,367 28,589
Shareholder’s equity 34,123 39,303 44,800 49,743 55,392 Share capital 3,463 3,463 3,463 3,463 3,463 Share premium 12,648 12,648 12,648 12,648 12,648 Retained earnings 9,577 11,346 16,196 20,558 25,542 Reserves 8,436 11,847 12,494 13,075 13,740
Minority interests 414 503 568 627 694
Total liabilities and shareholders’ equity 54,845 68,150 75,418 78,737 84,675
Gearing Gross debt 9,487 15,405 15,940 15,940 15,940 Cash and ST investments 3,864 11,082 15,829 24,212 29,329 Net debt/ (cash) 5,622 4,323 111 (8,272) (13,389)
Shareholders equity including minorities 34,537 39,806 45,368 50,370 56,086 Net debt-to-equity 16% 11% 0% -16% -24%
Source: Company data, HSBC estimates
191 Natural Resources & Energy China Equity abc July 2012
Jiangxi Copper: Cash flow statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Cash flow from operating activities Profit before taxation 6,061 7,709 7,685 7,832 8,950 Depreciation & amortisation 1,012 1,189 1,142 1,239 1,257 Changes in working capital (8,843) (1,743) (4) 4,682 (716) Net interest (paid)/received (135) (359) (174) (458) (276) Tax paid (807) (982) (1,060) (1,153) (1,958) Others 737 819824 (890) (860) Operating cash flow (1,973) 6,632 8,413 11,253 6,398
Cash flow from investing activities Capital expenditure (2,405) (2,462) (2,540) (2,540) (1,140) Acquisitions & disposals (488) (2,632) 57 - - Others (740) 12188 38 38 Investing cash flow (3,633) (4,973) (2,395) (2,502) (1,102)
Cash flow from financing activities Dividends paid (308) (1,385) (2,424) (970) (872) Changes in capital structure 6,739 - - - - Debt movements 1,319 6,280 535 - - Others 28 669618 602 694 Financing cash flow 7,778 5,563 (1,271) (368) (179)
Net changes in cash 2,171 7,223 4,746 8,383 5,117
Cash at start of year 1,703 3,864 11,082 15,829 24,212 FX effects (10) (5) - - - Cash at end of year 3,864 11,082 15,829 24,212 29,329
Source: Company data, HSBC estimates
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Financials & valuation: Maanshan Iron & Steel Neutral (V) Financial statements Key forecast drivers Year to 12/2011a 12/2012e 12/2013e 12/2014e Year to 12/2011a 12/2012e 12/2013e 12/2014e Profit & loss summary (RMBm) Crude steel production (kt) 16,680 18,551 19,461 19,461 Finished steel sales (kt) 15,910 17,668 18,534 18,534 Revenue 86,842 85,717 91,645 89,987 Average selling price (RMB/t) 4,381 4,027 4,104 4,030 EBITDA 6,061 4,440 6,186 6,904 Iron ore price (RMB/t) 1,200 1,020 1,000 900 Depreciation & amortisation -4,386 -4,388 -4,144 -3,613 Coking coal price (RMB/t) 1,625 1,560 1,583 1,536 Operating profit/EBIT 1,674 52 2,041 3,291 RMB:USD 6.46 6.25 6.13 6.12 Net interest -1,302 -1,222 -1,408 -1,406
PBT 301 -570 1,134 2,185 HSBC PBT 301 -570 1,134 2,185 Taxation -112 143 -283 -546 Valuation data Net profit 70 -371 737 1,421 Year to 12/2011a 12/2012e 12/2013e 12/2014e HSBC net profit 70 -371 737 1,421 EV/sales 0.4 0.3 0.3 0.3 Cash flow summary (RMBm) EV/EBITDA 5.0 6.5 4.5 3.9 Cash flow from operations 1,294 6,890 3,879 4,776 EV/IC 0.6 0.7 0.6 0.6 Capex -4,211 -4,000 -3,000 -3,000 PE* 135.8 - 12.8 6.7 Cash flow from investment -4,310 -4,063 -3,000 -3,000 PB 0.4 0.4 0.3 0.3 Dividends 0 0 0 -258 FCF yield (%) -45.7 23.0 5.1 17.5 Change in net debt 5,913 -1,278 -938 -1,501 Dividend yield (%) 0.0 0.0 2.7 5.3 FCF equity -4,427 2,234 492 1,694 *Based on HSBC EPS (diluted)
Balance sheet summary (RMBm) Intangible fixed assets 2,002 1,947 1,892 1,837 Issuer information
1 7 . Tangible fixed assets 37,353 37,020 35,931 35,373 Share price (HKD)1.49 Target price (HKD)1.75 4 Current assets 39,516 36,813 39,917 40,767 Cash & others 10,304 8,573 10,082 11,699 Reuters (Equity) 0323.HK Bloomberg (Equity) 323 HK Total assets 81,113 78,086 80,045 80,282 Market cap (USDm) 2,210 Market cap (HKDm) 17,242 Operating liabilities 21,146 23,338 23,989 22,947 Free float (%) 50 Enterprise value (RMBm) 29,148 Gross debt 31,034 28,026 28,597 28,713 Country China Sector Metals & Mining Net debt 20,731 19,453 18,515 17,014 Analyst Simon Francis Contact +852 2996 6620 Shareholders’ funds 26,954 26,584 27,321 28,483
Invested capital 47,422 43,870 43,669 43,330 Price relative 8 8 Ratio, growth and per share analysis 7 7 Year to 12/2011a 12/2012e 12/2013e 12/2014e 6 6 5 5 Y-o-y % change 4 4 Revenue 33.6 -1.3 6.9 -1.8 3 3 EBITDA -12.8 -26.7 39.3 11.6 2 2 Operating profit -20.1 -96.9 3807.0 61.2 1 1 PBT -82.4 -289.3 - 92.8 0 0 HSBC EPS -93.7 -632.6 - 92.8 2010 2011 2012 2013 Maanshan Iron & Steel Rel to HANG SENG CHINA ENTERPRISES INDEX Ratios (%) Source: HSBC Revenue/IC (x) 2.0 1.9 2.1 2.1
ROIC 2.4 0.1 3.5 5.7 ROE 0.3 -1.4 2.7 5.1 Note: price at close of 25 Jul 2012 ROA 1.5 0.7 2.5 3.5 EBITDA margin 7.0 5.2 6.7 7.7 Operating profit margin 1.9 0.1 2.2 3.7 EBITDA/net interest (x) 4.7 3.6 4.4 4.9 Net debt/equity 71.7 72.8 67.4 59.4 Net debt/EBITDA (x) 3.4 4.4 3.0 2.5 CF from operations/net debt 6.2 35.4 20.9 28.1 Per share data (RMB) EPS Rep (diluted) 0.01 -0.05 0.10 0.18 HSBC EPS (diluted) 0.01 -0.05 0.10 0.18 DPS 0.00 0.00 0.03 0.06 Book value 3.50 3.45 3.55 3.70
194 Natural Resources & Energy China Equity abc July 2012
Maanshan Iron & Steel (323 HK)
Chinese steelmakers, like Maanshan, face a tough outlook with weak demand, excess capacity and little supply-side discipline We recognise the high-beta nature of the stock but expect margins and returns to remain suppressed We resume coverage on Maanshan with a Neutral (V) rating and a target price of HKD1.75 based on a 0.4x 2012e PB
Resume with Neutral (V) over the next three years. This compares to Simon Francis* Head of Metals & Mining average growth of 14% p.a. in 2003-11. Maanshan is one of China’s leading steel makers Research, Asia Pacific The Hongkong and Shanghai with a capacity of c19mtpa. We are resuming We expect Chinese steel prices to continue to be Banking Corporation Limited +852 2996 6620 coverage with a Neutral (V) rating and a target driven by costs with the industry as a whole [email protected] price of HKD1.75 based on a 2012e PB of 0.4x. making poor margins. Maanshan is no exception Chris Chen* to this. Analyst Tough environment for Chinese steel The Hongkong and Shanghai Banking Corporation Limited makers… …and a poor outlook for earnings and +852 2822 4277 [email protected] Like Angang, and other steel producers in China, returns Amit Pansari* Maanshan faces issues that we believe are both As a result of these issues, the outlook for Analyst structural and substantial. The market remains Maanshan’s earnings and returns is poor, in our HSBC Bank plc +91 80 3001 3760 highly fragmented with competition based largely view. We forecast the company’s ROEs at [email protected] on selling price. The industry has excess production between -1% and +5% in 2012-14e. We expect *Employed by a non-US affiliate of HSBC Securities (USA) Inc, capacity and there is little to no supply-side Maanshan to post a loss in 2012e (1Q12 net loss and is not registered/ qualified discipline among producers. At the list-co level, was RMB468m) and to make a small profit in pursuant to FINRA regulations companies have very little upstream integration into 2013e. Our net income forecasts represent a profit raw materials and therefore almost no control over per tonne sold of just USD7 in 2013e and USD13 production costs. in 2014e. We do not see profitability returning to the levels enjoyed in the 2003-08 commodities So far the Chinese government has not been up-cycle anytime soon. successful in addressing these issues.
Furthermore, the demand outlook is weak. We forecast average annual demand growth of 5%
195 Natural Resources & Energy China Equity abc July 2012
Maanshan net income (RMBbn) improve because of the structural issues in the
4 industry mentioned above.
3 Expansion of Changjiang mostly
2 completed … In April 2011, Maanshan acquired a 55% equity 1 stake in Changjiang Iron and Steel, a 1mtpa long 0 products producer that is located close to
-1 Maanshan. The expansion of Changjiang’s capacity to 3mtpa has been mostly completed. In 2003 2004 2005 2006 2007 2008 2009 2010 2011
2012F 2013F 2014F January to May 2012, Changjiang produced 950k Source: Company data, HSBC estimates tonnes of steel products. We forecast Changjiang
will contribute 2.2m tonnes of steel products in Is there a risk of a stimulus-driven 2012e and 3m tonnes in 2013e when it reaches rally? full capacity. In 2011, Changjiang produced 1.1m Like Angang, Maanshan is a high beta stock (beta tonnes of steel products. of 1.24 measured against the HSCEI) and ... and Hefei could be relocated at historically there has been a close correlation some time between Chinese money supply growth and the share price. Maanshan has a plan to relocate its 1.5mtpa iron and steel making capacity at Hefei and to convert Maanshan share price vs. China M2 money supply growth Hefei into a pure processing plant. The NDRC has 8 30% not yet approved the project. Management believes the chance of getting approval is now 6 25% higher, following the recent approval of the 4 20% Fangchenggang and Zhanjiang projects. Once
2 15% approved, the relocation project will take approximately one and a half to two years to 0 10% complete. Jul-09 Jul-10 Jul-11 Jan-09 Jan-10 Jan-11 Jan-12 In our view, the biggest difficulty is that the Hefei Maanshan H (LHS) M2 y oy (RHS) plant employs some 6,000 people. As a state-
Source: Thomson Reuters Datastream, HSBC owned company, it is unlikely Maanshan will lay off people in order to streamline production. We Consequently, Maanshan is also viewed as a way think the move is likely to be expensive in terms to gain exposure to government stimulus. We make of capex and returns are likely to be poor. the same cautions as for Angang, namely, that: Balance sheet Our China economist does not expect fiscal We expect Maanshan’s balance sheet to continue stimulus of the magnitude seen in 2009. to improve over the next three years with net-debt- to-equity declining to 59% by the end of 2014 The Chinese government is stimulating from current levels of above 70%. because underlying demand is weak.
Even if demand can be stimulated, Maanshan’s earnings outlook is unlikely to
196 Natural Resources & Energy China Equity abc July 2012
Maanshan net debt (RMBbn) and gearing view this as a reasonable valuation in the context
25 100% of the weak earnings outlook and given previous
20 80% trough points. We forecast Maanshan’s ROEs at between -1% and +5% over the next three years. 15 60% 10 40% Angang’s and Maanshan’s PB
5 20% 2.5
0 0% 2.0
1.5 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012F 2013F 2014F Net Debt Net Debt/ Equity (RHS) 1.0
Source: Company data, HSBC estimates 0.5
0.0 We forecast capex at RMB4.0bn in 2012e, Jul-09 Jul-10 Jul-11 Jul-12 virtually all of which is maintenance capex. There Jan-09 Apr-09 Oct-09 Jan-10 Apr-10 Oct-10 Jan-11 Apr-11 Oct-11 Jan-12 Apr-12 Angang Maanshan are no major projects currently underway; Source: Company data, Thomson Reuters Datastream, HSBC although we do expect higher capex once the relocation of Hefei plant is approved.
Valuations and risks Maanshan’s ROE and PB
PB-based target price 1.8 25%
We value the Chinese steel stocks using a PB 1.5 20% methodology because margins are thin and 1.2 15% earnings are both weak and volatile. We determine the target PB primarily by reference to our ROE 0.9 10% forecasts as well as historical trends. 0.6 5% 0.3 0% Maanshan’s daily PB
1.8 1999 2000 2001 2002 2003 2004 2005 2006 2007 20 08 2009 2010 2011 P/BV (LHS) ROE (RHS)
1.4 Source: Company data, HSBC
1.0 We also calculate daily EV/EBITDA and EV per tonne of capacity valuations on a one-year 0.6 forward basis. Since iron ore prices were floated
0.2 in April 2010, Maanshan has traded at an average EV/tonne of USD338. Jul-09 Jul-10 Jul-11 Jul-12 Jan-09 Jan-10 Jan-11 Jan-12
Source: Company data, Thomson Reuters Datastream, HSBC We calculate Maanshan is currently trading at an EV/tonne of USD234, representing a discount of Our target PB for Maanshan is 0.4x. Our target 67% to the estimated replacement cost of multiple represents a 20% discount to our target USD700/tonne. The stock reached a peak for Angang of 0.5x, and is in line with the average valuation of USD635/tonne in October 2007 and a of a 20% discount over the past two years. We trough of USD175/tonne in October 2008.
197 Natural Resources & Energy China Equity abc July 2012
Risks Maanshan’s daily EV/EBITDA The main upside risk to our view is that Chinese 9 steel prices are stronger than expected. This could 8 arise from stronger-than-expected demand or from 7 structural changes in the industry, resulting in a reduction of the amount of excess capacity. The 6 company may be able to develop more niche 5 market products that attract better margins. The 4 company may be able to reduce production costs Jul-09 Jul-10 Jul-11 Jul-12 below our forecasts. Jan-09 Jan-10 Jan-11 Jan-12
The main negative risk, in our view, is that steel Source: Company data, Thomson Reuters Datastream, HSBC prices are lower than expected, resulting in lower Maanshan’s daily EV/t (USD/t) earnings and a lower valuation. The company’s proposed relocation of the Hefei plant may take 550 500 longer or cost more than expected. 450 HSBC ratings bands 400 For volatile stocks, the band for a Neutral rating, 350 300 is 10ppt above and below our hurdle rate, which 250 for China is 10%. Our target price, together with 200 the expected dividend yield, implies a potential Jul-09 Jul-10 Jul-11 Jul-12
return of 17%, which is within the Neutral band. Jan-09 Jan-10 Jan-11 Jan-12 On this basis we rate Maanshan Neutral (V). Source: Company data, Thomson Reuters Datastream, HSBC Potential return equals the percentage difference between the current share price and the target Poor earnings outlook price, including the forecast dividend yield when We expect Maanshan to generate a net loss of indicated. RMB371m in 2012e, and net income of RMB737m in 2013e and RMB1.4bn in 2014e. We are cautious that there is very little visibility to these forecasts given the low margin nature of the business and the highly volatile nature of the main drivers: steel, iron ore and coking coal prices.
We estimate Maanshan will achieve an average ROE of just 2% over the next three years.
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Historical and forecast ROEs Selling prices 25% We expect Maanshan’s average selling price to 20% decline by 8% y-o-y to RMB4,027/tonne in 2012e 15% and increase slightly by 2% y-o-y to RMB4,104/tonne in 2013e. We do not think steel 10% prices will pick up meaningfully in 3Q12e as 5% large steel companies, such as Baoshan and 0% WISCO, have already announced price cuts for -5% July deliveries. Maanshan is likely to follow suit to remain competitive. 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012F 2013F 2014F Source: Company data, HSBC estimates Production costs
We expect Maanshan’s production costs to Sales volume decline y-o-y mainly on lower raw material costs. Maanshan is currently operating at a c90% Maanshan imports 70-75% of its iron ore utilisation rate. Despite weak steel prices, requirement and sources the remaining from its management has no intention of cutting output – parent company and domestic third parties. The and nor have many other Chinese steel makers – average price of 62% Fe content iron ore cfr as the cost of resuming blast furnace production is China has declined to USD141/tonne in 1H12 considered high. from USD177/tonne in 1H11 and USD159/tonne Maanshan sold 15.9m tonnes of steel products in in 2H11. We estimate Maanshan’s average cost of 2011, up 10% y-o-y. Management reckons that iron ore will decline by 15% y-o-y to production from Maanshan ‘headquarters’ has RMB1,020/tonne in 2012e and by a further 2% y- declined y-o-y in the period from January to May o-y to RMB1,000/tonne in 2013e.
2012, reflecting some now-resolved operating Iron ore prices, 62% Fe, cfr China issues. Even so, total production and sales volume 200 are still likely to be higher in 2012e than in 2011, USD/t accounting for the contribution from Changjiang. 175
We forecast sales volume of 17.7m tonnes in 150 2012e, up 11% y-o-y and 18.5m tonnes in 2013e, 125 up 5% y-o-y. There is little room to increase production and sales volumes further given the 100 current utilisation rate unless management spends Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 money on additional capacity expansion. Iron ore fines import prices, cfr Tianjin port
Long products currently account for roughly half Source: Bloomberg of Maanshan’s sales mix. This proportion shall further increase after Changjiang reaches its full Maanshan purchases virtually all of its coking capacity of 3mtpa. This makes Maanshan by far coal from China. The average price of Liulin No.4 the most long products-focused company among coking coal fell by 4% y-o-y and 3% q-o-q in the main listed companies. 2Q12. We forecast Maanshan’s coal costs to fall by 4% y-o-y in 2012e and increase slightly by 2% y-o-y in 2013e.
199 Natural Resources & Energy China Equity abc July 2012
Chinese coking coal prices What’s the consensus? 1,800 Rmb/t This high degree of earnings sensitivity – and thus 1,700 uncertainty – is born out in consensus estimates. 1,600 The consensus forecast for 2012 (taking recent 1,500 1,400 estimates only) is for net income of RMB122m. 1,300 Recent estimates vary from a low of a net loss of 1,200 RMB1.0bn to a high of a net profit of RMB1.6bn. Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 HSBC versus consensus earnings No.4 Coking Coal: Lvliang: Liulin Year to Dec(RMBm) 2012e 2013e 2014e 1/3 Coking Coal: Linfen: Puxian 122 848 1,332 Consensus Source: SXCoal - High end estimate 1,575 3,790 5,333 - Low end estimate (1,023) 29 20
Earnings sensitivity HSBC estimate (371) 737 1,421 Source: Bloomberg, HSBC estimates Given the poor level of earnings, our earnings forecasts are highly sensitive to changes in the main earnings drivers; steel prices and iron ore and coking costs.
We estimate that a 1% increase in average steel prices would turn Maanshan’s loss of RMB371m into a net income of RMB91m in 2012e and increase Maanshan’s earnings by 68% in 2013e.
We estimate that a 1% increase in iron ore costs would further increase Maanshan’s losses by 50% in 2012e and decrease Maanshan’s earnings by 26% in 2013e.
200 Natural Resources & Energy China Equity abc July 2012
What is Maanshan Iron & Maanshan crude steel production (mt)
Steel? 20 Changjiang Hefei ac quisition Maanshan Iron & Steel (Maanshan) is one of the 11th 5y r plan acquisition 15 top ten steel producers in China. It is expected to Structural reform in the 10th 5y r plan have a crude steel capacity of c19mtpa by the end 10 of 2012e, with c14.5mtpa at its works in Maanshan, c1.5mtpa at Hefei Steel and c3mtpa at 5 Changjiang Steel. Maanshan is a state-owned 0 company and is 50% owned by Magang (Group)
Holding Company. 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: Company data, HSBC Production Maanshan mainly produces steel using the blast Sales furnace process. The company’s steel production Flat products accounted for c62% of sales units are located in inland areas and thus it has a volume, long products c37% and train wheels for cost disadvantage over the coastal steel makers. c1% in 2011. The company mainly sells its Maanshan produced c16.7m tonnes (up 10% products in the domestic market. y-o-y) of crude steel in 2011, helped by the Maanshan 2011 finished steel sales by products acquisition of Changjiang steel in May 2011. Maanshan’s ‘headquarters’ production remained Steel plates largely flat at c15mtpa from 2008 to 2010 as there 45% Section was no capacity growth during that period. steel The company produces both flat and long 17% products and produced c16m tonnes of finished Train steel in 2011. Maanshan is also the largest wheels Wire rods producer of train wheels in China. 1% 37%
Source: Company data, HSBC
Raw Materials Maanshan does not have any upstream integration in iron ore or coking coal.
