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Morningstar | Yanzhou's Decent 1H in Line; Capacity Expansion Remains Near-Term Catalyst

No-moat Yanzhou Coal’s decent first-half growth, with net profit rising 34% year over year to CNY 4.6 billion, was boosted by the strong turnaround at Yancoal Australia following its acquisition of Coal & Allied in September 2017. Commercial coal production jumped 40% year over year, with Yancoal Australia contributing 76% of the increment. The sound profitability at Coal & Allied also expanded Yancoal Australia’s gross margin to 53.6% in the first half from 49.1% a year ago. Domestic coal output also rose 19%, but rising labor and safety-related costs weighed on the segment’s profit margin. These are in line with our expectations. We think capacity expansion continues to be the key growth driver for Yanzhou and expect its output to reach 100 million tonnes in 2018, equivalent to 25% year-over-year growth. However, our bearish coal price outlook and cost inflation should dent Yanzhou’s profitability in the coming quarters. We maintain our full-year earnings forecast of CNY 9 billion for Yanzhou, but we lower our fair value estimate to HKD 8 per share from HKD 8.20 to reflect the weaker yuan against the Hong Kong dollar. Following a 38% share price fall from the recent peak of HKD 15.08 per share Feb. 5, we think the shares are fairly valued, with the coal price gains already largely reflected.

The strong turnaround at Yancoal Australia, which benefited from the rise in capacity coinciding with coal price gains, was the bright spot for Yanzhou, The acquisition of Coal & Allied and maiden contribution from phase 3 of the Moolarben coal mine drove Yancoal Australia’s production up 161% to 17 million tonnes in the first half, equivalent to 35% of the group’s total coal production. In addition, the sound profitability at Coal & Allied lifted Yancoal Australia’s unit profit sharply to CNY 328.6 per tonne from CNY 236.0 per tonne a year ago.

The improved balance sheet following Yancoal Australia’s rights issuance also helped to save financial expenses and boost overall margins. With 90% of coal output being sold on long-term contracts, we expect Coal & Allied’s net profit contribution to stabilize at CNY 2 billion-2.5 billion over the next five years, representing 20%-25% of our forecast earnings for Yanzhou.

In addition to the strong production growth in Australia, Yanzhou’s domestic operation also jumped 19% with the Yingpanhao coal mine in Erodes contributing since September 2017. We think aggressive expansion will remain the key growth driver in 2018 and 2019, with capacity additions from (1) the acquisition of Coal & Allied to add 26 million tons; (2) phase 3 of the Moolarben coal mine to add 6 million tons; (3) the commercial production of the Yanpinhao coal mine to add 12 million tons on a full-production base; and (4) production ramp-ups at the Shilawusu and Zhuanlongwan coal mines and phase 2 of the Moolarben coal mine. These will increase Yanzhou’s current capacity by about 40%. As such, we expect Yanzhou’s commercial coal production to grow 25% and 10% year over year in 2018 and 2019, respectively.

Recent coal demand has been strong due to the recovery of industrial activity and extreme weather conditions, which boosted electricity demand for heating and cooling coupled by limited hydropower output due to low waterflow. The QHD 5500 Kcal average spot coal price continued to rise 8% in the first half, and Yanzhou’s average selling price was up 6% to CNY 539 per tonne. However, the recent fall in coal price to CNY 610-615 per tonne from around CNY 700 in mid-June reaffirms our bearish long-term coal price outlook, and we expect coal prices to continue to weaken in the second half of 2018. Key drivers of lower prices are capacity expansions in China, with removal 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 help to boost supply 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. We think these, along with rising labor costs and stricter safety and environmental controls, will pressure Chinese coal miners’ profitability in the longer term.