02 December 2010 HONG KONG/CHINA EQUITY

Investment Research

Private Circulation Only

Ng Sem Guan, CFA +60 (3) 9207 7678 [email protected] China’s Steel Sector

Bright Spots in the New Landscape

As China‘s steel sector enters a new era of consolidation, we think it is time for a revisit. We are initiating coverage with an OVERWEIGHT rating driven by the following factors:

(i) We expect the Chinese government to stick to the magic “8%” GDP growth target after a near-unbroken record in the past three decades and given an impending crucial leadership change in 2012.

(ii) The robust GDP growth target suggests continued government spending in FAIs to balance the slowdown in the property markets in the coastal region, hence spurring demand in long steel products. Meanwhile, flat producers of specialised steel may benefit from consumption upgrading.

(iii) The multi-fold increase in iron ore and coking coal prices suggest that it is time for prices to stabilise; yet there is limited downside in view of higher production cost in China and a possible delay in opening new mines. Going forward, the market may eventually accept current selling prices, which still have slight upside potential.

(iv) The new landscape suggests that steel mills may return to mid-cycle ROEs similar to that in 2006, which translate into compelling valuations, especially after the recent market-wide correction.

OSK Research 1 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

CONTENTS

EXECUTIVE SUMMARY 3

EVOLUTION OF THE STEEL INDUSTRY 4

CHINA AND STEEL 6

CHINA STEEL INDUSTRY – WHAT’S NEXT? 8

IDENTIFYING THE “HOT SPOTS” 15

o PROPERTY: GRABBING A PIECE OF THE ACTION 16

o INFRASTRUCTURE: KEY THEME – DEVELOPMENT IN THE WEST 20

o OIL & GAS: MORE ON THE PIPELINE 22

o AUTOMOTIVE: CHINA’S EUPHORIA OVER CARS 24

o MACHINERY: PRIME BENEFICIARY OF INDUSTRIAL UPGRADING 26

o WHITE GOODS: MOVING UP THE VALUE CHAIN 27

o SHIPPING: THE RUSH TO CLEAR THE BACKLOG 28

o EXPORTS: LIKELY TO REMAIN WEAK 30

CONSOLIDATION WAVE IS HERE TO STAY 32

SOME UPSIDE FOR MATERIALS COST DESPITE LOOKING TOPPISH 36

IMPROVED AVERAGE SELLING PRICE OFFERS BETTER SPREAD 44

NORMALISING EARNINGS MOVING FORWARD 46

STABLE EARNINGS MAY TRANSLATE INTO HIGHER VALUATIONS 48

RISKS TO OUR BULLISH VIEW 51

COMPANY REPORTS: 53

o ANGANG STEEL COMPANY LIMITED (347.HK): A STEEL GIANT IN THE MAKING 54

o CHINA ORIENTAL GROUP CO LTD (581.HK): GET SET FOR A NEW ADVENTURE 65

o CHONGQING IRON & STEEL CO LTD (1053.HK): TOO MANY SPEED BUMPS 78

o MAANSHAN IRON & STEEL CO LTD (323.HK): ROOM FOR UPSIDE SURPRISE 89

o SHOUGANG CONCORD INTERNATIONAL ENTERPRISES (697.HK): VERTICAL INTEGRATION 101 PAYS OFF

OSK Research 2 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

EXECUTIVE SUMMARY

China likely to keep its economy burning bright. While some quarters are concerned over the fading effects of China’s RMB4trn stimulus packages and the end of the 11th Five-Year Plan, others point to signs of an overheating economy driving policy makers to possibly moderate economic growth. Nonetheless, we see no reason for the government not to keep the magic 8% GDP growth target for the medium term, especially as this rapid pace has been maintained over the past three decades and with the impending crucial leadership change for the country. Therefore, we expect the government to continue to spend on Fixed Asset Investments (FAI) while spurring private spending to narrow the income gap and improve the quality of life. This will both direct and indirectly drive steel demand.

“Steel” some bright spots. Zooming in on the steel industry, we are more upbeat on flat products, especially specialised steel, as China is moving to the third phase of consumption upgrading and the accompanying robust demand for white goods and automotives. The government’s efforts to promote industrial upgrading will also boost machinery demand, which will in turn bolster demand for steel plates and sheets. The housing euphoria in China is likely to continue but the momentum may soften, especially in the coastal region, where property prices have overshot the roof, prompting measures by the government to cool things down. However, FAIs remain vital to the Chinese economy and we expect the government to maintain spending although it may divert its focus to the western regions, hence compensating for the slowdown in the over-developed coastal region.

Iron ore and coking coal prices look toppish. After spiralling multi-fold in the past decade, we think that iron ore and coking coal prices may have reached a plateau, taking the cue from diminishing steel demand after miners secured 90% and 55% increases for both materials in 2Q10. Nonetheless, we see limited downside for the raw materials from current levels as China is still hungry for the commodities while gradual economic expansion in other parts of the world may further fuel demand. Prices will also be supported by the higher production cost of iron ore mines in China and the potential delay in commissioning new mines. Coking coal supply in China is also expected to be affected by the government’s clampdown on illegal mines.

Steel price may consolidate with an upward bias. With the new landscape for material prices and steel demand worldwide intact, we expect the market to slowly accept the current price as the new benchmark. The eventual agreement on the price level may see selling prices improve a little to reflect more reasonable steel production margins. We also expect the improving supply-demand dynamics to help steel mills better manage their inventory and switch their focus to raising production efficiency.

Poised for mid-cycle earnings. As we see a new landscape emerging for the steel industry, we are projecting for normalising returns for steel mills going forward. A comparison of their past ROEs showed that steel mills generally enjoyed mid-cycle ROEs in FY06 when prices generally moved within a narrow range. This analysis lends support to our view that steel mills under our universe are on course to returning to normalised earnings, and in turn satisfactory ROEs.

Initiate with OVERWEIGHT. The recent market-wide correction in the global equity markets including the HKSE has rendered steel stocks’ valuations more compelling, especially given the more optimistic sector outlook, backed by China’s continuous FAI efforts to keep the economy humming, in addition to rising purchasing power. Therefore, we initiate coverage on China’s steel sector with an overweight rating, and pick Magang as our Top BUY. We also line up Angang, China Oriental and SCIE in our BUY list. Chongang is the only stock we are initiating coverage on with a NEUTRAL as we see its earnings being impacted by its huge debt burden and depreciation charges arising from its relocation plan.

Stock Ticker Closing at 1 Dec FV Mkt Cap VolumePER (x) FY0 FY1 Rel. Performance % P/BV Rating HKD (HKD m) (m) FY1 FY2 ROE %DY %1‐mth 3‐mth 12mth (x) Angang 347 HK 11.34 13.75 67,567.0 17.6 18.4 12.2 1.4 2.7 ‐10.4 6.1 ‐14.5 1.5 Buy China Oriental 581 HK 3.00 4.25 8,760.0 0.2 7.0 4.7 13.2 2.8 1.7 ‐0.1 72.6 2.3 Buy Chongang 1053 HK 2.03 1.92 6,473.0 4.3 153.7 17.0 1.2 0.0 ‐7.0 ‐5.0 ‐22.8 0.6 Neutral Magang 323 HK 4.19 5.15 30,925.0 33.8 18.2 10.3 0.9 1.9 ‐5.3 ‐8.9 17.2 0.8 Buy Shougang 697 HK 1.18 1.80 9,647.0 69.0 13.6 9.3 ‐12.5 2.2 0.4 ‐9.8 ‐36.9 0.6 Buy

OSK Research 3 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

EVOLUTION OF THE STEEL INDUSTRY

The four phases of the global steel industry’s development since the 1950s...

Industrialization from 50s to 70s bumps up steel requirement. Post World War II, during the period between the 1950s to 1970s, global production output of steel climbed at an average 5.8% a year as industrialization took hold in most developed nations. As nations’ GDP, employment, and economic development experienced robust growth, their industries were correspondingly consuming more steel for their infrastructure, automotive, construction, engineering and shipping expansion needs.

Oil crisis marked the start of a long period of consolidation. The steel industry’s robust growth hit the brakes when the oil crisis erupted in 1973, marking the start of a long journey of industry consolidation spanning three decades from 1970s-2000. A sector-wide over-capacity in the global markets, followed by the collapse of the Soviet Union in 1990, wreaked havoc on the dynamics of the global steel supply and demand as the Soviet Union’s domestic annual consumption and demand of some 70m tonnes of steel collapsed overnight. The economic crisis in 1997 saw cheap steel from Asia, Latin America and Russia making their way to the world market. Amid the political and economic upheaval, the industry only managed to grow at a lethargic 0.7% per annum.

Exhibit 1: Global crude steel production

Mil Tonnes YoY Growth 1600 Stalemate years 15% CAGR: 0.7% 1400 10% 1200

1000 5% 800 600 0% 400 ‐5% 200 0 ‐10% 1975 1980 1985 1990 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E Source: World Steel Association, OSK

The “steel boom” in the new millennium. The global steel market made a strong comeback in 2002 as steel again became an important factor in a fresh round of global industrialisation spurred primarily by massive demand from China. Among many sectors, China’s construction, infrastructure and car- making sectors were expanding at a roaring pace as the country’s GDP returned to double-digit growth post 1997. From 2002-2007, global output of crude steel grew at a CAGR of 8.4%. Owing to China’s hunger for resources, the prices of raw materials ranging from iron ore, coke, coking coal to scrap metal went up many fold. Meanwhile, ports around the world, particularly in China, Australia and Brazil, experienced unprecedented levels of loading and off-loading of commodities, which sent freight rates to the roof until mid-2008. This was fuelled by the sudden shortage of supply which was further compounded by congestion at the ports.

OSK Research 4 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

A bubble from the West? The prime period for the commodity market lasted until the US subprime debt crisis broke out, following the collapse of decades-old Lehman Brothers in September 2008 which sent shock waves globally. The series of events that ensued led to the production engines for almost all the major industries, including steel, coming to a halt. Global crude steel production contracted with negative growth of -4.7% from 2007-2009 despite being cushioned by China’s resilient growth of 7.1%. Nonetheless, with governments around the world making quick decisions to implement various stimulus measures to generate some degree of optimism, this was good enough to help the steel industry return to a more meaningful recovery path.

OSK Research 5 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010 CHINA AND STEEL

China in brief. Many may not know the history of how China achieved dominance in the steel arena, but many still are familiar with its rise to become an economically superior country. Without delving into the details or its long history, we briefly examine the key historical events that moulded the nation into the superpower it is today, and how this helped shape the development of its steel industry. We shall begin with China’s first Five-Year economic plan in 1953 (a.k.a its “Great Leap Forward”) under the leadership of Mao Zedong up to the present 11th Five-Year plan, currently under the purview of Premier Wen Jiabao (see Exhibit 2).

Exhibit 2: Timeline of important events

Date Event(s)

1958 ‐ 1961 Mao Zedong launches the “Great Leap Forward”, a five‐year economic plan. Farming is collectivised and labour‐intensive industry is introduced. “The Great Chinese Famine” followed, due to massive institutional and policy changes. Iron and steel production was identified as a key requirement for economic advancement. Millions of peasants were ordered away from agricultural work to join the iron and steel production workforce. 1966 ‐ 1976 “Cultural Revolution”, a 10‐year political and ideological campaign aimed at reviving revolutionary spirit is introduced by Mao Zedong. 1977 Upon Mao’s passing, Deng Xiaoping emerges as the next leadership figure. China undertakes far‐reaching economic reforms. 1979 China imposes one‐child policy in effort to curb population growth. 1986 ‐ 1990 China’s “Open‐door policy” opens the country to foreign investment and encourages development of a market economy and private sector. 1989 Stock markets open in Shanghai and Shenzhen 1992 The IMF ranks China’s economy as the third largest in the world after US and Japan 1998 Zhu Rongji succeeds Li Peng as premier, and announces reforms in the wake of the Asian Finacial Crisis. Restructuring of thousands of state‐owned enterprises take place, and 4 million civil service jobs are axed. 2003 China and Hong Kong hit by the SARS virus. Launch of China’s first manned spacecraft into space. 2006 Work is completed on the structure of the Three Gorges Dam, the world’s largest hydropower project which started in 1993. 2008 Beijing hosts the XXIX Olympic Games. A massive 8.0 magnitude earthquake hits Sichuan province, killing tens of thousands. The Global financial crisis unfolds, and the Government announces a USD586bn stimulus package to avoid the economy from slowing. 2009 Russia and China sign USD25bn deal to supply China with oil for the next 20 years in exchange for loans. First sign of relaxation on the one child policy, as officials in Shanghai urge parents to have a second child to counter effects of an ageing population. 2010 China posts a 17.7% rise in exports in December 2009, suggesting it has overtaken Germany as the world’s biggest exporter. The World Expo 2010, the most expensive Expo in the history of the world's fairs, takes place in Shanghai China. It is also the largest World's Fair site ever at 5.28 square km.

Source: Various, OSK

OSK Research 6 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

China: The new steel powerhouse. Starting off with output of a mere 600,000 tonnes in the 1950s, China experienced a few distinct phases of growth, almost in tandem with the development of the global steel sector (shown in Exhibit 3). China initially chalked up a CAGR of 15.6% from 1951-1972 despite the drop in production arising from the great famine in 1961, and the mass strikes of factory workers stemming from the Cultural Revolution, which caused another fall in production in 1967. The steel industry recovered from these events, with output reaching 23m tonnes at the end of 1972. China subsequently saw its growth moderate to 6.2% from 1973-2000, during which the oil crisis and Asian financial crisis struck economies worldwide. Despite the slowdown, China was in a healthier position than the rest of the world, which saw growth decelerating to only a CAGR of 0.6%. China’s growth on the other hand accelerated to a stirring 18.1% during 2000-2009, buoyed by the country’s rapid economic development. Although China was not spared the recent financial market meltdown in 2008, its government’s swift decision to announce and immediately implement a RMB4trn (USD586bn) stimulus package with focus on spending in infrastructure, post earthquake reconstruction and rural development (see Exhibit 4) helped to lift the country up another notch, producing 46.3% of the world’s output of crude steel from just a third prior to the crisis, with an output of 567.8m metric tonnes in 2009.

Exhibit 3: China’s annual Crude Steel Production (1950-2009)

1951‐1972 1973‐2000 2001‐2009 y‐o‐y m tonnes CAGR: 15.3% CAGR: 6.2% CAGR: 18.1% growth 700 80%

600 60%

500 40%

400 20%

300 0% 0% growth line 200 ‐20%

100 ‐40%

0 ‐60% 1951 1953 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Source: National Bureau of Statistics, OSK

Exhibit 4: Breakdown of the RMB4trn Stimulus Package

Breakdown of funds distribution Trn RMB % (revised on March 2009 by the NDRC)

Public infrastructure development 1.50 37.5% (Railway, road, irrigation and airport construction)

Reconstruction works 1.00 25.0% (for regions hit by the Sichuan earthquake)

Rural development 0.37 9.3%

Technology advancement 0.37 9.3%

Promote energy saving and gas emission cuts 0.21 5.3%

Education, cultural & family planning purposes 0.15 3.8%

Source: NDRC, OSK

OSK Research 7 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010 CHINA STEEL INDUSTRY – WHAT’S NEXT?

“Steel” room to grow? Although China’s steel industry has obviously grown by leaps and bounds in the past decades, one can’t avoid investor concerns on the sustainability of those robust numbers in the coming years, especially with the effects from the RMB4trn stimulus packages now fading. We will take a quick look at the average steel consumption (ASC) compared to the nominal GDP per capita in China and other developed countries including US, Germany, Japan and others (see Exhibit 5). Despite the fact that China consumes more than 40% of total world steel demand and its ASC is nearly on par with that in most of the developed nations, its nominal GDP per capital is barely 10% of the US’. This data strongly suggests that there is room for steel demand to increase in China, especially given that the gradual improvement in GDP per capital may lift the nation’s purchasing power and hence boost steel requirements.

Exhibit 5: Steel consumption and GDP per capital

ASC Per Capita 1,200 5 mil tonnes of demand

1,000 Korea 800

600 Japan Austria 400 China Czech Republic Italy Germany Australia Canada 200 Russia Spain Brazil UK France India US 0 0 10,000 20,000 30,000 40,000 50,000 60,000 Nominal GDP per capita

Source: World Steel Association, OSK

The magic number “8” for GDP. China’s GDP has consistently exceeded its minimum targeted 8% annual growth since 1978 up to the present, with only 1998 and 1999 being the years when growth was below 8%. The most robust growth was achieved in 1994 (36%) whereas the lowest recorded was in 1999, at 3.6% (see Exhibit 6). Despite the onslaught of the Asian Financial Crisis in 1997, the SARS outbreak in 2003 and the Global Financial Crisis in 2008, China’s GDP has been growing at a CAGR of 16.2% since it adopted the “Open-door policy” from 1986 to 2009. With such a strong growth record, we do not see why China’s policy makers can’t set 8% as the country’s minimum GDP growth target going forward, especially since its current leader is preparing to be succeeded by a new leader in 2012 and would want to see the country achieve sparkling economic numbers before the handover. Furthermore, GDP must continue to grow in order to improve the nation’s purchasing power and narrow the gap between its low average nominal GDP per capita compared with that in the developed countries.

OSK Research 8 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 6: China’s GDP growth (YoY)

GDP Growth 40% Floor target of 8% growth 35% 30% 25% 20% 15% 10% 5% 0% 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: IMF, CEIC, OSK

A closer look at the Chinese economy. The nominal value of China’s GDP stood at RMB33.5trn (USD4.9trn) in 2009, marginally behind Japan’s nominal GDP of USD5.0trn, while US achieved a nominal GDP of USD14.1trn. Although impressed with this performance, we decided to make a basic economic study on the formation of GDP (See Exhibit 7) in order to project the possible areas that China’s policy makers may focus on in pushing through a potential growth target exceeding 8% GDP growth. We reckon that gross fixed capital formation comprising fixed asset investment by the government and private sector still dominates China’s GDP, accounting for 46.7% of the country’s total GDP, up from 42% in 2008. While private spending has inched up over the years, this only represents 36.1% of China’s economy. Already China’s GDP is on a higher base after decades of fast paced growth, which strongly indicates that there is a need for the Chinese government to continue to spur economic growth by spending in fixed capital investments, especially in public infrastructure, at least for the next few years until private spending starts to take the lead. The government is also likely to emphasise on encouraging the private sector to reinvest their profit in order to ensure the magical “8%” GDP growth number is achieved.

Exhibit 7: China’s GDP breakdown

RMB bn 40,000 Net Exports Changes in Inventories 35,000 Gross Fixed Capital Formation 30,000 Government Consumption Expenditure 25,000 Private Consumption Expenditure 20,000

15,000

10,000

5,000

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: IMF,CEIC, OSK

OSK Research 9 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Fixed asset investments play a vital role. As fixed capital formation carries the highest weightage in GDP, we analyse China’s fixed asset investments (FAI), which have been growing at an average 26.2% since 2003. China has poured in RMB22.5trn of FAI investments as at 2009 from RMB5.6trn in 2003, as show in Exhibit 8. The three largest constituents of the Government’s spending are: Manufacturing, with the biggest portion at 32%, followed by real estate with 22%, and the services sector - comprising transportation, storage and postal services with 11%. Although some may argue that the government’s measures to further tighten the real estate sector may dampen demand for long steel, we think that the weightage of real estate investment is too big for the government to clamp down on, and as such we expect those measures to only be limited to cooling house prices.

Exhibit 8: Fixed asset investments

2009 FAI breakdown

Manufacturing (31.4%) Year RMB trn YoY Growth

2003 5.6 n/a 13.0% Real Estate (22.0%)

2004 7.0 26.8% 3.1% 31.4% Transport, Storage and Postal Service (11.1%) 4.1% 2005 8.9 26.0% Water Conservancy, Environment & Utility Management (8.8%) 6.4% 2006 11.0 23.9% Electricity, Gas & Water Production and Supply (6.4%)

2007 13.7 24.8% 8.8% Mining (4.1%) 2008 17.3 25.9% Farming, Forestry, Animal 11.1% 22.0% Husbandry, Firshery (3.1%) 2009 22.5 30.0% Others (13.0%)

Source: CEIC, OSK

Worries of phasing out of stimulus and 11th plan may be overdone. Undeniably, the hefty RMB4trn of government stimulus packages that were supposed to be spent mostly in 2009 and 2010 have significantly benefited China’s economy and steel industry, judging from the growth numbers recorded in the past two years despite the onset of Global Financial Crisis. In addition, the 11th Five-Year Plan that provides the basis for shaping the country's development via economic and social targets covering the period of 2006 to 2010 has also come to the end. The market is now worried whether the government may begin to cut down its spending, especially on the FAI in the coming years, but we think these worries may have been overdone.

Exhibit 9: Draft of the 12th Five-Years Plan (2011-2015)

No. Key tasks and strategic priorities

1 Raising incomes faster across the country and keep them growing at the same pace as the economy; and see a significant reduction in the number of people living in poverty by narrowing income gaps between people in rural and urban areas, different regions and industries 2 Optimization of industrial structure (optimizing the metal industry, equipment manufacturing, energy, electronics) 3 Development of the service sector (improve consumption in real estate, tourism, transportation services etc) 4Coordinated regional development (strategies for western and central development, sound urbanization etc) 5Building a resource‐saving and environmental friendly society 6 Scientific, technological, education and human resource development 7Reforms in fiscal, taxation and monetary systems 8Promote a harmonious socialist society (improve healthcare standards, public safety etc)

Source: Various, OSK

OSK Research 10 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

12th Five-Year Plan on the way. With the existing Five-Year Plan coming to an end this year, the Communist Party of China’s (CPC) Central Committee concluded its 4-day meeting in Beijing on 18 Oct 2010 by issuing a draft of China’s new 12th Five-Year Plan, which will be subject to approval by the National People’s Congress when it convenes its annual meeting in March 2011. The key highlights of the 12th Five-Year Plan draft are summarised in Exhibit 9. We take some of the initial proposals, in particular raising incomes faster across the country and keeping incomes growing at the same pace as the economy, as positive indication that the government may continue to boost the economy in order to nurture a higher income society. As such, our expectation of at least 8% GDP growth seems reasonable. While the focus may now switch to the central and the west of China as the policy makers are placing priority on rural modernization in its next five-year development, this continues be a reflection of the government’s readiness to spend, except that it is making a major switch from developing the coastal regions that are now over crowded, towards the western part of China. We can expect more public amenities including speed trains, community halls, stadiums and others being built in the rural areas. Given that high property prices have eroded the lower and middle classes’ capability to consume, the Chinese government is allocating more resources to increase the supply of affordable housing for lower- income urban households. No matter where the development is, the government will continue to spend, which will eventually translate into steel consumption.

Efforts to promote industrial upgrading may lift steel demand. Apart from maintaining momentum in public spending, the Chinese government is clearly putting in more efforts to promote industrial upgrading in the next five-years plan. Among the key sectors mentioned are new energy, new materials, modern transport systems, electric automobiles, key capital goods, bio-tech and information technology. Upgrading these areas will directly and indirectly boost demand for steel, especially special steel categories to cater for advanced machinery and other general types of steel to construct more advanced plant facilities.

Striking a balance between consumption and investment. In recent years, China had experienced an imbalance between consumption and investment, with the investment to GDP ratio rising from 35% in 2000 to 47% in 2009 while the consumption to GDP ratio fell from 46% to 36% during the same period (see Exhibit 10). Hence the Chinese government’s aggressive and unprecedented measures should, along with several favourable macro-trends, bring about a substantial rise in domestic consumption as a percentage of GDP over the next five years.

Exhibit 10: Inverse relationship between private and government spending

Private Consumption Expenditure 70.0% Gross Fixed Capital Formation 60.0%

50.0%

40.0%

30.0%

20.0%

10.0%

0.0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: CEIC, OSK

OSK Research 11 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

High income society the catalyst for steel demand. In its draft on the next five-year plan, China’s government is committed to raise Chinese residents’ disposable income. Already, China has implemented policies this year to raise the minimum wage in a dozen provinces by 12% to 29%, with more to come in 2011. There is also a plan to lift the threshold of income tax payment, currently at RMB 2,000 per month, and increase the salaries of civil servants, all aimed at increasing purchasing power. The major boost to consumption in China lies in the under-developed consumer finance industry. Notably, consumer loans outstanding per capita in China as at end-2009 only amounted to USD608, less than one-tenth of USD7,934 in the US. This indicates significant room to grow in this sector to boost the consumption of many consumer discretionary products. A number of pure consumer finance companies were launched this year and these launches will continue into 2011 in response to the government’s initiatives to stimulate consumption.

Growing urbanization. China’s rate of urbanization has been growing at a decent average of 1.3% annually since 1996, expanding from 30% (373mil people) in 1996 to 46.6% (622mil people) in 2009. Despite being the world’s second largest economy, China still lags behind its developed peers such as Japan, US and South Korea, whose urbanization rates stood at 66%, 82% and 81% as at 2009 respectively. With urbanisation set to pick up steam in the western and central regions of China, we remain confident that China’s urbanization growth momentum will continue. Recently, the National Development and Reform Commission (NDRC) announced that China will step up its efforts and implement tougher reforms by breaking down the dual urban-rural structure. Also, the NDRC’s target of hitting an urbanization rate of at least 50% or more in the next 5 to 6 years looks achievable as the current urbanization rate is just 3.4% shy of the target rate.

Exhibit 11: China’s urbanization rate

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1949 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

Source: National Bureau of Statistics, OSK

OSK Research 12 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Three-phase consumption upgrading? China has long been recognized as a nation of bicyclists, but as its economy booms, the accompanying consumption shift has placed the country at the second and third phases of consumption upgrading (see Exhibit 12). Demand for white goods, automobiles, real estate and healthcare have overshadowed the need for basic goods among Chinese citizens given the country’s rapid pace of development. With China overtaking the US as the world’s largest auto market in 2009 and as the government develops the world's largest interstate-highway system, pedalling two- wheelers are being pushed aside to make room for cars instead. Segregating China into its three key regions, we currently see the western region making a transition from the first to the second phase, as evidenced by the government’s subsidies on white goods to rural residents, and the “vehicles to the countryside” programme to spur rural demand. As for the central and coastal regions, a burgeoning economy has led to a spike in demand for bigger homes, better cars and quality healthcare facilities, placing these regions at phase 3 of demand. Being the backbone of automobiles, construction activities, and medical equipment, steel will continue to play a principal role in the urbanization and development of China. We believe the domestic consumption theme will continue to play a vital role in boosting steel demand moving forward.

Exhibit 12: China’s three phase consumption upgrading

First Phase Second Phase Third Phase

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

Benchmark Products

Basic needs to small Focus Basic necessities Luxurious lifestyle family development

Source: CISA, OSK

Gradual shift from long to flat steel. Demand and consumption of steel products in China remain skewed towards long products (see Exhibits 13 and 14), which is normal in circumstances when a country is in the developing stage as the focus is on factory construction, building and residential development to enhancing public infrastructure as well as amenities. After the robust growth particularly in the coastal area, we are of the view that China will make a gradual consumption shift towards flat products, in line with the government’s efforts to encourage private spending. The slowdown in long products requirement is also expected to cap next year’s steel consumption to growth at only 4%.

OSK Research 13 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Long steel consumption skews towards the west. In 2009, long steel products represented 64.7% of total steel consumed in China. The Government’s fixed asset investments in infrastructure has been growing at an average of more than 20% over the last 7 years, and reconstruction works also have been on-going since 2008 in the earthquake-hit Sichuan province. Coastal China took up 58.6% of total demand, while central and western China consumed 28.7% and 12.7% respectively. With all the major events like Beijing Olympics in 2008 and recent Shanghai World Expo over, plus the fact that the coastal areas are now over-crowded with high-rise buildings, focus will obviously shift from the highly urbanized and developed coastal region to the west. In addition, as property prices in the coastal areas have risen to levels beyond the affordability of the man on the street, tightening measures may mainly focus on these areas. Meanwhile, we expect long steel consumption in the coastal may drop by 6% in 2011 before a moderate drop of 1% to 3% in next few years. While we still expect long steel demand in the west to increase by 10% and by 8% in the central region in the next few years, the relatively bigger base built over the years in the coastal area may pull down overall long steel consumption to a stagnant y-o-y change in 2011 before a marginal 2% to 4% growth in the next four years.

Flat and special steel outlook remain bright. Flat products, for which demand mainly comes from the shipping, white goods and machinery industries, accounted for 35.3% of total steel consumption in 2009, with coastal China having the highest consumption at 52.2% (100.2mil tonnes), followed by the central region, consuming 39.5% (75.9mil tonnes), and finally the western region, with 8.3% (15.8mil tonnes). In order of the most to the least consumed, hot rolled sheets represented 41% of total consumption (83.2mil tonnes), while plates only contributed 27.8% (56.3mil tonnes) in 2009 (see Exhibits 13 and 14). As China is now at the second and third phases of consumption upgrading and the government is making efforts to encourage domestic consumption, we expect the demand for flat products to remain strong across the board, although the West and Central regions still have room for further industrialization and may see growth of 13% and 10% respectively, compared with 9% for the coastal region, before slowing to 7%. We expect total steel consumption in China to grow at 4% moving into 2011, and maintain a range bound growth rate of 5%-6% yearly thereafter.

Exhibit 13: China’s steel consumption (2009)

mil tonnes kg per capita 377.2 250.0 400.0 205.8 350.0 200.0 300.0 250.0 150.0 209.7 177.7 183.7 100.8 100.2 200.0 133.9 100.0 75.9 150.0 44.4 100.0 74.7 50.0 15.8 50.0 0.0 0.0 Western China Central China Coastal China Western China Central China Coastal China

Flat Long Flat Long

Source: CISA, OSK Estimates

Exhibit 14: China’s steel consumption (2009)

Long Flat Long + Flat m tonnes west middle coastal Total y‐o‐y west middle coastal Total y‐o‐yTotaly‐o‐y 2009 44.4 100.8 205.8 350.9 15.8 75.9 100.2 192.0 542.9 2010E 50.9 115.6 226.3 392.9 11.9% 19.3 90.0 119.0 228.4 19.0% 621.2 14.4% 2011E 56.0 125.2 213.3 394.5 0.4% 21.8 99.0 129.7 250.5 9.7% 645.0 3.8% 2012E 61.6 135.5 206.0 403.2 2.2% 24.5 108.7 140.7 273.9 9.3% 677.1 5.0% 2013E 67.8 146.8 201.7 416.2 3.2% 27.6 119.1 151.0 297.7 8.7% 713.9 5.4% 2014E 74.6 159.0 198.9 432.5 3.9% 31.0 130.3 161.7 323.1 8.5% 755.5 5.8% 2015E 82.0 172.2 196.3 450.4 4.2% 34.9 142.6 173.0 350.5 8.5% 801.0 6.0%

Source: CISA, OSK Estimates

OSK Research 14 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010 IDENTIFYING THE “HOT SPOTS”

Demand is here to stay. Steel has had a major influence on our lives: the cars we drive, the buildings we work in, the homes in which we live and countless other facets in between. Steel is by far the most important, multi-functional and most adaptable of materials. The backbone of developed economies was laid on the strength and inherent use of steel. We do not see a perfect substitution for steel, as the starting point of objects such as precision surgical equipment to reinforced skyscrapers come from initially raw ore mined from the earth’s crust. The large numbers of different grades of steel with varying properties and alloying techniques being developed and discovered yearly strengthens the fact that steel will continue to be an important basic production material for years to come. Also, compared to other materials of its type, steel has low production costs. The energy required for extracting iron from ore is about 25 % of what is needed for extracting aluminium. Steel is environment-friendly as it can be recycled. Comprising 5.6% of the earth's crust, iron represents a secure raw material base. Steel production is 20x higher compared with the production of all non-ferrous metals put together.

Exhibit 15: Steel consumption segmentation in 2009

Long Products 33% Real Estate Flat Products 1% 2% 22% Infrastructure 3% 3% 18% Machinery

202.2 6% 33% 9% Others 36% 6% Automotive 9% 3% Hardware 3% Shipping 360.1 2% White Goods

64% 1% 18% Oil & Gas 1% Containers 22% 1% Packaging 1% Energy

Source: CISA, OSK Estimates

Where is steel being used? We mentioned in an earlier section that China’s consumption of steel is still skewed towards long products, as shown by the statistics published by the China Iron and Steel Association (CISA). Real estate development and construction industry consume approximately 32.8% and 21.7% of total steel in 2008 respectively, and we think the proportion may be even higher in 2009 driven by the property market boom and the stimulus packages. While equipment manufacturing, light industry and automotive were the major industries consuming flat steel, representing 18%, 5% and 5.6% respectively of total steel being consumed in 2008. Other major steel consuming industries are shipbuilding, petrochemical, packaging and others. Nonetheless, as not every product is in a favourable position as overall demand is only expected to pick up by 4% in 2011, we will take you through all the major industries that consume steel in order to identify the sector’s “hot spots” namely:

 Property  Infrastructure  Oil & Gas  Automotive  Machinery  White Goods  Shipping  Exports

OSK Research 15 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

PROPERTY: Grabbing a piece of the action

Tougher measures implemented. The new measures announced in China recently to curb rising property prices include: increasing the down payment requirement for first-time homebuyers to 30% (previously 20%), 50% down payment on second property purchases (previously 40%), while the latest move was to raise the one-year benchmark lending rate to 5.56%, up 25 basis points. Despite the slew of fiscal tightening, we believe that leniency will prevail in the western regions as the recent tightening measures are targeted at the main cities in the coastal regions, in which property prices are the highest in China. As we mentioned in the previous section, the government’s intention is to cool property prices rather than real estate investment activities, and policy makers have openly hinted at a potential property tax being implemented only in some coastal cities. Meanwhile, only a few cities in the coastal region have property prices exceeding RMB10,000 per square metre (see Exhibit 16).

Exhibit 16: Property prices in China’s main cities

Average Secondary Market Property Price (RMB/Sq m) YoY Growth (%) China Main City Region Jan-07 Jan-08 Jan-09 Jan-10 Aug-10 Jan-08 Jan-09 Jan-10 Aug-10 Beijing Coastal 10,390 14,470 15,892 25,612 26,450 39.3% 53.0% 146.5% 14.6% Shenzhen Coastal 9,676 10,035 9,501 22,613 21,364 3.7% -1.8% 133.7% 149.9% Shanghai Coastal 8,379 10,736 11,589 17,391 18,339 28.1% 38.3% 107.6% 273.9% Hangzhou Coastal 7,422 9,899 10,495 14,851 16,384 33.4% 41.4% 100.1% 259.5% Ningbo Coastal 8,402 8,724 10,364 12,656 14,159 3.8% 23.4% 50.6% 403.3% Guangzhou Coastal 10,718 12,670 11,174 12,790 13,621 18.2% 4.3% 19.3% 183.9% Qingdao Coastal 5,741 5,805 5,705 5,787 11,096 1.1% -0.6% 0.8% 34.6% Tianjin Coastal 6,900 7,665 6,890 8,930 10,810 11.1% -0.1% 29.4% 136.5% Fuzhou Coastal 5,258 7,122 6,997 8,344 10,505 35.5% 33.1% 58.7% 148.8% Xiamen Coastal 7,641 12,639 6,629 11,230 10,267 65.4% -13.2% 47.0% -22.9% Dalian Coastal 6,870 7,498 8,161 8,735 8,980 9.1% 18.8% 27.1% 30.6% Nanjing Coastal 6,457 7,153 6,876 6,943 7,001 10.8% 6.5% 7.5% -47.4% Jinan Coastal 4,109 4,304 4,791 6,255 6,823 4.7% 16.6% 52.2% -44.7% Haikou Coastal 3,165 3,652 4,279 4,856 6,245 15.4% 35.2% 53.4% 47.1% Shenyang Coastal 4,014 4,649 4,795 4,799 4,799 15.8% 19.5% 19.6% -34.0% Chengdu Middle 4,746 5,512 4,739 7,336 7,625 16.1% -0.1% 54.6% -12.4% Wuhan Middle 5,816 5,898 6,748 6,920 7,490 1.4% 16.0% 19.0% 114.1% Xian Middle 3,562 4,346 4,751 5,792 6,849 22.0% 33.4% 62.6% 27.4% Changsha Middle 3,882 4,851 6,155 6,040 6,280 25.0% 58.6% 55.6% 9.6% Zhengzhou Middle 3,314 4,384 4,411 5,545 5,749 32.3% 33.1% 67.3% 14.8% Hefei Middle 3,416 3,626 3,887 5,204 5,731 6.1% 13.8% 52.3% -30.0% Shijiazhuang Middle 3,978 5,161 4,870 5,030 5,482 29.7% 22.4% 26.4% 6.4% Changchun Middle 3,658 4,303 4,458 5,198 5,276 17.6% 21.9% 42.1% -52.6% Nanchang Middle 3,148 3,448 3,459 4,519 5,085 9.5% 9.9% 43.6% -49.1% Taiyuan Middle 4,223 4,654 4,469 4,649 5,062 10.2% 5.8% 10.1% -6.7% Chongqing Middle 2,636 3,440 3,637 4,163 4,867 30.5% 38.0% 57.9% 6.4% Yinchuan Middle 2,733 3,412 3,838 4,903 4,829 24.8% 40.4% 79.4% 28.8% Harbin Middle 3,125 3,738 4,068 4,375 4,580 19.6% 30.2% 40.0% -23.0% Guiyang west 4,910 4,678 4,810 6,715 8,665 -4.7% -2.0% 36.8% 50.5% Kunming west 4,036 4,675 4,226 6,467 8,557 15.8% 4.7% 60.2% 44.9% Nanning west 3,485 5,096 4,512 7,293 7,676 46.2% 29.5% 109.3% 55.3% Urumqi west 2,529 3,918 4,055 4,863 6,862 54.9% 60.3% 92.3% 138.6% Lanzhou west 3,086 2,591 2,961 4,810 6,760 -16.0% -4.1% 55.9% 112.0% Xining west 2,592 2,937 3,422 3,447 3,661 13.3% 32.0% 33.0% -14.6% Hohhot west 2,643 2,723 2,778 3,043 3,518 3.0% 5.1% 15.1% -27.1%

Source: OSK, CEIC

Market sentiment positive. To gauge the sentiment of consumers, we analyse China’s property climate index, which reflects the overall conditions of the sector by taking into account property prices, sales volume and consumer confidence. A reading below 100 indicates weak conditions and the reading is bullish when it surpasses 100. As shown in Exhibit 17, the index managed to sustain above the 100-mark despite the implementation of curtailment measures from January 2007 – January 2008, and only dipped below 100 in November 2008 during the financial crisis. However, the negative sentiment bottomed out in April 2009 and the index has regained momentum ever since, despite a fresh round of tightening measures being implemented at the start of 2009.

