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Morningstar | Baosteel’s FY18 Prelim Results in Line; Long-term Uncertainty Remains; Fairly Valued at CNY 7.20

Baosteel announced that preliminary net profit for 2018 is expected to increase by 8%-12% year over year to CNY 20.7 billion to CNY 21.5 billion, versus CNY 19.2 billion in 2017, in line with our expectations of CNY 21 billion. This implies that for fourth-quarter 2018, Baosteel’s net profit was around CNY 4.9 billion to CNY 5.7 billion, which was a 24% to 34% year-over-year decline from CNY 7.5 billion during the same period last year. Management attributed the year-over-year increase in profitability for the full year to the wider steel spread as a result of capacities shut down in China, improving product mix, cost-cutting and restructuring measures, and synergies from the merger with Wuhan Iron and Steel. As for the year-over-year decline in net profit in fourth-quarter 2018, we think this could be largely due to weaker steel prices as a result of: (1) the slowdown in the China autos and consumer white goods sectors (weakness in autos sector was previously flagged by management during the third quarter 2018 result announcement); and (2) higher than expected steel production. Our fair value estimate of CNY 7.20, no-moat and stable moat trend ratings remain intact. The ongoing supplyside reform which started in 2016 and the strong steel demand in China in 2018 resulted in a tighter steel market and higher profitability for the steel industry. However, we believe that long-term uncertainties remain due to the overcapacity issues in the steel industry. We think Baosteel is currently fairly valued, taking into account the long-term overcapacity issues in the steel industry.

Steel production remained strong in fourth-quarter 2018 based on our estimates as winter production curtailment is decided and imposed by local governments, which is different from fourth-quarter 2017 where there was a blanket curtailment on selected cities. This together with weaker steel demand resulted in lower steel prices in fourth-quarter 2018. Based on the pricing data announced by Baosteel, it is keeping steel prices for most of its products flat for February 2019 and increasing it by around CNY 50 per tonne in March 2019 after a decrease of around CNY 200 to CNY 300 per tonne in January 2019. We expect steel demand to gradually pick up after Chinese New Year, which falls on early February this year. We expect similar trends to be seen by Angang Steel as it is also predominantly exposed to flat steel products, which mainly depend on demand from autos, consumer goods, and shipbuilding sectors.

Our bearish long-term view for the steel sector remains intact. We think China is shifting towards producing steel from electric arc furnaces using steel scrap rather than the traditional blast furnace which uses iron ore and coking coal. We continue to believe that new electric arc furnaces can be built in the future to offset shuttered capacity helped by an increase in availability of steel scrap in China, and this drive ongoing overcapacity issues in China.