Regional. Metals, Mining, Coal, Steel More Excitement For This Space In Overweight (new) Initiating Coverage 25 September 2013

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1 Regional Initiating Coverage 25 September 213 Overweight (new) Alexander LATZER (852) Metals, Mining, Coal, Steel More Excitement For This Space In 214 We initiate coverage of five companies in the coal, metals and steel sectors in China with an overall positive view three BUY ratings, one HOLD and one SELL. We believe that 214 may provide some upside on improving global demand and rising political risk for the coal and metals sectors, which have been struggling for most of 212. We forecast an improvement in materials prices from the current levels, except for steel whose prices are chasing raw material costs lower. During 214, we expect nickel, aluminum, copper and coking coal to outperform. Thermal coal price is likely to rise by 5% from the current level by year-end on favourable seasonal factors. We are above consensus on copper, and well below on zinc relative to consensus for 214. We see the ban on ore exports from Indonesia as the biggest nearterm industry event. This should help boost the nickel price, and over time the alumina, and to a lesser extent aluminum prices. Chinese ore importers in the nickel pig iron and alumina sectors are most exposed. Our top pick based on total return is Chalco. We admit this is an out-of-consensus call, especially considering our long-term negative view of the company and industry. But we see some encouraging signs of change and the stock valuation seems to have incorporated most of the negatives. Our call hinges on aluminum price upside next year as supply growth slows and demand growth remains in the low teens in China. This is a Speculative BUY given the company s persistent losses and weak balance sheet. Our second pick in terms of total return is Jiangxi Copper, which we expect to benefit from our forecast increase in copper price between now and mid-214, before we see the market moving into oversupply in the second half of 214 as Chinese refinery production accelerates on the improving availability of copper concentrate and scrap supply. The thermal coal sector is heading into a slower growth period and returns will be under pressure for companies that cannot lift productivity or find growth. Our stable long-term pick is Shenhua, which we see as the one to own for those seeking long-term exposure to the coal sector. China Coal is a HOLD for those wishing exposure to the seasonal upside in the next few months. Our one SELL rating is Angang Steel based on our forecast for lower steel prices over the next few months and the weak earnings outlook for the next two reporting half-year periods. We also find that Angang s earnings quality has decreased as cash flow is not keeping pace with the improvement in net profit. We see continued oversupply in the steel sector keeping a lid on returns until 215 at the earliest. SEE APPENDIX I FOR IMPORTANT DISCLOSURES AND ANALYST CERTIFICATIONS

2 Metals, Mining, Coal, Steel Sector Contents Investment Summary... 3 Materials Price Forecasts... 4 Coal Outlook... 1 Aluminum Outlook Copper Outlook Steel Outlook China Shenhua Energy (188 HK) China Coal Energy (1898 HK) Jiangxi Copper (358 HK) Chalco (26 HK) Angang Steel (347 HK) September 213 Page 2 of 7

3 Metals, Mining, Coal, Steel Sector Investment summary: Materials price recovery, not relapse We initiate coverage of five companies in the coal, metals (copper/ aluminum), and steel sectors in China with an overall positive view three BUY ratings, one HOLD and one SELL. A summary of our investment recommendations, target prices and total return are summarised in the table below. The company sections at the back of this report provide much more details, including earnings sensitivity analyses. At the end of this section, we provide our earnings estimates and the comparison to consensus. Figure 1: Summary of ratings, target prices and up/downside return potential Target %Upside/ 214E Total Ticker Price Rating price (Downside) Div. Yld. Return (%) Shenhua 188 HK 25.5 BUY China Coal 1898 HK 4.99 HOLD Chalco 26 HK 2.79 BUY Jiangxi Copper 358 HK BUY Angang 347 HK 5.1 SELL 4.25 (16.7). (16.7) Source: Maybank Kim Eng estimates Our recommendations are supported by the companies business outlook, including stock valuations, and materials price forecasts (discussed in detail in the next section). We forecast an improvement in materials prices from the current low levels, except for steel prices, which are chasing raw material prices lower. However, towards late 214 and into 215, we expect materials prices to trend lower, except for aluminum, as supply overtakes demand. We foresee a continued challenging outlook for the Chinese corporates. With slower demand growth and lower selling prices, the challenge is to raise productivity to restore profit margins. Not every company is equipped to do this either because of difficult assets, poor industry dynamics or cash flow limitations. That leads us to our top long-term pick, Shenhua, which we see generating steady growth and cash flows from its mix of assets, supporting healthy dividends with upside from M&A due to its strong balance sheet. The share valuation has recovered from depressed levels but still stacks up well with global materials companies in any sector. We discuss this in more detail in the company section. On the flip side, we initiate coverage of China Coal with a HOLD rating in anticipation of the upcoming seasonal recovery in coal prices and because our EPS estimates appear to be slightly above consensus. Looking ahead, we find the share valuation a bit full based on our forecasts, and believe the stock may struggle in a slower coal demand growth environment. The company lacks a medium-term growth driver and is ramping up capex in coal/chemicals, which could lead to a deteriorating balance sheet. Our top pick based on total return is Chalco, which is a reversal of our long-standing negative view of the company and industry. We see some encouraging signs of change at the company and the stock valuation seems to have incorporated most of the negatives. Our call hinges on aluminum price upside next year from slower Chinese supply growth due to rising costs, in part due to the ban on bauxite exports from Indonesia. This is a Speculative BUY given the company s weak industry position and weak balance sheet. Our second pick in terms of total return is Jiangxi Copper, which we expect to benefit from our forecast increase in copper prices in mid-214. This stock has high leverage to the copper price and our strategy is to trade it, given our forecast for a copper market surplus and lower prices later next year. Jiangxi has relatively low returns vs. the global mining peer group and we discuss this in more detail in the company section. Returns could slightly improve if the 25 September 213 Page 3 of 7