OSK Research 16 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 17: China’s property climate index

Index Pts Curb Support Curb 110 108

106 1 2 3 9 10 104 6 7 8 102 4 5 11, 12, 13 100 98 Base= 100 96 94 92 90 07 08 09 10 07 07 08 09 08 09 10 08 09 10 07 07 08 09 08 09 10 07 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ Jul Jan Jun Jun Jun Oct Oct Oct Apr Apr Apr Feb Feb Feb Aug Aug Aug Dec Dec Dec Mar May

No Date Action Measure

1 January 2007 Govt says it will increase taxes & will start taxing the appreciation of Curb property values based on market prices 2 March 2007 Commerce ministry issues new rules making it harder for foreigners to invest Curb in property 3 August 2007 China bans foreign investors in Chinese real estate from borrowing offshore Curb

4 September 2007 The Central bank and the regulatory commission say they will ban banks Curb from lending to developers found to be hoarding land. Down payments for 2nd homes raised to 40% from 30%, and requirements for commercial properties increased to 50% from 40% 5 January 2008 Land that goes undeveloped for more than 1 year will be subject to an idle Curb land charge of 20%. Also, Deposits that banks must hold in reserve is raised for the 11th time since 2007. 6 September 2008 China cuts preferential housing mortgage rates 5 times, in line with interest Support rate cuts aimed at boosting the economy. 7 October 2008 China announces a series of policy changes: lower mortgage rates, reduced Support down payments, lower transaction taxes. 8 December 2008 2 year stimulus package introduced, with RMB400bn to be used on Support construction of affordable housing 9 December 2009 China announces individuals must own their homes for 5 years to be eligible Curb for sales tax exemption (previously 2 years) 10 March 2010 China orders 78 state companies whose core business is not property to Curb submit plans to divest 11 April 2010 China announces a rise in downpayments on 2nd homes to 50% from 40%. Curb Banks must charge a minimum mortgage rate on second homes of 1.1x the benchmark interest rate. Downpayment on first homes of over 90 square meters increase to 30% from 20% 12 July 2010 China plans to start levying property tax in 2012 in a pilot programme that Curb will first be rolled out in several cities 13 August 2010 Regulators order banks to stop extending mortgages to people buying their Curb 3rd homes in 4 cities ‐ Beijing, Shanghai, Shenzen and Hangzhou 14 Sep 2010 China raises downpayments on 1st homes to 30% from 20%, and 50% for Curb 2nd homes (initially 40%). A trial property tax in some cities will be implemented nationwide 15 October 2010 China raises its benchmark lending rates to 5.56% from 5.31%, in efforts to Curb curb a property bubble 16 November 2010 The Central Government said announced that it would increase banks' Curb reserve requirement ratio by 50 basis points starting from 29 November 2010

Source: Various, Bloomberg, OSK

OSK Research 17 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Building activities carry on but... Despite the tightening measures enforced since early 2007, the floor space under construction for residential and commercial properties has been steadily growing y-o-y from 1999 to the present in the whole of China. Residential floor space under construction registered the fastest growth (in descending order) in the West, Central and Costal areas, with CAGRs of 20%, 17% and 14% each, translating into a total of 3.1m of square metres being constructed in 2009. The same scenario was recorded for commercial buildings under construction, whereby the central and western areas achieved CAGRs of 23% and 22% respectively, while coastal growth came in at 16%, giving a total of 2.5m square meters being constructed in 2009. For 2010, given that the total 8-month numbers have exceeded the full year figures of 2009, the construction floor space for residential and commercial properties is set to continue on its momentum to breach the previous yearly highs. However, growth is expected to moderate in 2010, with the recent stream of curbing measures introduced by the Chinese government to cool the property market. The spillover effects of such measures should flow into 2011, possibly resulting in negative growth in the coastal area in the short to medium term.

Exhibit 18: Floor space under construction - residential

Coastal China '000 m3 Central China '000 m3 West China '000 m3 Coastal China % YoY 1,800 60% Central China % YoY West China % YoY 1,500 50%

1,200 40%

900 30%

600 20%

300 10%

0 0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 8M10

Source: OSK, CEIC

Exhibit 19: Floor space under construction - commercial

1,800 Coastal China m3 Central China m3 60% West China m3 Coastal China % YoY 1,500 Central China % YoY West China % YoY 50%

1,200 40%

900 30%

600 20%

300 10%

0 0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 8M10

Source: CEIC, OSK

OSK Research 18 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 20: Fixed asset investments – Real estate portion

RMB m Growth 6,000,000 24%

5,000,000 24%

4,000,000 23%

3,000,000 23%

2,000,000 22%

1,000,000 22%

0 21% 2003 2004 2005 2006 2007 2008 2009

Source: OSK, CEIC

Harsh, but not a permanent clampdown. We do not see the current measures chilling the property market as being long term in nature. Historically, real estate investments accounted for more than 20% of the government’s FAI in the past 7 years and this has been on the rise, from RMB1.3trn in 2003 to RMB4.9trn in 2009 (see Exhibit 20). Furthermore, we project that 70% of the FAIs in real estate were primary market transactions, which in turn contributed to almost 11% of China’s GDP in 2009. This further supports our view that the government cannot afford to suppress FAIs in the property market too drastically, if the annual target of 8% growth is to be met. Also, the recent measures would just serve as a temporary dampener on the appetite of the average Chinese citizen for property, as the mindset of amassing properties either for investment purposes or for future generations will continue to feed into demand, further fuelled by the fast rate of urbanization and globalisation shaping the face of China. Social housing may cushion the negative impact. As the Chinese Government recognises that high property prices have lowered the capability of the lower and middle classes to consume, it is allocating more resources to increase the supply of affordable housing for lower-income urban households. Based on the draft of the 12th Five-Yeas Plan, the government’s sponsored economic housing is expected to average around 25% of annual property supply in the next 5 years. Meanwhile, the average intensity of steel usage for property development has been rising over the years as new developments are becoming taller. For instance, we understand from our quantity surveyor contacts that the density of steel used in a ten-storey building is double that of a six-storey one. Impact more on conventional long products. While long steel is widely used in construction activities, the impact is mainly concentrated on conventional long steel products as these products ranging from bars, rebars, and light section steel and to a certain degree wire rods have been typically used in the construction of residential property. However, the five companies we are initiating coverage on have limited exposure in those products, especially as most of them have widened their product range to flat products in the past few years.

OSK Research 19 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

INFRASTRUCTURE: Key theme – Development in the west

Steel - the backbone of construction. Steel is greatly valued given its wide use in sustainable construction; hence the construction and infrastructure industry is the largest market for long steel products worldwide. Infrastructure typically refers to the technical structures that support a society. For example, applications of long products such as wire rods and bars are used in the construction of suspension cables for bridges while specialised sections are used in the making of columns for specific industrial or social buildings including airports, hospitals, stadiums, research laboratories, stations and others. We also see huge potential for modern long steel such as beams, heavy sections and channels, which were applied in modern skyscrapers and buildings, airport terminal and others. Apart from that, various natural disasters that have stuck China in recent years have heightened concerns for structural safety, strength and quality. As a result, there has been a shift in preference from other construction material to steel in infrastructure, industrial and residential construction projects. Nonetheless, China’s consumption of long steel products still has room to grow as indicated in the example of H-section steel which is one of the most widely used steel in developed countries, making up 3% to 5% of the total consumption of steel products, but only making up 1% of China’s total steel consumption.

Building momentum remains strong. Worries that the end of the current RMB4trn stimulus plan, which is the main driver of infrastructure development and which is running to the end of its course as implementation was mainly for the period from 2009 to 2010, will lead to a significant drop in infrastructure spending has no basis as the government needs to continue spending in infrastructure in order to achieve its growth target for the country, as explained in the earlier section. Meanwhile, the momentum remains positive for construction activities, taking the use of cement as an indirect proxy to building activities. China’s production of cement for 2009 stood at an all-time high of 1.6bn tonnes, up 18.4% from the previous year. While we see this growth pace moderate to an average 7.8% YTD, we think is still commendable given the higher base in 2009 (see exhibit 21).

Exhibit 21: China’s cement output

m tonnes Cement Production (m MT) (lhs) YoY Growth (%) (rhs) 200 60%

160 40%

120 20%

80 0%

40 ‐20%

0 ‐40% 02 03 04 05 06 07 08 09 10 02 03 04 05 06 07 08 09 10 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ Jul Jul Jul Jul Jul Jul Jul Jul Jul Jan Jan Jan Jan Jan Jan Jan Jan Jan

Source: Bloomberg, OSK

OSK Research 20 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Government likely to continue with FAIs. China’s gross fixed capital formation, which comprises land improvement, plant, machinery, equipment purchases, the construction of roads, railways, and the like, including schools, offices, hospitals, private residential dwellings, commercial and industrial buildings; is a key component of the Chinese economy. In 2009, 11% of FAI was allocated for the transportation industry (10% in 2008), representing an increase of RMB0.8trn to RMB2.5trn. Also, RMB2.5trn out of the RMB4trn stimulus plan was earmarked for infrastructure development and reconstruction works from 2009-2010, a telltale sign that China cannot afford to cut spending on development expenditure if it is to achieve a minimum 8% GDP growth. In line with its current 11th Five Year plan, two out of the government’s 12 main strategic priorities include optimising its current industrial structure and the development of the services sector (transportation, utilities, and amenities). The 11th Five Year Plan stresses the need for co-ordinated regional development moving inwards into the western and central regions, which would obviously carry over to the next plan.

Laying the railway tracks. This year, Chinese government has allocated a maiden RMB823.5bn to extend the country’s railway network to 90,000km by the end of 2010. In accordance with the revisions in the mid and long term development plan for China’s railway network in November 2008, the existing railway network will continue to expand and the planned operating mileage target for 2020 was raised to 120,000km from the original target of 100,000km. The new target implies 3,000km of new tracks being paved annually for the next ten years, which is below the 5,461km new tracks that were laid in 2009 and less than the 4,000km planned for 2010 (see Exhibit 22). Nonetheless, we suspect the target may be brought forward to 2015, possibly pushing the annual target of 6,000km in new tracks per annum. Our bullish assumption is on the back of:-

i) Railways are the most effective mode of transportation to bring coal, iron ore and other commodities out from the resource rich western region. As China continues to hunger for commodities that are currently being monopolised by few top miners, we believe the government will certainly expedite the laying of tracks to resolve the transportation bottleneck.

ii) Efforts to expand its railway network to the West are also in line with China’s focus on its12th Five-Year Plan to balance development across regions.

iii) The government has committed to developing public transportation and infrastructure in the next Five-Year Plans.

iv) The relatively low railway meter per capita of 0.06 is way below that in developed nations like US and Japan (see Exhibit 23) although China is the second largest economy in the world, which implies huge upside potential.

Exhibit 22: Railroad mileage in China

km 140,000 120,000 120,000

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

60,000

40,000

20,000

0 2001 2003 2005 2007 2009 …… 2020F

Source: Statistics and planning by the Ministry of Railways

OSK Research 21 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 23: Roadways and railways comparison (2009)

Total Land Area Roadways Railways Country (mil sq km) Length (km) Metres per capita Length (km) Metres per capita US 9.2 6,506,204 21.2 226,427 0.74 China 9.6 3,583,715 2.7 84,000 0.06 Japan 0.4 1,203,777 10.8 26,435 0.24

Source: CIA factbook, US Census Bureau, OSK

Exhibit 24: Railway network of China

Source: ChinaTravelGuide.com

More roads to be paved. Being the second largest economy in the world, we are confident that the construction of roadways in China will continue to gather pace. China currently has 3.6m km of roadways, coming in second to US, and has only half of the total road millage of the US. China is committed to establish a national network of 100,000km of highways by 2020. Meanwhile, many of China’s roads are poor in quality and hence require constant maintenance and upgrading. With concrete roads typically requiring the use of long steel products such as reinforcing steel bars, steel mesh and deformed steel bars (rebars) during construction, the development of roads is obviously positive for steel consumption.

OIL & GAS: More in the pipeline

Transporting oil. Apart from coal, which is the largest energy source for China, accounting for almost 70% of all energy needs, oil & gas is the next big area for energy. Oil & gas exploration hot spots are concentrated on the northern half of China, with the Junggar, Tarim, Qaidam, Erdos, Sichuan, Bohai and Songliao Basins being the key exploration regions. The oil and gas sector mainly uses flat steel products including casings, tubes, line pipes, drill pipes, seamless and welded pipe, high yield steel plates sections, bars, slabs, seamless rolled and many more. These are widely applied in offshore fabrication platforms, pressure vessels, pumps, valves, oil drilling components and the like.

OSK Research 22 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Aggressive pipeline projects may offset lower exports. In 2008, the US filed a trade case against China claiming that Chinese exporters and producers were dumping steel pipes in the US at prices that were 32% to 98% below their fair value, thus throwing local trade and jobs of steel workers in the US out of balance. Currently, the US Commerce Department imposes anti-dumping duty ranging from 48% – 98% on pipe imports as counter measures. Even though lingering trade uncertainty is currently clouding ties between the two countries, we view the demand for steel pipe to be partly cushioned by demand for pipelines announced within China. China Petroleum Planning and Engineering Institute recently said the country will triple the length of its natural gas pipelines in the next 5 years, targeting for 100,000km for 2015 (current target for 2010: 36,000km). The eastern portion of the second West-East pipeline is progressing well and feasibility studies are being undertaken for the third and fourth pipelines, for which details are expected to be announced in due course (see Exhibit 25 for more details). The implementation of such initiatives will undoubtedly spur demand for pipes and offset the protectionism measures in the US on China’s exports. Apart from the local pipeline, cross-border pipelines have been initiated, such as the Sino-Myanmar oil & gas pipeline (see Exhibit 26)

Exhibit 25: Completed/on-going projects

Distance Capacity Timeframe Project Coverage (km) Start Date Completion Date

1st West‐East gas pipeline 4,000 17 bcm 2002 2004 Lunnan (Xinjiang) ‐> Shanghai 2nd West‐East gas pipeline 9,102 30 bcm 2008 Western ‐ end 2009, Turkmenistan and China's Xinjiang Uygur Autonomous Eastern ‐ by June Region ‐> Yangtze and Pearl River Deltas 3rd pipeline Feasibility studies currently ongoing Xinjiang region ‐> Fujian province 4th pipeline Feasibility studies currently ongoing from Tarim Basin or from Sichuan Sino‐Myanmar gas pipeline 2,806 12 bcm Sep 2010 2013 Kyaukryu Port (West Myanmar) ‐> Guizhou and Guangxi Zhuang Autonomous Region (South China) Sino‐Myanmar oil pipeline 2,380 22m tonnes Sep 2010 2013 Kyaukryu Port (West Myanmar) ‐> Kunming city,

Source: OSK, various

Exhibit 26: Sino-Myanmar oil pipeline

Source: Reuters

OSK Research 23 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

AUTOMOTIVE: China’s euphoria over cars

China car boom could last a few years. The once kingdom of bicycles has now emerged as the world’s largest auto consumer cum maker in 2009. The country produced 14.2m cars, dethroning US as the top auto producing nation with only 5.7m units produced (see Exhibit 27). China also supplanted the US as the world’s largest auto market, with the nations’ vehicle sales soaring 46% y-o-y to 13.6m units, the fastest pace in 10 years, according to the China Association of Automobile Manufacturers. The brisk sales in the Chinese auto market is in contrast with the United States, where 10.43m units were sold last year, 2.8m units less than in 2008, as the global financial crisis and continuing uncertainties kept US consumers out of the showrooms. Boosted by the Government’s stimulus measures in 2009, policy incentives were announced in January last year, including: i) halving the purchase tax to 5% on vehicles with a displacement of less than 1.6 litres, and ii) giving rural consumers a RMB5,000 (USD735) subsidy for vehicles with a displacement under 1.3 litters. Although the government scaled back the subsidy by a notch on December 2009 and raised the tax on new vehicles with engines of 1.6 litres or smaller to 7.5% in an effort believed to keep the auto industry from overheating, the number of new cars on the road continued to rise in 2010. The “cars to the countryside” program which aims to lift the quality of life of farmers in the rural regions has been extended by another year to end-2010. A parallel program, “Motorbikes to the countryside”, has also been extended to 2013.

Exhibit 27: China’s automotive production

mil units 20 60% Production (lhs) 18 Growth (rhs) 50% 16 14 40% 12 10 30% 8 20% 6 4 10% 2 0 0% 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E

Source: CEIC, National Bureau of Statistics

China in the spotlight. Perhaps the greatest publicity for China’s ascent as a formidable auto giant came during the US’ auto crisis, when Sichuan Tengzhong Heavy Industrial Machinery Corp made a bid to purchase the Hummer brand of Sports Utility Vehicles from General Motors but this subsequently failed to materialize. Since then, Chinese automakers have been gradually making their move in US soil. In March 2010, Geely automotive sealed a deal to buy Swedish automaker Volvo from Ford, marking the biggest overseas acquisition by a Chinese automaker (USD1.8bn). Chinese electric car maker, BYD, which is partly owned by investor Warren Buffet, has also opened an office in Los Angeles with hopes to deliver its first vehicles to California consumers by the end of 2010. BYD also plans to bring an electric sedan to the US in 2011, as hybrid vehicles are well accepted among Americans. These developments clearly mark the era of China automakers as the brands to watch.

OSK Research 24 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 28: China’s automotive production vs other key countries

mil units

18 China US Japan Korea 15

12

9

6

3

0

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

Source: CEIC, OICA, OSK

Domestic auto ownership still low. Despite the impressive statistics, China’s domestic auto market still has abundant potential to expand, given its improving standards of living, growing GDP, and the plain fact that it has the lowest auto ownership per civilian compared with its developed peers. On average, there is only one car for every 18 Chinese civilians, which is behind the average car ownership in the US, Japan and Korea, with a car to every 1.3, 3.4 and 1.8 civilian. China’s vehicle ownership per capita is currently one of the lowest in the world, but has the potential to rise in tandem with its improving nominal GDP, as demonstrated in other developed nations (see Exhibit 29). Also, we suspect China is at the beginning of its third phase upgrading elaborated earlier, and there is still a long way before it hits a plateau. This does not include the many in the Central and West region who are still at the second phase of upgrading, and have yet to enter the third phase.

Exhibit 29: Vehicles to no. of people

motor vehichles per 1000 people 800 700 600 500 400 300 200 100 0 US Germany Japan France UK South China Korea

Source: nationmaster.com, OSK

OSK Research 25 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 30: Vehicle per capita and GDP

Vehicle Per Capita 0.9 0.8 US 0.7 0.6 Germany Japan 0.5 France 0.4 UK 0.3 Korea 0.2 0.1 China 0.0 0 10,000 20,000 30,000 40,000 50,000 Nominal GDP Per Capita (US$)

Source: IMF, nationmaster.com, OSK

Bright outlook for specialised steel producers. Steel makes up approximately 55% of an automobile's overall structural mass. Power trains, gear boxes and vehicle bodies are all made from steel; even tyres are strengthened with steel wire (i.e tyre cords). From conventional flat products to advanced high-strength steel (AHSS) such as automotive sheets, research and development in the field of automotives, steel is constantly being improved and evolved in response to today’s demanding quality, performance and safety standards. New types of automotive steel are constantly being tested and introduced to reduce density, improve strength, and increase elongation for structural improvements. Among the companies under our coverage, Angang has most prominent share of supplying to almost all the local car producers and Magang is also growing fast in this market segment. We also expect Chongang’s commissioning of 1780mm Hot Rolled Coils (HRC) mills to help the company penetrate this lucrative segment, especially with Chongqing province being one of China’s major auto production hubs.

MACHINERY: Prime beneficiary of industrial upgrading

Growth engine of the flat steel industry. Flat steel products are the key components of machinery, which use rolled sheets and plates. Generally, steel comprises more than 50% of a machine’s make-up, and the use of specialised steel is on the rise as more sophisticated machinery are being manufactured for industrial applications in a myriad of fields.

New focus of 12th Five-Year Plan. China’s machinery industry is benefiting from the government’s RMB4trn spending spree on large scale construction projects, which have in turn given rise to the need for large scale machines in the past two years. The sector has also benefitted from rapid industrialization and urbanization over the past decades. The machinery industry recorded an overall turnover of RMB10.79trn in 2009, of which the overall growth was driven mainly by the automotive sector, with nearly 30% of the output value being generated by automakers. According to the head of China Machinery Industry Federation (CMIF), China’s construction machinery sector is expected to continue growing steadily in tandem with China’s fixed asset investments, which is estimated to expand at around 20% every year, thus spurring an industry growth forecast of 20% in 2010. We believe that China can easily exceed this target for 2010 given that during the period January to August 2010, the gross output value of China’s machinery industry totalled nearly RMB9trn (USD1.3trn), representing a y- o-y increase of 35%. The good news obviously lies with the central government’s emphasis on lifting the quality of the country’s industrial sector, which in turn means that more upgrades across the sector are expected over the next five years.

OSK Research 26 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 31: Sales breakdown (YTD August 2010)

2.0% 0.9% 2.0% Agricultural Machinery 0.9% Internal Combustion Machinery

5.9% 3.4% 3.4% Engineering Machinery 3.4% 1.3% 3.4% Instrument & Meter 8.3% 1.3% Cultural & Office Equipment 8.3% General Petrochemical Machinery 31.5% 5.0% 5.0% Heavy Mining Machinery 4.2% 4.2% Machine Tool & Instrument 24.8% Electric Equipment & Apparatus 8.9% General Mechanical Component 0.4% 8.9% 24.8% 0.4% Food & Packaging Machinery 31.5% Automobile 5.9% Other Civil Machinery

Source: CEIC, OSK

Exhibit 32: Y-o-y sales comparison

RMB m RMB m Machine Tool & 900,000 3,000,000 Instrument (rhs) 800,000 Instrument & Meter 2,500,000 700,000 General Petrochemical Machinery 600,000 2,000,000 Heavy Mining 500,000 Machinery 1,500,000 General Mechanical 400,000 Component 300,000 1,000,000 Other Civil Machinery

200,000 Others 500,000 100,000 Automobile (rhs) ‐ 0 2006 2007 2008 2009 2010 YTD Electric Equipment & (Aug) Apparatus

Source: CEIC, OSK

WHITE GOODS: Moving up the value chain

Another “hot spot” for flat steel. The term “White Goods” is commonly used to refer to large electrical home appliances that are traditionally finished in white enamel, although modern appliances nowadays come in a variety of colour finishes. Flat steel products like HRC, plates, CRC and hot dip galvanizing are commonly used in the making of white goods. We believe these have been one of the reasons steel producers have been expanding their presence in flat steel, realising the vast potential demand from private spending.

Continuing government support. In February 2009, the Government started a rural appliance subsidy scheme to stimulate rural consumption and buoy the nation’s economic growth amid the global economic downturn. Under this scheme, Chinese farmers receive subsidies of 13% off the prices of about 20,000 designated types of refrigerators, televisions, washing machines, computers, air

OSK Research 27 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

conditioners, mobile phones, water heaters, microwave ovens and traditional ovens. With the continued subsidy on white goods for the less developed regions in China, we remain positive on continued demand growth in this sector. Furthermore, the Government also announced the addition of six types of home appliances to the existing subsidy list in 1H this year, including electric bikes, some exhaust ventilators, gas stoves, pressure cookers, electric cookers and DVD players. As shown in Exhibit 33, the implementation of such measures resulted in a y-o-y spike in demand for most of the white goods except air conditioners. Refrigerators recorded double digit growth of 24.7% in 2009 (2008 growth: 8.2%) to 59.3m units (2008:47.6m units) while colour TVs also registered y-o-y growth of 9.6% to 99m units, up 8.7m units from 2008. Recent September YTD figures for 2010 released by the ministry of commerce showed that the sales value of home appliances covered by the rural subsidy program tripled YoY to RMB115.84bn (USD17.35bn), with 52.6m units sold – a whopping 150% increase from a year ago. We do not see any slowdown in growth momentum in the medium term, in tandem with China’s rate of urbanization and its second and third phases of consumption upgrading.

Exhibit 33: China’s output of White Goods

Production (m unit) 120 Colour TV Refrigerator Air conditioner

100

80

60

40

20

0 2005 2006 2007 2008 2009

Source: CISA

SHIPPING: The rush to clear the backlog

Out of choppy waters. The shipping industry started on a prosperous note in the new millennium. The sustained strong growth trend in the world economy from 2003 to the summer of 2008 drove tonnage demand for the world’s merchant fleet by an annual average of 8%. Although the sector found itself in choppy waters at the onset of the US subprime crisis at 2007, only certain quarters worried about the large order books while most continued to enjoy the music. However, the buoyant mood quickly changed after the collapse of Lehman Brothers in September 2008 as fears spread that the global economy could go into depression like one it experienced in the 1930s. What this could mean for world shipping goes without saying. Fortunately, the global economy is expanding again after the steepest drop in economic activity and trade in over 60 years, thanks to the concerted efforts from policy makers around the world. While the sector seems to be out of the woods for now, the huge undelivered order book may put a cap on its recovery (see Exhibit 34).

OSK Research 28 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 34: Composition of new order book to existing shipping capacity

m DWT or 000,000 TEU Order Book 1500 90% Existing Capacity 1200 % OB / Existing Fleets 60% 900

600 30% 300

0 0%

‐ ‐ <200k >200k

Handy <1,000 >4,000 1,000 2,000

TEU TEU

‐ Capesize Panamax DWT DWT TEU TEU ‐ ‐ Tanker Tanker 1,999 3,999 Bulker Bulker Bulker Container Container Container Container

Source: Platou, OSK

Ship plate demand may pick up. Modern shipbuilding makes considerable use of prefabricated section makes of steel plates. Entire multi-deck segments of the hull or superstructure will be built elsewhere in the yard, transported to the building dock or slipway, and then lifted into place. As steel was accepted to eliminate brittle fracture in ships and we do not see any substitution, the huge scheduled delivery over the next two years (see Exhibit 35) may support demand for steel plates. However, we think the capacity built over the past few years throughout the shipping industry together with the huge delivery in the coming years may limit new orders, at least for the medium term. The absence of strong orderbooks has also resulted in sharply falling asset value on various types of vessels (see Exhibit 35) and steel mills can only expect more moderate margins moving forward, we may not see steel plates command the lucrative margins they used to for many years to come.

Exhibit 35: Building prices of various vessels

USD m 180 VLCC

150 Suezmax

120 Aframax

90 MR Clean Capesize 60 Panamax 30 Handymax 0 06 07 08 09 10 06 06 07 07 08 08 09 09 10 10 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ Jan Jan Jan Jan Jan Sep Sep Sep Sep Sep May May May May May

Source: Platou, OSK

OSK Research 29 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

EXPORTS: Likely to remain weak

China becomes a net steel exporter. Having become a net importer of steel since the early 80s, 2006 marked the year during which China’s steel industry underwent a transition which saw the country becoming a global net exporter of steel (see Exhibit 36). South Korea remains China’s top trading partner in steel, taking in more than 20% of China’s total steel exports in terms of tonnage (see exhibit 37). Flat products accounted for 47.7% of total exports while long products only accounted for 15% of China’s steel exports. Over the years, we also noticed that the Chinese government has moved from being pro export of steel by introducing various export incentives, to discouraging its export. Among others, it has removed various tax rebates while some products were slammed with export tax to encourage steel producers to stay within the country. These efforts also suggest policy makers realise that exporting steel does not bring good to the country as it only adds pressure on pollution, creates port congestion and others.

Exhibit 36: China’s imports and exports of finished steel (1990 – 2010)

'000 Tonnes 6,000 Net Importer

4,000

2,000

0

‐2,000

‐4,000

‐6,000

‐8,000 Net Exporter 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐

Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Source: OSK, Bloomberg

Exhibit 37: China’s export destinations

Weightage m tonnes 2008 2009 YoY change in '08 in '09

South Korea 14.0 5.6 ‐60% 24% 23% EU 7.6 1.6 ‐79% 13% 7% Vietnam 2.8 1.5 ‐46% 5% 6% India 2.0 1.2 ‐39% 3% 5% US 5.0 1.1 ‐79% 8% 4% Others 27.9 13.7 ‐51% 47% 56% total 59.2 24.6

Source: CISA, OSK

OSK Research 30 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Removal of export tax rebates. Since 15 July, China’s steel industry saw the removal of 9% in tax rebates for hot-rolled steel coil, sections, some narrow cold-rolled coil products and hot-dipped galvanized coil. The cuts suggest that China remains determined to consolidate its fragmented steel sector as well as ease trade friction with the US. With these measures potentially leading to a decline in exports in the short to medium term, we see the demand gap being filled by the domestic market, as evidenced by the gradual slowdown in exports of 5.6m tonnes in June (before the announcement) to 3m tonnes in September, implying a drop of 46.4%. Domestic consumption is positioned to continue to go up going forward, with the apparent steel consumption in China reaching a record high of 564.9m tonnes in 2009, up 112.3m tonnes, or 24.8% y-o-y. Furthermore, continued government spending in sectors such as infrastructure, oil & gas and machinery will continue to spur the need for domestic steel consumption.

Exhibit 38: China’s exports by product in 2009

m tonnes 14 11.8 12

10

8 6.3 6 3.7 4 2.9

2

0 Long Flat Tube Others

Source: CISA, OSK

OSK Research 31 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

CONSOLIDATION WAVE IS HERE TO STAY

China’s steel industry still fragmented. Explosive expansion in the past decade has made China the world’s top producer, accounting for almost half the world's total output, after ramping up production to fuel its rapid growth. Nonetheless, that massive output is churned out by some 3,000 steel mills, ranging from state-owned giants like Angang to the small private backyard smelters. Exhibit 39 clearly shows that the steel industry is over-crowded with small mills, with the top 10 steel mills in the world only representing 23.3% of total world crude steel production, while China’s top 10 steel makers account for 43.4% of the country’s production. The fragmented industry would find itself at a disadvantage in iron ore talks with "Big Three" miners such as Vale, BHP Billiton and Rio Tinto, which collectively dominate more than 70% of the global seaborne trade in iron ore.

Exhibit 39: Crude steel production by the top 10 steel mills (in order of the largest first)

CHINA WORLD

Hebei Iron & Steel Group ArcelorMittal 7.1% 6.3% Baosteel Group 2.6% Baosteel Group 6.8% 2.5% 2.2% POSCO Wuhan Iron & Steel Group 2.1% 5.3% 1.7% Anshan Iron & Steel Group 1.7% Nippon Steel 1.6% 5.1% 1.4% JFE Jiangsu Shagang Group 1.2% Jiangsu Shagang Group 4.6% Shandong Iron & Steel Group 56.6% Tata Steel Shougang Group 3.8% Anshan Iron & Steel Group 3.0% Hebei Xin Wu'an Iron & Steel Group 2.9% Severstal 2.6% Magang Group Holding Company 76.7% 2.1% Evraz Valin Iron & Steel Group Rest of World Rest of China

Source: World Steel Association, CISA

M&A is the new trend. The Merger and Acquisition (M&A) fever hit a new peak in 2006 with the merger of industry giants Arcelor and Mittal to form the colossus ArcelorMittal, an enterprise with a 2008 steel production of approximately 103m tonnes. Another milestone was Tata Steel’s 2007 acquisition of Corus Group, which contributed to the group’s ranking that year as the sixth-largest steel producer in the world and its current standing as the seventh largest. In the 2008 steel industry consolidation — which accelerated at a blistering pace over the past decade — hit a brick wall. With the advent of the global economic decline, and in particular the freezing of credit markets, demand plummeted and the availability of financing to support transactions all but disappeared. Yet, M&As remain a critically important business strategy to achieve synergy, expand the customer base, and enhance a competitive position. Especially with today’s challenging business environment, steel companies need to master the ability to carefully evaluate potential targets and quickly execute acquisitions in order to be as well- placed when the economy regains momentum.

OSK Research 32 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 40: M&As involving steel companies in China since 2005

Date Parties involved Details

Jun‐10 ‐ Hangang Hanbao Iron & Steel Co Ltd Hebei Iron & Steel Co Ltd agreed to acquire the entire share capital of Hangang Hanbao Iron & Steel ‐ Hebei Iron & Steel Group Ltd Co Ltd, for an estimated RMB16bn (USD2.3bn).

Mar‐10 ‐ Wuhan Iron & Steel Wuhan Iron & Steel (Group) Corp of China acquired a 60% interest in iron ore mine of China‐Africa ‐ China‐Africa Development Fund Co Ltd Development Fund Co Ltd, a China based investment company, for RMB467.3m (USD68.5m).

Feb‐10 ‐ Jinan Iron & Steel Co Ltd Jinan Iron & Steel Co Ltd, a 68.7%‐owned unit of Chinese state‐owned Shandong Iron & Steel Group ‐ Laiwu Steel Corp Co Ltd agreed to merge with Laiwu Steel Corp, a manufacturer and wholesaler of steel products in a stock swap transaction valued at RMB2.9bn (USD438.5m).

Aug‐09 ‐ Shougang Group Shougang and Changzhi signed an official contract of consolidation, with Shougang taking formal ‐ Shanxi Changzhi Steel Group control of the Changzhi group by acquiring 90% of its stake and paying Changzhi RMB500m.

Jul‐09 ‐ Baosteel Group Shanghai Ergang Co Ltd Baosteel Group Shanghai Ergang Co Ltd agreed to acquire the remaining 25% stake, which it did not ‐ Shanghai Shenjia Metal Products Co Ltd already own, in Shanghai Shenjia Metal Products Co Ltd, a manufacturer of concrete strands and wires for RMB40m (USD5.9m) in cash.

Mar‐09 ‐ Tangshan Fengrun Zhengda Iron & Steel Tangshan Fengrun Zhengda Iron & Steel Co Ltd, an indirect wholly‐owned unit of Arcelor Mittal NV’s ‐ Tangshan Fengrun Hengfeng Iron & Steel China Oriental Group Co Ltd’s majority‐owned subsidiary, agreed to acquire the iron and steel production assets of Tangshan Fengrun Hengfeng Iron & Steel Co Ltd for USD58.1m.

Mar‐09 ‐ Baosteel Group An official contract was signed to re‐organize Ningbo Iron & Steel Group so that Baosteel would ‐ Hangzhou Iron & Steel Group Company purchase a 56.2% controlling stake in Ningbo Iron & Steel for RMB2bn Yuan

Mar‐09 ‐ Hunan Valin Iron & Steel Group Hunan Valin Iron and Steel Group became the second largest shareholder of FMG Group (the 3rd ‐ FMG Group (Australia) largest iron ore supplier in Australia), having purchased 260m shares at AUD2.46 per share, amounting to AUD644.8m.

Nov‐08 ‐ Shandong Iron & Steel Group Chinese state‐owned Shandong Iron & Steel Group Co Ltd planned to merge with Jinghua Rizhao Iron ‐ Jinghua Rizhao Iron & Steel Holding Group & Steel Holding Group Co Ltd, an iron and steel manufacturer.

Sep‐08 ‐ Wuhan Steel Group Wuhan and Luizhou undergo formal restructuring. Guangxi Steel Group is set up with Wuhan Steel ‐ Liuzhou Steel holding 80%, and Guangxi SASAC injected its entire interest in Luizhou Steel for a 20% stake.