201 Natural Resources & Energy China Equity abc July 2012
Maanshan: Income statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Net Revenues 64,981 86,842 85,717 91,645 89,987 y-o-y change (%) 25% 34% -1% 7% -2%
Cost of sales 61,439 83,590 84,379 88,229 85,346
Gross Profit 3,542 3,252 1,338 3,416 4,641 y-o-y change (%) 40% -8% -59% 155% 36% Gross profit margin (%) 5% 4% 2% 4% 5%
Operating Expenses 1,446 1,577 1,286 1,375 1,350 Selling and distribution costs 238 286 171 183 180 Administrative expenses 1,208 1,291 1,114 1,191 1,170
Income from Operations 2,096 1,674 52 2,041 3,291 Operating profit margin (%) 3% 2% 0% 2% 4%
Non-operating income/(expenses) (385) (1,373) (622) (908) (1,106) Interest costs (914) (1,472) (1,345) (1,529) (1,547) Interest income 72 169 123 121 142 Exchange gains/(losses) 134 348 300 200 - Investment income 220 150 100 100 100 Others 103 (569) 200 200 200
PBT 1,711 301(570) 1,134 2,185 PBT margin (%) 3% 0% -1% 1% 2%
Taxation (520) (112) 143 (283) (546) Effective tax rate (%) 30% 37% 25% 25% 25%
Minority interests (90) (120) 57 (113) (219)
Net income 1,102 70 (371) 737 1,421 y-o-y change (%) 181% -94% -633% nm 93% Net income margin (%) 2% 0% 0% 1% 2%
EPS (RMB) 0.14 0.01 (0.05) 0.10 0.18 DPS (RMB) 0.05 0.00 0.00 0.03 0.06 Payout ratio 35% 0% n.a. 35% 35%
EBITDA 6,954 6,061 4,440 6,186 6,904 EBITDA margin (%) 11% 7% 5% 7% 8%
Source: Company data, HSBC estimates
202 Natural Resources & Energy China Equity abc July 2012
Maanshan: Balance sheet summary (RMBm) 2010a 2011a2012e 2013e 2014e Assets Current assets 30,515 39,516 36,813 39,917 40,767 Cash and bank balances 6,383 10,303 8,572 10,081 11,698 Trade receivables 9,472 10,634 10,568 11,299 11,094 Inventories 12,452 14,132 15,026 15,712 15,199 Others 2,209 4,447 2,648 2,825 2,776
Fixed assets 36,191 37,353 37,020 35,931 35,373 Property, plant and equipment 34,406 32,415 31,083 29,993 29,436 Construction in progress 1,785 4,937 5,937 5,937 5,937
Other assets 3,398 4,244 4,252 4,197 4,142 Intangibles 1,863 2,002 1,947 1,892 1,837 Long term equity investment 1,034 1,611 1,700 1,700 1,700 Investment properties 7 5 5 5 5 Deferred tax assets 494 626 600 600 600
Total assets 70,105 81,113 78,086 80,045 80,282
Liabilities Current liabilities 29,166 29,433 28,056 28,762 27,760 Short-term loans and borrowings 8,835 8,884 5,605 5,719 5,743 Trade payables 10,820 12,573 13,871 14,503 14,029 Tax payables (411) (326) 143 (283) (546) Other payables and accruals 9,923 8,302 8,438 8,823 8,535
Non-current liabilities 12,940 22,748 23,308 23,824 23,900 Bank loans 11,369 12,907 22,421 22,878 22,971 Convertible bond 998 9,244 - - - Deferred income 573 553 857 916 900 Others - 4430 30 30
Shareholders’ equity 27,294 26,954 26,584 27,321 28,483 Share capital 7,701 7,701 7,701 7,701 7,701 Capital reserve 8,338 8,338 8,338 8,338 8,338 Retained profits 8,008 7,456 7,085 7,822 8,985 Others 3,247 3,459 3,459 3,459 3,459
Minority interests 705 1,978 138 138 138
Total liabilities and shareholders’ equity 70,105 81,113 78,086 80,045 80,282
Gearing Gross debt 21,201 31,034 28,026 28,597 28,713 Cash and ST investment 6,384 10,304 8,573 10,082 11,699 Net debt/ (cash) 14,818 20,731 19,453 18,515 17,014
Shareholders equity including minorities 27,999 28,933 26,722 27,459 28,622 Net debt-to-equity 53% 72% 73% 67% 59%
Source: Company data, HSBC estimates
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Maanshan: Cash flow statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Cash flow from operating activities Profit before tax 1,711 301 (570) 1,134 2,185 Depreciation and amortisation 4,852 4,386 4,387 4,144 3,613 Change in working capital (8,512) (4,863) 2,874 (1,002) (258) Others 149 1,470 200 (397) (765) Operating cash flows (1,800) 1,294 6,890 3,879 4,776
Cash flow from investing activities Capital expenditure (2,081) (4,211) (4,000) (3,000) (3,000) Others 2,418 (99) (63) - - Investing cash flows 337 (4,310) (4,063) (3,000) (3,000)
Cash flow from financing activities Dividends paid (503) - - - (258) Debt movements 406 8,732 (3,008) 571 116 Others (760) (1,818) (1,550) 59 (17) Financing cash flows (856) 6,914 (4,559) 630 (158)
Net increase/ (decrease) in cash (2,319) 3,899 (1,731) 1,509 1,617 Exchange difference 2 22 - - - Net cash movement (2,318) 3,920 (1,731) 1,509 1,617
Source: Company data, HSBC estimates
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Financials & valuation: Mongolian Mining Corp Overweight (V) Financial statements Key forecast drivers Year to 12/2011a 12/2012e 12/2013e 12/2014e Year to 12/2011a 12/2012e 12/2013e 12/2014e Profit & loss summary (USDm) Raw coal production (mt) 7.1 11.7 15.7 17.0 HCC sales volume (mt) 1.5 6.8 9.3 9.5 Revenue 543 1,038 1,415 1,561 HCC selling price (USD/t) 156 135 140 146 EBITDA 166 299 447 565 SSCC sales volume (mt) 0 1 1 1 Depreciation & amortisation -19 -28 -36 -63 SSCC selling price (USD/t) 0 86 90 98 Operating profit/EBIT 146 271 411 502 Unit production cost (USD/t) 66 56 57 56 Net interest 10 -14 -17 -20
PBT 155 257 394 481 HSBC PBT 155 257 394 481 Taxation -36 -64 -99 -120 Valuation data Net profit 119 193 296 361 Year to 12/2011a 12/2012e 12/2013e 12/2014e HSBC net profit 119 193 296 361 EV/sales 4.2 2.3 1.7 1.6 Cash flow summary (USDm) EV/EBITDA 13.6 8.0 5.5 4.5 Cash flow from operations 21 192 313 418 EV/IC 1.8 1.5 1.3 1.1 Capex -292 -340 -380 -480 PE* 16.2 10.0 6.5 5.3 Cash flow from investment -215 -153 -380 -480 PB 2.5 2.0 1.5 1.2 Dividends 0 0 0 0 FCF yield (%) -14.6 -7.7 -3.5 -3.2 Change in net debt 758 148 67 62 Dividend yield (%) 0.0 0.0 0.0 0.0 FCF equity -281 -148 -67 -62 *Based on HSBC EPS (diluted)
Balance sheet summary (USDm) Intangible fixed assets 681 679 677 675 Issuer information
7 7 . Tangible fixed assets 530 844 1,190 1,609 Share price (HKD)4.03 Target price (HKD)7.15 4 Current assets 395 1,042 990 962 Cash & others 228 752 601 539 Reuters (Equity) 0975.HK Bloomberg (Equity) 975 HK Total assets 1,628 2,587 2,879 3,268 Market cap (USDm) 1,925 Market cap (HKDm) 14,931 Operating liabilities 148 242 322 350 Free float 40 Enterprise value (USDm) 2,402 Gross debt 562 1,234 1,150 1,150 Country Hong Kong Sector Metals & Mining Net debt 334 482 549 611 Analyst Simon Francis Contact +852 2996 6620 Shareholders’ funds 769 962 1,258 1,618
Invested capital 1,231 1,572 1,935 2,358 Price relative Ratio, growth and per share analysis 13 13 12 12 Year to 12/2011a 12/2012e 12/2013e 12/2014e 11 11 10 10 Y-o-y % change 9 9 8 8 7 7 Revenue 95.5 91.3 36.3 10.4 6 6 EBITDA 112.6 80.5 49.5 26.2 5 5 Operating profit 95.8 85.1 51.7 22.0 4 4 PBT 86.7 66.3 53.2 22.1 3 3 HSBC EPS 98.0 62.1 53.2 22.1 2010 2011 2012 2013 Mongolia Mining Corp Rel to HANG SENG INDEX Ratios (%) Revenue/IC (x) 0.7 0.7 0.8 0.7 Source: HSBC
ROIC 14.9 14.5 17.6 17.5 ROE 15.9 22.3 26.6 25.1 Note: price at close of 25 Jul 2012 ROA 9.6 10.5 12.2 12.9 EBITDA margin 30.6 28.8 31.6 36.2 Operating profit margin 27.0 26.1 29.1 32.1 EBITDA/net interest (x) 21.9 26.6 27.7 Net debt/equity 43.4 50.1 43.7 37.8 Net debt/EBITDA (x) 2.0 1.6 1.2 1.1 CF from operations/net debt 6.3 39.9 56.9 68.4 Per share data (USD) EPS Rep (diluted) 0.03 0.05 0.08 0.10 HSBC EPS (diluted) 0.03 0.05 0.08 0.10 DPS 0.00 0.00 0.00 0.00 Book value 0.21 0.26 0.34 0.44
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Mongolian Mining Corp (975 HK)
Mongolian Mining has excellent growth prospects, and the fastest forecast EPS growth in our Greater China/Mongolia universe Trading at a 44% discount to our life-of-mine DCF valuation, we view the stock as compellingly cheap We initiate coverage with an Overweight (V) and a target price of HKD7.15 based on a life-of-mine DCF valuation
Initiate with Overweight (V) We see the company gaining from the vast Simon Francis* Head of Metals & Mining amount of infrastructure being put in place to We initiate coverage of Mongolian Mining with Research, Asia Pacific reduce transportation hurdles. The Hongkong and Shanghai an OW(V) rating and target price of HKD7.15 Banking Corporation Limited +852 2996 6620 based on a life-of-mine DCF valuation. Natural advantages in Mongolia [email protected]
Mongolian Mining is a high-quality coking coal We see Mongolian Mining as enjoying natural Chris Chen* Analyst producer and exporter in Mongolia. It owns and advantages in supplying coal into China: The Hongkong and Shanghai Banking Corporation Limited operates an open-pit coking coal mine at Ukhaa Mongolia has most coal qualities and is +852 2822 4277 [email protected] Khudag, which is located within the Tavan Tolgoi within 300km of the border with China. coal formation and the Baruun Naran deposit. Amit Pansari* Analyst Both assets are in South Gobi, Mongolia. Mining conditions are generally favourable HSBC Bank plc with low-strip ratios that can be open-pit mined. +91 80 3001 3760 Strong demand for Mongolian coal [email protected] The infrastructure is land rather than sea *Employed by a non-US affiliate Mongolian Mining stands to be a major based and can be scaled cheaply, e.g., by of HSBC Securities (USA) Inc, beneficiary of increasing demand for Mongolian and is not registered/ qualified opening new border crossing points, building pursuant to FINRA regulations coals, especially from China. Mongolian coking additional storage facilities and new roads. coal exports have grown rapidly over the past few years. We estimate coking coal exports at 18.7m Weather conditions in southern Mongolia, tonnes in 2011, up from just 4.0m tonnes in 2008. while cold, are benign for the mining industry. Further, we calculate Mongolia has accounted for roughly two-thirds of the increase in world coking coal exports over the past three years.
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Strong earnings outlook driven by a result of the delay in the railway, the company is increasing production now examining whether it can modify its mine Mongolian Mining has the fastest earnings growth plan to extend the mining of hard coking coal prospects, we believe, among our Greater China grades by one more year. The results of this study metals and mining universe. We forecast EPS are expected by 3Q12. growth of 62% in 2012e and a further 53% in 2013e. The original plan was to construct the railway in One of the key features of the mine plan is the two stages, with an initial phase of 15mtpa and a rapid ramp-up in raw coal production. At Ukhaa second phase expanding capacity to 30mtpa, but Khudag, run-of-mine production rose from 1.8m now management is likely to build out the full tonnes in 2009 to 7.1m tonnes in 2011. In 4Q11, 30mtpa capacity in one go. This is partly because the run-of-mine production was 900k tonnes per Mongolian Mining’s own mining operations are month, equivalent to an annualised production now larger and also because other mines along the rate of c10.8mtpa. route have also increased output. It is likely that any excess railway capacity will be sold to other We expect Mongolian Mining’s raw coal coal mining companies at market rates. production, including Baruun Naran to rise by 65% y-o-y in 2012 to 11.7m tonnes and by a Mongolian royalties now settled further 34% y-o-y in 2013e to 15.7m tonnes. In 2011, Mongolian introduced a new royalty Railway project now approved regime whereby companies were charged a base royalty of 5% and an additional royalty based on The proposed railway from Ukhaa Khudag to the selling price of the product. One issue last year Gants Mod is expected to take two years to was that the coal price on which royalties were complete at a capex cost of around USD800m. calculated was often much higher than the actual This cost comprises USD700m for the Russian selling prices of the coal. This led to effective gauge (1,520mm) railway and another USD100m royalty rates being much higher than normal. for a trans-shipment facility at the Chinese border. This is necessary to link up with the Chinese This year, the system has been changed so that: 1) standard gauge (1,430mm) railway. the benchmark price on which royalties are calculated seem to more accurately reflect actual Management now expects to commence market prices; and 2) additional royalty charges construction this summer. We forecast project vary according to the selling price of the coal. For capex of USD300m in 2012e, a further USD300m coal prices of USD130-160/t, the additional in 2013e with the remainder spent in 2014-16e. royalty is 1.5%. These new rules have become We expect the railway to generate significant quite well established already and it seems transportation cost savings. Management estimates unlikely that there will be further changes. that transportation from Ukhaa Khudag to Gants As a result, we expect Mongolian Mining’s Mod costs USD24-25/t by gravel road, USD18-20/t effective royalty to decline from 8.9% in 2011 to by paved road and just USD10/t by railway. 6.5% in 2012e. One point worth noting is that Mongolian Mining needs the railway to be able to profitably transport thermal coal to China. The road haulage costs are too high for thermal coal to be sold at a profit. As
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Year to Dec (USD m) 2011 2012e 2013e 2014e 2015e 2016e 2017e 2018e 2019e 2020e 2021e 2022e 2023e 2024e 2025e …… 2045e Free cash flow calculation Revenue 543 1,038 1,415 1,561 1,378 1,360 1,622 1,671 1,721 1,772 1,826 1,880 1,937 1,995 2,055 612 Y-o-y 96% 91% 36% 10% -12% -1% 19% 3% 3% 3% 3% 3% 3% 3% 3% 3% EBIT 146 271 411 502 416 402 458 477 496 516 537 558 580 602 625 129 EBIT margin 27% 26% 29% 32% 30% 30% 28% 29% 29% 29% 29% 30% 30% 30% 30% 21% NOPAT 113 203 308 376 312 301 343 358 372 387 403 418 435 452 469 129 Capex, net (394) (340) (380) (480) (80) (80) (80) (80) (80) (80) (80) (80) (80) (80) (80) (80) Depreciation 19 28 36 63 81 85 89 74 76 77 78 79 79 80 80 85 Change in working capital (36) (29) (19) (6) 17 4 (14) (1) 1 2 5 21 3 3 4 9 Free operating CF (FoCF) (299) (137) (55) (47) 330 310 338 351 369 386 405 438 437 455 473 144 DCF Inputs WACC inputs Interest-bearing liabilities as a % of EV 30% Terminal FCF growth 0% WACC 8.4% Risk-free rate 3% NPV of free cash flows 3,876 Market risk 7% Add net cash/(debt) (482) Beta 1.00 Less market value of minorities - Cost of debt (pre-tax) 6% = Equity value 3,394 / Number of shares 3,705 / HKD:USD exchange rate 7.80 = NPV per share (HKD) 7.15
Source: HSBC estimates
Valuation and risks Earnings-based valuation Target price of HKD7.15 Mongolian Mining’s PE and EV/EBITDA valuations have fallen significantly since listing as Our life-of-mine DCF-valuation is HKD7.15 is the production at the main Ukhaa Khudag mine based on the following assumptions: has increased. While production volumes are Long-run production volume of 18mtpa from increasing rapidly at present, we view 2013 as the Ukhaa Khudag mine and 5mtpa from the first year of ‘normalised’ earnings and on that Baruun Naran mine. basis believe the stock has yet to establish a normal trading range. The Ukhaa Khudag mine to be depleted in 2040e and Baruun Naran mine to be depleted Daily PE of Mongolian Mining in 2045e. 45.0
Average recovery rate of 63% for hard coking 35.0 coal, 15% for thermal coal middlings and 25.0 75% for thermal coal products at Ukhaa Khudag mine; Average recovery rate of 60% 15.0 at Baruun Naran mine. 5.0 A cost of capital of 8.4%. Jul-11 Jul-12 Oct-10 Apr-11 Oct-11 Apr-12 Jan-11 Jan-12 Adjusted beta of 1.0 measured against the Source: Company data, Thomson Reuters Datastream, HSBC HSCEI index.
Borrowings representing 30% of EV.
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Daily EV/EBITDA of Mongolian Mining Mine output
35.0 x We forecast raw coking coal output of 11.7m 30.0 tonnes in 2012e, 15.7m tonnes in 2013e, and 25.0 17.0m tonnes in 2014e. 20.0 15.0 We expect output from the Ukhaa Khudag mine 10.0 to be 10.7m tonnes in 2012e, 14.7m tonnes in 5.0 2013e and 15.0m tonnes in 2014e. We assume the Ukhaa Khudag mine will start to produce thermal Jul-11 Jul-12 Oct-10 Apr-11 Oct-11 Apr-12 Jan-11 Jan-12 coal and less coking coal from 2015e onwards.
Source: Company data, Thomson Reuters Datastream, HSBC We forecast the Baruun Naran mine will contribute 1m tonnes of coal output in each of Risks 2012e and 2013e, and 2m tonnes of coal in 2014e. Our investment hinges upon the successful We expect production to ramp up to 5mtpa from development of the UHG and Baruun Naran 2017e onwards. Products from Baruun Naran mines and the company achieving our forecast mine are assumed to be all semi-soft coking coal. selling prices and production costs. The development of new mines is inherently risky and We expect the Ukhaa Khudag mine to be depleted there are risks that the development of these in 2040e and the Baruun Naran mine to be projects take longer or cost more than we depleted in 2045e. anticipate, resulting in lower earnings and a lower Sales volumes DCF valuation. Mongolian Mining sold 3.3m tonnes of raw hard HSBC ratings band coking coal, 1.5m tonnes of clean coking coal, For volatile stocks, the band for a Neutral rating is and 20k tonnes of thermal coal middling by- 10ppt above and below our hurdle rate, which for products in 2011. Mongolia is 10%. Our target price implies a We forecast the company will only sell 300k potential return of 77%, which is above the Neutral tonnes of raw coal (inventory carried forward band. On this basis, we rate Mongolian Mining from 2011), 6.8m tonnes of clean coking coal, Overweight (V). Potential return equals the 1.9m tonnes of thermal coal middlings, and 550k percentage difference between the current share tonnes of semi-soft coking coal produced from the price and the target price, including the forecast Baruun Naran mine in 2012e. dividend yield when indicated. Earnings outlook In 2013e, we expect all three 5mtpa coal handling and preparation plants to be completed and We expect Mongolian Mining to achieve net commissioned and the company has the capacity income of USD193m in 2012e, up 62% y-o-y, to wash all raw coal mined. We expect the USD296m in 2013e, up 53% y-o-y and USD361m Mongolian Mining to sell 9.3m tonnes of clean in 2014e, up 22% y-o-y. We expect growth to be coking coal, 2.2m tonnes of thermal coal mostly driven by higher volume and a better sales middlings, and 600k tonnes of semi-soft coking mix, partly offset by weaker coking coal prices. coal in 2013e.
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Selling prices What is Mongolian Mining Corporation? Management expects 1H12 prices to substantially deteriorate from 2011 due to weaker Chinese and Mongolian Mining Corp is the largest coking coal seaborne coking coal prices. We forecast producer and exporter in Mongolia. It had JORC Mongolian Mining’s average clean hard coking (Joint Ore Reserves Committee)-compliant coal coal price will slump by 13% y-o-y to USD135/t reserves of 460m tonnes and coal resources of in 2012e and rebound by 4% y-o-y to USD140/t c853m tonnes at the end of 2011. The company in 2013e. We estimate prices of average semi-soft owns and operates open-pit coal mines at the clean coal to be USD86/t in 2012e and rise by 5% Ukhaa Khudag deposit. In June 2011, company y-o-y to USD90/t. We assuming Mongolian acquired Baruun Naran, which holds the mining Mining will sell its thermal coal middlings at a license for the Baruun Naran coking coal mine. flat USD38/t in both 2012e and 2013e. Mongolian Mining produced c7.1m tonnes (+82% Production costs y-o-y) of run-of-mine coal in 2011 and sold c4.8m tonnes of raw and washed hard coking coal, all of We expect production costs to fall by 15% y-o-y which was exported to China. to USD56/t in 2012e and marginally increase by 1% y-o-y to USD57/t in 2013e. The lower costs in Run-of-Mine coal production (mt)
2012e are mainly due to lower transportation 8 costs, and VAT-related and royalty fees. We 6 assume other production costs to be mostly flat due to Mongolian Mining’s efforts on cost control 4 given the deteriorated coal market. 2
Mongolian Mining completed and commissions 0 the paved road between its Ukhaa Khudag coal 2009 2010 2011 mine and the Gants Modd border-crossing in Coal production 4Q11. We expect the paved road will save Mongolian Mining transportation costs amounting Source: Company data, HSBC to cUSD5/t. Coal assets Starting from 2013e, the company will sell mostly Ukhaa Khudag deposit clean coal, we estimate that will reduce the The Ukhaa Khudag deposit is situated in the Tavan effective royalty fee by cUSD3/t and VAT-related Tolgoi coal formation in South Gobi, Mongolia. expense by cUSD2/t. The deposit is the close to Baotou, China, which is Earnings sensitivity a major railway hub connecting Mongolian coal to the largest steel producing provinces in China. Due We estimate that a 1% increase in average selling to the favourable geological conditions and prices would raise our net profit estimate by 3% proximity to its target market in China, the each in both 2012e and 2013e. company has lower operational costs than most of its global competitors. The deposit has reserves of 275m tonnes and resources of c571m tonnes (67% coking and 33% thermal) at the end of 2011.
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Baruun Naran deposit analysis of the mine development, this is a strong In June 2011, company acquired the entire issued indication that Mongolian Mining will pay the full capital of QGX, which owns the Baruun Naran reserves adjustment. mine, for a consideration of USD464m. It is Given that Baruun Naran is located only 30km located c30 km away from the Ukhaa Khudag away from Ukhaa Khudag and it contains a large mine, in South Gobi, Mongolia. It had reserves of amount of high quality coking coal, there should c185m tonnes and resources of c282m tonnes be substantial capital and operating synergies (54% coking and 46% thermal). Mongolian between the two projects. For one thing, Mining targets to produce c1m tonnes of RoM substantial amounts of the infrastructure can be coal from this mine in 2012. shared across the two projects and transportation The consideration for Baruun Naran was USD464m, capacity can be increased. comprising USD379m in cash and USD85m in This year, management plans to test the mining convertible notes. This consideration is subject to a and washing of the Baruun Naran coals, and to reserves adjustments and a royalty provision. undertake some initial marketing. We factor in a The terms of the convertible note are a HKD10.92 washing yield of 60% though washing yields are conversion price – this was a 20% premium to still being assessed. We expect mine output to be market at the time of issue but is now at a 171% ramped up from the initial level of 1.0mtpa from premium – a 2% coupon, and maturities in 2014e onwards, once feasibility studies are January-March 2013. The note is not substantial completed. At this stage, Mongolian Mining does in terms of the overall business; we calculate that not know whether the asset will be own-mined or if it is fully converted, Mongolian Mining contract-mined. shareholders would be diluted by 2%. Coal resources The reserves adjustment is expected to be made in Coking Thermal Total Coking % Thermal % 1Q13 once a JORC-compliant resources statement Ukhaa Khudag is available. The adjustment is USD3 for each Measured 126.1 69.8 195.9 64% 36% Indicated 214.9 79 293.9 73% 27% tonne of reserves in excess of 105m tonnes, with Inferred 42.2 38.8 81 52% 48% UHG Total 383.2 187.6 570.8 67% 33% the payment limited to a maximum of USD105m Baruun Naran payable by Mongolian Mining. If reserves are less Measured 118.1 91 209.1 56% 44% Indicated 34.8 37.8 72.6 48% 52% than 105m tonnes, the seller will refund Inferred 0.5 0.5 0% 100% Mongolian Mining USD3 per tonne, up to a BN Total 152.9 129.3 282.2 54% 46% Total 536.1 316.9 853 63% 37% maximum of USD90m. Source: Company data, HSBC
In February 2010, McElroy Bryan Geological Services identified 282m tones of JORC- Coal infrastructure compliant measured and indicated resources. Coal handling and preparation plant Mongolian Mining has constructed a coal handling In March 2011, SRK Consulting completed a and preparation plant (CHPP), which comprises of reserves estimation of the Baruun Naran deposit, three processing modules of 5m tonnes of raw coal identifying c185m tonnes of open-pit mineable capacity each and a single product handling system. JORC-compliant proven and probable reserves. It started the first phase with the second and third Although these numbers may change once the phases likely to be operational within 2012. CHPP company completes its life-of-mine study and
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operations enable Mongolian Mining to produce and parallel to the existing coal transport gravel road sell washed coking coal products under its own from Ukhaa Khudag to Gashuun Sukhait. This road brand names and helps in reducing transportation is designed to accommodate a daily traffic density of and logistic costs. up to 2,000 trucks and an annual throughput capacity of 18m tonnes. The paved road has been launched Transport for operation. Mongolian Mining follows truck-and-road transport model, with combined operations via its coal Mongolian Mining has also completed an expansion handling facility at Tsagaan Khad and directly from of the Mongolian side of the border crossing at Ukhaa Khudag to stockpiles at the Gangimaodu Gashuun Sukhait during January 2012. It added border port in China. eight truck crossing lines and associated facilities and infrastructure to the existing four lines and raised In 2011, together with other coal transportation the handling capacity to 1,200 trucks in a single companies in the region, Mongolian Mining direction per day and increased border crossing contributed to the cost of the maintenance of the coal capacity at GS from 10mtpa to 25-30mtpa. haul gravel road between Ukhaa Khudag and Gashuun Sukhait. Mongolian Mining has also constructed a new, 245km hard-surface paved road
Mongolian Mining asset location
Source: Company data
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In order to increase reliability and self sufficiency of Power plant and water supply facilities coal transport, Mongolian Mining has started In 2011, Mongolian Mining constructed an construction of a 240km railway line connecting 18MW on-site power plant that uses the by- Ukhaa Khudag with Gashuun Sukhait. The product from coal mining and processing construction of the railways with c15m tonnes activities to generate power for its CHPP and capacity will end in 2014. Mongolian Mining will other operations. use it, primarily for its own operations, while any Mongolian Mining constructed and commissioned excess capacity will be rented to other mines. a water supply facility, with a capacity to supply up to 117 litres of water per second to support the operations of the group’s CHPP, as well as its production capacity expansion.
