See important disclosures, including any required research certifications, beginning on page 69 What's new Thermal coal stocks look better positioned over the next few quarters on a risk-reward basis, following the easing of the ‗perfect storm‘ in 1H12. This report marks the transfer of coverage to Dave Dai. What's the impact Following a golden decade of production growth (9% CAGR over 2001-11), industry production looks set to moderate to low single-digit (3%) growth rates onwards of 2013 with unsettling long-term concerns (railway and shale gas). Still, following the ‗perfect storm‘ in 1H12, we expect a much better demand- supply balance in 4Q12E and 2013E. Along with a demand recovery that should be supported by recent encouraging macro data, we also expect improvements from cost- driven supply discipline (18% of China‘s state-owned coal producers were loss-making in 8M12), normalising hydro output and import reductions. We expect system inventory to destock from 31 days of consumption in 2012 to 28 days in 2013. Continuing coal production cost rises could also lead to higher upside than downside risks for spot coal prices in 2013 (we expect a 1% YoY rise), whereas sector share prices factor in no price recovery. All these considerations underpin our positive investment thesis for thermal coal stocks in the near term, especially following the recent strength of early indicators like cement and steel. Along with our positive macro assessment, we have looked at costs in detail. While strong cost management in 3Q12 was a positive surprise, China Coal Energy‘s (China Coal) current cost structure is also less sensitive to wage inflation and policy changes vs. peers. Yanzhou Coal Mining (Yanzhou) has been the most leveraged stock in past upcycles, but its deteriorating profitability from expansion into low-margin mines in China and Australia, together with its substantial exposure to labour cost hikes, looks set to make its profits more vulnerable than peers. Given its higher earnings sensitivity to contract prices, China Coal could benefit the most if contract prices in China converge with spot prices. Even without full convergence this year, China Coal‘s track record shows it has been able to realise higher average prices than China Shenhua Energy (Shenhua). We have a cautious view in the medium term, as China‘s aggressive railway expansion could alleviate the long- lasting bottleneck, but we do not expect a meaningful breakthrough until after 2014 based on our sum- of-the-parts forecasts. Also, we see the development of shale gas as a long-term threat, either via US exports to Asia or China‘s own exploration, which could impose pressure on coal demand. What we recommend Shenhua is our top pick, as we believe it offers sustainable earnings growth, warranted by vertical integration. Having underperformed the market for three consecutive years, China Coal offers an attractive valuation, in our view. We therefore upgrade the stock to Buy (1) and believe it is a better recovery play than Yanzhou (Hold [3]). Risks to our sector view would be a worse- than-expected demand recovery and higher-than-expected cash costs. How we differ We are more bullish about demand and coal prices for 2013 and we have a differentiated view on costs. 19 November 2012 Reassessing costs and benefits Easing of perfect storm should create cyclical upside even for an industry with single-digit growth rates and long-term challenges While coal prices continue to be supported by supply and demand forces, cost differences should also play a role in stock picking Long-term investors should stay with Shenhua; upgrading China Coal to Buy as we see a better risk-adjusted return vs. Yanzhou China Thermal Coal Sector Key stock calls Source: Daiwa forecasts. Materials / China Dave Dai, CFA (852) 2848 4068 [email protected]Gary Zhou (852) 2773 8535 [email protected]New Prev. China Shenhua Energy (1088 HK) Rating Buy Buy Target 38.00 34.90 Upside p 23.6% China Coal Energy (1898 HK) Rating Buy Hold Target 9.00 7.00 Upside p 21.8% Yanzhou Coal Mining (1171 HK) Rating Hold Hold Target 11.30 12.60 Upside p 0.4% How do we justify our view? How do we justify our view?
Transcript
See important disclosures, including any required research certifications, beginning on page 69
What's new
Thermal coal stocks look better positioned over the next few quarters on a risk-reward basis, following the easing of the ‗perfect storm‘ in 1H12. This report marks the transfer of coverage to Dave Dai. What's the impact
Following a golden decade of production growth (9% CAGR over 2001-11), industry production looks set to moderate to low single-digit (3%) growth rates onwards of 2013 with unsettling long-term concerns (railway and shale gas). Still, following the ‗perfect storm‘ in 1H12, we expect a much better demand-supply balance in 4Q12E and 2013E. Along with a demand recovery that should be supported by recent encouraging macro data, we also expect improvements from cost-driven supply discipline (18% of China‘s state-owned coal producers were loss-making in 8M12), normalising hydro output and import reductions. We expect system inventory to destock from 31 days of consumption in 2012 to 28
days in 2013. Continuing coal production cost rises could also lead to higher upside than downside risks for spot coal prices in 2013 (we expect a 1% YoY rise), whereas sector share prices factor in no price recovery. All these considerations underpin our positive investment thesis for thermal coal stocks in the near term, especially following the recent strength of early indicators like cement and steel. Along with our positive macro assessment, we have looked at costs in detail. While strong cost management in 3Q12 was a positive surprise, China Coal Energy‘s (China Coal) current cost structure is also less sensitive to wage inflation and policy changes vs. peers. Yanzhou Coal Mining (Yanzhou) has been the most leveraged stock in past upcycles, but its deteriorating profitability from expansion into low-margin mines in China and Australia, together with its substantial exposure to labour cost hikes, looks set to make its profits more vulnerable than peers. Given its higher earnings sensitivity to contract prices, China Coal could benefit the most if contract prices in China converge with spot prices. Even without full convergence this year, China Coal‘s track record shows it has been able to realise higher average prices than China Shenhua Energy (Shenhua). We have a cautious view in the medium term, as China‘s aggressive railway expansion could alleviate the long-lasting bottleneck, but we do not
expect a meaningful breakthrough until after 2014 based on our sum-of-the-parts forecasts. Also, we see the development of shale gas as a long-term threat, either via US exports to Asia or China‘s own exploration, which could impose pressure on coal demand. What we recommend
Shenhua is our top pick, as we believe it offers sustainable earnings growth, warranted by vertical integration. Having underperformed the market for three consecutive years, China Coal offers an attractive valuation, in our view. We therefore upgrade the stock to Buy (1) and believe it is a better recovery play than Yanzhou (Hold [3]). Risks to our sector view would be a worse-than-expected demand recovery and higher-than-expected cash costs. How we differ
We are more bullish about demand and coal prices for 2013 and we have a differentiated view on costs.
x
19 November 2012
Reassessing costs and benefits
Easing of perfect storm should create cyclical upside even for an
industry with single-digit growth rates and long-term challenges
While coal prices continue to be supported by supply and demand
forces, cost differences should also play a role in stock picking
Long-term investors should stay with Shenhua; upgrading China
Coal to Buy as we see a better risk-adjusted return vs. Yanzhou
How do we justify our view?How do we justify our view?
China Thermal Coal Sector 19 November 2012
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How do we justify our view?
Growth outlook
Valuation
Earnings revisions
Growth outlook China coal: demand-supply growth trend
During 2001-11, China‘s commercial coal output and domestic coal consumption (calculated on apparent demand basis) rose at CAGRs of 9% and 10%, respectively. However, we expect both of these growth rates to moderate in 2012, and for the 2012-15 period, we project respective CAGRs of only 3% and 4%. China‘s latest 12th Five-Year Plan for the coal industry also suggests a similar CAGR for coal production.
Source: CEIC, Daiwa forecasts
Valuation China Thermal Coal Sector: one-year forward PER trend
The sector looks inexpensive to us, trading substantially below its past-5-year mean. Yanzhou is much more expensive than Shenhua and China Coal in terms of 2013 PERs based on our forecasts; hence, we have a Hold rating on Yanzhou (compared with Buy ratings on Shenhua and China Coal). After the transfer of coverage, we are raising our NAV-based target price for Shenhua by 9% and our DCF-based target price for China Coal by 29%. However, we lower our DCF-based target price for Yanzhou by 10% due to its bleak outlook.
Source: Bloomberg, Daiwa forecasts
Earnings revisions Bloomberg consensus revisions to 2012 net profit forecasts
The Bloomberg consensus 2012E EPS for Shenhua, China Coal and Yanzhou have been revised down by 9%, 24% and 38%, respectively, year-to-date. There were massive cuts in consensus earnings forecasts for Yanzhou following its disappointing 3Q12 results, while Shenhua and China Coal have seen slight upward revisions recently. In terms of our 2012 net-profit forecasts, we are revising up that for Shenhua slightly by 0.3%, but reducing China Coal‘s by 4% and cutting Yanzhou‘s by 20%.
Source: Bloomberg, Daiwa forecasts
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Shenhua China Coal Yanzhou
100)
China Thermal Coal Sector 19 November 2012
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Source: Daiwa forecasts; note: prices as of close on 16 November 2012
Sector stocks: key indicators
Share
Company Name Stock code Price New Prev. New Prev. % chg New Prev. % chg New Prev. % chg
China Coal Energy 1898 HK 7.39 Buy Hold 9.00 7.00 28.6% 0.654 0.681 (4.0%) 0.739 0.719 2.9%
China Shenhua Energy 1088 HK 30.75 Buy Buy 38.00 34.90 8.9% 2.373 2.366 0.3% 2.644 2.574 2.7%
Yanzhou Coal Mining 1171 HK 11.26 Hold Hold 11.30 12.60 (10.3%) 1.047 1.309 (20.0%) 0.716 1.524 (53.0%)
Rating Target price (local curr.) FY1
EPS (local curr.)
FY2
China Thermal Coal Sector 19 November 2012
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Prepare for a short cycle ............................................................................................................... 5
End of a golden decade; a ‗perfect storm‘ bears down ............................................................. 5
Positive expectations for China‘s economic recovery ............................................................. 9
How do the sector cycles relate to the economy? .................................................................. 10
What is the most important share-price driver? .................................................................... 11
Demand, supply and prices .................................................................................................... 11
Perfect storm should ease in 2H12 ......................................................................................... 13
Regional coal-price outlook ................................................................................................... 20
Cyclical opportunities bode well for the sector over the next six months
End of a golden decade; a ‘perfect storm’ bears down
Along with China‘s decade-long hyper economic growth, the country‘s coal industry has enjoyed sustainably high production growth over the past 10 years, especially given that coal is the main fossil fuel (coal remains the largest fuel source to generate electricity) to power the industrialized economy. During 2001-11, commercial coal output and domestic coal consumption (calculated on an apparent demand basis) have grown at CAGRs of 9% and 10%. However, we expect both of these growth rates to come off in 2012, and from 2012 to 2015, we only project 3% and 4% CAGRs. China‘s 12th Five Year Plan for the coal industry also suggests a similar CAGR for coal production. Coal demand-supply growth trend
Source: CEIC, Daiwa forecasts
Accordingly, the slowdown in China‘s real economy this year has put significant pressure on the industry‘s demand growth and companies‘ earnings due to the resulting falling coal prices and most recently, reduced output. China‘s thermal coal stocks have mostly underperformed the HSCEI index again YTD in 2012, marking the third consecutive year of underperformance since 2009. Shenhua and Yanzhou accordingly outperformed in 2011 and 2010. China Coal has underperformed since 2009.
Note: Shenhua-H and China Coal-H were listed in 2006 and 2007.
Business comparison
Company Revenue mix (FY11) Location of coal mines
ROE (FY12E)
Operating margin
(FY12E) EPS CARG (FY12-14E)
Shenhua Coal mining 67%
Inner Mongolia (most), Shaanxi 19.7% 31.0% 9.5%
Power generation 28%
Others 5%
China Coal Coal mining 82%
Shanxi (most), Shaanxi,
Shandong 10.2% 13.5% 9.0%
Coke 6%
Coal mining engineering 8%
Others 4%
Yanzhou Coal mining 96%
Shandong (most), Shaanxi, Inner Mongolia,
Australia 11.6% 11.3% -19.9%
Coal chemical 2%
Railway transportation 1%
Power generation 1%
Heating supply 0%
Source: Companies, Daiwa
Opportunity lies beneath crisis
Looking into what has happened this year in more detail, many analysts and investors described the industry scenario in 1H12 as a ‗perfect storm‘, whereby slowing demand coupled with resilient supply growth and rising imports weighed on spot coal prices starting in April. The spot coal price (represented by Qinhuangdao 5,500kcal, NAR) declined by 21% from April to the July trough. The corresponding extent of share-price declines has been largely due to the Bloomberg consensus downward revisions of earnings forecasts (see following chart). Most analysts adjusted their forecasts after the 1H12 and 3Q12 results. However, compared with the latest mean average (updated since the 1H12 results), we still see 6% and 3% downside for Yanzhou and China Coal earnings for 2012.
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China Thermal Coal Sector 19 November 2012
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Bloomberg-consensus revisions to 2012 net-profit forecasts
Source: Bloomberg
Changes in Bloomberg-consensus 2012 forecasts
2012E forecasts Shenhua Yanzhou China Coal
No. of net-profit forecasts 37 31 36
No. of net-profit forecasts updated post the 1H12 results 29 26 29
% of forecasts updated 78% 84% 81%
Mean (CNYm) 47,510 5,822 8,705
Mean post the 1H12 results (CNYm) 47,301 5,448 8,443
Downside 0% -6% -3%
Source: Bloomberg, calculated by Daiwa
The forecasts for 2013 are much more uncertain for Yanzhou with 13% downside for the consensus average. Changes in Bloomberg-consensus 2013 forecasts
2013E forecasts Shenhua Yanzhou China Coal
No. of net-profit forecasts 36 31 35
No. of net-profit forecasts updated post the 1H12 results 29 26 29
% of forecasts updated 81% 84% 83%
Mean (CNYm) 50,234 5,206 9,159
Mean post the 1H12 results (CNYm) 49,648 4,553 8,698
Downside -1% -13% -5%
Source: Bloomberg, calculated by Daiwa
While the consensus earnings may be revised down further in the next few months, the limited earnings downside expected for Shenhua and China Coal suggests that most of the risks may have been priced into the shares already. Based on our output and cost projections, we believe current share prices are pricing in a 3% YoY increase in contract prices (lower than +5% YoY in 2012) and a 1% YoY decline in the spot price. We believe the street‘s view on the spot price in 2013 could be too conservative, and we project a 1% YoY increase. Moreover, Yanzhou‘s current share price suggests a 3% YoY price recovery overseas (Australia), for which we see potential downside.
What could coal prices be pricing in vs. our forecasts?
What is priced in Contract Spot Overseas
Shenhua +3% -1% n.a.
China Coal +3% -1% n.a.
Yanzhou +3% -1% +3%
Daiwa forecasts Contract Spot Overseas
Shenhua +3% +1% n.a.
China Coal +3% +1% n.a.
Yanzhou +3% +1% 0%
Source: Daiwa forecasts
Our industry section of the report follows the key differentiated arguments as outlined below:
Short-term view – positive
We examined the factors that we believe led to the formation of the ‗perfect storm‘ in 1H12 and conclude that the storm is likely to ease. Our view is that the industry should see a much better demand-supply balance going into 2H12 (especially in 4Q12) and 2013 with inventory destocking. We have included a detailed bottom-up calculation of coal demand and the latest updates on coal supply and imports.
We forecast the spot coal price (Qinhuangdao 5,500 FOB) to reach CNY660/t before the end of 2012 and the average price to increase by 1% YoY in 2013 (still below CNY800/t by the end of 2013, and below the current price cap).
We look at the different scenarios for contract-price setting at the end of 2012 and assess how they could affect the future earnings of different companies. A convergence towards spot coal price linkage would be positive for the coal companies in general, in our view.
We analyse in detail the cost structures of different companies and the likely trends going forward.
Medium-term view – cautious
Our bottom-up analysis of the railway capacity expansion plan for transporting coal over the next few years suggests that a major transportation bottleneck breakthrough should only occur after 2014; and it could be delayed by any stronger-than-expected pick-up in coal demand.
We analyse the shale gas potential in the US and China, and how it would affect the share of coal in China‘s energy consumption in the long run.
We like Shenhua and China Coal
Our overall view on the sector is opportunistic in the short term, but we are concerned about the long term, especially with the easing of transportation bottlenecks and the potential threat to coal demand of shale gas, either from China itself or US exports in the future.
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China Thermal Coal Sector 19 November 2012
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As the market may continue to debate the level of coal demand and prices next year, while waiting for further economic indicators, we suggest investors focus on each company‘s fundamental differences in costs and future strategies on top of pricing.
Having underperformed the HSCEI Index for three consecutive years (including YTD 2012), due mostly to cost concerns, China Coal looks appealing short term as a recovery play, especially with the consensus earnings revisions stabilising recently (not the case for Yanzhou).
Following China Coal‘s strong cost management in 3Q12, we believe its future cost structure will be less exposed to cost elements with sustainable upside risk, such as labour costs and policy costs. We are comfortable with China Coal‘s realised coal prices, as the company has been more successful than Shenhua in the past at negotiating favourable contract prices, and we expect China Coal‘s sales to shift more towards spot coal in the future in a bid to increase its average prices. Contract re-pricing at the year-end could also provide upside for the company assuming it can negotiate higher coal sales prices. We see much bigger upside than downside for the company, and therefore upgrade our rating to Buy (1), from Hold (3), and see the stock as a recovery momentum play.
Shenhua is our long-term top pick, as we are convinced that the company will expand its vertically integrated strategy, bringing further cost savings and sustainable EPS growth for the overall business. Although Shenhua‘s earnings are much more defensive than its peers to changes in coal prices and costs, we believe that such earnings stability deserves a premium, especially with long-term investors looking for a stable player in the energy spectrum in their country portfolios. Given the high return in most of its business segments, we continue to see the stock trading at a premium valuation to close peers. Reiterate Buy (1) rating.
Conventional wisdom could still favour Yanzhou as a more leveraged play on a demand recovery. However, despite its high earnings sensitivity to coal prices, Yanzhou‘s deteriorating profitability has also led to its EPS becoming more sensitive to costs. With the company moving into more low-margin mines, we forecast a sequential net profit decline for the next few years, and expect its EBIT margin to drop below China Coal‘s. We see Yanzhou as a low-quality recovery play compared with China Coal, and therefore maintain our Hold (3) rating.
China Coal 8,867 9,800 10,297 9,032 9,527 10,123 -4.0 2.9 1.7 Buy Hold
Yanzhou 5,137 3,513 3,299 6,440 7,497 8,019 -20.0 -53.1 -58.9 Hold Hold
Source: Daiwa estimates
2013E EPS sensitivity to changes in thermal coal prices (%)
Every 1% increase in Contract Spot
Shenhua +0.3 +0.9
China Coal +1.9 +2.5
Yanzhou +0.7 +9.4
Source: Daiwa forecasts
Note: Yanzhou’s spot coal includes both China and Australian coal prices
2013E EPS sensitivity to changes in costs
Sensitivity 1% increase in cost
Shenhua 1.2%
China Coal 3.8%
Yanzhou 10.0%
Source: Daiwa estimates
Bull-bear cases for earnings
We analyse the impact of price and cost shifts on earnings in bull and bear scenarios.
In our bull case, spot coal prices would strengthen slightly and contract prices increase significantly on the back of full implementation of spot-linked contract pricing. Cash costs would remain flat YoY mostly.
