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Morningstar | Lower Production Drove Shenhua's Soft 1H; Shares Slightly Undervalued. See Updated Analyst Note from 06 Aug 2018

Narrow-moat China Shenhua's preliminary first-half result is no surprise, with net profit falling 7% year over year to CNY 24.5 billion, likely attributable to a 4% cut in coal output and softer prices. A 2% drop in Shenhua's long-term contact coal price, which accounts for about 80% of the company's coal output volume, and production suspension at Ha’erwusu and Baorixile Open-pit mines in Inner Mongolia since August 2017, hurts revenue. We expect output to recover in the second half with the mining approvals obtained. However, the recent decline in QHD 5500 kcal spot coal price to around CNY 600/ton from over CNY 700/ton in early June reaffirms our bearish coal price outlook, and we expect coal price weakness to weigh on coal miners' profits in the coming quarters.

We maintain our full-year 2018 earnings forecast of CNY 42.8 billion for Shenhua, but we lower our fair value estimate slightly to HKD 22.00 per share from HKD 22.50, reflecting a weaker renminbi against the Hong Kong dollar. Although we expect EPS to decline an average 2.3% over the next five years, we think the shares, currently trading at 0.9 time price/book, are slightly undervalued, relative to the company’s long-term healthy cash flows.

Helped by the extreme weather conditions (cold winter and hot May), and the pick-up in property investment due to low inventory, nationwide power demand remained strong, rising 9.4% year over year in the first half. This, along with a mild 2.6% growth in hydro power output, further boosted coal-fired power demand, and Shenhua's power output rose 9.5% year over year in the first-half. This should improve power segment profits, but Shenhua noticed the rising minority interest at power segment, and higher tax expenses dampened the positive impact. We think this implies that the jointly held power plants are doing better, and resulting in the higher than expected minority interest.

Turnover at Shenhua's coal rail-lines has picked-up slightly, rising 1.6% year over year in the first half, which is still lagging behind the 7.6% volume growth at its key competitor Daqin Line. While China's stricter air-pollution controls will continue to promote coal-rail transport replacing coal trucks and drive nationwide coal rail-transport volume growth in the coming years, we think the capacity constraints at Shenhua's connecting port Huanghua Port will contain volume growth at the company's core rail asset Shuohuang Line. Despite the limited growth outlook, we expect stable coal-transport volumes at Shuohuang Line to continue to provide robust cash flows to Shenhua over the next five years.