4 Metals, Mining, Coal, Steel Sector company is successful with one of its overseas copper growth projects. Our estimate is in line with the consensus in 214, but below for 213 and 215. Our one SELL rating is on Angang Steel based on our forecast for lower steel prices over the next few months and the weak earnings outlook for the next two reporting half-year periods. We also find that Angang s earnings quality appears to have decreased as cash flow is not keeping pace with the improvement in net profit. Its P/BV seems high given an ROE of 2-3.5%, particularly in comparison to its earlier history when its ROE was much higher and P/BV slightly lower. In general, Chinese steel companies are placed last among their global peers in terms of ROE. We include global comparison graphs of steel companies in the Angang section at the end of this report. Figure 2: Summary of EPS estimates vs. consensus for 213E-215E 213E 214E 215E EPS est. Consensus EPS vs. Cons. (%) EPS est. Consensus EPS vs. Cons. (%) EPS est. Consensus EPS vs. Cons. (%) Shenhua China Coal (2.) Chalco (.36) (.27) 32.7 (.23) (.19) 23.6 (.1) (.9) 5.6 Jiangxi Copper.83.9 (8.3) (.6) (13.4) Angang (1.1) Source: Bloomberg Consensus, Maybank Kim Eng estimates Outperforming in 214 will be nickel, aluminum and coking coal, with copper rising early but fading later in the year. Thermal coal price should benefit from improving seasonal factors by end- 213 and increase 5% YoY in 214. Materials price forecasts, rankings some volatility will return The following graphs and tables present our materials price forecasts through 217 (our long-term price assumption year), as well as where we stand relative to consensus. Our price forecasts and the YoY change are shown in the three graphs below. During 214, we expect nickel, aluminum, copper and coking coal to outperform. Thermal coal price is expected to bottom over the next few months and improve 5% from the current level by year-end on favourable seasonal factors, and then trade slightly higher during 214 averaging USD85/t, up 2% YoY (Newcastle high CV 6,kcal price FOB Australia). Figure 3: Forecast 213 (YoY chg.) Figure 4: Forecast 214 (YoY chg.) Figure 5: Forecast 215 (YoY chg.) Coking coal Iron ore Gold Gold Gold Copper Nickel Lead Iron ore Thermal coal Zinc Lead Copper Thermal coal Zinc Aluminium Coking coal Coking coal Zinc Copper Thermal coal Lead Aluminium Nickel Iron ore Nickel Aluminium -3% -2% -1% % 1% -1% -5% % 5% 1% -15% -1% -5% % 5% 1% Source: Bloomberg, Maybank Kim Eng Source: Bloomberg, Maybank Kim Eng Source: Bloomberg, Maybank Kim Eng During 214, the materials we expect to underperform are iron ore, gold and lead, and later in the year, copper. The zinc price is expected to be an average performer during the period but forecast to outperform lead after underperforming for much of the past year. The materials that are underperforming reflect our forecast for rising supply growth and slowing demand growth. We discuss gold further below. 25 September 213 Page 4 of 7

