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China Steel Sector
SECTOR REVIEW
Cost support drives strong margin
The uncertain macro environment bodes well with the bearish sentiment
on the Chinese steel sector. Nevertheless, we believe it is important to
realise that the strong margins of the top steel mills are driven by the cost
differentials between large and small producers, thus downside is limited
should the fundamentals turn more negative. We also highlight that on a
relative basis, it would take more deceleration in demand to deteriorate
the long segment than flat segment.
■
Demand risk remains: We believe the key question is how much of a
slowdown in demand is needed in order to reverse the steel sector’s
fundamentals into becoming incrementally negative: 4% for construction
steel and 1-2% for flat steel sequentially, in our estimates – implying a higher
risk to the flat segment.
■
Cost gap limits downside: Based on the cost curves and current steel
prices, we estimate limited downside to long products and a potential
US$70-80/tonne or 10% downside on flat products from where we are.
■
Upside risk on expectation: We maintain an OUTPERFORM for
Maanshan, upgrade Angang and Wuhan steel to a NEUTRAL from
Underperform, Baosteel to an OUTPERFORM from Underperform, and
maintain an UNDERPERFORM on Panzhihua. Current consensus has
factored in more than a 10% correction in the steel price in the coming
quarters in our assessment, and we see a short-term risk that 3Q08
earnings may surprise on the upside. At 1.2-1.6x P/B on 2008E, stocks have
factored in near mid-cycle outlook, implying 10-12% ROE or nearly 10%
decline in steel prices. If steel prices remain flat, ROE would reach 20-30%
in our estimate. Our risk-reward analysis suggests more favourable profile
for Maanshan, Baosteel and Angang. Our top pick remains Maanshan.
Cost support drives strong margin
The uncertain macro environment bodes well with bearish sentiment on the Chinese steel
sector. Nevertheless, we believe it is important to realise that the strong margins of the top
steel mills are driven by the cost differential between large and small producers, thus
downside is limited should the market balance deteriorate. We would also highlight it takes
more deceleration in demand to reverse the fundamentals for long, than flat, segment.
Demand risk remains
While Chinese steel sector’s supply picture is rationalising, we see potentially softening
demand in 2H08E in China, posing downside risk to steel prices/margins towards 4Q08E.
Tighter-than-expected energy bottlenecks, disruption in manufacturing activities around
the Beijing Olympics, decelerating export growth, uncertainties around the property sector,
and the start of demand push back in a high steel price environment are all emerging and
will lead to softening demand growth in the coming months, in our view. On a relative
basis, we expect to see more pressure in the flat steel segment than long products, given
the outlook in the downstream sectors driving demand for steel sheets/plates and
construction steel products. Incremental improvement to Chinese steel supply/demand
has been a key supporting factor to allow steel mills to pass on the rising costs to
downstream this year. How much growth deceleration would be needed to reverse the
positive fundamentals? – On a sensitivity basis, we estimate a sequential 4% deceleration
for the long segment and 1-2% for the flat segment. This could emerge if there is a 12%
deceleration in property sector for construction steel demand, a 10% deceleration in light
industry or auto output, or 5% for machinery output growth for the flat segment.
Cost gap limits downside
In our opinion, steel price hikes have been mostly driven by the cost push of marginal
producers, in the context of a relatively balanced steel market, rather than by a tight
supply. The expanding cost gap between large and small mills in China due to the pricing
difference between spot and contract input materials supports the above-mid-cycle unit
profit of major Chinese steel mills. This implies that even in a deteriorating supply/demand
scenario, domestic steel prices will be supported by the production cost of small mills,
although this is more a case for construction steel than flat steel, in our opinion. How much
potential downside is there to steel prices in China? Based on the cost curves and current
steel prices, we estimate limited downside on long products and potentially US$70-
80/tonne or 10% downside on flat products from here. In other words, we estimate rebar
(long product) should be supported at US$700/tonne versus the current spot of US$650/t,
while HRC (flat product) at US$700/tonnes vs the current spot at US$780/tonne.
Upside risk on expectation
We maintain an OUTPERFORM on Maanshan, upgrade Angang and Wuhan steel from an
Underperform to NEUTRAL, Baosteel from Underperform to OUTPERFORM, and
maintain an UNDERPERFORM on Panzhihua. Our top pick remains Maanshan. While
investor sentiment is turning bearish on the steel sector, given the uncertain macro
environment, we believe it is important to realise that the current margins of the major
listed steel mills are driven by the cost differential between large and small mills, thus the
downside is limited. In our assessment, current consensus has factored in more than a
10% correction in steel prices in the coming quarters (the breakeven level of the small
mills assuming flat spot raw material costs), and we see a short-term risk that 3Q08E
earnings may surprise market expectations on the upside. At 1.2-1.6x P/B on 2008E,
stocks have factored in near mid-cycle outlook, implying 10-12% ROE or nearly 10%
decline in steel prices. If steel prices remain flat, ROE would reach 20-30% in our estimate.
Our risk-reward analysis suggests more favourable profile for Maanshan, Baosteel and
Angang.
How much slowdown in
demand is needed to
reverse the steel sector’s
fundamentals to become
incrementally negative?
4% in construction steel and
1-2% in flat steel – implying
a higher risk to the flat
segment
Based on the cost curves for
Chinese mills, we estimate
limited downside on long
products and potentially
US$70-80/tonne or 10%
downside on flat products
from where we are
Current share prices have
factored in more than a 10%
correction in steel prices in
the coming quarters, and we
see a short-term risk that
3Q08 earnings may surprise
market expectations on the
upside
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