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Morningstar | NSSMC’s 2Q Fiscal 2019 Results in Line; FY19 Guidance Intact; ESIL Acquisition Makes Progress. See Updated Analyst Note from 04 Nov 2018

Nippon Steel & Sumitomo Metal’s, or NSSMC’s, second-quarter fiscal 2019 (ending March) pretax profit excluding extraordinary items, or EBT, increased by 28.5% year over year to JPY 63.8 billion from JPY 49.6 billion during the same period last year and is in line with company guidance and our expectations. If we exclude the impact from natural disaster of JPY 27 billion which resulted in lower shipments and higher costs, EBT would have increased by 83% year over year, above its guidance. The outperformance is mainly driven by higher EBT from the steel, engineering and construction, and system solutions divisions. Management attributed the better performance in the steel division to strong demand, especially from the automotive and industrial machinery sectors, higher steel prices and cost-cutting measures. The robust performance in the engineering and construction division is driven by improving the macro environment on the back of rising oil prices, which led to increase in capital investments by its end customers. Due to the advancement of technology, there is an increase in demand for IT systems and solutions for "Internet of Things," artificial intelligence, and other technology which resulted in the improvement in the system solutions division. An interim dividend of JPY 40 per share, in line with guidance, has been declared. Guidance for full-year fiscal dividend will be announced during the third-quarter results.

After factoring in the higher raw material prices, our latest foreign exchange assumptions along with minor adjustments to our model, we lowered our fair value estimate to JPY 2,370 from JPY 2,400. Our no-moat and stable moat trend ratings on the firm remain intact. In our view, there will be limited upside for NSSMC’s share price in the near term due to concerns on the impact of trade war between the U.S. and China.

NSSMC will adopt the IFRS accounting standard for its full-year fiscal 2019 results (which is a transition from its Japan GAAP now). Based on IFRS standards, guidance for full-year fiscal 2019 results remains largely intact. Management lowered the fiscal 2019 revenue guidance to JPY 6.2 trillion (from JPY 6.3 trillion) but kept the guidance for EBIT (excluding extraordinary items that are not related to operational activities) of JPY 350 billion and net profit of JPY 240 billion (from 195 billion in fiscal 2018). The firm expects the global economy to grow moderately and demand for steel and steel prices in japan to remain stable, while ongoing trade war concerns between the U.S. and China may cause some uncertainties. That said, management will continue to focus on cost-cutting, inventory management and production efficiency to improve on the profitability of the company.

As part of NSSMC’s mid-term management plan announced in March 2018, management stated that they are bidding for Essar Steel India Limited, or ESIL, together with ArcelorMittal. On Oct. 26, ESIL’s Committee of Creditors has agreed to accept the acquisition terms proposed by the joint venture set up by NSSMC and ArcelorMittal. The acquisition plan includes an up-front payment of USD 5.7 billion (JPY 640 billion) towards ESIL’s debt and an additional $1.1 billion (JPY 120 billion) capital injection into ESIL for its operations. ESIL is the fourth largest steel producer in India with an annual steel production capacity of 10 million tonnes and is only currently producing 6.5 million tonnes of crude steel. ArcelorMittal and NSSMC intends to increase the steel shipment to 8.5 million tonnes in the medium term and then to 12 million–15 million tonnes in the long term with further investments. Although the actual stake that NSSMC hold has not been disclosed, if we assume a 50% stake, it would cost NSSMC around JPY 380 billion, which is within its budgeted JPY 600 billion for investment and merger and acquisition activities in its mid-term management plan. Pending further details on ESIL, we have not included this acquisition in our model as it is still subjected to approval of several authorities. That said, we think that this acquisition, if it goes through, will contribute positively to NSSMC as it will allow the firm to participate in the growing Indian steel market. According to management, India is a closed market that is difficult for foreign steel companies to export into.

For further details of the ESIL acquisition and NSSMC’s mid-term management plan, please refer to our note “ArcelorMittal Takes a Big Step Toward Completing Its Proposed Acquisition of Essar Steel India” published on Oct. 30, 2018 and “NSSMC’s 2020 Midterm Plan Mainly Focuses on Steel; FVE Lowered to JPY 2,090; Shares Overvalued” published on March 4, 2018.