5 Metals, Mining, Coal, Steel Sector Figure 6: Materials price forecasts (metals USD/lb, gold USD/oz, coal and iron ore USD/tonne) CIF (63.5%) Iron ore Contract Coking coal Market Thermal coal Copper YoY Aluminum YoY Nickel YoY Zinc YoY Lead YoY Gold YoY Fines YoY HCC YoY Newcastle YoY % % %.85-42%.95-19% % % % % %.76-35% %.75-12%.78-18% % 78-48% % 72-45% %.99 3% %.98 3%.97 25% % % % 1 39% % % 1.4 5% 1. 2% % 1,572 28% % % 12 21% %.92-16% %.88-11%.94-14% 1,67 6% % % 94-22% 213E %.84-8% %.86-3%.96 3% 1,414-15% 133 4% % 83-12% 214E 3.5 4%.88 5% %.85-1%.94-2% 1,342-5% 122-8% 163 3% 85 2% 215E %.95 8% %.85 %.9-4% 1,138-15% 11-1% 169 4% 89 4% 216E % 1. 5% %.85 %.9 % 9-21% 99-11% 158-7% 85-4% long-term %.95-5% 6.5-1%.8-6%.85-6% 85-6% 8-19% 15-5% 8-6% Source: Bloomberg; Maybank Kim Eng forecasts More than any other time, political risk plays a hand in our forecasts for nickel, aluminum and gold. There is considerable risk in our forecasts for a few materials that rely on political factors. We have been a consistent bear on aluminum for many years as we realised early on how the Chinese have become experts in terms of production, while many others were focused only on China s rapid consumption growth. Our forecast outperformance of aluminum and nickel is premised on the expected ban by Indonesia of the export of bauxite and nickel ores according to the Mining Law of 29. It will take an act of Parliament to change the law to delay the ban or allow for exceptions. We do not expect the law to be strictly enforced for companies that are currently building refining capacity as many are not going to meet the deadline. But based on the current investments in refinery capacity, up to half the ore exports would be subject to the ban unless exceptions are granted. Our forecasts for the price appreciation of aluminum and nickel are modest as we assume that there will be some slippage in Indonesia s target ban. There has also been a large amount of stockpiling by importers to bridge them through 214 until either their plants are running or they can procure alternative sources of supply. Therefore the headline risk to prices may precede the actual impact that comes later in 214. A significant increase in Chinese ore imports points to active stockpiling before the Indonesian ban. As a result, the headline risk is likely to occur earlier in 214, but the actual impact later in the year. China continues to ramp up nickel pig iron production, which relies on imported nickel ores, about 85% of which comes from Indonesia. Production during 213 is expected to reach 45,t, up 36% YoY, according to Antaike. The material is used to make stainless steel, accounting for nearly two-thirds of the source of nickel units, followed by primary nickel about one-third, and stainless steel scrap the remainder. Stainless steel producers are integrating their operations with nickel pig iron producers to further lower costs as the industry has been under great pressure due to overcapacity. Our gold price forecast shows some appreciation later this and early next year based on continued instability in the Middle East, and more recently from continued easy monetary policy in the US, which has pushed the dollar down and boosted gold prices. We believe that the fundamental trend remains in place for lower prices due to the eventual end to the Federal Reserve s bond buying programme, which would lead to rising real interest rates and a firmer US dollar. However, supporting factors to our gold price forecast are continued strong Chinese buying, as well as political and financial instability. Besides the Middle East tensions, high debt levels persist in the developed world and in certain emerging economies as well (India and Indonesia). Were it not for these latter factors, our gold price forecast would be more bearish. The forecasts that are causing us to lose a bit of sleep are aluminum, copper and thermal coal. Starting from 2H14, we look for the aluminum price to outperform the copper price. For some time, we have been bullish on copper relative to aluminum because demand in China continues to outstrip supply. Starting in late 214, we look for supply growth in aluminum to begin to slow and in copper to begin to increase. In aluminum, this is due to the adverse impact to costs of the 25 September 213 Page 5 of 7

6 Metals, Mining, Coal, Steel Sector The biggest change in our thinking is our forecast for the aluminum price to outperform the copper price in 214. In the past, we have thrived being bullish copper and bearish aluminum and nickel. The ban on ore exports by Indonesia is expected to be more impactful for nickel relative to bauxite. For thermal coal, we see its best days in the past. Other than our expectation of a seasonal bounce in 4Q, we have kept our expectations low for 214 and 215. We continue to prefer coking over thermal coal longer term due to its relatively tighter supply availability. disruption to bauxite supply from Indonesia, which should become more apparent later in the year. In terms of the Indonesian export ban, we believe that the event risk is higher for disrupting nickel ores relative to bauxite ores so we are relatively more comfortable in our nickel price outlook. For copper, we forecast a slower rate of demand growth in China next year, and a change in how it obtains copper units. We expect China to accelerate its copper refinery production capacity with the feed increasing from copper concentrate and scrap imports (new mines, many of which are its own overseas investments). Were it not for a copper scrap shortage in the past year, we believe China s demand for refined copper would have been lower during 213F. Where we could be wrong is if China s 214 demand growth remains close to 1% as in 213F vs. our forecast of 6.7% or if supply growth disappoints. All it takes is a strike or two and the market is off to the races. Also, the new supply coming onstream is in Mongolia, Peru and Africa, countries not without their logistical and political challenges. With respect to thermal coal, we believe there is no shortage of resource availability and that over time it will lose market share to alternative sources of energy. We tend to favour coking over thermal coal for these reasons. This is reflected in our longer-term coal price forecast and we go into great detail about the changing power generation mix in China over the next seven years in the section on coal. However, over the next few years, much of the region including China and India will continue to rely on coal for power generation. As a result, we have kept out price expectations moderately positive for regional thermal coal, with it increasing 2% YoY in 214 and 4% YoY in 215 (Qinhuangdao thermal coal price is forecast to increase 6% YoY and 3% YoY in USD terms, and 5% YoY and 1% YoY in CNY terms, over the same period). Figure 7: Copper and aluminum monthly price history and forecast Copper (LHS) 15 Copper (US Cent/lb) Alumnium (RHS) Dash lines indicate forecast Aluminum (US Cent/lb) 1 6 Jan-8 Jun-8 Nov-8 Apr-9 Sep-9 Feb-1 Jul-1 Dec-1 May-11 Oct-11 Mar-12 Aug-12 Jan-13 Jun-13 Nov-13 Apr-14 Sep-14 Feb-15 Jul-15 Dec-15 May-16 Oct-16 Mar-17 Aug-17 Source: Bloomberg, Maybank Kim Eng forecast. Figure 8: Nickel and gold price history and forecast Gold (USD/oz) 1,8 1,6 1,4 1,2 1, Nickel (RHS) Source: Bloomberg, Maybank Kim Eng forecast. Gold (LHS) Dash lines indicate forecast Jan-8 Jun-8 Nov-8 Apr-9 Sep-9 Feb-1 Jul-1 Dec-1 May-11 Oct-11 Mar-12 Aug-12 Jan-13 Jun-13 Nov-13 Apr-14 Sep-14 Feb-15 Jul-15 Dec-15 May-16 Oct-16 Mar-17 Aug Nickel (USD/lb) Figure 9: Lead and zinc price history and forecast Lead Source: Bloomberg, Maybank Kim Eng forecast. Zinc Dash lines indicate forecast Jan-8 Jun-8 Nov-8 Apr-9 Sep-9 Feb-1 Jul-1 Dec-1 May-11 Oct-11 Mar-12 Aug-12 Jan-13 Jun-13 Nov-13 Apr-14 Sep-14 Feb-15 Jul-15 Dec-15 May-16 Oct-16 Mar-17 Aug September 213 Page 6 of 7