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Mongolian Mining: Income statement summary (USD m) 2010a 2011a2012e 2013e 2014e Net Revenues 278 543 1,038 1,415 1,561 y-o-y change (%) 314% 96% 91% 36% 10%
Cost of sales 164 336 664 864 905
Gross Profit 113 206 374 551 656 y-o-y change (%) 300% 82% 81% 47% 19% Gross profit margin (%) 41% 38% 36% 39% 42%
Operating expenses 38 60 103 140 155 As % revenues 14% 11% 10% 10% 10%
Income from Operations 75 146 271 411 502 Operating profit margin (%) 27% 27% 26% 29% 32%
Other Income/(expenses) 8 8 (14) (17) (20) Interest Income 0 22 24 34 28 Interest expenses (4) (12) (38) (51) (49) Others 12 (2)---
PBT 83 155257 394 481 PBT margin (%) 30% 29% 25% 28% 31%
Taxation 23 3664 99 120 Effective tax rate (%) 27% 23% 25% 25% 25%
Net income 60 119 193 296 361 y-o-y change (%) 486% 98% 62% 53% 22% Net income margin (%) 22% 22% 19% 21% 23%
EPS (USD) 0.02 0.03 0.05 0.08 0.10 DPS (USD) - ----
EBITDA 78 166299 447 565 EBITDA margin (%) 28% 31% 29% 32% 36%
Source: Company data, HSBC estimates
215 Natural Resources & Energy China Equity abc July 2012
Mongolian Mining: Balance sheet summary (USD m) 2010a 2011a2012e 2013e 2014e Assets Current assets 715 395 1,042 990 962 Cash and bank 328 41 752 601 539 Time deposit 347 187 - - - Trade receivable 0 37 71 97 107 Inventories 8 5891 118 124 Other receivables 32 72 128 174 193
Fixed assets 309 530 844 1,190 1,609 Property, plant and equipment 77 347 526 572 1,390 Construction in progress 233 183 318 618 218
Other assets 29 703 701 699 697 Intangible assets - 681 679 677 675 Others 29 2222 22 22
Total assets 1,053 1,628 2,587 2,879 3,268
Liabilities Current liabilities 132 554 714 711 738 Short-term bank loans 75 312 400 400 400 Other borrowings - 84 84 - - Current portion of long-term loans 11 22 - - - Trade payables 5 19 36 47 50 Others 41 118194 263 289
Non-current liabilities 194 306 911 911 911 Long-term bank loans 165 145 750 750 750 Deferred tax liability 5 150 150 150 150 Others 24 1111 11 11
Total liabilities 326 859 1,625 1,622 1,649
Shareholders’ equity 727 769 962 1,258 1,618 Share capital 37 37 37 37 37 Share premium 609 609 609 609 609 Retained earnings 61 180 373 669 1,030 Reserves 21 (57) (57) (57) (57)
Total liabilities and shareholders’ equity 1,053 1,628 2,587 2,879 3,268
Gearing Gross debt 251 562 1,234 1,150 1,150 Cash and ST investment 675 228 752 601 539 Net debt/ (cash) (424) 334 482 549 611
Shareholders equity including minorities 727 769 962 1,258 1,618 Net debt-to-equity -58% 43% 50% 44% 38%
Source: Company data, HSBC estimates
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Mongolian Mining: Cash flow statement summary (USD m) 2010a 2011a2012e 2013e 2014e Cash flow from operating activities Profit before tax 83 155 257 394 481 Depreciation and depreciation 3 19 28 36 63 Changes in operating assets and liabilities 7 (129) (29) (19) (6) Net interest income (expenses) (8) (8) (14) (17) (20) Tax paid (15) (26) (64) (99) (120) Others 0 1114 17 20 Operating cash flow 70 21 192 313 418
Cash flow from investing activities Capex (220) (292) (340) (380) (480) Others (344) 77187 - - Investing cash flow (564) (215) (153) (380) (480)
Cash flow from financing activities Changes in capital structure 618 - - - - Debt movements 221 (58) 672 (84) - Others (15) (22) - - - Financing cash flow 823 (80) 672 (84) -
Net increase/ (decrease) in cash 329 (274) 711 (151) (62) Net exchange adjustment (1) (13) - - - Net cash movement 328 (287) 711 (151) (62)
Source: Company data, HSBC estimates
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Financials & valuation: Shougang Fushan Overweight (V) Financial statements Key forecast drivers Year to 12/2011a 12/2012e 12/2013e 12/2014e Year to 12/2011a 12/2012e 12/2013e 12/2014e Profit & loss summary (HKDm) Raw coal sales volume (kt) 2,770 2,300 2,000 1,500 Clean coal sales volume (kt) 2,260 2,370 2,550 2,850 Revenue 7,139 6,792 7,048 6,918 Raw coal ASP (RMB/t) 873 823 835 812 EBITDA 4,150 3,452 3,460 3,250 Clean coal ASP (RMB/t) 1,549 1,497 1,518 1,477 Depreciation & amortisation -544 -443 -418 -450 Raw coal unit cost (RMB/t) 258 272 284 297 Operating profit/EBIT 3,606 3,009 3,043 2,800 Clean coal unit cost (RMB/t) 503 510 534 558 Net interest 37 20 35 48
PBT 3,930 3,314 3,362 3,132 HSBC PBT 3,930 3,314 3,362 3,132 Taxation -1,141 -828 -840 -783 Valuation data Net profit 2,256 2,113 2,143 1,997 Year to 12/2011a 12/2012e 12/2013e 12/2014e HSBC net profit 2,256 2,113 2,143 1,997 EV/sales 0.9 0.7 0.5 0.4 Cash flow summary (HKDm) EV/EBITDA 1.6 1.4 1.1 0.9 Cash flow from operations 3,180 2,119 2,601 2,428 EV/IC 0.4 0.3 0.2 0.2 Capex -346 -650 -650 -650 PE* 4.7 4.9 4.9 5.2 Cash flow from investment 114 -499 -577 -597 P/Book value 0.6 0.5 0.5 0.5 Dividends -861 -951 -964 -899 FCF yield (%) 23.2 17.6 19.4 18.3 Change in net debt -1,782 -1,757 -1,060 -733 Dividend yield (%) 9.6 9.1 9.2 8.6 FCF equity 2,425 1,836 2,031 1,912 *Based on HSBC EPS (diluted)
Balance sheet summary (HKDm) Intangible fixed assets 12,810 12,523 12,294 12,064 Issuer information
5 2 . Tangible fixed assets 3,103 3,598 4,059 4,489 Share price (HKD)1.97 Target price (HKD)3.00 3 Current assets 8,764 10,610 11,618 12,322 Cash & others 4,871 6,930 7,990 8,723 Reuters (Equity) 0639.HK Bloomberg (Equity) 639 HK Total assets 27,000 29,054 30,296 31,200 Market cap (USDm) 1,346 Market cap (HKDm) 10,445 Operating liabilities 3,413 3,038 3,012 3,030 Free float (%) 70 Enterprise value (HKDm) 4,714 Gross debt 898 1,200 1,200 1,200 Country China Sector Metals & Mining Net debt -3,974 -5,730 -6,790 -7,523 Analyst Chris Chen Contact +852 2822 4277 Shareholders’ funds 18,967 20,873 22,066 23,098
Invested capital 16,394 16,763 16,969 17,122 Price relative 10 10 Ratio, growth and per share analysis 9 9 Year to 12/2011a 12/2012e 12/2013e 12/2014e 8 8 7 7 Y-o-y % change 6 6 5 5 Revenue 28.8 -4.9 3.8 -1.8 4 4 EBITDA 26.5 -16.8 0.3 -6.1 3 3 Operating profit 28.1 -16.6 1.1 -8.0 2 2 PBT 33.4 -15.7 1.5 -6.8 1 1 HSBC EPS 25.1 -5.7 2.2 -6.8 2010 2011 2012 2013 Shougang Fushan Rel to HANG SENG CHINA ENTERPRISES INDEX Ratios (%) Source: HSBC Revenue/IC (x) 0.4 0.4 0.4 0.4
ROIC 15.9 13.6 13.5 12.3 ROE 12.2 10.6 10.0 8.8 Note: price at close of 25 Jul 2012 ROA 10.6 9.0 8.7 7.8 EBITDA margin 58.1 50.8 49.1 47.0 Operating profit margin 50.5 44.3 43.2 40.5 EBITDA/net interest (x) - - - - Net debt/equity -19.3 -25.3 -28.4 -30.1 Net debt/EBITDA (x) -1.0 -1.7 -2.0 -2.3 CF from operations/net debt Per share data (HKD) EPS Rep (diluted) 0.42 0.40 0.40 0.38 HSBC EPS (diluted) 0.42 0.40 0.40 0.38 DPS 0.19 0.18 0.18 0.17 Book value 3.53 3.94 4.16 4.36
218 Natural Resources & Energy China Equity abc July 2012
Shougang Fushan Resources (639 HK)
Fushan’s stable annual raw coal output and high quality coal offers strong cash flow and a high dividend yield We think Fushan’s share price correction over the past year has more than reflected the no-growth scenario and an expectation of weaker coking coal prices Resume coverage of Shougang Fushan with an Overweight (V) and a target price of HKD3.00 based on blended PE and DCF valuation
Resume at Overweight (V) sulphur content, all highly desirable for Chris Chen* Analyst steelmaking. We resume coverage of Shougang Fushan The Hongkong and Shanghai Banking Corporation Limited (Fushan) with an Overweight (V) rating and a Fushan’s coal attracts premium prices by virtue of +852 2822 4277 [email protected] target price of HKD3.00 based on a blended PE the excellent quality. In the future, the price Simon Francis* and DCF valuation. We apply a 50:50 blend premium may expand, reflecting increased demand Head of Metals & Mining between a PE-based target of HKD2.70 based on for high quality coking coal from large blast Research, Asia Pacific The Hongkong and Shanghai 6.7x 2012e PE, and a DCF valuation of HKD3.30. furnaces. We believe Fushan’s premium quality Banking Corporation Limited +852 2996 6620 hard coking coal should make its selling prices Despite its lack of volume growth, Fushan owns [email protected] more resilient in a volatile coking coal market. quality coal assets located in prime location, which Amit Pansari* Analyst offers stable operating cash flow to the company. Fushan vs. Liulin no.4 & no.9 clean coking coal prices HSBC Bank plc +91 80 3001 3760 Fushan’s share price has plummeted by 57% in 1,600 [email protected] 1,500 the past 12 months. We think the share price *Employed by a non-US affiliate 1,400 of HSBC Securities (USA) Inc, correction more than fully reflects Fushan’s lack 1,300 and is not registered/ qualified Rmb/t 1,200 pursuant to FINRA regulations of growth and an expectation of weaker coking 1,100 coal prices. 1,000 High quality coal assets, but… 1Q10 3Q10 1Q11 3Q11 1Q12 Fushan's clean coal ASP Fushan’s three mines in Liulin County, Shanxi Liulin no.4 coking coal, ex.VAT contain high quality coking coal with high Liulin no.9 coking coal, ex.VAT calorific value and caking ability and low ash and Source: SXCoal, HSBC
219 Natural Resources & Energy China Equity abc July 2012
Fushan’s major clients are located reasonably a coal project in Canada. We think the current close to Fushan’s mines, making transportation weak coking coal pricing may offer good cheap and convenient. Two of Fushan’s biggest opportunities time for the company to purchase clients are Shougang Group and Hebei Iron & assets at reasonable prices. Steel, which are located in Hebei Province. Strong balance sheet Another major client, Baotou Iron & Steel is located in Inner Mongolia. Fushan had net cash of HKD4.0bn at the end of 2011. We estimate the net cash balance will rise to …virtually no volume growth HKD5.7bn at the end of 2012e. This represents net One key issue for Fushan is its lack of organic cash per share of HKD1.08, equivalent to 55% of volume growth. Fushan’s three mines have a the current share price and 36% of our target price. combined capacity of ~6.3m tpa and are already operating at close to full utilisation rates. We see The strong cash balance and stable operating cash little growth in raw coal production volume over flow should position the company well for any the next couple of years. potential acquisitions or future projects including the Lianshan project. Lianshan seems unlikely to be approved soon Fushan’s greenfield Lianshan project is still Fushan’s historical and forecast net cash pending NDRC approval and we do not think the 8.0 approval will come through soon. Hard coking 7.0 coals are scarce resources in China and the 500m 6.0 tonnes of unexplored premium hard coking coal in 5.0 4.0 Lianshan mine are considered as strategic assets. HK$ bn HK$ 3.0 With Fushan being more than 70% owned by non- 2.0 Chinese domestic investors, we wonder whether 1.0 the group structure will have to change before the - project is approved. 2009 2010 2011 2012E 2013E 2014E
The Lianshan project has a designed capacity of Source: Company data, HSBC estimates
4m tpa. If approved it would take approximately As a cash rich company, Fushan offers attractive four years to construct and will add c60% to dividend yields. The company pays out ~45% of current production volume. net income, which implies dividend yields of c9% Future M&A in 2012-14e. We expect Fushan’s current three mines to be It seems unlikely to us that management will depleted by 2030e. Given the long delays in the substantially raise the dividend payout, because Lianshan project, management seems anxious to the company is focused on growing the business secure growth through acquisitions. As a foreign through acquisitions. enterprise, Fushan is not qualified to consolidate mines in China. Realistically, this means the only Share buyback coming to the end options are either to expand through joint ventures Fushan has bought back and cancelled 78.7m in China or to buy overseas assets. shares since December 2011. This effectively Management has been actively looking at increases Shougang Group’s stake in Fushan to overseas projects and they are currently looking at 29.9%. Once the interests exceed the 30%
220 Natural Resources & Energy China Equity abc July 2012
threshold, Shougang Group will have to make a Daily PE of Shougang Fushan mandatory offer under the Takeovers Code. This 26.0 would make any future overseas acquisitions 22.0 more difficult. That said, the company is not 18.0 likely to support its share price through further 14.0 share buybacks in the future in a falling market. 10.0 Fushan’s share buybacks 6.0 Date of Number of Highest price Lowest price repurchases Shares paid paid 2.0 repurchased Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 HKD HKD 20-Dec-11 950,000 2.58 2.55 Source: Company data, Thomson Reuters Datastream, HSBC 21-Dec-11 1,266,000 2.62 2.54 29-Dec-11 840,000 2.64 2.59 9-Jan-12 110,000 2.73 2.64 Our life-of-mine DCF valuation of HKD3.30 is 16-Apr-12 18,286,000 2.71 2.61 based on the following assumptions: 17-Apr-12 16,648,000 2.71 2.65 18-Apr-12 4,408,000 2.71 2.62 25-Apr-12 7,374,000 2.62 2.53 Long-term raw coal production volume of 9-May-12 9,644,000 2.60 2.56 6.25m tpa. 11-May-12 882,000 2.50 2.50 14-May-12 4,706,000 2.52 2.45 15-May-12 7,782,000 2.51 2.39 Average recovery rate of clean coal to remain 16-May-12 4,806,000 2.44 2.40 at 60%. 17-May-12 1,024,000 2.42 2.39 Total 78,726,000 2.73 2.39 A cost of capital of 11.9%. Source: Company data, HSBC
Adjusted beta of 1.3 measured against Valuation and risks HSCEI index.
Target price of HKD3.00 The company remaining in a net cash position We set a target price of HKD3.00 based on a in the long-run. We calculate that if Fushan blended PE and DCF valuation. We apply a was 30% financed by borrowings, our DCF 50:50 blend between a PE-based target of target price would rise to HKD3.65 per share. HKD2.70 based on 6.7x 2012e PE, and a DCF The downside risks to our valuation include valuation of HKD3.30. Weaker-than-expected demand from the steel Our PE valuation is based on Fushan trading at a sector and thus lower coking coal prices; 10% discount to its average PE over the past year. We exclude earlier periods when Fushan traded at Higher production costs due to new tax higher PEs because of the expectation at that time levies; that the Lianshan project may be approved. Our Overpaying for acquisitions target PE is justified by the weaker EPS growth expectation and margins in 2012-13e compared to Risks 2010-11. We see the following downside risks: Fushan’s earnings are predominantly driven by coking coal prices, which may be lower than we anticipate, resulting in weaker-than-expected earnings. The
221 Natural Resources & Energy China Equity abc July 2012
company may overpay for future acquisitions. Production volumes Production costs may be higher than we expect. Fushan’s current three mines in Shanxi are HSBC ratings bands already being operated at close to full capacity of 6.3mtpa. We expect raw coal production to stay For volatile stocks, the band for an Overweight flat over the long term at 6.25m tonnes and we rating is 10ppt above our hurdle rate, which for expect the current three mines to be depleted by China is 10%. Our target price, together with the 2030e. expected dividend yield, implies a potential return of 61%, which is within the Overweight band. On Sales mix this basis we rate Shougang Fushan Overweight We expect Fushan’s sales mix to gradually (V). Potential return equals the percentage improve following the commencement of difference between the current share price and the Zhaiyadi coal washing plants (2.1mtpa) in 4Q10. target price, including the forecast dividend yield Fushan now has the capacity to wash 100% of its when indicated. raw coal.
Earnings outlook We forecast that in 2012e Fushan will sell 2.4m We forecast Fushan will achieve net income of tonnes of clean coal (51% of total sales volume) HKD2.1bn in both 2012e and 2013e and and 2.3m tonnes of raw coal. HKD2.0bn in 2014e. We expect earnings in the In 2013e, we forecast Fushan will sell 2.0m next few years to be relatively flat reflecting a tonnes of raw coal. The remaining 4.3m tonnes of lack of volume growth. We expect earnings to raw coal will be processed into 2.6m tonnes of deteriorate in y-o-y terms in 2012e on lower clean coal, an 8% increase y-o-y. coking coal prices and higher production costs, partly offset by improving sales mix. In the long term, we expect Fushan to sell more clean coal eventually. We forecast that Fushan will start selling 100% clean coal from 2017e after all current raw coal sales contracts are expired.
DCF valuation Year to Dec (HKD m) 2011 2012e 2013e 2014e 2015e 2016e 2017e 2018e 2019e 2020e 2021e …… 2030e Free cash flow calculation Revenue 7,139 6,792 7,048 6,918 6,878 6,683 6,137 6,321 6,511 6,706 6,908 9,013 Y-o-y 29% -5% 4% -2% -1% -3% -8% 3% 3% 3% 3% 3% EBIT 3,606 3,009 3,043 2,800 2,666 2,408 1,872 1,928 1,986 2,046 2,107 2,749 EBIT margin 51% 44% 43% 40% 39% 36% 31% 31% 31% 31% 31% 31% NOPAT 2,559 2,257 2,282 2,100 2,000 1,806 1,404 1,446 1,490 1,534 1,580 2,062 Capex, net (346) (650) (650) (650) (650) (650) (650) (650) (650) (650) (650) (650) Depreciation & amortisation 544 443 418 450 483 515 548 510 536 562 588 674 Change in working capital (276) (158) 26 47 13 246 32 (213) 124 (50) (142) (49) Free operating CF (FoCF) 2,481 1,892 2,076 1,947 1,846 1,918 1,334 1,094 1,500 1,396 1,377 2,036 DCF Inputs WACC inputs Interest-bearing liabilities as a % of EV 0% Risk-free rate 3.0% WACC 11.9% Market risk 7.0% NPV of free cash flows 13,666 Beta 1.3 Add net cash/(debt) 5,730 Cost of debt (pre-tax) 6.0% Less market value of minorities (1,743) Terminal FCF growth 0.0% = Equity value 17,653 / Number of shares 5,340 = NPV per share (HKD) 3.31
Source: Company data, HSBC estimates
222 Natural Resources & Energy China Equity abc July 2012
Sales mix between raw coal and clean coal Production costs 6,000 Management has guided for a 15% y-o-y increase 5,000 in raw coal production costs in 2012e, though this 4,000 is off a base that excludes the one-off relocation 3,000 and environmental restoration costs of 2,000 Tonnes 000s RMB22/tonne in 2011. Including these costs, we 1,000 expect raw coal total production costs to rise by - 5% y-o-y to RMB272/tonne in 2012e on higher
2010 2011 material costs, staff costs and government levies. 2012E 2013E 2014E Raw coal Clean coal We forecast total production costs will rise by 4%
Source: Company data, HSBC estimates y-o-y in 2013e and 2014e.
Earnings sensitivity Selling prices Fushan’s earnings are sensitive to changes in Fushan achieved 1Q12 average selling prices of selling prices. We estimate that in 2012e, a 1% RMB1,518/tonne for clean coal (-1.4% y-o-y and increase in average selling prices would raise our flat q-o-q) and RMB974/tonne for raw coal net profit estimate by 1.6%. (+12% y-o-y and +9% q-o-q). Management expects 2Q12e prices to be weaker q-o-q (down What is Shougang Fushan? RMB50-70/tonne) due to mild domestic Shougang Fushan is the second largest producer oversupply of coking coal. of hard coking coal in China. It produces and sells We expect Fushan’s average raw coal prices to raw and clean coking coal to steel and decline by 6% y-o-y to RMB823/tonne in 2012e metallurgical companies in northern China. and rise by 1% y-o-y to RMB835/tonne in 2013e. The company owns three coking coal mines in We expect average clean coal selling prices to Liulin County, Shanxi province, with aggregate decline by 3% y-o-y to RMB1,497/tonne in 2012e reserves of c118m. Coking coal in this area are of and rise by 1% in 2013e to RMB1,518/tonne. very high quality and are highly desirable for steel Selling prices making due to its high calorific value, caking
1,700 index and low ash and sulphur. 1,500 Fushan’s three mines have a combined capacity of 1,300 6.3m tonnes and are already being operated at 1,100 Rmb/t close to full utilisation rates. Production volumes 900 have been generally flat over the past three years. 700
500 Coal mines
2009 2010 2011 Product Ownership Capacity, kt 2012E 2013E 2014E Raw coal Clean coal Xingwu Hard coking coal 88% 2,100 Jinjiazhuang Hard coking coal 65% 2,100 Zhaiyadi Semi-hard coking coal 95% 2,100 Source: Company data, HSBC estimates Source: Company data
223 Natural Resources & Energy China Equity abc July 2012
Raw coal production volume Major customers 6.5 Fushan’s major customers include Shougang Group, Hebei Iron & Steel, Baotou Iron & Steel 6.0 and Taiyuan Iron & Steel, all located in close 5.5 proximity to Fushan’s mines in Liulin. In 2011, sales to its five largest customers accounted for Tonnes m Tonnes 5.0 c69% of Fushan’s total sales. 4.5 Shareholders 4.0 Shougang Concord currently has a 27.6% equity 2007 2008 2009 2010 2011 stake in Shougang Fushan. Shougang first Source: Company data invested in Shougang Fushan in February 2009 buying a 12% stake at an average HK2.18 per The company also has three coal washing plants share. It further increased its stake to 20.02% in with a processing capacity of 6.3m tonnes that are September 2009, buying an 8% stake at an located close to the mines. average HKD4.28 per share from its parent. The R Coal washing plants stake was increased to 22.8% in December 2009 Commencement Ownership Capacity, kt in exchange for Shougang Concord’s 14.4% stake date in Mount Gibson and further increased to 27.6% Xingwu 2008 88% 1,200 Jinjiazhuang June 2009 65% 3,000 following the recent share buybacks. Zhaiyadi 4Q2010 95% 2,100
Source: Company data
224 Natural Resources & Energy China Equity abc July 2012
Shougang Fushan: Income statement summary (HKD m) 2010a 2011a2012e 2013e 2014e Net Revenues 5,543 7,139 6,792 7,048 6,918 y-o-y change (%) 24% 29% -5% 4% -2%
Cost of sales 1,452 2,110 2,289 2,455 2,596
Gross Profit 4,092 5,029 4,503 4,593 4,322 y-o-y change (%) 35% 23% -10% 2% -6% Gross profit margin (%) 74% 70% 66% 65% 62%
Operating expenses 1,277 1,423 1,494 1,551 1,522 Selling expenses 381 636 611 634 623 Admin expenses 621 606 611 634 623 Other operating expenses 275 181 272 282 277
Income from Operations 2,815 3,606 3,009 3,043 2,800 Operating profit margin (%) 51% 51% 44% 43% 40%
Other Income/(expenses) 131 324 305 319 333 Other operating income 144 287 285 285 285 Interest income 27 59 83 107 120 Interest expenses (40) (21) (63) (72) (72)
PBT 2,946 3,930 3,314 3,362 3,132 PBT margin (%) 53% 55% 49% 48% 45%
Taxation (529) (1,141) (828) (840) (783) Effective tax rate (%) 18% 29% 25% 25% 25%
Loss from discontinued operations (202) (139) - - -
Minority Interest (412) (394) (373) (378) (352)
Net Income 1,803 2,256 2,113 2,143 1,997 y-o-y change (%) 60% 25% -6% 1% -7% Net income margin (%) 33% 32% 31% 30% 29%
EPS (HKD) 0.34 0.42 0.40 0.40 0.38 DPS (HKD) 0.15 0.19 0.18 0.18 0.17 Payout ratio 45% 45% 45% 45% 45%
EBITDA 3,280 4,150 3,452 3,460 3,250 EBITDA margin (%) 59% 58% 51% 49% 47%
Source: Company data, HSBC estimates
225 Natural Resources & Energy China Equity abc July 2012
Shougang Fushan: Balance sheet summary (HKD m) 2010a 2011a 2012e 2013e 2014e Assets Current assets 6,895 8,764 10,610 11,618 12,322 Cash and bank 2,766 4,517 6,580 7,640 8,373 Pledged bank deposit 33 354 350 350 350 Amounts due from related parties/loan to a party 996 253 300 300 300 Trade and bills receivable 2,318 3,351 2,977 2,896 2,843 Inventories 135 191 219 235 249 Others 648 98 183 196 208
Fixed assets 2,732 3,103 3,598 4,059 4,489
Other assets 16,492 15,132 14,847 14,618 14,390 Mining rights 10,414 10,563 10,277 10,047 9,818 Goodwill 2,156 2,247 2,247 2,247 2,247 Others 3,922 2,322 2,323 2,324 2,325
Total assets 26,120 27,000 29,054 30,296 31,200
Liabilities Current liabilities 3,318 4,311 3,878 3,852 3,870 Borrowings 233 898 840 840 840 Trade and bills payable 538 1,031 941 908 960 Accruals and other payables 1,395 1,648 1,600 1,600 1,600 Others 1,152 734 497 504 470
Non-current liabilities 3,179 2,131 2,560 2,560 2,360 Long-term borrowings 898 - 360 360 360 Deferred tax liability 2,280 2,131 2,200 2,200 2,000
Total liabilities 6,496 6,442 6,438 6,412 6,230
Shareholders’ equity 18,150 18,967 20,873 22,066 23,098 Share capital 538 538 530 530 530 Share premium 14,619 14,619 14,619 14,619 14,619 Retained earnings 973 2,177 2,759 3,844 4,777 Reserves 2,020 1,633 2,966 3,073 3,173
Minority Interest 1,473 1,592 1,743 1,818 1,872
Total liabilities and shareholders’ equity 26,120 27,000 29,054 30,296 31,200
Gearing Gross debt 1,132 898 1,200 1,200 1,200 Cash and ST investment 3,323 4,871 6,930 7,990 8,723 Net debt/ (cash) (2,191) (3,974) (5,730) (6,790) (7,523)
Shareholders equity including minorities 19,623 20,558 22,617 23,884 24,970 Net debt-to-equity -11% -19% -25% -28% -30%
Source: Company data, HSBC estimates
226 Natural Resources & Energy China Equity abc July 2012
Shougang Fushan: Cash flow statement summary (HKD m) 2010a 2011a2012e 2013e 2014e Cash flow from operating activities Income before tax 2,946 3,930 3,314 3,362 3,132 Depreciation and amortisation 465 544 443 418 450 Changes in working capital (986) (276) (158) 26 47 Net interest received (paid) (34) 12 83 107 120 Tax paid (445) (839) (828) (840) (783) Others 180 (192)(735) (471) (538) Operating cash flow 2,126 3,180 2,119 2,601 2,428
