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Metals & Mining
China’s shift to a more sustainable growth model with focus on
urbanisation and rural investment is positive for metals demand
Strong cash generation to support capital management initiatives
and/or consolidation activity
Preference for upstream over midstream but steel looks oversold.
Top picks OW(V)-rated China Coal and POSCO
2011 outlook
A better year ahead
2010 has been a turbulent year for the Metals &
Mining sector, driven largely by macro forces,
Chinese policy changes and of course dollar swings.
For 2011, we believe the clouds should begin to lift.
China’s moves towards a more sustainable
consumption driven growth model should ultimately
prove positive for commodity markets.
While we forecast commodity prices to moderate
from current levels, prices should remain well
supported at relatively high levels, providing
strong cash generation and balance sheets. In turn,
we expect this will likely underpin further
consolidation activity and capital management
initiatives. Within the sector, we prefer coal and
steel plays over iron ore in the bulks, while
aluminium is preferred over copper in the metals.
Macro uncertainty and rising European sovereign
risks will likely remain an ongoing influence in
commodity (and equity) markets. So long as fullblown contagion is avoided, the prospect of subpar growth in the West and continued strength in
the East is perhaps the ‘goldilocks’ scenario for
commodity markets. Under such a scenario, Asian
inflationary pressures may be contained with its
growth avoiding derailment. This is crucial as it is
Asia that is driving global commodity markets at
present. Asia now accounts for nearly two-thirds
of global demand across most commodities. Over
the past decade, while commodities demand in the
US and Europe has actually fallen, the shortfall
has been more than offset by Asia.
China’s 12
th
Five-Year plan is critical in the
outlook for commodities. With the shift towards a
consumption (and more sustainable) driven
economic growth model (ie, less investment and
export-driven), the natural inclination is for
investors to think that this is negative for
commodities demand. We disagree. While growth
should clearly moderate to more sustainable
levels, in shifting to a more consumer-driven
economy, China will focus on urbanisation and
increasing investment in rural areas. Both are
supportive of commodities demand. Meanwhile,
increased focus on reducing carbon intensity
should help contain excess supply. Together,
these efforts should keep commodities market
relatively tight and support prices at higher for
longer levels.
In the rest of Asia, just like China, the process of
urbanisation and industrialisation remains well in
train. Barring any unforeseen events, sustained
economic growth in emerging markets should
continue to drive global commodities demand.
New capacity continues to be held back by
environmental, governmental and local approvals.
In such an environment, we expect commodity
prices to remain well supported at relatively (to
history) high levels. Given the volatility in
commodity markets, there will be times of
overshoot (from macro concerns or dollar
swings), but overall we remain in the ‘stronger for
longer’ camp.
Relatively high commodity prices should see the
sector generate strong cash flows. In our view,
this will underpin further consolidation activity
and or capital management initiatives. Indeed,
corporate interest is not only arriving from
horizontal integrations (growth in the same
sector). We are now seeing an increased appetite
from vertical integrations, for instance steel
companies acquiring raw material mines. In
addition, with many Asian countries now
recognising their dependence on imports, many
state enterprises are increasingly becoming active
in consolidation.
2011 high conviction idea
POSCO (005490 KS, OW(V),
KRW454,500, TP KRW650,000)
POSCO remains our top regional steel pick for its
diverse high-end product mix, low-cost operations
and resilient balance sheet. An aggressive
investment campaign through the cycle is likely to
ensure the company is well positioned for the next
upswing.
Year to date, POSCO shares (down 27%) have
underperformed the KOSPI (up 15%) and its
domestic peers Dongkuk (DKS) +4%, Hyundai
Steel (HSC) +27% but in line with its regional
peers (excluding India) at -30% .We believe there
have been two key factors driving this
underperformance:
1 2H10 disappointment – POSCO was not
alone in downgrading FY10 guidance, with
regional and global companies also doing the
same. A margin squeeze as a result of
sluggish regional demand is at the root of
2H10 disappointment. However, specific to
POSCO was the company’s overstocked
position in higher priced raw materials (at 3Q
contract price levels) due to expansion delays
mainly at Pohang No. 3 blast furnace
(+2mtpa). While this overstocked position
resulted in higher raw material costs in 4Q10,
it also means the benefit of lower 4Q10
contract prices for iron ore and coal in 1Q11.