Jul‐08 ‐ Sinosteel Sinosteel Group completes hostile take‐over of Midwest, with Sinosteel's shareholding increasing ‐ Midwest Australia from 55.6% to 90%. Midwest delists in Australia.

Jun‐08 ‐ Tangshan Steel Group Tangshan Steel and Hansteel set up Hebei Steel Group. Hebei Steel becomes the largest steel group ‐ Hansteel Group in terms of capacity.

Mar‐08 ‐ Jinlan Steel Group Jinlan Steel and Laigang create Shandong Steel Group, the second Group in China after Baosteel ‐ Laigang Group Group

Mar‐08 ‐ Baosteel Restructuring of Baosteel, Guangzhou Steel and Shaogang result in establishment of Guangdong Steel ‐ Shaogang Group ‐ Guangzhou Steel

Aug‐07 ‐ Wuhan Steel Group Wuhan Steel makes cash purchase of new shares in Kunming Steel, becoming its largest shareholder ‐ Kunming Steel at 48%

Jun‐07 ‐ Baosteel Group Xinjiang SASAC transfers 57% of Ba Yi Steel Group to Baosteel Group, with Ba Yi becoming a ‐ Ba Yi Steel Group subsidiary of Baosteel

Jun‐06 ‐ Shagang Shagang acquires 80% of Huaigang ‐ Jiangsu Huaigang

Dec‐05 ‐ Shougang Guizhou province SASAC injects Shougang with its 85% stake in Shuigang, Shougang becomes its ‐ Guizhou Shuigang Steel largest shareholder

Apr‐05 ‐ Wuhan Steel Hubei Province SASAC injects 51% of Egang into Wuhan Steel, Egang becomes Wuhan's subsidiary ‐ Echeng Steel

Source: OSK, various

OSK Research 33 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Chinese Government serious on consolidation. Chinese policy makers are obviously not happy with the iron ore price being controlled by the top three miners despite importing about half of seaborne trade iron ore. Among others, on 20 March 2009, the General Office of the State Council issued the Blueprint for the Adjustment and Revitalization of the Iron and Steel Industry, which sets forth the China government’s objectives of preventing over-capacity and encouraging consolidation in the steel industry. This was followed by the issuance of a new policy document aimed at putting more than 60% of domestic capacity in its top 10 mills by 2015, up from 44% in 2009. The local governments were ordered to submit consolidation plans to the Ministry of Industry and Information Technology (MIIT) as soon as possible. There is also news that the government is studying measures to reduce domestic iron ore miners' production costs and expand domestic supply capacity. It also called for the concentration of iron ore imports to regulate the iron ore trade. As a result, we are hoping that the number of steel manufacturers will decrease with the emergence of larger steel companies formed via strategic alliances as well as mergers and acquisitions. These larger companies may have rapidly acquired significant market share, resulting in further consolidation in the industry.

A few successful M&A stories in China. The world's total crude steel production was 1.22bn tonnes in 2009, with about 47% coming from China with its 570m-tonne output. Chinese steel producers took up 38 seats among the World Steel Association's list of top 80 large steel producers with capacity above 3m tonnes; five seats among the global top 10 steel producers, as well as nine seats among the top 20 producers with 10m tonnes capacity. The above statistics indicate that Chinese steel producers have played a significant role in the global steel industry. Over the years, a few Chinese enterprises that had M&As and restructurings with assets integration included Angang Steel and Benxi Iron & Steel plus the recently announced Pangang Group Steel Vanadium and Titanium Co (Pangang) (pending an asset injection into the listed company); Wuhan Iron & Steel and Echeng Iron & Steel, Kun Steel, Liuzhou Steel; Baosteel and Xinjiang Bayi; Shagang and Yonggang; Taiyuan Iron & Steel and Shanxi Xinlingang Steel. We also witnessed newly consolidated steel producers emerging in 2008 - including Shandong Iron and Steel Group, Hebei Iron and Steel Group, Guangdong Iron and Steel Group, Guangxi Iron and Steel Group. (See Exhibit 40). As for the steel mills under our coverage, we think Benxi may soon be absorbed under the listed company after years of delay, but a merger between Angang and Pangang’s listed entities may be complicated as both are listed and the poor profitability yet rich valuation in Pangang also suggest difficulty in making reasonable offer. China Oriental may also be on an aggressive lookout for an acquisition target after raising USD850m from its Senior Notes issuance.

Clamping down on outdated capacity. The government has set the target of reducing about 100m tonnes of outdated iron producing capacity in the 11th Five Years Plan (2006 – 2010), and 55m tonne of outdated steel producing capacity before 2007. In particular, BFs below 200 cubic meters and converters or electric furnaces below 20 tonnes were eliminated since 2007. In the name of efficiency improvement, the China government has also set targets to remove BFs of below 300 cubic meters by the end of this year and the policy makers also published an official list that name plants involved in this round of capacity elimination effort. Also rumoured are that the government is stepping up the effort to shut BFs of less than 400 cubic meters by the end of next year. It is also committed to not approve any steel project purely for new construction or capacity expansion purposes until the end-2011. Throughout China, it is strictly forbidden to construct iron and steel projects in the name of equivalent elimination of outdated production capacity so as to circumvent the regulations and approvals by the relevant authorities in charge of environment. We welcome the move as to contain steel capacity on the country wide basis.

Emission control is critical move. China’s pollution problem has shattered all precedents. Environmental degradation is now so severe that stark domestic and international repercussions have emerged including the recognition that pollution poses not only a major long-term burden on the Chinese public but also an acute political challenge to the ruling Communist Party. With the iron and steel industry known for waste emission, China’s leaders recognize that they must change course. Already, the Ministry of Environmental Protection was instructed to strictly verify environmental assessments and local governments should not approve construction projects or provide land permits to industries with excess production capacity.

OSK Research 34 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Power control is a new kid on the block. As part of the efforts to reduce emission, State Council investigation teams begin to check on carbon reduction effort in 18 provinces. China has set a target to cut its energy consumption per unit of GDP by 20% over the five-year period of 2006–2010, but only achieved a 16.59% reduction based on a government report dated 15 July 2010. Therefore, the 18 provinces have ordered high energy-consuming industries to suspend production in order to reach the year-end target. Apart from that, the government also introduced differential power prices aimed at discouraging inefficient energy consumers with power tariffs in such sectors raised by RMB0.1 to RMB0.3 per kWhr. Our quick check with the steel mills under our coverage show that the move obviously impacted some of their production but they expect the quantum to be limited as steel mills were given the flexibility of achieving the target reduction hence most of them have scheduled production lines which shutdown for maintenance during periods of weak demand. We counter checked this with China’s monthly crude steel production, which only dropped 7.1% m-o-m in September and quickly rose 4.9% the following month (see Exhibit 41), suggesting limited impact from the power cut.

Exhibit 41: China’s monthly crude steel production

m tonnes 60

50

40

30

20

10

0 05 06 05 07 06 08 07 09 08 10 09 10 05 05 06 06 07 07 08 08 09 09 10 10 05 05 06 06 07 07 08 08 09 09 10 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ Jul Jul Jul Jul Jul Jul Jan Jan Jan Jan Jan Jan Sep Sep Sep Sep Sep Sep Nov Nov Nov Nov Nov Mar Mar Mar Mar Mar Mar May May May May May May

Source: Bloomberg, OSK

OSK Research 35 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

SOME UPSIDE FOR MATERIALS COST DESPITE LOOKING TOPPISH

IRON ORE: Main feed of steelmaking

Iron ore rush. Iron ores are rocks and minerals from which metallic iron can be economically extracted. The ores are usually rich in iron oxides and vary in colour from dark grey, bright yellow, deep purple, to rusty red. The iron is usually found in the form of magnetite (Fe3O4), hematite (Fe2O3), goethite (FeO(OH)), limonite (FeO(OH).n(H2O)) or siderite (FeCO3). Hematite is also often referred to as “Direct Shipping Ore” (DSO) because it is mined and beneficiated using a relatively simple crushing and screening process before being exported for use in steel mills, as most hematite ore contain up to 66% iron. Other regularly found iron ore is magnetites which has lower iron content and must be upgraded to make it suitable for steelmaking. Magnetite ore is suitable for processing into iron ore pellets for use in modern steel production and currently accounts for approximately 50% of global iron ore production. The magnetic properties of magnetite enable it to be readily refined into iron ore concentrate. As currently 91.5% of China’s steel is produced in Basic Oxygen Furnaces (BOF) compared to only 70.6% globally (see Exhibit 42), together with China producing almost half of world steel, there is an extreme rush by China with regard to these resources.

Exhibit 42: Crude steel production by process in 2009

WORLD CHINA

1.3% 8.5%

28.1% BOF BOF

EAF EAF

Open Hearth

70.6%

91.5%

Source: World Steel Association

Exhibit 43: World iron ore reserves in 2009

Crude Ore Iron Content Average Fe % Australia 20,000 13,000 65.0% South Africa 1,000 650 65.0% Canada 1,700 1,100 64.7% India 7,000 4,500 64.3% Sweden 3,500 2,200 62.9% Venezuela 4,000 2,400 60.0% Mauritania 700 400 57.1% Mexico 700 400 57.1% Other countries 11,000 6,200 56.4% Russia 25,000 14,000 56.0% Iran 2,500 1,400 56.0% Brazil 16,000 8,900 55.6% Kazakhstan 8,300 3,300 39.8% China 22,000 7,200 32.7% US 6,900 2,100 30.4% Ukraine 30,000 9,000 30.0% Word Total 160,300 76,750 47.9% Source: US Geological Survey, OSK

OSK Research 36 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

China ramps up ore production. While China possesses large iron ore reserves (see Exhibit 44), the country does not have high quality domestic ore. Its deposit are widely dispersed, have low iron content (on average of 32.7%), and are contaminated by chemical impurities like phosphorus. In order to increase the iron content to approximately 65% before it can become usable, the production of iron ore in China usually includes a beneficiation process which entails higher production costs. Together with the mines normally coming up with smaller deposits that are scattered around, the average cost per tonne of bringing new iron ore capacity online has been increasing year after year, with our house estimates of around USD80 to USD100 a tonne at this juncture. Meanwhile, Hebei province has the highest production of iron ore, accounting for 40.7% of the country’s total production (see Exhibit 44). As part of the tightening of global iron ore supply, there is an apparent increase in domestic iron ore production (see Exhibit 45). Nonetheless, China’s domestic iron ore prices have been following the global price trend of imported iron ore in recent years, while the cost difference between domestic and imported iron ore is narrowing. The drop in ocean freight in the past two years also led to Chinese steel mills importing more raw materials rather than using relatively expensive domestic iron ore.

Exhibit 44: China’s iron ore production by province in 2009

Province m tonnes % of industry total

Hebei 357.9 40.7% Liaoning 130.8 14.9% Sichuan 83.4 9.5% Inner Mongolia 73.5 8.4% Shanxi 32.9 3.7% Anhui 25.9 2.9% Beijing 19.6 2.2% Shandong 19.1 2.2% Yunnan 18.1 2.1% Xinjiang 16.7 1.9% 777.9 88.4%

China total 880.2

Source: Mysteel.com

Exhibit 45: China’s iron ore production and importation

m tonnes China Import 120 China Production 100

80

60

40

20

0 04 05 06 07 08 09 04 05 06 07 08 09 10 04 05 06 07 08 09 10 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ Jan Jan Jan Jan Jan Jan Jan Sep Sep Sep Sep Sep Sep May May May May May May May

Source: Bloomberg, OSK

OSK Research 37 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

China hungry for overseas ore mines. As the result of the country’s poor quality iron ore reserve, Chinese companies have been actively searching for ore across the globe – to Africa, Australia, and South America. In the past few decades, we have been witnessing many steel mills partnering with overseas parties to venture into the resources sector, as we have listed a few major tie-ups in Exhibit 46. Although China’s outbound M&A deal value decreased in 2008 and 2009 due to the global financial crisis, Chinese companies still engaged themselves in a considerable number of transactions. Among the latest investments by Chinese steel mills are Wuhan Iron and Steel Group’s acquisition of a 20% stake in Consolidated Thompson Iron Mines for USD240m, and Angang’s AUD534m investment to finance an iron ore project in Australia (see Exhibit 46).

Exhibit 46: Some of the overseas iron ore mining investments by Chinese steel mills

Mine Duration Steelmaker Parties involved Location Reserves Production (tonnes) (years) (tonnes)

Wuhan Iron and Steel ‐ Wugang (Australia) Pty Ltd South Australia, ‐ 1 bn ‐ ‐ WPG Hawk Nest mining area

Maanshan iron & Steel Wheelarra JV with: Jimblebar mine at 25 ‐ 12m ‐ BHP Billiton Newman in Western ‐ Itochu Minerals & Energy Australia ‐ Mitsui Iron Ore Corp. ‐ Tangshan Iron & Steel ‐ Jiangsu Shagang Group

Anshan Iron & Steel Gindalbie Metals Karara Iron ore 30 2.5 bn from 1H2011 ‐ 2m (Parent of Angang) Project project, from August 2011 ‐ 8m Western Australia

Baosteel Group Corp Hamersley Iron Bao‐HI JV to mine 20 ‐ 10m tonnes iron ore in Western Australia Aquila Resources Ltd West Pilbara ‐‐40m tonnes Bayi Steel Coking Coal Group Xinjiang ‐‐‐ Currently 2.45m ‐ aiming for 7m tonnes of coal in the next 3 years

Chongqing Iron & Steel Asian Iron Holdings Limited Extension Hill ‐‐to start only in 4Q of 2013 (Group) Ltd (Parent of Magnetite Project at Chongang) Western Australia

Citic Pacific Mining Sino Iron Project at ‐ 2 bn 27.6m Cape Preston, Western Australia

Source: Various, OSK

OSK Research 38 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Most iron ore assets at parent’s level. We also reckon that since most of the mining assets in China are owned by state-owned enterprises (SOE) at the private level, there is thus no substantial benefit for listed steel mill entities to operate iron ore mines other than to offer a consistent supply. Magang is the only SOE steel mill under our universe that has a direct tie-up with BHP Billiton via the Wheelarra Joint Venture. Other than that, SOEs under our coverage namely Angang, Magang and Chongang have certain portions of their iron ore requirement fulfilled by their parent’s mines, mostly at arm’s length pricing except for Angang, which still enjoys a 5% discount from its parent. However, SCIE owns 68% of the small local mine with a 2m tonnes per year (tpy) iron ore pelletizing plant, plus a long term supply contract with Mt. Gibson that offers a 10% discount on the spot market price. China Oriental also owns an associate and subsidiary that owns an iron ore mine but the supply to the group remains small. Some quarters may argue that there is a potential mining asset injection by the parent into the listed company, but with iron ore spot prices continuing to climb – with the selling price more than doubled that in 2009 – the price tag of mines are likely at exuberant levels. We are cautious of any of such moves or direct acquisitions of mines at this juncture

Imports based on benchmark contract and spot. We notice that the larger steel enterprises normally enter into long-term contracts of three to ten-year terms with certain iron ore suppliers outside China. In most of these contracts, the agreed prices are subject to annual or quarterly review. Accordingly, the price of iron ore for each of the orders under the supply contracts will fluctuate according to the prevailing market price of iron ore and negotiations with suppliers. Steel mills also prefer to keep some buffer to purchase certain portions of their requirement on a spot basis in order to mitigate the risk of any surprise plunge in the spot market.

Exhibit 47: Prices of imported iron ore on spot and contract basis

USD per tonne Contract Spot 250

200

150

100

50

0 10 09 08 07 06 05 10 09 08 07 06 05 10 09 08 07 06 05 10 09 08 07 06 05

Jul Jul Jul Jul Jul Jul Jan Jan Jan Jan Jan Jan Oct Oct Oct Oct Oct Oct Apr Apr Apr Apr Apr Apr

Source: Steel Business Briefing, OSK

Quarterly pricing reduces earnings volatility. Since 1981, the benchmark iron ore contract pricing has been negotiated on an annual basis. Generally, the international iron ore market is divided into two parts - Asia and Europe, which fix their own prices separately. In the Asian market, Japanese steel companies are the major clients while German manufacturers represent the European market. On the other side, the world's major iron ore suppliers are Australia's Rio Tinto and BHP Billiton, as well as Brazil's Vale SA. Since 2008, Australia's third largest miner, Fortescue, began to participate in the talks as well. Under the convention, if any of these four mining companies reaches an agreement with any of the major steel makers, the price talks end and the other suppliers and steel firms must accept the new prices. This year marked the first time this long agreed mechanism was dismantled after Vale SA, the world’s largest iron ore producer, and BHP Billiton Ltd settled short-term contracts with Asian steel mills on a quarterly basis. The new system sets pricing based on the three-month average of iron ore price indices for the period ending one month before the onset of the new quarter.

OSK Research 39 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Projecting 15% increase in 2011 and flat thereafter. Iron ore prices had surged some 90% to mark the start of the new price mechanism for 2Q10 as prices moved up by another 20% in 3Q10 before dropping approximately 12% in 4Q10. We estimate the contract iron ore price to average at USD130 per tonne in 2010. With iron ore prices resuming on an uptrend in the spot market, the high production cost of local iron ore mines in China and the likelihood that scheduled projects will not come to market, particular given the complications such as logistics and deteriorating ore grade, we expect iron ore prices to average at around USD150 per tonne, or some 15% increase y-o-y. Despite some upside on the iron ore benchmark next year, we think that prices may start to consolidate beyond 2011, and hence expect a flattish price trend from 2012.

COKING COAL: Source of energy for blast furnaces

Coking coal is powering the steel sector. Global steel production is heavily reliant on coal. Coking coal is a direct input in the production of steel using the Blast Furnace (BF), which represented 70.6% of global crude steel production in 2009. Coking coal, also referred to as metallurgical coal, has particular physical properties that on heating to over 1000°C (in the absence of air) causes the coal to soften, liquefy, then resolidify into hard but porous lumps known as ‘coke’. As a major raw material fed into BFs, coking coal must be of high quality to support the charge of a BF, with as little degradation as possible to provide high thermal efficiency and metal reduction. Coking coal must also be low in sulphur, phosphorus and alkalis such as sodium and potassium. Almost all coking coal produced globally is transformed into coke in a coke oven and used in blast furnaces for the production of pig iron for steel alloy, although some is also used in the power sector. As BF technology is expected to continue to dominate the steel making industry, coking coal will continue to play a major part in the manufacture of the world’s steel for the foreseeable future.

Exhibit 48: Types of coal

Source: World Coal Institute

Plenty of coal in China but... China, the world’s largest producer and consumer of coking coal, produced 282.7m tonnes of coke from coking coal in 2009. Nonetheless, many of China’s coal mines are small in nature, utilise outdated technology, and many are illegal. Therefore, China has one of the world's deadliest records for miners, with poor safety standards accounting for thousands of deaths each year. The National Development and Reform Commission has ordered coal firms in major coal producing regions including Shanxi, Inner Mongolia, Henan and Shaanxi, to concentrate on coal mines and eliminate outdated small mines. According to the China Mining Association, the goal is to eventually boost the industry. Small coal mines using outdated technology are to be replaced by larger coal mines.

OSK Research 40 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Procuring coking coals from the domestic market at spot. From a quick check with Chinese steel mills under our coverage, we found that almost 100% of the coking coal supply is outsourced from the domestic spot market as their respective parents do not own any coal mines. This is with the exception of Shougang Concord International Enterprises, which owns direct interest of 24.4% in Fushan International Energy Group Ltd, the second largest coking coal mine operator in China. While SCIE may have hedged itself against escalating coking coal prices, the company does not directly procure coking coal from its associate as the company does not internally produce coke. Magang also owns an associate company that supports part of its internal coking coal requirements.

Coking coal prices with an upward bias. China’s announcement in August of further shutting down coking plants with capacity of not more than 400,000 tpy reflects the serious steps it is taking to tackle plant inefficiency, pollution and rampant mine accidents, following an order to eliminate small coking companies with a combined capacity of 84.12m tonnes at the end of 2009. Prior to that, three rounds of orders to shut down inefficient coking companies with a combined capacity of 65.58m metric tonnes per year were issued in October 2007, January 2008 and November 2008 respectively. Therefore, the Chinese coking coal market has been facing short supply as many steel mills and independent coke producers are starting to look for overseas supply in order to pressure local mines to reduce selling prices. Globally, coking coal miners are moving a step ahead of iron ore miners in setting the quarterly contract in March 2010, with BHP successfully negotiating a 55% price increase for 2Q10. With the supply of hard coking coal expected to remain tight, we expect blended coking coal to average at USD160 in 2010 and rise to USD180 per tonne in 2011 and thereafter. As for coke, its selling price in the Chinese domestic market this year may average at around USD230 and increase to USD265 per tonne in 2011 and beyond.

PCI COAL: Increasingly important to rein in production cost

Substitute to expensive coke. Pulverised Coal Injection (PCI) technology has been developed whereby coal is injected directly into the BF. The pulverised fuel provides the process heat in the BF to enable gasification of the coke. A secondary function is to provide some of the carbon for the reduction process. A wider range of coal can be used in PCI, including steam coal, which has lower carbon content than coking coal. This method has a number of advantages, including reducing overall costs and prolonging the life of existing coke batteries.

Some limit to substitution. While PCI coal is obviously of great help in trimming production cost, many criteria are used to measure the performance of coal injection, both technically and economically, such as coke replacement ratio as coal quality also may impact on many aspects of performance. Meanwhile, our discussions with steel mills suggest that the ideal rate is approximately 150kg PCI coal to one tonne of steel, and the ratio hardly exceeds 200kg of PCI coal.

SCRAP METAL: Supply to come forward in years to come

Recycling scrap. Steel is 100% recyclable without loss of quality. Obsolete scrap is derived from steel- containing goods at the end of their useful lives (e.g. a drink can, a 15-year-old car, a 50-year-old building). Revert scrap (home scrap) is steel waste produced and recycled within a steelworks. New production scrap is generated when steel is cut and formed during the manufacturing of finished products or components, and the scrap returned to steelworks and foundries. Meanwhile, as more than 90% of China’s steel mills operate a BOFs, steel scrap collected during the steelmaking process is

OSK Research 41 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

mixed with iron and small amounts of flux, and then a lance is introduced into the vessel and 99% pure oxygen is blown in, causing the temperature to rise to 1700°C. As scrap melts, its impurities are oxidised and its carbon content reduced by 90%, and this gives rise to liquid steel.

Upcoming scrap metal supply. With steel consumption increasing over the past decades, it would be a matter of time before the nation is produces much of its own scrap. We expect some Electric Arc Furnaces (EAF) to be slowly reintroduced in China. Already, Chongang recently announced to build a 1m tonne per year (tpy) EAF at its New District together with wire rods and bars rolling mills. We are projecting for local scrap in China to average at USD375 per tonne in 2010 and USD420 for 2011 and beyond.

Exhibit 49: Scrap price at China domestic market

RMB per tonne 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 05 06 07 08 09 10 05 06 07 08 09 10 05 05 06 06 07 07 08 08 09 09 10

Jun Jun Jun Jun Jun Jun Sep Sep Sep Sep Sep Sep Dec Dec Dec Dec Dec Mar Mar Mar Mar Mar Mar

Source: Steel Business Briefing, OSK

SHIPPING RATE: Sailing south

Massive new buildings may come on stream. With a huge undelivered order book, we expect some 120m Deadweight Tonnes (DWT) of new vessels to be scheduled for delivery in 2011. Assuming 15m of DWT deletion as ship sent for scrapping, some 105m DWT of new bulkers will start operation, representing 19% additional capacity (see exhibit 50). The massive delivery is obviously good news to steel makers as demand for steel plates will pick up as we mentioned in the earlier section, and the huge delivery may also pressure bulkers’ charter rates.

Baltic Dry Index likely to sink. Meanwhile, we only project a 4% y-o-y growth in China’s steel consumption. Therefore, the only hope for ship operators would be if international iron ore and coal prices get significantly lower to provide the incentive to import, but we are not hopeful. We are now projecting for the Baltic Dry Index (BDI) to average at 2,850 in 2010 and dip further to 2,500 in 2011 and 2,250 in 2012.

OSK Research 42 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 50: Projection of bulker capacity

Bulker m DWT 850

750 Scrap

650 Deliveries 550 Fleet development 450 350 250 150 50 ‐50 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10E FY11E FY12E FY13E FY14E FY15E

Source: Platou, OSK Estimates

Exhibit 51: Baltic Dry Index

14,000

12,000

10,000

8,000

6,000

4,000

2,000

0 09 08 10 09 07 05 10 10 09 08 06 06 05 05 09 05 08 07 07 06 09 08 06 00 07 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ Jul Jan Jan Jan Jun Jun Jun Jun Oct Oct Apr Apr Sep Sep Feb Sep Dec Dec Aug Aug Nov Mar Mar Mar May

Source: OSK, Bloomberg

Exhibit 52: Summary of Key Cost Assumptions

Average YTD 2011E 2012E USD per tonne 2010E (Nov) cost y‐o‐ycosty‐o‐y

Iron Ore 133 130 150 15.4% 150 0.0% Blended Coal 161 160 180 12.5% 180 0.0% Metallurgical Coke 227 230 265 15.2% 265 0.0% Metal Scrap 374 375 420 12.0% 420 0.0%

BDI Index (pts) 2,870 2,850 2,500 ‐12.3% 2,250 ‐10.0%

Source: OSK estimates, Steel Business Briefing

OSK Research 43 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

IMPROVED AVERAGE SELLING PRICE OFFERS BETTER SPREAD

Steel prices edge up. Year 2010 saw many changes to steel mills around the world, especially with miners now introducing a quarterly pricing mechanism for the two major feed materials of iron ore and coking coal. The new system also caused the first quarterly benchmark prices set for 2Q10 to increase by 90% for iron ore and while the coking coal contract surged 55%. This was despite the fact that the world was just pulling itself out from the financial crisis, as we have seen steel prices plummet in May 2010 for the first time after many years. Usually any benchmark price increase would have been followed by an uptick in steel prices around the world for the past many years. The continued improvement in the general economy plus restocking activities in July 2010 have helped the ASPs for steel products to edge higher although the upside was capped, followed by a small pullback. As China is entering the final phase of implementing the 11th Five-Year Plan together with RMB4trn stimulus packages that were supposed to be executed in 2009 and 2010, activities resumed quickly after the one-week Golden Holiday. Therefore, we have been witnessing an escalation in steel prices, especially since early November 2010 in China, with long steel selling prices moving up stronger than that for flat steel as the products are the mainstay for construction activities.

Exhibit 53: Steel prices and gross margin of steel mills

RMB/t GP margin Angang 6,000.0 35.0% 30.0% Magang 5,000.0 25.0% Shougang 4,000.0 20.0% Chonggang 3,000.0 15.0% 10.0% China 2,000.0 Oriental 5.0% 1,000.0 HRC 0.0% ‐ ‐5.0% Rebar 2005 2006 2007 2008 2009 2010YTD

Source: OSK, Steel Business Briefing

Room for flat steel prices to go up. While the ASP of flat steel products have been underperforming long steel prices, we expect this to quickly return to normal after the Lunar Calendar New Year in February 2011. We are basing this on the fact that construction may normalise after the end of this year, especially in view of the wintering season and pending official approval of China’s 12th Five-Year Plan in March 2011. The strong private consumption via the three phases of consumption upgrading that we elaborated on in an earlier section are expected to continue for many years to come and the export market may gradually return to historical levels, with countries around the world beginning to see positive recovery. We also believe that some of the steel mills under our coverage, namely Magang and Chongang – which are relatively new in the HRC and CRC market – to slowly improve on their profitability in the new segment after a few years of learning curve.

OSK Research 44 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 54: OSK steel prices assumption (based on basic specification)

Average YTD 2011E 2012E USD per tonne (ex‐VAT) Current Spot 2010E (Nov) ASP y‐o‐y ASP y‐o‐y

Hot Rolled Coil 552 519 520 580 11.5% 580 0.0% Cold Rolled Coil 677 659 660 720 9.1% 720 0.0% Hot Dip Galvanising 691 653 670 740 10.4% 740 0.0% Plate 582 548 550 620 12.7% 620 0.0% Welded Pipe 608 552 555 620 11.7% 620 0.0% Seamless Pipe 704 657 660 725 9.8% 725 0.0% Rebar 564 493 495 560 13.1% 560 0.0% Wire Rod 570 523 525 590 12.4% 590 0.0% H Beams 582 559 565 640 13.3% 640 0.0% Merchant Bar 558 521 525 590 12.4% 590 0.0% Billet 515 476 475 535 12.6% 535 0.0% Slab 521 481 480 545 13.5% 545 0.0%

Source: Steel Business Briefing

Niche products still lead the way. Although the tonnage of steel imported into China remains limited, we notice that the country is still reliant on overseas supply for specialised steel. Over the years, steel mills in China have begun to set up their own Research and Development units, which has resulted in a few of them successfully introducing new products. Among others, Angang has been successful in exploring new products so much so that its flat steel is now supplied to almost all the local car manufacturers while its silicon sheets provide good support to the machinery industry. However, Magang continues to dominate the market for heavy usage train wheels, and hence continues to enjoy lucrative margins. With the strong tie-up between China Oriental with Arcelor Mittal, we see the company continue to lead the large and medium steel section market in China, with potential of producing upcoming sheet pile products. SCIE’s latest upgrade on its plate plant to produce ticker plates and venture into downstream plate processing may also create a niche for the company in the fairly competitive steel plate market. We also believe Chongang may enjoy attractive margins from its newly commissioned 1780mm Hot Rolled Coils mills after a learning period with the new production line.

OSK Research 45 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

NORMALISING EARNINGS MOVING FORWARD

Balance supply-demand dynamics support prices and margin. Steel prices have been volatile and their cycle becoming shorter as we enter the New Millennium (see Exhibit 55). Nonetheless, prices only started to spurt sharply from 2H07 when selling prices continue to surge until the onset of summer in the Northern Hemisphere in 2008 as the world was stunned by the collapse of the century-old Lehman Brothers Those wild price swings translated into exceptionally robust margins as iron ore and coking coal stayed flat at the agreed benchmark in 2007. While we do not expect any extreme margins and continue to expect steel prices to be volatile in the coming years, we do see selling prices moving within a narrow range of around +/-10%, which we think can be easily managed by the steel mills. Especially with iron ore prices seemingly reaching a peak and our expectation of there being no sharp increase in coking coal prices, steel price will begin to consolidate but with some upward bias. We also believe that after few quarters of experience in handling the short term contract, steel mills will begin to get use to the short cycle benchmark. Together with the reasonable inventory cycle of only about two months at most of the Chinese steel mills under our coverage, the quarterly adjustment also helps to contain any risk of excessive write-downs in the event of a sharp plunge of material prices.

Exhibit 55: China steel prices

RMB tonne HRC 8,000 CRC Wire Rod 7,000 H Beams 6,000 Bar

5,000

4,000

3,000

2,000 Jan Jan Jan Jan Jan Jan Jan Jan Jul Jul Jul Jul Jul Jul Jul Jul

05 06 07 08 09 10 11F 12F

05 06 07 08 09 10 11F 12F

Source: Steel Business Briefing, Companies Data, OSK

2008 turbulence now over. While China as the world’s largest steel producer stood firm amid the crush of the financial crisis by achieving double-digit growth in crude steel output, many mills in the country on the other hand were stuck in the red in 2008 and 2009. As we expect margins to possibly return to more normal levels in view of the lower volatility in ASP, steel mills are now obviously out of the woods. Although not every product enjoys good margin, we are generally more favourable on flat steel producers and specialised steel manufacturers. (to expand later)

Exhibit 56: Profit and loss snapshot of steel mills under our coverage

2005 2006 2007 2008 2009 2010E 2011E 2012E RMB m

Angang 2,118.4 7,360.0 7,622.0 3,020.0 713.0 3,796.1 5,425.5 5,048.2 Magang 2,891.4 2,350.3 2,478.1 626.0 242.1 1,503.9 2,532.0 3,048.4 Chonggang 230.8 301.2 469.6 601.8 66.0 19.4 167.2 332.1 Shougang 299.6 222.4 1,300.5 1,728.0 ‐1,010.8 709.2 1,041.4 1,265.8 China Oriental 846.6 1,032.8 1,159.7 44.0 884.3 1,062.0 1,501.6 1,645.0

Source: Company Data, OSK Estimates

OSK Research 46 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Forging a steady path ahead? We have mentioned many times of potential steel prices and material costs being less volatile on expectation of these moving within a narrow range. Our estimates generally assume that steel mills will generate normalising returns with potential for gradual improvement going forward (with some adjustments on a company to company basis). We took a quick look at how steel price performed in the past and reckon that prices generally move within a narrow range from the period of 2006 to early 2007. Our quick comparison of the ROEs of steel mills under our universe (after making a few adjustments to better reflect their past ROE performance, such as Angang, which chalked up extreme ROEs in FY06 and FY07, whose numbers were distorted by the previous year’s lower shareholders funds), showed that steel mills generally enjoyed mid-cycle ROEs in FY06. The analysis also lends support to our view that steel mills under our universe are on the right path to returning to normalised earnings, and in turn satisfactory ROEs.

Exhibit 57: Historical returns made by steel mills under our universe

ROE GP Margin <‐‐‐‐‐‐‐‐‐‐Historical‐‐‐‐‐‐‐‐‐‐><‐‐‐‐‐‐‐‐‐‐Forecasted‐‐‐‐‐‐‐‐‐‐><‐‐‐‐‐‐‐‐‐‐Historical‐‐‐‐‐‐‐‐‐‐> <‐‐‐‐‐‐‐‐‐‐Forecasted‐‐‐‐‐‐‐‐‐‐> Trough Middle Peak 2010 2011 2012 Trough Middle Peak 2010 2011 2012 Angang 1.4% 18.1% 35.7% 7.0% 9.4% 8.4% 14.8% 17.3% 30.6% 18.2% 20.0% 19.7% Magang 0.9% 11.4% 16.3% 5.6% 8.8% 9.9% 12.6% 18.0% 21.1% 15.4% 16.0% 16.5% Chonggang 1.2% 7.7% 11.1% 0.4% 3.0% 5.7% 10.7% 13.8% 18.0% 11.3% 11.2% 11.6% Shougang ‐12.5% 15.4% 26.7% 8.0% 11.0% 12.3% ‐3.8% 11.9% 19.4% 10.3% 10.7% 11.0% China Oriental 0.7% 19.3% 20.5% 14.0% 17.2% 16.3% 5.8% 15.6% 18.2% 10.2% 11.2% 11.6%

Source: Company Data, OSK Estimates

Exhibit 58: China steel prices, raw materials and ROEs

RMB tonne HRC CRC USD per tonne 8,000 Wire Rod H Beams 250 Bar Iron Ore ‐ Contract (rhs) Iron Ore ‐ Spot (rhs) 7,000 200 6,000 150 5,000 100 4,000

3,000 50

2,000 0 Jan Jan Jan Jan Jan Jan Jan Jan Jul Jul Jul Jul Jul Jul Jul Jul

05 06 07 08 09 10 11F 12F

05 06 07 08 09 10 11F 12F

2005 2006 2007 2008 2009 2010F 2011F 2012F

Angang 19.9 14.6^ 14.1^ 5.6 1.4 7.0 9.4 8.4 Magang 16.3 12.1 11.4 2.6 0.9 5.6 8.8 9.9 Shougang 15.4 8.6 26.7 24.0 ‐12.5 8.0 11.0 12.3 Chonggang 5.9 7.7 10.3 11.1 1.2 0.4 3.0 5.7 China Oriental 20.0 20.5 19.3 0.7 13.2 14.0 17.2 16.3

^ Adjusted Source: OSK, Steel Business Briefing

OSK Research 47 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

STABLE EARNINGS MAY TRANSLATE INTO HIGHER VALUATIONS

How do you value steel stocks? Valuing public listed companies is an art. For the steel mills whose earnings are volatile in nature, a valuation methodology based on long-term cash flow such as Discounted Cash Flow (DCF), Free Cash Flow for Equity (FCFE) and others are generally unsuitable given the many uncertain variables. In the past, we had benchmarked steel stocks based on a combination of the Price Earnings Ratio (PER) and Price over Book (P/B) methodologies.

PER multiple to capture earnings volatility. While we expect the earnings of Chinese steel mills to stabilise for the next few years, investors may need some time to realise this. Judging from this, we think a PER methodology still an important yardstick in valuing steel stocks. Meanwhile, we are pegging our PER method based on criteria such as: (i) the historical PER trading band, (ii) the company’s prospects moving forward, and (iii) the liquidity of the particular stock. We have decided to tag Chinese steel stock at 10x to 16x by benchmarking their potential earnings for FY11 as investors are always forward-looking at between six and 12 months.

