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Morningstar | China Coal's 1Q In Line; Coal Production Expansion in 2019-21 a Key Highlight

No-moat-rated China Coal’s first quarter saw net profit well within expectations and largely flat at CNY 1.7 billion under IFRS. The commercial start of production of two coal mines in Inner Mongolia last November boosted output by 43%, offsetting coal price weakness and cost inflation. With visible coal projects in the pipeline, we think strong coal mining capacity growth will be the key highlight for China Coal in the coming three years. However, our bearish coal price outlook is unchanged. We make little change to our earnings forecasts, and we maintain our fair value estimate of HKD 4.18 per share.

We expect the QHD 5,500 kcal benchmark coal price to fall 8%-10% in 2019, which should cause China Coal’s gross margin to narrow to 16.0% in 2019 from 17.5% a year ago, leading to a 2.5% fall in net profit to CNY 4.4 billion. We think the shares are slightly undervalued at present, trading at only 0.4 times price/book compared with the 10-year average of 0.9 and our valuation of 0.5. Our midcycle coal price forecast of CNY 565 per ton, along with improving chemical segment profitability, suggests the company will be able to deliver healthy midcycle annual free cash flow of over CNY 10 billion.

China’s supply-side reform has seen China Coal’s coal output fall to 7,667 million tonnes in 2018 from 9,754 million tonnes in 2015. Following the two coal mines in Inner Mongolia, Nalinhe #2 and Muduchaideng, commencing production in November, China Coal saw its coal output jump 43% year over year in the first quarter of 2019 and 19% from a quarter ago. In addition to production ramp-up at the two mines, China Coal has capacities from the Xiaohuigou, Dahaize, and Libi coal mines to put into production in the coming two years. These will significantly boost China Coal’s production volume in 2019-21, and we estimate the company’s production will grow more than 30% in the next three years to over 100 million tonnes in 2021. This will help to offset some negative impacts from weakening coal prices, and we forecast China Coal’s net profit to grow at a compound annual rate of 6.2% over the next five years.

The weakening trend of coal prices, with the daily average of QHD 5,500 kcal benchmark coal price falling 4% sequentially to CNY 602 per tonne in the first quarter, reaffirms our bearish view on coal prices. While the wider range of mine safety checks and stricter constrains on coal imports have kept coal price above the "green zone" (CNY 500-570/tonne), we expect the lackluster coal demand and growth in supply will keep prices subdued. We expect coal prices to fall 8%-10% in 2019, averaging CNY 585-595 per tonne. Key reasons include the following: (1) Strong water flow since beginning of this year has been leading to sharp rising hydro power outputs. This, along with government’s supporting policy in clean and renewable energy sources, should see flat demand in coal-fired power generation, which will pressure coal demand. (2) Coal inventory at six major power plants stayed at 26 days, well above the normalized 18-20 days. In addition, according to SXcoal, China still has over 1 billion tonnes of coal mining capacity under construction/upgrade, representing 20%-25% of 2018’s coal output. We think growth in supply, coupled with China’s move to a less energy-intensive economic growth trajectory, will exacerbate the coal sector’s excess capacity.