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

Baosteel is one of the best Chinese steel companies in what is arguably the poorest industry. Its differentiated product portfolio and efficient production facilities have crowned it as one of the most profitable Chinese steel producers. Its exposure to the auto and consumer goods sectors has also resulted in less cyclicality compared with steel producers with high exposure to the construction sector. However, the steel industry remains fragmented and is affected by overcapacity issues, especially in China, resulting in steelmakers being price-takers. Currently, the Chinese steel industry is undergoing consolidation and capacity closures, as required by the Chinese government. A total of 115 million tons of capacity (mainly substandard steel, or ditiaogang) was shut down in 2016 and 2017. However, the actual impact on production could be less, as some of this capacity is either not producing or producing at a low utilization rate. In our view, new electric arc furnaces could be built to replace some of this lost capacity, resulting in ongoing overcapacity issues in China.Baosteel is taking part in the consolidation of the steel industry in China through a merger with Wuhan Iron and Steel. This was completed on March 1, 2017, and Baosteel emerged as the listed entity of the largest steel company in China and the second largest in the world, by capacity. We see potential synergies from the merger, as both companies have similar end markets, especially in the automotive and grain-oriented electrical steel sectors in China. This enlarged entity controls more than 60% of the domestic China cold-rolled automotive sheet market and 80% of the China grain-oriented electrical steel market.We expect the company to be able to improve its profitability in the future as it focuses more on high-strength steel for the automotive sector and reaps the benefits from its integration with Wuhan Iron and Steel. The long-term relationships with key customers in the automotive sector should help the company defend its 60%-plus share in the cold-rolled automotive sheet market in China, in our view.