P/B is a more stable valuation yardstick but... The steel industry is generally a high capex industry that requires substantial investment outlay and yet is subject to fluctuations in earnings. As a pure valuation based on PER methodology would fail to account for the tangible amounts invested in the business, we have always incorporated P/B as the secondary valuation yardstick on top of our PER methodology. To better value steel companies, we also scrutinise the historical P/B trend for proper benchmarking based on the standard deviation calculation. This method also provides good guidance in identifying the trough of a share price, especially during a down-cycle, as a historical band gives guidance on what investors are willing to pay during the nastiest cycle. Our database from 2005 benchmarking the starting point of the new mini cycle for steel and asset injection of an upstream operation by Angang’s parent also occurred during that period. Meanwhile, we think Chinese steel stocks should trade at +1 standard deviation of the historical trend given that steel mills normalise their earnings around those levels (see the respective company reports for more details).

Exhibit 59: Leading P/B valuation of steel mills under our coverage

(x) Angang 14.0 Shougang 12.0 Magang 10.0 Chonggang 8.0 China Oriental 6.0

4.0

2.0

0.0 1/3/2005 5/3/2005 9/3/2005 1/3/2006 5/3/2006 9/3/2006 1/3/2007 5/3/2007 9/3/2007 1/3/2008 5/3/2008 9/3/2008 1/3/2009 5/3/2009 9/3/2009 1/3/2010 5/3/2010 9/3/2010

Source: Steel Business Briefing, Companies Data, OSK

OSK Research 48 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 60: Valuation matrix of steel mills under our coverage

30-Nov-10 Target Mkt Cap P/E P/BV ROE EV/EBITDA Company Ticker Rating Price Price (RMB m) 2009 2010E 2011E 2009 2010E 2011E 2009 2010E 2011E 2009 2010E 2011E Angang 347.HK Buy 11.20 13.75 67,656.9 99.9 18.1 12.1 1.4 1.2 1.1 1.4 7.0 9.4 14.2 7.9 6.0 Magang 323.HK Buy 4.09 5.15 30,925.1 113.1 17.8 10.0 1.0 1.0 0.9 0.9 5.6 8.8 n.a. n.a. n.a. Chonggang 1053.HK Neutral 2.02 1.92 6,472.6 46.7 153.0 16.9 0.6 0.5 0.5 1.2 0.4 3.0 13.8 10.3 8.3 Shougang 697.HK Buy 1.18 1.80 9,646.9 n.m. 13.6 9.3 1.0 1.1 1.0 -12.5 8.0 11.0 n.m. 12.7 9.8 China Oriental 581.HK Buy 2.99 4.25 8,759.9 8.7 7.0 4.7 1.1 0.9 0.7 13.2 14.0 17.2 4.5 3.7 2.3

Source: OSK Estimates

Recent market correction offers the perfect opportunity to BUY. Stock markets have been enjoying a good ride since April 2009 as global governments’ quick action in introducing stimulus measures helped to stimulate the interest of investors from around the world who were betting on a green shoots recovery story. Steel stocks obviously joined the long bull rally in the equity markets, especially after steel counters had been unreasonably bashed down by the market earlier. Many steel counters crashed to around -2 standard deviation P/B valuation of their respective historical trading bands in 4Q08, which were levels we believe many investors of the new generation have never seen before, or at least in the past few years. Although steel counters have now rebounded, including the Chinese steel companies that have just come under our coverage universe, most of the steel stocks still offer decent returns as they are only priced slightly above the mean P/B of their historical bands despite their vastly improved fundamentals. Also, the recent market-wide correction has somewhat pared down their prices so drastically that they now offer respectable upside potential, especially amid a market that is awash with liquidity.

Initiate with OVERWEIGHT rating. We are generally optimistic on the China steel industry on anticipation of the Chinese government keeping its benchmark magical “8%” GDP growth for the medium term, which has been the case in the past three decades and crucial periods of leadership change in the country. This further suggests that continued government spending and moderate monetary tightening would prevail in order to achieve its target. Private spending is also expected to show stronger growth as the population gains purchasing power, being the government’s key emphasis in its 12th Five-Year Plan period (2011-2015). We are confident of there being “steel” pockets of bright spots in the steel industry that will drive demand by a moderate 4% in 2011. The toppish prices of raw material such as iron ore and coking coal but limited downside risk could also see production cost stabilising. With our expectations of steel price moving within a narrow range with an upward bias, we see steel mills returning to mid-cycle earnings. The recent market wide correction in the global equity markets globally including the HKSE has rendered H-share steel stocks’ valuations more compelling despite the absence of major earnings surprises like those during the last super cycle. Therefore, we initiate coverage on China’s steel sector with an overweight rating, and pick Magang as our Top BUY, and also line up Angang, China Oriental and SCIE in our BUY list. Chongang is the only stock we are initiating coverage on with a NEUTRAL as we see its earnings being impacted by its huge debt burden and depreciation charges arising from its massive relocation plan.

OSK Research 49 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 61: Share price performance of key global steel stocks

Company Closing Abs. Perf. (%) Rel. Perf. (%) 52 Weeks Off From Up From Avg 3 Mth Name CRY 30-Nov Beta 1 mth 3 mth 6 mth 12 mth 1 mth 3 mth 6 mth 12 mth High Low High Low Volume (m) Global ArcelorMittal EUR 24.38 1.5 3.9 5.0 -2.3 -6.0 8.2 1.8 -4.6 -12.7 35.46 21.33 -31.2% 14.3% 8.3 POSCO KRW 454,500.00 1.1 -2.1 -6.6 -3.6 -16.9 -2.7 -14.5 -17.0 -33.5 633,000.00 431,000.00 -28.2% 5.5% 0.3 Nippon Steel Corp JPY 277.00 1.2 14.6 2.5 -8.5 -6.1 3.1 -6.5 -11.2 -15.8 395.00 250.00 -29.9% 10.8% 27.8 Tata Steel Ltd INR 584.80 1.5 0.4 16.0 21.0 10.4 1.8 3.0 1.4 -12.5 739.00 448.65 -20.9% 30.3% 8.4 JFE Holdings Inc JPY 2,661.00 1.3 8.8 7.6 -9.0 0.1 -0.2 0.2 -11.2 -8.6 3870.00 2452.00 -31.2% 8.5% 3.2 Severstal OAO USD 14.28 1.7 6.5 19.5 32.6 86.2 8.2 11.6 23.2 72.4 15.92 7.68 -10.3% 85.9% 1.7 Evraz Group SA USD 30.60 1.7 1.1 17.5 13.2 23.1 3.4 10.9 5.8 16.3 43.15 21.59 -29.1% 41.7% 1.1 United States Steel Corp USD 47.89 1.9 12.2 9.7 1.7 11.7 11.7 -0.4 -7.0 -1.1 70.95 36.93 -32.5% 29.7% 11.9 China Steel Corp TWD 31.35 0.8 1.0 3.1 10.2 11.3 -0.1 -5.9 -6.6 -3.4 34.66 28.32 -9.5% 10.7% 22.3

China Hebei Iron & Steel Co Ltd CNY 3.80 1.1 -8.1 -1.8 -5.9 -42.7 -10.1 -13.9 -26.6 -51.6 7.75 3.58 -51.0% 6.1% 73.9 Baoshan Iron & Steel Co Ltd CNY 6.28 1.0 -11.2 0.8 -1.7 -15.9 -7.4 -9.1 -9.0 -12.8 9.72 5.72 -35.4% 9.8% 66.2 Wuhan Iron & Steel Co Ltd CNY 4.42 1.3 -11.0 -3.8 -8.0 -41.3 -7.9 -12.0 -15.9 -38.2 8.75 4.18 -49.5% 5.7% 52.4 Angang Steel Co Ltd HKD 11.2 1.4 -8.2 1.8 -1.6 -25.6 -7.7 -9.1 -12.5 -32.1 18.36 9.05 -39.0% 23.8% 17.6 Maanshan Iron & Steel HKD 4.09 1.3 -8.3 1.8 7.1 -19.1 -7.5 -8.0 -7.3 -26.1 6.11 3.27 -33.1% 25.1% 33.8 Chongqing Iron & Steel Co Ltd HKD 2.02 1.1 -7.3 8.6 7.4 -30.6 -7.0 -2.0 -7.2 -35.7 3.19 1.7 -36.7% 18.8% 4.3 Shougang Concord International Enterprises Co Ltd HKD 1.18 1.4 -9.2 0.9 -0.8 -18.6 -8.9 -6.8 -18.9 -25.9 2.33 0.98 -49.4% 20.4% 69.0 China Oriental Group Co Ltd HKD 2.99 1.0 -2.3 20.0 30.4 40.2 -2.2 8.5 11.2 23.3 3.50 1.80 -14.6% 66.1% 0.2

Source: Bloomberg, OSK Estimates

Exhibit 62: Valuation matrix of key global steel stocks

Company Closing Mkt PE(x) EV/EBITDA P/BV ROE Dvd % EBITDA N. Debt Name CRY30-NovCap (m)FY1fFY2fFY1fFY2fFY1fFY2fFY1fFY2fFY1fMargin /Equity Global ArcelorMittal EUR 24.38 38,055 13.6 10.6 8.3 6.6 0.8 0.8 5.9 7.5 n.a. 4.9 28.9 POSCO KRW 454,500.00 39,626,420 8.0 7.6 5.7 4.5 1.1 1.1 13.9 13.7 1.3 19.3 -2.0 Nippon Steel Corp JPY 277.00 1,885,534 11.9 9.8 7.0 6.3 1.0 0.9 7.5 9.5 0.5 9.2 55.4 Tata Steel Ltd INR 584.80 527,615 8.5 7.3 6.6 5.8 2.3 1.9 23.2 21.7 1.3 8.4 187.1 JFE Holdings Inc JPY 2,661.00 1,635,021 11.8 9.5 6.4 5.9 1.0 0.9 8.5 10.6 1.6 11.9 98.0 Severstal OAO USD 14.28 14,390 18.3 9.0 6.6 5.4 1.8 1.8 5.7 17.4 0.0 6.8 50.2 Evraz Group SA USD 30.60 13,438 n.a. 11.7 8.7 6.2 0.4 1.3 0.6 8.6 n.a. 12.7 69.0 United States Steel Corp USD 47.89 6,878 n.a. 19.4 17.1 6.7 1.5 1.6 -9.3 12.2 0.5 -10.6 43.6 China Steel Corp TWD 31.35 425,299 11.5 12.3 10.3 8.1 1.7 1.6 14.2 13.5 3.1 12.9 3.4 Average 11.9 10.8 8.5 6.2 1.3 1.3 7.8 12.7 1.2 8.4 59.3

China Hebei Iron & Steel Co Ltd CNY 3.80 26,132 19.5 13.2 21.6 18.0 0.9 0.9 3.6 6.2 n.a. 6.2 116.0 Baoshan Iron & Steel Co Ltd CNY 6.28 109,975 8.9 7.8 5.3 4.8 1.1 1.0 11.6 12.1 n.a. 14.5 55.7 Wuhan Iron & Steel Co Ltd CNY 4.42 34,645 13.6 10.0 6.7 5.5 1.2 1.2 7.2 10.9 n.a. 11.8 95.5 Angang Steel Co Ltd HKD 11.2 67,657 18.1 12.1 7.9 6.0 1.2 1.1 7.0 9.4 0.7 11.5 63.6 Maanshan Iron & Steel HKD 4.09 30,925 17.8 10.0 n.a. n.a. 1.0 0.9 5.6 8.8 - 11.9 55.1 Chongqing Iron & Steel Co Ltd HKD 2.02 6,473 153.0 17.0 10.3 8.3 0.5 0.5 0.4 3.0 - 6.2 111.7 Shougang Concord International Enterprises Co Ltd HKD 1.18 9,647 13.6 9.3 12.7 9.8 0.9 0.8 8.0 11.0 - (3.7) 94.2 China Oriental Group Co Ltd HKD 2.99 8,760 7.0 4.7 3.7 2.3 0.9 0.7 14.0 17.2 4.1 11.4 38.7 Average 34947.7 30.1 11.7 9.8 7.6 1.0 0.9 6.7 9.0 0.7 9.0 78.3

Source: Bloomberg, OSK Estimates

OSK Research 50 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

RISKS TO OUR BULLISH VIEW

Further tightening in China. As China’s steel industry largely supplies for domestic consumption, its demand is primarily affected by domestic economic conditions as well as the China government’s monetary and fiscal policies. As steel is used in various industries that are also cyclical in nature, including the machinery manufacturing, construction, electronic appliances, and automotive industries, the state of China’s economy has a significant impact on steel demand. While we expect steel demand to grow by only 4% in 2011, and skewed towards flat steel products, there is no assurance that fluctuations in market demand will not occur in the future, especially measures that policy makers implement, such as the recent increase in banks’ Statutory Reserve Requirement by 50 basis points - two times in just a matter of weeks. These latest measures have negatively impacted on steel prices and demand.

Unable to pass on higher materials cost. As the steel industry is cyclical in nature, steel price may stabilise and consolidate at current levels with a small upside potential, but we cannot assure that raw material prices will not increase substantially in the future. The Chinese steel mills under our coverage use primarily iron ore and coking coal, or coke, for their production processes. While steel mills will pass through their cost increases of raw materials based on prevailing market conditions, no assurance can be given that price fluctuations will not occur in the future, nor can cost increases be fully passed on. The best example is the 90% together with additional 25% increase in 2Q10 and 3Q10 iron ore respectively were not fully passed due to the onset of the European debt crisis and as customers were unable to swallow the big quantum of price increase as the economy was only at the recovery stage, which led to some steel mills slipping into the red.

Further clamp-down on mini BFs may pose risk to some steel mills. China’s steel industry is heavily regulated by the government and manufacturers must comply with various requirements mandated by the applicable laws and regulations, including the policies and guidelines established by local authorities designed for the implementation of such laws. Already, the government is taking tough measures to clamp down on blast furnaces of below 200 cubic metres capacity and converters or electric furnaces of below the capacity of 20 tonnes in 2007, while blast furnaces below the capacity of 300m3 will be eliminated by end-2010. The instructions to shut down those furnaces in 2007 have reduced outdated iron production capacity by 55m up to the end of 2007, with a target to totally remove 100m tonnes of outdated steelmaking facilities over the 11th Five-Year Plan (2006-2010) period. We understand that the Chinese government’s next move is to clamp down on BFs below 400 cubic metres and converters or electric furnaces with capacity of below 30 tonnes by end of 2011. This will involve 72m tpy of crude steel capacity and 25m tpy of finished steel capacity. Although none of the steel mills under our coverage operate furnaces of below of that size, China Oriental and Magang do have some BFs of 450 cubic metres and 500 cubic metres that are deemed next in line for scrapping by the government beyond 2011. Meanwhile, we doubt that that government would target it as we think this would affect significant steelmaking capacity in China, and scrapping it may bring about a shortage of steel supply in China and potentially drive up steel prices. Apart from that, Magang plans to replace the smaller furnaces with 5,000 cubic metres BFs under the proposed Greenfield project.

Additional costs for environmental protection. China could impose significant costs on and require significant efforts from the steel companies. Chinese policy makers have adopted extensive environmental laws and regulations with national and local standards in relation to emission control, discharge of waste water and storage, transportation, and treatment and disposal of waste materials. Compliance with environmental laws and regulations which apply to the steel industry may be difficult or involve significant costs. We understand that many steel mills in China do not comply with international environmental standards, especially the smaller mills. Meanwhile, we are unable to ascertain any impact of environmental protection effort by the government to impact on the steel mills under our coverage, and hence do not incorporate any of these costs in our financial model.

OSK Research 51 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Prolonged power restriction? The Energy Conservation and Emission Reduction’s Working Plan stipulates that by the end of the 11th Five-Year Plan, its total energy consumption in terms of gross domestic production shall be lower by 20%, and the total emission of major pollutants shall be reduced by 10%. Therefore, the various provincial governments had recently introduced restrictions on energy consumption by high energy consuming industries including steel mills, which have impacted on all the steel mills under our coverage to differing degrees. While we understand such restrictions have decelerated, we are unable to predict if there would be more such restrictions in the future.

OSK Research 52 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Company Reports

OSK Research 53 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Private Circulation Only Initiating Coverage

STEEL BUY Ng Sem Guan, CFA Angang Steel Company +(603) 9207 7678 Price HKD11.34 [email protected] Limited (347.HK) Target HKD13.75

A Steel Giant in The Making

We like Angang’s leadership in China’s flat steel industry, with potential M&As Stock Profile/Statistics very likely to propel the company to become the country’s largest steel mill. We Bloomberg Ticker 347 HK Share Capital (m) 1,085.8 also expect the company to continue to enjoy the 5% discount on its iron ore Market Cap (HKDm) 68,208.7 supply from its parent company but see the time lag benefit diminishing as feed 52 week H | L Price (HKD) 18.36 | 9.05 material prices go up. With earnings potentially normalising, we initiate Average Volume (3m) ‘000 17,655.2 YTD Returns (%) -33.8 coverage on Angang with a BUY rating and fair value of HKD13.75, premised on Beta (x) 1.42 16x PER and a 1.9x book value on FY11 numbers.

Major Shareholders (%) Flat steel specialist. Angang is the six largest steel mill in China based on crude Angang Holding 67.29% steel production in 2009 with primary focus on the flat steel segment. The various incentives for car and white goods ownership as part of the RMB4trn stimulus package introduced in late 2008 boosted the steel tonnage delivered to these Share Performance (%) industries the past two years. We expect the fascination for cars and as white goods Month Absolute Relative th 1m -8.0 -8.0 become a necessity in China to spur flat steel demand. As the 12 Five-Year Plan 3m 1.8 -10.3 (2011 to 2015) that is supposed to be approved in March 2011 has outlined 6m 1.8 -9.1 industrial upgrading as a key focus in the next five years, silicon steel - which has 12m -27.9 -32.7 magnetic properties - may also be next catalyst for Angang.

12-month Share Price Performance

14.80 Bayuquan & Putian plants solidifies its market positioning. The commissioning of the new state-of-the-art integrated mill at Bayuquan not only lifted the company’s 12.80 capacity in flat steel but also set a new benchmark in terms of production efficiency. 10.80 Its location near a port also facilitates imports and exports. Angang also announced 8.80 early this year that it is setting up a new cold rolled and galvanised line in Putian, 6.80 Fujian province to enlarge its market presence in South China. 4.80

2.80 M&As under the microscope. Angang is directly owned by State-Owned Asset 0.80 Jun-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Supervision & Administration Commission (SASAC) compared with most state- owned enterprises, which are administered through the Provincial SASAC given the company’s edge in M&As. In 2005, the establishment of Anben Iron & Steel group (Anben) marked the amalgamation of Angang Holding (Anshan) and Benxi Iron- Steel Group (Bengang). This was followed by the consolidation of Pangang into Anshan’s umbrella, and Bengang merging with Beitai Iron & Steel (Beigang) in June 2010. Nevertheless, as all the mergers have so far occurred at the holding company level, we expect it would take longer to combine the listed entities, especially since they are trading at a wide valuation range. The long overdue asset injection of Bengang into Angang may be the first such consolidation as Angang’s chairman took over the helm at Bengang only from June 2010.

FYE Dec (RMBm) 2008 2009 2010F 2011F 2012F Total Revenue 78,985.0 70,057.0 91,301.7 98,343.1 100,163.8 Net Profit 3,020.0 713.0 3,796.1 5,425.5 5,048.2 % chg YoY -60.4 -76.4 432.4 42.9 -7.0 Consensus Net Profit - - 3,987.3 5,666.1 7,435.9 Core EPS (sen) 0.417 0.099 0.525 0.750 0.698 DPS (sen) 0.210 0.060 0.262 0.375 0.349 Div. Yield (%) 2.1 0.6 2.7 4.1 3.8 PER (x) 23.9 101.3 18.4 12.2 13.1 P/BV (x) 1.4 1.4 1.3 1.1 1.1 EV/EBITDA (x) 11.3 14.3 8.0 6.0 5.5 ROE (%) 5.6 1.4 7.0 9.4 8.4 ROA (%) 3.3 0.7 3.7 5.2 4.9 Note: Core Numbers

OSK Research 54 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

COMPANY BACKGROUND

Listing of Angang. Angang Steel Company Limited (Angang) is a joint stock limited company incorporated on 8 May 1997. Pursuant to the reorganisation, Angang’s parent company, Anshan Iron and Steel (Anshan) injected its Cold Rolled Plant, Wire Rod Plant and Heavy Plate Mill into the company. The three plants had a net asset value of RMB2bn, with Angang issuing 1.319bn domestic state owned legal person shares as settlement. In July 1997, Angang issued 890m shares at HKD1.63 per share on the Hong Kong Stock Exchange, and subsequently issued 300m A-shares at RMB3.90 each on the Shenzhen Stock Exchange for a listing presence in both Hong Kong and China.

Exhibit 1: Expanded operation scale post acquisition of ANSI

Chemical Plant existing facilities of Facilities of ANSI (coal washing, producing the company coke)

Iron Manufacturing Steel Processing Centre Plant (scrap steel)

Steel Manfacturing Plant

Heavy Plates Sections

Wire Rod Medium Plate

Cold Rolled Sheet Hot Rolled Strip

Heavy Section Cold Rolled Silicon Steel

Seamless Steel Pipe

Source: OSK, Company announcement

Emergence of a major integrated steel mill. Subsequently on 26 Jan 2006, the Company issued 2.97bn A-shares at RMB4.29 per share to Angang Holding as partial payment of the consideration for the acquisition of 100% share capital of Angang New Steel and Iron Company Limited (ANSI). The acquisition marked an important milestone as the upstream facilities supplying the principal raw materials to the company, comprising coking and sintering, iron and steel manufacture, ancillary facilities plus some of the rolling operations that were previously undertaken by the parent Anshan were transferred to the company. This is the main platform from which the group emerged as one of the top integrated steel mills in China. While Angang focuses primarily on flat steel, its capacity also covers long steel with products including of hot rolled (HR) and cold rolled (CR) sheets, galvanised steel sheets, colour coating plates, silicon steel, medium and thick plates, wire rods, heavy sections and seamless steel pipes. Applications of these products are spread across industries such as automotive, infrastructure and construction, shipbuilding and white goods. Purely on Angang’s listed entity production, the group was the sixth largest steel mill in terms of crude steel production in China in 2009.

OSK Research 55 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

KEY HIGHLIGHT

M&A: Mega merger in store?

Establishment of Anben. As some of you might recall, 2005 was a major year for Anshan Iron and Steel Group (Anshan), with the announcement of its merger with one of the biggest iron and steel enterprises in northeast China, Benxi Iron-Steel Group (Bengang), to form Anben Iron & Steel group (Anben). However, despite the inauguration ceremony in 2005, the two companies still operate independently up to today, with no operating assets transferred to the new entity, Anben. Given such circumstances, Angang Holding (Anshan) remains the single largest shareholder of Angang with a 67.29% equity stake.

Enlarged entity for Bengang. Bengang offers a full range of flat steel products, with an output of 9m tonnes of crude steel in 2009. The company was established in 1905 and now has an annual crude steel capacity of 10m tpy, hot rolling capacity of 13m tpy and 3.5m tpy of capacity for cold rolled products. We also understand from sources that Bangang has 1.5bn tonnes of iron ore reserves, with an annual iron ore output of over 20m tpy. Bengang sank into the red in 2009 due to poor demand for flat products, registering a net loss of RMB1.5bn. However, it rebounded with RMB860m in net profit in 1HFY10 and a gearing that was adequately low at 0.6x. Bengang is fully owned by the Liaoning Provincial Government, and is currently in the process of merging with Beitai Iron & Steel (Beigang), as reported by Bloomberg on 8 June 2010. Bengang will retain its name as the new entity from the merger, while both companies unify their assets, sales, purchases, investments, R&D and human resources. Beigang is owned by the Beitai City Government, and is the 19th largest crude steel producer in China in 2009, with an output of 6.9m tonnes.

Pangang comes under Anshan umbrella. On 25 May 2010, Angang received the approval of China’s State-Owned Asset Supervision & Administration Commission (SASAC) to proceed with its consolidation with Panzhihua Iron & Steel Group (Pangang) from south-western China’s Sichuan province. Pangang is also owned by the central SASAC, as is Angang. Consequently, Angang announced changes at its holding company level whereby a new company called Angang Newco was established as the 100% owner of both Angang Holding and Panggang (see Exhibit 2).

Exhibit 2: Corporate structure upon completion of restructuring

SASAC

100%

Angang NewCo

100% 100%

Angang Holding Panggang

67.29%

Angang

Source: Company Data

All about Pangang. Pangang is the first integrated steel company utilizing vanadium titano-magnetite to produce steel products. The company has an annual capacity of 8.3m tpy of pig iron, 9.4m tonnes of crude steel and 8.9m tpy of of steel products. Pangang also has a rated capacity to produce 20k tpy vanadium products (V205), 300k tpy titanium concentrate and 93k titanium pigments.

OSK Research 56 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

A giant in the making? With the slew of rumours on the merger, we make a simple illustration to combine all the units we have mentioned earlier. Angang will emerge as the largest steel mill in China, overtaking Hebei Iron & Steel Group’s dominant position and second only to Acelor Mittal, the world’s largest steel maker, upon the combination of all the units with a potential annual crude steel capacity of approximately 48m tpy. The simple equation as shown below:-

( Bengang + Beigang) + (Angang + Pangang) = ~48m tpy (capacity)

Merger unlikely at the listed entity level. While we are excited with the new developments, we see most of the consolidation will occurring at the holding company level, taking the cue from the prolonged delay to inject Bengang into Angang since 2005. We are certainly looking at a longer time frame for a union of those entities at the listed company level, especially since those listed units are currently trading at very wide valuation range (see Exhibit 3). The expensive valuations, further compounded by Panggang’s poor financial performance, are obviously the major roadblock to Angang’s acquisition. However, with Angang’s chairman, Mr. Zhang Xiaogang, telling the media in June 2010 that a merger with Bengang will see substantial progress by year-end and at the same time taking over as President and General Manager of Bengang, the merger process may be expedited. Nevertheless, we still expect the merger of Bengang and Beigang to be complete first before moving into the second stage involving Angang.

Exhibit 3: Financial and valuation snapshot of the rumoured merger partner of Angang

in RMB Company Last Price Products Output (m tonnes) BV/share PB/share PER (FY10F) PER (FY11F) Gearing (%) ‐ Full range of flat Bengang 6.19 9.00 2.27 2.73 17.5 14.5 57.13 steel products ‐ HRC Beitai not listed 6.88 n.a. n.a. n.a. n.a. n.a. ‐ Wire Rod ‐ Hot rolled sheets Panggang 9.03 ‐ Strips 8.18 1.30 6.95 44.5 24.9 153.78 ‐ Plates

Source: OSK, Bloomberg, CISA

BAYUQUAN PLANT: A state-of-the-art facility

The Bayuquan project. Angang’s Bayuquan Steel Complex at Yingkou, Liaoning province, houses blast furnaces and converters that carry a crude steel capacity of 5m tpy. The continuous casting lines that include a 5,500mm heavy rolling line have a design capacity of 2m tpy and 1,580mm hot rolling lines whose rated capacity stand at 3m tpy. The total capex for the Bayuquan project is approximately RMB30bn, with construction starting in 2006 and completed in 2008. Trial operation began in August 2008, and in FY09, Bayuquan produced 5.3m tonnes of iron, 5m tonnes of steel and 4.4m tonnes of steel products.

Modern design plus great efficiencies. While the total investment exceeded the earlier budgeted RMB22.6bn, this was after incorporating seven units of wind power generators and cancelling the plan to build a 1m tpy cold rolling line. The plant has achieved tremendous efficiency, with its FY09 production topping the official rated capacity. The plant produces 3.2m tonnes of crude steel in 1HFY10 representing 64% of its annual capacity. Management confirmed that a reasonable production capacity for Bayuquan is 6.5m tpy. We also like Bayuquan’s location close to the shipbuilders in Dalian City, which positions it strategically for quick and convenient delivery of its ship plates. As heavy industries are well developed in Northern China, there is strong demand in the region for high quality steel products to be supplied to the shipbuilding, energy facilities, metal fabrication, heavy machinery, petrochemical and automotive industries. The plant, which situated near Bayuquan Port, will give it easy access to the import and export of raw materials and finished steel products.

OSK Research 57 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 4: Location map of Bayuquan

Source: Google Maps, Company Website

ANGANG PUTIAN: Inroads to the South

Establishment of Angang Putian. On 29 Jan 2010, Angang established a wholly owned subsidiary, Angang Cold Rolled Steel Sheets (Putian) Co. Ltd. (Angang Putian) with total investment of approximately RMB3.8bn. This new unit will engage in the construction and operation of new production facilities with a total annual designed capacity of 700k tpy of CR sheets and 300k tpy of hot galvanised coils. The production facilities will be capable of producing steel products with a thickness of 0.25mm to 2mm and a width of 700mm to 1,350mm.

Tapping on flat steel shortage on the South. The construction period for the new production facilities is estimated at 30 months. Therefore, we only expect this plant to start contributing from 2HFY12. We suspect the new plant is part of the group’s endeavours to expand its market share in the southern coastal region of China by leveraging on the accessibility of Fujian Province to roads, railroads and ports. The products will also cater mainly to electrical appliances, automobiles and architectural structures.

FLAT STEEL: Dominant player focused on automotive and specialise sheets

Unwavering focus on flat products. HRC and CRC products make up 37.6% and 35.8% of Angang’s revenue respectively, while medium and thick plates account for 15.4% of sales in 2009. Angang’s HRC division recorded sales of 8m tonnes while CRC clocked in sales of 4.1m tonnes, and medium and thick plates raked in sales of 3m tonnes. GP margins in 2009 remain commendable at 7.9% for HRC, 11.8% for CRC and 8.5% for medium and thick plates. In terms of domestic market share, heavy rails lead the pack with 18.8%, medium and heavy plates at 8.3% and finally HRC and CRC, which command 6.9% and 7.9% each. 1HFY10, Angang reported further margin improvement for HRC at 14.4%, while margins for CRC products more than doubled to 24.2%, up a strong 12.4% from FY09. Meanwhile, weak conditions in the shipping sector continued to drive down margins of medium and thick plates in 1HFY10 to 3.4%.

OSK Research 58 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Steel sheets tonnage to auto and E&E makers escalating. Following the implementation of various incentives for car and white goods ownership as part of the Chinese government’s RMB4trn stimulus package introduced in late 2008, the automotive plus electronic and electrical (E&E) industry in China also overtook US as the world’s main car consumer and producer. Based on the data provided by management, Angang’s sales tonnage of steel sheets comprise HR and CR sheets plus galvanised coils that reached 1.4m tonnes in 1HFY10 against 1.4m tonnes in FY08 and 1.7m tonnes in FY09 (see Exhibit 5). Meanwhile, Angang’s supplies steel sheets ranging from HR and CD sheets to galvanised coils to almost all the local car makers. The robust numbers may continue given that we expect car sales in China to continue to surge at double digits over the next few years, with volume potentially topping 30m new cars per annum by 2015. China’s improving purchasing power may also see demand for white goods rising in tandem with the growth in consumption.

Exhibit 5: Sales tonnage of steel sheets to auto makers

m tonnes Galvanised Sheets 1.8 CRC HRC 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 FY06 FY07 FY08 FY09 1HFY10

Source: Company Data

Specialised steel may ride on industrial upgrading. Silicon steel, an alloy of silicon and steel, possesses magnetic properties that allow it to be easily magnetised and de-magnetised. This product contributed 7.6% to Angang’s total revenue in 2009 and fetches a decent gross profit margin of 16%. Sales tonnage stood at 0.7m in 2009 and we expect a robust y-o-y sales growth of 38.5% for 2010. We expect sales to consolidate near the rated capacity moving forward given that China is moving into encouraging industrial upgrading during the 12th Five-Year Plan period. We expect margins to improve further to 20% for FY10 and stay range-bound at that level in the coming years.

Exhibit 6: Sales tonnage and gross margin of specialised steel

1.0 40% 0.9 35% 0.8 30% 0.7 0.6 25% 0.5 20% 0.4 15% 0.3 10% 0.2 0.1 5% 0.0 0% FY06 FY07 FY08 FY09 FY10E FY11E FY12E

Sales Tonnage (m) GP Margin

Source: Company Data, OSK estimates

OSK Research 59 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

LONG STEEL: No surprises

Long Steel completes the product range. Wire rod sales accounted for only 3.6% of Angang’s total revenue in FY09, notching up a GP margin of 11% and sales of 0.8m tonnes. Rails and steel sections made a slightly higher contribution of 4.8%, fetching a stronger margin of 25% and sales of 0.8m tonnes. The shift in consumption from long to flat products in China would lead to slower growth in both segments, with the outlook for long steel product prices holding at current levels. Our estimates show that tonnage growth for the year will be moderate at 3% and remain flattish for wire rods, while growth of wire roads will fall by 12.2%.

Exhibit 7: Sales tonnage and gross margin of wire rods & rails/sections

Wire Rods Rails / Sections 1.0 25% 0.9 30% 0.9 0.8 25% 0.8 20% 0.7 0.7 0.6 20% 0.6 15% 0.5 0.5 15% 0.4 0.4 10% 0.3 0.3 10% 0.2 5% 0.2 5% 0.1 0.1 0.0 0% 0.0 0% FY06 FY07 FY08 FY09 FY10E FY11E FY12E FY06 FY07 FY08 FY09 FY10E FY11E FY12E

Sales Tonnage (m) GP margin Sales Tonnage (m) GP margin

Source: Company Data/ OSK Estimates

SEAMLESS PIPES: No light at the end of tunnel?

Impacted by anti-dumping duty. In 2008, the US filed a trade case against China claiming that Chinese exporters and producers were dumping seamless pipes in the US at prices that were 32% to 98% below their fair value. In return, it imposed anti-dumping duty ranging from 48% to 98% on seamless pipe imports as counter measure. As China’s seamless market has relied heavily on exports to the US market and capacity expansion in the country had also gone overboard, this led to the segment slipping into the red in FY09 with a gross margin of -9%. The sales tonnages shrank to 390k tonnes from 550k tonnes in FY08. Meanwhile, the company announced it had won bids for national projects, including No.2 Gas Pipeline, and West-East Gas Pipeline Project (Qinhuangdao-Shenyang gas pipeline). Nonetheless, we only expect this division to improve sales and profitability gradually pending US removal of anti-dumping duty against Chinese seamless pipes.

Exhibit 8: Sales tonnage and gross margin of seamless pipes

600,000 30% 25% 500,000 20% 400,000 15% 10% 300,000 5% 200,000 0% ‐5% 100,000 ‐10% ‐ ‐15% FY06 FY07 FY08 FY09 FY10E FY11E FY12E

Sales Tonnage GP Margin Source: Company Data, OSK Estimates OSK Research 60 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

FINANCIAL REVIEW

Enjoying 5% discount on iron ore concentrate from parent. Angang has in past procured almost 70% of its iron ore concentrate requirements from its parent, Anshan. However, the commissioning of the Bayuquan plant raising the company’s iron ore requirement has seen this percentage falling to 59% in FY08 and only 44.9% in FY09. Apart from that, Angang procures almost its entire iron ore pellets and sinter ore from its parent. Its purchases of iron ore concentrate have traditionally enjoyed a 10% discount on the average imported price, although the discount was reduced to 5% from 2008. Basically the selling price is benchmarked against the average imported price of iron ore concentrate reported to China’s customs authorities in the preceding half-year reporting period, plus railway transportation costs from Bayuquan Port to the company. As for iron ore pellets, the selling price is based on the average price of similar products purchased in the preceding half-year reported period. The price of sinter ore, however, is referenced on the iron ore concentrate price supplied by the parent plus standard processing costs and a 10% gross profit.

Exhibit 9: Summary of terms and conditions on iron ore procured from Anshan

Items 2006 2007 2008 2009 2010 (1st half) Angang Holding to give a discount rate of 10% off the Iron Ore Angang Holding to give a discount rate of 5% off the average import price of iron average import price of iron concentrate reported to the Concentrate concentrate reported to the PRC custom in the preceding half year PRC custom in the preceding half year

Pellets Based on the average price of pellets purchased by the company from independent 3rd parties in the preceding half‐year reporting period

Sinter Ore The price of iron concentrate + processing cost of the supplier in the preceding half‐year reporting period + 10% gross profit

Source: Company Data, OSK

Iron ore discount from parent likely to stay and supply constant. The parent company has the flexibility to discontinue or lower its discount on the supply of iron ore to Angang after the agreement expires by end-2011. Nonetheless, with the iron ore price expected to stay above USD100 per tonne and according to Anshan’s review in the China Steel Year book 2010 that the full cost of iron ore produced by the group was below RMB500 per tonne, we think that Anshan can still afford to give Angang the 5% discount. Also, Anshan will continue to provide a consistent supply of iron ore to the company with potential escalation in volume in view of the new iron ore projects undertaken by the parent company. Among others, Anshan in July 2010 launched five new projects to expand the capacity of its captive iron ore mine to 39.5m tpy. The parent company also raised its stake in Australian Gindalbie Metal Co. to 36.28% and in the process became the company’s largest shareholder (see Exhibit 10 for more details). With ron ore price hitting the roof, we do not see any iron ore projects being undertaken by the listed company or any asset injection by the parent.