7 Metals, Mining, Coal, Steel Sector Comparison of price forecasts vs. consensus We are still doubters on the bullish consensus view on zinc prices, and note the downgrade of forecasts for a deep market shortage. China is moving to deficit, which is a positive, but inventories remain ample to meet shortages of supply. The following graphs compare our forecasts vs. the Bloomberg consensus, the forward curve, and current spot prices. For 214, we are above consensus on copper, and to a lesser extent on gold and iron ore. We are well below the consensus on zinc, and to a lesser extent on nickel, thermal coal and lead. Overall, we see market expectations as high for zinc and low for iron ore. In addition, we think the market could be surprised with copper price volatility next year due to a combination of Chinese imports and supply disruptions. We are most out of line with respect to zinc, where consensus expectations are high because of a view, advanced by some in the metals industry, of a shortage of capex in new supply growth. We remain doubters on the long-term shortage of zinc supply as the resources are there, and could come to market in a relatively short amount of time with moderate investment. Further, consensus forecasts for zinc market undersupply have considerably decreased over the past year, from over 1 million tonnes (mt) to about 2,t per annum, to the point that exchange inventories remain ample to meet shortages of supply. Figure 1: Copper (USD/lb) Figure 11: Aluminum (USD/lb) Figure 12:Nickel (USD/lb) Bloomberg consensus Bloomberg consensus Bloomberg consensus Kim Eng Kim Eng Kim Eng Forward curve Forward curve Forward curve Spot Spot Spot A 213E 214E 215E 212A 213E 214E 215E 212A 213E 214E 215E Source: Bloomberg, Maybank Kim Eng Source: Bloomberg, Maybank Kim Eng Source: Bloomberg, Maybank Kim Eng Figure 13: Zinc (USD/lb) Figure 14: Lead (USD/lb) Figure 15:Gold (USD/oz) Bloomberg consensus Bloomberg consensus Bloomberg consensus Kim Eng Kim Eng Kim Eng Forward curve Forward curve Spot Forward curve Spot , , , A 213E 214E 215E 212A 213E 214E 215E 212A 213E 214E 215E Source: Bloomberg, Maybank Kim Eng Source: Bloomberg, Maybank Kim Eng Source: Bloomberg, Maybank Kim Eng Figure 16: WTI (USD/bbl) Figure 17: Thermal coal (USD/t) Figure 18:Iron Ore (USD/t) Bloomberg consensus Bloomberg consensus Bloomberg consensus Kim Eng Forward curve Kim Eng Forward curve Spot Spot Spot A 213E 214E 215E 212A 213E 214E 215E 212A 213E 214E 215E Source: Bloomberg, Maybank Kim Eng Source: Bloomberg, Maybank Kim Eng Source: Bloomberg, Maybank Kim Eng 25 September 213 Page 7 of 7

