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Morningstar | VAT Cut Is a Positive to Chinese Coal Producers; While Our Bearish Coal Price Outlook Remains.

China will lower the value-added tax, or VAT, rates as part of a CNY 2 trillion cost cut package to support the slowing economy and tariff dispute with the U.S. This favors Chinese coal producers, who will enjoy a 3% VAT rate cut to 13% on domestic coal production. We expect the VAT rate cut to boost net profits by 4%-10% for the major coal producers we cover, after taking into account the cost-side VAT rate cuts. Among these, we think China Coal is best positioned to benefit with estimated 8%-10% net profit upside, given its high operating leverage and low profitability; while we estimate Yanzhou Coal would see a 6%-7% earnings upside, and 4%-5% for China Shenhua. However, we think part of the tax savings will be translated into lower coal prices, given the weakening demand outlook and growth in supply from Inner Mongolia.

We leave our earnings forecasts and our fair value estimate of HKD 22.00 per share for China Shenhua, HKD 4.10 for China Coal, and HKD 8.00 for Yanzhou Coal unchanged, ahead of annual results due out in late March. We expect little change to our midcycle coal price assumption of CNY 565 per tonne. At current trading levels, the three coal producers we cover are largely fairly-valued, after the recent share price rallies. Narrow-moat China Shenhua remains our preferred company. While the shares of Shenhua are fairly-valued relative to our fair value estimate, we think its good quality assets, integrated coal and power businesses, as well as strong management should underpin a long-term healthy growth and sustainable cash flows.

The QHD 5,500 kcal benchmark coal price rose to CNY 638 per tonne as of March 8, 2019, up from its recent low of CNY 582 at end of January. This was primarily driven by tight supply, due to stricter safety controls during the two sessions of National People’s Congress and Chinese People’s Political Consultative Conference, following a few coal mine disasters in Shanxi, Shaanxi, and Inner Mongolia. This is in line with our expectation, which will help to support coal producers’ profitability in the first quarter. We expect coal production to gradually recover from late March, and demand to fall amid the end of heating season. Along with a slowing economy in China and the U.S.-China trade impasse, this should see limited upside pressure on coal prices. 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 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.