Cash flow from investing activities Capex (759) (346)(650) (650) (650) Additions of non-current assets (42) (38) - - - Others 80 498 151 73 53 Investing cash flow (720) 114 (499) (577) (597)
Cash flow from financing activities Dividend paid (863) (861) (951) (964) (899) Changes in capital structure 15 (8) (204) - - Debt movements 334 (230) 302 - - Others (267) (563)1,296 - (200) Financing cash flow (781) (1,662) 444 (964) (1,099)
Net increase/ (decrease) in cash 625 1,632 2,063 1,060 733 Net exchange adjustment 37 119 - - - Net cash movement 662 1,751 2,063 1,060 733
Source: Company data, HSBC estimates
227 Natural Resources & Energy China Equity abc July 2012
Financials & valuation: Yanzhou Coal Mining Co Neutral (V) Financial statements Key forecast drivers Year to 12/2011a 12/2012e 12/2013e 12/2014e Year to 12/2011a 12/2012e 12/2013e 12/2014e Profit & loss summary (RMBm) Coal sales volume (mt) 64 81 86 96 - Self produced coal (mt) 51 61 66 76 Revenue 47,066 50,859 53,953 58,947 - Coal trade (mt) 13 20 20 20 EBITDA 16,008 11,830 12,530 14,221 Coal ASP (RMB/t) 708 610 607 596 Depreciation & amortisation -3,005 -3,778 -4,462 -4,811 Coal unit cost (RMB/t) 243 250 264 267 Operating profit/EBIT 13,003 8,053 8,068 9,410 RMB:USD 6.46 6.25 6.13 6.12 Net interest -482 -274 -300 -138
PBT 12,521 7,778 7,769 9,272 HSBC PBT 12,521 7,778 7,769 9,272 Taxation -3,545 -1,945 -1,942 -2,318 Valuation data Net profit 8,928 5,805 5,798 6,919 Year to 12/2011a 12/2012e 12/2013e 12/2014e HSBC net profit 8,928 5,805 5,798 6,919 EV/sales 1.3 1.3 1.3 1.1 Cash flow summary (RMBm) EV/EBITDA 3.9 5.5 5.5 4.7 Cash flow from operations 17,977 5,204 8,349 9,533 EV/IC 1.1 1.0 0.9 0.9 Capex -8,620 -12,000 -12,000 -8,000 PE* 5.0 7.7 7.8 6.5 Cash flow from investment -25,611 -8,998 -11,365 -7,229 PB 1.1 1.0 0.9 0.8 Dividends -2,902 -2,803 -1,451 -1,449 FCF yield (%) 16.0 -7.3 -3.3 8.5 Change in net debt 3,157 3,794 3,015 -2,304 Dividend yield (%) 6.2 3.2 3.2 3.8 FCF equity 7,182 -3,267 -1,475 3,848 *Based on HSBC EPS (diluted)
Balance sheet summary (RMBm) Intangible fixed assets 28,072 27,252 26,432 25,612 Issuer information
1 5 . Tangible fixed assets 31,274 40,336 48,715 52,744 Share price (HKD)11.10 Target price (HKD)12.80 3 Current assets 30,431 35,690 33,450 36,915 Cash & others 17,710 19,458 16,443 18,747 Reuters (Equity) 1171.HK Bloomberg (Equity) 1171 HK Total assets 97,152 108,356 113,744 120,491 Market cap (USDm) 11,355 Market cap (HKDm) 88,571 Operating liabilities 15,148 17,780 18,792 20,035 Free float (%) 47 Enterprise value (RMBm) 65,551 Gross debt 34,458 40,000 40,000 40,000 Country China Sector Metals & Mining Net debt 16,748 20,542 23,557 21,253 Analyst Simon Francis Contact +852 2996 6620 Shareholders’ funds 42,634 45,636 49,982 55,452
Invested capital 56,919 66,040 73,361 76,487 Price relative 38 38 Ratio, growth and per share analysis 33 33 Year to 12/2011a 12/2012e 12/2013e 12/2014e 28 28 Y-o-y % change 23 23 Revenue 38.7 8.1 6.1 9.3 18 18 EBITDA 2.0 -26.1 5.9 13.5 13 13 Operating profit 0.8 -38.1 0.2 16.6 PBT 0.3 -37.9 -0.1 19.3 8 8 HSBC EPS -3.8 -35.0 -0.1 19.3 2010 2011 2012 2013 Yanzhou Coal Mining Co Lt Rel to HANG SENG CHINA ENTERPRISES INDEX Ratios (%) Source: HSBC Revenue/IC (x) 0.9 0.8 0.8 0.8
ROIC 19.1 10.8 9.6 10.3 ROE 22.3 13.2 12.1 13.1 Note: price at close of 25 Jul 2012 ROA 11.3 6.4 5.9 6.6 EBITDA margin 34.0 23.3 23.2 24.1 Operating profit margin 27.6 15.8 15.0 16.0 EBITDA/net interest (x) 33.2 43.1 41.8 103.1 Net debt/equity 38.7 44.3 46.4 37.8 Net debt/EBITDA (x) 1.0 1.7 1.9 1.5 CF from operations/net debt 107.3 25.3 35.4 44.9 Per share data (RMB) EPS Rep (diluted) 1.82 1.18 1.18 1.41 HSBC EPS (diluted) 1.82 1.18 1.18 1.41 DPS 0.57 0.30 0.29 0.35 Book value 8.67 9.28 10.16 11.27
228 Natural Resources & Energy China Equity abc July 2012
Yanzhou Coal (1171 HK)
Yanzhou Coal has ambitious plans to triple production from 2011 to 2015. Much of this growth will be ‘back-end loaded’ meaning the immediate contribution to earnings is small With a substantial proportion of spot market sales, earnings are likely to decline sharply this year, though the shares have already been significantly sold-off Resume coverage with a Neutral (V) and a target price of HKD12.80 based on a blended PE and DCF valuation
Resume at Neutral (V) Ambitious plans to triple production… Simon Francis* Head of Metals & Mining Yanzhou Coal operates six mines in Shandong In 2011, Yanzhou Coal announced its aim to triple Research, Asia Pacific The Hongkong and Shanghai province with a combined capacity of c35mtpa its saleable coal production to 150mtpa in the 12th Banking Corporation Limited and two mines in Inner Mongolia with capacity of Five-Year Plan – i.e. by 2015. Broadly speaking, +852 2996 6620 [email protected] 7mtpa as at Dec 2011. The company also owns the plan is to have 50mtpa in each of Shandong Chris Chen* the Shanxi Neng Hua mine in Shanxi Province. In (where Yanzhou Coal is headquartered), Inner Analyst Mongolia (where is has relatively small The Hongkong and Shanghai Australia, Yanzhou operates through its wholly Banking Corporation Limited owned subsidiary Yancoal Australia, which is operations now but substantial plans for +852 2822 4277 [email protected] listed on the Australian Stock Exchange on 28 expansion) and Australia (where subsidiary Amit Pansari* June, following its merger with Gloucester Coal. Yancoal Australia has just been listed). Analyst HSBC Bank plc We resume coverage of Yanzhou Coal with a Over the past few years, the company has +91 80 3001 3760 [email protected] Neutral (V) rating and a target price of HKD12.80 developed a solid track record of buying assets based on a 50:50 blended PE and DCF valuation. *Employed by a non-US affiliate overseas. The acquisition of Felix Resources in of HSBC Securities (USA) Inc, Our PE valuation is HKD13.25, based on a 9.0x December 2009 and the acquisition of Gloucester and is not registered/ qualified pursuant to FINRA regulations 2012e PE, and our DCF valuation is HKD12.35. Coal this year are both a testament to this. The recent merger with Gloucester Coal boosts The primary factors by which Yanzhou Coal Yanzhou’s coal reserves by c293m tonnes and assesses acquisition opportunities are: 1) the should eventually boost production by c12mtpa. quality and quantity of reserves, and 2) the legal The main risks appear to be a slower-than- environment. The certainty of the legal expected build-out of the Australian mines, environment is important to management and that seaborne thermal coal prices falling more than we is reflected in its acquisitions to date being in expect and a volatile Australian dollar. Australia and not, for instance, in Indonesia or
229 Natural Resources & Energy China Equity abc July 2012
Yanzhou Coal’s existing and new projects Coal field Coal type Reserves Capacity 2011 output Status
Shandong 6 mines Thermal 1,763 34.0 34.0 Stable production Shandong Beisu Thermal/PCI 17 1.0 1.0 Stable production Shandong Yangsun Thermal/PCI 22 1.2 1.0 Stable production Heze Nenghua Zhaolou 1/3 coking 165 3.0 3.0 Stable production Heze Nenghua Wanfu PCI 160 1.8 - 2014-2015 Total Shandong 2,127 41.0 39.0
Shanxi Nenghua Tianchi Thermal 41 1.2 1.2 Stable production Total Shanxi 41 1.2 1.2
Ordos Neng Hua Anyuan Thermal 36 2.0 2.3 Stable production Ordos Neng Hua Wenyu Thermal 46 5.0 2.1 Stable production Haosheng Shilawusu Thermal 1,540 10.0 - 2014-2015 Zhuan Longwan Zhuan Longwan Thermal 250 5.0 - end-2013 Ying Panhao Ying Panhao Thermal 1,040 12.0 - 2014-2015 Total Inner Mongolia 2,912 34.0 4.4
YanCoal Australia Austar Semi-hard 44 3.6 1.9 Stable production YanCoal Australia Ashton Semi-soft 57 5.2 1.7 2011 production impacted YanCoal Australia Moolarben Thermal 315 16.0 5.6 expansion limited by port capacity YanCoal Australia Yarrabee PCI 57 3.0 3.1 Stable production YanCoal Australia Gloucester Basin Semi-hard/thermal 84 2.0 1.9 Rising to 3m tpa by 2015 YanCoal Australia Donaldson Semi-soft/thermal 161 5.0 1.6 Rising to 5m tpa by 2016 YanCoal Australia Middlemount Semi-hard/PCI 96 1.8 0.2 Rising to 2m tpa by 2014 Syntech Holdings Cameby Downs Thermal 440 16.0 0.8 Westfarmers Premier Thermal 472 5.0 - Total Australia 1,726 57.6 16.8
Source: Company data, HSBC estimates
Mongolia where the policy environment is less As of December 2011, Yanzhou has six mines in certain. We do not expect this acquisition strategy Shandong with a combined capacity of c35mtpa. to change in the immediate future. It has further acquired two mines, Beisu and Yangcun mines, with capacity of 1mtpa each this We estimate the development of mines that we April from its parent company. already know of will result in annual production of around 108mtpa of saleable coal. In that sense, the In Inner Mongolia, the company currently has two growth plans are already reasonably well-developed. mines with capacity of 7mtpa in total. There are three other mines under construction now with a We do not have sufficient operational or financial combined capacity of 28mtpa which management details to be able to model all the projects expects to commission from 2013e. individually and that means there are risks to our forecasts as these details become available. For In Australia, the original mines including Austar, example, capex or operational costs may be higher Ashton and Yarrabee are expected to reach than we anticipate and projects may be delayed. capacity of 30mtpa. The merger with Gloucester will add another c14mtpa. Although Yanzhou Coal’s long-term growth prospects appear to be good, we forecast only …yet the near-term outlook is tough anaemic growth over the next couple of years; the We expect Yanzhou Coal’s earnings to decline by expected development of most of these projects is 35% y-o-y in 2012e, driven mainly by weaker ‘back-end loaded’. selling prices. We believe Yanzhou Coal’s high exposure to spot market prices – both in China
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and in the international market – makes 2Q12e De-rated in terms of earnings earnings vulnerable to disappointments. valuations, yet outperforming other Plummeting Chinese thermal coal prices from major coal stocks April through June 2012 suggest much weaker Similar to other major Chinese coal stocks, earnings in q-o-q terms in 2Q12e. Yanzhou Coal shares have been substantially de- Strong cash balance rated in terms of earnings-based valuations over the past year. Despite its ambitious growth plans, we expect Yanzhou Coal to maintain a solid balance sheet Calculated on a daily one-year forward basis, the with net-debt-to-equity reaching a peak of 46% in PE valuation has declined from above 16x a year 2013e before declining to 38% in 2014e. ago to around 8x now and the daily, one-year forward EV/EBITDA multiple has declined from Yanzhou’s net debt (cash) (RMBbn) and gearing above 10x a year ago to below 6x now. 30 50% 25 Yanzhou Coal’s valuations rose sharply from 20 30% 15 October 2010 to July 2011, before being de-rated. 10% 10 Consequently, there is no established trading 5 -10% - range for the stock and no appropriate ‘average’ (5) -30% (10) multiple. We set our target PE at 9.0x 2012e, (15) -50% which is higher than the current multiple. 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012e 2013e 2014e We do expect coal prices to recover through Net debt (Cash) Net debt-to-equity (RHS) 2H12e (though we do not expect a dramatic
Source: Company data, HSBC estimates recovery) and that supports the notion that the earnings multiples has bottomed.
Valuation and risks At our target PE multiple, Yanzhou Coal would Target price of HKD12.80 trade a 10% discount to China Coal, which is We set a target price of HKD12.80 based on a broadly in line with the average so far this year. blended PE and DCF valuation. We apply a 50:50 Risks blend between a PE valuation of HKD13.25, based We see the following upside risks: Yanzhou on 9.0x 2012e, and a DCF valuation of HKD12.35. Coal’s earnings are predominantly driven by Our life-of-mine DCF valuation is based on the Chinese and international thermal and coking coal following assumptions: prices, which may be higher than we anticipate, resulting in better-than-expected earnings. The Long-term coal sales volume of 83m tpa from company is acquisitive and may acquire further the Chinese mines assets at cheap prices that have a positive impact Long-term coal sales volume from Australian on earnings and valuations. Current development- mine of 25m tpa stage assets may be developed more quickly than we currently forecast. Production costs may be Adjusted beta of 1.17 measured against lower than we expect. HSCEI index
A cost of capital of 11.2% Downside risks include lower-than-expected coal prices and slower or more costly development of The company remaining in a net cash position current projects compared to our expectations. in the long run
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DCF Valuation Year to Dec (RMBm) 2011 2012e 2013e 2014e 2015e 2016e 2017e 2018e 2019e 2020e 2021e …… Terminal Free cash flow calculation Revenue 47,066 50,859 53,953 58,947 61,372 62,826 63,737 65,814 67,771 69,783 71,857 145,260 Y-o-y 39% 8% 6% 9% 4% 2% 1% 3% 3% 3% 3% 3% EBIT 13,003 8,053 8,068 9,410 9,077 9,546 8,347 7,757 8,182 8,794 9,331 29,711 EBIT margin 28% 16% 15% 16% 15% 15% 13% 12% 12% 13% 13% 20% NOPAT 9,321 6,039 6,051 7,057 6,808 7,159 6,260 5,818 6,136 6,596 6,998 22,283 Capex, net (22,637) (12,000) (12,000) (8,000) (5,000) (5,000) (5,000) (5,000) (5,000) (5,000) (3,000) (3,000) Depreciation 2,986 3,758 4,442 4,791 4,982 5,072 5,322 5,382 5,422 5,232 5,181 2,989 Change in working capital 3,821 (878) 237 83 308 222 388 330 73 45 75 (86) Free operating CF (FoCF) (6,510) (3,081) (1,270) 3,931 7,097 7,453 6,970 6,530 6,631 6,872 9,254 22,186 DCF Inputs WACC inputs Interest-bearing liabilities as a % of EV 0% Terminal FCF growth 0.0% WACC 11.2% Risk-free rate 3.0% NPV of free cash flows 69,874 Market risk 7.0% Add net cash/(debt) (20,542) Beta 1.17 Less market value of minorities (720) Cost of debt (pre-tax) 6.0% = Equity value 48,613 / Number of shares 4,918 / HKD:RMB exchange rate 0.80 = NPV per share (HKD) 12.34
Source: Company data, HSBC estimates
Daily PE of Yanzhou Coal Yanzhou Coal’s daily PE relative to Shenhua and China Coal
18.0 26.0
16.0 22.0 14.0 18.0 12.0 14.0 10.0 8.0 10.0
6.0 6.0 Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12 Yanzhou Shenhua China Coal
Source: Company data, Thomson Reuters Datastream, HSBC Source: Company data, Thomson Reuters Datastream, HSBC
Daily EV/EBITDA of Yanzhou Coal
11.0 x 10.0 9.0 8.0 7.0 6.0 5.0 4.0 Jul-10 Jul-11 Jul-12 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Jan-10 Jan-11 Jan-12
Source: Company data, Thomson Reuters Datastream, HSBC
232 Natural Resources & Energy China Equity abc July 2012
HSBC ratings bands In Inner Mongolia, we forecast sales volume from For volatile stocks, the band for a Neutral rating, is Ordos Neng Hua and Xintai Coal Mining will 10ppt above and below our hurdle rate, which for reach 6.5m tonnes in 2012e and increase to 7.5m tonnes in 2013e. China is 10%. Our target price, together with the expected dividend yield, implies a potential return Selling prices of 19%, which is within the Neutral band. On this We expect the average selling prices to fall by basis we rate Yanzhou Coal Neutral (V). Potential 14% y-o-y in 2012e to RMB610/t and marginally return equals the percentage difference between the decrease to Rm607t in 2013e. In particular, we current share price and the target price, including forecast average selling prices of Yancoal the forecast dividend yield when indicated. Australia will drop by 24% y-o-y to RMB707/t in Earnings outlook 2012e and by a further 1% to RMB702/t, reflecting weaker international thermal and coking We forecast Yanzhou Coal will achieve net coal prices. income of just RMB5.8bn in 2012e, down 35% y-o-y, RMB5.8bn in 2013e, flat y-o-y and Production costs RMB6.9bn in 2014e, up 19% y-o-y. We expect We expect Yanzhou Coal’s cash production costs earnings to deteriorate in y-o-y terms in 2012e on to increase by 3% y-o-y in 2012e and by 5% y-o-y lower coal prices and higher production costs, in 2013e to RMB215/t and RMB225/t, partly offset by volume growth from Gloucester’s respectively, mainly on higher material costs and mines and new mines in China. staff costs. Sales volume Earnings sensitivity Yanzhou Coal sold 64m tonnes of commercial We estimate a 1% increase in average coal selling coal in 2011, of which 41m tonnes were from prices would raise our net profit by 4% in both mines in China, 10m tonnes were from mines in 2012e and 2013e. Australia and the remaining 13m tonnes were Acquisition of Gloucester Coal traded coal. We expect total sales volume to rise by 25% y-o-y to 81m tonnes in 2012e and by 7% The merger of Yancoal Australia and Gloucester y-o-y to 86m tonnes in 2013e. Coal has been completed, with the merged entity now listed on the ASX. It is Australia’s largest Most of the volume growth we forecast will likely listed pure-play coal company based on 2011 come from mines in Australia. We forecast sales saleable production. It is owned 78% by Yanzhou volumes from Yancoal Australia will reach 15m Coal and 22% by former Gloucester Coal tonnes in 2012e and 17m tonnes in 2013e. shareholders. At the ‘headquarters’ mines in Shandong, we expect sales volume to increase by 2m tonnes to 35m tonnes in 2012e and by a further 2m tonnes in 2013e. We expect growth to mainly come from the two mines, Beisu Mine (1mtpa) and Yangcun Mine (1.15mtpa), which were acquired in April 2012.
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Australian pure play coal companies CY11 saleable Merged entity pro-forma saleable coal production production (mt)*
14 12.8 12 9 10 8 6.1 4.4 4.4 6 3.8 4 2 0
Source: Gloucester Coal Yancoal Yancoal MergeCo New Hope New Gloucester W hitehaven Both Yancoal Australia prior to the merger and also Whitehaven/Aston *Gloucester coal production includes Donaldson production for the full year for Gloucester Coal had strategic infrastructure representation purpose only holdings in Australian ports that were considered Source: Gloucester Coal, HSBC sufficient to support the growth plans. The Gloucester Coal and Yancoal Australia project pipeline combined capacity at NSW port is c18.6mtpa currently and is expected to increase to 27.2mtpa by 2016. In addition, the merged entity also has a combined capacity of c4.4mtpa at Queensland port.
Merged entity combined NSW port capacity (mt)
30 27 . 1 25 23.5 24. 1 20.7 20 18.6 15 10 5 0 2012F 2013F 2014F 2015F 2016F PWCS NCIG PWCS T4
Source: Gloucester Coal Source: Gloucester Coal, HSBC estimates
Before the merger, Gloucester Coal had an Further, assets of both the companies are located attractive portfolio of assets and a decent growth in close proximity to each other which should profile and this should benefit the merged entity. provide for significant operational synergies in our view. Gloucester Coal and Yancoal Australia Gloucester estimates saleable production of the together estimate the present value of the potential merged entity to increase to more than 30m quantifiable synergies to be in the range of tonnes over the next four years from c13m tonnes cAUD220-380m, of which (45-54%) is expected currently, once production from new projects to accrue from infrastructure optimisation. starts to come on stream.
234 Natural Resources & Energy China Equity abc July 2012
Gloucester Coal and Yanzhou Coal Australian assets 15.4% interest in the Newcastle Coal Infrastructure Group
5.6% interest in the Wiggins Island Coal Export Terminal Gloucester Coal Gloucester Coal is an Australian coal producer with mining and exploration assets in the Gloucester Basin and lower Hunter Valley in New South Wales and the Bowen Basin in Queensland.
Growth by acquisitions The company has grown significantly by acquiring coal assets in Australia. It acquired a 50% stake in Middlemount in August 2010 and a 100% stake in Donaldson Coal Holdings and the Source: Gloucester Coal, HSBC Monash Project in May 2011. These acquisitions The merger proposal have provided Gloucester with a strong platform Yanzhou Coal entered into a merger proposal with for future growth. Gloucester Coal in December 2011, wherein Gloucester’s assets were to be combined with Yanzhou’s following Australian assets:
100% interest in the Austar coal mine
90% interest in the Ashton Coal joint venture
80% interest in the Moolarben joint venture
100% interest in the Yarrabee coal mine
Gloucester Coal’s coal asset summary Gloucester Basin Donaldson Middlemount Monash Stake 100% 100% 50%, balance Macarthur coal 100% Mining method Open cut Open cut & Underground Open cut Underground Status Producing Producing Producing Exploration Reserves 84 161 48 0 % share 29% 55% 16% 0% Resources 316 885 61 577 % share 17% 48% 3% 31% Basin Gloucester Gloucester Bowen Gloucester Nearest Port Newcastle Newcastle Abbott Point Newcastle Distance from port 95-115km 20-25km 300km from Abbott Point 95km Washing Stratford CHPP Bloomfield CHPP Middlemount CHPP na Coal type Semi-hard coking coal and Semi-soft coking coal and export PCI & semi-hard coking coal Semi-hard coking coal export thermal coal thermal coal and export thermal coal CY11 production 1.9mt 1.6mt* 0.23mt na
*Full-year production, acquisition by Gloucester effective 14 July 2011 Source: Company data, HSBC
235 Natural Resources & Energy China Equity abc July 2012
Gloucester coal asset acquisitions Gloucester Coal quarterly saleable coal production by mine (kt) Middlemount Donaldson Monash 1,400 Announced date Aug-10 May-11 May-11 Completion date Sep-10 Jul-11 Jul-11 1,200 Project location Australia Australia Australia 1,000 Project Status Exploration/ Producing Exploration/ development development 800 Coal Type Coking Thermal/Coking Thermal/Coking 600 % acquired 50% 100% 100% 400 Value (USDm) 346 618 32 Reserves (mt) 57 152 na 200 Resources (mt) 100 885 287 0 USD/t reserves 12.15 4.07 na USD/t resources 6.92 0.70 0.11 2011 Production na 1.6mt na 1Q10 2Q 10 3Q10 4Q10 1Q11 2Q 11 3Q11 4Q11 1Q12 Target capacity 1.8mtpa by 4.5-5mtpa by 9mtpa by FY22 Gloucester Donaldson Middlemount FY12* FY16 Source: Company data, HSBC *Environmental Impact Statement submitted to increase ROM production from 1.8mtpa to up to 5.4mtpa Source: Company data, HSBC Gloucester produced c4.8m tonnes of raw coal in 2011 and has plans to increase its raw coal Reserves and resources production to more than 10mtpa within four years Gloucester owns seven coal mines with a total on increased contributions from Middlemount and attributable coal reserves of c292m tonnes and Donaldson. The company expects to have a resources of c1,839m tonnes. Acquisition of capability to produce c40-50% coking coal post the Donaldson and Monash has significantly added to ramp up of Middlemount. Monash is currently in the existing Gloucester reserves and Donaldson the exploration stage and is expected to provide the alone now accounts for c55% of the company’s next big leap in growth with a capacity to produce reserves and c48% of its resources. c7mtpa coal, majority of which would be semi-soft
Gloucester coal reserves and resources (mt, %) coking coal. Reserves % Resources % Gloucester forecast coal production (mt) Gloucester Basin 84 29% 316 17% Middlemount 48 16% 61 3% Donaldson 161 55% 885 48% Monash 0 0% 577 31% Total 292 100% 1,839 100%
Source: Company data, HSBC
Production and sales Gloucester sells both coking and thermal coal and sold c2.85m tonnes of coal in 2011, including 0.93m tonnes coking coal (33%) and 1.91m Source: Company data tonnes of thermal coal (67%). Gloucester coal has continued to ramp up its Port infrastructure: Gloucester also has significant production over the last five quarters. It produced port capacity at the Newcastle Port for handling and c1.96m tonnes (up 5% q-o-q and 232% y-o-y) of export of coal produced at its mines. The Gloucester raw coal and c1.28m tonnes (up 13% q-o-q and basin mines are strategically located within 20- 273% y-o-y) of saleable coal in 1Q12. Gloucester 115km of the Newcastle Port. The company holds a basin accounted for c47% of the raw coal 11.6% stake in Newcastle Coal Infrastructure Group production while Donaldson contributed 39% and and has a 10 year rolling ship-or-pay agreement with Middlemount 14%. Port Waratah Coal Services for port capacity.
236 Natural Resources & Energy China Equity abc July 2012
Gloucester NSW Port Capacity (mt) mines as at end-2011. The company completed the merger of Yancoal Australia in June 2012. 14 11.7 12.0 11 .2 12 10.2 Production 10 8.7 The company primarily produces thermal, semi- 8 6.7 soft coking, semi-hard coking and PCI coal. 6 4.9 Yanzhou produced c56m tonnes of raw coal and 4 c51m tonnes of saleable coal in 2011 at an average 2 washing yield of c91%. The Shandong mines 0 contributed c61% of the raw coal and c66% of the 2010 2011 2012 2013 2014 2015 2016 saleable coal while Yanzhou Australia accounted for c23% of raw coal and only 19% of saleable coal Source: Company data production.
