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Morningstar | China Steel Corporation’s 2Q 2018 Results In Line With Preliminary; FVE Raised to TWD 15.80. See Updated Analyst Note from 13 Aug 2018

We raised our fair value estimate for China Steel Corporation, or CSC, to TWD 15.80 from TWD 15.10 after factoring in the strong performance of its steel division and our latest commodity price forecasts. Our no-moat and stable moat trend ratings on the firm are intact. CSC’s second-quarter 2018 earnings were in line with preliminary results announced previously, with EBIT increasing by 68% year over year to TWD 8.77 billion. Driven by a higher steel selling price and increased steel shipments year over year in second-quarter 2018, EBIT in the steel division increased by 83% to TWD 6.97 billion from TWD 3.82 billion in the year-ago period. In addition, the firm was not affected by the higher cost of semi-products that affected its profitability in first-quarter 2018. As for its nonsteel division, EBIT increased by 8% year over year to TWD 1.65 billion on the back of a 18% increase in revenue year over year. Net income in second-quarter 2018 increased by 94% year over year to TWD 6.56 billion on lower net financial expenses and lower losses from associates, as its stake in its Vietnam operations, Formosa Ha Tinh, has been classified as available-for-sale financial assets. Nonetheless, we still think that CSC’s current share price is overvalued, as we believe the steel industry will continue to suffer from overcapacity issues in the long run.

The ongoing supply-side reform in China, which started in 2016, and the strong steel demand in China this year have resulted in a tighter steel market and higher steel prices. Based on the pricing data announced by CSC for third-quarter 2018, it is increasing the prices for hot-rolled products, plates, bars, and wire rods by around TWD 500 per tonne and hot-dip galvanized sheets by around TWD 160 per tonne while keeping prices for the rest of its steel products unchanged. We think it is still too early to tell how much of these price increases will stick in the third quarter, as the third quarter is seasonally weak for CSC. CSC is expected to announce its steel prices for fourth-quarter 2018 at the end of August.

Our bearish long-term view for the steel sector is intact. Although a total of 115 million tons of capacity was shut down in 2016 and 2017, the actual impact on production could be less, as some of these production facilities were either not producing or producing at a low utilization rate. In 2018, only 30 million tons of capacity is expected to be shut down. However, the net impact on steel capacity in China is expected to be muted, as around 15 million-20 million tons of electric arc furnace capacity is expected to be added. Based on new policy on building new steel production capacity to replace obsolete facilities that was announced in January, we see that the Chinese government is promoting electric arc furnaces as opposed to blast furnace. For every 1.25 tons of old capacity closed, only 1 ton of new capacity can be built if it is going to be a blast furnace. However, if you are replacing old capacity with new electric arc furnaces, you can build 1 ton of new electric arc furnace capacity for every 1 ton of old capacity closed. This supports our view that China will be shifting more toward producing steel from electric arc furnaces using steel scrap rather than the traditional blast furnace, which uses iron ore and coking coal. We still believe that new electric arc furnaces could be built in the future to replace some of the lost capacity, as there is an increase in availability of steel scrap in China, resulting in ongoing overcapacity issues in China.