8 Metals, Mining, Coal, Steel Sector The fallout on materials from credit withdrawal, slower growth Corporates face challenges from slower demand growth. Lower unit costs have helped thus far in 213, mainly from energy, but further savings will require more difficult steps to raise productivity. Longer term, growth in China is expected to continue to slow as the economy steers away from the previous energy intensive/industrial growth model. The first step was the severe tightening of credit from late 211, which reduced aggregate demand growth for materials and created imbalances between supply and demand. While credit policy has since eased somewhat, we look for profit growth to slow under the pressure from slower demand growth and lower selling prices. Thus far in 213, unit costs have decreased for most materials companies due mainly to lower energy prices. Continuing the trend will be more difficult and require more management to increase asset productivity. The country also has to deal with a strong currency vs. its regional neighbours that will create problems for its exporters and for regional importers who are more accustomed to the deflationary impact of Chinese goods. Electricity sector provides a good overview of the future trend in demand Longer-term growth in alternative energy sources (hydro, wind, nuclear, gas) will lower the share of thermal power in China s total energy mix. Thermal power generation is expected to increase at 4% CAGR through 22, down from a 15%rate earlier and compared to 6% for total power generation in China. The electricity sector provides a good barometer of current demand, as well as the longer-term trend in the rate of growth for materials consumption given roughly 7% of the mix is primary industry. The growth rate of total power capacity installations is expected to slow to a CAGR of 6% over F vs. 16% from Thermal power capacity, the major source of which is coal, is expected to slow to a CAGR of 4% from vs. 15% from Alternative energy sources are stepping up in the period ahead, with nuclear increasing to 26%, up from 14% in the earlier eight-year period, and wind at 14%, solar 29%, and gas 9%. Hydro installations are expected to remain strong at 6.5% CAGR from , but well below the 14% rate in Sichuan is China s top hydropower generating province, running 35.27GW of hydropower units as at end-212. This year the province is expected to add an extra 11GW in capacity, following massive investment over the past few years. In Sichuan, the Jinping No.1 Hydro Power Plant is expected to commission in Jun 24 after nine years of construction (25). Total capacity of the power plant is 3.6GW, comprising six 6MW units at a total cost of CNY23.23b (USD3.8b). Despite the slowdown in the rate of capacity growth, total power generation capacity is expected to increase by 5% from 1.2 million MW in 212 (1,2GW) to over 1.8 million MW (1,8GW) in 22. Thermal capacity is expected to increase 37.5% from.8 million MW (8GW) in 212 to 1.1 million MW (1,1GW) in 22. Figure 19: Power generation breakdown Figure 2: Power capacity by source 1% 8% 6% 4% 2% Thermal Hydro Wind Nuclear Gas Solar MW Thermal Hydro Wind Nuclear Gas Solar 2,, 1,5, 1,, 5, % E 14E 15E 16E 17E 18E 19E 2E E 14E 15E 16E 17E 18E 19E 2E Source: CEC, Bloomberg, Maybank Kim Eng Source: CEC, Bloomberg, Maybank Kim Eng 25 September 213 Page 8 of 7

9 Metals, Mining, Coal, Steel Sector The implication is a slowdown in materials consumption Over the long term, the implication for materials consumption growth in China is positive in aggregate. But to gauge what that means in real terms each year vs. the prior period of strong growth, we have taken a closer look at thermal coal demand from the power segment (about 65% of coal demand). We assume China does need this much power generation capacity, but that power plant operating rates decline from current levels, and that thermal coal-fired plants lose some market share to other sources, such as hydrocarbon, mainly gas, and alternatives (nuclear, wind, solar). China may only need an incremental 65mt of raw thermal coal production from 212 to 22 vs. the 1.7 billion t from This implies an annual production need of about 1mt, which is about half the rate of 213mt/yr in the earlier eight-year period. For the eight-year period from 212 to 22, we believe China may only need an incremental 65 million tonnes (mt) of raw thermal coal production vs. the 1.7 billion tonnes of raw coal produced for the previous eight years from 24 to 212. This implies an annual production requirement of about 1mt from 214 to 22, which is about half the rate of 213mt/yr from 25 to 212. More aggressive assumptions using lower power plant operating rates result in the production requirement falling to 7mt per annum. The good news is that the adjustment appears to be front-end loaded during 213F, with low prices forcing closures of marginal coal mines leading us to forecast a 1.% decrease (36mt) in China s total raw coal production during 213. It is no wonder that several coal companies have mentioned that the golden age of thermal coal in China is a thing of the past. Their capex spending also indicates the trend, with a greater share of spending on coal/chemicals (China Coal), and in the case of Shenhua, power generation and infrastructure (rails and ports), and also chemicals. China Coal is moving more towards diversification, and Shenhua towards consolidation (buying coal from others to leverage its infrastructure advantage). For regional coal producers, the near-term adjustment has been painful, but over the longer term, the trend of rising costs in China and appreciating currency bodes well for continued increases in China s coal imports from regional suppliers. Supply-side discipline required to stabilise prices for the next upturn The implication for material prices is more complex. When Chinese growth was rapid and materials prices rising, profit margins were wide and equity valuations expanded. The shift to a slower rate of growth and lower prices will require more rational supply growth and therefore a more careful allocation of capital by mining companies and a focus on productivity gains. Most global materials companies have trimmed production and reduced staff, as well as lowered and redirected their capital allocation to the highest returning projects. China faces challenges in this regard, particularly in sectors plagued by overcapacity such as coal, steel and cement. China s challenges in these sectors have been the rest of the world s headache because the surplus has been exported. Additional capacity in metals/steel coming online at not the best of times Because of long lead times in the sector, new capacity is coming online that may push the market into oversupply and force out the competition. We see aluminum capacity outside China at risk, iron ore capacity in China at risk, and further cuts to global steel capacity, particularly in China. Because mining project lead times are very long (shorter for brownfield than greenfield), there is a queue of new projects coming online this year and next. These were in the works when Chinese growth was more rapid. For greenfield projects, 1 years is quite common from project conception, land acquisition and permitting feasibility studies and construction to first production. Some of the new projects are world-class in scale and cost, and will at least maintain the competitive position of the company undertaking the development, such as in iron ore and copper. In China, new aluminum and steel capacity continues to come online more than offsetting the curtailment of higher cost capacity. The Chinese government is taking the lead in capital allocation, a role played by managements and shareholders in companies in the developed markets. 25 September 213 Page 9 of 7