What is Yanzhou Coal? Yanzhou 2011 saleable coal production by mines Yanzhou Coal (Yanzhou) owned and operated 16 Yan zho u coal mines in China and Australia with total reserves Australia 19% of c3.0bn tonnes as at the end of 2011. In addition, it Shanxi had eight developmental-stage projects in China and Nenghua 2% Australia and 17 exploration tenements in Australia. Heze The company is a state-owned enterprise and is Nenghua Shandong 4% majorly (c53%) owned by the Yankuang Group. mines Ordo s 66% Neng Hua Coal Business 9%
In China, Yanzhou operates six underground coal mines in Shandong province with a combined Source: Company data, HSBC production capacity of c35mtpa at the end of 2011. It has further acquired two mines in 2012 with a Yanzhou’s mines in Shandong have very high capacity of 2mtpa. It also owns a railway quality coal with average washing yield of transportation network that links the six coal mines c100%, but Yancoal Australia yields are lower at in Shandong and two mines owned by the parent 73%. company to national railway connections and to the Yanzhou 2011 coal production summary (mt) Zouxian power station. The company also holds Raw % share Saleable % share Yield equity interests in Shanxi Nenghua Mines in Shanxi coal coal province, Heze Nenghua Mines in Shandong and Shandong mines 34.0 61% 33.8 66% 100% Yanzhou Australia 13.1 23% 9.6 19% 73% Ordos Neng Hua Mines in Inner Mongolia. Yanzhou Shanxi Nenghua 1.2 2% 1.2 2% 99% had total coal reserves of c1.97b tonnes at its Heze Nenghua 3.0 5% 1.9 4% 63% Ordos Neng Hua 4.4 8% 4.4 9% 100% Chinese coal mines as at end 2011. Total coal 55.7 100% 50.9 100% 91%
Source: Company data, HSBC In Australia, Yanzhou operates through its wholly owned subsidiary Yancoal Australia, which operates Yanzhou’s growth remained poor between 2005 mines, including Austar, Yarrabee, Ashton, and 2009 and its coal production volume Moolarben, Cameby Downs (acquired from Syntech stagnated at c35mtpa. At this time, it started in 2011) and Premier Coal Mine (acquired from looking for opportunities to acquire coal mines in Wesfarmers in 2011). Yanzhou had total coal both China and overseas. reserves of c1.02bn tonnes at its Australian coal
237 Natural Resources & Energy China Equity abc July 2012
Yanzhou successfully made its first major foray Yanzhou Coal sales volume by owned and trading (mt) into overseas coal mining operations with the 80 25% acquisition of Felix Resources in Australia in 60 20% December 2009. This acquisition was transformational for Yanzhou, as it provided the 40 15% company with growth prospects, a more 20 10% diversified product range, broader geographical 0 5% markets and access to world class assets. Since 2008 2009 2010 2011 then it has continued to acquire several coal and Self produced Trading other assets outside China. The acquisitions have T ra din g s hare (RHS ) helped Yanzhou to significantly increase its coal Source: Company data, HSBC output volume over the last two years. Yanzhou is currently in the process of acquiring Australian Yanzhou sells several different grades of coal coal producer Gloucester Coal. products that are distinguished primarily by the dust content: Yanzhou raw coal production volume (mt)
60 O utp ut ac celerate d No.1 Clean Coal contains less than 4% dust. pos t acquis itions 50 This coal is sold to Baoshan Iron & Steel and Output stagnated two steel producers in Shandong province, 40 Jinang Steel and Laiwu Steel. 30
20 No.2 Clean Coal contains less than 8% dust and is sold to Maanshan, Baosteel and 10 international steel producers. 0 2005 2006 2007 2008 2009 2010 2011 No. 3 Thermal Coal products have less than 12% dust and are sold to power companies. Source: Company data, HSBC
In addition, Yanzhou Coal sells some lower-grade Coal sales coal products called screened raw coal and mixed Yanzhou sold c64m tonnes (up 29% y-o-y) of coal coal. These products are usually bought by domestic in 2011 out of which c79% or 51m tonnes was self electricity generating companies, construction produced coal and c21% or 13m tonnes was coal companies and chemical producers. With the purchased for trading from third party. Yanzhou has acquisition of coal assets in Australia, Yanzhou has steadily increased its coal trading business over the now also started selling coking coal, although last four years with its share of traded coal increasing thermal coal remains a major proportion of self from just 7% in 2008 to 21% in 2011. produced coal sales.
238 Natural Resources & Energy China Equity abc July 2012
Coal sales breakdown by product category (2011) Yanzhou 2011 sales by customer group
Sales volume Sales price Revenues Po wer (mt) (RMB/t) (RMBbn) plants 20% Shandong Mines 33,276 686 22.8 No. 1 Clean Coal 534 1,102 0.6 No.2 Clean Coal 8,950 1,047 9.4 Metallurgic No. 3 Clean Coal 2,222 886 2.0 al Screened Raw Coal 13,495 498 6.7 producers Mixed Coal & Others 6,289 372 2.3 14% Shanxi Neng Hua 1,223 468 0.6 Fuel Screened Raw Coal 1,223 468 0.6 Constructi traders on and Heze Neng Hua 2,004 913 1.8 62% No. 2 Clean Coal 1,211 1,215 1.5 coke Screened Raw Coal 37 530 0.0 chemcials 4% Mixed Coal and Others 756 448 0.3 Ordos Neng Hua 4,379 291 1.3 Source: Company data, HSBC Screened Raw Coal 4,379 291 1.3 Yancoal Australia 10,060 930 9.4 Semi-hard coking coal 914 1119 1.0 Coal chemical business Semi-soft coking coal 1,049 1,258 1.3 PCI coal 2,333 1,281 3.0 The company’s coal chemical business produces Thermal coal 5,764 698 4.0 Sales of purchased coal 13,308 722 9.6 methanol from coal or natural gas. It runs its Total for the Group 64,250 708 45.5 business through Yulin Nenghua and Tianhao Source: Company data, HSBC data Chemicals. This segment accounted for c2% of company’s total revenues in 2011. During the Yanzhou has also increased its share of export sales year it produced and sold 532k tonnes (up 45%) since 2010. The company’s main export markets are and 529k tonnes (41%) of methanol, respectively. South Korea and Japan, which accounted for c67% of export sales volume in 2011. Electricity business
Yanzhou Coal export volume share The company generates electricity for its own use and for external sales to eight captive power 15% plants. In 2011, the company generated c1.4bnKWh of electricity and sold externally 10% c0.9bnKWh of it. In 2011, the segment accounted for c1% of the group’s revenues. 5% Shareholding structure
0% Yanzhou Coal’s share capital consists of 4,918m 2008 2009 2010 2011 shares. About 40% or 1,958m of the entire share capital are H shares listed in Hong Kong. HKSCC Source: Company data, HSBC Nominees Limited owns c1,949m of the H Shares, making it a 39.6% stakeholder in the company. Major customers The majority of the remaining c2,600m (A shares) The company supplies coal to a diverse customer are owned by Yankuang Group, which holds a base in power, metallurgical, chemical and 53% stake in the company. construction material industries. In 2011, its top five customers were Huadian Power International, The company has an ADR listed in the US (YZC Baoshan Iron & Steel, POSCO, Yankuang US). Each ADR is equivalent to 10 H shares listed Meihua Gongxiao and Linyi Yehua Coking, in Hong Kong. which together accounted for c19% of revenues.
239 Natural Resources & Energy China Equity abc July 2012
Yanzhou major coal assets summary
Major coal assets Shandong mines (China) Nantun Xinglong- Baodian Dongtan Jining II Jining III Total zhuang Background data: Commencement of construction 1966 1975 1977 1979 1989 1993 na Commencement of commercial production 1973 1981 1986 1989 1997 2000 na Coalfield area (square kilometres) 35.2 59.8 36.4 60 87.1 105.1 383.6 Reserve data (mt, as of Dec 2011) Total in-place proven and probable reserves 111.1 311.7 276.4 443.8 404.3 215.5 1,762.80 Mining recovery rate (%) 81.28 80.8 81.57 83.88 79.83 80.91 na Coal preparation plant recovery rate (%) 67.59 87.4 62.12 60.96 69.43 62.55 69.52 Depth of mine (meters underground) 397 429.2 474.7 710 593 556 na Avg. thickness of main coal seam (m) 8.6 8.3 8.8 8.4 6.8 6.2 na Type of coal Thermal coal Thermal coal Thermal coal Thermal coal Thermal coal Thermal coal na Leased / owned owned owned owned owned owned owned na Assigned / unassigned assigned assigned assigned assigned assigned assigned na Average calorific value (Kcal/kg) 5,572 5,881 5,890 5,586 5,467 5,412 na Sulfur content (%) 0.6 0.47 0.52 0.6 0.56 0.52 na Production data (mt) Raw coal production capacity 2.4 3 3 4 4 5 21.4 Designed washing capacity 1.8 3 3 4 3 5 19.8 Raw coal production (mt) 2006 3.9 7.2 5.6 8 4 6.8 35.5 2007 3.9 6.8 5.8 7.6 3.4 5.3 32.8 2008 3.5 6.6 6 7 3.9 6.1 33.1 2009 3.8 6.6 5.7 7.5 3.6 6.2 33.4 2010 3.6 6.8 6.1 7.4 4.2 6.2 34.3 2011 3.3 6.8 6.1 7.3 4.4 634 Coal Mines operated by Yancoal Australia Austar Yarrabee Ashton Moolarben Cameby Downs Premier Total Commencement of construction 1998 1981 2003 2009 2009 1996 na Commencement of commercial production 2000 1982 2004 2010 2010 1996 na Coalfield area (sq km) 63 62.7 19.2 17.4 27.2 141.8 1,214.64 Reserve data (mt) : Recoverable reserves 44.2 57.2 57.2 315 409 141 1,023.60 Depth of mine (meters underground) 500 N/A 190-280 N/A N/A N/A na Type of coal Semi-hard coking PCI coal Semi-soft coking Thermal coal Thermal coal Thermal coal na Leased/owned Owned owned owned owned owned owned na Assigned/unassigned assigned assigned assigned assigned assigned assigned na Average calorific value (Kcal/kg) 7,350 7,300 7,100 6,650 6,100 4,442 na Sulfur content (%) 1.8 0.7 0.65 0.5 0.5 0.5 na Production data: (mt) Designed raw coal production capacity 3.6 3 5.2 16 1.8 5 34.6 Designed coal preparation input washing capacity 3.3 2.4 6.5 16 1.8 N/A 30 Raw coal production 2006 0.4 0.4 2007 1.6 1.6 2008 1.9 1.9 2009 1.9 1.9 2010 1.7 2.3 2.7 3.9 10.6 2011 1.9 3.1 1.7 5.6 0.8 13.1 Cumulative raw coal production Dec 2011 9.4 5.4 4.4 9.5 0.8 29.5
Source: Company data, HSBC
240 Natural Resources & Energy China Equity abc July 2012
Yanzhou’s Australian coal assets Operational coal mine: - Yarrabee coal mine - Cameby Downs coal mine Developmental-stage project: - Althena project - Harrybrandt project - Wilpeena Project Queensland
Althena Gablee basin Western Australia Bowen basin Harrybrandt Yarrabee Operational coal mine: Wilpeena - Premier coal mine Cameby Down Developmental-stage project: Surat basin - Wilga project Gunnedah basin Ashton Austar Moolarben Wilga Basin Premier Coal Collie Basin Sydney basin Operational coal mine: - Ashton coal mine -Austarcoal mine - Moolarben coal mine
Source: Company data, HSBC
241 Natural Resources & Energy China Equity abc July 2012
Yanzhou Coal: Income statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Net Revenues 33,944 47,066 50,859 53,953 58,947 y-o-y change (%) 68% 39% 8% 6% 9%
Cost of sales 18,887 28,280 35,971 38,621 41,578
Gross Profit 15,058 18,786 14,888 15,332 17,368 y-o-y change (%) 65% 25% -21% 3% 13% Gross profit margin (%) 44% 40% 29% 28% 29%
Operating expenses 5,094 6,570 7,120 7,553 8,253 Operating expenses as % revenues 15% 14% 14% 14% 14%
Income from Operations 9,964 12,216 7,767 7,779 9,116 Operating profit margin (%) 29% 26% 15% 14% 15%
Other income/ (expense) net 2,930 787 285 289 294
EBIT 12,893 13,003 8,053 8,068 9,410 EBIT margin (%) 38% 28% 16% 15% 16%
Net finance income/ (expense) (416) (482) (274) (300) (138) Interest income 187 358 743 718 880 Interest expenses (603) (839) (1,018) (1,018) (1,018)
PBT 12,477 12,521 7,778 7,769 9,272 PBT margin (%) 37% 27% 15% 14% 16%
Taxation 3,171 3,545 1,945 1,942 2,318 Effective tax rate (%) 25% 28% 25% 25% 25%
Minority Interest 25 48 29 29 35
Net income 9,281 8,928 5,805 5,798 6,919 y-o-y change (%) 125% -4% -35% 0% 19% Net income margin (%) 27% 19% 11% 11% 12%
EPS (RMB) 1.89 1.82 1.18 1.18 1.41 DPS (RMB) 0.59 0.57 0.30 0.29 0.35 Payout ratio 31% 31% 25% 25% 25%
EBITDA 15,688 16,008 11,830 12,530 14,221 EBITDA margin (%) 46% 34% 23% 23% 24%
Source: Company data, HSBC estimates
242 Natural Resources & Energy China Equity abc July 2012
Yanzhou Coal: Balance sheet summary (RMBm) 2010a 2011a 2012e 2013e 2014e Assets Current assets 24,281 30,431 35,690 33,450 36,915 Cash and bank 6,771 8,145 9,894 6,879 9,183 Term deposits 2,568 9,543 9,543 9,543 9,543 Restricted cash 85 21 21 21 21 Bills and accounts receivable 10,017 7,312 9,754 10,347 11,305 Inventories 1,646 1,391 2,464 2,645 2,848 Other assets 3,194 4,018 4,015 4,015 4,015
Fixed assets 19,875 31,274 40,336 48,715 52,744
Other assets 28,600 35,447 32,330 31,579 30,833 Goodwill 1,197 1,866 1,866 1,866 1,866 Intangible assets 19,633 26,206 25,386 24,566 23,745 Prepaid lease payments 728 713 692 672 652 Investment in associate 1,076 1,703 1,789 1,878 1,972 Others 5,966 4,958 2,597 2,597 2,597
Total assets 72,756 97,152 108,356 113,744 120,491
Liabilities Current liabilities 10,134 34,721 37,765 38,777 40,020 Unsecured bank borrowing - due within one year 615 19,588 20,000 20,000 20,000 Accounts payable 1,554 2,241 2,957 3,174 3,417 Accruals and other payables 3,821 7,345 10,791 11,586 12,473 Others 4,144 5,547 4,018 4,017 4,130
Non-current liabilities 25,184 19,105 24,236 24,236 24,236 Long-term loans 22,401 14,869 20,000 20,000 20,000 Deferred tax liability 2,601 3,895 3,895 3,895 3,895 Others 182 340 340 340 340
Total liabilities 35,317 53,827 62,001 63,013 64,256
Shareholders’ equity 37,332 42,634 45,636 49,982 55,452 Share capital 4,918 4,918 4,918 4,918 4,918 Share premium 2,981 2,981 2,981 2,981 2,981 Retained earnings 21,591 26,446 28,750 32,401 37,040 Reserves 7,842 8,289 8,986 9,682 10,512
Minority Interest 107 691 720 749 784
Total liabilities and shareholders’ equity 72,756 97,152 108,356 113,744 120,491
Gearing Gross debt 23,016 34,458 40,000 40,000 40,000 Cash and ST investment 9,424 17,710 19,458 16,443 18,747 Net debt/ (cash) 13,592 16,748 20,542 23,557 21,253
Shareholders equity including minorities 37,438 43,325 46,355 50,731 56,235 Net debt-to-equity 36% 39% 44% 46% 38%
Source: Company data, HSBC estimates
243 Natural Resources & Energy China Equity abc July 2012
Yanzhou Coal: Cash flow statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Cash flow from operating activities Profit before taxation 12,477 12,521 7,778 7,769 9,272 Depreciation and amortisation 2,794 3,005 3,778 4,462 4,811 Changes in operating assets and liabilities (5,647) 3,821 (878) 237 83 Loss(gain) on assets disposal 17 109 - - - Net interest received/paid (415) (265) 1,018 1,018 1,018 Tax paid (2,039) (2,156) (1,945) (1,942) (2,318) Others (1,793) 943(4,547) (3,194) (3,332) Operating cash flow 5,395 17,977 5,204 8,349 9,533
Cash flow from investing activities Capex (3,577) (8,620) (12,000) (12,000) (8,000) Additions of other non-current assets (35) (53) 2,277 (89) (94) Proceeds from assets disposal 205 58 - - - Acquisitions & investment 1,015 (9,620) - - - Others (3,488) (7,377) 726 725 865 Investing cash flow (5,880) (25,611) (8,998) (11,365) (7,229)
Cash flow from financing activities Dividend paid (1,231) (2,902) (2,803) (1,451) (1,449) Debt movements (129) 12,345 5,542 - - Others - (2)2,803 1,451 1,449 Financing cash flow (1,361) 9,441 5,542 - -
Net increase/ (decrease) in cash (1,845) 1,807 1,749 (3,015) 2,304 Net exchange adjustment 94 (433) - - - Net cash movement (1,751) 1,374 1,749 (3,015) 2,304
Source: Company data, HSBC estimates
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245 Natural Resources & Energy China Equity abc July 2012
Financials & valuation: Zhaojin Mining Industry Overweight (V) Financial statements Key forecast drivers Year to 12/2011a 12/2012e 12/2013e 12/2014e Year to 12/2011a 12/2012e 12/2013e 12/2014e Profit & loss summary (RMBm) Gold production (t) 23.6 23.9 26.2 28.8 - from own mines 11.8 13.3 14.8 16.6 Revenue 5,741 7,457 8,244 9,245 - from other sources 11.7 10.6 11.4 12.3 EBITDA 2,864 3,454 3,710 3,999 Gold prices (USD/oz) 1,571 1,760 1,775 1,750 Depreciation & amortisation -471 -449 -490 -491 Unit cost (USD/oz) 598 711 747 766 Operating profit/EBIT 2,393 3,004 3,219 3,508 Net interest -86 -142 -150 -137
PBT 2,287 2,842 3,050 3,351 HSBC PBT 2,287 2,842 3,050 3,351 Taxation -564 -711 -762 -838 Valuation data Net profit 1,662 2,089 2,241 2,463 Year to 12/2011a 12/2012e 12/2013e 12/2014e HSBC net profit 1,662 2,089 2,241 2,463 EV/sales 4.1 3.2 2.8 2.3 Cash flow summary (RMBm) EV/EBITDA 8.1 6.9 6.2 5.4 Cash flow from operations 2,079 2,030 2,386 2,546 EV/IC 2.9 2.3 2.1 1.9 Capex -1,709 -2,120 -917 -519 PE* 12.7 10.2 9.6 8.7 Cash flow from investment -2,269 -2,128 -917 -519 PB 3.2 2.7 2.2 1.9 Dividends -458 -612 -731 -784 FCF yield (%) 0.7 0.8 8.4 11.2 Change in net debt 765 630 -979 -1,536 Dividend yield (%) 2.9 3.4 3.6 4.0 FCF equity 158 174 1,813 2,421 *Based on HSBC EPS (diluted)
Balance sheet summary (RMBm) Intangible fixed assets 3,178 3,491 3,608 3,628 Issuer information
6 2 . Tangible fixed assets 4,927 6,358 6,750 6,840 Share price (HKD)8.82 Target price (HKD)14.30 1 Current assets 3,962 4,626 5,947 7,907 Cash & others 1,246 1,146 2,125 3,660 Reuters (Equity) 1818.HK Bloomberg (Equity) 1818 HK Total assets 13,291 15,715 17,546 19,615 Market cap (USDm) 3,314 Market cap (HKDm) 25,850 Operating liabilities 2,580 2,937 3,212 3,552 Free float (%) 62 Enterprise value (RMBm) 24,170 Gross debt 3,159 3,690 3,690 3,690 Country China Sector Metals & Mining Net debt 1,913 2,544 1,565 30 Analyst Thomas J Zhu Contact +852 2822 4325 Shareholders’ funds 6,584 8,112 9,622 11,300
Invested capital 8,240 10,392 10,969 11,162 Price relative 25 25 Ratio, growth and per share analysis 23 23 21 21 Year to 12/2011a 12/2012e 12/2013e 12/2014e 19 19 17 17 Y-o-y % change 15 15 13 13 Revenue 40.1 29.9 10.6 12.1 11 11 EBITDA 38.3 20.6 7.4 7.8 9 9 Operating profit 38.7 25.5 7.1 9.0 7 7 PBT 38.4 24.3 7.3 9.9 5 5 HSBC EPS -30.9 24.6 6.4 9.9 2010 2011 2012 2013 Zhaojin Mining Industry Rel to HANG SENG CHINA ENTERPRISES INDEX Ratios (%) Source: HSBC Revenue/IC (x) 0.8 0.8 0.8 0.8
ROIC 23.9 24.2 22.6 23.8 ROE 27.8 28.4 25.3 23.5 Note: price at close of 25 Jul 2012 ROA 15.8 15.5 14.5 14.2 EBITDA margin 49.9 46.3 45.0 43.3 Operating profit margin 41.7 40.3 39.0 37.9 EBITDA/net interest (x) 33.4 24.3 24.8 29.2 Net debt/equity 27.3 29.7 15.5 0.2 Net debt/EBITDA (x) 0.7 0.7 0.4 0.0 CF from operations/net debt 108.6 79.8 152.5 8604.7 Per share data (RMB) EPS Rep (diluted) 0.57 0.71 0.76 0.83 HSBC EPS (diluted) 0.57 0.71 0.76 0.83 DPS 0.21 0.25 0.26 0.29 Book value 2.26 2.74 3.24 3.81
246 Natural Resources & Energy China Equity abc July 2012
Zhaojin Mining (1818 HK)
Zhaojin offers the highest earnings leverage to gold among major Chinese companies; we expect it to deliver a CAGR of 12% in self-produced gold in 2011-14e We think Zhaojin’s shares will be driven by higher gold prices and further resources growth through acquisitions or explorations Initiate coverage with an Overweight (V) and a target price of HKD14.30 based on blended PE and DCF valuations
Initiating with Overweight (V) Revenue split in 2012e Thomas Zhu* Analyst Zhaojin is one of the largest gold producers in Non-gold The Hongkong and Shanghai Banking Corporation Limited 10% China. The company has seven gold mines in +852 2822 4325 Shandong and multiple mines in other provinces, [email protected] including Gansu, Liaoning, Xinjiang, and Guangxi. Simon Francis* Head of Metals & Mining We initiate coverage of Zhaojin with an Overweight Research, Asia Pacific The Hongkong and Shanghai (V) rating and a target price of HKD14.30, based on Banking Corporation Limited a 50:50 blend of our PE and DCF valuations. Our PE +852 2996 6620 [email protected] valuation is HKD13.30, based on a 15.0x 2012e PE, Amit Pansari* and our DCF valuation is HKD15.20. Gold Analyst 90% HSBC Bank plc Our positive view on the stock reflects two main Source: HSBC estimates +91 80 3001 3760 factors. Firstly, we have a positive view on gold; [email protected] Zhaojin is the purest gold exposure among the Positive outlook for gold in 2H12e *Employed by a non-US affiliate of HSBC Securities (USA) Inc, major listed companies in Hong Kong/China. Our Precious Metals Analyst James Steel believes and is not registered/ qualified pursuant to FINRA regulations Secondly, the company has excellent resources that gold should regain its lustre as a safe-haven growth prospects. asset in Gold Outlook – Higher in a time of crisis, 15 Purest Hong Kong-listed gold play June 2012. He believes that currency moves, notably Zhaojin has the highest percentage of revenues in the EUR/USD, will remain key for gold prices. from gold among major peers. In 2011, revenues He expects gold prices to rise above USD1,900/oz from gold represented c89% of total revenues, by year-end 2012 based on the likely impact of easy compared to c69% for Zijin (2899 HK, OW(V)). monetary policy. This represents more than a 19% We expect Zhaojin’s gold revenue percentage to appreciation from the current level. remain high at c90% in 2012-13e. The company strategy is to focus on gold, instead of diversifying into other metals.
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Gold prices, USD/oz Resources increase from exploration, tonnes
Current 1H12 avg 2H12e avg Upside to Upside to 160 2H12e avg 2H12e high 140 1,601 1,650 1,870 17% >19% 120 Source: Bloomberg, HSBC estimates 100
80 Earnings sensitive to gold prices 60 Our view on gold prices is positive for Zhaojin as the 40 company’s earnings are highly sensitive to gold 20 - prices. We estimate that for a 10% increase in gold 2008 2009 2010 2011 2012e prices, Zhaojin’s earnings should increase by 16% in
2012e and 2013e. This is the highest earnings Source: Company data, HSBC estimates sensitivity to gold among major Chinese companies. Good acquisition prospects Earnings sensitivity to gold prices in 2012e We think Zhaojin has good acquisition prospects as Gold prices, USD/oz 1,426 1,584 1,760 1,936 2,130 the company has obtained preferential rights to Net income, RMBm 1,453 1,754 2,089 2,424 2,793 acquire and consolidate local gold resources in Source: HSBC estimates several regions. The rights were secured via Great exploration potential cooperation agreements with local governments in provinces, including Xinjiang, Liaoning and Hebei. Zhaojin has good resources growth prospects These areas have prospective gold resources of from exploration as many of its mines are located over 1,000 tonnes, according to management. For in gold-rich fracture zones. Most of its mines in 2012, Zhaojin plans to acquire about 50 tonnes of Shandong are located in the gold-rich Zhaoping gold resources with a focus on Xinjiang, Gansu, and Wang’er Mountain fracture zones. In Inner Mongolia and Shandong. This represents a addition, a number of mines outside Shandong are c9% increase in resources from end-2011. located in gold-rich zones like the Gansu Min county and Li county fracture zones and Xinjiang Sustained volume growth East Junggar fracture zone. In 2012, management We forecast that Zhaojin will produce 13.3 tonnes plans to focus on exploration of the Canzhuang, of gold from self-owned mines in 2012e, up 13% Xiadian, Sanfengshan and Zaozigou mines and y-o-y. We expect the growth rate is sustainable, as plans to increase gold resources by 80 tonnes we expect the company to deliver a CAGR of 12% through exploration. This represents a c14% in gold production volume in 2012-14e. We think increase in resources from end-2011. CAGR is quite fast among the major gold miners.
