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Morningstar | Baosteel’s 2018 In Line, but 1Q Was Below Expectations; Cutting FVE to CNY 6.90

After rolling our model forward and updating our commodities and foreign exchange forecasts to factor in higher iron ore prices, we are lowering our fair value estimate for Baosteel to CNY 6.90 from CNY 7.20. Our no-moat and stable moat trend ratings remain intact. We think Baosteel is slightly overvalued, as we believe the steel industry is highly commoditized and will continue to suffer from overcapacity issues in the long run. The company reported both its full-year 2018 and first-quarter 2019 performance together, and the weakening trend is notable from the fourth quarter of 2018 on softer auto-related demand and the rising iron ore costs. We assume operating margin hovers around 5% over the next five years, a decline from the 9% of the past two years.

Baosteel’s 2018 net profit increased by 12.5% year over year to CNY 21.6 billion, slightly above the preliminary net profit of between CNY 20.7 billion and CNY 21.5 billion. Management attributed the year-over-year increase in profitability for the full year to the wider steel spread as a result of capacities shut down in China, improving product mix, cost-cutting and restructuring measures, and synergies from the merger with Wuhan Iron and Steel. For fourth-quarter 2018, Baosteel’s net profit came in at CNY 5.8 billion, which was a 22% year-over-year decline from CNY 7.5 billion during the same period last year. This decline in net profit could be due to the slowdown in the China auto and consumer white goods sectors (weakness in the auto sector was flagged by management during the third-quarter 2018 results) and year-over-year decline in steel prices. For first-quarter 2019, net profit declined by 45% year over year to CNY 2.8 billion from CNY 5 billion during the same period last year. The is mainly due to the continued weakness in the auto sector and high iron ore prices due to supply disruptions caused by an accident at Vale’s mine in Brazil and a cyclone in Australia.

Steel production remained strong in the fourth quarter of 2018 and first quarter of 2019 as winter production curtailment is decided and imposed by local governments, which is different from fourth-quarter 2017 and first-quarter 2018, when there was a blanket curtailment on selected cities. This, together with weaker steel end demand, resulted in lower steel prices in fourth-quarter 2018 and first-quarter 2019. Demand has been picking up gradually after the Chinese New Year in February 2019, and there was a lag before Baosteel started to increase the steel prices by around CNY 50 per metric ton in March 2019 and by a larger magnitude of around CNY 200-400 per ton in April 2019 while keeping it largely flat in May 2019. This lag in increasing its steel prices in an environment where iron ore prices remained high, resulted in steel margins being pressured in first-quarter 2019. We expect this to improve slightly in the second quarter after the steel price increase in April 2019, but the current high iron ore prices would mean that a larger increase in steel prices is needed for Baosteel to achieve similar steel margins as last year. Hence, we expect its steel margins to remain under pressure in the near term.

In terms of steel demand for 2019, management now expects that the decline in demand from the auto sector could be more moderate than previously expected because of the value-added tax cut introduced on April 1, 2019. Meanwhile, management continues to expect strong demand from the consumer goods, capital equipment, and the oil and gas sectors. However, because of the increase in iron ore prices, management expects steel margins to decline year over year in 2019.

Nonetheless, our bearish long-term view for the steel sector remains intact. We think China is shifting toward producing steel from electric arc furnaces using steel scrap rather than the traditional blast furnace, which uses iron ore and coking coal. We continue to believe that new electric arc furnaces can be built to offset shuttered capacity, helped by an increase in availability of steel scrap in China, and drive ongoing overcapacity issues in China.