Steel stocks are undervalued as sector fundamentals pick up
Some steelmakers will outperform the industry amid government reforms to tackle overcapacity, analysts say
The Chinese steel industry’s fundamentals are improving from a very low base, but valuations for some stocks haven’t caught up with the pace as investors dismiss signs of a pick-up, analysts said.
An example of a steelmaker enjoying a resurgence in the current environment is Liaoning-based Angang Steel, according to a research report by Jefferies analysts Po Wei and Howard Lau.
They say the company, after reporting 94 per cent year-on-year net profit growth in the first half, will see earnings remain high in the third quarter.
“We think two fundamental fronts are improving for Angang,” Wei and Lau wrote. “First, although happening at a slow pace, China’s steel mill capacities are indeed shutting down especially in inland regions such as Shanxi and Sichuan where products could not be exported. The government’s plan is to close down 3 per cent of capacity every year.
“Second, iron ore suppliers are becoming more fragmented too, extracting less profitability out of the value chain.”
Additionally, Jefferies expects to see a stronger than normal seasonal rebound in construction demand in the fourth quarter after extreme weather conditions this summer disrupted most building activity in east and central China. Growth in steel demand in the second half may still slow to around 2 per cent year-on-year, down from 5 per cent in the first half, as China’s fixed-asset investment growth declines.
Jefferies reiterated its buy rating on Angang Steel, based on its cheap valuation, with a target price of HK$4.80.
Angang’s surge in first-half profits this year amounted to 300 million yuan, as gross profit in the second quarter climbed dramatically to 185 yuan per tonne from minus 132 yuan per tonne in the first quarter.
China International Capital Corporation (CICC) wrote in a report that although the steel sector as a whole will be hard pressed to deliver significant returns, some steelmakers still have a chance to outperform the benchmarks.
The brokerage firm suggested investors focus on companies with low price-to-book ratios and strong earnings performance, as well as state-owned enterprises that are benefiting from the government’s reforms to cut overcapacity. Specific recommendations included Hebei Iron and Steel, Xinyu Iron and Steel, Angang, Beijing Shougang and Fangda Special Steel from the A-share market, and Hong Kong-listed Angang.
The current round of capacity reduction efforts is more likely to succeed than previous ones, CICC analysts said.
In February, the State Council announced plans to eliminate 100 to 150 million tonnes of steel production capacity over the next five years, along with supporting policies including special bonuses and subsidies, debt-to-equity swaps and state-owned enterprises’ consolidation and restructuring.
Capacity reduction targets have exceeded 150 million tonnes in provinces which have released their targets, CICC said.
“We believe the ongoing round of production capacity reduction will likely be completed over 2016 to 2018, and the possibility for stepped-up efforts to reduce capacity should not be ruled out,” the report said.
Capacity reduction can help improve long-term profitability in the steel sector as it would drive up the capacity utilisation of steelmakers, they added.
Assuming net exports of steel products remain unchanged and domestic demand falls 1.5 per cent each year between 2016 and 2020, steelmakers’ profitability will likely recover to above 50 yuan per tonne, the same as in 2013 to 2014, but lower than 2011’s level of 200 yuan per tonne in the long term.
Profitability of 100 yuan per tonne is a reasonable level for the industry, CICC said.