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Morningstar | Baosteel’s 1H18 Beat Expectations as the Steel Market Remains Tight; Shares Fairly Valued at CNY 8. See Updated Analyst Note from 28 Aug 2018

Baosteel’s first-half 2018 operating profit increased by 39% year over year to CNY 14.2 billion from CNY 10.2 billion during the year-ago period on a strong performance at its steel division as it continues to benefit from cost-cutting and the synergies from its merger with Wuhan Iron and Steel. This implies that second-quarter 2018 operating profit nearly doubled to CNY 7.1 billion from CNY 3.6 billion a year ago. On the bottom line, second-quarter 2018 net income increased by 109% year over year to CNY 5.0 billion from CNY 2.4 billion during the year-ago period. The higher net income was due to higher income from fair value changes of financial instruments, which was partly offset by (1) higher financial expenses on foreign exchange losses due to the depreciation of the Chinese yuan; and (2) a higher tax rate, as it does not have any tax credit to utilize in the second quarter. Our CNY 8 fair value estimate for Baosteel is intact, along with our no-moat and stable moat trend ratings. The ongoing supply-side reform, which started in 2016, and the strong steel demand in China this year have resulted in a tighter steel market and higher profitability for the steel industry. We think Baosteel is currently fairly valued, as we believe that the market has priced in the near-term positives of a tight steel market and long-term uncertainties due to the overcapacity issues in the steel industry.

Recently, Hebei Province’s Tangshan City announced that it will lower the allowed utilization rate of blast furnaces by 50% starting from Sept. 1, which is one month earlier than the winter production curtailment season in 2017, or two and a half months earlier than the central government’s mandated Nov. 15 start date. We expect there could be more news flow on this winter production curtailment to come in the next few weeks. We expect this curtailment, which should last until mid-March 2019, to support steel prices for the rest of 2018. We think Baosteel, which is not affected by the production curtailment as it has no plants in affected areas, could increase its market share during this period.

In terms of steel demand, management expects demand from the automotive sector to continue growing in second-half 2018, albeit at a slower pace. Management also expects growth in the consumer white goods, shipbuilding, capital equipment, and oil and gas industries. On the flip side, management expects some weakness in demand from the infrastructure industry. Baosteel announced that it expects to spend CNY 18.9 billion from now until 2021 to build blast furnace number 3 (with 3.6 million tonnes of crude steel capacity) at its Zhanjiang plant via its capacity swap plan.

Our bearish long-term view for the steel sector is intact. Although a total of 115 million tons of capacity has been shut down in 2016 and 2017, the actual impact on production could be less, as some of this capacity was either not producing or producing at a low utilization rate. In 2018, only around 30 million tons of capacity is expected to be shut down. However, the net impact on steel capacity in China is expected to be muted, as around 15 million-20 million tons of electric arc furnace capacity are expected to be added. Based on the new policy on building new steel production capacity to replace obsolete facilities that was announced in January, we see that the Chinese government is promoting electric arc furnaces as opposed to blast furnaces. For every 1.25 tons of old capacity closed, only 1 ton of new capacity can be built if it is going to be a blast furnace. However, if old capacity is being replaced with new electric arc furnaces, the ratio is 1:1. This supports our view that China is shifting towards producing steel from electric arc furnaces using steel scrap rather than the traditional blast furnace, which uses iron ore and coking coal. We still believe that new electric arc furnaces can be built in the future to offset shuttered capacity, helped by an increase in availability of steel scrap in China, and this will drive ongoing overcapacity issues in China.