10 Metals, Mining, Coal, Steel Sector We have seen little evidence that the Chinese government is being effective in this role. The only way forward is a move towards market-based costs and pricing to force the appropriate allocation of capital. Thus far, private companies appear to be reacting most quickly while SOEs, with some exceptions, are being supported at the local and state levels, for example through preferential tax treatment and low-cost loans. Coal outlook: Setting up for a weak recovery, watch out for policy risk (resource tax and power tariff rate cut) During the next 12 months, we look for the thermal coal price in China to outperform the regional one due mainly to better demand growth outlook. Our biggest concern is a further weakening of demand from India. The biggest risk to our expectation for coal prices in China to outperform is if Chinese coal supply growth recovers and increases to 5% or above per annum. Our forecasts for coal (thermal and coking coal) in China and the region are in the table below. We forecast that both the Chinese and regional coal markets will see thermal coal prices bottom out during the next three months due to seasonal factors lifting demand (colder weather) and limited supply (rainy season), as well as diminished hydropower availability in China. But in the long term, we forecast lower thermal coal prices, reflecting the outlook for ample supply and importantly, a more competitive energy mix as discussed earlier. Figure 21: Coal price forecasts (Coal pricing in USD/t) E 214E 215E Long-term Thermal coal: Newcastle 6, kcal FOB Australia Chg. 39% 21% -22% -12% 2% 4% -1% Qinhuangdao 5,8 kcal (VAT excl.) Chg. 25% 21% -15% -14% 5% 3% -1% Coking coal: Australia prime hard coking coal* Chg. 143% 67% -35% -18% 3% 4% -11% Shanxi coking coal price (VAT excl.) Chg. 33% 11% -15% -2% 5% 6% -12% **Pricing is FOB Australia and based on weekly spot market for the history and quarterly contract for the forecast period. Source: Bloomberg, McCloskey, Maybank Kim Eng estimates During the next 12 months, we look for the thermal coal price in China to outperform the regional one due mainly to a relatively better demand growth outlook. Beyond the seasonal factors, the fundamental picture in China is slowly improving based on a bottoming of industrial demand, supply-side cuts in response to lower prices, and inventory de-stocking at power plants. Power demand growth in China is increasing on a YoY basis, though it is likely to materially slow from the pace over the summer. Coking coal prices in both China and the region have increased over 1% from the lows in mid-july due to restocking by steel companies, far outperforming thermal coal. In China, local governments are moving to support large coal companies, while the central government is likely to roll out policies to control coal usage and increase fees. The most impactful of these could be the longawaited rollout of the resource tax on the mining sector. Our biggest concern on the regional front and the biggest source of downside risk to thermal and for that matter coking coal prices in the region is India. The country accounts for just over 1% of global seaborne thermal coal demand but about 2% of the seaborne demand in Asia. Its weakening currency is putting pressure on the already low profit margins of its power producers that rely on thermal coal imports, mainly from Indonesia, but also Africa, to augment lagging domestic coal production. Thus far, the prices of lower quality (calorific) coal have been adversely impacted. In addition, one likely outcome is higher interest rates, which would depress demand in the aggregate and for coal in the country. In China, while local governments are moving to support large coal companies, the central governmental is likely to roll out policies to control coal usage and increase fees. Industry reports point to plans by the NDRC to control coal use in key cities such as Beijing, Tianjin, Hebei, the Yangtze River Delta, Pearl River Delta and Shandong in response to high pollution levels this past winter. Meanwhile, the Ministry of Finance indicated it will press ahead with the resource tax reform for coal later this year. A resource tax has been rumoured to be in the pipeline for the past few years but has been stalled due to the weak economy 25 September 213 Page 1 of 7

11 Metals, Mining, Coal, Steel Sector and industry opposition. It may gather momentum in the current environment and given the policy direction of the new government. Momentum lacking in coal market business and current prices Chinese thermal coal prices remain weak as power producers put off buying for now. Thermal coal market fundamentals continue to improve in China but prices remain lacklustre and have underperformed coking coal in both China and the region. The outperformance of coking coal can be attributed to better supply management by regional producers and a burst of buying activity by Chinese steel mills in August. The upside momentum in the coking coal contract price for 4Q13 from USD145/tonne in 3Q13 may have also sparked some advance buying. However, if the recent pullback in iron ore is any guide, the rally may prove to be short-lived. Figure 22: Qinhuangdao thermal coal price and inventory (mt) QHD stocks QHD coal price (USS/t) Jan 2 Nov 2 Sep 3 Jul 4 May 5 Mar 6 Jan 7 Nov 7 Sep 8 Jul 9 May 1 Mar 11 Jan 12 Nov 12 Sep 13 Source: Bloomberg, Steelhome Figure 23: Coking coal prices in China (VAT incl.) and Australia (USD/tonne) Chinese and regional coking coal prices have turned higher, finding support from steel mill restocking and wellmanaged supply. A nearterm pause is likely as demand slows Jan 7 May 7 Sep 7 Jan 8 May 8 Sep 8 Shanxi coking coal (VAT incl.) Newcastle Premium HCC (FOB Australia, VAT not applied) Jan 9 May 9 Sep 9 Jan 1 May 1 Sep 1 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 Sep 13 Source: Steelhome, McCloskey Fundamentals for Chinese thermal coal market slowly improving China s thermal coal price premium relative to the similar grade Australia price delivered to southern China has decreased to a slight discount from a 2% premium earlier in 2H12. The comparison is useful as an indicator of relative pricing trends and tells us that Chinese prices are currently well supported, having deflated more in line with those in the region. As a result, China s thermal coal imports are expected to slow over the next six months as consumers favour domestic supply. De-stocking by power producers continues with inventory falling by over a third to 18 days in August vs. the high of 3 days in September last year. Imports are expected to slow during 2H13 vs. the rate in 1H13, which will slightly increase the consumption of domestic coal. In addition, China 25 September 213 Page 11 of 7