Cooperation agreements with governments Counterparty Location Agreement Potential gold resources in the region Tuoli county government Xinjiang Mineral Resources Integration Agreement 500 tonnes (reserves) Chongli county government Hebei Strategic cooperation Framework Agreement 130 tonnes (prospective reserves) Fengcheng municipal government Liaoning Framework Agreement on Jointly Developing Fengcheng 70.2 tonnes (proven gold metal); Gold Resources 470 tonnes (prospective gold metal) Aletai municipal government Xinjiang Framework Agreement on Integration of Gold Resources Over 20.0 tonnes (proved gold reserves) Qinghe county government Xinjiang Framework Agreement on Cooperation of Gold Resources n.a.
Source: Company data, HSBC
248 Natural Resources & Energy China Equity abc July 2012
Production volume of self-owned mines, tonnes High inventories are the biggest
18.0 16% concern 15% 16.0 We calculate that Zhaojin’s inventory turnover 14% days came to 360 days by the end of 1Q12e, up 14.0 13% from 291 days in 2011. We think the high 12% 12.0 11% inventory was probably as a result of management 10.0 10% slowing down gold sales in 1Q12, hoping to sell 2010 2011 2012E 2013E 2014E inventory at higher prices later on.
Production YoY (RHS) While this increases Zhaojin’s earnings sensitivity to gold prices, it also increases uncertainty in Source: Company data, HSBC estimates Zhaojin’s full-year earnings. We calculate that
Zhaojin’s earnings in 1Q12e only represented Strong balance sheet 10% of our and consensus full-year forecast for We expect Zhaojin to have RMB2.5bn of net debt 2012e. Zhaojin might miss our full-year forecast by the end of 2012e, with a net-debt-to-equity if: 1) the company cannot sell excess inventories ratio of 30%. We expect the company to turn net at desirable prices, or 2) Zhaojin has to make cash after 2014e. substantial provisions for inventories, especially
Net debt/(cash), RMBm for concentrates purchased from third parties.
3,000 40% Inventory turnover days 2,500 30% 400 2,000 350 1,500 20% 300 1,000 10% 250 500 200 0 0% 150 2010 2011 2012E 2013E 2014E 100 50 Net debt/(cash) Net debt-to-equity (RHS) 0
Source: Company data, HSBC estimates 2008 2009 2010 2011 1Q12
Source: Company data, HSBC estimates Professional management Chairman Lu Dongshang has 30 years of Valuation and risks experience in the gold industry and President Target price at HKD14.30 Weng Zhanbin has 23 years of experience. We set our target price at HKD14.30 based on a Chairman Lu is also Chairman of Zhaojin Group, 50:50 blend of our PE and life-of-mine DCF Vice President of the China Gold Association, valuations. Our PE valuation is HKD13.30, based Chairman of the Board of the China Mining on a 15.0x 2012e PE, and our DCF valuation is Association and a Council Member of the HKD15.20. Shanghai Gold Exchange. We think management’s strong professional experience and connections should benefit operations and future acquisitions.
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Our target PE multiple is based on a 20% discount Risks to Zhaojin’s average PE over the past two years. We We see the following downside risks: Zhaojin think our target PE is justified as it reflects: 1) the Mining’s earnings are predominantly driven by relatively long-term trading multiple of the gold prices, which may be lower than we company, and 2) the company’s lower EPS growth anticipate, resulting in weaker-than-expected and margins in 2012-13e compared to 2010-11. earnings. The company may not be able to sell all
Daily PE of Zhaojin excessive inventories at desired prices, resulting in weaker-than-expected sales and potential 28.0 inventory writedowns. Production costs may be 23.0 higher than we expect as volume contribution increases from the high-cost mines outside 18.0 Shandong. 13.0 HSBC ratings bands 8.0 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 For volatile stocks, the band for an Overweight rating, is 10ppt above our hurdle rate, which for Daily P/E China is 10%. Our target price, together with the Source: Bloomberg, HSBC expected dividend yield, implies a potential return
of 66%, which is within the Overweight band. On Our life-of-mine DCF valuation is based on the this basis we rate Zhaojin Overweight (V). Potential following assumptions: return equals the percentage difference between the A cost of capital of 6.7% current share price and the target price, including the forecast dividend yield when indicated. Adjusted beta of 0.71 measured against the HSCEI index
Borrowings representing 30% of EV
Gold resources of c558 tonnes
Long-run production of c23.0 tpa of mined gold
Gold prices forecasts of USD1,760/oz in 2012e, USD1,775/oz in 2013e and long-run forecast of USD1,500/oz
Copper prices forecasts of USD8,000/tonne in 2012e, USD7,500/tonne in 2013e and long- run forecast of USD6,200/tonne
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DCF valuation Year to Dec (RMBm) 2011 2012e 2013e 2014e 2015e 2016e 2017e 2018e 2019e 2020e 2021e …… 2037E Free cash flow calculation Revenues 5,741 7,457 8,244 9,245 8,531 9,387 10,206 11,087 11,832 12,210 12,600 21,245 Y-o-y 40% 30% 11% 12% -8% 10% 9% 9% 7% 3% 3% 3% EBIT 2,393 3,004 3,219 3,508 3,021 3,347 3,648 3,973 4,246 4,375 4,508 7,290 EBIT margin 42% 40% 39% 38% 35% 36% 36% 36% 36% 36% 36% 34% Tax rate 25% 25% 25% 25% 25% 25% 25% 25% 25% 25% 25% 25% NOPAT 1,807 2,253 2,414 2,631 2,266 2,510 2,736 2,980 3,185 3,282 3,381 5,468 Capex, net (1,924) (2,200) (1,000) (600) (600) (600) (450) (340) (235) (185) (185) (10) D&A 471 449 490 491 480 466 446 420 388 353 316 9 Changes in working capital (347) (308) (67) (84) 29 (63) (62) (66) (56) (29) (31) (55) Free operating CF 6 195 1,837 2,438 2,175 2,313 2,670 2,993 3,282 3,420 3,482 5,411 DCF inputs WACC inputs Interest-bearing debt as % of EV 30% Risk-free rate 3.0% WACC 6.7% Market risk premium 7.0% NPV of free cash flows 39,151 Beta 0.71 Less net debt/(cash) 2,544 Cost of debt (pre-tax) 5.0% Less minority interests 456 HKD/RMB 1.25 Equity value (HKD m) 45,116 Shares outstanding 2,966 NPV per share (HKD) 15.21
Source: Company data, HSBC estimates
Earnings outlook We expect Zhaojin to produce 16.6 tonnes of gold from self-owned mines in 2014e, up 12% y-o-y. We forecast Zhaojin will achieve net income of Canzhuang mine in Shandong should be the RMB2.1bn in 2012e, RMB2.2bn in 2013e and primary driver for the growth as we expect capacity RMB2.5bn in 2014e. The earnings growth would at the mine to increase from 650tpd to 1,500tpd by be primarily driven by volume growth in self- the end of 2013e. The Zaozigou, Qinghe and produced gold. Fengcheng mines would continue to contribute to Production and sales volumes the growth as we expect them to reach a designed We expect Zhaojin to produce 13.3 tonnes of gold capacity of 2,000tpd by the end of 2013e. from self-owned mines in 2012e, up 13% y-o-y. We expect Zhaojin to produce 5.0 tonnes of gold The growth is primarily driven by the Zaozigou from third-party concentrates in 2012e, up 35% mine in Gansu, Qinghe mine in Xinjiang and y-o-y. This is in line with management’s Fengcheng mine in Liaoning. Zhaojin plans to guidance. We forecast Zhaojin will produce 5.8 increase capacities at these mines to 2,000tpd in tonnes of gold from third-party concentrates in order to better utilise the resources. We expect the 2013e and 6.7 tonnes in 2014e, representing a effective capacities to reach 1,000tpd for CAGR of 15% in 2012-14e. Zaozigou, 800tpd for Qinghe and 800tpd for Fengcheng in 2012e. Gold and copper prices Our precious metals analyst James Steel forecasts We forecast Zhaojin’s gold production from self- London PM gold prices to average USD1,760/oz owned mines to reach 14.8 tonnes in 2013e, up in 2012e and to stay almost flat at USD1,775/oz 11% y-o-y. We expect the growth to continue to in 2013e and USD1,750/oz in 2014e. be driven by the Zaozigou, Qinghe and Fengcheng. We expect effective capacities to reach 1,500tpd for all three mines.
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We expect LME copper prices to average USD8,000/tonne in 2012e, USD7,500/tonne in 2013e, down 12% y-o-y and USD8,000/tonne in 2014e, up 7% y-o-y.
Gold and copper prices 2010 2011 2012e 2013e 2014e Gold prices 1,225 1,571 1,760 1,775 1,750 y-o-y 26% 28% 12% 1% -1% Copper prices 7,556 8,820 8,000 7,500 8,000 y-o-y 46% 17% -9% -6% 7%
Source: Bloomberg, HSBC estimates
Earnings sensitivity Zhaojin’s earnings are sensitive to gold prices. For a 10% change in gold prices, Zhaojin’s earnings will change by 16% in 2012e and 2013e.
Earnings sensitivities in 2012e, RMBm Gold prices, USD/oz 1,426 1,584 1,760 1,936 2,130 Net income 1,453 1,754 2,089 2,424 2,793
Source: HSBC estimates
Earnings sensitivities in 2013e, RMBm Gold prices, USD/oz 1,438 1,598 1,775 1,953 2,148 Net income 1,541 1,873 2,241 2,610 3,016
Source: HSBC estimates
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What is Zhaojin Mining? production from 2007 to 2011, while the output of gold from its own mines outpaced at a CAGR of Zhaojin Mining is one of the largest gold producers 17% during the same period. In 2012e, we in China. The company sells Au9999 and Au9995 estimate Zhaojin to produce 13.3 tonnes of gold standard gold bullion under the brand name of from own mines, 5.0 tonnes from purchased Zhaojin. The company operates seven gold mines in concentrates and toll-treat 5.5 tonnes of gold for Zhaoyuan district. Apart from these operations, the its clients. We expect company to sell 23.8 tonnes company has multiple mines and exploration of gold in 2012e. tenements in other provinces, including Gansu, Liaoning, Xinjiang, and Guangxi. Production mix of self-owned mines, 2011
The company has c297 tonnes gold reserves and J inchiling Others Outside c558 tonnes of gold resources, according to JORC 9.0 % 0. 5% Zhaoy uan Canz hua ng 27.9% (Joint Ore Reserves Committee) standards. During 5.6% the period June 2006 to 2011, Zhaojin has shown substantial growth in reserves and resources, which Jintingling Day ingezh 5. 4% increased at CAGRs of 20% and 29%, respectively. uang Hed ong In 2011, Zhaojin’s gold reserves increased by c45 13.6% 7.6% tonnes and gold resources increased by c62 tonnes Xiadian from geological explorations and asset acquisitions. 30. 3%
Source: Company data, HSBC Gold production Zhaojin’s production comes from three sources: Asset details gold produced from own mines (51% of 2011 Xiadian Mine, Shandong (100% stake) total), toll-treating gold from its clients (33%), The Xiadian Mine is located c35 km south of and gold produced from concentrates procured Zhaoyuan City. We estimate the mine to from third party suppliers (16%). In 2011, contribute 28% of total gold production from the company produced c24 tonnes of gold, out of company’s own mines in 2012e. According to which c16 tonnes were from its own mines. The JORC standards, the mine had c61 tonnes of company achieved a CAGR of 5% in its gold reserves and c107 tonnes of resources at the end
Gold production grew at a CAGR of 5% Gold produced from own mines grew at a CAGR of 17%
25 15% 14 25% 11 20% 23 10% 5% 8 15% 20 0% 6 10% 18 -5% 3 5% 15 -10% 0 0% 2007 2008 2009 010 2 2011 2007 2008 2009 2010 2011
Total gold production (t) YoY - RHS Gold from ow n m ines YoY - R HS
Source: Company data, HSBC Source: Company data, HSBC
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of 2010. The mine produced c3.6 tonnes of gold of Zhaojin’s gold production from its own mines in in 2011. We expect this figure increase to 3.7 2012e. According to JORC standards, the mine had tonnes in 2012. c11 tonnes of reserves and c22 tonnes of resources at the end of 2010. The mine produced c0.7 tonnes of Dayingezhuang Mine, Shandong (100%) gold in 2011. We expect this figure to be flat at 0.8 The Dayingezhuang Mine is located c18 km tonnes in 2012e. southwest of Zhaoyuan City. We estimate the mine to contribute 13% of total gold production Jintingling Mine, Shandong (100%) from the company’s own mines in 2012e. The Jintingling Mine is located c10km southwest According to JORC standards, the mine had c95 of Zhaoyuan City. We estimate the mine to tonnes of reserves and c129 tonnes of resources at contribute 5% of Zhaojin’s gold production from the end of 2010. The mine produced 1.6 tonnes of its own mines in 2012e. According to JORC gold in 2011. We expect this figure to remain flat standards, the mine had c15 tonnes of reserves and at 1.7 tonnes in 2012. c24 tonnes of resources at the end of 2010. The mine produced c0.6 tonnes of gold in 2011. We Hedong Mine, Shandong (100%) expect production to be flat at 0.6 tonnes in 2012e. The Hedong Mine is located c30km northwest of Zhaoyuan City. We estimate the mine to Zhaoyuan Zhaojin – Daqinjia, Shandong (90%) contribute 7% of total gold production from the We estimate the mine to contribute 0.4% of company’s own mines in 2012e. According to Zhaojin’s gold production from its own mines in JORC standards, the mine had c12 tonnes of 2012e. According to JORC standards, the mine had reserves and c17 tonnes of resources at the end of c4.3 tonnes of gold reserves at the end of 2011. 2010. The mine produced c0.9 tonnes of gold in Zhaojin produced 0.1 tonnes of gold in Daqinjia in 2011. We expect this figure to be flat at 0.9 tonnes 2011. We expect production to be flat at 0.1 tonnes in 2012e. in 2012.
Jinchiling Mine, Shandong (100%) Gold operations outside Shandong The Jinchiling Mine is located c7km northwest of The company has been actively acquiring gold Zhaoyuan City. We estimate the mine to contribute assets outside Shandong. The company presently 8% of total gold production from the company’s has gold assets in 10 provinces other than own mines in 2012e. According to JORC standards, Shandong. We estimate Zhaojin to produce 33% the mine had c3 tonnes of reserves and c4 tonnes of self produced gold from mines outside Shandong. resources at the end of 2010. The mine produced Zhaojin’s management expects mines outside c1.1 tonnes of gold in 2011. We expect this figure to Shandong to contribute more than 50% of the be flat at c1.1 tonnes in 2012e. There are three company’s production going forward. cyanidation plants and a smelting plant alongside the mine. These facilities are used to treat Zhaojin’s In 2011, Zhaojin made investments of RMB739m gold concentrates and toll-treat concentrates from to acquire new mine assets and to increase its third parties. stakes in existing assets. In Xingjiang, the company acquired a 50% stake in Sanfengshan Canzhuang Mine, Shandong (100%) Mining, a 79% stake in the Dishui Mine, a 15% Zhaojin Mining acquired the Canzhuang Mine in stake in the Qinghe Mine and a 20% stake in December 2009 for a sum of RMB426m Zhaojin Xinhe. (USD62m). We estimate the mine to contribute 6%
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Major gold assets acquisitions since IPO Dates Target Location Stakes Consideration Gold resources Average grade (RMBm) (tonnes) (g/t) 6/22/2007 Zhaojin Beijiang Mining Xinjiang 100% 74 3.7 (reserves) n.a. 6/22/2007 Minxian Tianhao Gold Gansu 100% 65 1.0 (reserves) n.a. 6/22/2007 Xixia Zhaojin Henan 100% 20 3.1 (reserves) n.a. 6/28/2007 Sarekuobu gold mine Xinjiang 100% 7 3.1 2.7 8/22/2007 Xingta Mining Xinjiang 95% 20 n.a. n.a. 9/28/2007 Fukang Mining Sichuan 100% 27 1.4 8.2 1/2/2008 Fengningjinling Mining Hebei 52% 310 21.0 n.a. 1/19/2009 Zaozigou gold mine Gansu 52% 55 10.8 4.1 2/18/2009 Tianshanze Co. Xinjiang 100% 10 0.2 22.0 2/18/2009 Tianyun Co. Xinjiang 100% 20 0.5 10.0 6/28/2009 Xinyuan Mining Xinjiang 80% 27 2.2 5.4 12/15/2009 Canzhuang gold mine Shandong 100% 427 20.1 4.2 3/5/2010 Qinghe Mining Xinjiang 80% 185 14.2 5.6 3/5/2010 Hezheng Mining Gansu 80% 48 4.4 n.a. 4/28/2010 Longxin Mining Guangxi 100% 47 2.4 4.0 5/24/2010 Baiyun gold mine Liaoning 55% 200 22.8 n.a. 5/28/2010 Xinfengyuan Mining Liaoning 100% 48 n.a. n.a. 10/15/2010 Sanfengshan Xinjiang 50% 100 3.3 n.a. 12/8/2011 Zaoyangshan Shandong 100% 28 1.3 3.3 12/8/2011 Daqinjia Shandong 90% 27 3.9 4.0 12/8/2011 Jishan Shandong 95% 6 1.4 4.1 12/20/2011 Dishui Xinjiang 79% 600 2.2 0.4 3/25/2012 Hou Cang Shandong 100% 245 15.7 2.7 3/25/2012 Jin Han Zun Shandong 100% 353 10.5 4.6
Source: Company data, HSBC
In Gansu, the group acquired a 15% equity Bond issues interest in Hezheng Mining and also signed seven The company issued corporate bonds worth framework agreements on resource integration. cRMB1.5bn (USD218m) during December 2009. Overall, the group added c7 tonnes of gold These bonds had seven years of maturity and paid resources through acquisitions in 2011. an interest rate of 5% per annum. These bonds are listed on the Shanghai Stock Exchange. Overseas acquisition Zhaojin acquired a 2.15% stake in Citigold during Company management July 2010 for a sum of AUD2m. Citigold has Mr. Lu Dongshang is the Chairman and an resources of c342 tonnes at an average grade of Executive Director of the company. He is also the 14g/tonne. Chairman of and the Communist Party secretary IPO and share issues to Zhaojin Group. Mr. Lu Dongshang is also the vice president of the China Gold Association. Zhaojin shares were listed on the Hong Kong Mr. Weng Zhanbin is the President of the Stock Exchange in December 2006. The company company. He is also the Chairman of Fengning issued 199m new shares at HKD12.68 per share Jinlong Gold Industry Co Ltd. and Director of and raised proceeds of HKD2.4bn. Quwo County Zhaojin Mining Co Ltd. In addition, In May 2008, the company issued 729m new he serves as a Director and Chairman of Sparky shares during a 1:1 bonus issue. The issue price International Trade Co Ltd. In the past, he has held amounted to RMB1.00 per share, with RMB0.25 various important posts in the mining industry, from capitalisation of retained profits and including being Communist Party deputy secretary RMB0.75 from capitalisation of capital reserves. of Zhaoyuan Jinchiling Gold Mine.
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Mr. Zhang Banglong has been the CFO of the company since 2005. Earlier he served as the deputy chief accountant and chief accountant of the China Yangzi Group Co Ltd and also as the chief accountant and deputy general manager of the Macat Group Textile Co Ltd. Major Shareholders
Shandong Zhaojin Group Co Ltd owns a c38% stake in the company and is the largest shareholder in Zhaojin. Shanghai Yuyuan Tourist Mart Co Ltd is the second largest shareholder of the company with a c26 % stake.