2 Hyundai Steel’s blast furnace expansion –
The start up of HSC’s second blast furnace
(4mtpa, cumulative 8mtpa since the beginning
of 2010) along with its announcement that it
will consider a third blast furnace (c4mtpa)
has raised investor concerns on oversupply.
This has not been helped by POSCO’s own
announcement that it will invest KRW1.6trn
for a 3.3mt of HRC plant in Gwangyang
(operational in 2014e). The reality here is that
Korea has been a significant importer of
around 14-15mtpa of high-end flat steel for a
very long time, primarily from Japanese mills.
HSC and POSCO’s growth will replace
imports so it will ultimately be the Japanese
mills that will lose out, not POSCO. In any
case, Japanese exports will likely fill the void
created by China’s continued withdrawal
from export markets as it looks to reduce the
economy’s export reliance.
We see POSCO as a value play with strong
organic growth potential going forward. At
0.9x PB, POSCO shares trade at a significant
discount to its regional peer average PB of 1.1x
and in line with late 2008/early 2009 global
financial crisis valuation levels. With domestic
capacity of 34mtpa set grow to 41mt over the next
few years with additional potential upside from
offshore capacity growth in Indonesia and India,
earnings are poised to grow accordingly, all other
factors being equal.
Valuation
We maintain our OW(V) rating with a target price
of KRW650,000, valuing the stock at 1.3x PB
(same) and our 2011e book value of
KRW515,705 per share. We arrive at a PB
multiple of 1.3x from our residual income model
(P/B= ROE-g/COE-g) using our 2010-12 forecast
ROE of 16%.
Risks
The upside and downside risks for POSCO lie in
the movement of steel prices. The key downside
risks are a more severe slowdown in the US or
China, which in turn would negatively impact
steel consumption growth. On the raw material
side, movements in iron ore, coal and nickel
prices provide additional risk.
Winners from Chinese growth
Over the past decade, heavy FAI in domestic
infrastructure and construction projects has
provided the major backbone to China’s, and in
turn, global demand for commodities. With the
12
th
Five-Year plan expected to mark China’s
shift from an investment-/export-driven economy
to a consumption-based growth model, the natural
inclination for investors is to conclude that
commodities will be the loser. In our view, this is
too simplistic and ignores China’s progressive or
gradual approach, and more importantly the fact
that urbanisation and rural investment will remain
a significant part of the shift towards a
consumption-based economy.
Baosteel (600019 CH, OW(V),
RMB6.28, TP RMB8.5)
With its dominant market position in both the
domestic home appliances and automobiles
industry, we see Baosteel as a key beneficiary of
consumption-driven Chinese economic growth.
Management sees its key 2010 end-use demand
segments being automobiles (19.6% of sales) and
home appliances (11.5%). Looking forward to
2011, the company projects home appliance
production growing by 15% while the domestic
auto industry is forecast to increase output by
10% y-o-y. As China’s national steel champion,
Baosteel has set ambitious targets in its 2010-15
Strategic Development Plan, aiming to grow
revenue to RMB270bn by 2015 (+37% from 2010
levels) with 2015 crude steel capacity increasing
to 33mt (+25% from 2010 levels).
Valuation
We have an Overweight (V) rating on Baosteel and
our target price of RMB8.50 is based on 1.4x PB
and 2011e book value of RMB6.29/share. We arrive
at a PB of 1.4x from our residual income model (PB
= ROE-g/COE-g) using a sustainable ROE of 15%,
in line with its 2002-09 historical average.
Risks
The key downside risk, in our view, lies in the
movement of steel prices. On the raw material
side, movements in coal, nickel, and iron ore
prices provide additional risks. In particular,
Baosteel relies on imported iron ore from
Australia and Brazil.
Stock most at risk:
Maanshan Iron & Steel (323 HK, N(V),
H-share: HKD4.09, TP HKD4.7;
A-share: RMB3.43, TP RMB3.9)
The shift away from investment-driven growth
inherently means that large-scale capital
commitment to infrastructure and construction
projects may be a thing of the past. As a steel
company strongly leveraged to construction-
driven long steel products, Maanshan stands out
as a losing player in this changing market
dynamic. That said, we believe the current
pipeline of existing road, rail and construction
projects will ensure steady demand in the
near/medium term, with a gradual decline the
most likely outcome. As such, Maanshan should
be able to optimise its product mix going forward
to successfully adapt to shifting demand.