Exhibit 10: Some of the iron ore projects undertaken by Anshan

Mine Duration Capacity Steelmaker Party involved Location Reserves Production (tonnes) (years) (tonnes) (tonnes) Anshan Iron & Steel Gindalbie Metals Karara Iron ore Project project, Western Australia 30 2.5 bn ‐ from 1H2011 ‐ 2m from August 2011 ‐ 8m Anben Mountains ‐ 9.3 bn ‐ ‐ Zhaoyang mine ‐ 0.25 bn ‐ ‐ Bengang mines ‐ 1.3 bn ‐‐ Small mines in Liaoning province for consolidation ‐ 6 bn ‐‐

Source: CISA, Various, OSK

OSK Research 61 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

But time lag impact may disappear? Other than the discount, Angang has in the past also enjoyed the benefit of a time lag involving iron ore cost as the selling prices are benchmarked to the preceding half-year reporting period. The continuing escalation in iron ore price in the past decades has given Angang the advantage since the previous half year’s selling prices are normally cheaper. However, this benefit may reverse in the event that iron ore price plunges, like what happened in 4QFY08 to 1HFY09 during which the company had to pay the still relatively expensive iron ore price based on the early part of 2008 prices. While we do not expect the trend to reverse, we expect the time lag impact to narrow as we expect iron prices to move only in a narrow range, especially from 2011 to 2012.

Mid-cycle margin moving forward. Overall, we expect Angang to record mid-cycle margins for most of its products in the coming years as we see steel prices consolidating at current levels, although with a small upside potential. However, we expect Angang’s net profit to go down by 7% in FY12 to RMB5.048bn after recording a robust 42.9% growth in FY11 to RMB5.425bn, mainly in the absence of the time lag benefit from the price of iron ore supplied by its parent.

Exhibit 11: Financial performance of Angang

RMB m Core net profit (rhs) RMB m 120,000 9,000 Revenue (lhs) 8,000 100,000 7,000 80,000 6,000 5,000 60,000 4,000 40,000 3,000 2,000 20,000 1,000 0 0 FY05 FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Source: Company Data, OSK Estimates

50% dividend payout. Angang is among the most generous steel mills under our coverage, having consistently paid out some 50% of its net profit in the form of dividend to reward its shareholders. Based on the 50% payout ratio assumption, we are projecting for Angang to frank RMB0.262, RMB0.375 and RMB0.349 as dividend payments for FY10 to FY12 respectively. The dividend translates into a satisfactory yield of 3% to 4%.

OSK Research 62 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

VALUATION AND RECOMMENDATION

Premium valuation over its peers. Being the largest integrated steel mill listed on the Hong Kong Stock Exchange via direct holding by the Central SASAC, and the company’s advantage against its peers in any potential acquisition of the steel companies within the SASAC umbrella, have together contributed to the company’s premium valuation over its peers. That said, the company also benefits from its leading position in the flat steel market and discount, plus the time lag in sourcing iron ore from its parent company.

Exhibit 12: Angang PER & PB Valuation

Leading PER Leading P/B & ROE (x) ROE (%) (x) Leading P/E 50.0 4.0 20 Leading 45.0 +1 STD 18 3.5 P/B 40.0 MEAN 16 +1 STD 35.0 3.0 ‐1 STD 14 30.0 MEAN 2.5 25.0 12 ‐1 STD 20.0 2.0 10 15.0 8 ROE 10.0 1.5 5.0 6 Adj. ROE 1.0 0.0 4 0.5 10 10 10 09 09 09 08 08 08 07 07 07 06 06 06 05 05 05 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ 2 Jan Jan Jan Jan Jan Jan Sep Sep Sep Sep Sep Sep May May May May May May 0.0 0 Jan‐05 Jan‐06 Jan‐07 Jan‐08 Jan‐09 Jan‐10

Source: Company Data, OSK Estimates

Wide trading range. From a quick analysis on Angang’s share price performance in the past few years in terms of PER and P/B valuation, we found that the stock has surpassed 50x and has consistently stayed above 20x on a 1-year leading PER as its forward earnings were impacted by the financial crisis in 2HFY08. The stock traded at a single digit leading PER in 2005 and 2006 as the market may not have incorporated the earnings contribution from the integrated steel assets injected by its parent. Otherwise, the stock stayed at around the mid- to high-teens in 2007, in line with the bull run on the Hong Kong equity market. As for the leading P/B valuation, the inclusion of its parent’s up- and downstream assets in early FY06 pushed the company’s valuation to above 1x book value and escalated all the way to 3.78x in October 2007 at the peak of the equity bull cycle before being bashed down to below 1x at the onset of the financial crisis. The liquidity injection across the world to help spur the global economy has put equities market under the limelight, prompting investors looking for a potential green shoots recovery among commodity stocks to drive the stock to around 2x. It was only when steel prices plunged in May that its valuation returned to approximately 1x book value.

Initiate Angang with a BUY. The recent market-wide correction has taken Angang’s P/B to below the mean of its historical trading band. Given the recovery in earnings and China’s steel industry consolidating to a more normalise level, we think Angang justifies a valuation of +1 standard deviation of its historical band in terms of a leading P/B of 1.9x. As for our earnings based valuation, we adopt the lower leading PER range that the company is traded at in 2007 and apply a 16x FY11 EPS as our PER benchmark for the leading steel mill. The combination of 1.9x book value/share and 16x PER methodology based on FY11 numbers imply a 12-month target price of HKD13.75 for Angang. The 20% upside plus satisfactory dividend prompt us to initiate Angang with a BUY rating.

OSK Research 63 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Financial Summary (FYE 31 December) Valuation and Growth Financial Ratios 2008A 2009A 2010F 2011F 2012F 2008A 2009A 2010F 2011F 2012F Valuation Ratios Profitability Ratios PER (Basic) (x) 23.9 101.3 18.4 12.2 13.1 Gross margin 16.4 14.8 18.2 20.0 19.7 Dividend yield 2.1 0.6 2.7 4.1 3.8 EBITDA margin 11.8 11.2 14.4 16.3 15.9 P/BV (x) 1.4 1.4 1.3 1.1 1.1 Core net margin 3.8 1.0 4.2 5.5 5.0 Growth ROA (Core) 3.3 0.7 3.7 5.2 4.9 Revenue (%) 21.0 -11.3 30.3 7.7 1.9 ROE (Core) 5.6 1.4 7.0 9.4 8.4 EBITDA (%) -39.3 -15.8 67.5 21.4 -0.3 Balance Sheet Ratios Core Net profit (%) -60.4 -76.4 432.4 42.9 -7.0 Current ratio 0.9 0.7 0.9 1.1 1.3 Gross debt/equity 0.5 0.6 0.5 0.4 0.3 Per Share Data Net debt/equity 0.4 0.6 0.4 0.2 0.1 (RMB) 2008A 2009A 2010F 2011F 2012F Inventory Days 57.3 65.2 65.2 65.2 65.2 EPS (Basic) 0.417 0.099 0.525 0.750 0.698 Receivable Days 13.9 21.6 20.8 20.8 20.8 DPS 0.210 0.060 0.262 0.375 0.349 Payable Days 43.1 41.3 32.6 32.6 32.6 Payout ratio 50.8 57.7 50.0 50.0 50.0 BV/S 7.32 7.23 7.69 8.18 8.50 Balance Sheet (RMBm) 2008A 2009A 2010F 2011F 2012F Income Statement Fixed Asset (RMBm) 2008A 2009A 2010F 2011F 2012F Property, plant & equipments 43,256.0 53,807.0 52,979.7 51,550.8 47,612.9 Total revenue 78,985.0 70,057.0 91,301.7 98,343.1 100,163.8 Investment 2,307.0 1,790.0 2,063.9 2,358.9 2,659.4 Cost of sales -66,033.0 -59,674.0 -74,719.8 -78,672.6 -80,473.8 Intangible assets 18.0 13.0 8.0 3.0 0.0 Gross profit 12,952.0 10,383.0 16,581.9 19,670.5 19,690.0 Others 26,445.0 20,878.0 15,878.0 10,878.0 7,878.0 Selling & distribution costs -1,687.0 -1,081.0 -1,658.3 -1,786.2 -1,819.3 Total fixed assets 72,026.0 76,488.0 70,929.6 64,790.8 58,150.4 General and administrative -1,884.0 -1,534.0 -1,831.0 -1,972.2 -2,008.7 Current Asset Operating profit expenses -31.0 103.0 93.0 100.1 102.0 Cash and cash equivalents 2,974.0 2,242.0 5,206.0 10,349.7 15,238.7 Amount due from related EBITDA 9,350.0 7,871.0 13,185.6 16,012.1 15,963.9 companies 2,673.0 5,648.0 5,648.0 5,648.0 5,648.0 Depreciation -4,779.0 -6,269.0 -7,332.3 -7,933.9 -8,440.9 Inventories 10,372.0 10,658.0 13,349.9 14,056.2 14,378.0 Finance costs -777.0 -940.0 -1,137.3 -1,124.2 -1,071.2 Trade receivables 3,000.0 4,145.0 5,215.0 5,617.2 5,721.2 Exceptional gain / loss -27.0 39.0 0.0 0.0 0.0 Others 3,781.0 3,945.0 3,409.9 3,657.2 3,721.2 Associate / JV contribution 80.0 176.0 273.9 295.0 300.5 Total current assets 22,800.0 26,638.0 32,828.9 39,328.2 44,707.1 Pre-tax profit 3,847.0 877.0 4,989.9 7,249.1 6,752.4 Current Liabilities Taxation -854.0 -166.0 -1,229.4 -1,786.1 -1,663.7 Trade payables 7,805.0 6,744.0 6,670.2 7,023.0 7,183.8 Minority interests 0.0 41.0 35.7 -37.4 -40.5 Short-term loans 8,601.0 21,363.0 19,363.0 17,363.0 15,363.0 Reported net profit 2,993.0 752.0 3,796.1 5,425.5 5,048.2 Amount due to related cos 2,165.0 2,732.0 2,732.0 2,732.0 2,732.0 Core net profit 3,020.0 713.0 3,796.1 5,425.5 5,048.2 Others 5,578.0 6,989.0 8,369.0 8,811.7 9,013.5 Total current liabilities 24,149.0 37,828.0 37,134.1 35,929.8 34,292.3 Cashflow Statement Long-Term Liabilities (RMBm) 2008A 2009A 2010F 2011F 2012F Borrowings 17,565.0 11,502.0 9,502.0 7,502.0 5,502.0 Operating Cashflow Others 141.0 139.0 139.0 139.0 139.0 Pre-tax profit 3,847.0 877.0 4,989.9 7,249.1 6,752.4 Total long term liabilities 17,706.0 11,641.0 9,641.0 7,641.0 5,641.0 Depreciation & amortisation 4,914.0 6,412.0 7,332.3 7,933.9 8,440.9 Shareholders' funds Others 1,962.0 23.0 863.4 829.2 770.7 Share Capital 7,235.0 7,235.0 7,235.0 7,235.0 7,235.0 Change in working capital 2,978.0 -5,122.0 -1,920.7 -560.2 -127.2 Reserves 45,736.0 45,056.0 48,418.0 51,945.5 54,280.9 Tax paid -2,870.0 781.0 -1,229.4 -1,786.1 -1,663.7 Equity attributable to owner 52,971.0 52,291.0 55,653.0 59,180.5 61,515.9 Total operating cashflow 10,831.0 2,971.0 10,035.4 13,665.9 14,173.0 Minority interests 0.0 1,366.0 1,330.3 1,367.8 1,408.2 Investing Cashflow Capex -14,679.0 -6,318.0 -1,500.0 -1,500.0 -1,500.0 Investments -1,301.0 -143.0 0.0 0.0 0.0 Others 1.0 1,221.0 0.0 0.0 0.0 Total investing cashflow -15,979.0 -5,240.0 -1,500.0 -1,500.0 -1,500.0 Financing Cashflow Equity raised 0.0 0.0 0.0 0.0 0.0 Debt raised / paid 6,749.0 3,056.0 -4,000.0 -4,000.0 -4,000.0 Interest paid -769.0 -929.0 -1,137.3 -1,124.2 -1,071.2 Dividend paid -3,977.0 -1,519.0 0.0 0.0 0.0 Others -1,614.0 929.0 -434.1 -1,898.1 -2,712.8 Total financing cashflow 389.0 1,537.0 -5,571.4 -7,022.3 -7,783.9 Net cash inflow / (outflow) -4,759.0 -732.0 2,964.0 5,143.6 4,889.1 Cash - beg 7,733.0 2,974.0 2,242.0 5,206.0 10,349.7 Others 0.0 0.0 0.0 0.0 0.0 Cash - end 2,974.0 2,242.0 5,206.0 10,349.7 15,238.7 Company data, OSK Estimates

OSK Research 64 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Private Circulation Only Initiate Coverage

STEEL BUY Ng Sem Guan, CFA China Oriental Group Co +(603) 9207 7678 Price HKD3.00 [email protected] Ltd (581.HK) Target HKD4.25

Get Set for a New Adventure

We like China Oriental Group’s (China Oriental) leadership in H-section steel, Stock Profile/Statistics which offers bright prospects due to the growing emphasis on structural safety Bloomberg Ticker 581 HK Share Capital (m) 2,929.7 and the huge untapped market. The issuance of Senior Notes has put the Market Cap (HKDm) 8,789.2 company on ready mode to grab any suitable investments to broaden its 52 week H | L Price (HKD) 3.50 | 1.80 product range and expand vertically. Given its unwarranted cheap valuation, we Average Volume (3m) ‘000 197.7 YTD Returns (%) 7.5 initiate coverage on China Oriental with a BUY, and a target price of HKD4.25. Beta (x) 1.00

Major Shareholders (%) Leading H-section maker. China Oriental is an integrated steel manufacturer engaged in H-section, strips, cold-rolled sheets and galvanised sheets. The % Mr Han Jingyuan 45.1 company is a market leader in medium and large H-sections, with a market share of ArcelorMittal 29.6 28.5% in 2009. The company has introduced new products and established direct Deutsche Bank & ING Bank 17.4 sales channels to improve margins. We see bright prospects from the growing

Share Performance (%) emphasis on structural safety and modern building plus currently low usage of H- Month Absolute Relative sections of only 1% in China. As for strip products, we only expect organic growth 1m -2.6 -1.2 and a minor contribution from cold rolled and galvanised sheets. 3m 21.5 7.3 6m 29.4 10.8 12m 33.7 22.5 A matter of the right investment. The issuance of USD850m Senior Notes not only

helped to part refinance the company’s existing borrowings totalling USD300m, but 12-month Share Price Performance

also provided funding for potential new investments. Among others, China Oriental is

3.80 on the lookout for acquisition targets given its proven record in integrating the steel

3.30 business. It is also targeting to introduce new product comprising steel sheet piles as well as high speed wire rods to complete its long steel product range, and to phase 2.80 out the selling of semi-finished steel. It also plans to invest in a coking plant, iron ore 2.30 assets and a scrap metal recycling centre for the purpose of vertical integration but 1.80 we think that the coke plant is a more likely investment at this juncture. Meanwhile,

1.30 the company has invested in constructing a cargo site and a 10% stake in

0.80 Caofeidian Port, which gives it easy access to railway and shipping transportation. Jun-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Below par valuation unwarranted. China Oriental’s poor liquidity of only 7.9% may justify some discount, but the stock is trading below its book value and at a low single digit PER that is unfounded. Worries of the company’s 450 cubic metres BF and 40 tonnes converter furnaces being earmarked for the government’s next scrapping exercise may also be overdone considering that there is no official announcement to date and the elimination of particular scale furnaces may result in a supply dearth. We are pricing China Oriental at 8x PER and 1.36x P/B, or +1 standard deviation of its trading band based on FY11 numbers, to derive a fair value of HKD4.25, and hence initiate coverage with a BUY.

FYE Dec (RMBm) 2008 2009 2010F 2011F 2012F Total Revenue 19388.2 20589.1 30414.4 35340.8 36231.1 Core Net Profit 44.0 884.3 1062.0 1501.6 1645.0 % chg YoY -96.2 1908.4 20.1 41.4 9.5 Consensus Net Profit - - 1319.0 1588.0 1442.0 Core EPS (sen) 0.015 0.302 0.363 0.513 0.562 Gross DPS (sen) 0.057 0.076 0.073 0.122 0.112 Gross Div. Yield (%) 2.2 2.9 2.8 5.0 4.6 PER (x) 175.5 8.7 7.0 4.7 4.3 P/BV (x) 1.2 1.1 0.9 0.8 0.7 EV/EBITDA (x) 12.7 4.5 3.7 2.3 1.7 ROE (%) 0.7 13.2 14.0 17.2 16.3 ROA (%) 0.4 6.0 5.6 6.3 6.4 Note: Core Numbers

OSK Research 65 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

COMPANY BACKGROUND

Large privately owned steel company. Listed on the main board of the Hong Kong Stock Exchange on 2 March 2004, China Oriental Group (China Oriental) is an integrated iron and steel manufacturer in the China, engaged in the production of 4 principal steel products, namely i) H-section steel, ii) strips and strip products iii) cold-rolled sheets and galvanised sheets and iv) semi finished steel - billets. The company has a production capacity of 11m tpy of crude steel, with an additional capacity of 2m tonnes from facilities leased from Qianxi County Jinxi Wan Tong Ductile Iron Pipes Co Ltd (Jinxi-Wantong). China Oriental has a commendable market share of 28.5% (as at 2009) for H-Section steel products, which are primarily used as structural support for construction and infrastructure works.

Exhibit 1: Corporate structure of China Oriental (simplified version)

ChinaOriental Group Co Ltd

100% 97.6% 81.5% 71%

Foshan Jinxi Jinlan Cold Rolled Hebei Jinxi Iron and Steel Group Hebei Jinxi Iron & Steel Group Co Oriental Fullhero Leasing Co Ltd Sheet Co Ltd Zhengda Iron and Steel Co Ltd Ltd ("Jinxi Jinlan") ("Zhengda Iron & Steel")

Source: Company Data

Jinxi is the key production site. The Jinxi production site is China Oriental’s key production site in Tangshan city, Hebei province. The company has the other two production sites in Tangshan City, namely Zhengda and Wantong. However, its Jinlan Production Site is located in Foshan City, Guangdong province.

Exhibit 2: The location map of China Oriental’s prime plant

Source: Company Data

A bond with ArcelorMittal. China Oriental receives strong support from it strategic shareholder and partner, ArcelorMittal, the world’s largest steel company in terms of crude steel output (77.5m tonnes as at 2009). ArcelorMittal currently holds a 29.6% interest in the company, and is tits second largest shareholder. Through this coorperation, we see China Oriental benefiting from ArcelorMittal’s advanced steel production technologies, management expertise and global distribution and sourcing networks.

OSK Research 66 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

KEY HIGHLIGHT

H-SECTION: Solidifying its market leadership

Leading H-section steel player in China. H-section steel products are used in large-scale construction projects principally as structural support, for example in skyscrapers, airport terminals, offshore oil platforms and other infrastructure and buildings. China Oriental is China’s market leader for medium and large H-section products with a 28.5% share in 2009 based on domestic sales volume, according to data published by Steelwin.com. The company has the capacity to produce 3m tpy of H-section steel products comprising 1m tonnes of large-sized and 2m tonnes of medium and small-sized H-section steel products. The products’ cross-sectional dimensions range from 100x100mm to 900x300mm.

New products and direct sales. The company is aggressively seeking to improve its product mix by introducing new products. In 2009, China Oriental developed a type of H-section steel product used in steel poles to support overhead contact wires for electric railways. This product increased the company’s profitability as it is priced higher than other H-section steel products. Apart from that, the company has also established direct sales channels with domestic customers for its railway track H- section steel products and a number of overseas customers for its general products. For example, on 9 June, 2010, China Oriental entered into a five-year strategic cooperation agreement with China Railway Materials Commercial Corporation (CRMCC), pursuant to which CRMCC agreed to purchase from the company steel products totalling 1.356m tonnes in 2010, with future amounts to be negotiated. The types and amount of specific steel products will be determined under separate annual sales contracts.

Growing emphasis on structural safety. The various natural disasters that have struck China in recent years such as earthquakes in Sichuan Province in May 2008 and in Qinghai Province in April 2010 not only increased demand for steel products for reconstruction works but heightened concerns for structural safety, strength and quality. As there has been a shift in preference from other construction materials to steel in infrastructure, industrial, commercial and residential construction projects, we see increasing demand for structural steel in China. The structural steel volume sold has grown substantially from 26.4m tonnes in 2005 to 50.7m tonnes in 2009 at a CAGR of 17.7%, H-section steel, a subset of structural steel, is divided into two categories: hot-rolled H-section steel and welded H-section steel. Worth noting is that consumption of H-section steel in China only makes up 1% of total steel consumption in China compare with 3% to 5% in developed countries.

Exhibit 3: Performance of H-Section steel by China Oriental

3.5 20% Sales Tonnage (m) GP Margin 18% 3.0 16% 2.5 14% 12% 2.0 10% 1.5 8%

1.0 6% 4% 0.5 2% 0.0 0% FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Source: Company Data, OSK Estimates

Great potential for H-sections. H-section steel contributed 36% of revenue in FY09 and 34.1% for 1HFY10. The company registered healthy sales of 1.5m tonnes of H-section steel in 1HFY10, representing 60% of FY09’s total sales tonnage of 2.5m. The GP margins of section steel stood at 9.5% in FY09 but we expect this to drop to only 8.3% in FY10 on a combination of higher raw material costs and power restrictions. We see margin and sales tonnage continuing to improve with volume expected to surpass 3m tonnes in FY12, and GP margin to advance to 10.9% in FY11 and 11.3% for FY12.

OSK Research 67 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

STRIPS: Climbing up the value chain

Making strip products more competitive. China Oriental has 3.5m tpy capacity for strips and strip products of thickness ranging from 2mm to 4mm and width ranging from 145mm to 735mm. Most of the company’s strips and strip products are sold to downstream steel manufacturers which further process them into other steel products such as welded steel pipes. While part of China’s strip products is channelled to its subsidiary for CR-products, the products are also sold to external cold-roll mills. China Oriental also developed high value-added ultra thin steel sheets in 2008 targeted primarily at electronic consumer product manufacturers.

Exhibit 4: Performance of China Oriental’s strip products

4.0 9% Sales Tonnage (m) GP Margin 3.5 8% 7% 3.0 6% 2.5 5% 2.0 4% 1.5 3% 1.0 2%

0.5 1%

0.0 0% FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Source: Company Data, OSK Estimates

Organic growth for strips. Some 40.9% of China Oriental’s revenue came from strips in 2009, during which 2.9m tonnes were sold. The GP margin was slightly higher compared to H-section steel, at 12.8% in FY09, but we expect margins to drop to 7.9% in FY10 as 1HFY10 margin shrank to 10.8%, and expect further weakening following the surge of iron ore price in 2HFY10. We are assuming a conservative GP margin of 8.2% for FY11 and 8.5% in FY12, with volume growth of a mere 1% y-o-y in the next two years.

COLD ROLLED AND GALVANISED SHEETS: Production line on the mend

Expanding to south China. The company’s involvement in cold-rolled sheets and galvanized sheets is via 81.5%-owned Foshan Jin Xi Jin Lan Cold Rolled Sheets Co. Ltd (Foashan Jinxi), whose plant is located in Foshan City, Guangdong province. Jinxi Jinlan’s main products are cold-rolled sheets and galvanized sheets. Its main customers are color-coated manufacturers, pipe manufacturers, household electrical appliance manufacturers and companies in the furniture industry, many of which are located in Guangdong. This enables Jinxi Jinlan to deliver its products promptly to its customers while incurring low transportation costs.

Minor contribution. China Oriental has a capacity for cold-rolled sheets and galvanized sheets of 500k tpy. This division only account for 5.5% of the group’s revenue in FY09, based on the 286k tonnes of processed steel sheets sold. While the company only generated a GP margin of barely 0.1% in FY09, we expect it to gradually improve the margin to 4.1% in FY10, 5% in FY11 and 6% in FY12 on accounting for management’s efforts to manoeuvre its production line to improve production efficiency.

OSK Research 68 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 5: Performance of cold rolled and galvanised sheets products by China Oriental

0.5 25% Sales Tonnage (m) GP Margin 0.5 0.4 20% 0.4 0.3 15% 0.3 0.2 10% 0.2 0.1 5% 0.1 0.0 0% FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Source: Company Data, OSK Estimates

BILLETS: Slowly phasing out sales of semi finished steel

Mainly for internal use. China Oriental uses more than 75% of the billets it produces for its own production of other steel products, with the excess sold to other steel manufacturers. Revenue contribution from semi finished steel stood at 17.6% in FY09, but increased to 21.7% in 1HFY10. Billets generally fetch lower GP margins. While it generated a margin of 9% in FY09, we only expect a GP margin of 6% in FY10, 7.3% in FY11 and 7.7% in FY12. The company intends to improve its downstream product portfolio to include steel bar products and high speed wire rods, which will lead to the gradual phasing out of external billets sales. Nevertheless, we continue to project high tonnage of billets being sold for the next few years until there is a more concrete announcement on the downstream investment.

Exhibit 6: Performance of billets by China Oriental

3.5 35% Sales Tonnage (m) GP Margin

3.0 30% 25% 2.5 20% 2.0 15% 1.5 10% 1.0 5%

0.5 0%

0.0 ‐5% FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Source: Company Data, OSK Estimates

OSK Research 69 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

SENIOR NOTES: Room for opportunities

USD550m Senior Notes The company issued USD550m 8% Senior Notes in August 2010 that will be due in 2015. Proceeds are to be used to acquire steel mills in China (primarily in Hebei province); continued improvement of capex projects at the Group’s current production facilities, investments in iron ore assets, and working capital requirements. The Senior Notes are guaranteed by the subsidiary guarantors on a senior unsubordinated basis and are secured by a pledge of collateral.

Second issuance of USD300m. Although China Oriental’s first Senior Notes issuance were rated Ba1 by Moody’s Investors Service, or junk classification, the Notes have received good market response and are trading at a premium to its par value since their listing. Taking the cue from its performance so far as a sign that there is strong market appetite for the company’s Notes, China Oriental has issued its second Senior Notes issuance amounting to USD300m, solely to refinance its outstanding short-term debts. Although the issuance also received a similar rating from Moody’s, the Notes are price at only 7% compare to 8% for its first issuance.

Exhibit 7: Price trend of China Oriental’s Senior Notes

USD300m @ 7% coupon USD550m @ 8% coupon USD USD 101 110 100 108 99 106 98 97 104 96 102 95 100 94 93 98 92 96 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ Oct Oct Oct Nov Nov Nov Nov Nov Nov Nov Nov Nov Nov Nov Nov Nov Nov Nov Oct Sep Sep Sep Sep Sep Aug Aug Aug Nov Nov Nov Nov ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ 6 8 1 3 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 27 20 13 29 22 15 25 18 11 24 17 10

Source: Bloomberg

Lining up the investment targets. The company has used up a portion of the net proceeds from its first Senior Notes for working capital requirements, with the balance invested in short term deposits or money market instruments pending good investment opportunities. In the five years from 2010 to 2015, the company has outlined the use the proceeds for potential acquisitions of steel mills in China, primarily in Hebei province, continuous improvements in capital expenditure at the company’s current production facilities, potential investments in iron ore assets, invest in acquiring steel mills, iron ore assets and expansion of the existing plus new products.

Exhibit 8: Types of investment China Oriental wishes to undertake in next five years

 acquisition of steel mills in China;  expansion of its production capacity for H-section steel products;  development of production facilities to produce new products, such as steel sheet piles and high speed wire rods;  continuous improvement capital expenditure projects at the Group’s current production facilities;  construction of new coking plants; and  investment in iron ore assets.

Source: Company Data

OSK Research 70 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

M&A: Actively on the lookout

M&A opportunities abound in Hebei. Hebei has been China’s largest steel producing province since 2001, accounting for 23.8% of China’s total steel production in 2009, thanks to its large iron ore reserves, well developed infrastructure and convenient access to railway, road and port facilities. As with the Chinese steel sector in general, Hebei’s steel industry is also highly fragmented. The majority of steel producers in Hebei are privately owned, not state-owned, and many have inefficient, small scale operations and outdated equipment. Three Hebei-based steel producers were ranked in the top 20 in China in terms of production volume in 1H10. In recent years, the Hebei steel sector has seen a wave of industry consolidation. For example, Heibei Iron and Steel Group was established in June 2008 through the merger of Tangshan Iron and Steel Company Ltd and Handan Iron and Steel Company Ltd, both state owned, and subsequently completed a series of acquisitions of steel producers in Hebei province. Similarly, Hebei Xinwuan Iron and Steel Group was established in January 2006 through the consolidation of 12 private steel producers in Handan area.

Top agenda of China Oriental? Hebei Jinxi Iron and Steel Group, the main operating subsidiary of China Oriental, has acquired Jinxi Jinlan and Zhengda Iron and Steel, and leased production facilities with capacity of approximately 2m tpy from Jinxi-Wantong. As China government’s policy is to encourage greater resource efficiency and economies of scale in steel production, the process of consolidation in Hebei’s steel sector is expected to continue in the coming years. As the company’s management has experience in the acquisition and integration of the steel business, as demonstrated by its past success story, we expect China Oriental to aggressively look out for acquisition targets, especially with the availability of huge funding from its Senior Notes issuances. The company has committed to achieving a greater market share, production efficiency and economies of scale via consolidation, which will in turn enhance its overall competitiveness.

Acquisition of Jinxi-Wantong just a matter of time. The company, through production facilities leased from Jinxi-Wantong of 2m tpy of crude steel capacity and operating one steel bar rolling machine, produces 800k tpy of steel bar products. The company incurs a lease rental of RMB36m per annum. While the lease is expiring on 4 Dec 2010, we think the management may put on hold plans to acquire and opt to renew the lease as this plant was completely shut down for November and December 2010 under a government directive on energy conservation. As the new steel bar rolling line is also pending official commissioning given the power disruption, we have not incorporated any contribution from the rolling mill until more clarity from the management.

GREENFIELD PROJECTS: Optimizing the product mix

Introducing sheet piles. China Oriental is seeking to expand its product portfolio. Steel sheet piles are used in sheet piling which consists of a series of panels with interlocking connections that are driven into the ground to form an impenetrable barrier. Sheet piling is a proven technology in the construction industry and is used in the construction of quays, harbours and flood prevention infrastructures. We believe that the demand for steel sheet piles in China will go up significantly as a result of increasing construction activities and severe flood across the country. According to its management, all domestic demand for steel sheet piles is currently being met by imports due to a lack of domestic production. The company and its partner ArcelorMittal are currently in discussions on a potential joint venture for the manufacture and sale of steel sheet piles in China.

Expanding the long products mix. China Oriental’s other planned new products include high speed wire rods, which are a type of steel rod widely used in reinforced concrete or welded structures in construction. High speed wire rods can be processed into various types of wire products, bolts and screws and other machinery spare parts or tools. While we do not expect lucrative margins for wire rods, we do expect the new products to widen the company’s mix in the long products segment.

OSK Research 71 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Vertical investments? China Oriental also aims to ensure a stable supply of raw materials that it requires for production of steel products. As such, it regularly monitors the market and intends to take necessary measures including investing in iron ore assets and establishing new coking plants. China Oriental believes this will assist the company in creating a vertically integrated production platform. Meanwhile, we think the coke plant is a more likely investment than the acquisition of iron ore assets given that the currently high ore prices suggest that investment return may be poor.

Scrap metal recycling center? China Oriental Company and the Caofeidian Industrial Management Committee (CIMC) signed a cooperation agreement on 16 Sept 2010 to invest in the Caofeidian Industrial Zone in Tangshan City in Hebei to develop a scrap recycling business involving the use of scrap metal and other materials for the manufacture of steel products. The project is currently at the preliminary planning stage and is subject to relevant government permits and licences. The expected total investment is approximately USD100m. As we expect China to generate a substantial volume of scrap at least 10 years down the road, we think this project’s actual implementation may take time although management is looking for early exposure.

Government approval the main hurdle. In a statement on 26 Sept 2009, China’s policy makers said iron and steel projects purely for new construction or capacity expansion purposes would no longer be approved or supported. As such, government approval may be the major roadblock to actual implementation of any Greenfield projects.

LOGISTICS TIE-UP: Ensuring smooth transportation

Cooperation with Asia Energy Logistics. China Oriental in November 2009 entered into a co- operative framework agreement with Asia Energy Logistics Group Limited (AELG), under which AELG will assist the Company in constructing a cargo site at Santunying station along the Zunxiao Railway and providing railway logistics and transportation services to Jinxi Limited for the two years ending 23 Nov 2011. This will lower the Company’s transportation cost and increase efficiency, as well as shorten the transportation distance from the original 521 kilometres to 96 km in the future, thereby effectively reducing the distance and enhancing transportation capacity.

Acquisition of Caofeidian Port Co. On 21 Oct 2010, China Oriental and Foshan Nanhai Leju Trading Transportation Ltd entered into a sale and purchase agreement whereby the company agreed to acquire a 10% equity interest in Tangshan Caofeidian Mining Port Ltd (Caofeidian Port Co) from Foshan for RMB50m. Caofeidian Port Co is currently constructing Caofeidian Port at a rapidly developing designated industrial zone and the port, upon commissioning, can cater for vessels of over 300,000 tonnes. China Oriental is expected to invest a further RMB45m as Caofeidian Port Co’s paid up capital will increase to RMB950m. We believe the investment will assure that the group gets a steady logistics means for the importation and transportation of iron ore, especially given the congestion at China’s major ports.

REAL ESTATE: Balancing long term investment

Small step into real estate. Boyuan Real Estate (BRE), incorporated in December 2009, acquired land use rights in Qianxi County, Hebei Province, from the local Bureau of Land and Resources for RMB193m. The plan is to develop a residential community targeting high income families, with development to be implemented in 3 phases, and encompassing a construction area of 310k square meters. While we do not expect significant financial impact from this venture and management claims that this is to diversify its income in view of its cyclical steel earnings, we remain believers that a company should do what it does best and stay focused on its core business.

OSK Research 72 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

FINANCIAL REVIEW

Power restriction may dampens 2HFY10 performance. Tangshan Municipal People’s Government has issued notices to certain subsidiaries of the company imposing restrictions on their energy consumption and control the production of steel products. In response to these restrictions, China Oriental took steps to optimize its product mix in order to attain what it believes to be the optimal balance between production efficiency and energy savings during the restriction period. After taking into account various factors, the Group suspended its production facilities partially and its H-section steel production lines since 16 Oct 2010, and further suspended all production related operations at Jinxi Wan Tong since 29 October 2010 for repair and maintenance so as to meet the energy consumption restriction imposed by the local government. The company partially restarted its H-section steel production lines in November 2010 with a target to produce approximately 60,000 tonnes to 80,000 tonnes of H-section steel products during the month.

Exhibit 9: Impressive efficiency and profitability record

1H 2010 2009 Jinxi Industry Ranking out of Jinxi Industry Ranking out of Limited Average 70 Limited Average 66 Steel productivity per employee 906 315 1 736 270 2 (tonnes/year) ROE (%) 23.4% 5.6% 3 17.9% 3.0% 9

Source: CISA, Company Data

Impressive efficiency and profitability record. According to statistics published by the China Iron and Steel Association (CISA), Jinxi Limited, the main operating subsidiary of the Company, ranked 7th and 6th in terms of profit after tax for the year 2009 and 1H10 respectively among the large and medium- sized steel companies that are CISA members. The company was also the most efficient steel mill in terms of productivity per employee for 1HFY10, up from the number two spot. As for ROE comparison, it is ranked number nine in 2009, rising to third place in 1H10.

Exhibit 10: Financial performance of China Oriental

40,000 2,000 Revenue (lhs) PAT (rhs) 35,000 1,800 1,600 30,000 1,400 25,000 1,200 20,000 1,000

15,000 800 600 10,000 400 5,000 200 ‐ ‐ FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Source: CISA, Company Data

OSK Research 73 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

New profit record in FY11? After a volatile earnings cycle, we think China Oriental’s earnings will stabilise in line with our expectation of normalising earnings. We expect the company’s core net profit to break RMB1.5bn in FY11, followed by RMB1.645bn in FY12. We also believe our estimates are conservative, judging from a reasonable margin assumption for most of its main steel products. We also have not accounted for any potential contribution from the commissioning of its 800k tpy rebar production.

20% payout ratio. The company is committed to distribute no less than 20% of its profit as dividend after its listing. However, the actual dividend and its percentage to profit would be at the discretion of the board and will depend upon the company’s future operation and earnings, capital requirements and surplus, general financial condition, contractual restrictions, and other factors that the Board considers relevant. Based on the 20% payout ratio assumption, we expect the company to frank RMB0.073, RMB0.122 and RMB0.112 for FY10 to FY12 respectively. This conservative dividend assumption translates into an attractive dividend yield of around 5% for FY11 and FY12.

