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Morningstar | Baosteel's 3Q Results Largely in Line as Steel Market Remains Tight; Fairly Valued at CNY 7.20

Baosteel's third quarter was largely in line with our expectations, with operating profit increasing 29% to CNY 7.8 billion from CNY 6.1 billion in the same period last year on strong performance at the steel division, as it continues to benefit from cost-cutting measures and the synergies from its merger with Wuhan Iron and Steel. However, third-quarter net income growth lagged, increasing only 4% year over year to CNY 5.7 billion from CNY 5.5 billion. This was mainly due to lower investment income, a higher tax rate, and financial expenses. Management noted that third-quarter steel demand was supported by improving demand from machinery, shipbuilding, and the real estate construction sectors but mitigated by a slowdown in demand from the infrastructure, auto, and consumer white goods sectors.

We lowered our fair value estimate to CNY 7.20 per share from CNY 7.40 after factoring in our latest foreign exchange assumptions and commodities price deck, where we increased raw material prices in the near term. Our no-moat and stable moat trend ratings are intact. The ongoing supply-side reform that started in 2016 and the strong steel demand in China this year 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 while long-term uncertainties due to the overcapacity issues in the steel industry remain.

Although the winter production curtailment this year is decided and imposed by local governments, which is different from last year where there was a blanket curtailment on selected cities, we do not think this will necessarily result in less production curtailment being imposed. For instance, Hebei province’s Tangshan city has categorized its steel mills into four groups according to their pollution control efforts and varied the degrees of cuts from 70% to zero accordingly. This is a way to penalize those steel mills that are unwilling to make extra efforts in reducing pollutant emissions while rewarding those that have put in extra effort to install environmental protection facilities. We continue to expect the winter production curtailment, which should last until mid-March 2019, to support steel prices for the rest of 2018. This is evidenced by the latest pricing data announced by Baosteel, where it increased steel prices for most of its products by CNY 50-150 per tonne in October and kept it at the current high level in November. 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 outlook, management is now less optimistic on demand from the automotive sector and expects minimal to low-single-digit year-on-year demand growth in 2018. Demand from the machinery sector is expected to remain strong, supported by infrastructure spending. As for demand from consumer white goods sector, management expects it to remain healthy but noted that there could be uncertainty due to trade war concerns.

Our bearish long-term view for the steel sector is intact. Although a total of 115 million tons of capacity was 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 is expected to be added. Based on the new policy on building new steel production capacity to replace obsolete facilities, announced in January, we see that the Chinese government is promoting electric arc furnaces instead of 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 toward producing steel from electric arc furnaces using steel scrap rather than traditional blast furnaces, which use iron ore and coking coal. Helped by an increase in availability of steel scrap in China, we continue to believe that new electric arc furnaces can be built in the future to offset shuttered capacity, and this should drive ongoing overcapacity issues in China.