Steel investors advised to go with strength

PUBLISHED : Sunday, 04 November, 2007, 12:00am
UPDATED : Sunday, 04 November, 2007, 12:00am


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China's steelmakers slumped last week after reporting lower third-quarter profits. But while the market is wary about next year's profitability - due to raw material costs - analysts say the weakened share prices provide a buying opportunity for quality steel stocks.

'The mainland steel industry is still on the up-cycle and worth investing in, but you need to be selective,' says Helen Lau, an analyst at Daiwa Securities.

The rise in raw material costs - iron ore, coking coal and freight expenses - seems inevitable, Ms Lau says. It is just a matter of magnitude. The market is forecasting a 25 per cent to 50 per cent jump in iron ore contracts and a 10 per cent to 25 per cent rise in coking coal deals for next year.

But the demand for steel is strong amid the mainland's robust economic growth. Steel prices are expected to rise 4 per cent to 5 per cent next year.

This will only slightly offset the negative impact of raw material increases, and profit margins are likely to be squeezed.

Ms Lau advises steel industry investors to head for quality. That means companies with large production capacity making high-value-added products, such as Angang Steel, which also has the potential to buy assets from its parent.

Either that or choose a small company with growth potential, such as China Nickel Resources, which has a cost advantage because it secures its nickel supply from Indonesia at lower prices.

Big steelmakers announced their third-quarter results last week. Baoshan Iron & Steel (Baosteel), the Shanghai-listed unit of the nation's top steelmaker, surprised the market with a 50 per cent slump in third-quarter profits to 2.39 billion yuan on higher costs.

Maanshan Iron & Steel's third-quarter profit slid 18.7 per cent to 490 million yuan, and Angang's third-quarter profit declined 17.5 per cent to 1.76 billion yuan.

Baosteel was hit by volatile prices in nickel, a raw material for making stainless steel. Anhui-based Maanshan suffered from high operating costs due to its newly opened, 5-million-tonne-a-year plant, which could not run at full capacity, plus higher depreciation and other financial expenses.

Profits at Liaoning-based Angang, which exports one-fifth of its products, were hurt by higher taxes after value-added tax rebates on exports of some steel products were cut on April 15 and June 1.

It also took a hit from an increase in transport costs.

Hong Kong investors can't buy Baosteel, but they can purchase Angang and Maanshan, which are listed on both the Hong Kong and mainland bourses.

Shares of Angang, the listed arm of the mainland's No3 steelmaker, fell 12 per cent in three days, closing at HK$26.40 on Friday, after it announced third-quarter earnings on Tuesday night.

Maanshan shares slumped 13.5 per cent in four days, closing at HK$6.51 on Friday, after reporting earnings on Monday night.

At these levels, Angang is trading at 18.1 times 2007 or 16.1 times 2008 forecast earnings, while Maanshan is trading at 14.9 times 2007 or 11.4 times 2008 forecast earnings, much lower than the Hang Seng China Enterprises Index, or the H-share Index's 27.4 times 2007 forecast earnings.

Ms Lau says she likes Angang the most among Hong Kong-listed mainland steelmakers.

'When the stock trades lower than 13 times 2008 forecast earnings, it should be a buying opportunity. Even it shoots up to 15 times, it's still a fair price,' she says.

China Nickel, also a steelmaker, is trading at only 5.4 times 2008 forecast earnings. This is much lower than its rivals' average of 12 times, providing an upside, Ms Lau says.

Zhang Feng, an analyst at JP Morgan, also says the recent share price weakness of Angang provides a good buying opportunity, although Angang's third-quarter profit was below his expectations.

Angang may more than double its capacity through organic growth and acquisitions to 40 million tonnes by 2010, from the current 16 million tonnes, Mr Zhang says.

Together with its cost advantage of buying iron ore at a 10 per cent discount from its parent, and its improving product mix, Angang should trade at premium to its rivals, he says.

Mr Zhang retains his 'overweight' rating on Angang with a target price of HK$31.90, implying a 17 times 2008 forecast earnings or 21 per cent upside from its current share price. But he has downgraded Maanshan's rating to 'neutral' from 'overweight' after the disappointing third-quarter earnings.

Some analysts suggests that if you like the steel industry, you should buy the iron ore producers as they are benefiting the most from the booming demand. However, so far no such stocks are available in Hong Kong.

Applying pressure

Rising raw material costs have squeezed earnings at steelmakers

The market is forecasting an increase in iron ore contracts next year of up to 50%