OSK Research 74 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

VALUATION AND RECOMMENDATION

Share price goes up and down. China Oriental had been trading at a depressed single digit PER until the end of 2007 at the peak of the bull run in the HKSE and ArcelorMittal’s acquisition of a stake in the company during the period. As its earnings were badly impacted from 2HFY08, the stock was trading at artificially high PERs that we deem makes it an outlier. While the earning outlook has progressively improved, the company remains at an undemanding single digit leading PER. Its P/B, on the other hand, has been consistently trading below its book value up to early 2007 when the market wide bull run pushed it beyond 2x BV/share. The financial tsunami in 2008 saw its P/B valuation falling below mean level again despite much improved environment.

Exhibit 11: China Oriental historical trading band

Leading PER Leading PB & ROE

(x) Leading P/E (x) Leading P/B (%) +1 STD +1 STD 2.5 25 14.0 MEAN MEAN ‐1 STD 12.0 2.0 20 ‐1 STD ROE 10.0 1.5 15 8.0

6.0 1.0 10

4.0 0.5 5 2.0

0.0 0.0 0 10 10 09 09 08 08 07 07 06 06 05 05 10 09 08 07 06 05 05 05 05 06 06 06 07 07 07 08 08 08 09 09 09 10 10 10 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐

Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep May May May May May May May May May May May May

Source: Company Data, OSK Estimates

Poor stock liquidity. ArcelorMittal acquired approximately a 28% equity interest in the company from Smart Triumph and Ms. Chen Ningning and became the China Oriental’s second largest shareholder. The company also extended an unconditional mandatory cash offer, which upon the closing in February 2008, ArcelorMittal’s equity interest in the Company rose to approximately 47%. In order for the Company to satisfy the minimum public float requirement of the HKSE, AcelorMittal transferred shares representing 9.9% and 7.5% of the Company’s issued share capital to ING Bank N.V. and Deutsche Bank respectively. ArcelorMittal also entered into two option agreements with the investment bank whereby it granted the put options to ING Bank N.V. and Deutsche Bank to sell all of the shares they hold in China Oriental on the expiry date of 30 April 2011 at the strike price of HKD5.7938 (subject to adjustments plus interest, minus any net dividends during the period). We expect both investment banks to renew the put option agreements on their expiry, and therefore see actual liquidity of the stock at only 7.9%, and hence a hurdle to institutional investors making any major investment. We also suspect this may be one of the major reasons why China Oriental always trades at a cheaper valuation than its peers.

Is the risk of scrapping mini facilities bearable? Other than liquidity, the major risk facing the company is policy risk, whereby the government is serious in clamping down on mini steelmaking facilities to resolve overcapacity issues and improve environmental control. Already it had eliminated BFs below 200 cubic metres in capacity and converters or electric furnaces below the capacity of 20 tonnes in 2007. The government is currently stepping up efforts to close down BFs below 300 cubic metres by end of this year. We understand that its next move is to clamp down on BFs below 400 cubic metres and converters or electric furnaces below the capacity of 30 tonnes by end of 2011, involving 72m tpy of crude steel capacity and 25m tpy of finished steel capacity. Although China Oriental has nine units of BF with furnace sizes of 450 cubic metres and two units of 40 tonnes converter furnace (including Jinxi-Wantong) that may be next in line for scrapping, we doubt that government would target it as we think this represents significant steelmaking capacity in China, and scrapping it may bring about a sudden shortage of steel supply in China and potentially drive steel prices to the roof.

OSK Research 75 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

China Oriental is a BUY. The recent market wide correction has brought down the company’s valuation to a very undemanding leading P/B and PER. While we reckon China Oriental justifies a discount to its larger peer give its poor liquidity, we think the company warrants a pricing of at least half of Angang and Magang’s target PERs. Therefore, we are valuing the company based on 8x FY11 EPS. In view of the improving market outlook and with the company earnings potentially charting a new record in FY11, we think the company deserves to trade at +1 standard deviation of its historical trading band of 1.36x on FY11 numbers. We derive our 12-month target price of HKD4.25 from a simple blended valuation and rate China Oriental a BUY.

OSK Research 76 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Financial Summary (FYE 31 December) Valuation and Growth Financial Ratios 2008A 2009A 2010F 2011F 2012F 2008A 2009A 2010F 2011F 2012F Valuation Ratios Profitability Ratios PER (Basic) (x) 175.5 8.7 7.0 4.7 4.3 Gross margin 5.8 14.0 10.2 11.2 11.6 Dividend yield 2.2 2.9 2.8 5.0 4.6 EBITDA margin 4.0 11.2 8.5 9.5 9.9 P/BV (x) 1.2 1.1 0.9 0.8 0.7 Core net margin 0.2 4.3 3.5 4.2 4.5 Growth ROA (Core) 0.4 6.0 5.6 6.3 6.4 Revenue (%) 43.6 6.2 47.7 16.2 2.5 ROE (Core) 0.7 13.2 14.0 17.2 16.3 EBITDA (%) -60.5 195.9 12.4 30.3 6.7 Balance Sheet Ratios Core Net profit (%) -96.2 1908.4 20.1 41.4 9.5 Current ratio 0.9 1.0 1.2 1.2 1.2 Gross debt/equity 0.3 0.4 0.7 0.6 0.5 Per Share Data Net debt/equity 0.2 0.2 0.1 -0.1 -0.2 (RMB) 2008A 2009A 2010F 2011F 2012F Inventory Days 31.3 53.6 53.6 53.6 53.6 EPS (Basic) 0.015 0.302 0.363 0.513 0.562 Receivable Days 32.6 21.2 36.5 36.5 36.5 DPS 0.057 0.076 0.073 0.122 0.112 Payable Days 44.3 35.6 34.2 34.2 34.2 Payout ratio 380.3 25.1 20.0 20.0 20.0 BV/S 2.14 2.45 2.74 3.22 3.67 Balance Sheet (RMBm) 2008A 2009A 2010F 2011F 2012F Income Statement Fixed Asset (RMBm) 2008A 2009A 2010F 2011F 2012F Property, plant & equipments 8286.8 8625.6 8255.1 7847.2 7401.8 Total revenue 19388.2 20589.1 30414.4 35340.8 36231.1 Investment 28.5 27.9 28.1 28.2 28.4 Cost of sales -18273.2 -17699.8 -27313.7 -31373.9 -32024.2 Intangible assets 7.7 0.0 0.0 0.0 0.0 Gross profit 1115.0 2889.3 3100.8 3966.8 4206.8 Others 400.4 154.1 154.1 154.1 154.1 Selling & distribution costs -80.3 -57.0 -91.2 -106.0 -108.7 Total fixed assets 8723.3 8807.6 8437.4 8029.6 7584.3 General and administrative -281.9 -283.5 -456.2 -530.1 -543.5 Current Asset Operating profit/expenses 24.0 -250.6 30.4 35.3 36.2 Cash and cash equivalents 728.8 644.0 4852.8 6197.5 7937.8 EBITDA 776.7 2298.2 2583.7 3366.0 3590.9 Amount due from related cos 1567.4 2598.0 4012.7 4609.2 4704.7 Depreciation & amortisation -573.5 -847.5 -870.4 -907.9 -945.4 Inventories 1734.0 1197.1 3037.7 3529.8 3618.7 Finance costs -91.6 -137.1 -268.0 -406.8 -406.8 Trade receivables 1382.5 1942.4 2190.8 2468.8 2519.1 Exceptional items 0.0 0.0 0.0 280.0 0.0 Others 5412.7 6381.5 14094.1 16805.3 18780.3 Associate / JV's contribution 2.0 0.2 0.2 0.2 0.2 Total current assets Pre-tax profit 113.6 1313.7 1445.4 2331.5 2238.8 Current Liabilities 2219.4 1725.8 2562.7 2943.6 3004.6 Taxation -70.6 -341.3 -361.3 -512.8 -559.7 Trade payables 1697.2 1796.5 0.0 0.0 0.0 Minority interests 1.1 -88.1 -22.1 -37.0 -34.2 Short-term loans 0.0 0.0 0.0 0.0 0.0 Reported net profit 44.0 884.3 1062.0 1781.6 1645.0 Amount due to related cos 2264.5 2798.5 5387.6 6127.8 6246.3 Core net profit 44.0 884.3 1062.0 1501.6 1645.0 Others 6181.1 6320.7 7950.3 9071.4 9250.9 Total current liabilities Cashflow Statement Long-Term Liabilities 489.2 758.9 0.0 0.0 0.0 (RMBm) 2008A 2009A 2010F 2011F 2012F Borrowings 0.0 0.0 5599.9 5319.9 5319.9 Operating cashflow Others 975.7 648.8 648.8 648.8 648.8 Pre-tax profit 113.6 1313.7 1445.4 2331.5 2238.8 Total long term liabilities 1465.0 1407.7 6248.7 5968.7 5968.7 Depreciation & amortisation 573.5 847.9 870.4 907.9 945.4 Shareholders' funds Others 2280.5 246.6 267.8 406.6 406.6 Share Capital 2501.4 2501.4 2501.4 2501.4 2501.4 Change in working capital -2391.8 -2140.7 -420.2 -245.4 -55.1 Reserves 3763.9 4667.4 5517.0 6942.3 8258.3 Tax paid -427.8 -16.0 -361.3 -512.8 -559.7 Equity attributable to owner 6265.2 7168.8 8018.4 9443.6 10759.6 Total operating cashflow 147.9 251.6 1802.2 2887.8 2976.1 Minority interests 224.7 292.0 314.1 351.1 385.3 Investing cashflow Capex -953.6 -930.9 -500.0 -500.0 -500.0 Investments -247.0 207.3 0.0 0.0 0.0 Others -309.8 48.7 0.0 0.0 0.0 Total investing cashflow -1510.4 -674.8 -500.0 -500.0 -500.0 Financing cashflow Equity raised 0.0 0.0 0.0 0.0 0.0 Debt raised / paid 982.2 361.4 0.0 0.0 0.0 Dividend paid 0.0 0.0 -268.0 -406.8 -406.8 Others 427.5 -22.6 3174.6 -636.3 -329.0 Total financing cashflow 1409.7 338.8 2906.6 -1043.1 -735.8 Net cash inflow / (outflow) 47.2 -84.4 4208.8 1344.7 1740.3 Cash - beg 689.6 728.8 644.0 4852.8 6197.5 Others -8.0 -0.4 0.0 0.0 0.0 Cash - end 728.8 644.0 4852.8 6197.5 7937.8 Source: Company data, OSK Estimates

OSK Research 77 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Private Circulation Only Initiating Coverage

STEEL NEUTRAL Ng Sem Guan, CFA Chongqing Iron & Steel +(603) 9207 7678 Price HKD2.03 [email protected] Co Ltd (1053.HK) Target HKD1.92

Too Many Speed Bumps

Chongqing Iron & Steel Co. Ltd. (Chongang) is an integrated steel mill that Stock Profile/Statistics produces steel plates, sections, wire rods, and hot and cold-rolled sheets. Bloomberg Ticker 1053 HK Share Capital (m) 538.1 Although its relocation and investments in new facilities at a new site offers Market Cap (HKDm) 6,468.0 bright long term prospects, we are concerned that the higher financing and 52 week H | L Price (HKD) 3.19 | 1.70 depreciation charges arising from this hefty investment may cap its earnings Average Volume (3m) ‘000 4,308.8 YTD Returns (%) -30.2 upside. The poor earnings, which lifts its PER despite the low P/B and huge Beta (x) 1.13 discount to its A-share, prompt us to initiate coverage on Chongang with a NEUTRAL rating and a FV of HKD1.92. Major Shareholders (%)

Chongqing Iron & Steel (Group) 48.23% Co. Ltd. Lack of clarity on huge asset investments. Chongang is busy undertaking environmental protection relocation. The company and its parent are also adding new facilities, which will eventually scale up the group’s steelmaking capacity to 10m

Share Performance (%) tpy. We expect the injection of assets by its parent into the listed company via the Month Absolute Relative issuance of new shares of Chongang. We also see some downside to our estimates, 1m -7.3 -7.8 which include only projects that have been announced and a low effective 3m 9.8 -4.7 depreciation purely based on its historical rate. 6m 8.0 -5.9 12m -32.2 -36.5

A volume game for plates. The commissioning of the 1.8m tpy 4100mm plate mill 12-month Share Price Performance

in New District will add to the competition in steel plate. We expect sales to expand,

2.60 especially with the huge undelivered backlog of orders for new vessels schedule for 2.40 delivery in the next two years, plus the strategic location of its plant next to the 2.20 Yangtze River, which is one of the important shipbuilding hubs. Nonetheless, we 2.00

1.80 only expect a gradual improvement on profit margin and the relocation of its 1.60 2700mm plate mill may cause some production disruption. 1.40 1.20 “Long” on the West Development. Chongang is also involved in the small to 1.00

0.80 medium steel section and wire rods, and is investing in a new bars and wire rods mill Jun-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 via the EAF route. The margins for long products improved in FY09, which we believe was owing to post earthquake reconstruction in Sichuan. With the government switching focus to developing the central and west regions of China, we see Chongang enjoying logistical advantages. Capitalising on Chongqing’s auto- city status. Chongang’s cold rolled (CR) sheet mill has been in the red since 2005. The commissioning of a 1780mm hot rolled mill in August 2010 may gradually improve the competitiveness of the CR plant via internally sourced feed coils. Being situated in the auto hubs also gives the company accessibility to the automotive industry but we see only a gradual pick up in margin as we expect a gestation period for learning.

FYE Dec (RMBm) 2008 2009 2010F 2011F 2012F Total Revenue 16482.2 10634.0 16334.7 22695.0 26157.2 Core Net Profit 601.8 66.0 19.4 167.2 332.1 % chg YoY 28.2 -89.0 -70.6 760.1 98.6 Consensus Net Profit - - 93.0 252.3 623.3 Core EPS (sen) 0.347 0.038 0.011 0.096 0.192 DPS (sen) 0.100 0.000 0.000 0.019 0.038 Div. Yield (%) 5.5 0.0 0.0 1.2 2.3 PER (x) 5.2 47.0 153.7 17.0 8.6 P/BV (x) 0.6 0.6 0.5 0.5 0.5 EV/EBITDA (x) 5.8 13.8 10.3 8.3 6.9 ROE (%) 11.1 1.2 0.4 3.0 5.7 ROA (%) 5.1 0.5 0.1 0.9 1.6 Note: Core Numbers

OSK Research 78 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

COMPANY BACKGROUND

Briefly on Chongang. Chongqing Iron & Steel (Chongang) was established in the PRC on August 1997 as part of the restructuring undertaken by its holding company, the state-owned enterprise known as Chongqing Iron & Steel (Group). The iron and steel business of Chongqing Hengda, one of the group subsidiaries, was taken over by Chongang, with Chongang issuing 650m shares to the state owned holding company. Subsequently, Chongang issued 413.9m H-shares which were then listed on the Stock Exchange of Hong Kong in October 1997. In 2002, Chongang acquired all the assets and liabilities of Hengda, and disposed of its entire interest in Hengda to its holding company. Post disposal, Chongang had not more subsidiaries. In February 2007, the company issued 350m ordinary shares denominated in Renminbi and listed them on the A-share market of Shanghai Stock Exchange.

Exhibit 1: Corporate Structure of Chongang

State‐owned Assets Supervision and Administrative Commission (SASAC) of Chongqing

100%

Chongqing Iron & Steel (Group) Company Limited

48.23%

ChongqingIron & Steel Company Limited (Chonggang)

Source: Company Data

An integrated steel mill. Chongang’s principal business is rooted in the manufacture and sale of medium and wide gauge steel plates, steel sections, wire rods plus hot and cold-rolled sheets. The company sells its excess upstream production in semi finished form, namely as steel billets, and also sells the by-products from the coking and smelting process. These by-products are water granulated slag, coking-by products, steel scrap, recycle water, self generated electricity and steam, which accounted for 4.7% of the company’s total revenue in 2009.

Plant relocation. The plant was originally located at Dadukou District in Chongqing City but is now progressively being relocated to Yanjia Industrial Zone in the city’s Changshou District, as part of energy saving and emissions reduction, industrial layout and planning guidelines stipulated by the Chongqing’s Municipal Government. Meanwhile, a few new facilities have been installed and are at the initial stage of commissioning, while the relocation of existing capacity and building of new facilities may take two or three more years for full completion, even though the group is targeting for completion by end-2011.

OSK Research 79 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

KEY HIGHLIGHT

STEEL PLATES: Volume games

From medium gauge to wide-thick steel plates. Steel plates are Chongang’s bread and butter, comprising 40.5% of the company’s total revenue in 2009, fetching a decent GP margin of 13.4%. The company is one of the key producers of medium-gauge plates in China. Chongang specialises in steel plates for shipbuilding, pressure vessel plates, steel plates for boilers, steel plates for bridge building and low-alloy high strength steel plates. The existing plates mill in Dadukao District in Chongqing City comes with a 2700mm rolling mill. The company recently commissioned its 1.8m tpy 4100mm plate mills in Yanjia Industrial Zone in Changshou District, for which it has a budgeted of RMB1.9bn. This facility and the new products are expected to give the company a competitive edge in supplying wide-thick steel plates, particularly to the nearby shipbuilding industry.

Relocating the 2700mm rolling mill. In conjunction with the company’s move to relocate from Dadukou, Chongang has secured a RMB440m finance lease with Minsheng Financial as part of the financing package for the relocation of its 2700mm rolling mill. The lease period is 36 months and payments begin in the 13th month after the lease inception date, at an annual lease interest rate of 5.472%. The higher relocation cost is to ensure the protective demolition and utilization of all existing equipment and steel structures of the production plant.

Exhibit 2: Steel plates performance

Sales Tonnage (m) GP Margin Steel plates 3.0 30% GP Margin 2.5 25%

2.0 20%

1.5 15%

1.0 10%

0.5 5%

0.0 0% FY05 FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Source: Company Data, OSK Estimates

Timely to ride on possible surge in plate demand. As we see a possible rush in delivering the backlog in orders of new build vessels in the next two years, we expect demand for steel plates from shipbuilding industry to go up. In addition, the plant is strategically located next to the Yangtze River (the world’s third longest river), which is the most important river for China’s economy, and also one of the most important hubs for the shipbuilding industry on the river bank. While we reckon the extraordinary GP margin of 27.2% in FY07 and 26.9% in FY08 are no longer attainable, we still expect margins to pick up slightly from 8.9% in 1HFY10 to 11.5% in FY11 and 12% in FY12. The commissioning of a 4100mm plate mill has seen positive impact to the 1HFY10 sale tonnage of steel plate at 870,000 tonne.

OSK Research 80 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

SMALL & MEDIUM SECTION: Wider applications

Uptick economy activities in Centre China may boost section demand. Chongang involvement in steel section is limited to small to medium range that is widely used in machinery, construction, shipbuilding, mine exploration and transportation industries. Given the wide application, we reckon the GP margin for this product has improved from below 4% prior to FY08 to 9.5% in FY09, in line with fast growing economy activities in the Centre China. While we do expect part of the improvement is driven by the sudden surge in demand of post earthquake construction activities in Sichuan province, we expect the GP margin of its products to consolidate at a reasonable 9% given that the development focus of the central government is switching to the centre and west region of China.

Exhibit 3: Steel sections performance

Sales Tonnage GP Margin (m) Steel sections 1.2 GP Margin 12%

1.0 10%

0.8 8%

0.6 6%

0.4 4%

0.2 2%

0.0 0% FY05 FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Source: Company Data, OSK Estimates

Relocation of section mill remains unknown. Although section mill must be relocate to the new district as part of the Chongang effort to observed the directive given by the Municipal Government of Chongqing City, the company has not make any official announcement on its plan for relocating this plant. Taking cue from the RMB440m expected to be spend for relocating the 2700mm plate mills, we expect section mill relocation may cost around RMB300m. Investors should also take note of potential dip in production tonnage for steel section during the relocation period that we have not incorporate those in our model given the sketchy information. For the time being, we are projecting a sales tonnage of above 900,000 tonnes a year based on the past three years’ track record.

OSK Research 81 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

WIRE RODS / BARS: Positioning for the “West Development”

Proxy to construction activities. The company has been producing more than 500,000 tpy of high speed wire rods since 2007, with GP margins peaking at 11.1% in FY09. Chongang’s high speed wire rod is mainly used in the construction industry and in other downstream manufacturing activities. We suspect the sudden surge in margin of wire rods in FY09 may have been contributed by reconstruction activities in the Wenchuan earthquake zone in 2008.

Investment in integrated long steelmaking via EAF route. On 15 Oct 2010, Chongang announced it is investing RMB1.4bn in an integrated steel plant in the parent group’s land in Jiangnan Town, Changshou District, Chongqing City. The plant has a new ultra high powered Electric Arc Furnace (EAF), an auxiliary furnace, a vacuum furnace, a 400/210mm round billet continuous caster, a new 50-150mm rod rolling production line and a 5.5-50mm wire rod production line. Construction commenced in November 2010 and is estimated to be completed and ready for trial production by the end of 2011. Chongang estimates the construction period to take 22 months. The completion of this project will enable the company to produce 1.04m tonnes of electric furnace steel and 1m tonnes of steel products, of which 0.6m tonnes would be large sized bars and 0.4m tonnes of small sized bars and wire rods. In addition, we also expect the relocation of the existing wire rod line to take place in the next one or two years. We think this may cost the company around RMB150m and a six-month disruption in production.

Exhibit 4: Wire rods performance

Sales Tonnage (m) Wire Rods GP Margin GP Margin 0.9 12% 0.8 10% 0.7 0.6 8% 0.5 6% 0.4 0.3 4% 0.2 2% 0.1 0.0 0% FY05 FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Source: Company Data, OSK Estimates

EAF - a surprise move. While we can understand management’s intention to expand its long product capacity in order to ride on the China government’s efforts to encourage development in the Centre and West regions of the country, the EAF investment came as a surprise. Meanwhile, only 8.5% of China’s crude steel in 2009 was produced via electric furnaces. Despite the fact that China is expected to generate an enormous amount of steel scrap following the surge in steel demand in the past decades, we still see steel recycling taking at least another 10 years to become more apparent. Nonetheless, given the fact that recycling technology is obviously more environmentally friendlier than BF technology, we welcome the move although we would have to monitor the development closely before being able to quantify the actual financial impact on the group.

OSK Research 82 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

HOT AND COLD ROLLED COILS: Huge room to grow

HRC the new kid on the block. The 1780mm Hot Rolled Coils (HRC) project entered into trial operation in August 2010. Although information on the 1780mm rolling mill is scarce, we expect this segment to be loss making this year given the potential learning curve plus initial commissioning costs. As such, we expect a gradual improvement in GP margins of 2.3% and 4.4% in FY11 and FY12 respectively.

CRC mill expansion. The board also approved in October 2009 an investment of RM299.8m to carry out a 450,000 tpy expansion and reform project at the company’s cold rolling plants. In the past, CRC products have been loss making as Chongang relies on external supply of HRC feed. While we expect the situation to improve after production at the 1780mm hot rolling line progresses, we are still projecting a gross loss margin of 3.9% for FY10 before barely breaking even at the GP level in FY11 (1.1%). However, we expect margins to continue to improve after the long learning process, with an expected GP margin increase to 4.9% in FY12.

Set to capitalize on Chongqing’s auto city status. Being located in one of the country’s major automotive hubs, Chongang hasn’t quite been able to capture a slice of the action in the automotive sector. Despite operating a CRC mill since 2005, this division has been registering losses, which it blamed on the outsourcing of HRC. We are hopeful that the expansion and renovation works currently being undertaken at the cold rolling plant would enhance production efficiency and product quality, which would eventually allow the company to participate in supplying to the booming automotive industry. Also, its recent trial operation of a 1780mm hot rolling line in August will complement the company’s foray into the auto market in the medium to longer term.

Exhibit 5: CRC & HRC

CRC HRC Sales Tonnage Sales Tonnage GP Margin (m) Cold Rolled Plates GP Margin (m) HRC GP Margin 4.5% 0.25 GP Margin 10% 1.4 5%

5% 1.2 4% 0.20 0% 3% 1.0 2.3% ‐5% 2% 0.15 ‐10% 0.8 1% ‐15% 0% 0.10 0.6 ‐20% ‐1% 0.4 ‐25% ‐2% 0.05 ‐3.0% 0.2 ‐30% ‐3% 0.13 1.00 1.30 0.00 ‐35% 0.0 ‐4% FY05 FY06 FY07 FY08 FY09 FY10F FY11F FY12F FY05 FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Source: Company Data, OSK Estimates

M&A: Assets injection by parent company on the pipeline.

10m tonnes of aspiration. Chongang has undertaken an environmental protection strategy to relocate its existing operations from Dadukou District to the city’s New District since its announcement in August 2008. The relocation and new plant investment is progressing rapidly. The company is targeting for 6.3m tpy capacity upon completion of the first phase of relocation. However, with the relocation of all of its existing lines to Changshou District will eventually see the group raising its capacity to 10m tpy.

OSK Research 83 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

A huge asset injection in the pipeline. We are projecting total cost of almost RMB20bn for the entire relocation and expansion programme that includes only projects that have been announced in the past. This amount is slightly lower than the group’s official estimate in the China Steel Year Book 2010 of RMB24bn. Meanwhile, some of the projects were directly undertaken by the listed company, such as the 4100mm steel plate rolling mill but the remaining ones were financed by the parent company of Chongang. Despite the fact that some assets like the steel smelting production lines are currently authorised by the parent company for use without charges until 31 March 2011, we believe the entire steel assets will be eventually injected into the listed unit. The value of those assets may have outsized the company’s balance sheet capability. Therefore, we suspect Chongang may eventually issue new shares to the listed company in exchange for certain assets that are currently owned by the parent group, this being the easier way out.

Exhibit 6: Chongang’s capex on the pipeline

Announced RMB (m) 4100mm Plates Mills 1.3m tpy 1,918.0 1780mm HRC Mills 2m tpy 2,500.0 ^ CRC Expansion 450k tpy 300.0 EAF + WR/Bar Rolling Mills 1m tpy 1,400.0 Relocation of 2700mm Plate Mills 1.3m tpy 440.0 Limestone transportation system 61.0 Jinjiang Logistic Base Project 1,300.0 TOTAL 7,919.0 ^

Pending Announcement RMB (m) Relocation of Section Mills 1m tpy 300.0 ^ Relocation of WR/Bar Mills 600k tpy 150.0 ^ Acquisition of parent BF 4,000.0 ^ New BF for relocation of existing 3.5m tpy 5,000.0 ^ Relocation / new coke plant 3m tpy 2,000.0 ^ TOTAL 11,450.0 ^

^OSK Estimates

Source: Company Data, OSK Estimates

OSK Research 84 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

FINANCIAL REVIEW

Two arduous years. Undeniably, the past two years have been exceptionally difficult ones for Chongang, which saw its revenue plunge 35.5% y-o-y and recording a profit of RMB66m in FY09. Revenue is expected to improve, however, by 54.1% owing to the commissioning of the new 4100mm plate mill and higher ASPs for all its products. Nonetheless, we are only projecting for the company to barely breaking even with a net profit of RM21.7m in FY10. We also foresee tough going for Chongang in the next few years as it may be impacted by higher financing and depreciation charges.

Exhibit 7: Financial performance of Chongang

RMB m RMB m Core net profit (rhs) 30,000 700 Revenue (lhs)

25,000 600

500 20,000 400 15,000 300 10,000 200

5,000 100

0 0 FY05 FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Source: Company Data, OSK Estimates

High financing and depreciation to cap earnings upside. Our earnings model so far only accounts for the investments and borrowing packages that have been officially announced. Already, we expect total borrowings and net gearing to exceed RMB8bn and 1.05x in FY11. Other than that, we also expect depreciation charges to inch up moving forward. As we are only assuming effective depreciation charges of 3.6% based on the company’s past track record, we see potentially higher charges given that the historical rate may not be a good yardstick as most of the plants at the Old District were old and may have fully depreciated. Therefore, there is some downside risk to our earnings estimates if Chongang eventually adopted higher depreciation charges. Meanwhile, we reckon that China’s steel mills adopt a useful life range of 5 to 15 years, which translates into an effective depreciation of 6.6% to 20%, which is more aggressive than Chongang’s historical rate.

Speed bumps before clean acceleration. Management has acknowledged that there will be higher costs during the initial start-up before operations smoothen out from the relocation undertaken earlier, which we duly agree. For 9MFY10, the company’s selling expenses arising from the 4100mm thick plates operation which recently started on a trial have increased. The new product lines within the New District of Changshou would eventually lead to margin improvement going forward, but we expect a gestation period due to the learning curve considering that the facility and its machineries are new.

OSK Research 85 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 8: Financial performance of Chongang

RMB m Long Term Finance RMB m 10000 Lease (lhs) 800 Long Term Borrowing (lhs) 700 8000 Short Term Finance Lease (lhs) 600 Short Term 6000 Borrowing (lhs) 500 Interest Expenses (rhs) 400 4000 300

200 2000 100

0 0 FY05 FY07 FY09 FY11F FY13F FY15F

Source: Company Data, OSK Estimates

OSK Research 86 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

VALUATION AND RECOMMENDATION

P/B cheap but PER expensive. Chongang is currently trading at only 0.6x P/B based on its FY11 figures and thus appears to be cheap as this is at only around -1 standard deviation of its historical trading band. The P/B is also the cheapest among the China steel stocks under our coverage. Nevertheless, we think this may be fair as it is a true reflection of its poor earnings potential in the coming years, at least for the medium term. Chongang’s weak earnings has winched up its PER valuation to the high teens based on its FY11 earnings. In view of this, together with the downside risk to our projection, we see no reason to invest in the counter at this juncture.

Exhibit 9: Chongang’s historical trading band

Leading PER Leading P/B & ROE

(x) (x) Leading P/B ROE (%) 50.00 Leading P/E 1.6 +1 STD 12 45.00 +1 STD 1.4 MEAN 10 40.00 MEAN ‐1 STD 1.2 35.00 ‐1 STD ROE 8 30.00 1.0 25.00 0.8 6 20.00 0.6 15.00 4 0.4 10.00 2 5.00 0.2 0.00 0.0 0 10 10 09 09 08 08 07 07 06 06 05 05 10 09 08 07 06 05 10 09 08 07 06 05 10 10 09 09 08 08 07 07 06 06 05 05 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ Jan Jan Jan Jan Jan Jan Sep Sep Sep Sep Sep Sep Jan Jan Jan Jan Jan Jan May May May May May May Sep Sep Sep Sep Sep Sep May May May May May May

Source: Company Data, OSK Estimates

Initiate with NEUTRAL recommendation. Despite the poor medium term outlook for Chongang, we reckon the company is the only dual listed China steel stock that is currently trading at some 40% discount to the price of its A-share, whereas its H-share peers are presently trading at a premium to their respective A-stocks. Together with its substantial discount to the company’s book value, we are initiating coverage on Chongang with a NEUTRAL recommendation and a target price of HKD1.92. The fair value is derived from a blended valuation of 10x PER and 0.8x BV/share, or +1 standard deviation of its historical trading band based on FY11 numbers. We urge investors to revisit the counter upon more clarity on its long-term relocation plan, which may help improve its earnings outlook.

OSK Research 87 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Financial Summary (FYE 31 December) Valuation and Growth Financial Ratios 2008A 2009A 2010F 2011F 2012F 2008A 2009A 2010F 2011F 2012F Valuation Ratios Profitability Ratios PER (Basic) (x) 5.2 47.0 153.7 17.0 8.6 Gross margin 18.0 13.8 11.3 11.2 11.6 Dividend yield 5.5 0.0 0.0 1.2 2.3 EBITDA margin 7.2 6.1 5.2 5.1 5.5 P/BV (x) 0.6 0.6 0.5 0.5 0.5 Core net margin 3.7 0.6 0.1 0.7 1.3 Growth ROA (Core) 5.1 0.5 0.1 0.9 1.6 Revenue (%) 37.1 -35.5 53.6 38.9 15.3 ROE (Core) 11.1 1.2 0.4 3.0 5.7 EBITDA (%) 16.5 -44.9 30.2 36.0 25.4 Balance Sheet Ratios Core Net profit (%) 28.2 -89.0 -70.6 760.1 98.6 Current ratio 1.3 1.1 1.1 1.1 1.0 Gross debt/equity 0.8 1.3 1.3 1.5 1.3 Per Share Data Net debt/equity 0.6 1.0 0.9 1.1 1.1 (RMB) 2008A 2009A 2010F 2011F 2012F Inventory Days 82.6 161.9 94.2 84.8 84.8 EPS (Basic) 0.347 0.038 0.011 0.096 0.192 Receivable Days 22.8 63.4 37.4 34.9 34.9 DPS 0.100 0.000 0.000 0.019 0.038 Payable Days 45.4 104.9 94.2 102.8 102.8 Payout ratio 28.9 0.0 0.0 20.0 20.0 BV/S 3.25 3.20 3.21 3.28 3.44 Balance Sheet (RMBm) 2008A 2009A 2010F 2011F 2012F Income Statement Fixed Asset (RMBm) 2008A 2009A 2010F 2011F 2012F Property, plant & equipments 6704.1 7951.1 9510.1 10998.0 11432.5 Total revenue 16482.2 10634.0 16334.7 22695.0 26157.2 Investment 5.0 5.0 5.0 5.0 5.0 Cost of sales -13516.5 -9166.9 -14488.8 -20155.4 -23112.8 Intangible assets 0.0 0.0 0.0 0.0 0.0 Gross profit 2965.7 1467.1 1845.8 2539.6 3044.4 Others 423.2 505.0 505.0 505.0 505.0 Selling & distribution costs -258.9 -293.8 -367.2 -510.2 -588.0 Total fixed assets 7132.3 8461.1 10020.1 11508.0 11942.5 General and administrative -1528.9 -533.7 -662.1 -919.9 -1060.2 Current Asset Operating profit/expenses 4.9 12.5 32.7 45.4 52.3 Cash and cash equivalents 1147.1 1404.9 1640.3 2048.3 1121.4 EBITDA 1182.8 652.1 849.2 1155.0 1448.5 Inventories 3057.7 4066.2 3740.0 4682.1 5369.1 Depreciation & amortisation -314.2 -297.9 -441.0 -512.1 -565.5 Trade receivables 1031.3 1848.4 1672.8 2169.1 2500.0 Finance costs -259.3 -277.1 -387.1 -460.8 -521.4 Others 56.6 187.8 187.8 187.8 187.8 Exceptional items -2.9 19.0 0.0 0.0 0.0 Total current assets 5292.7 7507.3 7240.9 9087.3 9178.4 Pre-tax profit 606.3 96.0 21.2 182.1 361.6 Current Liabilities Taxation -7.5 -11.0 -1.3 -11.2 -22.3 Trade payables 1682.1 2634.6 3737.6 5674.6 6507.2 Minority interests 0.0 0.0 -0.4 -3.6 -7.2 Short-term loans 2238.0 4104.0 2304.0 2304.0 2304.0 Reported net profit 598.8 85.0 19.4 167.2 332.1 Finance lease 0.0 76.4 280.0 280.0 706.7 Core net profit 601.8 66.0 19.4 167.2 332.1 Others 79.1 0.0 0.0 0.0 0.0 Total current liabilities 3999.2 6815.0 6321.6 8258.6 9517.9 Cashflow Statement Long-Term Liabilities (RMBm) 2008A 2009A 2010F 2011F 2012F Borrowings 2324.1 1760.4 3460.4 3160.4 2860.4 Operating cashflow Finance lease 0.0 1130.8 1050.8 2610.8 1904.1 Pre-tax profit 606.3 96.0 21.2 182.1 361.6 Others 474.5 723.3 723.3 723.3 723.3 Depreciation & amortisation 319.0 303.1 441.0 512.1 565.5 Total long term liabilities 2798.5 3614.5 5234.5 6494.5 5487.8 Others 1125.7 229.6 387.1 460.8 521.4 Shareholders' funds Change in working capital -1513.6 -1357.7 1604.8 498.5 -185.3 Share Capital 1733.1 1733.1 1733.1 1733.1 1733.1 Tax paid -54.0 -80.9 -1.3 -11.2 -22.3 Reserves 3894.1 3805.8 3825.2 3959.0 4224.6 Total operating cashflow 483.5 -809.9 2452.8 1642.2 1240.9 Equity attributable to owner 5627.3 5538.9 5558.4 5692.1 5957.8 Investing cashflow Minority interests 0 0 146.5 150.1 157.4 Capex -1227.1 -1132.2 -2000.0 -2000.0 -1000.0 Investments 0.0 0.0 146.1 0.00.0 Others 10.2 12.5 0.0 0.0 0.0 Total investing cashflow -1216.9 -1119.7 -1853.9 -2000.0 -1000.0 Financing cashflow Equity raised 0.0 0.0 0.0 0.0 0.0 Debt raised / paid 1383.8 1302.3 23.6 1260.0 -580.0 Dividend paid 0.0 0.0 -387.1 -460.8 -521.4 Others -474.4 885.1 0.0 -33.4 -66.4 Total financing cashflow 909.4 2187.5 -363.5 765.8 -1167.8 Net cash inflow / (outflow) 176.0 257.9 235.4 408.0 -926.9 Cash - beg 971.1 1147.1 1404.9 1640.3 2048.3 Others 0.0 0.0 0.0 0.0 0.0 Cash - end 1147.1 1404.9 1640.3 2048.3 1121.4

Company data, OSK Estimates

OSK Research 88 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Private Circulation Only Initiate Coverage

STEEL BUY Ng Sem Guan, CFA Maanshan Iron & Steel Co +(603) 9207 7678 Price HKD4.19 [email protected] Ltd (323.HK) Target HKD5.15

Room For Upside Surprise

Maanshan Iron & Steel Co. Ltd. (Magang) is China’s eighth largest steel mill Stock Profile/Statistics which boasts of a balanced mix of long and flat steel products. It has a plant in Bloomberg Ticker 323 HK Share Capital (m) 1,732.9 Anhui province. We like Magang as the company may beat our estimates Market Cap (HKDm) 31,115.8 despite our FY11 numbers being above the consensus and comparable for 52 week H | L Price (HKD) 6.11 | 3.27 FY12. We also expect some surprise value creation from a potential M&A given Average Volume (3m) ‘000 33,967.3 YTD Returns (%) -26.2 its proven capability in past acquisitions. We value Magang based on a Beta (x) 1.30 combination of 16x EPS and 1.31x BV/share derived from FY11 figures. Magang is our Top BUY for the steel sector, with a target price of HKD5.15. Major Shareholders (%)

Magang Holding 50.5% From long to flat steel. Magang has always been appreciated as a long steel producer despite its present balance of long and flat steel capacities. The commissioning of its integrated plant in mid-2007 next to its existing plant propelled Share Performance (%) its steelmaking capacity by 5m tpy, primarily for flat steel. Meanwhile, the major thin Month Absolute Relative 1m -7.9 -8.9 plates produced by the company are categorised as hot and cold-rolled thin plates, 3m 3.0 -6.1 galvanised plates and coil-coating plates. Unlike long steel, namely wire rods, rebar 6m 7.9 -5.0 and steel sections that the company is riding on the West Development plus growing 12m -21.1 -26.9 emphasis on modern-cum-safe buildings, the outlook for thin plates used widely in

12-month Share Price Performance automobiles, electrical appliances, machinery businesses and petroleum

5.80 transportation looks bright.