Under our bear-case scenario, the spot price would drop by 2% YoY from the level in 2012, while there would be no change in contract prices in 2013. Cash cost growth would be maintained at the past-5-year mean.
As a result, we see more upside than downside for Shenhua and China Coal. (Refer to the discussions below on each of these variables and likely associated events.)
Bull-bear case: impact of price and cost shifts on earnings
Most of the China thermal coal stocks under our coverage are trading currently at an attractive discount to their own historical mean (except for Yanzhou), with the forward PERs and PBRs trading close to 1SD below the mean.
On a relative basis, they are also cheaper than the regional peer average on both forward PERs and PBRs.
Although we do not see EV/reserve as a fair comparison due to large differences in local markets and profitability, the Chinese companies are trading at PBR/PER discounts to most of their regional peers.
Global valuation comparison table
Company name Stock code Rating Market cap PER (x) PBR (x) ROE (%) Div yield (%) EPS CAGR (%)
Source: Bloomberg forecasts for non-rated stocks, Daiwa forecasts for rated stocks
Note: Updated as of November 16, 2012
China coal sector: 12-month forward PER history
Source: Bloomberg, Daiwa forecasts
China coal sector: 12-month forward PBR history
Source: Bloomberg, Daiwa forecasts
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China Thermal Coal Sector 19 November 2012
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EV/tonne (reserve) comparison
Source: Bloomberg, companies, Daiwa
Positive expectations for China’s economic recovery
Chi Sun, Daiwa‘s China economist, and Mingchun Sun, Daiwa‘s regional head of economic research, have recently highlighted their positive stance towards a recovery in GDP in China for 4Q12 and 2013 (see our China Weekly Economic Monitor: Stronger growth in October of 9 November 2012). Despite weaker-than-expected GDP growth for 3Q12, Chi and Mingchun remain upbeat on China‘s economy in 4Q, based on
sequential growth in 3Q12 (7.4% YoY), especially in September. With more stimulus measures in the pipeline and destocking coming to an end, they forecast growth to rebound strongly in 4Q12 (to 8.2% YoY). Daiwa forecasts GDP growth of 7.8% YoY for 2012 and 8.0% YoY for 2013. The latest support for our argument is the rise of the official manufacturing PMI, which improved from 49.8 for September to 50.2 for October. Of the 11 sub-indices, 10 rose in October. Notably, four (new orders, purchase quantity, imports, and input prices) recorded their highest readings for six months, and two (production and new export orders) had their highest readings for five months. Overall, the October PMI shows more signs of a recovery, suggesting that the set of strong economic data for September should be sustained in October. As Chi and Mingchun believe destocking will end and the impact of recent stimulus measures will become more obvious, they expect a strong rebound in IP and GDP growth for 4Q12. In our opinion, such a recovery track will have a positive impact on coal demand, in that it should boost the intrinsic demand from key coal users, like power, steel and construction materials and chemicals, which we explain in detail in the following section.
China macroeconomic indicators: actual and Daiwa forecasts
The sector is viewed by many investors as being high-beta and leveraged on economic activity. However, examining historical share-price performances compared with other materials sectors, including coking coal, steel, cement, aluminium and copper, it seems that thermal coal is a mid-cycle performer. According to Felix Lam, Daiwa‘s Hong Kong/China head of materials, while all material stocks are cyclical in nature, some tend to move earlier than the others. In China, cement and steel usually react ahead of others. In our view, this can be explained by the structure of China‘s economy, with fixed asset investment (FAI) being a primary driver in recent years. Even though domestic consumption has been playing an increasing role in the nation‘s GDP, FAI (mainly public infrastructure) remains the major tool for government to lift the economy, especially when it faces external challenges. To build infrastructure, cement and steel are the obvious bulk materials needed. While copper, aluminium, and other non-ferrous metals are also used in infrastructure construction, their demand is sensitive to manufacturing industries and export markets. These areas are facing challenges and tend to recover at a later stage of an economic cycle. As a result non-ferrous metal stocks lag behind cement and steel stocks when the market rebounds on expectations of an economic recovery. Among all the major commodities, thermal coal prices are usually among the latest to run up, as 60% of thermal coal is used for generating electricity in China. Demand for electricity does not fluctuate as much as industrial and construction activity along an economic cycle in China. Notably, cement and construction related steel products are local materials, while non-ferrous metals and coal are well-traded globally. This also explains why cement and steel move ahead of others in the China cyclical material space.
In conclusion, it is apparent that the share-price performance of the thermal coal sector tends to lag that of other early indicator sectors, especially the coking-coal sector. During the market recovery through 2009 after the 2008 financial crisis, the coking-coal sector reaped most of the gains during the earlier part of 2009 while thermal coal did not catch up until the end of 2010. Looking at the recent rebound in share prices since the July bottom, the thermal sector only rallied by 4% throughout 3Q12, and by a further 4% in October, while the steel and cement stocks picked up strongly in October (see following table). Quarterly sector share-price performance
We conducted a correlation analysis between share-price performances in recent years and: 1) port inventory (measured by Qinhuangdao), 2) power plant inventory, and 3) spot coal prices (measured by Qinhuangdao 5,500 kcal). We found that the relationship between the share-price performances and power plant inventory days is the strongest (correlation co-efficiency of negative 0.56x for power plant inventory). Correlation between share-price performance and power plant inventory days
Source: CCTD, Bloomberg
Correlation between share-price performance and port inventory
Source: CCTD, Bloomberg
Correlation between share-price performance and coal prices
Source: CCTD, Bloomberg
We forecast China‘s stock of coal inventory to be reduced from 31 days in 2012 to 28 days in 2013 as we expect accelerated demand growth in 2013, and believe this fundamental change supports our positive industry outlook in the near term. Forecasts of total inventory trend
Source: CCTD, Bloomberg
Demand, supply and prices
In our bottom-up demand/supply analysis, we look for a weaker seller‘s market in 2H12 and expect China‘s spot coal prices (Qinhuangdao 5,500 kcal FOB price) to edge up slowly to CNY660/t by year-end. On an annualized basis, this rise in spot coal in 2H12 would still represent a 13.7% YoY fall in average spot coal prices during 2012. Compared with 1H12 (production and consumption growth of 5.6% YoY and 2.8% YoY, with an ex-import oversupply of 102m tonnes), we expect a much better demand-supply balance in 2H12 (production and consumption growth of 0.3% YoY and 3.9% YoY, with an ex-import supply shortage of 72m tonnes). We forecast system inventory to have increased by 27% YoY to 321m tonnes (or 31 days of demand) by the end of 2012. However, on our forecasts, the balance would continue to improve in 2013 with demand growth (4.9% YoY) outpacing supply growth (2.5% YoY). With a steady rise in imported coal (up 1.8% YoY for 2013E), we expect system inventory to destock by 3 days to 28 days (or 303m tonnes). As a result, we expect the spot coal price to see a further 1% increase, although remaining below the current price cap (CNY800/tonne) throughout the whole year. Our forecast for slower production growth in 2013 is based on: 1) pressure from the government for destocking to continue in the industry (as quoted by the local press), 2) small mines that were shut down recently due to safety measures may not fully resume until after the National People‘s Congress in March
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Correlation = -0.56
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10,000
Mar
-08
Jun-
08
Sep
-08
Dec
-08
Mar
-09
Jun-
09
Sep
-09
Dec
-09
Mar
-10
Jun-
10
Sep
-10
Dec
-10
Mar
-11
Jun-
11
Sep
-11
Dec
-11
Mar
-12
Jun-
12
Sep
-12
(HKD bn)('000 tonne)
Qinghuangdao inventory (LHS) Total market cap (RHS)
Correlation = -0.14
400
600
800
1,000
1,200
1,400
1,600
550
650
750
850
950
1,050
Mar
-08
Jun-
08
Sep
-08
Dec
-08
Mar
-09
Jun-
09
Sep
-09
Dec
-09
Mar
-10
Jun-
10
Sep
-10
Dec
-10
Mar
-11
Jun-
11
Sep
-11
Dec
-11
Mar
-12
Jun-
12
Sep
-12
(HKD bn)(CNY/tonne)
QHD 5,500kcal coal FOB price (LHS) Total market cap (RHS)
Correlation = 0.14
0
5
10
15
20
25
30
35
0
50
100
150
200
250
300
350
2008A 2009A 2010A 2011A 2012E 2013E 2014E 2015E
(Days)(Mil tonnes)
Total system inventory Inventory days (RHS)
China Thermal Coal Sector 19 November 2012
- 12 -
2013, based on our industry research, 3) a number of large coal mines are barely profitable (according to government data, about 17.8% of scalable state-owned coal producers recorded losses in 8M12), and we estimate the large coal mines accounted for 2/3 of market share in terms of production in 2011, and 4) a continuing rise in coal production costs, which would push up the price floor. Cash production costs have increased by a high single-digit percentage per year over the past 10 years, and even the well-managed listed companies (such as the three listed producers) have seen a similar trend. Many costs are on an unavoidable upward trend, like labour costs (true for both China and key producing countries), raw-material costs (tyres, diesel and explosives), and government taxes (such as China‘s changing resources tax and Australia‘s carbon tax). If we take a theoretical cost rise of 10% in 2013 with recovering demand, we estimate the theoretical price floor would exceed the CNY615 floor seen in 2012, especially if supply (as prices and profitability could recovery slowly) were to increase at a slower rate than demand. Selected production costs in China
1Q07 2Q07 3Q07 4Q07 1Q08 2Q08
Average cost (CNY/t) 214.38 216.61 211.76 228.60 241.87 295.73
YoY (%) 7.67 10.25 12.45 9.75 12.82 36.53
3Q08 4Q08 1Q09 2Q09 3Q09 2Q10
Average cost (CNY/t) 239.93 283.34 264.41 268.48 263.10 293.98
YoY (%) 13.30 23.93 9.33 -9.21 9.66 9.50
Source: SX Coal
Note: not all quarters are available and the data ceased publication in 2010
As we discussed in our introduction, three major factors occurred coincidentally in 1H12, which created a perfect storm scenario, weighing on thermal coal prices in China (Qinhuangdao 5,500 kcal down by 21% from CNY790/tonne in early April to CNY615/tonne in mid-July before edging up recently). Qinhuangdao inventory (the largest coal port in China) experienced a sharp inventory build-up within a matter of 40 days (up 83% from 5.2m tonnes in late April to 9.5m tonnes by mid-June). However, inventory has started to ease recently to 5.4m tonnes as of mid-October after the destocking in 3Q12 and completion of the Daqing railway maintenance. Following the maintenance, inventory has rebounded to close to 6m tonnes in mid-November, which is much higher than the level at the same time in 2011. However, as October power output suggests a small demand recovery, we expect a sequential coal demand improvement starting in 4Q12. China: Qinhuangdao port inventory and spot coal prices
Source: SX Coal
Meanwhile, inventory at the power plant level also came down from the 28-day peak in June to 24 days as of early September before edging up again throughout September and October. Based on our industry research, the rise in inventory through September and October at the power plant level was due to pre-emptive re-stocking activity ahead of: 1) the Golden Week holiday at the beginning of October, 2) maintenance carried out on the Daqin railway from 8-22 October, and 3) restocking ahead of the winter peak demand. While the overall inventory level remains high compared with the past few years, we believe it should gradually come down in the next few quarters, with a more favourable demand-supply situation.
Coal inventory levels at power plants and inland coal price
Source: CCTD
In the following section, we examine how each variable caused the price collapse in 1H12 and where we could see improvement in 2H12.
1) Slightly higher demand growth in 2H12
The slowdown in demand growth was first detected through the disappointing manufacturing PMI and power consumption numbers in April 2012. While the market widely expected these to have bottomed out in July, the August number slipped again, especially with the manufacturing PMI dropping below 50 for the first time since November 2011. However, the PMI improved back to above 50 in October. Meanwhile, power output also beat the usual seasonality of September and October (-0.2% MoM for October vs. the historical mean of -2.7% MoM), suggesting a small demand recovery. China: manufacturing PMI vs. power output growth
Source: CEIC
What could cause a swing in demand would be physical production for the steel industry, which consumed 11% of power usage for the first 7 months of 2012 and 15% of total coal consumption (mainly coking coal) in 1H12. Given the increasing number of loss-making steel companies in China, daily average production of crude steel declined in September, but has rebounded since
October. The rebound supports what we discovered on our latest trip in China. In her report published on 26 September 2012, Penetrating China’s steel heart, Daiwa steel analyst Joey Chen believes that after experiencing weakening demand growth and steel prices YTD, steel mills and steel traders have already turned prudent about their
production and inventory levels since 1H12. They see limited downside to steel prices and demand from current levels. Joey expects demand to improve slightly in 2H12 due to seasonal factors and on the back of a slow pick-up in infrastructure construction, which would translate into a rebound in steel prices in the next few months. In addition, the low inventory level for steel traders is likely to be positive for steel prices. The steel traders and mills Joey visited said they were seeing a shortage of different steel products, as buying interest has picked up driven by a recovery in steel prices. More traders have started restocking, in anticipation of higher steel prices ahead. They also indicated that they are likely to stock up on some products ahead of spring and Lunar New Year in 2013. With traders currently accounting for about 65-70% of domestic sales volume, Joey believes their sentiment and behaviour will determine steel prices in the short term. Given traders‘ current restocking from low inventory and our anticipation of some demand recovery, Joey continues to expect steel prices to rise in the next few months. Daiwa‘s house view is that China‘s total crude steel production will only increase by 5.4% YoY to 720m tonnes for 2012, following 9% YoY growth in 2011. China: daily average crude steel production
Source: China Iron and Steel Association
China: power consumption breakdown by industry (7M12)
Source: CEIC
China has recently approved a series of infrastructure projects amounting to more than CNY800bn. Although many of these projects have some overlap with the projects announced by local governments, we see it as confidence booster. The biggest challenge, however, is not a lack of FAI, but rather how to fund these investments. Daiwa‘s Chi Sun believes that China is encouraging more diversified sources of funding to manage banking system risks to avoid a build-up of bad loans. Daiwa forecasts China‘s FAI growth to remain at decent levels going forward (20.5% YoY for 2012 and 18.0% YoY for 2013). China: FAI and new loan growth
Source: CEIC
We project the consumption of coal for power usage in China to increase by 2% YoY for 2012, followed by 7% YoY growth for 2013 and 6% YoY for 2014, given the relationship between power consumption and economic output, and normalizing hydro power output after 2012. We forecast the consumption of coal for construction (cement) usage to rise by 7% YoY for 2012, followed by 6% YoY growth for 2013 and 5% YoY for 2014, while we expect no growth for chemical usage. As a result, we forecast total commercial coal consumption growth of
2.8% YoY for 2012, followed by accelerated growth of 4.9% and 4.8% YoY for 2013 and 2014, respectively. In our 2012 forecasts, power, steel, construction and chemical usage account for 51%, 17%, 13% and 3% of total consumption. China: monthly steel/cement/fertilizer production (YoY)
China has become a net coal importer since 2009 with total imported volume increasing every year, driven by: 1) continuing domestic railway bottlenecks, 2) pressure for coastal provinces to achieve energy efficiency and environmental targets (outsourcing mining process, which creates pollution and consumer energy), and 3) price arbitrage opportunities. (The last reason has been especially prevailing this year.) In 1H12, China imported total raw coal of 140mt (98% YoY growth), mostly driven by price arbitrage between domestic and import coal prices. However, driven by the earlier recovery of regional coal prices than China domestic prices, coal imports were only 63mt in 3Q12, up just 19% YoY. Based on our own calculations, taking the Newcastle (6,000 kcal) FOB price adjusted for freight and VAT, imported coal was cheaper than the Qinhuangdao price adjusted for Guangzhou CFR from March to July 2012. However, the arrival price (CFR) in the Guangzhou port of high-ash Indonesia Kalimantan has not meaningfully recovered, which leaves price arbitrage open. However, during the regional price recovery from August-September (8% for Newcastle, 8% for Richards Bay and 10% for ARA in Europe), import volume was under pressure as price arbitrage became less profitable. Despite the FOB price weakness in exporting ports in October, the arbitrage gaps are still very small considering freight rates are rebounding.
(20)
(10)
0
10
20
30
40
Jan-
11
Feb
-11
Mar
-11
Apr
-11
May
-11
Jun-
11
Jul-1
1
Aug
-11
Sep
-11
Oct
-11
Nov
-11
Dec
-11
Jan-
12
Feb
-12
Mar
-12
Apr
-12
May
-12
Jun-
12
Jul-1
2
Aug
-12
Sep
-12
(%)
Crude steel Cement Fertilizer
Power51.2%
Steel16.7%
Construction13.4%
Chemical2.5%
Others16.1%
China Thermal Coal Sector 19 November 2012
- 16 -
China: total monthly raw coal imports and growth rate
Source: CCTD
Guangzhou port CFR price difference with Australian imported coal
Source: CCTD, Daiwa
Guangzhou port CFR price difference with Indonesia imported coal
Source: CCTD, Daiwa
Regional coal prices (Newcastle, Richards Bay, ARA)
Source: SX Coal
Last, based on cost curves projected by E.ON. in its presentation materials, we calculate that assuming no major changes throughout 1H12, current FOB prices could lead to the high-cash-cost producers in Australia and Indonesia being phased out, which is another reason for the recent support of regional coal prices.
(100)
0
100
200
300
400
500
600
0
5
10
15
20
25
30
Jan-
04
Jun-
04
Nov
-04
Apr
-05
Sep
-05
Feb
-06
Jul-0
6
Dec
-06
May
-07
Oct
-07
Mar
-08
Aug
-08
Jan-
09
Jun-
09
Nov
-09
Apr
-10
Sep
-10
Feb
-11
Jul-1
1
Dec
-11
May
-12
(%)(mn tonne)
Total coal imports (LHS) YoY (RHS)
(30)
(20)
(10)
0
10
20
30
(250)
(150)
(50)
50
150
250
Jan-
09
Apr
-09
Jul-0
9
Oct
-09
Jan-
10
Apr
-10
Jul-1
0
Oct
-10
Jan-
11
Apr
-11
Jul-1
1
Oct
-11
Jan-
12
Apr
-12
Jul-1
2
Oct
-12
(mn tonne)(CNY/tonne)
Monthly net import (RHS) QHD premium to Newcastle (LHS)
(30)
(20)
(10)
0
10
20
30
(300)
(200)
(100)
0
100
200
300
Feb
-09
May
-09
Aug
-09
Nov
-09
Feb
-10
May
-10
Aug
-10
Nov
-10
Feb
-11
May
-11
Aug
-11
Nov
-11
Feb
-12
May
-12
Aug
-12
(mn tonne)(CNY/tonne)
Monthly net imports QHD premium to Indonesia (LHS)
40
60
80
100
120
140
160
180
200
220
May
-08
Aug
-08
Nov
-08
Feb
-09
May
-09
Aug
-09
Nov
-09
Feb
-10
May
-10
Aug
-10
Nov
-10
Feb
-11
May
-11
Aug
-11
Nov
-11
Feb
-12
May
-12
Aug
-12
(USD/tonne)
Newcastle Richards Bay ARA Ports
China Thermal Coal Sector 19 November 2012
- 17 -
Cash cost curve of coal exporting countries and current FOB coal prices
Source: E.ON., SX Coal
Daiwa‘s house forecast suggests total imported coal of 218m tonnes for 2012 (166m tonnes of thermal coal and 52m tonnes of metallurgical or coking coal). As China imported a total of 140mt of coal in 1H12, implied growth for 2H12 would be a 30% YoY (44% HoH) drop.
