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Morningstar | Yanzhou’s 3Q Slightly Missed; Lower Production on Safety Check Remains the Near-Term Challenge. See Updated Analyst Note from 28 Oct 2018

Yanzhou Coal’s third-quarter performance was a little disappointing. Recurring net profit fell 4.6% year over year to CNY 1.4 billion under PRC GAAP, despite the strong turnaround at Yancoal Australia following its acquisition of Allie & Coal in September 2017. The near-term challenge remains stricter safety controls in China, which led to a 15% production cut quarter on quarter, as well as a boost in unit production cost on operating leverage. We expect the headwinds to persist through the fourth quarter, and Yanzhou’s overall production is likely to be 5%-8% below our expectation, with safety checks expanded in the fourth quarter amid the recent accident in Shandong. We lower our full-year 2018 net profit forecast by 11% to CNY 8.1 billion but keep our 2019 forecast at CNY 9.7 billion with volume recovering from the temporary production suspension and capacity expansion being the key growth drivers.

We maintain our fair value estimate of HKD 8.00 per share, as we expect output to recover, while our long-term bearish outlook on coal prices is unchanged. Following a 50% share price fall from the peak of HKD 15.08 on Feb. 5, we think the shares are fairly valued, with the uptick in coal prices largely reflected.

The strong performance at Yancoal Australia, which benefited from increased capacity coinciding with higher coal prices, continued to be the bright spot for Yanzhou. The acquisition of Coal & Allied in September 2017, and maiden contribution from phase 3 of Moolarben coal mine, drove Yancoal Australia’s production up 80% to 8.4 million tonnes in the third-quarter, equivalent to 38% of the group’s total coal production. In addition, the sound profitability at Coal & Allied lifted Yancoal Australia’s unit profit sharply to CNY 377.5 per tonne from CNY 300.2 per tonne a year ago.

With 90% of coal output being sold on long-term contracts, we expect Coal & Allied’s net profit contribution to stabilize at CNY 2–2.5 billion on an annualized basis, representing 20%-25% of our forecast earnings for Yanzhou for the next five years. In addition, we expect the production recovery from safety checks, along with capacity expansion at phase 3 of Moolarben coal mine in Australia, and Yingpanhao coal mine in Inner Mongolia to drive Yanzhou’s total output volume to CNY 110 million tonnes in 2019, representing 20% year-over-year growth from our forecast 92 million tonnes in 2018.

Due to seasonal restocking by power plants and the government’s intention to limit coal imports, the QHD 5500 kcal spot coal price surged to about CNY 644 per tonne on Oct. 26, from the recent low of CNY 592 per tonne on Aug. 3. However, with coal inventory at the six major power plants rising to over 30 days, compared with 14-16 days last year, and a normalized 18-20 days, we think further stocking by the power plants is limited and this should cap further near-term coal price upside. In addition, we think the U.S.-China trade war is likely to be prolonged, which could weaken China’s activity levels and cut power demand growth. Our supply/demand model suggests, if China’s GDP growth slows 1% in 2019, nationwide power demand would be likely to fall by 0.9%. Given China’s current policy to prioritize use of clean and renewable power sources, we think coal fired plants could bear the brunt of any electricity consumption slowdown and thus, this would eat into coal demand.

We maintain our bearish long-term coal price outlook and our midcycle assumption of CNY 565 per ton. Key drivers of lower prices are capacity expansions in China, with a repeal of the 276-day production constraints, growth in supply from Inner Mongolia, and loosening coal import restrictions. In addition, we think the improving coal rail-transport infrastructure, with the new rail corridor Menghua line commencing service in 2020, will also help to reduce bottlenecks and flatten the cost curve. In the long term, we think the decline in electricity-intensity of the Chinese economy and the shift toward an anything-but-coal energy policy will continue to dent coal demand and limit any material price increase.