Loving the Unloved Coal Company
We recommend a long position in China Shen Hua Energy (SHSE:601088) with a target price of HKD37.98, which represents an upside of 51% from current level. Faced with the weak coal cycle, the peer group has underperformed the market in 2012 through 2013. The company is trading at the low end of its 10-year historical valuation. Our worst case generates HKD15.96 (down approximately 43%). But despite the worst case, the up/down ratio is still 1.2x and there is still a dividend yield of 4.8%. We believe that the stock has an asymmetrical risk/reward profile at the current level.
· In fiscal year 2012, 601088 generated CNY250,260 million (US$40.9 billion) in revenue, largely from China with small contribution from Indonesia and Australia. It operates three segments: coal production (66% of revenue), coal- fired power generation (28% of revenue) and coal distribution (2% of revenue).
· 601088 sells thermal coal, which is used in power generation. It does not produce coking coal, which is used in steel manufacturing. In fiscal year 2012, 601088 sold 464.6 million tons (Mt) of coal. Domestic sales account for about 80% of total coal sales volume, while the remaining 20% of coal sales volume is exported. About 70% of the domestic coal sales volume went to power generation (including its own power plants), while about 30% went to coal trading companies and customers in metallurgical, construction and chemical sectors. The company is the largest thermal coal producer in China. In 2010, it accounted about 7.5% of China’s production, well over twice as much as the next largest player.
· 601088 is also China’s largest coal exporter, focusing on the Asia Pacific coal market. It is one of the four authorized coal exporters in China, accounting for about 25% of China’s coal export. However, the domestic market is more important to 601088 as China is a net importer of coal and the export quota is controlled due to coal shortages in China.
· As of December 2012, 601088 has a proven and probable reserve (under JORC standard) of 9.04 billion tonnes which could last about 30 years based on 2012 production.
1. A low-cost producer with leading market share.
China’s coal market is fragmented and dominated by local companies, but it is consolidating. The local producers can be classified into three groups:
1. Top producers: Some are publicly listed while others are State Owned Enterprise (SOE) controlled by central government.
2. Local SOE that are controlled by local government.
3. Township and Village Enterprises (TVE) that are controlled by agricultural collectives.
Although TVE and local SOE in aggregate account for about 75% of total thermal coal output, the top 10 contribute a significant proportion of the total production on a standalone basis. Furthermore, TVE and local SOE typically have small production, poor efficiency, lack of access to capital and poor safety records. Thus, there is a trend of the top 10 increasing their market share at the expense of the TVE and local SOEs. By 2015, it is estimated that the top 10 will account for 40% to 50% of total thermal coal production. The company 601088 is well positioned to take an increasing share of the market as the largest coal producer in China and a low-cost producer of thermal coal. Its total cost of production for thermal coal is estimated about RMB250 per ton, which places it in the first quartile of China’s thermal cost curve.
2. Integrated business model provides competitive advantage.
The company 601088’s vertically integrated business model provides it with competitive advantage over the other Chinese coal producers because it owns a power business and coal transportation networks, which includes railway, ports and ships.
Its power business provides a stable captive market for its coal production. In 2012, about 80% of the coal consumed by its power business came from its coal operations, which amounts to 17% of its total coal sales volume. Power prices in China are regulated by the Chinese government, based on the principle of cost plus a reasonable return, but prices can be subjected to political considerations on the inflationary pressure on the citizens.
Moreover, power prices are not directly linked to coal input price, which is market driven. Hence, only a portion of the coal price increase may be passed through to the customers. Therefore, coal fired power generators enjoy predictability in revenue but volatility in their profit margin. However, there are measures that act as circuit breakers. The Chinese government can limit coal prices when prices reach levels unbearable for power generators or increase power tariffs when the situation permits. In effect, the power business acts like a downside protection, compensating the coal operations during times of low coal prices. It also allows 601088 to grow in step with China’s economic growth.
China’s coal industry is characterized by geographic separation of the regions of supply and demand. The coal rich areas are in the Western and Northern regions of China, while the demand centers are concentrated in the coastal cities, which are in the Eastern region of China. For most coal producers, the railway system is the most important mean of coal transportation, while some may use inland river passage. Notably, 601088’s coal transportation network connects the coal-rich areas of Shanxi, Shaanxi and Inner Mongolia to Tianjin. Furthermore its railway network connects to its ports, allowing 601088 to dominate the seaborne trade and achieve consistent supply despite the distribution challenge in China.
Another Chinese coal producer with its railway network is Yitai, the largest coal enterprise in Inner Mongolia, but its railway is mainly used to link their coal mines to the national railway system and its scale is not as extensive as that of 601088. The other coal producers rely on the national railway system but they have to share the capacity, which is allocated by the government. The company 601088 has the flexibility of using both its coal transportation network and the national railway. In fiscal year 2012, about 78% of its railway turnover was on its own railway network while the remaining 22% of its railway turnover was on the national railway network.
Its vertically integrated model is not easy to duplicate. It took about two decade for 601088 to reach its current model. In the 1990s, 601088 took over the railway and port facilities of Huaneng, a key SOE. In the 2000s, it also took over Huaneng’s power generation business. Furthermore, the consolidation and integration was driven by the Chinese government as 160088 was previously a key SOE. The competitiveness advantage is reflected in its ROIC, which has averaged 18.1% over the last eight years.
3. The current weak cycle of the cyclical coal market presents an opportunity to gain exposure to China’s long-term structural growth.
China’s power industry is heavily dependent on thermal coal. Coal fired generation accounts for 78% of installed generation in 2011 and it is expected to decrease slightly to 72% of installed generation by 2020, while nuclear power is expected to increase its share. The current environment of slow power consumption growth, weak domestic coal demand, sharp fall of coal prices to its five-year low and increase in operating cost has affected all Chinese coal producers. But the long-term structural story of China’s power industry supporting its economic growth remains intact.
4. Attractive risk/reward profile at current level.
The company 601088 is currently trading at EV/EBIT of 6x, lower than its valuation during the recent Global Financial Crisis of 8x to 9x. Assuming a 10-year EV/EBIT historical average of 12x on 2014 EBIT of CNY67.4 billion will lead to HKD37.98 price target, representing an upside of 51% from the current level. Meanwhile the stock is paying a dividend yield of 4.8% while we wait for its valuation to normalize. Even at a low EV/EBIT ratio of 5x — a worst-case scenario — the stock price will be at HKD15.96, a downside of 43% from the current level. This translates to an up/down ratio of 1.2x, without factoring in the dividend yield.