3) Low hydro season and winter re-stocking should boost coal purchases in 4Q12
Following a year of serious droughts in 2011 (c.50% YoY decline in rainfall), hydro power has recovered since 2Q12 with China‘s rainfall normalizing. In the first 10 months, hydro power output increased by 24.2% YoY compared with a 1.6% YoY decline for thermal power. Given China‘s higher dispatch priority for hydro (16% of total power output in the first 10 months of total output), thermal power has been under pressure as a result of direct competition.
The off-season impact on hydro power has emerged later than we expected. Tracking water outflow velocity of China‘s largest hydro dam, the Three Gorges dam, we note there was a rebound in early October compared with a historically downward slope. However, the water level upstream from the dam itself has tracked historical seasonal inflow, which means with less rain going into 4Q12, water outflow (or driver of electricity) should also ease soon. Three Gorges dam: water outflow velocity
Source: China Yangtze Power
Three Gorges dam: upstream water level
Source: China Yangtze Power
Also, northern China has experienced an earlier-than-expected winter this year, with most cities starting the heating season 1-2 weeks earlier than usual. As heat is generated from both central heating facilities and co-generation power plants (mostly based on coal fuel), we expect the winter effect to increase the demand for coal-fired power generation as a whole. The cold weather arriving earlier this year in the northern China regions has made people wonder if this winter will be colder than in the past. According to forecasts from the Hong Kong Observatory, winter should arrive earlier this year in Hong Kong, last longer and be colder because global warming is causing the icebergs to melt in the Arctic, which absorbs heat from the environment. Mr. Shun Chi-ming, the Hong Kong Observatory Director, warned that there could be more extreme weather going forward, with cold spells coming more often and lasting longer. His view is shared by Mr. Zhu Congwen, a research analyst at Chinese Academy of Meteorological Sciences. Mr. Zhu believes the accelerating melting of the icebergs would increase the atmospheric pressure in the North Pole, which could push the cold air to the lower latitude zones and cause abnormal temperature declines in China. However, some researchers think it is still too early to forecast the winter temperature, as it could be affected by many other factors such as the average Pacific Ocean sea surface temperature near the equator, which is not easy to forecast at the moment. Average temperatures in Beijing
Source: Bloomberg
4) Better-than-expected supply discipline
Coal producers in key provinces have been under pressure since July to cut production, even in the top-3 producing provinces, Shanxi, Inner Mongolia and Shaanxi (where notable cuts took place in September). We believe the production cuts are to stop the losses and due to the temporary shutdown of mines for safety measures.
150
250
350
450
550
650
Jan-Feb Apr Jun Aug Oct Dec
(Bn KWh)
2007 2008 2009
2010 2011 2012
0
5,000
10,000
15,000
20,000
25,000
30,000
35,000
40,000
Jan-
12
Jan-
12
Feb
-12
Mar
-12
Mar
-12
Apr
-12
May
-12
May
-12
Jun-
12
Jul-1
2
Jul-1
2
Aug
-12
Sep
-12
Sep
-12
Oct
-12
Nov
-12
(m³/s)
2010 2011 2012
130
140
150
160
170
180
190
200
1-Ja
n
22-J
an
12-F
eb
4-M
ar
25-M
ar
15-A
pr
6-M
ay
27-M
ay
17-J
un
8-Ju
l
29-J
ul
19-A
ug
9-S
ep
30-S
ep
21-O
ct
11-N
ov
(m)
2010 2011 2012
0
5
10
15
20
25
1-Oct-2012 15-Oct-2012 29-Oct-2012 12-Nov-2012
(℃)
2012 2011 Historical average (2008-2011)
China Thermal Coal Sector 19 November 2012
- 19 -
In terms of listed companies, we have seen a similar trend for Shenhua in recent months, but for China Coal, monthly output in July and September outperformed the key provinces on a MoM basis. Shenhua‘s key production base is Inner Mongolia, and China Coal‘s is mostly in Shanxi. According to local press reports, in the first 8 months of 2012, 16 large state-owned coal producers recorded a net loss, making 17.8% of scalable coal producers loss-making. This is also another angle from which to look at the floor for coal prices, and with production costs rising over time, the floor price should also be higher with self-corrective market decisions based on loss ratios. Loss ratio of state-owned coal producers
Source: CEIC
Raw coal production MoM by province
Source: SX Coal
Raw coal production MoM of Shenhua and China Coal
Source: SX Coal
Going forward, the three companies we cover are likely to come under less pressure to cut production as a result of them having tightened up their safety standards as required by the government. All three companies, especially Yanzhou (zero fatalities for 5 consecutive years from 2007-11) have kept annual fatality rates (measured by number of deaths per million tonnes) at much lower levels than the national average. The biggest question now is whether the small mines that have been recently shut down will resume production after November 2012. Based on our industry research, some industry experts do not believe full production will resume until the 18th National People‘s Congress commences in March 2013 when long-term safety measures are likely to be introduced, which could lead to a sustained destocking trend throughout 1Q13. As demand returns steadily, production at the mines could resume, especially with small mines accounting for a meaningful market share (we estimate one-third of the market in 2011). Fatality rates
All local mines have been shut down, with resumption of production not expected before December 2012. Only Longmay Mining Group's production has not been affected.
Jilin In the Baishan area, only 2-3 local mines are still operating.
Qinhai Almost all local mines have been shut, and only a few large mines are still in operation.
Gansu All small mines have been shut. Large mines are still operating but safety inspections are conducted every day.
Shaanxi
In the Yulin area, one-third of the coal mines have been shut. Small mines with annual production under 300 kilo tonnes will not resume production until the end of the year.
Shanxi
In the Lvliang area, small private mines have been shut. In the Lishi area, all mines have been shut. In the Datong area, all mines will be shut until the end of November were they except those under Datong Coal Mine Group. In the Yangyuan Pingding area, most mines have been shut down.
Inner Mongolia Some underground mines have been shut but open-pit mines have not been not been affected.
Shandong Small mines with annual production under 300 kilo tonnes would be shut from early November this year.
Anhui About 10% of Huaibei's production has been cut, but Huainan was not affected by and large.
Henan Small mines continued to be closed since last inspection in August.
Sichuan In Panzhihua area, only Panmei Company is still operating, and all else were shut.
Chongqin Only SOE mines are still operating, and small local mines were shut.
Source: SX Coal, Daiwa
Regional coal-price outlook
Thermal coal
Based on forecasts by our Japan Resources Team, the thermal coal seaborne trade market will be saddled with a supply glut of 5mt in 2012. Supply volumes of thermal coal look set to rise by 5% YoY to 814mt, while demand volumes will be up 4% YoY to 809mt. We forecast output in major coal-producing countries such as Indonesia, Australia, Colombia and South Africa to increase by 3-7% YoY, with steady exports overall. For Indonesia, the world‘s largest thermal coal supplier, we forecast coal exports (incl. coking coal) to rise by 6% YoY for 2012. We also assume thermal coal export volume growth of 6% YoY growth for Australia and 3% YoY for South Africa. However, we forecast Colombia‘s exports to increase by 7% YoY, as a major supplier plans to add capacity, but coal railway workers went on strike at end-July. Our forecast for China‘s import volumes of thermal coal currently calls for 159mt, 15% above the year-earlier level. Total import volumes for Jan-Jul 2012 were up 57% YoY to 102mt. However, the rapid increase in 1H12 led to an inventory glut, so import volumes are likely to lose a lot of momentum in 2H12. Meanwhile, our forecast for India‘s import volumes of thermal coal is 59mt, up 10% YoY. August announcements showed that FY11 imports jumped by 33% to 66mt. We expect gains in import volume to narrow in FY12 along with slowing economic
growth. That said, India‘s appetite for thermal coal imports is hard to forecast, making it a variable factor for our outlook of seaborne trade supply/demand. Industry publications say that state-owned Coal India (COAL IN, INR351.15, Buy [1]) has decided to import roughly 15% of the domestic demand volume in order to meet its obligation to supply coal to domestic customers (electric power companies). This would come to an import of nearly 20mt. However, we will need to decide whether to change our import volume forecast for 2012 after gauging whether the firm will actually carry out the import plan. For 2013, we envisage a supply glut of 15mt. The oversupply will likely contract YoY, but we think supply/demand will remain very loose. We forecast thermal coal output to increase by 4.6% YoY to 852mt, while demand looks set to rise by 3.5% to 837mt. Supply volumes of thermal coal in the seaborne trade market are likely to lose a considerable amount of momentum YoY. In our view, the combination of erosion in supply/demand and plummeting prices will force some high-cost manufacturers to stop producing thermal coal, while the main suppliers probably will not seek to aggressively increase output.
Price trend
We forecast Japan-Australia contract prices (Australia FOB) to fall by 22% YoY to USD90/t in FY13 and remain flat at USD90/t in FY14. The FY12 contract price has been settled at USD115/ t. We forecast thermal coal spot prices to remain in the USD80-100/t range for the next six months. A sharp improvement in supply/demand conditions in the seaborne trade market is hard to picture. However, an unexpectedly steep price decline since spring has pushed recent spot prices down to the level of production costs at major suppliers in Australia and elsewhere. This indicates that spot prices are likely to stay steady and low for the time being. We have kept our outlook for long-term thermal coal prices at USD90/t because production costs are around that level for new suppliers such as Australia, which is a marginal producer. Recent spot prices have been trending below that line, but we see no need to revise our long-term forecast at this juncture. At current spot prices, Australian thermal coal suppliers are above cash cost, but many seem to be in the red or at the break-even point on a total cost basis. Sales at contract prices (USD15/t for FY12) account for over half of the total at many Australian suppliers, so we have seen no decisive moves to curtail production or close mines yet. Nevertheless, some suppliers have been reducing contractor jobs and/or cutting headcount, so they could start closing mines if thermal coal prices remain soft.
China Thermal Coal Sector 19 November 2012
- 21 -
Meanwhile, some US coal suppliers are cutting back production. On 21 June, Arch Coal announced plans to close three mines in the Appalachia region, and Consol Energy decided to idle its Fola complex in West Virginia early in July. Regional thermal coal imports/exports forecasts (m tonne)
Despite the bottoming of coastal coal prices, there have been mixed signals for mine-mouth coal prices. For example, the Shanxi Datong Nanjiao (5,500 kcal) mine-mouth price saw a bit leg down adjustment in mid-August (from CNY500/t to CNY440/t), while Inner Mongolia Ordos (5,500kcal) and Shaanxi Yulin (5,500kcal) have seen small rebounds in recent weeks.
Mine-mouth coal prices
Source: SX Coal
History suggests a strong correlation over time between mine-mouth and coastal prices (we take an average of mine-mouth prices from Shanxi, Inner Mongolia and Shaanxi to compare with the Circum-Bohai Sea Price Index). From time to time, there have been small time lags. However, given that seaborne coal accounts for about 40% of total coal demand in China, we believe that mine-mouth prices should follow trends in coastal prices eventually, given some time lags. Mine-mouth vs. seaborne coal prices
Source: SX Coal, calculated by Daiwa
Looking at the locations of producing mines of the three coal produces, the following maps illustrate that Shenhua is more focused in Inner Mongolia (especially on the west side where rail transport is available), whereas most of China Coal‘s reserves are in Shanxi Province. Yanzhou‘s key production in China is in Shandong but has expanded to Shanxi, Henan and Inner Mongolia; the Australia business is run throughout its subsidiary, Yancoal Australia (Not rated), which has recently expanded further following the acquisition of Gloucester (GCL) (Not listed).
BSPI Index (LHS) Average mine-mouth price 5,500kcal (RHS)
China Thermal Coal Sector 19 November 2012
- 22 -
Coal mine locations
Source: Companies
Near-term opportunity: convergence of spot and contract prices
Contract coal has played an important role throughout China‘s transition from a planned economy to a quasi-market economy. Before the 1980s, all coal was priced by the central government, with the total contract volume planned by the government. After the 1980s, the planned proportion accounted for about 50% and in 2012 was reduced further. Coal-price adjustments in 1958, 1965, and 1979 were due to low profitability of the coal producers. China: raw-coal price adjustments before 1992
Year
Coal price (CNY/tonne)
Coal costs (CNY/tonne)
Net profit (CNY/tonne)
Net margin (%)
Before After Before After Before After Before After
1958 11.0 13.4 9.3 10.2 1.7 3.2 15.6 24.1
1965 15.4 17.3 14.3 15.8 1.1 1.6 7.0 9.0
1979 15.9 21.0 13.5 17.8 2.4 3.2 14.9 15.2
1985 23.8 26.9 17.8 23.4 6.0 3.5 25.2 13.0
Source: Various sources
From 1979-92, the country began to introduce a market mechanism by allowing market pricing outside the planned quota. In 1993, it extended the reform with market pricing becoming the main standard. The government issued guidance prices for contract coal until 2002, when guidance was formally suspended and pricing was left to the buyers and sellers. However, coal pricing has not been 100% market-based due to government intervention. For instance, following a failure in negotiations in 2004, the NDRC provided a guidance cap of an 8% increase. In 2011, the government capped the contract price at the
2010 level amid inflation, and at a 5% maximum increase in 2012 given the fast deteriorating profitability of power plants. Meanwhile, the NDRC has capped spot-coal prices twice, introducing a cap at the final price of 19 June in 2008 (range of CNY840-860/tonne) and, most recently, CNY800/tonne (Circum-Bohai coastal prices at 5,500kcal) throughout 2012. Government intervention since the reform
Contract Spot
2005 Provided guidance of 8% cap n.a.
2008 n.a. Capped at 19 June prices
2011 Cap at 0% n.a.
2012 Cap at 5% Capped at CNY800/t
Source: Various sources
During 1H12, following reduced gap between spot and contract prices, the NDRC launched a study of contract-spot convergence. Based on our industry research, the study was suggested by coal users, especially power plants, and did not receive a lot of support from coal producers. Recent press reports suggest there could be two different versions of the proposal. The first version suggests contract coal sales run for periods of 2-5 years and the contract price be based on a benchmark plus an adjustment-variable formula with the benchmark price decided by the NDRC, which means the government would be able to limit volatility. The second version is free price-setting by the buyers and sellers for contract coal, which would mean it was free from government intervention. Besides coal-price changes, there could also be policies on power prices linked to changes in coal prices and railway quota allocations. However, there has not been an official document on the details and it remains speculation at this time.
Reasons why full convergence is difficult
Based on our recent discussions with industry experts and listed companies, many believe that these measures do not represent substantial reforms compared with the previous pricing mechanism. There are also difficulties linking a market-based coal price with a market-based power price, which has been the key conflict over the past decade. In China, electricity prices are fully regulated by the NDRC at both the on-grid (tariffs paid by the power grid companies to the power plants) and end-user (tariffs paid by the users to the power grids) levels. In the past decade, there have been a few times when inflation has been the key impediment to electricity price hikes (especially after 2006), resulting in volatile profitability for the power producers. With the relatively soft economic growth currently, if China were to link fully
Beijing
Guangdong
Guangxi
Hunan
Hubei
Hainan
Xinjiang
Qinghai
Ningxia
Shaanxi
Jiangxi
Jiangsu
Shanghai
Hebei
Inner Mongolia
Shanxi Shandong
Tibet (Xizang)
Sichuan
Yunan
Guizhou
Henan
Heilongjiang
Jilin
Liaoning
Anhui
Zhejiang
TaiwanFujian
Gansu
Australia
China
China Shenhua
China Coal
Yanzhou Coal
China Thermal Coal Sector 19 November 2012
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fuel prices with electricity prices, a sudden sharp rise in coal prices could squeeze further the already weak margins of industrial users such as steel mills and aluminium smelters (industrial users account for more than 70% of total power consumption currently). Another important issue is the railway transport quota, which has been used to guarantee the transportation of key contract coal supplies in the past. If China opens its coal market fully, it could become increasingly difficult for coal companies to secure railway transport, especially ahead of periods of peak demand. In our view, until China resolves fully the issues of the market pricing of electricity and transportation bottlenecks, any reform of coal pricing would continue to be only partial. In fact, the NDRC reduced the proportion of contract coal in the market by cutting railway quotas for cross-provincial transportation for 2012, while the target shipments for 2012 were 11% YoY lower at 834m tonnes, which accounts for 36% of our forecast 2012 total rail-shipment forecast for coal. PRC Government: target shipments by rail (m tonnes)
Year Cross-provincial
target YoY (%) Actual total rail
shipment YoY (%) % of key target
2008 785
1,691
46.4
2009 846 7.8 1,751 3.5 48.3
2010 907 7.2 2,000 14.3 45.3
2011 932 2.8 2,270 13.5 41.1
2012E 834 -10.5 2,350 3.5 35.5
Source: NDRC
Any market-based contract pricing is positive for coal producers
As we expect the spot-coal price to remain higher than the contract price, we expect the proportion of contract sales to total sales to fall further in the future. We forecast a 3% YoY increase in the contract-coal price for 2012. However, any move towards a more market-based system could benefit the listed coal producers we cover much more, as gap between contract and spot-coal prices is generally larger than 3% currently. In the above discussion, we exclude Yanzhou as the company sells most of its coal in China in the sport market. Based on the disclosed prices and our forecasts (for 2012), the gap between Shenhua‘s average spot and contract prices gap is the largest. The difference between Shenhua‘s and China Coal‘s average contract prices is the result of the former‘s larger contract sales through what Shenhua calls ‗direct arrival‘ (transported directly to customers by rail) and the mine mouth, with only about 46% (2011) shipped by sea to customers. Seaborne prices are generally higher due to the higher transportation costs. However, looking at different channels, Shenhua still sells contract coal at a big discount to spot coal, especially for direct arrival and the seaborne market.