12 Metals, Mining, Coal, Steel Sector imposed a 3% import tax on lignite coal imports (low calorific value, high ash coals) effective at the end of August. This will be a marginal positive for domestic coal prices. Figure 24: Thermal coal price (5,8kcal) Qinhuangdao vs. Newcastle, and premium (discount) delivered to China The premium of thermal coal prices in China over those of the region has turned to a slight discount, which should lead to coal imports being displaced by domestic coal consumption in the near term. (USD/t) Qinhuangdao coal price (LHS) Qinhuangdao premium (discount) Newcastle coal price (LHS) Premium (discount) 4% 3% 2% 1% % -1% -2% -3% -4% Jan-1 May-1 Sep-1 Jan-2 May-2 Sep-2 Jan-3 May-3 Sep-3 Jan-4 May-4 Sep-4 Jan-5 May-5 Sep-5 Jan-6 May-6 Sep-6 Jan-7 May-7 Sep-7 Jan-8 May-8 Sep-8 Jan-9 May-9 Sep-9 Jan-1 May-1 Sep-1 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13 Source: McCloskey, Maybank Kim Eng estimates The intent of the import tax on low CV coal (lignite) is to help reduce pollution from coal-fired power plants. The tax follows the drafting of a plan by China s National Energy Agency for an outright ban on low quality coal imports. The ban and import tax are contentious issues for power plants and traders in China, and also violates the ASEAN-China Free Trade Agreement. For China, it will be a slight positive for domestic coal producers and a slight negative for power producers who use this coal for blending. For the region, it will be a slight negative for exporters of low-rank coals, mainly in Indonesia. China imported a total of 36mt of lignite during the first seven months of this year, up 17% YoY, of which 34.8mt, or nearly 97%, was from Indonesia. China s total raw coal production decreased 3% YoY in July in both the month and on a YTD basis, indicating the pressure being felt on small- and medium-sized producers from lower prices. The most notable decrease was in Inner Mongolia, the leading coal producer in China, where output was down 12% YTD through July and 9% YoY in the month. Production was up in Shaanxi and largely flat in Shanxi. Small producers are being squeezed while larger (mainly SOE) producers are taking share. China s power consumption increased strongly in July, due to higher industrial activity and hot weather. Total consumption was 495b kwh, up 8.8% YoY and 12.9% MoM. Industrial consumption also increased for the fifth straight month to 36.9bn kwh, up 8.1% YoY and 7% MoM. Looking ahead, maintenance on the Daqin railway, China s largest coal line by volume (with a capacity of about 44mt) is scheduled for maintenance work during September, which should further tighten supplies at the port. This is largely a shifting of inventory from the port to the mine, but usually provides some support for prices before the seasonal demand reaches higher levels. 25 September 213 Page 12 of 7

13 Metals, Mining, Coal, Steel Sector Figure 25: China coal days inventory at power plants and in total Power plants continue to de-stock with inventory at 18 days in August, down by over a third from the high of 3 days in September last year Power plants (thermal) Jan 5 Apr 5 Jul 5 Oct 5 Jan 6 Apr 6 Jul 6 Oct 6 Jan 7 Apr 7 Jul 7 Oct 7 Jan 8 Apr 8 Jul 8 Oct 8 Jan 9 Apr 9 Jul 9 Oct 9 Jan 1 Apr 1 Jul 1 Oct 1 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13 Jul 13 Total Source: McCloskey, CCTD, Maybank Kim Eng estimates China s coal production growth is down 3% YoY through July, led by a 12% YoY decrease in Inner Mongolia, the country s largest coal producer by province. Figure 26: China's coal production by province lower YoY (million t) Jul YTD Jul YTD Inner Mongolia YoY chg. -9% -12% Shanxi YoY chg. -1% 1% Shaanxi YoY chg. 13% 6% SUB TOTAL , ,39.2 YoY chg. -1% -4% % share China 65% 65% 63% 65% Other Provinces YoY chg. -6% -3% TOTAL CHINA 3. 2, ,132.2 YoY chg. -3% -3% Source: McCloskey After a three-and-a-half-year decline from Jan 21, power generation growth is recovering strongly. Total power generation growth turned strongly positive in April led by a pickup in thermal power, and the trend has continued during the very hot summer period. The improvement is also the result of recovering industrial activity, as well as the seasonal decline of hydropower generation. The data below indicate a 14% increase in total power generation during August, with a 23% rise in the thermal component. We are looking for YoY growth to slow to a more sustainable level in the months ahead once we are past the summer period, a rate that would reveal more about underlying industrial demand growth. Figure 27: Monthly power generation and pct. change (bn kwh) Jan&Feb-7 May-7 Aug-7 Nov-7 Mar-8 Jun-8 Sep-8 Dec-8 Apr-9 Jul-9 Oct-9 Jan&Feb-1 May-1 Aug-1 Nov-1 Mar-11 Jun-11 Sep-11 Dec-11 Apr-12 Jul-12 Oct-12 Jan&Feb-13 May-13 Aug-13 Source: China NBS Monthly power generation (LHS) (%) Figure 28: Power generation by source and pct. change YoY % Chg. Thermal Hydro (2) (4) Jan&Feb-7 May-7 Aug-7 Nov-7 Mar-8 Jun-8 Sep-8 Dec-8 Apr-9 Jul-9 Oct-9 Jan&Feb-1 May-1 Aug-1 Nov-1 Mar-11 Jun-11 Sep-11 Dec-11 Apr-12 Jul-12 Oct-12 Jan&Feb-13 May-13 Aug-13 Source: China NBS China s coal imports, both thermal and coking, remain at high levels, though they are down from peaks reached earlier this year after rising strongly in the past few years. We look for imports to stabilise near current lower levels before moving higher again. We forecast continued increases in China s coal imports longer term, as shown in our supply/demand table in the next section. 25 September 213 Page 13 of 7