Valuation
We have a Neutral (V) rating and a target price of
HKD4.70 for the H-shares based on 1.1x PB and
2011e book value of HKD4.55/share. We arrive at
a PB of 1.1x from our residual income model (PB =
ROE-g/ COE-g) using a sustainable ROE estimate
of 9% in line with our forecast average ROE over
2010-12. Our target price for the A-shares, at
RMB3.90, is based on the A-share discount to the
H-shares at the time the target prices were set.
Risks
Movement in steel prices represents a key risk for
the stock. Any potential credit tightening by the
government, having an impact on stimulus
spending, represents a key downside risk, as
Maanshan, with its exposure to long steel, has
been a key beneficiary of the stimulus. A better
than expected recovery in the train wheels
segment poses a key upside risk.
Cash-rich companies
A broad-based recovery from the carnage of the
global financial crisis has seen balance sheets
across the Metals & Mining spectrum largely
restored. Support from strengthened demand
(particularly from Asia) and firm commodity
prices have allowed for positive cash-flow
generation. We see companies across the sector
deploying capital in developing extensive
pipelines of growth projects. In the absence of
viable greenfield projects, industry consolidation
should be an ongoing theme in 2011. In particular,
mid-stream smelters that have been excessively
squeezed by upstream raw material costs are likely
to accelerate investment in upstream assets. For
those industry players that are constrained to single
commodities with near to medium term
headwinds, diversification into other commodities
through acquisitions is seen as a viable pathway.
China Coal (1898 HK, OW(V),
H-share: HKD12.28, TP HKD18.6;
A-share: RMB10.59, TP RMB16)
China Coal has acquired 10bt of coal resources in
four coal bases, and the parent also increased its
coal resources by 2bt through consolidation of
local coal mines in Shanxi. The acquisitions will
support the volume growth and its targets to
double output to 200mtpy and earnings to
RMB20bn by 2014. Volume growth will come
from (1) capacity planned or under construction –
50mtpa in 4 years (2) Shanxi/Shaanxi/Inner
Mongolia new resources with production of
20mtpa (3) parent M&A with a capacity of
40mtpa and resources of more than 2bt. The
restructuring will be in steps and expect most
injections to take place in 2013/2014.
Valuation
We have an Overweight (V) rating on China Coal.
Our H-share target price of HKD18.6 is based on
a 2011e PE of 17x using the midpoint of China
Shenhua Energy’s average PE of 20x since its
listing and the global coal peers’ PE of 14x. This
target PE is below China Coal’s average PE of
23x. Our A-share target price of RMB16 is based
on an A- to H-share discount of 14%.
Risks
Downside risks to our rating and estimates include
slower-than-expected Chinese economic and
industrial growth and an increase in the coal
resource tax. In addition, the company’s relatively
risky investments in coal-to-chemical operations
remain a concern.
Potential share price catalysts include higher-thanexpected coal prices, an upgrade in the company’s
output guidance and progress on the coal mine
acquisitions. The resumption of a coal-power
linkage, permitting power companies to raise
tariffs, would be positive for thermal coal prices.
Stock most at risk:
Chalco (2600 HK, N(V),
H-share: HKD6.95, TP HKD8.5;
A-share: RMB10.10, TP RMB14)
Given unfavourable aluminium price moves for
much of 2010 and a continually rising cost base,
Chalco has been one of the few companies in our
coverage universe that has not been cash-flow
positive. With 2010e year-end gearing
(ND/ND+E) at 126%, Chalco’s balance sheet is
cash constrained. However, this has not stopped
the company embarking on domestic growth
projects and diversifying into iron ore through its
Simandou iron ore investment. As a result of these
coming capex commitments, we believe a
potential new issue of 1bn A-shares remains a key
overhang on the stock heading into 2011, which
we estimate may dilute 2011 EPS by 6%.
Valuation
We have a Neutral (V) rating on Chalco with an
H-share target price of HKD8.50, valuing the
stock at an equally blended EV/EBITDA and NPV
valuation approach. We apply an EV/EBITDA
multiple of 10.5x, in line with its five-year
average, to our 2011e EBITDA for Chalco and
arrive at a value of HKD5.66 per share. We arrive
at an NPV of HKD11.33 per share using a DCF
valuation assuming a WACC of 8.8%. We value
Chalco’s core business at HKD7.55 and Chalco’s
stake in Simandou at HKD3.78. Our Chalco Ashare target price is RMB14.00 based on the
current premium to the H-shares.
Risks
The main upside and downside risks for Chalco,
in our view, relate to movements in aluminium,
alumina and energy prices.
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