Major China coal producers: contract and spot prices
(CNY/tonne) 2008 2009 2010 2011 2012E
Shenhua
Spot 438 421 457 508 467
Contract 336 362 362 338 355
Difference 30% 16% 26% 50% 32%
China Coal
Spot 612 417 521 562 517
Contract 365 402 410 425 468
Difference 68% 4% 27% 32% 11%
Source: Companies
Shenhua: breakdown of contract and spot prices by delivery method (CNY/t)
Spot 2007 2008 2009 2010 2011 9M12
Total 265 438 421 457 508 472
Mine mouth 102 163 178 142 171 138
Direct arrival (rail) 289 387 401 406 473 416
Seaborne 399 614 473 590 630 568
Contract
Total 311 336 362 362 338 349
Mine mouth 0 79 105 163 162 184
Direct arrival (rail) 229 261 278 263 251 253
Seaborne 360 409 441 462 451 481
Difference
Total -15% 30% 16% 26% 50% 35%
Mine mouth - 106% 70% -13% 5% -25%
Direct arrival (rail) 26% 48% 44% 55% 88% 64%
Seaborne 11% 50% 7% 28% 40% 18%
Source: Company
However, if there is a convergence of contract and spot coal pricing, we still see China Coal as a bigger beneficiary in terms of net profit as the company‘s earnings are the most sensitive to changes in contract-coal prices. We estimate that every 1% rise in the contract price on top of our 3% YoY contract price increase assumption for 2012 leads to about a 2% rise in our 2013 EPS forecast. This is due to the company‘s higher gross margin and large non-coal business. 2013E EPS sensitivity to changes in thermal-coal prices (%)
Every 1% increase in Contract Spot
Shenhua +0.3 +0.9
China Coal +1.9 +2.5
Yanzhou +0.7 +9.4
Source: Daiwa estimates
Note: For domestic thermal coal only, Yanzhou is also sensitive to changes in Australia coal prices and domestic coking-coal prices
Key risk is a flat contract price
As mentioned, the issue of market-based contract pricing has yet to be finalised and there are still numerous uncertainties going into the year-end negotiations. If the contract price is not allowed to change for 2013, as was the case in 2011, there could be risk to the Bloomberg-consensus EPS forecasts for 2013, especially for China Coal.
China Thermal Coal Sector 19 November 2012
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2013E EPS downside if there is no change in contract price
% Earnings downside
Shenhua -0.9
China Coal -5.7
Yanzhou -2.1
Source: Daiwa estimates
To mitigate its high sensitivity to contract-coal pricing, China Coal has been selling more coal on the spot market over the past few years (48% for 2011 compared with 13% for 2006). In our forecasts, we assume a slow shift into more spot coal (59% by 2014E). As can be seen from the following table, in 2011, the frozen contract price led to a YoY decline in China Coal‘s contract coal sales. Compared with Shenhua‘s much larger output of contract coal (we believe China Coal has been more flexible in the past in being able to take advantage of price differences in different cycles), China Coal‘s growth rate of the realised contract price has been larger. Given this, we estimate the potential earnings downside to our 2013 EPS forecast would be less than 5.7%. Lastly, Shenhua‘s 9M12 prices suggest a premium of mine-mouth contract prices over spot prices, which could be a potential risk when convergence takes place. On the positive side, most of China Coal‘s sales go to the seaborne market, reducing such risks. China Coal: contract/spot sales split
Total 100% 100% 100% 100% 100% 100% 100% 100% 100%
Contract 87% 88% 84% 73% 70% 52% 52% 46% 41%
Spot 13% 12% 16% 27% 30% 48% 47% 54% 59%
Source: Company, Daiwa forecasts
ASP coal-price changes over the past few years
Shenhua 2008 2009 2010 2011
Spot -4% 9% 11% -10%
Contract 8% 0% -7% 5%
China Coal
Spot -32% 25% 8% -8%
Contract 10% 2% 4% 10%
Source: Company
The benefits of vertical integration
In recent years, vertical integration has been a trend among companies seeking earnings stability. The most common choice is coal-power integration, which can involve power plants acquiring captive coal mines or coal producers securing demand through their own power plants. The two best examples in the listed universe are Shenhua and China Resources Power (836 HK, HKD16.86, Buy [1]). Shenhua owns a more
complete value chain (coal mines, power plants, railway lines, ports, and ships) than the latter (coal mines and power plants: we forecast a self-sufficiency ratio in coal of 30% for 2012). Based on 2011 numbers, our back-of-the-envelope calculation (assuming internal costs were similar to outsourced levels) shows that Shenhua achieved a cost-of-sales saving of 12% in its coal-mining business as a result of using its own railway lines, ports, and ships, and a cost-of-sales saving of 21% in its power business as a result of using its own coal. Meanwhile, the transportation businesses have positive gross-profit margins except for the shipping business, which is currently facing margin pressure. For the coal business, the largest cost saving comes from the operation of the Shuohuang railway line (53% owned by Shenhua with the remainder mostly owned by Daqing Railway Group), China‘s second-largest coal-transportation rail line in terms of volume after the Daqing line. Shenhua: savings from vertical integration
Coal (CNYm) 2009 2010 2011 2012E 2013E 2014E
Total revenue 84,606 106,103 140,112 152,409 166,190 178,817
Total COGS 43,838 63,786 92,847 104,809 113,640 122,561
Total transport costs 27,017 29,565 35,824 39,732 42,499 45,394
Total internal COGS 19,414 22,128 24,992 30,087 34,942 39,744
As a % 72% 75% 70% 76% 82% 88%
Cost savings attributable to internal transport 9,144 10,121 10,942 13,013 15,467 17,941
As a % 21% 16% 12% 12% 14% 15%
Power (CNYm)
Total revenue 32,680 44,195 57,791 68,966 74,240 80,392
Total COGS 24,727 35,331 46,715 52,085 55,805 60,219
Total fuel cost 16,834 25,690 34,825 38,094 40,927 44,282
Total internal fuel cost 14,142 22,875 29,600 31,357 33,875 36,545
China Coal also operates non-coal assets such as a coal-mining machinery business, but internal sales are small, resulting in limited cost savings. However, the company is the market leader in manufacturing coal-mining equipment in China and stable sales growth in this area provides diversification benefits. Yanzhou Coal operates a small, 200km rail line connecting its coal mines in Shandong Province, but the level of integration is minimal. Meanwhile, most of the company‘s power business serves its coal-chemical assets.
China Thermal Coal Sector 19 November 2012
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Near-term risk: rising costs
A trend globally that China has not been immune to is rising coal-production and selling costs. Over the past five years, Shenhua‘s unit production costs have increased at a CAGR of 5%, lower than the 7% for China Coal and 10% for Yanzhou. It is important to note that Shenhua‘s materials costs, labour costs, and depreciation costs are significantly lower than those of China Coal and Yanzhou on a per-tonne basis. For 1H12, Shenhua saw a similar YoY rise in unit costs (10%) as China Coal (8%) and Yanzhou (11%). China Thermal Coal Sector: unit cost of sales of self-produced coal
Source: Companies
China Thermal Coal Sector: unit cost of sales breakdown
Shenhua 2007 2008 2009 2010 2011
Materials costs 18.2 23.1 21.6 21.5 22.8
Staff costs 10.2 12.0 11.3 13.9 14.6
Depreciation and amortisation 16.9 18.0 20.2 20.9 20.8
Repair and maintenance 9.4 8.9 8.5 9.6 7.5
Other production costs 20.3 33.4 39.1 43.5 53.0
Cost of transportation (assuming same as third parties) 105.9 99.9 106.2 94.4 92.5
Other costs (including third parties) 1.5 2.6 4.0 10.3 7.5
Self-produced coal 182.3 197.8 210.9 214.0 218.8
China Coal 2007 2008 2009 2010 2011
Materials costs 81.2 98.8 73.0 73.2 80.6
Staff costs 19.5 24.2 28.2 31.2 29.8
Depreciation and amortisation 13.4 13.5 24.0 32.2 35.0
Repair and maintenance 6.1 7.9 6.1 8.0 11.6
Transportation costs 85.8 88.4 84.0 89.4 91.2
Coal sustainable development fund (reserve) - - - 16.5 19.1
Materials and electricity 49.1 57.8 58.1 49.2 60.1
Staff costs 71.9 77.3 96.1 103.1 114.8
Depreciation and amortisation 34.6 31.8 42.9 42.7 44.2
Repairs and Maintenance 13.3 0.0 0.0 0.0 0.0
Land restoration and related 25.0 96.6 50.9 33.9 33.8
Transportation 19.7 18.8 14.4 27.2 26.0
Business tax and surcharges 0.0 11.5 12.3 11.1 11.4
Resources tax 0.0 0.0 0.0 0.0 0.0
Other cost of coal sales 23.2 27.3 15.7 40.4 52.0
Self-produced coal 236.8 321.1 290.3 307.6 342.3
Source: Companies
Shenhua‘s much lower raw-material costs are likely due to more ideal exploration conditions at its mines (and thus lower exploration costs), and the attractive acquisition costs for the Shendong coal mines (underground mine blocks that have achieved similar cash costs as comparable open-pit mines). China Coal and Yanzhou have much higher production costs due to less-perfect mine conditions and much high acquisition costs (higher non-cash depreciation unit costs). Thus, the construction of coal mines tends to have a decisive impact on the level of commodity and equipment costs. Shenhua also operates a very large coal-trading business in third-party coal so the unit transportation costs shown in the preceding table include the coal volume from this. However, given the company‘s unique vertically integrated model of railway lines, ports and shipping business, excluding internal transportation costs the unit costs of external transportation are significantly lower than those of China Coal. Railway lines account for the majority of the transportation costs and the profitability of the lines is impressively high (48% for 2011), so the costs of running an internal transportation operation are lower than using outside contractors. Yanzhou sells coal mostly in Shandong, and therefore enjoys much lower transportation costs, but it is interesting to note that it has substantially higher staff costs per unit of coal sales than its peers, which could be explained by the tonnage production per employee (self-produced coal divided by the total number of employees). Yanzhou‘s productivity could improve in the future with output from Australia mines growing at a faster rate than those in China, but this is unlikely to lead to a fall in unit labour costs given the much higher labour costs in Australia and potential labour-shortage issues. China Thermal Coal Sector: production per employees
’000 tonnes/head 2007 2008 2009 2010 2011
Shenhua 2.7 3.1 3.4 3.8 3.4
China Coal 1.3 1.5 1.4 1.6 1.8
Yanzhou 0.8 0.7 0.7 0.9 0.9
Source: Companies
0
50
100
150
200
250
300
350
400
2007 2008 2009 2010 2011
(Rmb/tonne)
Shenhua China Coal Yanzhou
China Thermal Coal Sector 19 November 2012
- 26 -
China Thermal Coal Sector: unit transportation costs of coal sales
Source: Companies
China Thermal Coal Sector: gross margin of coal-sales division
Source: Companies
Likely cost trends
Although some of the raw-material costs (such as steel products and parts) have softened as a result of the global economic slowdown and oversupply, other costs such as diesel fuel (crude oil), electricity, tyres (rubber), and explosives (ammonium) have been more stable in recent years. Prices of steel, crude oil, rubber, and ammonium
Source: Bloomberg
Labour costs, which accounted for one of the largest absolute cost increases in the past, may continue to rise due to continuing wage inflation in China. Australia‘s average labour cost over the past few years increased by about 3-6% a year from January 2007-May 2012, lower than that in China. However, the mining industry in Australia has faced a serious labour shortage, and therefore much greater wage inflation (5-9% a year over the same period). Construction and mining labourers rank behind engineering and legal professionals in terms of the average wage for major occupations. BIS Shrapnel forecasts Australia‘s all-industry labour cost to rise by an average of 4.2% for the seven years from FY12-18. With more people retiring, the supply of labour is likely to increase at a slower rate over the coming decade. BIS Shrapnel expects this to lead not only to a shortage of skilled labour, but of every type of labour. Meanwhile, the demand for labour should continue to rise — particularly in periods of strong investment and economic growth. A sustained shortage of labour is likely to result in a long-term upward rise in wage-inflation pressures.
Source: Australian Bureau of Statistics (May 2010)
Australia: average wage – mining industry vs. all industries
Source: Australian Bureau of Statistics
Australia carbon tax
Another cost that could rise in Australia is the newly imposed (July 2012) carbon tax on fugitive greenhouse gas emissions (those resulting from leaks and other unintended or irregular releases of gas). Our calculation suggests this could elevate Yanzhou‘s average production cost in Australia by 2-3%, based on industry experts‘ expectations, but mines with large gas emissions could see a significant rise in charges. The carbon tax per tonne (AUD23) is fixed until 2015, and so investors will have to face uncertainties in market pricing after that. Shenhua and China Coal currently have no operations in Australia, so are not subject to these Australia-specific risks. We provide more detailed analysis in Yanzhou‘s company section.
Scenarios for resources-tax reform
China has long delayed the reform of resource taxes, which could lead to a big rise in costs in the future. Currently, the resources tax for thermal coal is levied on the sales volume (CNY2-4/tonne), representing less than 1% of the mine-mouth price. The government has been trying to change the volume-based tax levy to a price-based one for many years. In October 2011, the central government issued the Decision of the State Council on Amending the Provisional Regulation on
Resources Tax, and set the resources tax rate for crude oil and natural gas at 5-10% of sales income. As coal accounts for a much greater proportion in China‘s energy mix (70% of primary energy consumption for 2011) than oil and gas, the government has been very cautious about reforming the coal-resource tax. On 29 August 2012, China‘s finance minister, Xie Xuren, noted in a report to the National People‘s Congress Standing Committee that resources-tax reform should be deepened, and a price-based tax levy should be applied to mineral products including coal. Comparison of current and expected new resource-tax rate
Types of coal Province Current tax rate
(CNY/tonne) Expected new tax rate
(% of mine-mouth price)
Coking coal All 8-20 5-10%
Thermal coal and others
Anhui 2.0
5-10%
Gansu 3.0
Guizhou 2.5
Hebei 3.0
Heilongjiang 2.3
Henan 4.0
Hunan 2.5
Inner Mongolia 3.2
Jilin 2.5
Liaoning 2.8
Ningxia 2.3
Shaanxi 3.2
Shandong 3.6
Shanxi 3.2
Sichuan 2.5
Xinjiang 3.0
Yunnan 3.0
Source: NDRC, Daiwa
In the event that a price-based tax levy is applied, Yanzhou would face much greater cost pressure than its peers as the company sells more coking coal than thermal coal, thus would see higher absolute charges. We calculate that a tax of 5% of mine-mouth prices (simply derived by subtracting unit transportation costs from the unit realised ASP), would result in an 8% rise in costs for Yanzhou and a 17% rise based on a tax of 10% on mine-mouth prices. Shenhua and China Coal would see a similar impact. China Thermal Coal Sector: impact on unit selling cost in 2013
CNY/t Average ASP Transportation Ex-transportation At 5% At 10%
Shenhua 425 92 333 17 33
China Coal 508 105 403 20 40
Yanzhou 546 26 520 26 52
Cost increase (at 5%) Cost increase (at 10%)
Shenhua +5% +11%
China Coal +5% +10%
Yanzhou +8% +17%
Source: Company, Daiwa forecasts
According to a report by China Business Journal in September 2012, there were more than 20 kinds of taxes and fees levied on coal production, amounting to about CNY140/tonne. There are also other non-official charges, such as tipping fees for railway transportation, which we estimate amount to about CNY60/tonne. If
0 200 400 600 800 1,0001,2001,4001,6001,8002,000
Farm, forestry and garden workers
Storepersons
Miscellaneous factory process workers
Miscellaneous clerical and administrative …
Truck drivers
All occupations
Accountants, auditors and company …
Construction and mining labourers
Legal professionals
Engineering professionals
(AUD per week)
500
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1,500
2,000
2,500
Feb
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-07
Aug
-07
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-07
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-08
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-08
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(AUD per week)
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China Thermal Coal Sector 19 November 2012
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such taxes and fees are reduced or cancelled, we believe the impact of any resources-tax reform would be much smaller. In addition, coal producers could try to transfer some of the cost pressure to their downstream customers. Different provinces have different fees; for example, the coal sustainable-development fund (a fee levied by Shanxi government) is unique to Shanxi (where China Coal has the most exposure) and other provinces mostly charge coal-price adjustment fund. A list of major taxes and fees
(CNY/tonne) Shanxi Inner Mongolia Shaanxi
Coal price-adjustment fund n.a. Lignite: 8 Anthracite: 20
Ecological and environmental restoration and treatment deposit
10 based on area 3
Coal mine transformation fund and environmental restoration fund
5 n.a. n.a.
Coal mine maintenance fee
8.5 9.5 10.5
Water resources compensation fees
Raw coal: 2 Clean coal: 3 Coking coal: 4
based on water used based on water used
Mining resources compensation charges
1% of sales income 1% of sales income 1% of sales income
Exploration rights usage fee
based on area (CNY100-500/sq km)
based on area (CNY100-500/sq km)
based on area (CNY100-500/sq km)
Mining rights usage fee based on area (CNY1,000/sq km)
based on area (CNY1,000/sq km)
based on area (CNY1,000/sq km)
Safety production fee Open-cut mine: 5 Others: 15-30
Open-cut mine: 5 Others: 15-30
Open-cut mine: 5 Others: 15-30
Source: NDRC, Daiwa
In the nutshell, China Coal‘s unit sales-cost base is more sensitive to raw-material cost changes while Yanzhou is most sensitive to changes in labour costs (both in China and Australia) and resources-tax changes. Shenhua is most sensitive to transportation costs, but close to half of it is from internal railway and shipping, which would reduce half of the impact at net profit level. If certain fees are reduced or temporarily waived, such as the coal-development fund, China Coal would benefit more. China Thermal Coal Sector: total unit cost sensitivity to changes in cost items
Sensitivity Shenhua China Coal Yangzhou
10% change in raw-material costs 0.6% 2.3% 1.8%
10% change in labour costs 0.9% 0.9% 3.4%
10% change in transportation costs 4.2% 2.6% 0.8%
Resources tax (at 5% scenario) 5.0% 5.0% 8.0%
Source: Daiwa estimates
China Thermal Coal Sector: 2013E EPS sensitivity to change in costs
Sensitivity 1% increase in costs
Shenhua 1.2%
China Coal 3.8%
Yanzhou 10.0%
Source: Daiwa estimates
Long-term risk #1: transportation bottleneck
In March 2012, China announced its 12th Five-Year Plan (2011-15) targets for the coal industry, including the 2015 targets for production, transport, and environmental issues. The key figures for 2015 are: annual capacity of 4.1bn tpa (tonnes per annum), annual production volume of 3.9bn tpa, total railway capacity of 2.8-3.0bn tpa (actual volume of 2.6bn tpa), and total seaborne transported capacity of 800m tpa (actual volume of 750m tpa). The production target is consistent with our forecast by 2015 (3.98bn tpa). Targets based on the 12
th Five-Year Plan
Matrices Targets in 2015
Production
Capacity Annual capacity of 4.1bn tpa by 2015: large coal mines: 2.6bn tpa (63% share), mines with capacity >0.3m tonnes account for 900m tonnes (22% of all) and rest at 600m tonnes (15% share)
Production By 2015, coal production controlled at about 3.9bn tpa
New capacity During the 12th FYP, build carry-forward capacity of 360m tonnes/year, newly build 740m tonnes/year, and complete 750m tonnes/year
Companies Have 10 producers with production of 1bn tonnes/year, 10 with 50m tonnes/year, both of which account for 60% of the total share
Technology Mechanisation to reach >75%: large mines (>95%), mines with capacity >0.3m tonnes (>70%), other mines (>55%)
Safety By 2015, fatal accidents and major coal accidents to drop by 12.5% and 15% compared with 2010; death rate to drop to below 28%
Utilisation Coal-bed methane (CBM) reserves to increase by 1tn cm and CBM production to be up to 30bn cm/year
Environment Land reclamation rate to exceed 60%
Resources saving
Energy saving up to 95m tonnes of standard coal
Transportation
Net exports Net exports from coal-exporting provinces to amount to 1.66bn tonnes/year (1.58bn from Shanxi, Shaanxi, Inner Mongolia and Gansu) with the main destinations eastern China, Beijing-Tianjin-Hebei area, central east and northeast, and a small amount of volume to the Sichuan-Chongqing area; from Xinjiang (300m tonnes) to Western Gansu, Qinghai, the Sichuan-Chongqing area; Yunnan and Guizhou (500m tonnes) to Guangdong, Guangxi and Hunan
Net imports Total net importing volume to amount to 1.62bn tonnes/year: 16.2bn for eastern China, the Beijing-Tianjin-Hebei area, central east and northeast, and 400m tonnes for Sichuan-Chongqing
Railway To raise railway transportation volume to 2.6bn tonnes with total capacity of 2.8-3bn tonnes/year; for Shanxi, Shaanxi, and Inner Mongolia, outbound rail output and capacity of 1.43bn tonnes and 2bn tonnes, respectively; Lanxin line reconstruction and Lanyu line to support Xinjiang outbound transport
Seaborne North-south seaborne transport system: Jinzhou, Qinhuangdao, Tianjin, Tangshan, Huanghua, Qingdao, Rizhao, Lianyungang - offload at ports in Jiangsu, Shanghai, Zhejiang, Fujian, Guangdong, Guangxi and Hainan; by 2015, seaborne volume to reach 750m tonnes/year from northern ports with a capacity of 800m tonnes/year
Source: NDRC
Based on the plans: 1) 67% of coal would be transported by rail from the ‗Three West‘ region (Shanxi, Shaanxi, and Western Inner Mongolia), Xinjiang, Yunnan, and Guizhou to eastern China, the Beijing-Tianjin-Hebei area, the central east and northeast, and 2) 19% of coal would be shipped from northern sea ports to southern sea ports.
