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Morningstar | Shenhua’s Full-Year 2018 Result in Line; Shares Are Slightly Undervalued.

Narrow-moat China Shenhua’s full-year 2018 result contains few surprises, with net profit falling 8% year over year to CNY 44 billion. This implies a flat recurring fourth-quarter performance, despite an 8.8% drop in the benchmark QHD 5,500 kcal spot coal prices. We think this reflects Shenhua’s competitive advantage with integrated coal power business, as stronger power demand, coinciding with falling coal price, helped to offset the weakness at coal segment. In addition, with 82% of coal outputs being sold through long-term contracts, Shenhua’s coal-segment profitability is also less volatile compared with spot prices. Shenhua and GD Power have completed the setup of a joint venture, and Shenhua has transferred its 18 thermal power assets to the new entity, in which it holds a 44% stake. We expect limited near-term impact to Shenhua’s bottom line, but revenue will fall and investment income will rise, as the contribution from these assets will not be included in the consolidated revenue. Given most of these power assets are located in highly overlapped regions, we expect the reduced competition to create positive synergy and benefit Shenhua’s long-term outlook. We tweak our earnings forecasts to reflect these changes, while maintaining our key assumptions and midcycle outlook, as well as our fair value estimate of HKD 22.00 per share.

Despite in line results and healthy long-term business outlook, Shenhua’s share price fell 7% on March 25, following its annual result announcement, as investors demanded a higher dividend payout ratio or special dividend, as Shenhua has turned to a net cash position of CNY 10 billion in 2018. We think the shares are slightly undervalued presently, trading at 0.9 times price/book, which is well below its 10-year average of 1.8 times price/book and our valuation of 1.1 times price/book. The company’s proposed dividend payout of CNY 0.88 per share suggests a 40% payout ratio, consistent with the company’s historical practice.

Shenhua’s operating performance in the second half was decent, with all the business segments--coal, power, and coal rail-transportation--posting positive growth. Coal production recovered following the mining approvals obtained at the Ha’erwusu and Baorixile open-pit mines in Inner Mongolia, with output volume rising 4.5% sequentially in the second half, leading to flat full-year production volume. Power segment saw a decent 8.5% year-over-year sales volume growth in 2018, which is higher than the 7.3% growth of nationwide coal-fired power outputs. Turnover at coal rail-transport operations also improved to 4.0% year over year for full-year 2018 from 1.6% in first half, catching up to the 4.3% volume growth recorded by its key competitor Daqin Line.

The QHD 5,500 kcal benchmark coal price weakened to CNY 620 per tonne as of March 22, 2019, from its peak of about CNY 700 per tonne in mid-June last year. This is in line with our expectations, while the recent tight supply due to stricter safety controls following a few coal mine disasters in Shanxi, Shaanxi and Inner Mongolia has keep coal prices elevated over the past month, we expect coal production to gradually recover from late March, and demand to fall amid the end of winter heating season in North China. Along with a slowing economy in China and the U.S.-China trade impasse, coal prices are likely to remain constrained. We maintain our bearish long-term coal price outlook and our midcycle assumption of CNY 565 per ton. We think growth in supply from Inner Mongolia will keep prices subdued, and we expect the downward trend in the coal price to weigh on coal miners’ profits in the coming quarters. However, we expect positive earnings growth at Shenhua’s power and rail segment to continue to help offset the weakness at Shenhua’s coal segment amid falling coal prices, and we forecast Shenhua’s overall net profit to remain largely flat at CNY 44 billion between 2019 and 2023.

By year-end 2018, Shenhua’s approved coal production capacity was 339 million tons. Although the company has no new construction plans in its pipeline, asset injection from its parent becomes a catalyst for Shenhua in 2019. To avoid competition within the group, Shenhua’s parent, the former Shenhua Group, committed in 2014 to injecting 14 coal assets into Shenhua by first-half 2019. We expect the asset acquisition to bring about 200 million tons of new capacity to Shenhua, or 60% growth. We haven’t included any of these asset injections into our current forecasts. While we don’t think this will materially hurt Shenhua’s overall financial health, given its net cash position and sound credibility to fundraising, we believe this may be the reason that the dividend upside is capped. However, we think Shenhua’s growth outlook and strong operating cash flows, should lead to growing dividends in the longer term. Despite no special dividend offered in 2018, Shenhua’s proposed dividend of CNY 0.88 per share implies a 5.6% dividend yield at its current trading level, which is still sound, in our view.