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Morningstar | Lower Production Drags on Shenhua's 1H; Shares Slightly Undervalued

Narrow-moat China Shenhua Energy's soft first-half result, with net profit falling 6.8% year over year to CNY 24.5 billion, was expected. The production suspension at the Ha’erwusu and Baorixile open-pit mines in Inner Mongolia since August 2017 continued to hurt revenue from self-produced coal, which also drove unit production costs up 9.8%, given the volume drop. We think these are only temporary factors, and we expect Shenhua’s production to recover in the second half with the mining approvals obtained. However, the recent fall in the QHD 5500 Kcal spot coal price to CNY 610-615 per tonne from around CNY 700 in mid-June reaffirms our bearish coal price outlook. We maintain our midcycle assumption of CNY 565 per tonne and expect the downward trend in coal price to weigh on coal miners’ profits in the coming quarters.

We maintain our full-year earnings forecast of CNY 42.8 billion and our fair value estimate of HKD 22 per share. Although we expect Shenhua’s net profit to decline an average of 2.3% over the next five years, we think the shares are slightly undervalued, currently trading at 3.4 times enterprise value/EBITDA, well below their 10-year average of 6.2 times and our valuation of 4.0 times EV/EBITDA. In addition, we expect Shenhua to return total free cash flow of CNY 244 billion over the next five years, compared with CNY 181 billion over the past five years. We think the strong cash flows, coupled with government encouragement, could lead to better-than-expected dividend payouts.

Helped by the extreme weather conditions (cold winter and hot May), and pickups 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. This favors Shenhua, as coal-fired generation accounts for 98% of its total power output, driving its utilization to improve 8% to 2,364 hours in the first half versus 2,051 hours for Huaneng. The strong power sales volume growth, along with a 1.6% rise in price and 2.1% drop in unit costs, boosted power segment operating profit 66.6% to CNY 5.4 billion, helping to partly offset the CNY 1.1 billion decline in coal segment profit. Since the power business is not wholly owned, however, the increased minority interest ate into bottom-line performance. Looking into the second half, we think the U.S. trade war may drive a higher uncertainty of power demand growth, and our expectation of stronger hydro-water flows and China’s promotion of the use of gas to replace coal in power generation should mean coal-fired power growth will be less exciting.

The QHD 5500 Kcal average spot coal price continued to rise 8% in the first half of 2018, while Shenhua’s average coal sale price rose only 1.6%, which also lagged the 6% rise for China Coal. This suggests Shenhua has higher volume sold on long-term contracts, with lower prices echoing government’s preferred "green zone" range of CNY 500-570 per tonne. Given our bearish long-term coal price outlook, we maintain 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 boost supply 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.

Shenhua’s logistic business continues to post a steady growth, with operating profit rising 9.1% to CNY 109 billion. However, turnover at its coal rail transport operations was up only 1.6% year over year in the first-half, which is still lagging the 7.6% volume growth at 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 Huanghua Port will restrict volume growth at the company’s core rail asset Shuohuang Line. Despite the limited growth outlook, we expect stable coal transport volume at Shuohuang Line to continue to provide robust cash flows to Shenhua over the next five years.