5.30 4.80 Surprises from train wheels and M&As. While many are shocked when sales of 4.30

3.80 train wheels plummetted in FY09, we belive this was due to timing mismatch as 3.30 demand may surge when new railways are put on official service. We expect back 2.80

2.30 loaded demand for train wheels in the coming years and Magang continues to 1.80 dominate this market, especially with huge export orders suggesting global 1.30 recognition. The announcement of Magang starting negotiations to acquire 0.80 Jun-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Changjiang Iron & Steel Co (Changang) also surprised many as they had low expectations of the company being involved in M&As. Although the detail remain sketchy, we are hopeful of Magang’s management adding value in Changang, taking the cue from its success in turnaround Hefei Iron and Steel (Hegang). Nevertheless, we are not hopeful of any approval on its greenfield expansion plan until 2012.

Earning upside installed. Our FY11 estimates exceed street estimates while our FY12 was almost in line with consensus, but we felt our numbers offer some room for upward revision on the back of conservative margin assumptions. Magang has made headway in supplying thin sheets to auto makers and its long presence in the long steel market also may offer better margin. Together with a potential value enhancement via M&A, we value Magang like Angang and rate the company our Top BUY.

FYE Dec (RMBm) 2008 2009 2010F 2011F 2012F Total Revenue 70,009.6 50,411.6 65,496.0 72,958.1 75,089.8 Core Net Profit 626.0 242.1 1,503.9 2,532.0 3,048.4 % chg YoY -74.7 -61.3 521.2 68.4 20.4 Consensus Net Profit - - 1,568.1 2,268.1 3,060.8 Core EPS (sen) 0.081 0.031 0.195 0.329 0.396 DPS (sen) 0.000 0.040 0.068 0.115 0.139 Div. Yield (%) 0.0 1.1 1.9 3.4 4.1 PER (x) 45.4 117.3 18.2 10.3 8.5 P/BV (x) 1.1 1.1 1.0 0.9 0.8 EV/EBITDA (x) 7.0 7.3 5.6 4.1 3.1 ROE (%) 2.6 0.9 5.6 8.8 9.9 ROA (%) 0.9 0.4 2.2 3.7 4.4 Note: Core Numbers

OSK Research 89 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

COMPANY BACKGROUND

Maanshan Iron & Steel (Magang), located in Maanshan City in eastern China’s Anhui Province, was established on September 1993. Magang’s H-shares were listed in November 1993 on the Hong Kong Stock Exchange, and subsequently the listing of it’s A-shares on January 1994 on the Shanghai Stock Exchange. Magang’s parent, Magang Group Holding (Masteel) is under the management of the Anhui provincial government and the Provincial State Owned Assets Supervision & Administration Commission (Provincial SASAC). The Company has achieved many firsts in China’s steel industry, such as: i) the first wheel tire plant, ii) the first high speed wire rod mill, iii) the first hot rolled H-section line, and (iv) being the first steel company to be listed in Hong Kong.

Exhibit 1: Corporate Structure

State‐Owned Enterprise (SASAC)

100%

Magang (Group) Holding

50.47%

Maanshan Iron & Steel

‐ Maanshan Iron and Steel (Australia) Proprietary Limited (100%) ‐ Ma Steel International Trade and Economics Corporation (100%) ‐ Ma Steel (Jinhua) Processing and Distribution Co Ltd (75%) ‐ Anhui Masteel Holly Industries Co Ltd (71%) ‐ Ma Steel (Yangzhou) Processing and Distribution Co Ltd (71%) ‐ Ma Steel (Hefei) Iron & Steel Co Ltd (71%) ‐ Anhui Masteel K.Wah New Building Materials Co Ltd (70%) ‐ Ma Steel (Wuhu) Processing and Distribution Co Ltd (70%) ‐ Ma Steel (Guangzhou) Processing and Distribution Co Ltd (66.67%) ‐ Ma Steel (Hefei) Processing and Distribution Co Ltd (61%) ‐ Design & Research Institute of Maanshan Iron & Steel Co Ltd (58.96%) ‐ Maanshan BOC‐Ma Steel Gases Company Limited (50%) ‐ Maanshan Harbor Group Co Ltd (45%)

Source: Company Data, OSK

Balance steel mixed. Magang is eight largest steel mills in China involved in the manufacture and sales of iron and steel products, segregated into four main categories, namely steel plates, steel sheets, steel sections, wire rods and train wheels. Angang produces plates mainly for automobiles, sections for construction and infrastructure usage, high speed wire rods used in armoured cum reinforcing concrete, and train wheels which are used in railway transportation and port machinery.

Exhibit 2: Product offering

Magang

Steel Plates Section Steel Wire Rods Train Wheels

H‐shaped Steel Thin Plates Medium Plates Medium‐ High Speed Wheels Wheel Rims ‐ Hot‐Rolled Thin Plates shaped Steel Wire Rod ‐ Cold Rolled Thin Plates ‐ Galvanised Plates ‐Coil‐Coating Plates

Source: Company Data, OSK

OSK Research 90 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

KEY HIGHLIGHT

FLAT STEEL: Huge room for improvements

Magang new focus on thin plates. The commissioning of an integrated steel facility in the “New Area” next to its existing plant marked a level up for Magang. Apart from raising its steelmaking capacity by 5m tpy, the plant also set a new milestone for the company in the flat steel area. Meanwhile, major thin plates produced by the company can be further categorised into hot and cold-rolled thin plates, galvanised plates and coil-coating plates. Hot-rolled thin plates are mostly used in the construction, automobile, bridge-building, machinery businesses and petroleum transportation, while cold-rolled thin plates are used in high-grade light industries, home electrical appliances, and medium and high-grade production of automobile parts. Galvanised plates are used in the plates of automobiles, home electrical appliances, high-grade construction plates, and also in businesses such as packaging and utensil manufacturing. Coil-coating plates can be used in both the interiors and exteriors of construction projects, home electrical appliances and steel windows.

Exhibit 3: Magang’s flat steel products mix

tonnes 10,000,000 12% 9,000,000 10% 8,000,000 Silicon Steel 7,000,000 PPGI 8% 6,000,000 GI 5,000,000 6% CRC 4,000,000 HRC 4% 3,000,000 Plates 2,000,000 2% GP Margin 1,000,000 ‐ 0% FY08 FY09 FY10F FY11F FY12F

Source: CISA, Company Data, OSK Estimates

Magang making inroads into automotive steel sheets. The Company is strengthening its strategic cooperation with end-customers and finetuned its export strategies, thereby balancing its production and sales and achieved timely recovery of capital. By establishing strategic alliances with well-known domestic automobile and home appliance enterprises, the Company satisfactorily resolved the issue of balancing various parties’ interests. Since the commissioning of a new plant, the company has made significant strides in supplying thin plates to Chinese auto manufacturers that were previously monopolised by Baosteel and Angang. Among others, Magang has signed long term supply agreements with a few auto makers, including Anhui-based Jianghuai Auto and Chery Auto, as well as Chongqing- based Changan Auto. The company targets to boost its auto sheet production from 400k tonnes in FY09 to 600k in FY10. We are optimistic that rising car ownership in China, which we expect to grow at double-digit percentage on escalating purchasing power, will spell bright prospects for sales of thin plates and improvements on profitability.

OSK Research 91 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Medium plates to benefit from backlog delivery of new vessels. Medium plates are widely used in boilers, pressurised utensils, shipbuilding, container manufacturing, and so forth. The tonnage of plates used in building ship structures is expected to increase in the next two years as we expect huge deliveries of new build vessels backlog. While margin is expected to widen, we only expect a gradual improvement, mainly driven by spiralling demand. As such, the extraordinary margins prior to the financial downturn may not be seen again for many years to come, especially with prices of new build vessels having collapsed and the excess supply may overwhelm demand, especially with major delivery of new ships happening in the coming years. We believe the company will gradually shift its focus to supplying medium plates to other industries.

Exhibit 4: Performance of steel plates

10 30% 9 25% 8 7 20% 6 5 15% 4 10% 3 2 5% 1 0 0% FY04 FY05 FY06 FY07 FY08 FY09 FY10F FY11F FY12F Sales Volume (m tonnes) GP Margin

Source: Company Data, OSK Estimates

Upward bias for steel plate margin. Steel plates accounted for 48.8% of Magang’s revenue in 2009, with the sales tonnage of 7.8m representing an increase of 17% y-o-y. While the GP margins only stood at 1.9% in FY09, its profitability improved to 10.5% in 1HFY10. We see margins holding at 9% for a full year average of FY10 after factoring in the price correction, which was further dampened by high material costs. Despite the bright prospects for auto demand from on the back of China’s robust economy, the low vehicle ownership per capita, the government’s efforts to bring cars and bikes to rural areas through subsidy programmes and the numerous improvements in private spending that will indirectly push up demand for flat steel, especially thin plates, we are only incorporating a marginal improvement in GP margin to 9.2% in FY11 and 9.7% in FY12. Given the conservative assumption and years of learning experience in this new production line, we see some upward bias on our projections.

OSK Research 92 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

WIRE RODS / REBAR: Magang’s bread and butter

An old timer. Magang has always been associated with long steel, especially with wire rods and rebar contributing to 30% of the company’s revenue in FY09. The company owns the core technology and patent for the high-efficiency, low-cost cold-forged steel with wire-softening treatment. Magang’s major wire rod products include the high-speed wire rod materials and hot-rolled reinforcing steel used in armoured concrete. High-speed wire rod products are mostly used in the production of robust materials, re-stressing strand steel wires and spring steel wires, and are occasionally used in construction materials.

Exhibit 5: Performance of wire rods / rebar

6 20% 18% 5 16% 4 14% 12% 3 10% 8% 2 6% 1 4% 2% 0 0% FY04 FY05 FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Sales Volume (m tonnes) GP Margin

Source: Company Data, OSK Estimates

Riding on the “West Development”. As wire rods and steel bars are mostly used in construction sites, we expect Magang’s plant - located near the central region of China – to benefit from the government’s emphasis on the the development of the west. Also, the rising purchasing power also translates into escalating demand for downstream wire products like bolt and nuts, which bodes well for Magang. Nonetheless, given the potential slowdown of the property market, which may directly and partially hit wire rods demand, we only incorporate a conservative GP margin of 3.4% for FY10, 5.6% for FY11 and 5.9% for FY12. We also see limited growth for wire rod volume in the coming years.

OSK Research 93 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

STEEL SECTIONS: Niche long steel products

Great prospects for steel sections. Magang’s steel sections products include H-shaped steel and common medium-shaped steel. H-shaped steel is mostly used in construction, steel structures, machinery manufacturing and the construction of petroleum drilling platforms and railways. As the country develops as more skyscrapers and public amenities like airports are built in China, the need for steel sections grows. These products may also benefit from the government’s efforts to promote industrial upgrading as more plants are built for the next five years given that their main structure are normally supported by steel sections. Apart from that, as we mentioned in our sector report, segments in which there is now relatively low usage of steel sections in China compared with those in the developed countries also suggest that there is huge potential for such products. Nonetheless, we prefer to keep our tonnage and margin assumptions conservative until more concrete developments emerge.

Exhibit 6: Performance of steel sections

3.0 25%

2.5 20% 2.0 15% 1.5 10% 1.0

0.5 5%

0.0 0% FY04 FY05 FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Sales Volume (m tonnes) GP Margin

Source: Company Data, OSK Estimates

Conservative estimates. In 2009, 15.9% of Magang’s revenue was from steel sections, with total sales tonnage of 2.5m. GP margins for steel sections were 12% and 5.1% for FY09 and 1HFY10 respectively, and our margin estimate for FY10 is 4.8%. We see flat sales tonnage for steel sections of 1%-2% going forward given the high base effect from construction and infrastructure works in China arising from its stimulus packages ending in 2010, and also the fact that Magang is switching its focus to thin plates manufacturing. We expect steel section GP margins to improve to 7.9% in FY11 and 8.2% in FY12.

OSK Research 94 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

TRAIN WHEELS: Back-loaded demand to emerge

Dominating the train wheels market. Magang’s lead in the train wheels market is unbreakable. It produces train wheels and wheel rims which are widely used in railway transport, port machinery, petrochemical industries, aerospace industry, and so forth. The company owns the core technology and patent for train wheels used for high-speed railroads. Magang’s train wheel products are also bestowed the honour of “Famous Brand of China”.

Train wheels to benefit from higher FAIs. China’s fixed asset investments on railroads have been growing at a CAGR of 52.3% y-o-y since 2005, from RMB126.8bn to RMB682.3bn in 2009. The global downturn saw FAI investments in railroads register strong growth in 2008 and 2009 (more than 60% growth), driven by the government’s stimulus measures. The Ministry of Railways disclosed that the FAI target for 2010 would be RMB823.5bn, which translates into a y-o-y growth of 21%, coming off a high base in 2009. Nonetheless, sales of Magang’s train wheels have not been growing in tandem with China’s FAI on railways, especially in FY09, when it experienced a drastic drop of 42% in sales tonnage. We think the hiccup was purely due to timing mismatch as many railroads being paved have not been actually put on official operation, and hence poor demand for train wheels is still poor.

Exhibit 7: China’s Railway FAIs vs Magang’s train wheels sales

RMB bn m tonnes 900 300,000 800 250,000 700 600 200,000 500 150,000 400 300 100,000 200 50,000 100 0 0 FY05 FY06 FY07 FY08 FY09 FY10E China's FAI on Railways Magang's Train Wheels

Source: Statistics and Planning of the Ministry of Railways

Magang brand recognised worldwide. Magang recently secured a wheel contract (in March 2010) from Germany's Deutsche Bahn AG (Germany’s national railway company) for 1,232 units of wheels. The customer also ordered another 15,000 units of train wheels for the whole of 2010, representing 20% of Deutsche Bahn's annual requirement. We are positive on this contract as Magang’s capacity has been mostly tailored for domestic demand, and the contract signifies foreign confidence in Magang’s expertise and involvement in China’s high-speed railway links and metro lines. We also note that Magang supplies half of US conglomerate, General Electric’s, railway wheel demand.

OSK Research 95 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Volume and margin set to expand. While the sales tonnage plunged in FY09, the GP margin was not impacted but even improved to 37.5% from 31.4% in FY08. We expect a lower margin of 32.6% for FY10 and gradually improving to 34.4% and 36.4% for FY11 and FY12 respectively. We also factor in almost a 20% growth in sales tonnage for FY10 to FY12 given the potential of demand picking up in the next few years on demand for back loaded train wheels as railway tracks are gradually come into operation. Apart from that, China’s enormous railroad mileage may eventually see the increase in replacement of train wheels although the lifespan of the new generation of train wheels has doubled from eight to nine years to 15 to 16 years.

Exhibit 8: Performance of train wheels

300,000 45% 40% 250,000 35% 200,000 30% 25% 150,000 20% 100,000 15% 10% 50,000 5% 0 0% FY04 FY05 FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Sales Volume (tonnes) GP Margin

Source: Company Data, OSK Estimates

GREENFIELD EXPANSION: Many road blocks in medium term

Magang’s expansion proposal. That Magang is targeting to expand its capacity is nothing new but approval from the Central Government seems unlikely at least for the next one year as there is a strong directive from policy makers not to approve any new capacity or project in the name of equivalent elimination of outdated capacity until end-2011. We understand that the company plans to build a new 3m tpy steel mill under 71%-owned Hefei Iron and Steel (Hegang). The plant includes a 3m tpy 1,580mm hot-strip mill and a 1.5m tpy 1,550 cold strip mill. Upon approval, Hegang’s existing 1.4m tpy wire rods mill will have to be relocated out of Hefei City to Magang’s site in Maanshan City. We also heard that the plan is actually to replace a few of the old cum mini BFs below 500 cubic metres with a 5,000-cu metres furnace with a rated capacity of 5m tpy. A hot and cold rolling line will also be installed under this plan but we are unsure of the capacity of each product. We believe the company may take on the proposal with internal generated funds plus some debt financing given its strong balance sheet. However, we have not incorporated this project into our financial model given the uncertainties surrounding the expansion plan.

OSK Research 96 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

M&A: Acquisition within Anhui Province

Sealing its position in Anhui? Steel Business Briefing reported that Magang’s board got the go-ahead on 6 Sept 2010 to proceed with the merger with Anhui’s Changjiang Iron & Steel Co (Changang). Nonetheless, its filing to HKSE only stated that Magang is currently negotiating on its investment in the restructuring of Changang. The acquisition target is also based in Maanshan City, eastern China. The unit has the capacity of producing 1.5m tonnes of rebar and wire rod a year, and the company has started to expand its capacity to 3m tpy. Sources suggest that a new rolling mill for both wire rods and rebar will be installed along with BF and converters.

Magang may add value to Changang. We are obviously excited with the development as Magang’s management has proven its capability in turning around Hegang within just one quarter after acquiring the latter. To recap, Magang acquired 71% interest of Hegang in May 2006 for RMB350m. Hegang is a distressed asset as it has been losing money in the past, dragged down by a heavy social burden and a lack of management expertise. Immediately after the acquisition, Magang’s management improved on the steel product quality and removed the quality discount that Hegang had previously given to its customer on poorly finished steel. The inclusion of Hegang into Magang’s central procurement system also allowed the company to enjoy bulk discounts on main feed materials. Nonetheless, we need more information like acquisition cost, Changang’s present financial position and other details to ascertain the quantum of value that Magang may extract from this M&A.

IRON ORE: Consistent ore supply from Wheelarra JV and parent company

Mainly on long term contracts. Approximately 70% of Magang’s iron ore requirement is imported from three world giants, namely Vale, Rio Tinto and BHP Billiton. The company imports via long term contracts and the prices were previously fixed on an annual basis until recent changes to the quarterly contract. Magang’s procurement decision is based on the spread between the contract price and local spot prices of iron ore. Such as during 2HFY08 when iron ore prices slumped after the onset of the financial tsunami and domestic iron ore was cheaper than the contract price, the company had purchased much more iron ore from the domestic market but shifted to more contracted iron ore in 2HFY09 as the spot price escalated.

Iron ore JV. Magang is part of the Wheelarra Joint Venture set up by iron ore giant BHP Billiton in 2004, which also involves three other parties, namely Jiangsu Shagang, Wuhan Iron & Steel and Tangshan Iron & Steel. Under the terms of the joint venture, the four Chinese still mills collectively have a 40% share in a sub-lease over BHP’s Jimblebar mine near Newman in Western Australia. Jimblebar contains 247m tonnes of proved and probable iron ore with an Fe content of 61.5%. Magang and Shagang receive about 2.5m tonnes per year of iron ore supply from the JV while Wugang and Tanggang receive 3.5m tonnes per year.

Exhibit 9: Snapshot of Wheelarra Joint Venture

Mine Parties involved Duration Joint Venture Mine Reserves Production (m tonnes) (crude steel output in 2009) (years) (tonnes)

BHP Billiton's Wheelarra ‐ Magang (14.8mt) Jimblebar mine at 25 247 12 JV ‐ Wugang (30.3mt) Newman in Western ‐ Tanggang (7.6mt) Australia ‐ Shagang (n/a)

Source: OSK, Bloomberg, Company

Parent’s iron ore at arm’s length pricing. Magang sources about 15% of its iron ore requirement from its parent, Masteel. The selling price of iron ore from its parent is determined by arm’s length negotiations. The price for a particular half year will be first be arrived at with reference to the weighted average price for each percentage point of iron content in a tonne of similar type of iron ore supplied by the three largest independent suppliers of iron ore to the group in the preceding half year. However, the price shall be further adjusted retrospectively at the end of that particular half year and shall not be higher than the three largest independent suppliers’. OSK Research 97 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

FINANCIAL REVIEW

Conservative margin assumption. We believe the margin assumptions for some of the steel products may have upside potential. Overall, we only project for Magang to return to mid cycle GP margins together with some margin improvement over the years on efficiency enhancements. Nonetheless, products like thin plates may actually help to lift the steel plate division’s margin after a few years of learning on the hot and cold rolling line. Also, the bright prospects for white goods and automotive demand may eventually drive demand for thin plates, and hence margins. Given the company’s years of experience in wire rods and rebar production, we also think our margin assumption of below 6% until FY12 are conservative. However, steel section margins may also driven by the emphasis on modern cum safe buildings, and train wheels margin may also surpass 40% GP margin in the event of higher than expected railroads being officially commissioned in the next few years. As such, we believe our earnings estimates are subject to upward adjustment if margins beat our expectation.

Exhibit 10: Gross margin of key steel products

GP Margin 2005 2006 2007 2008 2009 2010F 2011F 2012F Steel Plates 16.2% 10.9% 9.0% 5.8% 1.9% 9.0% 9.2% 9.7% Section Steels 17.2% 9.4% 12.9% 10.5% 7.9% 4.8% 7.9% 8.2% Wire Rods 7.1% 7.8% 6.9% 5.4% 4.3% 3.4% 5.6% 5.9%

Train Wheels and Tyres 27.1% 42.4% 38.5% 31.4% 37.5% 32.6% 34.4% 36.4%

Source: Company Data, OSK Estimates

Net profit may breach RMB3bn from FY12. Meanwhile, based on our conservative normalised margin, we are projecting for Magang’s net profit to return to the RMB3bn mark, having reached this level briefly in FY04 fuelled by the boom in construction activities. If our projection of improving demand and supply dynamics will lead to gradually widening margins for Magang, the RMB3bn net profit figure is likely to be a new level that investors may benchmark against vis-a-vis the company.

Exhibit 11: Financial performance of Magang

RMB m Revenue PAT Margin 80,000 10% 70,000 9% 8% 60,000 7% 50,000 6% 40,000 5% 30,000 4% 3% 20,000 2% 10,000 1% 0 0% FY05 FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Source: Company Data, OSK Estimates

A 35% dividend payout. Magang has been consistently distributing 35% of its net profit in the form of dividends to reward its shareholders prior to the financial crisis. As we expect the profit to normalise in the coming years together with the company’s solid balance sheet, we expect Magang to practice a 35% payout ratio, and accordingly frank RMB0.068, RMB0.115 and RMB0.139 as the dividend payments for FY10 to FY12 respectively. The dividend translates into a satisfactory yield of 2% to 4%. As we expect the company’s net gearing at only 42.7% by end-FY10 and return to net cash for FY12 onwards, we think the company would have the ability to undertake a reasonable scale of acquisition or Greenfield projects.

OSK Research 98 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

VALUATION AND RECOMMENDATION

A cyclical stock but... Magang has been trading at a single digit 1-year leading PER until end-FY06 where its share price begin to pick up on excitement over its new 5m tpy new facilities plus the bull run in the general equity market on HKSE. The onset of the financial crisis in 3QFY08 that led to the collapse of steel mills’ earnings saw Magang’s PER multiple surge above 20x and dip into negative territory on subsequent losses from 4QFY08. The continuous improvement in earnings have seen the PER multiple for Magang drop to around the mid-teens. On the other hand, its leading P/B parameter surged all the way from trading below its book value to 2x P/B in October 2007. The stock dropped to below -2 standard deviations and subsequently recovered to just under +2 standard deviations, on market optimism of a potential green shoot recovery in commodity stocks riding on the stimulus packages introduced by various governments.

Exhibit 12: Magang historical trading band

Leading P/B & ROE Leading PER (x) Leading P/B ROE (%) (x) Leading P/E 2.5 18.0 50.0 +1 STD +1 STD MEAN 45.0 15.0 2.0 40.0 MEAN ‐1 STD 35.0 ‐1 STD ROE 12.0 30.0 1.5 25.0 9.0 20.0 1.0 15.0 6.0 10.0 0.5 3.0 5.0 0.0 0.0 0.0 05 06 07 08 09 10 05 06 07 08 09 10 05 06 07 08 09 10 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ 05 06 07 08 09 10 05 05 06 06 07 07 08 08 09 09 10 10 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ Jan Jan Jan Jan Jan Jan Sep Sep Sep Sep Sep Sep May May May May May May Jan Jan Jan Jan Jan Jan Sep Sep Sep Sep Sep Sep May May May May May May

Source: Company Data, OSK Estimates

Our Top BUY. The recent market-wide correction brought down the stock’s P/B to again below its book value and also below the mean of its historical trading band. Based on our projection of Magang returning to mid cycle earnings and margins stabilisign on gradual enhancement, we think the cheap valuations are unwarranted. As Magang still has room to augment its bottomline and earnings to potentially exceed our projections, we think it is justified for the company to trade parallel to Angang, which has relatively less room to enhance profitability. In addition, the company may also surprise the market with M&As via the acquisition of Changang, from which we believe management would be able to create additional value, going by its success on turning around Hegang. Therefore, we are valuing Magang based on a blended valuation of 16x PER and 1.31x book value/share, or +1 standard deviation of its historical band benchmarked against FY11 numbers. We derive a fair value of HKD5.15 for Magang and rate the company as our Top BUY among China’s steel counters under our universe.

OSK Research 99 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Financial Summary (FYE 31 December) Valuation and Growth Financial Ratios 2008A 2009A 2010F 2011F 2012F 2008A 2009A 2010F 2011F 2012F Valuation Ratios Profitability Ratios PER (Basic) (x) 45.4 117.3 18.2 10.3 8.5 Gross margin 12.6 15.0 15.4 16.0 16.5 Dividend yield 0.0 1.1 1.9 3.4 4.1 EBITDA margin 9.9 12.0 12.0 12.6 13.1 P/BV (x) 1.1 1.1 1.0 0.9 0.8 Core net margin 0.9 0.5 2.3 3.5 4.1 Growth ROA (Core) 0.9 0.4 2.2 3.7 4.4 Revenue (%) 42.7 -28.0 29.9 11.4 2.9 ROE (Core) 2.6 0.9 5.6 8.8 9.9 EBITDA (%) -2.2 -12.6 29.9 17.2 6.9 Balance Sheet Ratios Core Net profit (%) -74.7 -61.3 521.2 68.4 20.4 Current ratio 1.0 1.1 1.3 1.5 1.7 Gross debt/equity 0.8 0.8 0.7 0.5 0.4 Per Share Data Net debt/equity 0.6 0.5 0.4 0.2 0.0 (RMB) 2008A 2009A 2010F 2011F 2012F Inventory Days 57.9 75.3 83.0 83.0 83.0 EPS (Basic) 0.081 0.031 0.195 0.329 0.396 Receivable Days 9.9 38.0 32.5 32.5 32.5 DPS 0.000 0.040 0.068 0.115 0.139 Payable Days 51.1 99.8 64.1 64.1 64.1 Payout ratio 0.0 78.5 35.0 35.0 35.0 BV/S 3.38 3.44 3.59 3.85 4.13 Balance Sheet (RMBm) 2008A 2009A 2010F 2011F 2012F Income Statement Fixed Asset (RMBm) 2008A 2009A 2010F 2011F 2012F Property, plant & equipments 40769.5 38272.9 34524.0 30680.4 25801.8 Total revenue 70009.6 50411.6 65496.0 72958.1 75089.8 Investment 910.4 1004.1 1194.5 1515.0 1900.9 Cost of revenue -61207.9 -42849.7 -55409.4 -61267.6 -62686.8 Intangible assets 85.2 109.1 104.1 99.1 94.1 Gross profit 8801.7 7561.8 10086.6 11690.5 12403.0 Others 5132.2 4547.5 3547.5 2547.5 2526.3 Distribution costs -1145.3 -448.6 -989.0 -1101.6 -1133.8 Total fixed assets 46897.2 43933.6 39370.1 34841.9 30323.0 Administrative expenses -951.1 -1170.7 -1475.8 -1643.9 -1692.0 Current Asset Operating income / expenses 227.1 115.8 248.7 277.0 285.1 Cash and cash equivalents 5437.4 5780.5 3518.1 7538.6 11868.9 EBITDA 6932.4 6058.3 7870.5 9222.0 9862.3 Inventories 9702.5 8836.0 12594.9 13926.5 14249.1 Depreciation & amortization -4569.8 -4824.8 -4953.9 -5048.6 -5104.8 Trade receivables 1894.0 5244.1 5828.6 6492.7 6682.4 Finance costs -1840.3 -1004.2 -1013.0 -968.3 -898.8 Others 2352.5 4331.8 6151.3 6485.8 6581.3 Exceptional item 84.2 150.4 0.0 0.0 0.0 Total current assets 19386.3 24192.5 28092.9 34443.6 39381.7 Associate 199.4 183.2 190.4 320.5 385.9 Current Liabilities Pre-tax profit 805.9 562.9 2094.0 3525.5 4244.6 Trade payables 8574.3 11715.4 9726.3 10754.6 11003.7 Taxation -74.6 -29.0 -475.9 -801.3 -964.7 Short-term loans 1377.6 1989.2 1489.2 989.2 500.0 Minority interests -21.0 -141.4 -114.2 -192.3 -231.5 Taxation 0.0 34.1 34.1 34.1 34.1 Reported Net profit 710.2 392.5 1503.9 2532.0 3048.4 Others 8574.3 7853.1 10369.2 11465.5 11731.0 Core Net Profit 626.0 242.1 1503.9 2532.0 3048.4 Total current liabilities 18526.2 21591.9 21618.8 23243.4 23268.9 Long-Term Liabilities Cashflow Statement Borrowings 20659.3 18769.4 16769.4 14769.4 12769.4 (RMBm) 2008A 2009A 2010F 2011F 2012F Others 571.0 579.9 579.9 579.9 579.9 Operating cashflow Total long term liabilities 21230.3 19349.3 17349.3 15349.3 13349.3 Pre-tax profit 805.9 562.9 2094.0 3525.5 4244.6 Shareholders' funds Depreciation & amortisation 4569.8 4824.8 4953.9 5048.6 5104.8 Share Capital 7700.7 7700.7 7700.7 7700.7 7700.7 Others 3038.0 723.2 822.7 647.8 513.0 Reserves 18306.3 18764.0 19959.8 21965.4 24127.6 Change in working capital 660.3 716.3 -5636.0 -205.5 -93.1 Equity attributable to owner 26007.0 26464.7 27660.5 29666.1 31828.3 Tax paid -686.1 -158.5 -475.9 -801.3 -964.7 Minority interests 520.1 720.2 834.4 1026.7 1258.3 Total operating cashflow 8387.8 6668.7 1758.6 8215.1 8804.5 Investing cashflow Capex -3504.7 -1580.0 -1200.0 -1200.0 -221.2 Investments 60.3 92.1 0.0 0.0 0.0 Others 123.1 -2516.1 1000.0 1000.0 21.2 Total investing cashflow -3321.2 -4004.0 -200.0 -200.0 -200.0 Financing cashflow Equity raised 3071.3 0.0 0.0 0.0 0.0 Debt raised / paid -5428.4 -1446.6 -2500.0 -2500.0 -2489.2 Dividend paid -1129.4 -410.0 -308.0 -526.4 -886.2 Others -1626.7 -763.0 -1013.0 -968.3 -898.8 Total financing cashflow -5113.1 -2619.7 -3821.1 -3994.6 -4274.3 Net cash inflow / (outflow) -46.6 45.0 -2262.4 4020.5 4330.2 Cash - beg 5524.0 5437.5 5780.5 3518.1 7538.6 Others -39.9 20.6 0.0 0.0 0.0 Cash - end 5437.5 5503.0 3518.1 7538.6 11868.9 Source: Company data, OSK Estimates

OSK Research 100 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Private Circulation Only Initiating Coverage

STEEL BUY Ng Sem Guan, CFA Shougang Concord Int’l +(603) 9207 7678 Price HKD1.18 [email protected] Enterprises (697.HK) Target HKD1.80

Vertical Integration Pays Off

Shougang Concord International Enterprise (SCIE) is one steel mill that is truly Stock Profile/Statistics integrated in terms of supply of feed material such as iron ore and coking coal. Bloomberg Ticker 697 HK Share Capital (m) 8,175.4 The company also hedges against the volatility in shipping rates via its Market Cap (HKDm) 9,646.9 ownership of two capsize bulk vessels, as well as having a hand in the 52 week H | L Price (HKD) 2.33 | 0.98 booming auto market via its associate investment in steel tyre cords. Although Average Volume (3m) ‘000 68,871.9 YTD Returns (%) -39.2 their investment is beginning to pay off, SCIE is still trading at undemanding Beta (x) 1.39 valuations. We initiate coverage on SCIE with a BUY rating and a fair value of HKD1.80. Major Shareholders (%)

Shougang Holding 42.15% Cheung Kong (Holdings) Ltd 5.57% Volume and value-add play for steel. 2010 marked a turning point for SCIE’s steel plate division as the commissioning of an ultra thick slab caster and roughing mill elevated the group’s slab and plate-making capacity to 3.6m and 2.6m tonnes per Share Performance (%) year (tpy). The massive backlog in undelivered newbuild vessels plus its strong ties Month Absolute Relative 1m -9.2 -9.7 with Hyundai Heavy Industries Co. Ltd are expected to spur demand and margins. 3m 4.4 -9.8 However, as the worldwide over-supply of vessels may dampen the long-term 6m -5.6 -19.6 outlook for ship plates, the company is shifting its focus to supply to other industries. 12m -21.9 -30.7 Steel plate pre-treatment and processing centre are other key areas to enhance the

12-month Share Price Performance company’s competitive edge.

1.50 Iron ore and coking coal exposure. The group’s 24.4% stake in Fushan 1.40 International Energy Group Ltd (Fushan) has given SCIE exposure to the tightly-held 1.30 supply of coking coal, which offers an indirect hedge against rising coke prices. Its 1.20 solid balance sheet and profit stream from Fushan not only offers an attractive 1.10 dividend return tied to a payout ratio of 40%, but also aggressive business growth 1.00 via acquisitions or Greenfield mines and clean coal processing plant investments. 0.90 Apart from coal, SCIE’s iron ore exposure is via a lifelong offtake agreement with 0.80 Jun-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Australia-listed Mt. Gibson, which offers selling prices at a 10% discount to the spot index for up to 6m tpy. The company also owns 68% of two local magnetite iron ore mines with a collective capacity of 1m tpy, plus a 2m tpy of iron ore pelletization plant.

Riding the auto boom but sailing through rough waters. SCIE also involved in tyre steel cords via its 36.7% interest in Shougang Concord Century (SCC), which is aggressively expanding its production capacity target to 160k tpy by 2012 to ride on the booming auto industry in China. However, the shipping business is mainly to hedge against volatile charter rates. We expect a challenging environment in the next two years as we are only projecting a BDI Index of 2,250 pts but the expiry of a 15-year lease in 2012 may see this division becoming profitable moving into FY13.