Asset locations
Heilongjiang
Inner Jiling Mongolia Liaoning Xinjiang Beijing Gansu Tianjin Company Headquarters Ningxia Shangdong Qinghai Jiangsu Shaanxi Henan Tibet Shanghai Anhui Sichuan Hubei Chongqing Zhejiang Jiangxi Hunan Guizhou Fujian
Yunnan Guangdong Guangxi Macau Ta iwan New Acquisition Projects in 2011 Hong Kong E xistin g P rojects Hainan
Source: Company data, HSBC
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Zhaojin Mining: Income statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Net Revenues 4,098 5,741 7,457 8,244 9,245 y-o-y change (%) 47% 40% 30% 11% 12%
Cost of sales 1,787 2,677 3,558 4,036 4,627
Gross profit 2,311 3,064 3,899 4,209 4,617 y-o-y change (%) 59% 33% 27% 8% 10% Gross profit margin (%) 56% 53% 52% 51% 50%
Operating expenses 585 670 895 989 1,109 Selling & distribution expenses 38 56 75 82 92 Admin expenses 547 615 820 907 1,017
Income from Operations 1,726 2,393 3,004 3,219 3,508 Operating profit margin (%) 42% 42% 40% 39% 38%
Other income/(expenses) (74) (107) (162) (170) (157) Interest income 14 12 12 16 29 Interest expenses (92) (98) (154) (166) (166) Share of profit/(loss) from associates 4 7 5 5 5 Others 1 (28)(25) (25) (25)
PBT 1,652 2,287 2,842 3,050 3,351 PBT margin (%) 40% 40% 38% 37% 36%
Taxation (410) (564) (711) (762) (838) Effective tax rate (%) 25% 25% 25% 25% 25%
Minority interests 40 61 43 46 50
Net income 1,202 1,662 2,089 2,241 2,463 y-o-y change (%) 59% 38% 26% 7% 10% Net income margin (%) 29% 29% 28% 27% 27%
EPS (RMB) 0.82 0.57 0.71 0.76 0.83 DPS (RMB) 0.30 0.21 0.25 0.26 0.29 Payout ratio (%) 36% 37% 35% 35% 35%
EBITDA 2,071 2,864 3,454 3,710 3,999 EBITDA margin (%) 51% 50% 46% 45% 43%
Source: Company data, HSBC estimates
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Zhaojin Mining: Balance sheet summary (RMBm) 2010a 2011a2012e 2013e 2014e Assets Current assets 2,183 3,962 4,626 5,947 7,907 Cash 782 1,246 1,146 2,125 3,660 Trade & notes receivables 199 46 143 158 177 Inventories 779 2,131 2,437 2,764 3,169 Prepayments & other receivables 373 521 800 800 800 Investments & others 49 18 100 100 100
Fixed assets 3,691 4,927 6,358 6,750 6,840
Other assets 3,541 4,403 4,731 4,848 4,868 Mining & exploration rights 2,374 2,591 2,911 3,028 3,048 Goodwill 559 587 580 580 580 Interests in associates 39 42 40 40 40 Land lease prepayments 176 237 240 240 240 Deferred tax assets 119 159 160 160 160 Others 274 786800 800 800
Total assets 9,415 13,291 15,715 17,546 19,615
Liabilities Current liabilities 1,485 3,911 4,857 5,132 5,472 S-T borrowings 370 1,510 2,000 2,000 2,000 Trade payables 447 1,538 2,047 2,322 2,662 Others 669 863810 810 810
Non-current liabilities 2,154 2,383 2,290 2,290 2,290 L-T borrowings 71 158 200 200 200 Corporate bonds 1,490 1,491 1,490 1,490 1,490 Others 594 734600 600 600
Total liabilities 3,639 6,294 7,147 7,422 7,762
Shareholder’s equity 5,387 6,584 8,112 9,622 11,300 Share capital 1,457 2,915 2,966 2,966 2,966 Share premium 1,507 751 751 751 751 Other reserves 2,423 2,917 4,394 5,905 7,583
Minority interests 388 414 456 502 552
Total liabilities and shareholders’ equity 9,415 13,291 15,715 17,546 19,615
Gearing Gross debt 1,930 3,159 3,690 3,690 3,690 Cash and ST investment 782 1,246 1,146 2,125 3,660 Net debt/ (cash) 1,148 1,913 2,544 1,565 30
Shareholders equity including minorities 5,776 6,997 8,568 10,124 11,853 Net debt-to-equity 20% 27% 30% 15% 0%
Source: Company data, HSBC estimates
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Zhaojin Mining: Cash flow statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Cash flow from operating activities Profit before taxation 1,652 2,287 2,842 3,050 3,351 Depreciation & amortisation 301 472 449 490 491 Changes in working capital (596) (347) (308) (67) (84) Net interest (paid)/received (71) (112) (142) (150) (137) Tax paid (357) (446) (711) (762) (838) Others 156 226(101) (174) (237) Operating cash flow 1,084 2,079 2,030 2,386 2,546
Cash flow from investing activities Capital expenditure (1,322) (1,709) (2,120) (917) (519) Acquisitions & disposals (575) (138) 2 - - Others 25 (421) (11) - - Investing cash flow (1,873) (2,269) (2,128) (917) (519)
Cash flow from financing activities Dividends paid (321) (458) (612) (731) (784) Changes in capital structure - - 51 - - Debt movements (241) 1,224 531 - - Others (77) (112) 29 241 294 Financing cash flow (639) 654 (1) (490) (491)
Net changes in cash (1,428) 464 (100) 979 1,536
Cash at start of year 2,214 782 1,246 1,146 2,125 Cash at end of year 786 1,246 1,146 2,125 3,660
Source: Company data, HSBC estimates
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Financials & valuation: Zijin Mining Group Co Ltd Overweight (V) Financial statements Key forecast drivers Year to 12/2011a 12/2012e 12/2013e 12/2014e Year to 12/2011a 12/2012e 12/2013e 12/2014e Profit & loss summary (RMBm) Mined gold production (t) 28.6 29.4 29.5 32.8 Mined copper production (t) 85,468 103,250 123,835 149,774 Revenue 39,764 45,956 46,926 50,221 Gold prices (USD/oz) 1,571 1,760 1,775 1,750 EBITDA 10,761 11,222 12,095 13,746 Copper prices (USD/t) 8,820 8,000 7,500 8,000 Depreciation & amortisation -958 -1,065 -1,269 -1,391 Gold unit cost (USD/oz) 1,425 1,637 1,651 1,628 Operating profit/EBIT 9,803 10,157 10,826 12,355 Copper concs unit cost (USD/t) 1,784 2,065 2,169 2,234 Net interest -496 -365 -395 -309 PBT 9,276 9,742 10,381 11,995 HSBC PBT 9,276 9,742 10,381 11,995 Taxation -2,366 -2,435 -2,595 -2,999 Valuation data Net profit 5,713 6,064 6,462 7,467 Year to 12/2011a 12/2012e 12/2013e 12/2014e HSBC net profit 5,713 6,064 6,462 7,467 EV/sales 1.1 1.0 0.9 0.8 Cash flow summary (RMBm) EV/EBITDA 4.1 4.1 3.7 2.9 Cash flow from operations 6,390 7,691 8,870 9,806 EV/IC 1.8 1.5 1.3 1.1 Capex -6,885 -5,400 -5,400 -2,682 PE* 7.2 6.8 6.4 5.5 Cash flow from investment -7,704 -7,595 -5,400 -2,682 PB 1.6 1.4 1.2 1.1 Dividends -1,454 -1,721 -1,819 -1,939 FCF yield (%) -2.1 5.9 8.8 18.1 Change in net debt 399 1,620 -1,650 -5,186 Dividend yield (%) 4.2 4.4 4.7 5.4 FCF equity -850 2,439 3,639 7,476 *Based on HSBC EPS (diluted)
Balance sheet summary (RMBm) Intangible fixed assets 7,477 7,600 7,759 7,900 Issuer information
6 1 . Tangible fixed assets 18,378 22,819 26,790 27,939 Share price (HKD)2.29 Target price (HKD)3.70 6 Current assets 17,932 20,433 22,182 27,810 Cash & others 6,180 6,968 8,618 13,804 Reuters (Equity) 2899.HK Bloomberg (Equity) 2899 HK Total assets 52,320 61,352 67,231 74,150 Market cap (USDm) 10,902 Market cap (HKDm) 85,034 Operating liabilities 12,808 13,944 13,976 14,139 Free float (%) 71 Enterprise value (RMBm) 46,215 Gross debt 9,380 11,788 11,788 11,788 Country China Sector Metals & Mining Net debt 3,200 4,819 3,169 -2,017 Analyst Thomas J Zhu Contact +852 2822 4325 Shareholders’ funds 25,009 29,254 33,777 39,004
Invested capital 24,799 29,939 34,136 35,707 Price relative 7 7 Ratio, growth and per share analysis 6 6 Year to 12/2011a 12/2012e 12/2013e 12/2014e 5 5 Y-o-y % change 4 4 Revenue 39.3 15.6 2.1 7.0 3 3 EBITDA 21.3 4.3 7.8 13.6 2 2 Operating profit 22.3 3.6 6.6 14.1 PBT 26.5 5.0 6.6 15.6 1 1 HSBC EPS -21.1 6.2 6.6 15.5 2010 2011 2012 2013 Zijin Mining Group Co Ltd Rel to HANG SENG CHINA ENTERPRISES INDEX Ratios (%) Source: HSBC Revenue/IC (x) 1.8 1.7 1.5 1.4
ROIC 33.5 28.5 25.9 27.1 ROE 24.4 22.4 20.5 20.5 Note: price at close of 25 Jul 2012 ROA 16.3 13.6 12.8 13.4 EBITDA margin 27.1 24.4 25.8 27.4 Operating profit margin 24.7 22.1 23.1 24.6 EBITDA/net interest (x) 21.7 30.8 30.7 44.5 Net debt/equity 10.6 13.5 7.6 -4.2 Net debt/EBITDA (x) 0.3 0.4 0.3 -0.1 CF from operations/net debt 199.7 159.6 279.9 - Per share data (RMB) EPS Rep (diluted) 0.26 0.28 0.30 0.34 HSBC EPS (diluted) 0.26 0.28 0.30 0.34 DPS 0.08 0.08 0.09 0.10 Book value 1.15 1.34 1.55 1.79
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Zijin Mining (2899 HK)
Zijin has very competitive gold production costs; we expect its copper production to grow at a CAGR of 21% in 2011-14e We think Zijin’s share price will be driven by higher gold or copper prices, further acquisitions, and corporate image recovery after the Zijinshan copper mine resumes production in 2H12e Initiate coverage with an Overweight (V) and a target price of HKD3.70 based on blended PE and DCF valuations
Initiating with Overweight (V) Strong competitive position Thomas Zhu* Analyst Zijin Mining is a diversified mining company, Zijin is among the largest mined gold and copper The Hongkong and Shanghai Banking Corporation Limited primarily involved in gold and copper mining. It producers in China, representing 9% of China’s +852 2822 4325 [email protected] is the largest gold producer in China. We initiate mined gold production in 2011 and c3% of mined copper production. Simon Francis* coverage of Zijin with an Overweight (V) rating Head of Metals & Mining and a target price of HKD3.70 based on a 50:50 Research, Asia Pacific In addition, the company has very large mineral The Hongkong and Shanghai blend of our PE and DCF valuations. Our PE resources and long mine lives. The company had Banking Corporation Limited +852 2996 6620 valuation is HKD3.30, based on a 9.5x 2012e PE, resources of c1,043 tonnes of gold and c13.0m [email protected] and our DCF valuation is HKD4.00. tonnes of copper as at the end of 2011 under a Amit Pansari* Analyst Our positive view on the stock reflects three main mixture of Chinese and international mining HSBC Bank plc standards. We estimate that mine lives are c35 +91 80 3001 3760 factors. Firstly, we have a positive view on gold [email protected] years for gold and c50 years for copper. and Zijin’s earnings are sensitive to gold prices. *Employed by a non-US affiliate of HSBC Securities (USA) Inc, Secondly, the company offers a robust mined Mineral resources and is not registered/ qualified copper volume CAGR of c21% in 2011-14e. Last, tonnes pursuant to FINRA regulations but not the least, we think the stock should be re- Gold 1,043 rated following the recent conclusion of the CSRC Copper (tonnes m) 13.0 Lead & Zinc (tonnes m) 6.5 investigation and the resumption of production at Molybdenum 484,700 the Zijinshan copper mine in 2H12e. Management Tungsten 173,400 Iron ore (tonnes m) 214 is planning a reverse roadshow to the Zijinshan Coal (tonnes m) 459 copper mine in 2H12e. We think this will be the Source: Company data, HSBC catalyst for the re-rating.
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Positive outlook for gold in 2H12e Cash cost of major gold miners, 2012e Our Precious Metals Analyst James Steel believes 2,200 2,000 that gold should regain its lustre as a safe-haven 1,800 1,600 asset in Gold Outlook – Higher in a time of crisis, 1,400 1,200 15 June 2012. He believes that currency moves, 1,000 notably in the EUR/USD, will remain key for gold 800 600 prices. He believes gold prices should rise above 400 Cash percost ounce 200 USD1,900/oz by the year-end 2012 based on the 0 likely impact of easy monetary policy. This 0.2 5.3 10.5 15.2 20.7 24.3 26.4 29.9 32.8 represents more than a 19% appreciation from the Cumulative production, m oz current level. Source: HSBC estimates
Gold prices, USD/oz Robust copper volume growth Current 1H12 avg 2H12e avg Upside to Upside to 2H12e avg 2H12e high We expect Zijin to produce 103,250 tonnes of 1,601 1,650 1,870 17% >19% mined copper in 2012e, up 21% y-o-y and mainly Source: Bloomberg, HSBC estimates driven by the Duobaoshan mine. We forecast that
mined copper production will reach 149,774 Earnings sensitive to gold and copper tonnes in 2014e, representing a CAGR of 21% in prices 2012-14e and driven by both the Zijinshan and the Our view on gold prices is positive for Zijin as the Duobaoshan mines. We expect the Zijinshan company earnings are sensitive to gold prices. We copper mine to resume production in 2H12e. estimate that for a 10% increase in gold prices, Mined copper production Zijin’s earnings should increase by c8% in 2012e. For a 10% increase in copper prices, Zijin’s 160,000 25% 20% earnings should increase by c4% in 2012e. 140,000 15% Earnings sensitivities in 2012e, RMBm 120,000 10%
Tonnes 5% Gold prices in 2012e, USD/oz 100,000 0% 1,426 1,584 1,760 1,936 2,130 6,480 4,759 5,171 5,629 6,086 6,589 80,000 -5% 7,200 4,966 5,378 5,835 6,293 6,796 2010 2011 2012E 2013E 2014E 8,000 5,195 5,607 6,064 6,522 7,025 2012e, Copper Copper prices in 8,800 5,424 5,836 6,294 6,751 7,254 9,680 5,677 6,088 6,546 7,003 7,506 Mined copper production YoY (RHS) Source: HSBC estimates Source: Company data, HSBC estimates Competitive gold production costs Corporate image recovery should We estimate that Zijin’s average gold production lead to re-rating cost will be RMB96/g (USD 478/oz) in 2012e and cash cost will be RMB78/g (USD388/oz), very Zijin had to suspend production at the Zijinshan competitive compared to its global peers. We copper mine after a mine accident in 2010. The think the low costs are driven by: 1) its open-pit company was also put under investigation by the mining at major mines; 2) large production scale CSRC for its information disclosure concerning at Zijinshan; and 3) leading processing and the accident. As a result, Zijin shares got de-rated smelting technologies. from c15x PE to c10x soon after the accident.
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Copper production at the Zijinshan mine Recent acquisitions
45,000 150% Date Target Consideration __ Gold (tonnes)__ Copper (tonnes m) RMBm Resources Reserves Resources 35,000 100% 2011/08 Zuoan gold 422 39 21 n.a. 25,000 50% mine 2011/11 Lixian gold 1,154 119 n.a. n.a. Tonnes 15,000 0% project 2011/11 Gold Eagle 1,438 109 n.a. 1.5 5,000 -50% 2012/05 Norton Gold 1,107 185 31 n.a. Source: Company data, HSBC 2010 2011 2012E 2013E 2014E
Copper production at ZJS YoY (RHS) Strong balance sheet We expect Zijin will have RMB4.8bn of net debt Source: Company data, HSBC by the end of 2012e, with a net-debt-to-equity ratio of 14%. We expect the company to turn net We think the mine’s resumption in 2H12e, along cash by the end of 2014e. with the recent conclusion of the CSRC investigation, will lead to the stock’s re-rating by: Net debt/(cash)
1) removing the major uncertainties resulting 6,000 18% from the mine accidents, and 2) mending Zijin’s corporate image. We think the reverse roadshow 4,000 12% that management is planning in 2H12e will be the 2,000 6%
catalyst for the re-rating. Rmb m 0 0% Further M&A 2010 2011 2012E 2013E 2014E Zijin is among the most active Chinese companies (2,000) -6% in acquisitions, both in China and overseas. The Net debt/(cash) Net debt-to-equity (RHS) company has recently acquired Norton Gold (NGF AU, not rated), the Zuoan Gold Mine in Source: Company data, HSBC
Kyrgyzstan and the Lixian Gold Nine in Gansu. It also bought a 45% stake in the Xietongmen Professional management project in Tibet. We think Zijin is likely to remain Chairman Chen Jinghe has 27 years of experience active in M&A, especially in large-scale projects in gold mining and also serves as vice president of overseas, as the company plans to spend RMB5- the China Gold Association. We think 10bn on acquisitions per year and aims to become management’s experience should benefit Zijin in a leading international mining company. both operations and acquisitions. Lacklustre near-term gold volume growth is the major concern We expect mined gold production to be flat in 2012-13e. We forecast that gold production should be 29.4 tonnes in 2012e and 29.5 tonnes in 2013e. We expect gold production growth to pick up again from 2014e as we forecast the company will produce 32.8 tonnes of mined gold in 2014e,
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up 11% y-o-y and driven by new capacities in Daily PE of Zijin Kyrgyzstan, Gansu and Tajikistan. 24.0 Mined gold production 19.0 33.0 15% 14.0 32.0 10% 9.0 31.0 5% 4.0 30.0 0% Tonnes Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 29.0 -5% 28.0 -10% Daily P/E 2010 2011 2012E 2013E 2014E
Source: Bloomberg, HSBC Mined gold production YoY (RHS) Our life-of-mine DCF valuation is based on the Source: Company data, HSBC estimates following assumptions:
Valuation and risks A cost of capital of 10.0%
Target price of HKD3.70 Adjusted beta of 1.23 measured against the We set a target price of HKD3.70 based on HSCEI index blended PE and life-of-mine DCF valuations. We Borrowings representing 20% of EV apply a 50:50 blend of our PE valuation of HKD3.30, based on 9.5x 2012e PE, and our DCF Gold resources of c1,040 tonnes and copper valuation of HKD4.00. resources of c11.0m tonnes
Our PE valuation is based on a 10% discount to Long-term production of 30.0 tpa of mined Zhaojin’s average PE over the past two years. We gold and 227,661 tpa of mined copper think our target PE is justified as it reflects: 1) the Gold prices forecasts of USD1,760/oz in relatively long-term trading multiple of the 2012e, USD1,775/oz in 2013e and long-run company, and 2) the company’s lower EPS forecast of USD1,500/oz growth and margins in 2012-13e compared to 2010-11. Copper prices forecasts of USD8,000/tonne in 2012e, USD7,500/tonne in 2013e and long- run forecast of USD6,200/tonne Risks We see the following downside risks: Zijin Mining’s earnings are predominantly driven by gold and copper prices which may be lower than we anticipate, resulting in weaker-than-expected earnings. The company may suffer further delay with the Zijinshan copper mine resumption and the capacity ramp-up may be slower than we forecast. Production costs may be higher than we expect.
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Year to Dec (RMBm) 2011 2012e 2013e 2014e 2015e 2016e 2017e 2018e 2019e 2020e 2021e …… 2062e Free cash flow calculation Revenues 39,764 45,956 46,926 50,221 51,483 47,746 50,186 52,661 54,808 53,563 55,433 153,959 Y-o-y 39% 16% 2% 7% 3% -7% 5% 5% 4% -2% 3% 3% EBIT 9,803 10,157 10,826 12,355 14,166 9,856 10,660 11,475 12,113 10,756 11,193 12,403 EBIT margin 25% 22% 23% 25% 28% 21% 21% 22% 22% 20% 20% 8% Tax rate 26% 25% 25% 25% 25% 25% 25% 25% 25% 25% 25% 25% NOPAT 7,303 7,618 8,119 9,266 10,624 7,392 7,995 8,606 9,085 8,067 8,394 9,302 Capex, net (4,732) (5,400) (5,400) (2,682) (2,464) (2,246) (2,028) (1,810) (1,592) (1,374) (1,356) 0 D&A 958 1,065 1,269 1,391 1,435 1,460 1,469 1,461 1,440 1,405 1,361 0 Changes in working capital (1,864) (582) (66) (280) 31 39 (274) (278) (249) 23 (232) (667) Free operating CF 1,665 2,701 3,922 7,695 9,626 6,646 7,162 7,980 8,683 8,120 8,168 8,635 DCF inputs WACC inputs Interest-bearing debt as % of EV 20% Risk-free rate 3.0% WACC 10.0% Market risk premium 7.0% NPV of free cash flows 76,253 Beta 1.23 Less net debt/(cash) 4,819 Cost of debt (pre-tax) 5.0% Less minority interests 1,242 HKD/RMB 1.25 Equity value (HKD m) 87,598 Shares outstanding 21,812 NPV per share (HKD) 4.02
Source: Company data, HSBC estimates
HSBC ratings bands We forecast gold production to remain flat at 29.5 For volatile stocks, the band for an Overweight tonnes in 2013e and copper production should rise rating, is 10ppt above our hurdle rate, which for by another 20% to 123,835 tonnes. Growth in China is 10%. Our target price, together with the copper production should be driven by both the Zijinshan copper mine production resumption and expected dividend yield, implies a potential return the Duobaoshan mine ramp-up. We expect of 66%, which is within the Overweight band. On Zijinshan to produce 21,200 tonnes of mined this basis we rate Zijin Overweight (V). Potential copper in 2013e, up 123% y-o-y as the mine return equals the percentage difference between resumes production in 2H12e. We expect the current share price and the target price, Duobaoshan to produce 28,000 tonnes of copper including the forecast dividend yield when in concentrates in 2013e, up 45% y-o-y as the indicated. mine gets ramped up to its designed capacity in Earnings outlook 2H13e. We forecast Zijin will achieve net income of We expect gold production to reach 32.8 tonnes in RMB6.1bn in 2012e, RMB6.5bn in 2013e and 2014e, up 11% y-o-y. We expect the growth to be RMB7.5bn in 2014e. The earnings growth will be driven by the Yate mine in Gansu and the Zuoan primarily driven by volume growth in copper and mine in Kyrgyzstan. We forecast that copper gold, in our view. production to reach 149,774 tonnes in 2014e, up Production and sales volumes 21% y-o-y, primarily driven by the Zijinshan mine capacity ramp-up. We expect Zijin to produce 29.4 tonnes of mined gold in 2012e, up 3% y-o-y and 103,250 tonnes of Gold and copper prices mined copper, up 21% y-o-y. Growth in copper Our precious metals analyst James Steel forecasts production should be driven by the Duobaoshan London PM gold prices to average USD1,760/oz mine in Heilongjiang, which should come on stream in 2012e.
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in 2012e and to stay almost flat at USD1,775/oz in 2013e and USD1,750/oz in 2014e.
We expect LME copper prices to average USD8,000/tonne in 2012e, USD7,500/tonne in 2013e, down 12% y-o-y and USD8,000/tonne in 2014e, up 7% y-o-y.
Gold and copper prices 2010 2011 2012e 2013e 2014e Gold prices 1,225 1,571 1,760 1,775 1,750 y-o-y 26% 28% 12% 1% -1% Copper prices 7,556 8,820 8,000 7,500 8,000 y-o-y 46% 17% -9% -6% 7%
Source: Bloomberg, HSBC estimates
Earnings sensitivity Zijin’s earnings are sensitive to gold and copper prices. For a 10% change in gold prices, Zijin’s earnings will change by 8% in 2012e and by 7% in 2013e. For a 10% change in copper prices, Zijin’s earnings will change by 4% in 2012e and 2013e.
Earnings sensitivities in 2012e, RMBm Gold prices in 2012e, USD/oz 1,426 1,584 1,760 1,936 2,130 6,480 4,759 5,171 5,629 6,086 6,589 7,200 4,966 5,378 5,835 6,293 6,796 8,000 5,195 5,607 6,064 6,522 7,025 2012e, Copper Copper prices in 8,800 5,424 5,836 6,294 6,751 7,254 9,680 5,677 6,088 6,546 7,003 7,506 Source: HSBC estimates
Earnings sensitivities in 2013e, RMBm Gold prices in 2013e, USD/oz 1,438 1,598 1,775 1,953 2,148 6,075 5,104 5,513 5,967 6,421 6,921 6,750 5,339 5,748 6,202 6,656 7,155 7,500 5,599 6,008 6,462 6,916 7,416 2013e, Copper Copper prices in 8,250 5,860 6,269 6,723 7,177 7,677 9,075 6,146 6,555 7,009 7,464 7,963 Source: HSBC estimates
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What is Zijin Mining? The company produced 57.5 tonnes of refinery gold in 2011, of which Henan Luoyang Zijin Zijin Mining is a diversified mining company, primarily involved in gold and copper mining. It Yinhui Gold Refinery Company accounted for is one of the largest gold producers in China. c62% of the production.
In 2011, the company produced c86 tonnes of Mined gold production stagnant over past four years gold, out of which 28.6 tonnes came from its own 40 40% mines. This represents c10% of total mine- 32 30% produced gold in the China. In 2011, 69% of 24 20% Zijin’s revenues and c68% of its profits came 16 10% from gold segment. The second most important 8 0% segment for Zijin is copper mining. The 0 -10% contribution of the copper segment towards 2011 2005 2006 2007 2008 2009 2010 2011 sales and profits were 11% and 22%, respectively. Business overview Mined Gold production (t) -LHS YoY - RHS
Gold Source: Company data, HSBC estimates
In 2011, the company produced 28.6 tonnes of gold Total gold production grew at CAGR 27% (2005-11) out of its own mines. Its total gold production and 100 150 % mine-produced gold output grew at CAGRs of 27% 75 100 % and 11%, respectively, in 2005-11. 50 50% The majority (c72% in 2011) of mine-produced 25 0% gold come from three of its mines: Zijinshan, 0 -50% Hunchun Shuguang and Guizhou Shuiyindong. 2005 2006 2007 2008 2009 2010 2011 Zijinshan is the largest producer, accounting for c56% of the total mine-produced gold by the T otal gold production (t) YoY - RHS company in 2011. Source: Company data, HSBC estimates
2011 revenue breakdown (after elimination) 2011 net profit breakdown Iron 13% Others 9. 8% Zinc Zinc& Lead 7% 0.4% Gold Copper 68.1% 11% C opp er Gold 21.7% 69%
Source: Company data, HSBC estimates Source: Company data, HSBC estimates
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Key assets profile Location Main products Resources (t) Production (t) Ownership Gold Mines Zijinshan Fujian Bullion 128 16.2 100% Hunchun Shuguang Mine Jilin Concentrates 78 2.3 100% Guizhou Shuiyindong Guizhou Bullion 127 2.1 56%
Refinery Luoyang Zijin Henan Refinery gold 35.8 70%
Copper mines Location Main products Resources (mt) Production (kt) Ownership Ashele Xinjiang Concentrates 0.9 32.7 51% Qinghai Derni Qinghai Concentrates 0.4 28.1 100% Hunchun Shuguang Jilin Concentrates 0.3 9.0 100% Zijinshan Fujian Cathodes & Concentrates 2.6 8.9 100%
Source: Company data, HSBC estimates
Major gold mines & refineries Qinghai Deerni (c32%), Hunchun Shuguang Zijinshan (100% owned): Zijinshan has gold (c10%) and Zijinshan (c10%). resources of 128 tonnes at an average grade of Copper production grew at CAGR 28% (2005-11) 0.45g/tonne (“NI 43-101” technical standards). In
2011, output from this mine was 16.2 tonnes 96 125% mine-produced gold. 80 100% 64 75% Hunchun Shuguang Mine (100%): 2011 gold 48 50% output from this mine was 2.33 tonnes or c8% of 32 25% total mine produced gold. Zijinshan has gold 16 0% 0 -25% resources of c78 tonnes (“NI 43-101” technical 2005 2006 20 07 2008 2009 2010 2011 standards) at an average grade of 0.44g/tonne.
Guizhou Shuiyindong (56%): 2011 gold output C opp er production (kt) YoY - R HS from this mine was 2.1 tonnes. Shuiyindong mine Source: Company data, HSBC estimates has total resource/reserves of 127 tonnes gold (under Chinese mining standards), among which Major Copper mines 104 tonnes are minable resources. Ashele (51% owned): Ashele Mine produced copper concentrates containing 32.7k tonnes of Henan Luoyang Zijin Yinhui Gold Refinery copper in 2011. The mine contains 0.9m tonnes of Company (70%): The company produced 35.8 copper reserves with an average grade of 2.4% tonnes of refinery gold in 2011. and zinc reserves of 0.4m tonnes with an average Copper grade of 1.08%.
