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Morningstar | China Coal’s 3Q Slightly Beats on Better-Than-Expected Coal-Chemical Performance

Driven by stronger-than-expected coal-chemical performance, China Coal’s third quarter slightly beat our expectations, with net profit rising 86% to CNY 1.4 billion under PRC GAAP, implying flat sequential performance. Production ramped up at the company’s core olefin projects, coinciding with stronger prices, raising chemical segment profit in the first three quarters. However, the 2% decline in gross margin suggests this business is still facing challenges when it comes to alleviating cost pressure, and our cautious view on the coal-chemical segment is unchanged. Coal segment performance was largely on track, with growth in coal trading volume offsetting lower production and softening coal prices. Our long-term bearish outlook on coal prices is unchanged, and we maintain our fair value estimate of HKD 4.10 per share, but we lift our near-term earnings forecasts by 4%-5% in 2018 and 2019 to CNY 5.1 billion and 4.1 billion, respectively, to reflect the stronger-than-expected chemical earnings.

We think the shares are slightly undervalued, trading at only 0.4 times price/book, compared with its 10-year average of 0.6 times and our valuation of 0.5 times. Our midcycle coal price forecast of CNY 565 per ton, along with improving profitability at chemical segment, suggests the company will still earn a sound operating margin of 13.9% compared with our estimated 12.4% in 2018, with healthy free cash flow of about CNY 6 billion on an annual basis.

Driven by heating season restocking by power plants, the QHD 5500 kcal spot coal price surged up to about CNY 660 per tonne on Oct. 23, from the third-quarter average of CNY 633. However, with coal inventory at the six major power plants rising to over 30 days, compared with 14-16 days last year and a normalized 18-20 days, we think further coal price upside should be limited. We maintain our bearish long-term coal price outlook and our midcycle assumption of CNY 565 per ton.

Key drivers of lower prices are capacity expansions in China, with a 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 reduce bottlenecks 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.

Although China Coal’s chemical segment saw an impressive 65% year-over-year revenue growth in the first three quarters of 2018, driven by strong olefin production volume growth as the Mengda project commenced contribution in August 2017, unit production cost at its olefin projects rose to CNY 6,166 per ton from CNY 5,376 per ton a year ago, representing a 15% rise in unit production cost. We think this reflects the challenges of gaining scale benefits and we remain cautious on the company’s coal-chemical business. We think volatile production volumes and costs, as well as the cyclical chemical prices, add risk to China Coal’s earnings. The good news is that cash flows are healthier, as while the company still has a few chemical projects in the pipeline, its capital expenditure for this segment has fallen sharply to CNY 1 billion in 2017 from a significant CNY 18 billion in 2013. We think this will help improve the company’s financial position and put it on firmer footing to face the next round of macroeconomic risks.