China Thermal Coal Sector 19 November 2012
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China: coal supply flow during the 12th
FYP
Source: 12th Five-Year Plan for the coal industry
Based on these targets, rail volume would account for 19% of total production by 2015, from 18% for 2011, and seaborne volume would account for 67% by 2015, from 65% for 2011, which suggests that transportation capacity would only increase marginally faster than total coal production. Railway and seaborne shipments of coal
Source: 12-th five-year plan for coal industry
Rail transport has been the major transportation bottleneck as production has become more concentrated. In 2011, Shanxi, Inner Mongolia, and Shaanxi produced 59% of China‘s raw coal, while the top-three coal-producing provinces produced 41% and 47% of total coal production in 1996 and 2005, respectively. Shanxi has always been the largest producer, while Inner Mongolia and Shaanxi have become among the top-three producers following increases in transportation capacity.
Market share by provincial production (1996-2011)
1996 Share 2005 Share 2011 Share
Shanxi 25.8% Shanxi 24.2% Inner Mongolia 25.5%
Henan 7.9% Inner Mongolia 11.9% Shanxi 22.7%
Chongqing 7.6% Henan 10.7% Shaanxi 10.6%
Shandong 6.4% Shandong 7.7% Henan 5.1%
Heilongjiang 5.9% Guizhou 6.1% Guizhou 4.4%
Source: CCTD
China: medium-to-long term railway plan (2008)
Source: NDRC
We have conducted an SOTP analysis of each of the new rail lines due to be opened over the next few years. Most of the new capacity will be in the ‗Three West‘ region, and total rail capacity could improve meaningfully in 2015. We forecast total coal-loading rail capacity to rise by 6% YoY for 2013, mostly due to capacity expansion of Shuohuang line (from 191m tpa to 244m tpa: we expect this to reach 350m tpa by 2015) and the Houyue line (from 99m tpa to 109m tpa: we look for 129m tpa after 2015). We also forecast a 6% YoY capacity increase for 2014, followed by a 13% YoY rise for 2015. Compared with our total commercial coal-demand and production-growth forecasts of 4% YoY and 3% YoY, respectively, for 2013, the railway capacity bottleneck should ease only slightly over the next few years. Therefore, it is fair to conclude that the railway bottleneck (especially for coal coming from the Three West region) will not be meaningfully alleviated until 2015. It thus seems that average transportation costs are unlikely to decline over the near term (through a reduced reliance on trucking costs, which are higher than rail-transportation costs). Thus, we believe it is still too early to see a reduced cost spread between mine-mouth and seaborne coal prices.
17.6 19.2
64.5 66.7
0
10
20
30
40
50
60
70
2011 2015E
(%)
Rail-backed Seaborne
China Thermal Coal Sector 19 November 2012
- 30 -
Rail transported coal as a % of total coal production
Lanxin No.2 Urumqi, Xinjiang Lanzhou, Gansu end of 2014 10 30 300
Sub-total 20 20 20 30 50 320
Others 1,333 1,335 1,337 1,339 1,342 1,342
Country total 2,270 2,354 2,496 2,655 3,000 3,957
Annual addition 270 84 142 159 345 957
Total YoY 14% 4% 6% 6% 13%
Source: Daiwa forecasts, NDRC
Long-term risk #2: threat from shale gas
The development of shale-gas resources represents the most significant advance in the oil and gas industry for many decades, particularly in the US, which is leading the world in shale gas and oil development. Although the US has been producing oil and gas from shale formations for decades, it was not until hydraulic fracturing and horizontal drilling technologies were combined that shale activity really took off in the early 2000s. Shale gas has been the primary source of the
recent growth in US gas production and reserves, helping to push up total gas production in the country to its highest levels since 2007. The Henry Hub gas price is currently close to USD3/MMBtu, which is about 80% lower than the peak in 2008. There have been increasing industry concerns about whether US shale gas will have an impact on global energy prices once exports start after the completion of export facilities such as LNG ports.
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1,500
2,000
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2006
2007
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E
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E
2015
E
(%)(m tonne)
Coal transported by railway (LHS) % of transported coal (RHS)
China Thermal Coal Sector 19 November 2012
- 31 -
Henry Hub gas price in the US
Source: Bloomberg
About 66m tpa of LNG capacity is planned to come online in North America between 2015 and 2020, but only one field (Cheniere at 14m tpa) has received all the required government approvals. Daiwa‘s Regional Head of Oil & Gas, Adrian Loh, believes that about 20m tpa could make its way into Asia by 2020 out of the 66m tpa – and there is upside potential to this rather than downside. We note that quite a few Asia oil companies are involved in this project (Kogas, PetroChina, Petronas, and Mitsubishi) so the implication is that they want to supply this gas to their home markets, or at least Asia, rather than serve Europe.
Potential impact on long-term coal demand in China
Another worrying issue is China‘s own shale gas. The US Energy Information Administration (EIA) estimates that the country‘s total technically recoverable shale gas resources are currently 1,275tcf, 13x that of its conventional gas resources. However, Adrian expressed a cautious view about long-term shale gas development in China in his report, China shale: a long-term paradigm shift, published in April 2012. China‘s shale-gas production targets appear very ambitious to us, with 6.5bcm (230bcf) targeted for 2015 and 60- 100bcm for 2020, compared with Daiwa‘s forecasts of 10bcm (353bcf) and 15bcm (530bcf), respectively. Although the country appears to have a large shale resource base, our cautious view is predicated on the belief that much exploration and evaluation work needs to be done to prove the productivity and commerciality of its shale basins. Given our forecast for China‘s gas demand to more than triple to 387bcm by 2030 (a 6.6% CAGR from 2010-30), any incremental shale-gas production should displace gas imports, in our view.
Comparing shale-gas production: PRC Government targets vs. Daiwa forecasts
Source: Reuters, Daiwa forecasts
Note: Daiwa forecasts are combined shale gas and CBM production
As China‘s economy moves from hyper-growth to stabile economic growth, we expect total energy consumption to normalise to mid-single-digit percentage growth. Total primary energy consumption increased at a 9% CAGR from 2001-11 while average GDP growth was 10.4% a year. However, as China promotes energy efficiency (currently targeting unit GDP energy consumption to decline by 16% for 2015 from the 2010 level), we expect the multiple to (energy consumption divided by GDP) decline from 0.58x for 2010 to 0.49x for 2015. As other energy sources such as natural gas (including unconventional gas, eg, coal-bed methane and shale gas) and alternative energy (including hydro, nuclear, wind, biomass, and solar power and waste-energy) are supported by strong policy incentives, we forecast a CAGR of 19% from 2011-15 and total energy consumption to only increase by 4% a year over the same period. Given mounting environmental concerns, we forecast coal‘s contribution to China‘s total energy mix to fall from 69% for 2011 to 62% for 2015 and the consumption CAGR to decline from 8.8% over the past decade to only 1.2% from 2011-15. For some years in the following decade, there could even be some YoY declines. The impact could be larger from 2016-20, for which we forecast a CAGR of only 0.4% in coal consumption due to lower overall energy consumption growth and more sustainable usage growth in oil, alternative energy, and natural gas. We note that we forecast a 12% CAGR in natural-gas consumption over 2016-20, and estimate that each 5pp rise in this would reduce coal demand by about 1pp a year over the period.
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-02
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-04
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-05
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6
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-09
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-10
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-12
(USD/MMBtu)(USD/short ton)
Central Appalachian coal price (LHS) Henry Hub gas price (RHS)
Although not included at the listed company level, Shenhua‘s parent company, Shenhua Group (Not listed), has been investing aggressively in renewable energy (mostly wind power) through Shenhua Guohua Energy (Not listed). For 2011, Shenhua Guohua Energy‘s total installed wind power capacity was 3.44GW, the fifth-highest in China. Also, we believe that the thermal coal companies could consider entering the shale-gas producing chain. In May 2012, Mainland news reported that Shenhua Group had hired a number of shale-gas experts to work on shale-gas exploration and development. In the second batch of public tenders, which were opened recently, Shenhua Group will be qualified to participate as the tenders are open to all China-registered companies (the first batch was on an invitation-only basis). Compared with only four blocks offered (two failed to attract bids) in first batch, a total of 20 blocks will be up for auction this time.
Public bidding results of the first batch of shale gas (2011)
Therefore, coal producers that now heavily rely on profits from coal mining should also prepare for a shift in long-term strategy to areas with more sustainability. This is partially why Yanzhou has been actively investing in overseas markets such as Australia (coal) and Canada (potash). How much more the company can diversify over the near term depends on the robustness of its balance sheet. Among the China thermal-coal companies, we see Shenhua as the best-positioned in terms of its balance sheet given its net-cash position, followed by China Coal, which has a reasonable net-gearing ratio that we do not expect to rise significantly over the next few years. We are concerned about Yanzhou‘s balance sheet, especially given a falling gross margin and ROE.
(10)
0
10
20
30
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
E
2014
E
2016
E
2018
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2020
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2022
E
2024
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2026
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2028
E
(%)
Total Alternativenergy Oil
Coal Natural Gas
China Thermal Coal Sector 19 November 2012
- 33 -
China coal producers: net gearing
Source: Bloomberg, Daiwa forecasts
China coal producers: FCF projections
Source: Bloomberg, Daiwa forecasts
Investments need to be value-added
In terms of ROI (calculated by dividing the change in the amount of EBIT by the average capex spent), we expect those of Shenhua and China Coal to remain mostly positive over the next few years but be below their past-five-year averages. We expect Yanzhou‘s one-year ROI to turn negative for 2012 with possible losses in Australia and more low-margin mines contributing to output growth in the PRC. This is another lesson that not all investments are good. China coal producers: ROI
Source: Bloomberg, Daiwa forecasts
(60)
(40)
(20)
0
20
40
60
2007 2008 2009 2010 2011 2012E 2013E 2014E
(%)
Shenhua China Coal Yanzhou
(20,000)
(10,000)
0
10,000
20,000
30,000
40,000
2012E 2013E 2014E
(CNYm)
Shenhua China Coal Yanzhou
(100)
(50)
0
50
100
2007 2008 2009 2010 2011 2012E 2013E 2014E
(%)
Shenhua China Coal Yanzhou
China Thermal Coal Sector 19 November 2012
- 34 -
Appendix: the top players in the industry
Shenhua Group
The parent group of the listed company, China Shenhua Energy (1088 HK), has been the largest coal producer in China for a number of years. It is directly controlled by central government‘s State-owned Assets Supervision and Administration Commission (SASAC).
China National Coal Corp
The parent group of the listed company, China Coal Energy (1899 HK), is one of the key state-owned enterprises (SOE) controlled by Shanxi Province SASAC. It was the second-largest raw-coal producer in China in 2011. China National Coal‘s major businesses include coal production and trading, coal-mining equipment manufacturing, coal chemicals, pit-mouth power generation, as well as coal-mine construction.
Shanxi Coking Coal Group
The group was established in 2001 and is owned solely by Shanxi Province SASAC. It manages one of the 14 large-scale coal-production bases designated by the central government and is the parent of the listed Xishan Coal Electricity Group (000983 CH) and Shanxi Coking Group Company (600740 CH). The group ranked top and fourth in coking-coal and raw-coal production, respectively, for 2011.
Shanxi Datong Coal Mine Group
Restructured in 2000, the group is the third-largest player in China in terms of 2011 raw-coal production. Its owns 73 coal mines in Shanxi province and Inner Mongolia. The group‘s subsidiary, Datong Coal Industry (601001 CH), was listed on the A-share market in 2006. The group is directly controlled by Shanxi Province SASAC.
Shaanxi Coal and Chemical Industry Group
The group is directly owned by Shaanxi Province SASAC. It was the sixth-largest raw-coal producer in China in 2011. Its coal resources are mainly located in the Yulin, Yanan, Xianyang, Weinan, and Tongchuan regions of Shaanxi Province.
Henan Coal Chemical Industry Group
Based in Zhengzhou, the group is one of the top-10 raw-coal producers in China, the largest methanol producer in central China, and largest coal-gas supplier in Asia. It is directly owned by Henan Province SASAC and has businesses in Henan, Guizhou, Xinjiang, Inner
Mongolia, Anhui, Sichuan, Qinghai, Shanghai, and Shaanxi provinces.
Hebei Jizhong Energy Group
The group was founded in 2008 and is directly controlled by Hebei Province SASAC. It was the fifth-largest raw-coal producer in China in 2011, and has coal mines in Hebei and Shanxi provinces. Three of its subsidiaries are listed domestic: Jizhong Energy Resources (000937 CH), North China Pharmaceutical Group (600812 CH), and Hebei Jinniu Chemical Industry (600722 CH).
Shanxi Lu’an Mining Industry Group
The group is the one of the top-five coal players in Shanxi Province and one of the top-10 raw-coal producers in China. It was restructured in 2000 and is directly held by Shanxi Province SASAC. The group has five developed coal mines –Lu‘an, Wuxia, Lu‘ning, Lu‘meng, and Lu‘xin – in Shanxi province. It is the parent group of the listed vehicle, Lu‘an Huanneng (601699 CH).
Anhui Huainan Mining Group
The group was restructured in 1998 and is directly controlled by Anhui Province SASAC. It was one of the top-10 raw-coal producers in China in 2011. The group owns 74% of the coal resources of Anhui Province and 50% of those in the eastern China region. Its key asset, Huainan mine, is one of the five major coal mines in China.
Hebei Kailuan Group
Hebwi Kailuan Group was the top-10 raw-coal producers in China in 2011 and is directly owned by Hebei Province SASAC. It owns more than 10 productive coal mines in China. It is the parent of Kailuan Energy Chemical (600997 CH) listed on the A-share market.
Shandong Yankuang Group
The parent group of the listed company, Yanzho Coal Mining Company (1711 HK). Following restructuring in 2006, the group became solely owned by Shandong Province SASAC. It is one of the top-10 raw-coal producers in China in 2011 and has three industrial parks in Shandong Lunan, Yanzhou, and Zoucheng. Outside Shandong province, it owns and operates five production bases in Shaanxi, Inner Mongolia, Guizhou, Xinjiang, and Australia.
China Thermal Coal Sector 19 November 2012
- 35 -
Top-20 coal producers: annual coal production and capacity expansion plans 2012-15E (m tonnes)
No. Company Name in Chinese 2008 2009 2010 2011 2012E 2013E 2014E 2015E
Source: China National Coal Association, CCTD, SX Coal, Daiwa forecasts
See important disclosures, including any required research certifications, beginning on page 69
What's new
Shenhua‘s vertical integration has given it greater earnings stability than its peers. We expect the company to be a leader in terms of profit margins, with the highest ROE/ROI among its peers going forward. This report marks the transfer of coverage to Dave Dai. What's the impact
While Shenhua‘s shipping business is likely to be loss-making this year, we believe the downside should be minimal as we expect its power, railway and port operations to remain profitable. One may argue the stock is expensive compared with its industry peers. However, a breakdown of its profit returns for the past five years shows that Shenhua‘s coal and railway businesses are more profitable. We also expect the power business to trade at a market-leader premium
given Shenhua‘s more stable coal supply and favourable coal prices. Putting the synergies it benefits from into perspective, in 2011 Shenhua saved 12% on the cost of sales for its coal-mining business through internal sales to its railway, ports and shipping businesses, and 21% on the cost of sales for its power business on the back of internal coal sales. Although any upside in spot and contract-coal prices may not result in greater earnings upside given its already fat profit margin, we think Shenhua is at a sweet ‗low-cost‘ spot as it has the lowest cash cost among its peers, which we expect to cap any margin erosion going forward. We believe the expansion of its power and transport businesses would create more cost synergies and earnings growth. What we recommend
We raise our NAV-based six-month target price to HKD38 and reiterate our Buy (1) rating to incorporate further long-term benefits that we see from vertical integration. The 2013E PER of 9.4x is undemanding, as it is 30% lower than the stock‘s past-five-year trading mean. A 4% dividend yield (based on our 2013 forecasts) is also the best among its peers.
How we differ
Our 2013-14E EPS are 5-8% above consensus as we are more bullish on a coal-price recovery in 2013.
Energy / China 1088 HK
19 November 2012
China Shenhua Energy
A premium for earnings stability
Shenhua is our top pick as we expect sustainable earnings
visibility, supported by its deepening vertical integration
Not the biggest beneficiary of coal-price recovery, but earnings
structure should be the most defensive against rising costs
Earnings upside could largely come from expanding power and
rail businesses; ROE and dividend yield should remain superior
How do we justify our view?How do we justify our view?
China Thermal Coal Sector 19 November 2012
- 37 -
Growth outlook China Shenhua: net profit and YoY
We forecast Shenhua‘s earnings growth to slow, from a CAGR of 20% for 2008-11 to a CAGR of 10% for 2012-14. We believe the stock is still attractive given its superior earnings stability.
Source: Company, Daiwa forecasts
Valuation Shenhua: one-year-forward PER history
The stock is trading at an undemanding 2013E PER of 9.4x, which is 30% lower than its past-five-year average 12-month-forward PER of 13.4x. This is also almost 1SD below its past five-year average.
