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Morningstar | Angang Steel’s 3Q 2018 in line With Prelim; Overcapacity Issues Continue to Dim Outlook

Angang Steel announced third-quarter 2018 earnings that were in line with preliminary results announced earlier in October. Net profit increased by 41% year over year to CNY 2.42 billion versus CNY 1.72 billion during the same period last year, based on restated numbers that take into account the consolidation of Angang Chaoyang’s results following the completion of its acquisition on Sept. 30. Management attributed the strong performance to better product mix leading to a higher average selling price for steel products, cost-cutting measures, and better management of its raw material procurement, which, in our view, reduced its impairment charges. The ongoing supply side reform that started since 2016 and the strong steel demand in China this year resulted in a tighter steel market and higher profitability for the steel industry. We factored Angang Chaoyang’s full-year performance into our 2018 forecast and updated our model to incorporate our latest commodities price deck and foreign exchange rate assumptions. As a result, our fair value estimate for A shares is increased to CNY 4.46 (from CNY 4.38) but our fair value estimate of HKD 5.00 for H shares is unchanged due to the depreciating Chinese yuan. Our no-moat and stable moat trend ratings on the firm remain intact. Nonetheless, we still think that Angang Steel’s current share price is overvalued as we believe the steel industry is highly commoditized and will continue to suffer from overcapacity issues.

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 that this will necessarily result in less production curtailment being imposed. For instance, Hebei province’s Tangshan city have 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 stubborn and 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. We think Angang Steel, which is not affected by the production curtailment as it has no plants in impacted areas, could increase its market share during this period.

Our bearish long-term view for the steel sector remains intact. Although a total of 115 million tons of capacity has been 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 to 20 million tons of electric arc furnace capacity are expected to be added. Based on the new policy on building new steel production capacity to replace obsolete facilities that was announced in January, we see that the Chinese government is promoting electric arc furnaces compared with 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 the traditional blast furnace that uses 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.