Copper mine business accounted for 11% 2011 Qinghai Deerni Mine (60%): This mine sales and 22% of net profit of Zijin. In 2011, the produced copper concentrates containing 28.1k company produced 88 tonnes of copper. During tonnes copper in 2011. The mine has 0.4m tonnes 2005-11 copper production grew at a CAGR of of resources of grade 1.16% (“NI 43-101” 28%. Zijin produces copper mainly from four technical standards). mines – Ashele (c37% of 2011 production),
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Hunchun Shuguang Mine (100%): This mine Resources figure (as of 31 December 2011) produced copper concentrates containing 9k 2011 Y-o-Y tonnes copper in 2011. The mine has 0.3m tonnes Gold (t)* 1,043 39% Copper (mt) 13 10% of resources of grade 0.17% (“NI 43-101” Zinc (mt) 5.4 23% technical standards). Lead (mt) 1.1 24% Nickel (t) 607,100 0% Molybdenum (t) 484,700 -10% Zijinshan (100% interest): Zijinshan mine Tin (t) 99,300 0% produced 1.4k tonnes of copper cathodes and Silver (t) 1,549 --15% Iron ore (mt) 214 16% produced copper concentrates containing 7.5k tonnes Coal (mt) 459 0% Tungsten (t,) 173,400 0% of copper. The mine has 2.6m tonnes of resources of Sulfur iron (mt) 83.7 25% grade 0.47% (“NI 43-101” technical standards). Cobalt (t) 21,600 N/A *Including 117.07 tonnes of gold with other metals Source: Company data, HSBC estimates Lead and Zinc In 2011, c7% of the company’s sales came from the Mineral resources zinc and lead segment; however profit from this segment was less than 0.5% of total profit. In 2011, The company had resources of c1,043 tonnes of Zijin produced 223k tonnes zinc. Most of the gold, c13m tonnes of copper, and c5.2m tonnes of production comes from Bayannaoer Zijin Zinc zinc and 1.1m tonnes of lead in 2011. The Refinery Plant (c84%), Wulatehouqi Zijin (c9%) and company exhibited strong resource growth. Gold Ashele Copper (6%). The company produced lead and copper resources grew at CAGRs of 19% and concentrates containing 3.6k tonnes lead in 2011. 11%, respectively, during 2005-11. Silver, Iron ore and others Company management Zijin produced 145.5 tonnes of silver in 2011. The Mr. Chen Jinghe has been the Chairman of Zijin majority of the production came from Wuping Zijin Mining since 2009. Prior to this he served as the (24%), Ashele Copper Mine (24%), Shanxi Zijin President of the company. He is a delegate to the (15%) and Wuhou Zijin (8%) Along with this, the 10th People’s Congress of Fujian Province and company produced iron concentrates of 2m tonnes. the Vice-President of the China Gold Association. In 2011, sales from this segment were c13% of total Mr. Luo Yingnan is President and a Director of Zijin sales and profit from this segment was c10% of Mining. Prior to this, he was Vice-Chairman of the total profits. company from August 2006 to November 2009. He
Gold resources grew at CAGR 19% (2005-11) Copper resources grew at CAGR 11% since (2005-11)
1,200 50% 12 45 %
960 40% 9 30 % 720 30% 6 15 % 480 20% 240 10% 3 0% 0 0% 0 -15% 2005 2006 2007 2008 2009 2010 2011 2005 2006 2007 20 08 2009 2010 2011
Gold resourc e (t) YoY - RHS Copper resource (mt) YoY - R HS
Source: Company data, HSBC estimates Source: Company data, HSBC estimates
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served as Director and General Manager of the IPO and secondary listing company from August 2000 to August 2006. Zijin listed on the Hong Kong Stock Exchange in Mr. Liu Xiaochu has been Vice-Chairman of the December 2003 and issued c400m new shares at company since August 2000. He resigned as an HKD3.30/share. The company raised net proceeds Executive Director with effect from 28 March 2012. of cHKD1.1bn (cUSD148m). Major shareholders Zijin listed on the Shanghai Stock Exchange in April 2008 and issued 1.4bn new shares at Minxi Xinghang State-owned Assets Investment RMB7.13/share. The company raised net proceeds Co is the largest shareholder of Zijin and holds a of cRMB9.8bn (cUSD1.4bn). c29% stake in the company. As at 31 December 2011, Zijin Mining has a total of Mr. Chen Fashu and Xinhuadu Industrial Group 21,811,963,650 ordinary shares (nominal value of both hold a c11% stake in Zijin and are the second RMB0.1 each). Of this 6,008,160,000 shares (H and third largest shareholders in the company, shares) are listed on Hong Kong Stock Exchange, respectively. Mr Chen Fashu owns a c74% representing c28% of the total issued shares, and the interest in Xinhuadu Industrial Group. Effectively, remaining 15,803,803,650 shares (A shares) are Mr. Chen Fashu holds 19.4% of Zijin Mining. listed on the Shanghai Stock Exchange, representing c72% of the total issued shares.
Zijin Mining asset locations
Duo Bao Shan Copper Mine Ashele Copper Mine
MengkuIron Mine Hun Chun Gold & Copper Mine
Yang Jin Gou Tungston Mine Qi Tai Coal Mine
Dong Ping Gold Mine Wu La General lead & Zinc Mine Urad Houqi Zinc Mine
Yi Xing ZhaiGold Mine Longkou Gold Mine
DeerniCopper Mine Lu Yuan Gou G old Mine Luoyang Cky Yin Hui Gold Refinery
LixianGold Mine
CaodiGold Mine Tang jiaPing MolybdanurnMine Dongbei zhai Gold Mine Yu Long Copper Mine JiaoChong Gol d Mine Xie TongmaoGold Mine An Hua county LianJia Ping Gold Mine Muli Gold Mine Makeng Iron Mine Xiangri-La Copper Mine Hui Long Gold Mine
Yuanyang Gold MineShuiYinging Gold Mine Zijinshan Gold and Copper Mine
Masupo Tungsten Mine Yin Yan Tin Mine
Source: Company data, HSBC
270 Natural Resources & Energy China Equity abc July 2012
Zijin Mining: Income statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Net Revenues 28,540 39,764 45,956 46,926 50,221 y-o-y change (%) 36% 39% 16% 2% 7%
Cost of sales 18,690 27,919 33,777 34,035 35,355
Gross profit 9,849 11,845 12,179 12,890 14,866 y-o-y change (%) 45% 20% 3% 6% 15% Gross profit margin (%) 35% 30% 27% 27% 30%
Operating expenses 1,831 2,043 2,022 2,065 2,511 Selling & distribution expenses 469 433 414 422 502 Admin expenses 1,362 1,609 1,608 1,642 2,009
Income from Operation 8,018 9,803 10,157 10,826 12,355 Operating profit margin (%) 28% 25% 22% 23% 25%
Other income/(expenses) (687) (526) (415) (445) (359) Interest income 122 131 164 195 280 Interest expenses (313) (628) (529) (589) (589) Share of profit/(loss) from associates/JV 137 205 200 200 200 Others (633) (235)(250) (250) (250)
PBT 7,332 9,276 9,742 10,381 11,995 PBT margin (%) 26% 23% 21% 22% 24%
Taxation (1,576) (2,366) (2,435) (2,595) (2,999) Effective tax rate (%) 21% 26% 25% 25% 25%
Minority interests 928 1,198 1,242 1,324 1,529
Net income 4,828 5,713 6,064 6,462 7,467 y-o-y change (%) 36% 18% 6% 7% 16% Net income margin 17% 14% 13% 14% 15%
EPS (RMB) 0.33 0.26 0.28 0.30 0.34 DPS (RMB) 0.10 0.08 0.08 0.09 0.10 Payout ratio (%) 30% 30% 30% 30% 30%
EBITDA 8,868 10,761 11,222 12,095 13,746 EBITDA margin (%) 31% 27% 24% 26% 27%
Source: Company data, HSBC estimates
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Zijin Mining: Balance sheet summary (RMBm) 2010a 2011a2012e 2013e 2014e Assets Current assets 11,061 17,932 20,433 22,182 27,810 Cash 4,651 6,180 6,968 8,618 13,804 Trade & bills receivable 996 1,064 1,637 1,671 1,789 Prepayments & other receivables 1,424 2,679 2,500 2,500 2,500 Inventories 3,483 7,160 8,329 8,392 8,718 Others 507 8491,000 1,000 1,000
Fixed assets 12,557 18,378 22,819 26,790 27,939 Property, plant and equipment 8,445 10,145 14,319 18,290 19,439 CIP & construction materials 4,113 8,232 8,500 8,500 8,500
Other assets 14,784 16,011 18,100 18,259 18,400 Mining & trading rights 5,293 7,138 7,300 7,459 7,600 Long-term equity & other investments 4,786 4,193 5,500 5,500 5,500 Goodwill 383 339 300 300 300 Others 4,321 4,340 5,000 5,000 5,000
Total assets 38,401 52,320 61,352 67,231 74,150
Liabilities Current liabilities 9,636 16,365 18,764 18,796 18,959 Short-term borrowings 5,149 4,032 5,300 5,300 5,300 Held-for-trading financial liabilities 2 4,006 4,600 4,600 4,600 Trade payables 1,025 3,232 4,164 4,196 4,359 Others 3,461 5,095 4,700 4,700 4,700
Non-current liabilities 2,736 5,823 6,968 6,968 6,968 Long-term borrowings 2,303 2,361 3,500 3,500 3,500 Bonds payable - 2,988 2,988 2,988 2,988 Others 433 475480 480 480
Total liabilities 12,373 22,188 25,732 25,764 25,926
Shareholder’s equity 21,832 25,009 29,254 33,777 39,004 Share capital 1,454 2,181 2,181 2,181 2,181 Share premium 9,699 8,972 8,972 8,972 8,972 Other reserves 10,679 13,856 18,101 22,624 27,851
Minority interests 4,197 5,124 6,366 7,690 9,219
Total liabilities and shareholders’ equity 38,401 52,320 61,352 67,231 74,150
Gearing Gross debt 7,452 9,380 11,788 11,788 11,788 Cash and ST investment 4,651 6,180 6,968 8,618 13,804 Net debt/ (cash) 2,800 3,200 4,819 3,169 (2,017)
Shareholders equity including minorities 26,029 30,133 35,620 41,467 48,223 Net debt-to-equity 11% 11% 14% 8% -4%
Source: Company data, HSBC estimates
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Zijin Mining: Cash flow statement summary (RMBm) 2010a 2011a2012e 2013e 2014e Cash flow from operating activities Profit after tax 5,756 6,911 7,306 7,786 8,997 Depreciation & amortisation 1,079 1,155 1,065 1,269 1,391 Changes in working capital (1,107) (1,864) (582) (66) (280) Others 193 188(99) (119) (301) Operating cash flow 5,920 6,390 7,691 8,870 9,806
Cash flow from investing activities Capital expenditure (4,467) (6,885) (5,400) (5,400) (2,682) Others (1,825) (819) (2,195) - - Investing cash flow (6,292) (7,704) (7,595) (5,400) (2,682)
Cash flow from financing activities Dividends paid (1,454) (1,454) (1,721) (1,819) (1,939) Debt movements 3,000 5,546 2,408 - - Others (360) (1,559) 5 - - Financing cash flow 1,185 2,533 693 (1,819) (1,939)
Net changes in cash 814 1,219 788 1,650 5,186
Cash at start of year 2,999 3,791 6,180 6,968 8,618 FX effects (21) (93) - - - Cash at end of year 3,791 4,917 6,968 8,618 13,804
Source: Company data, HSBC estimates
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Disclosure appendix
Analyst Certification The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Simon Francis, Thomas J Zhu, Chris Chen, Amit Pansari, James Steel, Howard Wen, Hongbin Qu, Jun Wei Sun and Andrew Keen Important disclosures Stock ratings and basis for financial analysis HSBC believes that investors utilise various disciplines and investment horizons when making investment decisions, which depend largely on individual circumstances such as the investor’s existing holdings, risk tolerance and other considerations. Given these differences, HSBC has two principal aims in its equity research: (1) to identify long-term investment opportunities based on particular themes or ideas that may affect the future earnings or cash flows of companies on a 12-month horizon; and (2) from time to time to identify short-term investment opportunities that are derived from fundamental, quantitative, technical or event-driven techniques on a 0- to 3-month horizon and which may differ from our long-term investment rating. HSBC has assigned ratings for its long-term investment opportunities as described below. This report addresses only the long-term investment opportunities of the companies referred to in the report. As and when HSBC publishes a short-term trading idea the stocks to which these relate are identified on the website at www.hsbcnet.com/research. Details of these short-term investment opportunities can be found under the Reports section of this website. HSBC believes an investor’s decision to buy or sell a stock should depend on individual circumstances such as the investor’s existing holdings and other considerations. Different securities firms use a variety of ratings terms as well as different rating systems to describe their recommendations. Investors should carefully read the definitions of the ratings used in each research report. In addition, because research reports contain more complete information concerning the analysts’ views, investors should carefully read the entire research report and should not infer its contents from the rating. In any case, ratings should not be used or relied on in isolation as investment advice. Rating definitions for long-term investment opportunities Stock ratings HSBC assigns ratings to its stocks in this sector on the following basis: For each stock we set a required rate of return calculated from the cost of equity for that stock’s domestic or, as appropriate, regional market established by our strategy team. The target price for a stock represents the value the analyst expects the stock to reach over our performance horizon. The performance horizon is 12 months. For a stock to be classified as Overweight, the potential return, which equals the percentage difference between the current share price and the target price, including the forecast dividend yield when indicated, must exceed the required return by at least 5ppt over the next 12 months (or 10ppt for a stock classified as Volatile*). For a stock to be classified as Underweight, the stock must be expected to underperform its required return by at least 5ppt over the next 12 months (or 10ppt for a stock classified as Volatile*). Stocks between these bands are classified as Neutral. Our ratings are re-calibrated against these bands at the time of any ‘material change’ (initiation of coverage, change of volatility status or change in target price). Notwithstanding this, and although ratings are subject to ongoing management review, expected returns will be permitted to move outside the bands as a result of normal share price fluctuations without necessarily triggering a rating change. *A stock will be classified as volatile if its historical volatility has exceeded 40%, if the stock has been listed for less than 12 months (unless it is in an industry or sector where volatility is low) or if the analyst expects significant volatility. However, stocks which we do not consider volatile may in fact also behave in such a way. Historical volatility is defined as the past month’s average of the daily 365-day moving average volatilities. In order to avoid misleadingly frequent changes in rating, however, volatility has to move 2.5ppt past the 40% benchmark in either direction for a stock’s status to change.
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Rating distribution for long-term investment opportunities As of 30 July 2012, the distribution of all ratings published is as follows: Overweight (Buy) 50% (26% of these provided with Investment Banking Services) Neutral (Hold) 37% (26% of these provided with Investment Banking Services) Underweight (Sell) 13% (18% of these provided with Investment Banking Services)
Information regarding company share price performance and history of HSBC ratings and target prices in respect of its long- term investment opportunities for the companies the subject of this report,is available from www.hsbcnet.com/research. HSBC & Analyst disclosures Disclosure checklist Company Ticker Recent price Price Date Disclosure ALUMINUM CORP OF CHINA 2600.HK 3.09 27-Jul-2012 2,5,6,7,11 ANGANG STEEL 0347.HK 3.65 27-Jul-2012 4,11 CHINA COAL ENERGY CO 1898.HK 6.62 27-Jul-2012 4,11 CHINA SHENHUA ENERGY 1088.HK 28.40 27-Jul-2012 4,11 CHINA STEEL CORP 2002.TW 26.00 27-Jul-2012 1,5,7 JIANGXI COPPER CO LTD 0358.HK 16.90 27-Jul-2012 7,11 MAANSHAN IRON & STEEL 0323.HK 1.60 27-Jul-2012 7,11 SHOUGANG FUSHAN 0639.HK 2.14 27-Jul-2012 4,11 YANZHOU COAL MINING 1171.HK 11.24 27-Jul-2012 4,11 ZHAOJIN MINING INDUSTRY 1818.HK 9.58 27-Jul-2012 11 ZIJIN MINING GROUP CO LTD 2899.HK 2.41 27-Jul-2012 11
Source: HSBC
1 HSBC* has managed or co-managed a public offering of securities for this company within the past 12 months. 2 HSBC expects to receive or intends to seek compensation for investment banking services from this company in the next 3 months. 3 At the time of publication of this report, HSBC Securities (USA) Inc. is a Market Maker in securities issued by this company. 4 As of 30 June 2012 HSBC beneficially owned 1% or more of a class of common equity securities of this company. 5 As of 30 June 2012, this company was a client of HSBC or had during the preceding 12-month period been a client of and/or paid compensation to HSBC in respect of investment banking services. 6 As of 30 June 2012, this company was a client of HSBC or had during the preceding 12-month period been a client of and/or paid compensation to HSBC in respect of non-investment banking securities-related services. 7 As of 30 June 2012, this company was a client of HSBC or had during the preceding 12-month period been a client of and/or paid compensation to HSBC in respect of non-securities services. 8 A covering analyst/s has received compensation from this company in the past 12 months. 9 A covering analyst/s or a member of his/her household has a financial interest in the securities of this company, as detailed below. 10 A covering analyst/s or a member of his/her household is an officer, director or supervisory board member of this company, as detailed below. 11 At the time of publication of this report, HSBC is a non-US Market Maker in securities issued by this company and/or in securities in respect of this company
Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenue. For disclosures in respect of any company mentioned in this report, please see the most recently published report on that company available at www.hsbcnet.com/research. *HSBC Legal Entities are listed in the Disclaimer below.
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Additional disclosures 1 This report is dated as at 31 July 2012. 2 All market data included in this report are dated as at close 25 July 2012, unless otherwise indicated in the report. 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its Research business. HSBC’s analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBC’s Investment Banking business. Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or price sensitive information is handled in an appropriate manner. 4 As of 30 June 2012, HSBC and/or its affiliates (including the funds, portfolios and investment clubs in securities managed by such entities) either, directly or indirectly, own or are involved in the acquisition, sale or intermediation of, 1% or more of the total capital of the subject companies securities in the market for the following Company(ies): ANGANG STEEL, CHINA COAL ENERGY CO, CHINA SHENHUA ENERGY, SHOUGANG FUSHAN, YANZHOU COAL MINING 5 As of 20 July 2012, HSBC owned a significant interest in the debt securities of the following company(ies): ALUMINUM CORP OF CHINA
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Disclaimer
*Legal entities as at 12 June 2012 Issuer of report ‘UAE’ HSBC Bank Middle East Limited, Dubai; ‘HK’ The Hongkong and Shanghai Banking The Hongkong and Shanghai Banking Corporation Limited, Hong Kong; ‘TW’ HSBC Securities (Taiwan) Corporation Limited; ‘CA’ HSBC Corporation Limited Bank Canada, Toronto; HSBC Bank, Paris Branch; HSBC France; ‘DE’ HSBC Trinkaus & Burkhardt AG, Düsseldorf; 000 HSBC Bank (RR), Moscow; ‘IN’ HSBC Securities and Capital Markets (India) Level 19, 1 Queen’s Road Central Private Limited, Mumbai; ‘JP’ HSBC Securities (Japan) Limited, Tokyo; ‘EG’ HSBC Securities Egypt Hong Kong SAR SAE, Cairo; ‘CN’ HSBC Investment Bank Asia Limited, Beijing Representative Office; The Hongkong Telephone: +852 2843 9111 and Shanghai Banking Corporation Limited, Singapore Branch; The Hongkong and Shanghai Banking Telex: 75100 CAPEL HX Corporation Limited, Seoul Securities Branch; The Hongkong and Shanghai Banking Corporation Fax: +852 2596 0200 Limited, Seoul Branch; HSBC Securities (South Africa) (Pty) Ltd, Johannesburg; ‘GR’ HSBC Securities SA, Athens; HSBC Bank plc, London, Madrid, Milan, Stockholm, Tel Aviv; ‘US’ HSBC Website: www.research.hsbc.com Securities (USA) Inc, New York; HSBC Yatirim Menkul Degerler AS, Istanbul; HSBC México, SA, Institución de Banca Múltiple, Grupo Financiero HSBC; HSBC Bank Brasil SA – Banco Múltiplo; HSBC Bank Australia Limited; HSBC Bank Argentina SA; HSBC Saudi Arabia Limited; The Hongkong and Shanghai Banking Corporation Limited, New Zealand Branch incorporated in Hong Kong SAR This document has been issued by The Hongkong and Shanghai Banking Corporation Limited (“HSBC”) in the conduct of its Hong Kong regulated business for the information of its institutional and professional investor (as defined by Securities and Future Ordinance (Chapter 571)) customers; it is not intended for and should not be distributed to retail customers in Hong Kong. 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Global Natural Resources & Energy
Research Team Metals and Mining Chemicals EMEA Europe Andrew Keen Dr Geoff Haire Global Sector Head, Metals and Mining +44 20 7991 6892 [email protected] +44 20 7991 6764 [email protected] Sebastian Satz, CFA Thorsten Zimmermann, CFA +44 20 7991 6894 [email protected] +44 20 7991 6835 [email protected] Jesko Mayer-Wegelin, CFA Vladimir Zhukov +49 211 910 3719 [email protected] +7 495 783 8316 [email protected] CEEMEA CEEMEA Cor Booysen Yonah Weisz +27 11 6764224 [email protected] +972 3 710 1198 [email protected] Richard Hart Sriharsha Pappu, CFA +27 11 676 4218 [email protected] +971 4 423 6924 [email protected] North America & Latin America Omprakash Vaswani +91 80 3001 3786 [email protected] Jonathan Brandt +1 212 525 4499 [email protected] Asia James Steel Dennis Yoo, CFA +1 212 525 3117 [email protected] +852 2996 6917 [email protected] Patrick Chidley, CFA +1 212 525 4915 [email protected] Utilities Europe Howard Wen Adam Dickens +1 212 525 3726 [email protected] +44 20 7991 6798 [email protected] Asia Simon Francis José A López Regional Head of Metals and Mining, Asia Pacific +44 20 7991 6710 [email protected] +852 2996 6620 [email protected] Verity Mitchell Thomas Zhu +44 20 7991 6840 [email protected] + 852 2822 4325 [email protected] Asia Chris Chen Jenny Cosgrove +852 2822 4277 [email protected] Regional Head of Utilities and Alternative Energy, Asia Pacific Jigar Mistry, CFA +852 2996 6619 [email protected] +91 22 2268 1079 [email protected] Arun Kumar Singh Amit Pansari, CFA Analyst +91 80 3001 3760 [email protected] +91 22 2268 1778 [email protected] Energy Latin America Europe Eduardo J Gomide Paul Spedding +55 11 3371 9502 [email protected] Global Sector Co-head, Oil and Gas CEEMEA +44 20 7991 6787 [email protected] Levent Bayar David Phillips Analyst Global Sector Co-head, Oil and Gas +90 212 376 46 17 [email protected] +44 20 7991 2344 [email protected] Dmytro Konovalov Peter Hitchens +7 495 258 3152 [email protected] +44 20 7991 6822 [email protected] Phillip Lindsay Alternative Energy +44 207 991 2577 [email protected] Jenny Cosgrove Kirtan Mehta, CFA Regional Head of Utilities and Alternative Energy, Asia Pacific +91 80 3001 3779 [email protected] +852 2996 6619 [email protected] CEEMEA, Latam Charanjit Singh Anisa Redman +91 80 3001 3776 [email protected] +1 212 525 4917 [email protected] Gloria Ho Bülent Yurdagül +852 2996 6941 [email protected] +90 212 376 46 12 [email protected] Ildar Khaziev, CFA Specialist Sales +7 495 645 4549 [email protected] Mark van Lonkhuyzen Middle East +44 20 7991 1329 [email protected] John Tottie, CFA +966 1 299 2101 [email protected] Billal Ismail +44 20 7991 5362 [email protected] Asia Thomas Hilboldt Annabelle O'Connor Regional Head of Oil, Gas and Petrochemical Research, Asia Pacific +44 20 7991 5040 [email protected] +852 2822 2922 [email protected] James Lesser Kevin Lian +44 207 991 1382 [email protected] +852 2822 4337 [email protected] Dennis Yoo, CFA +852 2996 6917 [email protected] Kumar Manish +91 22 2268 1238 [email protected] Puneet Gulati +91 22 681235 [email protected] SI Tingting +852 2996 6590 [email protected]
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Natural Resources & Energy China Equity July 2012
Simon Francis* Metals & Mining Head of Metals & Mining Research, Asia Pacific The Hongkong and Shanghai Banking Corporation Limited +852 2996 6620 [email protected]
Simon Francis joined HSBC as Regional Sector Head of Metals & Mining in March 2012. He is a Chartered Accountant (UK ACA) with Metals & Mining a degree in mathematics from the University of London. Simon’s equity research experience in Asia spans almost 20 years, virtually all of it covering the Metals & Mining sector. He has lived in various countries in Asia and worked for various financial institutions. From 2003 to 2012, he was regional sector head at prominent securities firms in Hong Kong, achieving significant recognition in the Greenwich Asia, Greenwich Europe, and Greenwich US surveys. Back to reality – launching coverage in China, Taiwan and Mongolia Thomas Zhu* Analyst, Metals & Mining, Asia Pacific The Hongkong and Shanghai Banking Corporation Limited +852 2822 4325 [email protected]
Thomas Zhu joined HSBC in March 2012 as Metals & Mining Analyst for the Asia-Pacific region. He holds a Master’s degree in Business from Tsinghua University, Beijing. Following completion of a rigorous graduate training programme at a global investment bank, Thomas worked with Simon Francis as a metals analyst from 2009 to 2012.
Chris Chen* Analyst, Metals & Mining, Asia Pacific The Hongkong and Shanghai Banking Corporation Limited
+852 2822 4277 China Equity [email protected] We forecast a return to normalized demand growth and prices. Commodities markets are not Chris Chen holds a first class honours degree in accounting and finance from the Hong Kong University of Science & Technology. tight enough to drive up prices, though downside risks are largely cost-curve limited. We Before joining HSBC’s Metals & Mining team as Associate Analyst in 2012, she worked for a global assurance, tax and advisory services firm as an audit associate and with Simon Francis as a research associate. believe China is roughly a decade away from peak consumption levels
Amit Pansari, CFA* Analyst Stock valuations are at trough levels. Commodities prices should recover somewhat in 2H12 HSBC Bank plc +91 80 3001 3760 although risks to demand remain. We see the investment opportunities as being poor in steel [email protected] and aluminium, better in copper, thermal and metallurgical coal, and good in gold Amit Pansari joined HSBC in June 2007 as a part of the Metals & Mining Research team. Prior to joining HSBC, he worked as a research analyst with a global analytical company and as a business analyst with an Indian fast-moving consumer good company. Amit is a Chartered Accountant and a CFA charter holder. We initiate/resume coverage of 14 stocks. Our top picks are China Shenhua, Mongolian Mining,
Andrew Keen* Zijin Mining, Shougang Fushan Resources and China Metal Recycling Global Sector Head, Metals and Mining HSBC Bank plc +44 20 7991 6764 [email protected]
Andrew Keen joined HSBC in 2009 as the Head of Metals and Mining Research for EMEA. He has been a sell-side metals and mining equity analyst since 2006 and joined HSBC from a US brokerage. His prior experience includes managing base metals commodity research for an industry consultancy and he spent his early career in the Australian mining industry.
James Steel Analyst HSBC Securities (USA) Inc. +1 212 525 6515 [email protected]
James Steel is HSBC’s Chief Commodities Analyst with specific responsibilities for precious metals. Jim joined HSBC in May 2006. Previously Jim ran the New York research department of a large US commodities brokerage house. He also worked for The Economist in the Economist Intelligence Unit covering commodity producing nations. Jim’s primary duties at HSBC include the production of daily market reports, including long term outlooks for the precious and base metals. These include supply/demand and price forecasts, as well as qualitative analyses. Jim is a frequent speaker at commodities related conferences. He is often quoted in the financial media and frequently appears on CNBC. Jim studied economics in London and New York. By Simon Francis and team
*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations.
July 2012 Disclosures and Disclaimer This report must be read with the disclosures and analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it