The 2012-13 Bloomberg-consensus EPS forecasts for Shenhua have been revised down by 9-14% YTD, due, in our view, to declining average spot-coal prices. However, the magnitude of the cuts is much less than those for its peers (24-49% YTD downward revisions).
Source: Bloomberg, Daiwa
How do we justify our view?
Growth outlook
Valuation
Earnings revisions
26,641
31,706
38,834
45,677 47,205
52,588 56,636
29.4
19.0
22.5
17.6
3.3
11.4
7.7
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
0
10,000
20,000
30,000
40,000
50,000
60,000
2008 2009 2010 2011 2012E 2013E 2014E
(%)(CNYm)
Net profit (LHS) YoY growth (RHS)
0
5
10
15
20
25
30
35
Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
(x)
18.8x Avg+1SD
13.4x Avg
24.1x Avg+2SD
8.1x Avg-1SD
2.7x Avg-2SD
75
80
85
90
95
100
105
Jan-
12
Feb
-12
Mar
-12
Apr
-12
May
-12
Jun-
12
Jul-1
2
Aug
-12
Sep
-12
Oct
-12
Nov
-12
2012E 2013E
(Rebased to 100)
Buy (unchanged)
Outperform
Hold
Underperform
Sell
1
2
3
4
5
China Thermal Coal Sector 19 November 2012
- 38 -
Key assumptions
Profit and loss (CNYm)
Cash flow (CNYm)
Source: FactSet, Daiwa forecasts
Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E
China Shenhua Energy is the largest coal producer in China with a fully integrated operation from coal mining to transportation to power generation. The majority of the company's coal sales, as well as its assets, are within China. The company produces mainly bituminous coal for consumption in thermal power plants within China.
As at 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E
Earnings growth sustainability from deepening vertical integration
A long-term value investment
Shenhua is well known for its vertically integrated business model. Coal, power generation, railway transportation and port transportation account for 74%, 15%, 10% and 1% of the company‘s one-year forward NAV, according to our estimates. In 2011, 19% of the company‘s commercial coal output was consumed internally by its power segment. Some 77% of all the coal the company transported in 2011 was through its own railways, while 58% of the seaborne coal it produced that year was shipped from its self-owned ports. Shenhua: revenue breakdown
CNYm 2010 2011 2012E 2013E 2014E
Coal 106,103 140,112 152,409 166,190 178,817
Power 44,195 57,791 68,966 74,240 80,392
Railway 2,285 2,745 3,338 3,866 4,446
Port 152 147 164 176 189
Shipping 902 2,961 2,564 2,820 3,102
Others 4,025 4,441 4,441 4,441 4,441
Total 157,662 208,197 231,882 251,734 271,386
Source: Company, Daiwa forecasts
Shenhua: gross-margin breakdown
CNYm 2010 2011 2012E 2013E 2014E
Coal 33% 30% 27% 26% 25%
Power 20% 19% 24% 24% 25%
Railway 49% 48% 48% 48% 48%
Port 29% 35% 41% 45% 45%
Shipping 13% 14% -7% 2% 11%
Total 43% 38% 37% 36% 36%
Source: Company, Daiwa forecasts
Rationale behind its integration strategy
We believe Shenhua‘s integration strategy is simple for three reasons. First, it has access to coal resources from distant areas like Inner Mongolia through its extensive self-owned railway network. Although it has alleviated a nation-wide transportation bottleneck in recent years, on the back of an increase in capacity build-out and slowing coal demand, we do not expect a full breakthrough until after 2014, pending the completion of Zhangtang Railway and several other major railway lines that focus on coal transportation. Second, on the demand side, Shenhua‘s sizeable coal-fired power-generation business (still growing rapidly in terms of capacity) has provided sustainable demand for the
company‘s output plans and a meaningful hedge against coal-price fluctuations. Third, as the railways usually lead to the ports, Shenhua‘s stake in the country‘s coal port and shipping businesses also should ensure its throughput quotas for its railway business. Of course, the company‘s ancillary supporting business lines (railway, port & shipping) are not without commercial benefit, as the cost of operating railways and ports is still significantly lower than paying for third-party services. Based on the company‘s 2011 numbers, our rough calculation takes into account cost savings (assuming similar levels of internal costs as those outsourced) and shows that Shenhua saved 12% on the cost of sales for its coal-mining business by using its internal railways, ports and shipping services, and 21% on the cost of sales for its power business through internal sales of coal. These synergies are especially valid as the company‘s transportation business offers a positive gross-profit margin except for its shipping business, which is currently under pressure. For the coal business, the largest cost synergy comes from operating the Shuohuang Railway (53% owned by Shenhua and the remainder mostly owned by Daqing Railway Group [Not rated]), China‘s second-largest coal-transportation railway after the Daqing Railway. Shenhua: vertical-integration synergy
Coal (CNYm) 2009 2010 2011 2012E 2013E 2014E
Total revenue 84,606 106,103 140,112 152,409 166,190 178,817
Total COGS 43,838 63,786 92,847 104,809 113,640 122,561
Total transport costs 27,017 29,565 35,824 39,732 42,499 45,394
Total internal COGS 19,414 22,128 24,992 30,087 34,942 39,744
As a % 72% 75% 70% 76% 82% 88%
Cost savings attributable to internal transport 9,144 10,121 10,942 13,013 15,467 17,941
As a % 21% 16% 12% 12% 14% 15%
Power (CNYm)
Total revenue 32,680 44,195 57,791 68,966 74,240 80,392
Total COGS 24,727 35,331 46,715 52,085 55,805 60,219
Total fuel cost 16,834 25,690 34,825 38,094 40,927 44,282
Total internal fuel cost 14,142 22,875 29,600 31,357 33,875 36,545
The advantage of vertical integration has supported Shenhua‘s sustainably high gross-profit margin trend compared with that of its peers, despite operating in a commodity business. Based on the following chart, Shenhua has shown a better quarterly gross margin than its peers for most of the time over the past five years, and the difference became apparent during the economic downturns in 2009 and 2012.
China Thermal Coal Sector 19 November 2012
- 41 -
China Thermal Coal Sector: quarterly gross-margin comparison (PRC GAAP)
Source: Companies
Valuation supported by deepening vertical integration
The stock is trading currently at a 9.4x 2013E PER, which is 30% below its past five-year trading average. We are raising our six-month target price from HKD34.9 to HKD38.0 as we believe Shenhua will continue to benefit from deepening vertical integration. Shenhua: one-year forward PER valuation history
Source: Bloomberg, Daiwa forecasts
Shenhua: one-year-forward PBR valuation history
Source: Bloomberg, Daiwa forecasts
Shenhua: one-year-forward EV/reserve history
Source: Bloomberg, Daiwa forecasts
One could say that Shenhua‘s vertical integration is not attractive from a valuation perspective, as the 2013E PER for the whole company is higher than that for each standalone business. However, we believe some of Shenhua‘s operations deserve to trade at a premium valuation compared with the peer average. For example, the listed IPPs that we cover are trading at similar one-year forward PERs, but at a lower average PBR than Shenhua. However, as it sees a stable fuel cost due to its internal coal supplies, we think the standalone power business deserves to trade at a valuation that is similar to that of the valuation leader, which is China Resources Power. We therefore believe a 1.5x one-year forward PBR, on the back of an expected high ROE, is reasonable for the power division. For the railway business, the company‘s only peer (Daqin Railway) is trading currently at a single-digit PER, with single-digit 2012-14 EPS growth, according to the Bloomberg consensus. However, we believe Shenhua‘s railway business has more promising expansion plans than Daqin‘s, with its Shuohuang line expanding to a second phase, with total capacity improving by more than 40% in three years‘ time. Also, historically Shenhua‘s Shuohuang Railway has had a better gross-profit margin than Daqin‘s, which should justify a premium over Daqin‘s PER on a one-year forward basis. Shuohuang also could be less affected by demand weakness, due to Shenhua‘s internal sales. On a PBR basis, we think Shenhua‘s railway asset also deserves a premium valuation to that of Daqin as its calculated segment profit/segment equity is the highest among all of Shenhua‘s business segments. Shenhua: segmental profit/calculation of segmental equity
Business Valuation Target multiple Total asset value (HKDm)
%
Coal DCF 10.3% WACC, 1% terminal 565,685 74%
Power PBR 1.5x 2013E PBR 110,332 15%
Railway Book value 1.5x 2013E PBR 74,621 10%
Ports Book value 1x 2013E PBR 10,056 1%
Total
760,695 100%
Shares
19,890
NAV/share (HKD)
38.0
Target price (HKD)
38.0
Source: Daiwa forecasts
Expanding the power business
Downstream, Shenhua‘s power-generation capacity has grown by more than 20% YoY over the past five years, providing a good hedge when coal prices decline. In the past, most of Shenhua‘s capacity addition has come from its parent injecting assets with attractive valuations. Going forward, management is guiding for 2GW in annual capacity additions, which implies 5-7% YoY growth. Although the pace of growth is likely to slow over the next few years, we believe Shenhua‘s power segment still will be big enough to provide downside protection for the company‘s main coal-mining business.
Power segment: capacity expansion
Source: Company
Extending transport business
Shenhua is the largest shareholder in Shenhuang Railway, the second-largest west-east coal channel in China. Shenhua expects to expand the capacity of the Shuohuang Railway (the second section of the Shenhuang Railway) to 350m tonnes in 2015. This would support Shenhua‘s coal-production expansion during the 12th Five-Year Plan period. Shenhuang Railway
Section Origin Destination Shenhua's ownership
Current capacity (m tonnes per
year)
Capacity target for 2015E (m tonnes per
year)
1st section Shenmu, Shaanxi
Shuozhou, Shanxi 100% 200 200
2st section Shuozhou,
Shanxi Huanghua
Port, Hebei 52.7% 190 350
Source: Company
Construction of the Bazhun Railway (200m tonnes per year), the Baoshen Railway expansion (100m tonnes per year), the Dazhun Railway (200m tonnes per year), and the Zhunchi Railway (200m tonnes per year) should be finished before 2015, and would significantly improve the company‘s ability to transport coal from production bases through the its railway networks.
Shenhua currently owns two ports (the Huanghua Port and Shenhua Tianjin Coal Dock), from which 48% of its seaborne coal was shipped in 9M12. We expect the capacity expansion of Phase III of the Huanghua Port to be completed before the end of 2012, increasing the port‘s capacity by 50m tonnes to 150m tonnes. To enhance the company‘s ability to receive seaborne coal shipments from North China and overseas, Shenhua is also speeding up the construction of the Zhuhai Gaolan Port (40m tonnes) and carrying out preparatory work for Fujian Luoyuan Bay and Zhejiang Zhoushan Port. Shenhua: port turnover volume forecast
Million tonnes 2010 2011 2012E 2013E 2014E
Huanghua Port 87.2 95.7 102.2 107.5 113.2
Shenhua Tianjin Coal Dock 22.5 25.5 27.2 28.7 30.2
Source: Company, Daiwa forecasts
China Thermal Coal Sector 19 November 2012
- 44 -
The port transportation segment under the 12th
Five-Year Plan
Source: Company
A fifth round of asset injections by the parent, Shenhua Group, would go to Shenhua Coal Liquefaction and Chemical Co, and supporting coal mines. Shenhua has a good track record when it comes to parent injections, but this time we are concerned that the group‘s coal-chemical business might not be as profitable as Shenhua‘s existing business. However, we are still waiting for the group‘s and Shenhua‘s final decision on the valuation of the assets that would be injected this time round. China and international dry-bulk indexes
Source: SX Coal
A long-term portfolio choice
Shenhua and its close peers are categorised as ‗energy‘ stocks in the main industry indices. Shenhua‘s main competitors for index weights are usually CNOOC, PetroChina, Sinopec, Kunlun Energy and its coal peers. Year-to-date, the Bloomberg consensus has been revising downs its 2012-13 earnings forecasts substantially for Sinopec, Yanzhou and China Coal, while Shenhua, PetroChina and CNOOC have been more resilient. Of course, there could be upside revisions to earnings forecasts if the cycle returns for heavily overdone names but, regardless, we believe Shenhua deserves to trade at a premium valuation to its peers as we expect continued strong earnings visibility. The most famous names in the energy sector
Stock Code
CNOOC 838 HK
PetroChina 857 HK
Sinopec 386 HK
Shenhua 1088 HK
Kunlun Energy 135 HK
China Coal 1898 HK
Inner Mongolia Yitai 900948 CN
Yanzhou 1171 HK
China Oilfield Services 2883 HK
Source: Daiwa
China Energy Sector: Bloomberg-consensus 2012 EPS-forecast revisions
Source: Bloomberg
0
1,000
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4,000
5,000
0
500
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2,000
2,500
3,000
Jan-
09
Apr
-09
Jul-0
9
Oct
-09
Jan-
10
Apr
-10
Jul-1
0
Oct
-10
Jan-
11
Apr
-11
Jul-1
1
Oct
-11
Jan-
12
Apr
-12
Jul-1
2
Oct
-12
(Units)(Units)
China Coastal Bulk (Coal) Freight Index Baltic Dry Index
60
70
80
90
100
110
Jan-
12
Feb
-12
Mar
-12
Apr
-12
May
-12
Jun-
12
Jul-1
2
Aug
-12
Sep
-12
Oct
-12
Nov
-12
Shenhua China Coal Yanzhou
Petrochina Sinopec CNOOC
(Rebased to 100)
China Thermal Coal Sector 19 November 2012
- 45 -
Peer group valuations
Company name Stock code Rating Market cap P/E ratio (x) P/B ratio (x) ROE (%) Div yield (%) EPS CAGR
Most of Shenhua‘s coal mines are located in Inner Mongolia, where exploration costs are relatively lower than in inland provinces such as Shanxi and Shaanxi. On a unit-production-cash-cost basis, Shenhua has significantly lower costs than its peers. China Thermal Coal Sector: mine locations
Source: Companies
Coal Thermal Coal Sector: unit cash cost comparison (2011)
Source: Companies
We forecast Shenhua‘s saleable coal production to increase by 6-7% YoY on average for 2013-15, which would be slower than the double-digit-percentage annual growth for the past five years. Shenhua: coal production and sales
Million tonnes 2010 2011 2012E 2013E 2014E
Raw production (m tonnes) 272.9 313.2 335.9 358.2 382.1
Saleable production (m tonnes) 245.6 281.9 302.3 322.4 343.9
Total coal sales (m tonnes) 313.1 387.3 431.9 461.9 493.4
Export (m tonnes) 10.3 5.6 8.0 10.0 12.0
Source: Company, Daiwa forecasts
Beijing
Guangdong
Guangxi
Hunan
Hubei
Hainan
Xinjiang
Qinghai
Ningxia
Shaanxi
Jiangxi
Jiangsu
Shanghai
Hebei
Inner Mongolia
Shanxi Shandong
Tibet (Xizang)
Sichuan
Yunan
Guizhou
Henan
Heilongjiang
Jilin
Liaoning
Anhui
Zhejiang
TaiwanFujian
Gansu
Australia
China
China Shenhua
China Coal
Yanzhou Coal
0
50
100
150
200
250
300
350
Shenhua China Coal Yanzhou
(CNY/tonne)
Materials & electricity Wages
Repair and maintenance Others (taxes, fees, etc.)
China Thermal Coal Sector 19 November 2012
- 46 -
Shenhua: domestic coal sales volume
Million tonnes 2010 2011 2012E 2013E 2014E
By contract
Long-term contract 169.0 171.7 169.5 180.8 192.6
Spot market 133.8 210.0 254.3 271.2 288.8
By transport
Mine-mouth 31.3 52.0 57.7 61.6 65.6
Direct arrival 111.3 125.2 139.0 148.2 157.9
Seaborne 160.2 204.5 227.1 242.1 257.9
Source: Company, Daiwa forecasts
Shenhua: coal-price forecasts
CNY/tonne 2010 2011 2012E 2013E 2014E
Long-term contract 362.1 337.8 354.7 365.3 365.3
Spot market 457.0 507.7 467.3 472.0 476.7
- Mine mouth 142.2 171.0 162.5 164.1 165.7
- Direct arrival (rail) 406.2 473.0 425.7 430.0 434.3
- Seaborne 590.0 629.7 535.2 540.6 546.0
Export 566.5 747.7 598.2 604.1 610.2
Source: Company, Daiwa forecasts
In terms of exposure to different costs, Shenhua is more exposed to transportation costs than its peers for its coal segment but such exposure is largely reduced as it has its own railways and ports. The company‘s defensive nature will also mean that its earnings would be less negatively affected by an unexpected increases in raw-material costs, labour costs and the coal resource tax. Total unit cost sensitivity to changes in cost items
Sensitivity Shenhua China Coal Yangzhou
10% change in raw-material costs 0.6% 2.3% 1.8%
10% change in labour costs 0.9% 0.9% 3.4%
10% change in transportation costs* 4.2% 2.6% 0.8%
Resources tax (5% scenario) 5% 5% 8%
Source: Daiwa estimates
Risks
The key risk to our call would be worse-than-expected coal demand. If the recovery in coal prices in 2013 turns out to be weaker than expected, there could also be downside to our target price. Other risk factors include lower-than-expected power demand and railway turnover. As power demand growth in China has been weak since April this year (until a rebound in October), we think there could be risk to our power output assumptions if we see lower-than-expected power demand next year due to a weak economy. Railway turnover for Shenhua has been stable in the past as the company mainly serves its own coal transportation needs. However, if coal demand next year is much worse than expected, this could also put pressure on railway turnover.
China Thermal Coal Sector 19 November 2012
- 47 -
Shenhua: business and locations
Source: Company
See important disclosures, including any required research certifications, beginning on page 69
What's new
Having underperformed the HSCEI Index for three consecutive years, we see a favourable risk-reward profile for China Coal in the near term. This report marks the transfer of coverage to Dave Dai. What's the impact
The company‘s strong cost management was a surprise to us in 3Q12 although cost escalation in 4Q in prior years has been a seasonal case. What we like about its current cost structure is that it is less exposed to some imminent cost inflation factors such as labour costs. Its closest peer, Yanzhou, has great earnings risk if labour costs rise more than expected; hence we project a lower rise in operating costs (4% YoY) for China Coal in 2013. China Coal‘s earnings visibility is more straightforward with: 1) no margin erosion from overseas operations, 2) a cost structure that is
less affected by rising labour costs and risks of changing resources tax (which should be implemented in steps). For 2013, we project YoY earnings decline for Yanzhou but positive growth for China Coal, driven by self-production growth of 14% YoY, on the back of two new mines. Our modest EPS revisions for 2012-14E reflect our more positive view on a coal price recovery.
As China Coal has historically realised better contract prices than Shenhua, it has more positive earnings leverage if the contract coal price moves towards market prices going forward, especially in the seaborne coal market where the contract price remains lower than spot prices. The parent company‘s declared aim to increase its stake by up to 2.5% between October 2012 and October 2013 is not substantial, but suggests some insight on an undervalued business.
What we recommend
We raise our DCF-based six-month target price to HKD9.00 (from HKD7.00), due mostly to changes in our long-term assumptions for the spot/contract coal mix. Its valuation looks appealing to us, trading below book, at a 12-month forward PER that is 56% below its past-5-year mean, with an ROE of 11% over 2013-14E.
