CORPORATES SECTOR IN-DEPTH Steelmakers - China 27 March 2017 Softening Demand, Increased Inventory Will Weigh on Prices and Reduce 2017 Earnings TABLE OF CONTENTS Chinese steel companies’ earnings will likely weaken in 2017 after substantial Chinese steel companies’ earnings improvement in 2016. The decline will result primarily from a slight weakening of domestic will likely weaken in 2017 after substantial improvement in 2016 2 demand amid continued excess capacity and a build-up of steel inventory in early 2017. Domestic steel demand will decline 4 These factors will depress steel prices, which have reached a four-year high. Elevated raw Declining steel exports will worsen material prices and reduced exports will also weigh on steel producers' earnings. domestic oversupply and weigh on prices 6 Domestic steel demand will decline. Property investment, the largest driver of Chinese Capacity reduction will continue but steel demand, will likely slow this year following the government's tightening of policy in encounter hurdles 7 an effort to curb property-price growth. Auto sales, and subsequently production, will also SOE reform and tight credit environment will continue to drive slow owing to a reduced tax break on small-vehicle sales. These pressures will be lessened by steel consolidation 8 government-led infrastructure investment, which will remain robust. Moody's Related Research 10 Declining steel exports will worsen oversupply and weigh on prices. We expect steel exports to decline by a high-single-digit percentage this year, following a 3.5% decrease in Contacts 2016. The decline will be driven by increased trade barriers outside China and a narrowing Jiming Zou 86-21-2057-4018 price gap between the domestic and international markets, which makes exports less Vice President - Senior attractive. Analyst [email protected] Capacity reduction will continue but encounter hurdles. The Chinese government's Danny Chan 86-21-2057-4033 target to reduce the country’s steel-production capacity by 50 million tonnes in 2017, if Associate Analyst achieved, should temper the downward pressure on steel prices and earnings. However, the [email protected] capacity-reduction effort will face hurdles that could slow the pace of reduction, such as the Chris Park 852-3758-1366 steel sector's improved profitability and the impact of the closures on the steel-producing Associate Managing Director regions' economies and employment. [email protected] SOE reform and tight credit environment will continue to drive steel consolidation. Gary Lau 852-3758-1377 The Chinese government's ongoing efforts to increase the efficiency and profitability of state- MD-Corporate Finance [email protected] owned enterprises (SOEs) will encourage large steel SOEs to merge with each other and acquire smaller competitors, and lead to the closure of weaker producers. We expect large steel SOEs to improve their reported financials by renegotiating terms and conditions of their existing liabilities or carrying out debt-to-equity swaps as a part of the SOE reforms. Stringent lending requirements will also make it difficult for struggling producers to continue operating. Consolidation will increase the large companies' market share. MOODY'S INVESTORS SERVICE CORPORATES Chinese steel companies’ earnings will likely weaken in 2017 after substantial improvement in 2016 We expect Chinese steelmakers' earnings to be lower this year than in 2016 (Exhibit 1) because steel prices will decline due to a slight weakening of domestic demand amid continued excess capacity and increased steel inventory. Elevated raw material prices and reduced exports will also weigh on earnings. The potential for further cost reductions appears limited following substantial restructurings at many steel companies during 2014-16. Exhibit 1 Chinese Steel Companies' Earnings Will Likely Decline in 2017 Following Strong Recovery in 2016 Aggregate pre-tax profit of large and mid-size steel producers in China Sources: China Iron & Steel Association, Moody's Investors Service estimate for 2017 Chinese steelmakers' earnings increased significantly in 2016 owing to a jump in steel prices resulting from a slight increase in demand and substantial cut in production capacity during the year. Large and mid-size Chinese steel companies recorded a total RMB30 billion of pre-tax profit in 2016 versus RMB64.5 billion of losses in 2015, according to the China Iron & Steel Association. Those losses resulted from a sharp decline in steel prices amid weak demand and oversupply. But it will be difficult for steel companies to sustain throughout 2017 the strong earnings they generated in 2016 and so far this year. This is because the recent increase in steel prices - prices nearly doubled during the past 14 months and reached a four-year high in early 2017 (Exhibit 2) - caused steelmakers to continue producing and distributors to build up inventory (Exhibit 3). Prices will decline from this high level as demand weakens and de-stocking takes place. In addition, we believe the price increase has been driven partly by a significant amount of futures trading activity which, unlike demand, is volatile and often unsustainable. The anticipated moderation in domestic credit supply in 2017 will potentially tame speculative steel futures trading and drive prices back to the level reflecting the actual demand and supply balance. This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history. 