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Morningstar | CSC’s 3Q18 Results in Line with Preliminary; FVE Raised to TWD 23 on Continued Strong Performance

We raised our fair value estimate for China Steel Corporation, or CSC, to TWD 23 from TWD 22 after factoring in the strong performance of its steel division and our latest commodities price forecasts. Our no-moat and stable moat trend ratings on the firm remain intact. CSC’s third-quarter 2018 earnings were in line with preliminary results announced previously, with EBIT increased by 111% year over year to TWD 10.23 billion from TWD 4.84 billion in the same period last year. Meanwhile, EBIT in the steel division increased by 161% to TWD 8.10 billion from TWD 3.10 billion in the same period last year, driven by higher average steel selling price and flattish raw material costs year over year. As for its non-steel division, EBIT increased by 17% year over year to TWD 2.43 billion on the back of a similar 17% increase in revenue year over year. Nonetheless, we still think that CSC’s current share price is slightly overvalued as we believe the steel industry will continue to suffer from overcapacity issues in the long run.

The ongoing supply side reform which started since 2016 and the strong steel demand in China this year resulted in a tighter steel market and higher profitability for the steel industry. Based on the pricing data announced by CSC for fourth-quarter 2018, it is increasing the prices for its steel products by 1.4% on average, or TWD 326 per tonne. We believe the high steel prices could be sustainable for the rest of 2018 supported by: (1) winter curtailment in China which should last until mid-March 2019; and (2) an increase in orders mainly for its plates and hot rolled products driven by higher demand growth and lower steel imports, respectively. Although the winter production curtailment in China this year is decided and imposed by local governments, which is different from last year where there was a blanket curtailment on selected cities, we do not think that this will necessarily result in less production curtailment being imposed. Besides, management is also seeing some preorders for its plates in fourth-quarter 2018 as maintenance for its plates production line is scheduled from March 2019 until second-quarter 2019. Impact to shipments due to this maintenance is expected to be minimal, around 100 thousand tonnes, or less than 1% of our forecast annual shipment volume. CSC is expected to announce its steel selling prices for first-quarter 2019 on Nov. 23.

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 this capacity was either not producing or producing at a low utilization rate. In 2018, only around 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 the new policy on building new steel production capacity to replace obsolete facilities, announced in January, we see that the Chinese government is promoting electric arc furnaces instead of blast furnaces. 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 old capacity is being replaced with new electric arc furnaces, the ratio is 1:1. This supports our view that China is shifting toward producing steel from electric arc furnaces using steel scrap rather than the traditional blast furnaces, which uses iron ore and coking coal. Helped by an increase in availability of steel scrap in China, we continue to believe that new electric arc furnaces can be built in the future to offset shuttered capacity, and this should drive ongoing overcapacity issues in China.