How we differ
Our 2012-14E EPS are slightly higher than the consensus mean but much
higher than other brokers‘ latest forecasts due to our more optimistic view on coal price and costs.
Energy / China 1898 HK
19 November 2012
China Coal Energy
Favourable odds in play
We think China Coal offers a favourable risk-adjusted reward
profile as a better play on a coal demand recovery than Yanzhou
Unlike Yanzhou, China Coal does not face profitability issues
from organic expansion and enjoys a lower threat on costs
Raise target price to HKD9.00 and upgrade to Buy; a cyclical
momentum play
Source: Daiwa forecasts
Source: FactSet, Daiwa forecasts
Energy / China
China Coal Energy1898 HK
Target (HKD): 7.00 g 9.00
Upside: 20.2%
19 Nov price (HKD): 7.49
Buy (from Hold)
Outperform
Hold
Underperform
Sell
1
2
3
4
5
Forecast revisions (%)
Year to 31 Dec 12E 13E 14E
Revenue change (3.8) (0.6) 4.0
Net profit change (4.0) 2.9 1.7
Core EPS (FD) change (4.0) 2.9 1.7
55
66
78
89
100
6.0
7.1
8.3
9.4
10.5
Nov-11 Feb-12 May-12 Aug-12
Share price performance
China Coal (LHS) Relative to HSI (RHS)
(HKD) (%)
12-month range 6.09-10.38
Market cap (USDbn) 12.81
3m avg daily turnover (USDm) 30.03
Shares outstanding (m) 13,259
Major shareholder China National Coal Group (57.5%)
How do we justify our view?How do we justify our view?
China Thermal Coal Sector 19 November 2012
- 49 -
Growth outlook China Coal: net profit and YoY growth rates (2008-14E)
We forecast China Coal‘s net profit to decline by 12% YoY for 2012 as a result of a falling spot coal price and the company‘s high sensitivity to coal price changes. However, we expect its earnings to pick up again starting from 2013, driven primarily by a coal price recovery, and forecast growth of 13% YoY for 2013 and 5% YoY for 2014.
Source: Company, Daiwa forecasts
Valuation China Coal: 12-month forward PER trend
The stock is trading currently at a PER of 8.0x based on our 2013 EPS forecast, substantially below its past-5-year average 12-month forward PER of 14.2x, and not much higher than its trough PER of 5.7x at the end of 2008. China Coal‘s 2013E PER also stands almost 1SD below its past-five-year average. We believe its current valuation looks attractive in view of the favourable earnings-growth outlook we see for the company.
Source: Bloomberg, Daiwa estimates
Earnings revisions China Coal: consensus EPS forecast revisions (2012-13E)
The 2012-13 Bloomberg-consensus EPS forecasts for China Coal have been revised down by 24-33% YTD, which we consider reasonable and believe can be explained by the larger-than-expected decline in the spot coal price.
Source: Bloomberg
How do we justify our view?
Growth outlook
Valuation
Earnings revisions
7,131 7,409 7,466
9,802
8,667
9,800 10,297
18.5
3.90.8
31.3
-11.6
13.1
5.1
-20.0
-10.0
0.0
10.0
20.0
30.0
40.0
0
2,000
4,000
6,000
8,000
10,000
12,000
2008 2009 2010 2011 2012E 2013E 2014E
(% )(CNYm)
Net profit (LHS) YoY growth (RHS)
0
5
10
15
20
25
30
35
40
45
50
Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
(x )
20.4x Avg+1SD
14.2x Avg
8.1x Avg-1SD
1.9x Avg-2SD
26.6 Avg+2SD
60
65
70
75
80
85
90
95
100
105
Jan-
12
Feb
-12
Mar
-12
Apr
-12
May
-12
Jun-
12
Jul-1
2
Aug
-12
Sep
-12
Oct
-12
Nov
-12
2012E 2013E
(Rebased to 100)
Buy (from Hold)
Outperform
Hold
Underperform
Sell
1
2
3
4
5
China Thermal Coal Sector 19 November 2012
- 50 -
Key assumptions
Profit and loss (CNYm)
Cash flow (CNYm)
Source: FactSet, Daiwa forecasts
Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E
State-owned China Coal is a leading coal miner in China producing and selling mainly thermal coal. The company also manufactures coal mining equipment and offers coal mine design services.
As at 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E
We upgrade our rating on China Coal to Buy (1) from Hold (3)
A pure thermal coal story in China
Among China‘s three listed coal companies, we believe China Coal offers a much purer play on China‘s domestic market. A large part of Yanzhou‘s future earnings growth is likely to come from its operations in Australia. Shenhua does not have a big overseas business but its business model of full vertical integration also means that coal is only 74% of the group‘s NAV, based on our forecasts. China Coal runs non-coal businesses such as coal-mining equipment, power plants and aluminium smelting. However, its coal-related business will represent close to 90% of its 2012 gross profit based on our forecast, so the company‘s level of vertical integration is much smaller than that of Shenhua. China Coal: revenue breakdown
In terms of coal sales, we forecast China Coal to record 14% YoY growth in self-produced commercial output for 2013 on the back of its planned opening of two new mines next year, Wangjialing and Hecaogou. We forecast the company‘s total sales volume of commercial coal to increase by 11% YoY for 2013, as we believe the scope of its coal-trading business should be limited by its own organic output growth. China coal: coal production and sales-volume trend
(m tonnes) 2010 2011 2012E 2013E 2014E
Raw coal production 122.5 129.2 138.0 157.5 177.0
Commercial coal production 94.4 102.8 110.4 126.0 141.6
Sales volume of commercial coal 117.3 134.7 142.3 157.5 172.7
3. Import and export agency - total 3.6 3.7 3.7 3.7 3.7
Total sales volume 117.3 134.7 142.3 157.5 172.7
Source: Company, Daiwa forecasts
China Coal: coal price trend
(CNY/tonne)
2,010
2,011 2012E 2013E 2014E
I. Self-produced commercial coal 456 500 496 508 513
(I) Thermal coal 446 493 454 458 463
1. Domestic sale 443 490 451 455 460
- Long-term contract 410 425 468 482 482
- Spot trading 521 562 517 522 527
2. Export 662 795 676 683 689
(II) Coking coal 1,267 1,382 1,064 1,011 1,011
II. Proprietary coal trading - total 621 699 594 600 606
III. Import and export agency - total 13 15 14 14 14
Average coal price 476 532 518 526 530
Source: Company, Daiwa forecasts
More exposure to seaborne prices
We estimate that China Coal generates a much higher proportion of its coal sales at coastal ports (ie, exposed to the seaborne market) than Shenhua and Yanzhou, with more mine-mouth and direct arrivals. This also means that China Coal should be able to realise a higher coal price recovery on average than its peers in
China Thermal Coal Sector 19 November 2012
- 53 -
2013 given the much stronger supply forces (with easing inventory and imports declining from the high base in 1H12) in the seaborne market.
Solid market position in mining equipment
Accounting for close to 10% of its total revenue for 2012 on our forecasts, China Coal‘s coal-mining-equipment division is the largest market player in the PRC, ranking ahead of Zhengzhou Coal Mining Machinery, Tiandi, Sanyi, ERA Mining Machinery and International Mining Machinery (IMM) (all not rated). Having recorded a sales CAGR of 23% for the past 5 years, we expect this business line to maintain mid-teens revenue growth with stable operating margin growth over the next few years. Given what we consider as the sustainable growth of this business, we forecast an increase in the share of divisional sales to external customers (from 87% for 2012E to 90% by 2014E). Also, China Coal has promising prospects overseas, in our view, with previous sales made to Russia, Vietnam and India in recent years. Sales of major Chinese coal-mining-equipment makers
Source: Companies
Crossing swords with Yanzhou
A few years ago, it would have been far-fetched to think that China Coal could one day surpass Yanzhou in terms of profitability. However, this has now materialised, with Yanzhou‘s profitability dragged down since mid-2012 by its less profitable expansion in China and Australia. We expect China Coal to beat Yanzhou in terms of both operating margins and ROE starting in 2012 despite falling slightly behind in gross margins onwards of 2012.
China Coal and Yanzhou: operating margin comparison
Source: Company, Daiwa forecasts
China Coal and Yanzhou: ROE comparison
Source: Company, Daiwa forecasts
Positive cost surprise in 3Q12
For 3Q12, China Coal reported a surprise drop in its unit production cost (excluding transportation costs) of 22% QoQ under PRC GAAP. Management‘s official explanation was strengthened cost management. Looking at the historical trend, however, the unit cost tends to fluctuate with weak seasonal patterns, but over the past few years it has tended to peak in the fourth quarter of the year, with an average cost increase of 26% QoQ. Even if we assume a large QoQ unit cost hike in 4Q12, we still believe that the company‘s overall unit cost increase for 2012 should be manageable, at around 6% YoY.
(CNYbn)
Acquired by Caterpillar
in Nov 2011 Acquired by Joy Global
in Jul 2011
0
2
4
6
8
10
China Coal(1898 HK)
ZMJ(601717 CH)
Tiandi(600582 CH)
SANYI(631 HK)
ERA (8043 HK)
IMM (1683 HK)
2010 2011
0
5
10
15
20
25
30
35
2010 2011 2012E 2013E 2014E
(% )
China Coal Yanzhou
0
5
10
15
20
25
30
2010 2011 2012E 2013E 2014E
(% )
China Coal Yanzhou
China Thermal Coal Sector 19 November 2012
- 54 -
China Coal: quarterly unit selling cost trend
Source: Company, calculated by Daiwa
China Coal: quarterly gross margin trend
Source: Company
Less exposure to labour and policy risks vs. peers
As discussed in the industry section of this sector report, China Coal has much smaller exposure to labour costs and resources taxes than its peers. Total unit cost sensitivity to changes in cost items
Sensitivity Shenhua China Coal Yangzhou
10% change in raw-material costs 0.6% 2.3% 1.8%
10% change in labour costs 0.9% 0.9% 3.4%
10% change in transportation costs 4.2% 2.6% 0.8%
Resources tax (at 5% scenario) 5% 5% 8%
Source: Daiwa estimates
2013E EPS sensitivity to change in costs
Company 1% increase in costs
Shenhua 1.2%
China Coal 3.8%
Yanzhou 10.0%
Source: Daiwa estimates
More upside from possible contract-spot price convergence
As discussed in the industry section of this report, the PRC Government has initiated talks with China‘s power and coal producers to converge spot prices with contract prices for coal. Although we see a full convergence as unlikely this year, any linkage between spot and contract pricing should be positive for coal producers exposed to the seaborne market, especially China Coal, whose average contract price is lower than its spot price. As we expect the spot coal price to remain at a premium to the contract price for the rest of this year and in 2013, we project the contract sales proportion of China Coal and Shenhua‘s total coal sales volume to decline further going forward. We forecast a 3% YoY increase in the contract coal price for 2012, as contract coal prices are currently at a discount to average spot coal prices for the major coal producers. However, any move towards more market-based conversion could benefit the listed coal producers in our coverage much more, as the gap is generally larger than 3%. We have excluded Yanzhou from this illustration, as the company sells most of its coal in China in the spot market. Based on the disclosed prices and our forecasts (for 2012), Shenhua seems to have a much bigger gap between its average spot and contract prices than China Coal. The difference between Shenhua and China Coal‘s average contract prices results from Shenhua‘s larger contract sales via direct arrivals and mine-mouth sales, and only about 46% (2011) to the seaborne market. Seaborne prices are generally higher due to higher transportation costs. However, looking at the different channels, Shenhua still sells contract coal at a big discount to China Coal, especially for direct arrivals and the seaborne market. Contract-spot prices of major coal producers
2008 2009 2010 2011 2012E
Shenhua
Spot 438 421 457 508 456
Contract 336 362 362 338 355
Difference 30% 16% 26% 50% 28%
China Coal
Spot 612 417 521 562 517
Contract 365 402 410 425 468
Difference 68% 4% 27% 32% 11%
Source: Companies, Daiwa forecasts
150
170
190
210
230
250
270
290
1Q 2Q 3Q 4Q
(CNY/tonne)
2009 2010 2011 2012
25
27
29
31
33
35
37
39
41
43
45
1Q 2Q 3Q 4Q
(CNY/tonne)
2009 2010 2011 2012
China Thermal Coal Sector 19 November 2012
- 55 -
Shenhua: contract/spot price breakdown by delivery (CNY/t)
Spot 2007 2008 2009 2010 2011 9M12
Total 265 438 421 457 508 472
Mine mouth 102 163 178 142 171 138
Direct arrival (rail) 289 387 401 406 473 416
Seaborne 399 614 473 590 630 568
Contract
Total 311 336 362 362 338 349
Mine mouth 0 79 105 163 162 184
Direct arrival (rail) 229 261 278 263 251 253
Seaborne 360 409 441 462 451 481
Difference
Total -15% 30% 16% 26% 50% 35%
Mine mouth - 106% 70% -13% 5% -25%
Direct arrival (rail) 26% 48% 44% 55% 88% 64%
Seaborne 11% 50% 7% 28% 40% 18%
Source: Company
China Coal‘s earnings are the most sensitive of the three coal producers to changes in contract coal prices. We calculate that every 1% increase in the contract price on top of our 3% assumption would lead to about a 2% boost to our 2013 EPS forecast. 2013E EPS sensitivity to changes in thermal coal prices (%)
Every 1% increase in: Contract price Spot price
Shenhua +0.3 +0.9
China Coal +1.9 +2.5
Yanzhou +0.7 +9.4
Source: Daiwa forecasts
Note: Yanzhou’s spot coal includes both China and Australian coal prices
Key risk would be a flat contract price
As discussed in further detail earlier in this report, any reform of the coal price mechanism is still under discussion and there are still various uncertainties going into the year-end negotiations. If the contract price is not allowed to change for 2013 in the way that happened in 2011, we would see downside to our earnings forecasts for 2013, especially for China Coal. 2013E EPS downside in case of no change in contract price
% EPS downside
Shenhua -0.9
China Coal -5.7
Yanzhou -2.1
Source: Daiwa forecasts
In this case, a natural counter-strategy for China Coal would be to sell more in the spot market. In our current forecasts, we already assume a slow shift into more spot coal. In 2011, the frozen contract price led to a YoY decline in China Coal‘s contract coal sales. Compared with Shenhua‘s much larger output (and perhaps more social responsibility for contract coal), we believe that China Coal has historically been more flexible to take advantage of price differences in different cycles, and that compared with Shenhua the growth rate of its realised contract price has been larger. In the event of no change in the contract price in 2013, we calculate that there would be downside potential to our 2013
EPS forecast for China Coal of 5.7%. Lastly, Shenhua‘s 9M12 prices suggest a premium of mine-mouth contract prices over spot prices, which could be a potential risk when convergence takes place. On the positive side, most of China Coal‘s sales go to the seaborne market, reducing such risks. China Coal: contract/spot sales volume split
Total 100% 100% 100% 100% 100% 100% 100% 100% 100%
Contract 87% 88% 84% 73% 70% 52% 52% 46% 41%
Spot 13% 12% 16% 27% 30% 48% 47% 54% 59%
Source: Company, Daiwa forecasts
Realised changes in coal prices (YoY)
Shenhua 2008 2009 2010 2011
Spot -4% 9% 11% -10%
Contract 8% 0% -7% 5%
China Coal
Spot -32% 25% 8% -8%
Contract 10% 2% 4% 10%
Source: Company
Valuation looks attractive
Given the company‘s slightly better-than-expected operations for 3Q12 and following a transfer of coverage, we are making modest revisions to our 2012-14 earnings forecasts for China Coal. The stock is now trading significantly below its past-5-year averages in terms of both forward PER and PBR. We are raising our DCF-based six-month target price from to HKD9.00 (from HKD7.00), reflecting mainly a lower-than-expected unit cost for 3Q12 and our assumption of a gradual long-term shift towards more spot coal sales, implying higher long-term average selling prices than our previous forecasts. China Coal: 12-month forward PER trend
See important disclosures, including any required research certifications, beginning on page 69
What's new
We continue to see few catalysts for the stock following Yanzhou‘s disappointing 3Q12 results. Our forecasts now incorporate the newly acquired Gloucester (GCL) of Australia. This report marks the transfer of coverage to Dave Dai. What's the impact
Yanzhou once had the best gross margin in the sector, supported by the profitability of its Shandong operations. However, this is no longer the case given its aggressive expansion into low-margin mines in China and Australia. While the merger of GCL with Yanzhou‘s 78%-owned Australian subsidiary, Yancoal Australia (Not rated), offers wider access to port throughput, the coal-mine assets could burden the overall Australia business with high costs and low
prices, as well as potential compensation to shareholders of Yancoal Australia by the end of 2013. We now forecast Yanzhou‘s overall gross margin to fall from 40% for 2011 to 18% for 2014 (32% previously) and a compound annual decline in EPS of 20% for 2012-14 (a 12% increase previously). The company‘s earnings are the most sensitive among its peers to changes in spot-coal prices, as we estimate there would be 9% upside to 2013 EPS for every 1% rise in the spot price. However, Yanzhou‘s earnings sensitivity to changes in unit production costs is also high, at 10%, with large exposure to labour costs and resource taxes. We are cutting our 2012-14 EPS forecasts by 20-59% due to the worse-than-expected 3Q12 results and continuing cost pressures. What we recommend
We are lowering our DCF-based six-month target price to HKD11.30. The stock‘s valuation now appears stretched, with the 2013E PER near its past-five-year mean. The main risks to our call would be stronger-than-expected coal-price rises and lower-than-expected cost increases. How we differ
Our 2012-14 EPS forecasts are 13-43% below those of the Bloomberg
consensus as we are less optimistic about the Australia operation. Also, the consensus forecasts may not fully reflect Yanzhou‘s 3Q12 net loss.
Energy / China 1171 HK
19 November 2012
Yanzhou Coal Mining
Value-destructive expansion
Yanzhou‘s aggressive expansion strategy is coming at the
expense of rapidly eroding margins and a depressed ROE
Despite high earnings sensitivity to spot-coal prices, risk-reward
profile looks unfavourable given considerable cost pressure
The stock is much more expensive than its peers on a PER basis;
How do we justify our view?How do we justify our view?
China Thermal Coal Sector 19 November 2012
- 58 -
Growth outlook Yanzhou: profitability
We forecast Yanzhou‘s gross margin to fall from 40% for 2011 to a range of 18-25% over 2012-14, due to rapid cost hikes, especially for the company‘s Australia business. Meanwhile, we forecast Yanzhou‘s EBIT margin to fall from 26% in 2011 to 7-11% over 2012-14 and its net margin to fall from 19% in 2011 to 5-10% over 2012-14.
Source: Company, Daiwa forecasts
Valuation Yanzhou: forward PER history
The stock is trading currently at a PER of 12.6x on our 2013 EPS forecast, in line with its past-five-year average 12-month forward PER of 12.6x. We believe it is not attractive at this level given the company‘s deteriorating earnings outlook.
