Evraz - Buy on Chinese Stimulus and Potential Coal Market Recovery

We upgrade Evraz to BUY and add the stock to our trade ideas. We expect the company's steel division to operate at 100% capacity in 2020, with exports benefiting from China's infrastructure stimulus package and domestic sales from relatively resilient rail product supplies to state-owned Russian Railways. One positive trigger could come from a rebound in coking coal prices thanks to the tightening supply-demand situation on the coal market amid the recovery of steelmaking facilities in India, Japan and South Korea. > Major infrastructure stimulus announced in China. At China's annual Two Session parliamentary meetings on May 22, a further boost to infrastructure investment was announced: the issuance limits for infrastructure-related special purpose local government bonds was increased almost 75% y-o-y to CNY3.75 trln ($525 bln), CNY600 bln ($84 bln) was earmarked from the central government for investment and an additional CNY100 bln ($14 bln) will be directed toward rail construction. While part of this stimulus will admittedly be spent on new infrastructure (5G networks, EV charging, etc.) that will not require much steel, a good sharе of the stimulus package will still go toward older and more steel-intensive types of infrastructure, such as major transportation projects. This should provide decent support for Chinese demand for long steel products and prices this year, in our view. > Chinese policy creates export opportunities for Evraz. Given that scrap availability in China is currently low, we believe that China will produce more longs from the BOF process (meaning higher demand for iron ore and coking coal) and will import more billets (a trend already seen in the recent statistics). This creates a nice backdrop for Evraz, which is the Russian leader in exports of long steel and coking coal to Asian markets. In addition, China has strict requirements for high vanadium content in long steel products (improving their tensile strength) and Evraz is the only Russian producer able to produce high-vanadium steel thanks to its resource base. Export sales have a relatively low margin compared with domestic HVA sales, but still, in times of weak demand at home, being able to profitably export can ensure close to 100% steel capacity utilization.> Rail sales in Russia supportive for quality of product mix. In Russia, support for earnings comes through a high share of sales of rail products (around 30% of Evraz's total domestic sales last year), which are sold primarily to state-owned Russian Railways (volumes and prices are agreed on annual terms). For instance, recent statistics provided by Metal Expert show Evraz's domestic sales declining 19% y-o-y in April, whereas weak demand from the construction sector was offset by a 28% y-o-y pickup in rail sales. > Risks in coking coal price skewed to the upside. Hard coking coal prices in the seaborne market fell from $150/tonne at the beginning of the year to $110/tonne FOB Australia in May. This owed to weak steel production in India (down 70% versus normal levels), South Korea and Japan. The gradual lifting of lockdowns across the globe should increase steel production in key coal-importing regions and boost demand for coking coal. An additional factor may come from cost support: around 27% of producers are already loss-making if accounting for business cash costs (i.e. including fixed costs and stay-in-business capex), according to CRU. Energy cost growth (subject to oil price moves) should push the global cost curve higher, thereby accelerating production rationalization. Recent statistics provided by Russian energy monitoring agency CDU TEK show a nearly 30% y-o-y drop in Evraz's coal mining in 5m20. This means that Evraz has probably already cut its production. We now expect the company's coal production to drop 15% to 22 mln tonnes this year (the y-o-y decline in 2H20 should be lower than in 1H20, as there was a very high base in 1H19), following the production halt at Mezhegeyugol, a relatively high-cost asset . In addition, a number of global producers have removed their production guidance with the intention of scaling back shipments.> Adding the stock to our trade ideas list. We think that exports to China and sales to Russian Railways will support Evraz's earnings in 1H20. We expect around $1 bln in EBITDA (down around 10% H-o-H). Assuming a 21% increase in export steel semis sales in 2020 (offsetting weak domestic demand but bearing a low margin), a 15% drop in coking coal mining, a conservative 10% recovery in Evraz's export billet price from spot levels and a 28% recovery in seaborne HCC prices to $140/tonne, Evraz should generate $1.7-1.8 bln in EBITDA this year. FCF this year should be around $460 mln (8.5% yield), which is likely to be a trough. Finally we note that Evraz is committed to a minimum yearly dividend of $300 mln (6% yield), which could be higher in case of moderate steel and coal price growth. In 2021, should the recovery stay on track, the FCF yield should expand to above 15%. In the global environment of low rates, we believe that these valuations are attractive. In addition, we think that Evraz should benefit from increased global demand for risk assets, as it is trading in the LSE's premium segment and is a constituent of the FTSE 100 index. We open a trade idea to buy Evraz stock and upgrade the stock to BUY given the upside revealed by recent price movements. We will publish our revised projections for the company's financials shortly.> Risks to our trade idea. The slow removal of lockdowns in India could cap coking coal demand. Severe coking coal import restrictions in China could pressure seaborne pricing. A correction in oil prices could push mining costs down. A second wave of the coronavirus in major coal-consuming regions, or in the US following the wave of protests, could result in renewed lockdowns.