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Morningstar | Shenhua’s 1Q in Line; Shares Slightly Undervalued.

Narrow-moat China Shenhua’s first-quarter result contains little surprise, with net profit rising 5% year over year to CNY 12.9 billion, despite a 14% drop in the benchmark QHD 5,500 kcal spot coal prices. We think this reflects Shenhua’s competitive advantage with its integrated coal power business, as growing power demand, coinciding with a falling coal price, helped to offset the weakness in the coal segment. In addition, with about 90% 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 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 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 expect the QHD 5,500 kcal benchmark coal price to fall 8-10% year over year in 2019, and we maintain both our full-year 2019 net profit forecast of CNY 44.2 billion, as well as our fair value estimate of HKD 22.00 per share.

Despite in line results and healthy long-term cash flow outlook, Shenhua’s share performance has lagged its major peers since its announcement of  2018 annual results, with share price falling 11% versus 5-6% rises for  China Coal and Yanzhou Coal, as investors demand a higher dividend payout ratio or special dividend, as Shenhua turned to a net cash position of CNY 10 billion in 2018. We think the shares are undervalued presently, trading at only 0.8 times price/book, well below its 10-year average of 1.8 times and our valuation of 1.1 times price/book.

In line with industry peers, Shenhua has suffered from falling coal price and rising unit production cost in the first quarter, leading to 6.7% fall in coal segment gross profit. Our bearish coal price outlook is unchanged, we expect the lackluster coal demand and growth in supply will keep prices subdued. We maintain our midcycle coal price assumption of CNY 565 per tonne, and we expect the coal price to fall 8%-10% in 2019, averaging at CNY 585-595 per tonne. This will weigh on coal miners’ profitability. However, as 90% of its coal output will be sold through contracts, Shenhua’s coal segment profitability is less volatile compared with coal price swings. In addition, we expect positive earnings growth from Shenhua’s power and rail segment to continue to help offset the weakness in 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.