FYE Dec (RMBm) 2008A 2009A 2010F 2011F 2012F Total Revenue 17464.7 11357.6 15473.2 18609.0 20843.3 Core Net Profit 1728.0 -1010.8 709.2 1041.4 1265.8 % chg YoY 32.9 -158.5 170.2 46.8 21.6 Consensus Net Profit - - 953.3 1,371.3 1,516.8 Core EPS (sen) 0.241 -0.124 0.087 0.127 0.155 DPS (sen) 0.050 0.000 0.026 0.038 0.046 Div. Yield (%) 4.2 0.0 2.2 3.2 3.9 PER (x) 4.9 n.m. 13.6 9.3 7.6 P/BV (x) 1.0 1.0 1.1 1.0 0.9 EV/EBITDA (x) 3.7 n.m. 12.7 9.8 8.0 ROE (%) 24.0 -12.5 8.0 11.0 12.3 ROA (%) 9.2 -4.5 2.9 4.1 4.9 Note: Core Numbers

OSK Research 101 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

COMPANY BACKGROUND

A vertically integrated player. Shougang Concord International Enterprises (SCIE) is part of Beijing-based Shougang Group, which was the seventh largest steel group in China in terms of crude steel production in 2009. The group holds 42.15% equity interest in the company via Shougang Holdings and Cheung Kong (Holdings) Ltd, also a long term investor in the company, with shareholding of 5.57% in SCIE. The company is a vertically integrated steel company with operations that can be segregated into five major segments, comprising steel manufacturing, mineral exploration, trading of iron ore and steel products, shipping, and finally steel cords for tyres.

Exhibit 1: Corporate structure of SCIE

Shougang Concord International

Steel Manufacturing Mineral Exploration Trading of Iron Ore and Shipping Steel Cords for Tyres Steel Products 36.7% 76% 100% 24% 68% 6.33% 100% 100% Qinhuangdao Fushan Qinhuangdao Shougang Qinhuangado Australasian Shougang Shougang Shougang Plate International Shouqin Longhui Concord Shouqin Metal Resources Concord Steel Concrod Century Materials Mill Energy Mining Shipping

51% 13.81% Qinhuangdao 49% Shouqin Steels APAC Resources Machinery & 14.28% Delivery 25.92%

Mount Gibson Iron

Source: Company, OSK

Steel manufacturing operations. SCIE core focus is in the manufacturing of heavy plates applied in the shipbuilding, oil& gas, infrastructure and industrial sectors. As some of the business activities are only at the associate level hence equity accounting of the bottomline, the manufacturing of slabs and heavy plates make up 76% of the Group’s turnover in 2009. SCIE’s 76%-owned Qinhuangdao Shouqin Metal Materials (Shouqin) is a fully integrated plate manufacturer Hebei province’s Qinhuangdao City. The plant comprises 2 BF, 2 convertors, a casting machine and a hot rolling production line which was commissioned at end-2006. SCIE also has another plant, namely Qinghuangdao Shougang Plate Mill (QZP), which manufactures medium plates (3 metre-long plates) with a hot rolling facility that has been in operation since 1993.

Mineral exploration and trading. SCIE’s wholly-owned subsidiary, Shougang Concord Steel, has signed a long-term off-take agreement with Australian-listed iron ore producer Mount Gibson Iron limited (Mt. Gibson) to allow the company to procure 80% of the latter’s available iron ore at a 10% discount to the agreed benchmark price. SCIE also owns 68% of Qinhuangdao Shouqin Longhui Mining (SQLH), which has two magnetite iron ore mines and a 2m tpy iron ore pelletization plant in Qinhuagdao. As for coking coal, SCIE has a 24.4% stake in Fushan International Energy Group Ltd. (Fushan), a Hong Kong listed coking coal producer in China. Fushan currently operates three premium coal mines in Shanxi province.

Other key businesses. Apart from the steel business, SCIE is also engaged in the shipping business through Shougang Concord Shipping. The company operates 2 capesize bulkers that are on “sale and lease back” on 15-year leases each, and subsequently on time charter to third parties at forward rates for periods ranging from 3-18 months. In addition, SCIE also manufactures the steel cords used in tyres via its 36.7% equity interest in Hong Kong-listed Shougang Concord Century (SCC).

OSK Research 102 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

KEY HIGHLIGHT

STEELMAKING: Volume and value adding games moving forward

Ramping up steelmaking capacity. 2010 was a milestone for SCIE’s steel manufacturing business after two new facilities it invested in in Shouqin came into operation. The company has invested RMB500m in an ultra thick slab caster that allows it to produce slab of maximum thickness of 400mm from 300mm previously. The ticker slab not only gives the company an edge over its competitors to produce ticker steel plates but also raises its slab making capacity in Shouqin to 3.6m tpy from the existing 2.6m tpy. Meanwhile, the company also added a roughing mill to the existing hot rolling line which increased its plates rolling capacity by 600k tpy to 1.8m tpy. SCIE also operates another 900k tpy plate rolling facility via QZP, which currently relies on Shouqin for its slab supply.

Reduce exposure in ship plates. Steel plates have always been related to the shipping industry, especially since the global shipping market is booming and is seeing tremendous growth in the dry bulk side. The world’s shipbuilding industry is expanding capacity vigorously and the global fleet growing rapidly prior to the onset of the financial crisis in 2008, as newbuild vessel prices shot to the roof and vessel manufacturers did not mind paying lofty prices just to ensure a constant supply of steel plates. Nonetheless, those days are unlikely to repeat in many years to come. After the collapse of Lehman Brothers in September 2008, excess ship capacity flooded every corner of the world as many undelivered new build vessels that were supposed to enter the market in the next two to three years ended up being parked at the shores. Realising the challenges facing the shipping industry, the company has gradually switched its production focus, with a projected output of only 30% expected to be supplied to the shipbuilding industry in FY10 compared with 50% in FY08 and 35% in FY09. With many new build vessels scheduled for delivery, we expect the company to continue to supply about 30% of its plates to the shipbuilding industry. Furthermore, Hyundai Heavy Industries Co. Ltd, the world’s largest ship maker and which owns 20% equity interest in Shouqin, is also expected to place constant ship plates orders with the company.

Exhibit 2: Industry breakdown of SCIE’s heavy plate output

FY08 FY09 FY10F Shipbuilding

10% 10% 10% 30% Infrastructure 35% 20%

50% Industrial 35% 40% machinery/ petrochemical 20% 20% Others (buildings 20% and capital goods)

Source: Company Data

Raising supply to industrial machinery and petrochemical sectors. Over the years, SCIE has been gradually switching its heavy plate output to cater more to the promising industrial like machinery and petrochemical industry. The supply of steel plates to this industry has increased from 20% in FY08 to 35% in FY09 and is projected to go up to 40% of its output in FY10. The company has begun supplying steel plates to PetroChina Company Ltd for the second phase of the East-West pipeline from 2008 at an annual tonnage of about 200k tonnes. Although this contract is expected to last for five to six years from the date of commissioning, including other pipeline projects at the planning stage as we have explained in the earlier section, we understand that the profit margin for this type of contract is thin and via open tenders. The group’s steel plates are also supplied for infrastructure development and other buildings, and the capital goods industry, which have consistently consumed 20% and 10% respectively of its total steel plate production in the past few years.

OSK Research 103 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Adding value to steel plates. In order to improve the group’s competitiveness in steel plate manufacturing, SCIE has taken up 49% equity interest in Qinhuangdao Shouqin Steel Machining & Delivery Co. Ltd (QSSMD), with the remaining 51% owned by the company’s subsidiary, Shouqin. The company is principally involved in various steel plate pre-treatment and processing, including ship plate pre-treatment, subsection shipbuilding, heavy machine processing, high value added steel structures and others. The plant, located in the East section of the Economy and Technology Development Zone in Shanhaiguan District, Qinhuangdao city, covers 1165 acres and has a 500 meter seaport line that facilitates the delivery of finished goods to complete modules that are normally bulky in nature. In addition, the plant is adjacent to Shanhaiguan Shipbuilding Industry Co. Ltd, and hence enjoys logistical advantages in supplying bare and processed steel plates to this company. As the plant was only commissioned in late 2009 plus this is a relatively new business to the group, we only expect a gradual increase in earnings contribution from this unit.

Exhibit 3: Value adding process offer by QSSMD and top customer of steel plates

Source: Company Data

Volume and value adding games forward. With the days of extraordinary margins for steel plates fuelled by the booming shipping industry now over, the group’s steel plates manufacturing relies a lot on organic growth in sales tonnage. While we expect margins to pick up somewhat on the rush by shipbuilders to deliver on backlog orders, we think the quantum may be marginal. As the company’s recent plant upgrading given the company’s higher slab and plates capacity, we think the volume may increase on a gradual basis. Its venture into a steel processing centre via QSSMD is also expected to give the company an edge over its peers, and gradually improve the overall profitability of its steel division.

Exhibit 4: Snapshot of SCIE’s steel manufacturing

m tonnes QZP ‐ Plate SQ ‐ Plate SQ ‐ Slab GP margin 3.5 SQ ‐ GP Margin QZP ‐ GP Margin 30% 25% 3.0 20% 2.5 15% 2.0 10%

1.5 5% 0% 1.0 ‐5% 0.5 ‐10% 0.0 ‐15% FY07 FY08 FY09 FY10F FY11F FY12F

Source: Company Data, OSK Estimates OSK Research 104 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

MINERAL EXPLORATION: Perfectly integrated in steelmaking

Coking coal exposure via Fushan. SCIE owns a 24.4% stake in Fushan, which operates three premium coking coal mines, namely Xingwu, Jinjiazhuang and Zhaiyadi - all located in Shanxi province and which have a collective capacity of 6.3m tpy. Fushan has a sound reputation, with a key customer being Hebei Iron & Steel Group, the largest steel mill in China, and which accounts for 34% of the Group’s turnover in 1HFY10. The last reporting period also saw Fushan producing 3m tonnes of raw coking coal and enjoying a robust EBITDA margin of 59.6%. Despite the fact that its interest in Fushan does not offer direct integration into SCIE’s steelmaking operation in the outsourcing of coke supply, the selling prices of coke and coking coal are perfectly correlated, and thus offer an ideal hedge for the group.

Exhibit 5: Snapshot to Fushan’s raw and clean coking coal capacity

Mines Xingwu Jinjiazhuang Zhaiyadi Total

Type of Production Hard coking coal Hard coking coal Semi‐hard coking coal

Capacity per annum (mt) ‐ raw coking coal 2.1 2.1 2.1 6.3 ‐ clean coking coal 1.2 3.0 2.1 6.3

Reserves (mt) 43.19 40.43 47.19 130.81

Output for 2009 (mt) ‐ raw coking coal 1.683 1.912 2.594 6.189 ‐ clean coking coal 0.717 0.276 n.a. 0.993

Utilisation rate 80.1% 91.0% 123.5%

Source: Company, OSK

6.3m tpy clean coal capacity in 2011. Fushan is vigorously expanding its clean coking coal operation with the aim of strengthening its long term strategic cooperation with major steel manufacturers. This helps in developing a better client mix and laying the foundation for the company’s rapid growth. Meanwhile, Fushan owns a 1.2m tpy in coal washing capacity in Xingwu and commissioned a 3m tpy processing facility at Jinjiazhuang in 2Q09. The third coal processing facility at Zhaiyadi, with 2.1m tpy, is currently under commissioning and will make full contribution from FY11. The company aims to raise its clean coke capacity to 11m tpy after commissioning its fourth clean processing facility of 5m tpy capacity in 2HFY11.

Benefiting from tight supply of coking coal. Given the high incidence of mine accidents over the years plus government measures to clamp down on illegal and outdated capacity, a number of tough measures have been implemented over the years. We note that despite the clampdown, Fushan’s mines are relatively untouched given their decent buffer of 2.1m tonnes of raw coke capacity, which is well above the 0.4m tonnes red zone elimination. In actual fact, the consolidation of the coking plants bode well for Fushan as the closures create a temporary shortage in supply of coke. Our forecast for average selling prices of raw coal for FY10 and FY11 are HKD765 and HKD853 respectively while the ASP estimates for clean coke is HKD1,434 and HKD1,591, increasing at a rate of 5.4% and 11% y-o-y for FY10 and FY11 respectively. We understand that Fushan is aggressively looking to acquire coking coal mines, having signed a few MOUs in the past two years but which subsequently expired on technical grounds. We also do not discount the possibility of Fushan undertaking any greenfield coking coal mine exploration given its strong net cash position, which we project at HKD1.94bn by end-FY10. The company may also leverage on its solid balance sheet to undertake an attractive bond or bank financing that may avoid any form of equity financing that may dilute the equity interest of its existing shareholders. This aside, the company is also committed to allocate at least 40% of its net profit for dividend distribution.

OSK Research 105 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Exhibit 6: Financial snapshot of Fushan

HKD m FY08 FY09 FY10F FY11F FY12F

Revenue 1,896.6 4,470.1 5,136.0 6,087.4 6,151.5 EBITDA 1,200.6 2,607.5 3,257.4 3,851.4 3,883.9 Net profit 589.2 1,305.4 1,597.3 1,952.1 1,978.5 ROE (%) 5.44 8.25 9.52 10.87 10.34 ROA (%) 3.06 5.79 6.74 7.81 7.56 Net Gearing (%) 8.1 Net Cash Net Cash Net Cash Net Cash

Source: OSK estimates, Company

Local and overseas iron ore exposure. SCIE’s upstream iron ore activities stem from two main sources - a lifelong offtake agreement from Australia’s Mt. Gibson, in which Fushan owns an effective interest of 18% (refer to Exhibit 7 - corporate structure for more information). The company also owns a local mine via 68%-owned SQLH.

Exhibit 7: Summary of Mount Gibson’s mines

Tallering Peak Koolan Island Extension Hill

Ore Reserves 30.2 12.2 14.3 (mil tonnes) Capex required 20.0 n.a. 88.0 ($ mil) Production for 2010 3.1 3.3 3.0 (estimated) (mil wmt) (2009: 2.7) (2009: 2.7) (first ore shipment expected in early 2011)

Source: OSK, company

Mt. Gibson’s iron ore mines in Western Australia. Mt. Gibson, whose operations are based in Western Australia, owns and operates two hematite iron ore mines in Tallering Peak and Koolan Island, and the right to mine at Extension Hill, which is currently under development with expected commissioning in 2H11. Mt. Gibson targets to produce 10m tonnes of hematite iron ore per annum for the three mines by 2012. A lifelong offtake agreement (for the entire life of the mine) has been entered into between Mt. Gibson and SCIE, with SCIE agreeing to purchase 80% of its available production at a cost that is 10% lower than the Hamersley benchmark prices (announced by Rio Tinto on annual basis), while the remaining 20% of production will be channelled to APAC Resources. However, the company announced a revised pricing mechanism on 8 Nov 2010 stating that the spot mechanism based on Platts Iron Ore Index price would be used to better reflect price movements subsequent to the change of benchmark mechanism to a quarterly basis. Meanwhile, we have not incorporated any dividend income from Mt. Gibson to Fushan, which will in turn flow to SCIE pending the commissioning of Extension Hill, which may still require capex spending.

Exhibit 8: Financial snapshot of Mount Gibson

FYEJune FY07FY08FY09FY10 (unaudited) Revenue ($AUD mil) 162.8 432.7 410.8 539.2 Net Profit ($AUD mil) 47.8 113.3 42.6 132.4 ROE (%) 17.3 21.6 6.2 15.5 ROA (%) 11.4 14.3 4.3 11.0 EPS ($AUD) 0.08 0.14 0.05 0.12 PER (X) (historical) 29.3 21.9 19.7 12.6 Net Gearing (%) 20.6 18.4 Net cash Net cash

Source: OSK, company

OSK Research 106 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Converting local iron ore fines to pellets. Apart from Mt. Gibson supplying SCIE with high quality hematite ore that the company sells to the third parties, SQLH supplies some of its pellets directly to the group. SQLH is strategically located 25km from its steel manufacturing plants, thus saving on the transportation of iron ore. The company owns two magnetite iron ore mines with a collective capacity of 1m tpy (500,000 tonne each). SCLH also operates a 2m tpy iron ore pelletization plant that outsources the shortfall of iron ore fine supply from external parties. As the production cost of iron ore pellets is based on internal ore of around RMB700 per tonne and is expected to gradually decline to RMB600 upon achieving its design production capacity, together with our expectation of iron ore prices staying at around USD150 per tonne for the next two years, we see positive contribution by SQLH. Meanwhile, we are projecting an EBITDA of HKD197.7m for FY10, HKD262.3m for FY11 and HKD328.2m for FY12.

IRON ORE AND STEEL TRADING: Easy money with low risk

High returns, yet low risk. The company’s trading business involves mainly iron ore products as the steel tonnage transacted in the past is negligible. As we mentioned earlier, the company does not consume the iron ore purchased from the Mt. Gibson but instead sells them in the open market. With the 10% discount from Mt. Gibson, the company takes on almost no risk in its transactions as most of them are contracted on a back-to-back basis with buyers at the prevailing market prices. Together with the expected increase in supply of iron ore from Mt. Gibson upon the commissioning of Extension Hill by end-2011, we expect some 6m tpy of iron ore to be supplied to Shougang Concord Steel in 2013. Based on our iron ore price assumption of USD130 per tonne for FY10 and USD150 for FY11, we expect EBITDA of HKD476m in FY10, HKD474.5.5m for FY11 and HKD598.1m for FY12 respectively.

Exhibit 9: Mt. Gibson supply of iron ore to SCIE

m tonnes Sales tonnage 7 EBITDA margin 13.5% 6 13.0%

5 12.5%

4 12.0%

3 11.5%

2 11.0%

1 10.5%

0 10.0% FY10F FY11F FY12F FY13F FY14F FY15F

Source: Company Data, OSK Estimates

OSK Research 107 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

SHIPPING: Outlook may improve post expiry of lease

In rough waters. The company’s exposure to the shipping business is mainly to hedge against volatile charter rates as the company’s business directly and indirectly needs vessels to transport its feed material. The company operates 2 Capesize bulkers that are on “sale and lease back” on 15-year leases each, when are then time chartered to third parties at forward rates for periods ranging from 3-18 months. Although this division contributed to a bumper EBITDA of HKD323.8m in FY08, we expect a challenging environment in the next two years as we are only projecting a BDI Index of 2,250 pts for FY11 and FY12. Meanwhile, we are projecting an EBITDA of HKD50.2m for FY10 based on the average BDI Index of 2,850 pts, HKD20.3m for FY11 and a loss of HKD1.8m for FY12. The loss at EBITDA level for FY12 will be on the back of a one-off maintenance cost expected upon the company re-purchasing the two vessels at the end of the lease period at a token sum. We expect the shipping division to return to profit after the company fully owns the ship in FY13 as it will have a remaining useful life of around 10 years.

STEEL TYRE CORD: Riding on China’s automotive boom

Room to grow in the automotive space. SCC has two main business segments - steel cord manufacturing for radial tyres and the sales, processing and trading of copper and brass products. The steel cord manufacturing plants are located in Jiaxing City (Zhejiang Province) and Tengzhou City (Shandong Province), through its operational arms Jiangxing Eastern Steel Cord (JESC) and Tengzhou Eastern Steel Cord (TESC), which commissioned the first phase of its plant in late 2009. TESC aims to have an annual production capacity of 100,000 tpy from FY11 to complementing its existing capacity at JESC, pushing up capacity to 60,000 tpy. SCC’s management has set a production capacity target of more than 160,000 by 2012 on anticipation of strong demand growth from autos, which is in line with our view that the automotive sector will continue to boom given the low levels of vehicle per capita in China, which is experiencing robust GDP growth. We expect SCIE’s share of profit to amount to HKD66.5m in FY10, HKD103m for FY11 and HKD126.2m for FY12 respectively, based on the equity interest of 36.7%.

Exhibit 10: Financial snapshot and planned production expansion of SCC

HKD’000 FYE 2007 FYE 2008 FYE 2009 Revenue 704,716 831,640 1,099,272 Gross profit 92,237 70,882 180,495 EBITDA 184,897 110,666 282,979 Tonnes FY09 FY10F FY11E FY12E Profit for the year 105,762 34,762 171,314 JESC 60,000 60,000 60,000 60,000 Earnings per Share (basic) (HK 8.22 1.87 9.03 TESC 0 30,000 100,000 100,000 cents) Capacity 60,000 90,000 160,000 160,000 Net gearing Net cash Net cash 22.0% ROE (%) 9.0 2.1 8.8 Net book value per Share (HK$) 1.08 0.98 1.08

Source: OSK estimates, company

OSK Research 108 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

FINANCIAL REVIEW

Quick review of past financial performance. FY09 was without doubt a challenging year for SCIE, whose revenue fell 35% y-o-y to HKD11.4bn, registering a core loss of HKD1.01bn after stripping off an exceptional gain mainly from its divestment of Mt. Gibson in exchange for equity interest in Fushan, which was completed that year. The steel manufacturing business, which contributes to 75% of SCIE’s revenue, was the main reason for the loss as the collapse in the shipbuilding market caused ASP and demand for steel plates to plummet. Encouraging improvements in SCIE’s business segments were seen in 1HFY10 as turnover increased by 24% to HKD6.9bn from the same period in the preceding year. The recovery in earnings momentum in its bottomline saw its return to profit with HKD434m in 1H10. Nonetheless, the steel manufacturing side still incurred losses although at a lower HKD103m compared with HKD800m in 2009.

Exhibit 11: SCIE’s Revenue and PAT breakdown (1H2010)

HKD m FY09 1H10 400 243.9 141.2 13.8% Steel 200 114.4 116.1 manufacturing 28.8 35.8 6.0 0 ‐61.4 Shipping ‐200 ‐102.6 operations ‐400 21.1% ‐600 Steel and iron ‐800 ore trading 63.5% ‐1,000 1.7% ‐1,200 Mineral ‐1,183.7 exploration ‐1,400 Steel Shipping Steel and iron Mineral Others manufacturing operations ore trading exploration

Source: Company, OSK

Exhibit 12: Financial performance of SCIE

RMB m Revenue (lhs) RMB m 25,000 Core PAT (rhs) 2,000

1,500 20,000 1,000

15,000 500

10,000 0 ‐500 5,000 ‐1,000

0 ‐1,500 FY05 FY06 FY07 FY08 FY09 FY10F FY11F FY12F

Source: Company Data, OSK

OSK Research 109 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Upstream investment begins to pay off. While we have expected steel manufacturing business continue to be exigent with SCIE’s exposure only to the steel plates market and its heydays are over at least for some years, we see gradual improvement in the next few years. The still heavy scheduled delivery of the backlog in ship new builds, the recent addition of a ticker slab caster and roughing mill plus its venture into a downstream value adding steel plate processing centre, will together bring about improved profitability for this division. Also, from its timely investment in Mt. Gibson’s rights issue during the onset of the Financial Crisis at the end of 2008, both parties signed a lifetime off-take agreement for the entire life of Mount Gibson’s three iron ore mines; which will start to contribute handsome profits from supply that is priced at 10% below that in the spot market. The full operation of the iron ore mine with the pelletization plant of 76%-owned SQLH will also beef up the group’s bottomline. Apart from that, the associate investment in Fushan and SCC may also be ripe for significant contribution as it rides on tight coking coal supply and China’s booming automotive market respectively. Overall, we expect more diversified earnings to start making its way into SCIE’s accounts and project a net profit of HKD709.2m for FY10, HKD1.04bn for FY11 and finally to HKD1.26bn in FY12.

30% - 40% dividend payout. The board has committed to resume a dividend payout of 30% to 40% of earnings after skipping it dividend distribution in FY09 owing to a core operating loss of RM1bn. We are incorporating a lower payout range committed by the management of 30%, from which we derive a satisfactory dividend HKD0.026 for FY10, HKD0.038 for FY11 and HKD0.046 for FY12.

OSK Research 110 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

VALUATION AND RECOMMENDATION

SCIE trading at below mean P/B. From our P/B ratio analysis, we find that SCIE is trading at below the mean of its historical trading band. We suspect that the stock is mispriced, especially since its upstream integration efforts are beginning to pay off and the company expects to return to double digit ROEs in FY11. Meanwhile, the company is trading at 1.1x of the leading P/B valuation compared to its mean of 1.3x. We think the market has continued to perceive SCIE as a pure steel plate manufacturer for which the market outlook is not favorable and thus avoided investing in its shares.

Exhibit 13: SCIE’s PE, PB and ROE Leading PB & ROE Leading PER(x) (x) ROE (%) (x) Leading P/E 4.5 30 20.0 +1 STD Leading P/B 18.0 MEAN 4.0 +1 STD 25 16.0 ‐1 STD 3.5 MEAN 20 ‐1 STD 14.0 3.0 15 ROE 12.0 2.5 10 10.0 2.0 5 8.0 1.5 0 6.0 4.0 1.0 ‐5 2.0 0.5 ‐10 0.0 0.0 ‐15 10 09 08 07 06 05 10 10 10 09 09 09 08 08 08 07 07 07 06 06 06 05 05 05 10 10 09 09 08 08 07 07 06 06 05 05 ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ ‐ Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep May May May May May May May May May May May May

Source: Company Data, OSK Estimates

Cheaper exposure to Fushan. While the company is trading between mean and +1 standard deviation on the leading PER band, we take a quick look on how it is being valued based on sum of parts methodology. Already, its associate stakes in Fushan and SCC are worth HKD7.6bn, which implies that investors are only valuing SCIE’s other businesses comprising steel plate manufacturing, iron ore exploration and trading as well as its shipping business, at a mere HKD1.97bn, or 4.3x FY11 earnings.

Exhibit 14: SOP’s valuation of SCIE

Implied Sum of Parts Valuation

Current Price Market Cap. Value Value Name of Listed Company (HKD) Effective Stake (%) (HKDm) (HKDm) (HKD/Share) Fushan International Energy Group Ltd (639.HK) 5.360 24.4% 28839.8 7047.7 0.862 Shougang Concord Century (103.HK) 0.880 36.7% 1691.2 621.2 0.076 Total market capitalisation 7668.9 0.938

FY11 Net Profit Implied PER Value Value Other Entities (HKDm) (x) (HKDm) (HKD/Share) Steel plate manufacturing, iron ore trading and shipping (core) 461.3 4.3 1978.1 0.24

Total Sum of the Parts (SOP) of SCIE 1.180 100.0% 9646.9 9646.9 1.180

Source: Company Data, OSK Estimates

Initiate with BUY. The combination of a cheap valuation and brighter outlook for the upstream operation prompt us to initiate coverage on SCIE with a BUY rating. We think that the recent market- wide correction in the global equity market including Hong Kong Stock Exchange in view of rising tension between South and North Korea, worries over Ireland potentially asking for another bailout, plus possible further tightening measures by the Chinese government, have given rise to an opportunity for investors to accumulate the stock at an attractive level. We value SCIE at HKD1.80 based on 10x PER and 2x BV/share, or +1 standard deviation of its historical trading band benchmarking FY11 numbers.

OSK Research 111 See important disclosures at the end of this report OSK Research China’s Steel Sector Initiation December 2, 2010

Financial Summary (FYE 31 Dec) Valuation and Growth Financial Ratios 2008A 2009A 2010F 2011F 2012F 2008A 2009A 2010F 2011F 2012F Valuation Ratios Profitability Ratios PER (Basic) (x) 4.9 n.m. 13.6 9.3 7.6 Gross margin 18.7 -3.8 10.3 10.7 11.0 Dividend yield 4.2 0.0 2.2 3.2 3.9 EBITDA margin 18.3 -4.4 10.0 10.4 10.7 P/BV (x) 1.0 1.0 1.1 1.0 0.9 Core net margin 9.9 -8.9 4.6 5.6 6.1 Growth ROA (Core) 9.2 -4.5 2.9 4.1 4.9 Revenue (%) 53.1 -35.0 36.2 20.3 12.0 ROE (Core) 24.0 -12.5 8.0 11.0 12.3 EBITDA (%) 34.2 -115.7 408.3 24.8 15.2 Balance Sheet Ratios Core Net profit (%) 32.9 -158.5 170.2 46.8 21.6 Current ratio 1.3 0.5 0.6 0.7 0.7 Gross debt/equity 1.0 1.2 1.2 1.1 0.9 Per Share Data Net debt/equity 0.4 1.0 1.1 0.9 0.8 (RMB) 2008A 2009A 2010F 2011F 2012F Inventory Days 48.5 50.2 38.8 38.8 38.8 EPS (Basic) 0.241 -0.124 0.087 0.127 0.155 Receivable Days 19.2 25.2 32.2 32.2 32.2 DPS 0.050 0.000 0.026 0.038 0.046 Payable Days 35.3 36.1 16.6 16.6 16.6 Payout ratio 25.3 0.0 30.0 30.0 30.0 BV/S 1.05 1.05 1.11 1.20 1.31 Balance Sheet (RMBm) 2008A 2009A 2010F 2011F 2012F Income Statement Fixed Asset (RMBm) 2008A 2009A 2010F 2011F 2012F Property, plant & equipments 9,078.4 10,251.8 11,026.3 10,504.6 9,969.7 Total revenue 17,464.7 11,357.6 15,473.2 18,609.0 20,843.3 Intangible assets 394.9 342.2 342.2 342.2 342.2 Cost of sales -14,201.7 -11,784.4 -13,882.4 -16,626.2 -18,560.6 Investment 1,047.4 6,475.0 6,762.4 7,131.0 7,522.1 Gross profit 3,263.0 -426.8 1,590.8 1,982.8 2,282.7 Others 644.4 1,413.1 1,413.1 1,413.1 1,413.1 Other operating income 102.7 47.5 30.9 37.2 41.7 Total fixed assets 11,165.2 18,482.2 19,544.0 19,391.0 19,247.2 Unallocated corporate expenses -174.2 -121.5 -77.4 -93.0 -104.2 Current Asset EBITDA 3,191.5 -500.9 1,544.3 1,927.0 2,220.2 Cash and cash equivalents 3,383.0 1,372.3 493.2 839.3 871.4 Depreciation & amortisation -546.2 -669.1 -725.5 -771.7 -784.9 Restricted bank deposit 650.6 280.8 280.8 280.8 280.8 Finance costs -448.7 -392.9 -474.2 -525.5 -539.5 Inventories 1,886.3 1,619.7 1,474.7 1,766.1 1,971.6 Profit before EI 2,196.6 -1,562.9 344.6 629.8 895.8 Trade receivables 920.1 783.9 1,366.3 1,643.2 1,840.5 Exceptional item -308.5 1,082.4 0.0 0.0 0.0 Others 3,022.8 1,707.9 1,785.0 1,869.2 1,929.1 Associate -22.4 402.0 456.8 580.1 609.7 Total current assets 9,862.7 5,764.6 5,400.0 6,398.7 6,893.5 Pre-tax profit 1,865.6 -78.4 801.4 1,209.9 1,505.5 Current Liabilities Taxation -39.0 -142.5 -15.4 -28.1 -40.0 Trade payables 1,373.6 1,165.5 630.6 755.2 843.1 Minority interests -407.2 292.6 -76.8 -140.4 -199.7 Short-term loans 3,141.7 6,010.2 5,710.2 5,410.2 4,910.2 Net profit 1,419.5 71.7 709.2 1,041.4 1,265.8 Taxation 33.4 184.7 184.7 184.7 184.7 Core Net Profit 1,728.0 -1,010.8 709.2 1,041.4 1,265.8 Others 3,229.6 3,198.3 3,057.2 3,308.8 3,486.2 Total current liabilities 7,778.2 10,558.7 9,582.7 9,659.0 9,424.2 Cashflow Statement Long-Term Liabilities (RMBm) 2008A 2009A 2010F 2011F 2012F Borrowings 4,138.2 3,898.9 4,998.9 4,898.9 4,398.9 Operating Cashflow Deferred tax liabilities 50.1 48.3 48.3 48.3 48.3 Pre-tax profit 1,872.1 -78.4 801.4 1,209.9 1,505.5 Others 0.0 0.0 0.0 0.0 0.0 Depreciation & amortisation 547.8 662.2 725.5 771.7 784.9 Total long term liabilities 4,188.3 3,947.2 5,047.2 4,947.2 4,447.2 Others 374.8 -1,295.3 -487.8 -617.3 -651.4 Shareholders' funds Change in working capital -2,054.4 968.1 -1,190.5 -276.3 -197.5 Share Capital 1,435.1 1,635.1 1,635.1 1,635.1 1,635.1 Tax paid -21.9 -30.4 -15.4 -28.1 -40.0 Reserves 6,128.8 6,946.2 7,442.6 8,171.6 9,057.6 Total operating cashflow 718.4 226.1 -166.7 1,059.9 1,401.5 Equity attributable to owner 7,563.8 8,581.2 9,077.7 9,806.7 10,692.7 Investing Cashflow Minority Interests 1,497.5 1,159.6 1,236.4 1,376.8 1,576.5 Capex -1,803.4 -2,232.6 -1,500.0 -250.0 -250.0 Investments 20.6 -2,537.1 0.0 0.0 0.0 Others -890.6 335.1 200.4 248.6 260.3 Total investing cashflow -2,673.4 -4,434.6 -1,299.6 -1.4 10.3 Financing Cashflow Equity raised 105.4 0.0 0.0 0.0 0.0 Debt raised / paid 2,681.3 2,480.1 800.0 -400.0 -1,000.0 Dividend paid -727.0 -297.2 -212.8 -312.4 -379.7 Others -35.3 7.0 -0.1 0.0 0.0 Total financing cashflow 2,024.4 2,189.9 587.1 -712.4 -1,379.7 Net cash inflow / (outflow) 69.4 -2,018.6 -879.2 346.1 32.1 Cash - beg 3,256.8 3,383.0 1,372.4 493.2 839.3 Others 56.8 8.0 0.0 0.0 0.0 Cash - end 3,383.0 1,372.4 493.2 839.3 871.4 Source: Company data, OSK Estimates

OSK Research 112 See important disclosures at the end of this report OSK Research December 2, 2010

OSK Research Guide to Investment Ratings

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

Disclaimer

This report is published by OSK Securities Hong Kong Limited (“OSKSHK”), a subsidiary of OSK Investment Bank Berhad (“OSKIB”). The research is based on information obtained from sources believed to be reliable, but we do not make any representation or warranty as to its accuracy, completeness or correctness. Opinions expressed are subject to change without notice. This report is prepared for internal circulation. Any recommendation contained in this report does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee. This report is for the information of addresses only and is not to be taken in substitution for the exercise of judgment by addressees, who should obtain separate legal or financial advice. OSKSHK and OSKIB accept no liability whatsoever for any direct or consequential loss arising from any use of this report or further communication given in relation to this report. This report is not to be construed as an offer or a solicitation of an offer to buy or sell any securities. This report is for the use of intended recipients only and may not be reproduced, distributed or published for any purpose without prior consent of OSKSHK.

OSKSHK, OSKIB and their associates, their directors, and/or employees may have positions in, and may effect transactions in securities mentioned herein and may also perform or seek to perform broking, investment banking and other services for the company covered in this report. OSKSHK, OSKIB and/or other affiliates may beneficially own a total of 1% or more of any class of common equity securities of the subject company. OSKSHK, OSKIB and/or other affiliates may, within the past 12 months, have received compensation and/or within the next 3 months seek to obtain compensation for investment banking services from the subject company.

Risk Disclosure Statements

The prices of securities fluctuate, sometimes dramatically. The price of a security may move up or down, and may become valueless. It is as likely that losses will be incurred rather than profit made as a result of buying and selling securities. Growth Enterprise Market (“GEM”) stocks involve a high investment risk. In particular, companies may list on GEM with neither a track record of profitability nor any obligation to forecast future profitability. GEM stocks may be very volatile and illiquid. You should make the decision to invest only after due and careful consideration. The greater risk profile and other characteristics of GEM mean that it is a market more suited to professional and other sophisticated investors. You should seek independent professional advice if you are uncertain of or have not understood the nature and risks involved in trading of GEM stocks.

All Rights Reserved. Published and printed by :

OSK SECURITIES HONG KONG LIMITED (A subsidiary of OSK Investment Bank Berhad, Malaysia)

Kuala Lumpur Hong Kong Singapore Jakarta Shanghai

Malaysia Research Office Hong Kong Office Singapore Office Jakarta Office Shanghai Office OSK Research Sdn. Bhd. OSK Securities DMG & Partners PT OSK Nusadana OSK (China) Investment 6th Floor, Plaza OSK Hong Kong Ltd. Securities Pte. Ltd. Securities Indonesia Advisory Co., Ltd. Jalan Ampang 1201-1203, 12/F, #22-01 Ocean Towers Plaza Lippo, 4th Floor, Room 6506, Plaza 66 50450 Kuala Lumpur World-Wide House 20 Raffles Place JI. Jend. Sudirman Kav. 25. No. 1266 West Nanjing Road Malaysia 19 Des Voeux Road Singapore 048620 Jakarta 12920 Shanghai 200040 Tel : +(60) 3 9207 7688 Central, Hong Kong Tel : +(65) 6438 8810 Indonesia China Fax : +(60) 3 2175 3202 Tel: +(852) 2525 1118 Fax: +(65) 65354809 Tel: +(6221) 520 4599 Tel: +(8621) 6288 9611 Fax: +(852) 2537 1332 Fax: +(6221) 520 4505 Fax: +(8621) 6288 9633