The 2012-13 Bloomberg-consensus EPS forecasts for Yanzhou have been cut sharply YTD, by 38-49%. The latest large revisions were seen after the company‘s 3Q12 net loss.
Source: Bloomberg, Daiwa
How do we justify our view?
Growth outlook
Valuation
Earnings revisions
44
40
25
20 18
2926
118 7
27
19
106 5
0
10
20
30
40
50
2010A 2011A 2012E 2013E 2014E
(%)
Gross margin EBIT margin Net margin
0
5
10
15
20
25
30
35
Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
(x)
19.6x Avg+1SD
12.6x Avg
26.7x Avg+2SD
5.5x Avg-1SD
40
50
60
70
80
90
100
110
Jan-
12
Feb
-12
Mar
-12
Apr
-12
May
-12
Jun-
12
Jul-1
2
Aug
-12
Sep
-12
Oct
-12
Nov
-12
2012E 2013E
(Rebased to 100)
Buy
Outperform
Hold (unchanged)
Underperform
Sell
1
2
3
4
5
China Thermal Coal Sector 19 November 2012
- 59 -
Key assumptions
Profit and loss (CNYm)
Cash flow (CNYm)
Source: FactSet, Daiwa forecasts
Year to 31 Dec 2007 2008 2009 2010 2011 2012E 2013E 2014E
Although Yanzhou made impressive overseas acquisitions in the past, the recent operational environment in Australia and the newly added GCL assets (the merger was finalised in June this year) have, in our view, put significant pressure on the company‘s overall profitability. Yancoal Australia: share price vs. local index and other Australia materials stocks
Source: Bloomberg
GCL is an Australian entity involved in coal production, exploration, and mining operations in the Gloucester Basin and Hunter Valley in New South Wales and in the Bowen Basin, Queensland. The company produces metallurgical and thermal coal for export, with two open-cut operational mines in the Gloucester Basin (Stratford and Duralie) and Donaldson Coal in the Hunter Valley, which consists of two underground mines (Tasman and Abel), and one open-cut mine (Donaldson). In Queensland, GCL has joint control and holds a near 50% interest in the Middlemount Coal open-cut mine located in the Bowen Basin. The company has large coal-reserve and resources bases, with reserves of 293m tonnes and resources of 1.8bn tonnes (on an equity basis). In New South Wales, GCL has an 11.6% interest in Newcastle Coal Infrastructure Group (NCIG) and port allocations at
Port Waratah Coal Services (PWCS), to support its current production and planned production-growth activity. In Queensland, through its near 50% ownership in Middlemount Coal, GCL has port allocation at Abbot Point Coal Terminal (APCT) and (until 2014) Dalrymple Bay Coal Terminal (DBCT), and through Middlemount Coal‘s interests in the North Queensland Coal Terminal Pty Ltd (NQCT) is seeking additional allocation of up to 1m tpa (on a 100% basis) at APCT. GCL: asset locations
Source: GCL
Rationale behind the merger
According to Yancoal Australia (Not rated), the merger with GCL provides a business-growth plan supported by large and diversified coal-reserve and coal-resource bases of 697m tonnes and 3.5bn tonnes, respectively (on an equity basis). The merged entity has substantial port and rail capacity and allocations in place to support the production-growth plans of the combined operations. It also has substantial New South Wales port allocations, with a 27% interest in NCIG and significant PWCS capacity allocations. Combined New South Wales port capacity is about 18.6m tpa for 2012 and should increase to about 27.2m tpa in 2016. We believe opportunities exist for Yancoal Australia to leverage on future projects to utilise excess New South Wales port capacity. The merged company also has port capacity in Queensland at APCT, DBCT (until 2014), and at RG Tanna and Wiggins Island (capacity allocation only) to support production from Middlemount mine and Yarrabee mine.
50
60
70
80
90
100
110
120
130
140
28-Jun-12 19-Jul-12 9-Aug-12 30-Aug-12 20-Sep-12
Yancoal Australia BHP Rio Tinto
Anglo American Xstrata Glencore
ASX Index
(Rebased to 100)
China Thermal Coal Sector 19 November 2012
- 62 -
But at what cost...
The following shows the pro-forma projections based on the listing document. It appears that GCL in FY11 could generate a positive net profit of AUD27m and Yancoal AUD288m. Pro-forma financials of the Yancoal Australia and GCL (FY11)
AUDm GCL Yancoal Combined
Current assets 244 1,385 914
Non-current assets 2,179 3,973 7,166
Total assets 2,423 5,357 8,080
Current liabilities 867 1,175 1,043
Non-current liabilities 871 2,420 4,653
Total liabilities 1,738 3,595 5,696
Total equity 684 1,763 2,384
Revenue 396 1,462 1,858
EBITDA 85 602 687
EBIT 48 475 523
Profit before tax 35 420 -
Net profit 27 288 -
Source: Yancoal Australia
However, GCL recorded a loss for the period from July to December 2011. The company explained that the first quarter of the period saw a gradual softening of overseas demand for export coal, in particular metallurgical coal. The situation deteriorated in the second quarter. Coal prices during the period were volatile, more so in the metallurgical coal market. Thermal coal prices were subdued at times. However, movements in prices, in most cases, coincided with changes in the value of the Australia Dollar. Movements in metallurgical coal prices were more aligned with slowing of product demand from overseas users and general global economic conditions, affecting non-premium coking-coal products and low-volatile pulverised coal injection products in particular. GCL: financial information
AUDm 6 months to Dec 2011 12 months to June 2011
Revenue 227 307
EBITDAT 35 90
Depreciation and amortisation -26 -19
EBITT 9 72
Transaction cost -41 -9
EBIT -33 62
Finance cost -24 14
Profit before tax -57 77
Income tax 20 -22
Net profit -37 55
Source: GCL
Before the merger with GCL, in 1H12, Yancoal Australia‘s profitability deteriorated, with recurring earnings declining substantially. One-off items included in 1H12 were: 1) foreign-currency gains of AUD14m grouped as part of revenue, 2) foreign-currency gains of AUD15m grouped as part of other income, 3) an acquisition gain of AUD218m, and 4) a positive tax charge of AUD192m. The tax charge is related to the Minerals Resource Rent Tax (MRRT).
Yancoal Australia: financials
AUDm 1H11 1H12
Revenue 743 601
Other income 154 235
Change in inventories -41 -42
Raw materials -86 -87
Employee benefits expenses -77 -96
Depreciation -60 -66
Transportation -80 -79
Contractual services -81 -116
Government royalty -52 -42
Changes in overburden 5 6
Transaction costs 0 -45
Other expenses -27 -27
Finance costs -36 -19
Profit before tax 361 223
Income tax -108 192
Net profit 254 414
Revenue adjusted for one-off items 714 587
Profit before tax adjusted for one-off items 181 -24
Source: Company
The MRRT is a tax on 30% of the ‗super profits‘ (defined as assessable receipts minus deductible expenditure including an MRRT allowance) from mining of iron ore and coal in Australia. Effective from 1 July 2012, we expect the MRRT to increase the tax burden on Yancoal Australia. Future deductible expenditure includes a starting base allowance to be based on the value of the mining assets as at 1 May 2010 plus capital expenditure to 30 June 2012, depreciated over the life of the mines. Projects are also eligible for the 25% extraction allowance that reduces the effective statutory tax rate to 22.5% of the super profits. State royalties are creditable for MRRT purposes, and MRRT payments are deductible for company income-tax purposes.
Cost burden from carbon tax from July 2012
Another future increase in costs for the whole Australia business is associated with the carbon-tax scheme there. The Government‘s Clean Energy Bills contain a mechanism for pricing carbon emissions and came into effect on 1 July 2012. The carbon-pricing mechanism affects an entity differently depending on whether it is directly liable under the scheme (liable entity) or is indirectly affected (eg, by purchasing goods from a liable entity). In the utilities industry, there was a listed player, CLP (2 HK, HKD66.2, Hold [3]), that was directly affected by the scheme as a local user. In 2011, the company booked a HKD1.9bn provision after assessing the impact of the scheme. For coal mines, the carbon tax is charged on fugitive greenhouse gas emissions.
China Thermal Coal Sector 19 November 2012
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According to KPMG, the government estimates that a carbon price of AUD23 would translate into about AUD1.4/tonne for ‗average non-gassy mines‘ but could rise to AUD7.4/tonne for ‗average gassy mines‘ and AUD25 for ‗coal for the gassiest‘ mines. To alleviate such cost pressure, an assistance package of AUD1.3bn over six years is available for existing but not new mines. Most industry experts believe that 18 mines in New South Wales and seven in Queensland will be eligible. These mines must have a fugitive emissions intensity of 0.1 tonne of CO2-e per tonne of saleable coal, based on 2008-09 data. Assistance will be provided on up to 80% of the fugitive emission above 0.1 tonne of CO2-e per tonne of saleable coal. This assistance will be capped based on the higher of the 2007-08 or 2008-09 production levels. This means that most of Yanzhou‘s mines in Australia are not eligible for assistance under the scheme based on the years of production. Open-cut mines should have less fugitive emissions than underground mines and Yanzhou seems to have a balanced portfolio between the two in Australia. Operational years of Yanzhou’s Australian mines
GCL Operation Type
Duralie Mar-03 Open cut
Stradford Since 1995 Open cut
Abel Feasibility Open-cut/underground
Tasman Feasibility Open-cut/underground
Donaldson To cease in 2013
Middlemount Nov-11 Open cut
Monash Exploration Underground
Yancoal Operation Type
Austra >60 years ago Underground
Yarrabee Since 1994 Open-cut/underground
Ashton Early 2011 Open-cut/underground
Moolarben May-10 Open cut
Cambry Down Late 2010 Open cut
Westfarm Premier Late 2011 Open cut
Source: Company
While we do not have the emission data for individual mines to calculate the associated tax, the Australia Climate Change Minister, Greg Combet, said t0 the domestic press that under the carbon tax companies would incur an average additional cost of only AUD2 for every tonne of coal produced, which we estimate would then account for 2.4% and 2% of Yancoal‘s and GCL‘s 2011 sales costs, respectively. However, a Wood Mackenzie report published earlier this year noted that under a carbon permit price of AUD23/tonne, the weighted-average cost per marketable tonne was about AUD3, but if the carbon price reaches AUD40/tonne after 2015, the cost impact becomes AUD4.6 per marketable tonne. Given the range, we believe it is reasonable to assume the combined company will see a 2-3% unit cost increase for 2013.
Deteriorating operations
We expect Yanzhou to increase its coal sales over the next few years in three areas: 1) in China (mostly from new mines in Heze City (Shandong Province) and Ordos City (Inner Mongolia), 2) in Australia (largely from GCL), and 3) coal trading. The above changes in the sales mix will have a negative impact on overall profitability as: 1) Yanzhou‘s Shandong operations are the most profitable (a gross margin of close to 50%) but capacity is not growing any longer, 2) GCL is likely to see a negative gross margin based on our price and cost forecasts, and 3) externally purchased coal should remain a business on which margins are thin. We forecast the overall unit cost of sales to rise by 6% (or 7% for its China operations) YoY for 2013 (higher than for its peers), driven by both changes in locations and the sensitivity of the company‘s to rising labour costs. Yanzhou: coal sales mix
’000 tonnes 2010 2011 2012E 2013E 2014E
China (self-produced) 36,234 40,882 43,602 48,438 55,025
Australia (self-produced) 8,022 10,060 13,795 19,470 23,053
1. Total for the Company 33,657 33,276 33,276 33,276 33,276
2. Shanxi Neng Hua 1,498 1,223 1,285 1,285 1,285
3. Heze Neng Hua 1,079 2,004 2,338 2,672 3,006
4. Ordos Neng Hua 0 4,379 6,703 11,205 17,458
5. Yancoal Australia 8,022 10,060 12,021 13,780 15,466
6. External 5,378 13,308 23,954 26,350 26,350
7. GCL - - 1,774 5,690 7,586
Total 49,634 64,250 81,352 94,258 104,428
Source: Company, Daiwa forecasts
Yanzhou: coal selling-price forecasts
CNY/tonne 2010 2011 2012E 2013E 2014E
1. Total for the company 634 686 611 618 624
2. Shanxi Neng Hua 382 468 421 428 435
3. Heze Neng Hua 772 913 798 853 848
4. Ordos Neng Hua 0 291 291 280 284
5. Yancoal Australia 774 930 744 744 751
6. External 742 722 665 671 685
7. GCL 815 1,004 746 670 641
Total 663 708 624 618 607
Source: Company, Daiwa forecasts
Yanzhou: unit cost of sales forecasts
CNY /tonne 2010 2011 2012E 2013E 2014E
1. Total for the company 259 289 335 359 378
2. Shanxi Neng Hua 250 333 350 375 395
3. Heze Neng Hua 660 649 590 633 665
4. Ordos Neng Hua 0 159 200 215 225
5. Yancoal Australia 393 426 533 570 587
6. External 736 718 660 673 673
7. GCL 614 732 746 784 784
Total 365 427 465 494 496
Source: Company, Daiwa forecasts
China Thermal Coal Sector 19 November 2012
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Yanzhou: gross margin by mines
2010 2011 2012E 2013E 2014E
1. Total for the company 59.1 57.9 45.2 41.8 39.4
2. Shanxi Neng Hua 34.7 28.9 16.8 12.4 9.4
3. Heze Neng Hua 14.5 28.9 26.1 25.8 21.5
4. Ordos Neng Hua - - 27.3 23.4 20.7
5. Yancoal Australia (ex GCL) - 31.0 28.4 23.3 21.8
6. External 0.9 0.7 0.7 -0.3 1.6
7. GCL 24.7 27.1 -0.1 -17.0 -22.3
Total 44.4 39.3 25.0 19.6 17.9
Source: Company, Daiwa forecasts
Deteriorating gross margins could directly depress the EBIT margin and net margin as well as the ROE. We forecast Yanzhou‘s net gearing ratio to reach 46% for 2013, which is the highest among its peers. Yanzhou: profitability
Source: Company, Daiwa forecasts
Yanzhou: ROE
Source: Company, Daiwa forecasts
Yanzhou: net gearing ratio
Source: Company, Daiwa forecasts
Potash operations are non-core
In July 2011, Yanzhou proposed acquiring Canadian potash exploration permits for USD260m. The permits cover a total area of about 5,364 sq km in Canada‘s Saskatchewan province. The company needs to conduct further exploration to produce a formal reserves estimate. Mining giants such as BHP Billiton (Not rated) and Potash Corp (Not listed) operate in the same province. In the announcement, Yanzhou‘s view was: ‗The company, through the transaction, will be able to fully leverage its mining expertise and to enhance commercial benefits. The company will consistently adhere to market-focused business principles and localised operating approaches in overseas investment, to carry out the follow-up exploration activities and other operations with respect to the relevant Canadian potash resources accordingly‘. Potash, a potassium nutrient used to shield crops from dryness and disease, has seen very volatile spot prices in recent years. Besides volatile pricing, we are not sure whether potash, a non-core and unfamiliar business for Yanzhou as a coal company, could create value for the overall business, despite the profitability of experienced potash miners. We have not incorporated any impact from the potential purchase of this business into our earnings forecasts.
Potassium chloride (muriate of potash) FOB Vancouver price
Source: Bloomberg
Lowering DCF-based target price to HKD11.30
We are cutting our 2012-14 earnings forecasts sharply on the back of recent market changes in output and prices, as well as disappointing operations in 3Q12. The stock now looks expensive to us, with a 12-month forward PER multiple, at 13x, close to its past-five-year average, while its peers are trading below their past-five-year averages. Yanzhou‘s 12-month forward PBR multiple is also below the stock‘s past-five-year average mean, highlighting our concern about the ROE. We are not sure whether an EV/reserve measure is an effective tool with which to value Yanzhou given that the profitability of mines tends to vary substantially, but even on this basis Yanzhou‘s valuation looks far from attractive. We are revising down Yanzhou‘s coal-output forecasts for 2012-14, by 1-5%. We are revising up our average coal-selling price forecasts by 2-4% on the back of a higher expected revenue contribution from the Australian coal business, which has a higher ASP. The major reason for the cuts to our 2012-14 earnings forecasts is the unit-cost rise that we see (we are increasing our unit-cost forecasts for the period by 4-14%, mainly because we see higher cost pressure from the Australian business over the next few years). Given the 0.4% upside potential to our new target price, we maintain our Hold (3) rating. The key risks to our call would be stronger-than-expected coal-price rises and lower-than-expected cost increases. As we mentioned previously, Yanzhou‘s earnings are highly sensitive to coal-price rises and unit-cost hikes. These could be the two main share-price swing factors. In addition, based on the share swap agreement signed during the acquisition of GCL, Yancoal Australia has issued 87.6m contingent value rights (CVR shares) to
GCL‘s shareholders. The CVR shares are to be repurchased following implementation of the merger proposal at a ‗repurchase price‘ equal to the amount by which the price of Yancoal Australia ordinary shares on Australian Stock Exchange is less than AUD6.96, based on the 90 day volume-weighted average price 18 months after the merger proposal is implemented, subject to a cap of AUD3.00 per CVR share and other conditions. This could result in a maximum payment of AUD263m for Yancoal Australia by the end of 2013, which we see as an additional risk to Yanzhou Coal. Yanzhou: Daiwa earnings- forecast revisions
Deputy Head of Hong Kong and China Research; Pan-Asia/Regional Head of Clean Energy and Utilities; Utilities; Power Equipment; Renewables (Hong Kong, China)
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China Thermal Coal Sector 19 November 2012
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In addition to the purchase price of a financial instrument, we will collect a trading commission* for each transaction as agreed beforehand with you. Since commissions may be included in the purchase price or may not be charged for certain transactions, we recommend that you confirm the commission for each transaction.
In some cases, we may also charge a maximum of ¥ 2 million (including tax) per year as a standing proxy fee for our deposit of your securities, if you are a non-resident of Japan.
For derivative and margin transactions etc., we may require collateral or margin requirements in accordance with an agreement made beforehand with you. Ordinarily in such cases, the amount of the transaction will be in excess of the required collateral or margin requirements.
There is a risk that you will incur losses on your transactions due to changes in the market price of financial instruments based on fluctuations in interest rates, exchange rates, stock prices, real estate prices, commodity prices, and others. In addition, depending on the content of the transaction, the loss could exceed the amount of the collateral or margin requirements.
There may be a difference between bid price etc. and ask price etc. of OTC derivatives handled by us.
Before engaging in any trading, please thoroughly confirm accounting and tax treatments regarding your trading in financial instruments with such experts as certified public accountants. *The amount of the trading commission cannot be stated here in advance because it will be determined between our company and you based on current market conditions and the content of each transaction etc.
When making an actual transaction, please be sure to carefully read the materials presented to you prior to the execution of agreement, and to take responsibility for your own decisions regarding the signing of the agreement with us.
Corporate Name: Daiwa Securities Co. Ltd. Financial instruments firm: chief of Kanto Local Finance Bureau (Kin-sho) No.108 Memberships: Japan Securities Dealers Association, Financial Futures Association of Japan Japan Securities Investment Advisers Association Type II Financial Instruments Firms Association
