Morningstar | China Steel Industry: Overcapacity Issues Are Here to Stay. See Updated Analyst Note from 19 Sep 2018
China's steel industry has long been affected by overcapacity issues. From 2016 to 2017, the Chinese government began to rationalize the steel industry by shutting down 115 million tonnes of steel production capacity. This is in addition to the shutdown of around 120 million-140 million tonnes of off-the-books induction furnace capacity, which produced substandard steel, or ditiaogang, from melting scrap. This tightened the steel market in China, leading to higher steel prices and profitability for the steelmakers. Share prices of our Asian steel coverage nearly doubled from the beginning of 2016 to peak in February 2018. However, in recent months, our Asian steel coverage has declined by around 20% from its peak. This could be partly due to: (1) trade war concerns; and (2) concerns regarding a slowdown in Chinese steel demand going forward, driven by weaker construction end demand. In the long run, we expect overcapacity issue to persist, as new electric arc furnaces are expected to be built concurrent with declining apparent steel demand. We remain selective and prefer companies that focus on high-grade steel products and have a diversified business model.We revised our models by factoring in the higher steel price assumptions in the near-term and have incorporated our updated supply/demand assumptions, commodities, and foreign exchange price deck. As a result, we lowered our fair value estimate for Posco to KRW 336,000 (from KRW 365,000), or $75 per ADR (from $81); that for NSSMC to JPY 2,400 (from JPY 2,510); that for Baosteel to CNY 7.40 (from CNY 8.00); and that for Angang Steel to HKD 5.00 (from HKD 5.40), or CNY 4.38 (from CNY 4.70) for its A shares. Our fair value estimate for Angang Steel also takes into account the acquisition of Angang Chaoyang going through following shareholders’ approval (from a 50/50 chance of this happening previously). Meanwhile, we have increased our fair value estimate for China Steel to TWD 22.00 (from TWD 15.80), mainly owing to a higher exit multiple used. We increase the exit multiple to 10 times enterprise value/EBITDA (from 7 times), which is higher than its Asian peers under our coverage. The stock has been trading at around 50% premium to its Asian peers historically, and we think this is likely due to: (1) it being majority owned by local investors (more than 80% owned by local investors, of which around 20% is owned by the government and around 40% is owned by local retail investors); (2) its high dividend payout ratio of 90% on average for the past 10 years through cash and share dividends, translating into an annual cash dividend yield of more than 4%; and (3) it being the top 15 component of the Taiwan Stock Exchange Capitalization Weighted Stock Index, or TAIEX. Despite the higher fair value estimate, we think China Steel is still overvalued, as it is predominantly focused on the commodity steel grade, resulting in it not having an edge over its peers and continuing to face strong competition from peers in the steel industry. Our no-moat and stable moat trend ratings for all of these companies are intact.
For further details, please see our latest report “China Steel Industry: Are Overcapacity Issues Resolved?†published on Sept. 19.
China Steel is engaged in the manufacture and sale of steel products and machinery, transportation and electrical machine engineering contracting. Through its subsidiaries, Co. is engaged in the provision of transportation services; the manufacture and sale of aluminum products and other non-ferrous metal products; common and equity investment; the development and rental of non-current assets; the provision of guard and system security services; the design of software system; the manufacture, purchase and sale of magnetic powder; the provision of enterprise management advisory services; the design for environmental mechanical and electrical engineering; and waste management.
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