China Steel Sector:On the road to re-rating as sector bottoms out
Decline in ore prices dampened the elasticity of industry chain in 2014. Capacityexpansion of the four largest overseas mines led to the collapse of imported iron oreprices in 2014. The CIF prices of ores plummeted from USD135/tonne at the start of2014 to USD80/tonne in November 2014. The industry chain of ferrous metals inChina was greatly impacted: 1) Some ore traders left the market. The acceleratedore price decline, together with tightening credit policies following the Qingdao Portfinancing fraud, disrupted the cash flows of some traders and forced them out of themarket; 2) Steel costs kept falling. As steel prices dropped along with falling oreprices, rebar and hot-rolled prices slumped 12.5% and 13.8%, respectively, fromtheir peaks in early 2014. Due to the extended one-way decline in ore prices, evenlow season restocking failed to restore the elasticity of steel prices; 3) Frustrated bythe prolonged downturn of the steel market, some traders dropped out, pushing thesocial inventory level to new lows. As of 5th Dec, the social inventory of steelcontracted by 28% YoY. We expect steel prices to remain flattish in the winterreserve months; 4) Nevertheless, the profitability of steel mills improved in 2014, asthey managed to profit from the time lag between the ore price fall and theresulting steel price drop.
Elasticity of industry chain will continue to weaken in 2015. The overseas mines willcontinue to expand their capacities in 2015. Excluding FMG, a high-cost producer,we project CIF prices at domestic ports from other producers, namely Rio Tinto, BHPBilliton and Vale, to retreat to USD40-60/tonne, a reasonable level compared withthe prevailing CIF price of USD80/tonne. Taking into account the expansion plans ofoverseas miners, we forecast the overseas ore cost to drop by USD10/tonne in 2015.
Given this assumption, 1) ore traders will continue to exit this unprofitable market; 2)the elasticity of steel prices will weaken; 3) steel traders will lose interest in thetrade; and 4) with inventory piling up, steel mills have to deal with downstreamdirectly. In the absence of corrections and destocking brought about by high and lowseasons, steel price swings will be smoothened out. Although there may be sporadicupheavals in certain months caused by short-lived stimulants, the outlook of theferrous metal industry chain in 2015 will look like a bouncing ball losing momentum.
Reiterate “Neutral” sector rating and raise the TP of Angang and Magang. As thesector gradually bottoms out and demand keeps shrinking, the price gap betweensteels of same types but different quality is narrowing. For example, Baosteel’s grossmargin and valuation are similar to those of Angang. However, as demand recovers,the gross margin of quality names will rebound. The divergence in earnings amongsteelmakers will surface. As seen by Angang’s performance, large-scaled steel mills aremore resilient to market risks and are better positioned for re-rating. We lift our TP onAngang to HK$6.78, equivalent to 0.8x 2015 PB. We also lift our TP on Magang toHK$2.32, equivalent to 0.6x 2015 PB. Following the Shanghai-Hong Kong StockConnect launch, we prefer Baosteel (600019), both valuation and earnings of whichare at cyclical lows.
Catalysts: Elasticity of steel prices is dissipating as ore prices approach the trough.
As earnings bottom out, re-rating will follow. We expect the industry and its profit tohit bottom in 2015 and some steel mills may even cease operation. By that time,re-rating should not be far away.