2 27 March 2017 Steelmakers - China: Softening Demand, Increased Inventory Will Weigh on Prices and Reduce 2017 Earnings MOODY'S INVESTORS SERVICE CORPORATES Exhibit 2 Steel Price Will Decline from Four-Year High Hit in Early 2017 China hot rolled steel sheet spot price Sources: Bloomberg, Moody's Investors Service estimate for 2017 Exhibit 3 Steel Inventory Build-Up in Early 2017 Will Pressure Steel Prices LGMI Social Steel Stock Index 250 200 150 100 50 0 2012-03-01 2012-09-01 2013-03-01 2013-09-01 2014-03-01 2014-09-01 2015-03-01 2015-09-01 2016-03-01 2016-09-01 2017-03-01 Source: LangeSteel Elevated raw material prices will also eat into steelmakers' earnings this year. Prices for major raw materials used in steel production, such as iron ore and foundry coke, increased by almost 90% and 130%, respectively, from 1 March 2016 to 1 March 2017 (Exhibit 4), although the foundry coke price has fallen since December 2016. Additionally, Chinese steel companies' bargaining power against major overseas iron-ore suppliers is weak. The fragmented nature of China's steel industry means no producer has meaningful bargaining power. 3 27 March 2017 Steelmakers - China: Softening Demand, Increased Inventory Will Weigh on Prices and Reduce 2017 Earnings MOODY'S INVESTORS SERVICE CORPORATES Exhibit 4 Elevated Prices of Iron Ore and Coke Will Also Weigh on Steelmakers' Earnings Source: Bloomberg Domestic steel demand will decline We expect steel demand growth in China to turn negative in 2017 as the domestic property and automotive sectors begin to slow, and despite robust infrastructure investments. Steel demand in China has generally been declining since 2014 as the government shifts economic growth drivers to domestic consumption and services from exports and government-led infrastructure investment. But apparent steel demand (total output less net exports) rose 2.3% in 2016 after declining 5.8% in 2015, based on our calculations using data from China’s Iron & Steel Association and General Administration of Customs (Exhibit 5). Last year's growth came partly from policy support, including accommodative real estate policies during the first nine months of the year, tax incentives for light- vehicle purchases and ample credit supply. These supports are receding, however. Exhibit 5 Steel Demand Will Decline Slightly in 2017 After Rising in 2016 Sources: China Iron & Steel Association, China's General Administration of Customs, Moody’s Investors Service estimate for 2017 Property development, which represents 30%-40% of Chinese steel demand, according to China's Iron & Steel Association, will likely slow in 2017 because the government has tightened policies in an effort to cool real estate prices and curb investments by speculative buyers. The government has introduced more restrictive policies since September and October 2016, such as higher down-payment requirements, additional purchase restrictions for home buyers and constraints on debt issuance by property developers. We forecast that nationwide contracted sales in 2017 will be largely flat or decline slightly following 36.2% growth in 2016 (Exhibit 6, also refer to China Property Focus). The weakness in contracted sales will slow property investment and reduce steel demand. 4 27 March 2017 Steelmakers - China: Softening Demand, Increased Inventory Will Weigh on Prices and Reduce 2017 Earnings MOODY'S INVESTORS SERVICE CORPORATES Exhibit 6 Chinese Residential Property Sales Growth (3-Month Moving Average) Will Moderate Further in 2017 Source: National Bureau of Statistics of China We expect auto-sales growth in 2017 to be lower than the 13.7% in 2016 (Exhibit 7, also refer to Global Automotive Outlook), because the government reduced a tax incentive. The tax rate on purchases of passenger vehicles with engines that are 1.6 liters and smaller climbed to 7.5% at the start of this year from 5% in 2016, but remains below the 10% normal rate. Sales growth slowed to 8.8% in the first two months of 2017, according to the China Association of Automobile Manufacturers. We estimate the automotive sector represents about 8% of Chinese steel demand. Exhibit 7 Automotive Sales in China Will Slow in 2017 Due to Reduced Tax Break on Small-Car Purchases 35.00% 32.45% 30.00% 25.00% 20.00% 15.00% 13.94% 13.74% 10.00% 6.80% 5.00% 4.15% 4.57% 2.72% 0.00% 2010 2011 2012 2013 2014 2015 2016 2017e Sources: China Association of Automobile Manufacturers, Moody's Investors Service estimate for 2017 China’s official Purchasing Managers' Index was 51.6 in February, indicating an increase in manufacturing.