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Morningstar | Shenhua’s 3Q In Line With Our Expectations; Strong Growth at Power Segment a Bright Spot

Narrow-moat Shenhua’s solid third-quarter performance was broadly in line with our expectations. Net profit rose 3% year over year to CNY 12.7 billion, with all the business segments--coal, power, and transportation--posting positive earnings growth. Strong growth at power segment was the bright spot. Contrary to steep industrywide profit declines on rising fuel costs, Shenhua’s power business saw a sharp 29% rise in gross profit contributing 65% of the group’s gross profit growth in the third quarter. This was helped by 7.3% growth in power output, 2.3% higher tariff, as well as a marginal decline in unit coal cost compared with a year ago, which reaffirms Shenhua’s competitiveness with an integrated coal and power business. We maintain both our full-year 2018 earnings forecast of CNY 42.8 billion and our fair value estimate of HKD 22 per share. Our bearish coal price outlook remains, which we expect to drive Shenhua’s overall net profit down by an average of 2.3% over the next five years.

We think the shares are slightly undervalued, currently trading at 3.6 times enterprise value/EBITDA, well below the company’s 10-year average of 6.2 times and our valuation of 4.4 times EV/EBITDA. In addition, despite our forecasts of profit downside, we expect Shenhua to return a 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 flow, coupled with the government’s encouragement, could lead to better-than-expected dividend payouts.

Helped by production recovery at the Haerwusu open-pit mine after a temporary suspension, Shenhua’s coal output rose 6.6% in the third quarter, which helped cut unit production costs by 1% to CNY 108 per metric ton in the third quarter from CNY 109 in the first half, given the volume increase. This, along with a 2.2% rise in average coal selling prices, has lifted the segment’s gross profit by 3% from a year ago. However, the recent fall in QHD 5500 kcal spot coal price to CNY 641 per metric ton on Oct. 30 reaffirms our bearish coal price outlook. With coal inventory at six major power plants of about 32 days compared with 14-16 days at the same time last year and a normalized 18-20 days, we expect the coal price to weaken in the fourth quarter, as further stock by the power plants is limited despite the coming of peak heating season. We maintain our midcycle coal price assumption of CNY 565 per ton, and we expect the downward trend in coal price to weigh on coal miners’ profits in the coming quarters.

Helped by rising demand from the service sector and residential usage, nationwide power consumption rose 8% year over year in the third quarter. Shenhua saw a decent 7.3% power output growth, with utilization improving 320 hours to 1,368 hours in the third quarter, versus 1,129 for Huaneng. In addition, compared with a 7%-9% rise in unit fuel costs for coal-fired independent power producers, Shenhua managed to keep its fuel costs relatively stable from a year ago. The strong power sales volume growth, along with a 2.3% rise in tariff and a marginal 0.5% drop in unit cost, boosted power segment gross profit by 29% to CNY 4.8 billion, contributing 65% of Shenhua’s gross profit growth in the third quarter. However, the U.S.-China trade war appears to be prolonged, which could weaken China’s activity and cut power demand growth. Our supply/demand model suggests that if China’s GDP growth slows 1% in 2019, nationwide power demand would be likely to fall by 0.9%. Coal-fired power plants are in the worst position, given China’s current policy of prioritizing clean and renewable power sources. However, we think the slower power demand growth should be offset by margin expansion on lower coal prices.

Shenhua’s logistic business continues to grow steadily, with gross profit rising 5.6% to CNY 5.8 billion. Turnover at coal rail transport operations also improved to 2.8% year over year for the cumulative nine months, from 1.6% in the first half, but it is still lagging the 5.4% volume growth at its key competitor Daqin Line. While China’s stricter air-pollution controls will continue to promote rail transport for coal over 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 restrict volume growth at the company’s core rail asset Shuohuang Line, and with the excess capacity in bulk terminals, we think capacity expansion at Huanenghua Port is unlikely. 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.