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Morningstar | China Coal Beats on Higher Coal Trading Volume and Improving Chemical Profit; Shares Undervalued. See Updated Analyst Note from 22 Aug 2018

No-moat-rated China Coal’s strong first-half result, with recurring net profit rising 54% year over year to CNY 3.4 billion, came in above our expectations. The higher-than-expected earnings were boosted by a sharp 70% increase in coal trading volume, compared with 9.9% growth for the country as whole. We estimate that this, along with increased sales at its coal-chemical segment following the start of the Mengda engineering plastics project, contributed more than 80% of the increment of the company’ first-half profit. The core coal mining business remained largely on track, with small coal price gains being offset by lower output volume and 3.5% cost inflation in unit production cost amid rising labor expenses. Our long-term bearish outlook on coal price is unchanged, while we lift our 2018 and 2019 earnings forecasts by 55%-65% to CNY 4.8 billion and 3.9 billion for China Coal, to reflect the company’s strategic move toward higher coal-trading volumes amid limited coal production growth in the coming two years, as well as the announced acquisition of China Coal Electric, which will expand the company’s sales in mining machinery.

We lower our fair value estimate slightly to HKD 4.10 per share from HKD 4.28, after taking into account the recent Chinese yuan depreciation against the Hong Kong dollar. We think the shares are undervalued, trading at only 0.4 times price/book, compared with the 10-year average of 0.6 times and our valuation of 0.5 times. Our midcycle coal price forecast of CNY 565 per ton suggests the company will still earn a sound operating margin of 13.8%, with health free cash flow of about CNY 6 billion on an annual basis.

The average QHD 5500 kcal spot coal price continued to rise 8% in the first-half 2018, following a sharp rebound in 2017. This should be attributed to the recovery of industrial activity and extreme weather conditions. The latter boosted electricity demand for heating and cooling and limited hydropower output due to low waterflow. However, the recent fall in coal price to CNY 612 per ton, from CNY 676 as of the end of June, reaffirms our bearish long-term coal price outlook and we maintain our midcycle assumption of CNY 565 per ton. Key drivers of lower prices are capacity expansions in China, with 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 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.

China Coal’s chemical segment saw impressive 181.5% year-over-year growth in its operating profit, driven by strong olefin production volume growth as the Mengda project commenced contribution in August 2017. However, unit profit fell sharply to CNY 1,289 per ton from CNY 1,696 per ton a year ago. We remain cautious on the company’s coal-chemical business, and we think unreliable production volumes and costs, as well as the cyclical chemical prices, should mean greater risks for this business. While the company still has a few chemical projects in the pipeline, its capital expenditure for this segment dropped sharply to CNY 1 billion in 2017 from a significant CNY 18 billion in 2013. We think this will help to reduce the company’s overall risk, sustain healthy cash flows, and position it well for long-term healthy growth.

China Coal announced to acquire 100% China Coal Electric, a mining equipment company, with a total consideration of CNY 257 million. We expect this transaction to create positive synergy to China Coal’s existing mining equipment business, which will enhance the company’s competitiveness by expanding product portfolio and sales channels. We estimate that the acquisition will increase the mining equipment segment’s net asset and net profit by 20% and 15%, respectively. However, the valuation of 1.1 times price/book and 35 times price/earnings looks less attractive, compared with the average of 0.8-0.9 times price/book and 15-25 times price/earnings for mining equipment companies in China, as well as 0.4 times price/book for China Coal’s existing assets.