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.