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Morningstar | Following Its Preliminary Guidance, Angang Steel’s Results Are In Line; Overcapacity Dims Outlook

Angang Steel announced first-half 2018 earnings that were in line with preliminary results announced in July, with net profit jumping 92% year over year to CNY 3.50 billion versus CNY 1.82 billion during the year-ago period. This implies that second-quarter 2018 net profit increased by 153% year over year to CNY 1.91 billion versus CNY 0.75 billion during the year-ago period. Pretax profit for second-quarter 2018 increased by a larger magnitude of 232% year over year to CNY 2.55 billion from CNY 0.77 billion during the year-ago period. With more clarity on its strong performance, we raise our fair value estimate for Angang Steel to HKD 5.40 (CNY 4.70) from HKD 5.15 (CNY 4.35), following revised assumptions. We still factor in a 50/50 chance for the acquisition of Angang Chaoyang to go through. Our no-moat and stable moat trend ratings on the firm are 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.

The ongoing supply-side reform, which 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. Management attributed the strong first-half performance to better product mix, leading to a higher average selling price for steel products, cost-cutting measures, and better management of its inventories, which in our view kept impairment charges at a low level.

Recently, Hebei Province’s Tangshan City announced that it will lower the allowed utilization rate of blast furnaces by 50% starting from Sept. 1, which is one month earlier than the winter production curtailment season in 2017, or two and a half months earlier than the central government’s mandated Nov. 15 start date. We expect there could be more news flow on this winter production curtailment to come in the next few weeks. We expect this 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 affected areas, could increase its market share during this period.

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 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 believ that the Chinese government is promoting electric arc furnaces as opposed to 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 towards producing steel from electric arc furnaces using steel scrap, rather than the traditional blast furnace, which uses iron ore and coking coal. We still 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 will drive ongoing overcapacity issues in China.