14 Metals, Mining, Coal, Steel Sector Figure 29: China thermal coal trade (mt) Imports & Exports 8 4 (4) (8) (12) (16) (2) (24) Source: China NBS Import Export Net Export Jan 5 Jul 5 Jan 6 Jul 6 Jan 7 Jul 7 Jan 8 Jul 8 Jan 9 Jul 9 Jan 1 Jul 1 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul (4) (8) (12) (16) (2) (24) Net Exports Figure 3: China coking coal trade (mt) Imports & Exports 2 (2) (4) (6) (8) Source: China NBS Import Export Net Export Jan 5 Jul 5 Jan 6 Jul 6 Jan 7 Jul 7 Jan 8 Jul 8 Jan 9 Jul 9 Jan 1 Jul 1 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 2 (2) (4) (6) (8) Net Exports Coal consumption is expected to increase 2% this year, the slowest on record, and will require continued consolidation of supply given our consumption growth forecast of 3% in 214 and 215. China coal industry production/consumption model The table below summarises our forecast of China s total raw coal production, consumption, and trade. We look for China s raw coal production to slow and for imports to continue rising. Coal consumption in aggregate is expected to increase by 2% this year, which would be the slowest rate of growth since the early 199s, according to our records. The trend of slowing demand growth and inventory destocking will require continued consolidation of the supply base in order to support prices. Figure 31: Chinese coal industry supply/demand growth rates slowing Raw Coal (million tons) 25A 26A 27A 28A 29A 21A 211E 212A 213E 214E 215E Production 2,113 2,373 2,523 2,716 3,5 3,24 3,519 3,66 3,624 3,733 3,845 Incremental Prod Incremental Prod (%) 8.% 12.3% 6.3% 7.7% 12.3% 6.2% 8.6% 4.% -1.% 3.% 3.% Export Export Growth (%) -17.2% -11.8% -16.% -14.7% -5.6% -19.5% -18.7% -37.2% -12.5% -24.8% -33.% Import Import Growth (%) 41.3% 46.5% 32.6% -21.5% 213.6% 32.% 11.2% 57.7% 8.5% 5.% 5.% Net Export (Import) Net Export growth (%) -33% -45% -9% 129% -1958% 43% 15% 66% 9% 6% 6% Inventory (total EOY) Inventory change Days of supply (total inv.) Domestic Consumption 2,31 2,344 2,516 2,672 3,169 3,336 3,597 3,96 3,984 4,14 4,227 Incremental Cons (Mt) Incremental Cons (%) 7.2% 15.4% 7.4% 6.2% 18.6% 5.3% 7.8% 8.6% 2.% 3.% 3.% Note: coking coal approx. 75mts Source: CCTD, Bloomberg, McCloskey, Steelhome, Maybank Kim Eng estimates Aluminum outlook: Surplus, but price support on rising costs Chinese aluminum supply has been encouraged by superior returns compared to selling electricity. Lower coal prices have made power generation more profitable, which may help reduce the incentive for, and slow the growth of, aluminum supply. Our forecasts for the global and Chinese aluminum markets are contained in the table below. We look for the combined market to remain in surplus the next few years due to continued capacity additions in China, which are more than offsetting production curtailments. According to ANZ China, as of July, idle aluminum smelting capacity was 5.5mt, but new capacity additions were 1.5mt, with an additional 5.1mt under construction (23% of forecast 213 consumption). From 215, we forecast that China will move closer to a balance between supply and demand, as production growth slows on diminishing industry profitability due to rising costs for raw materials and from regulatory fees. The hole is quite deep though in terms of global annual oversupply and the level of inventory. The Chinese are very good at funding and building aluminum smelters and power plants a match made in heaven. The trend in the aluminum market has been to bring on new highly efficient low-cost capacity to replace older, higher-cost ones. 25 September 213 Page 14 of 7

15 Metals, Mining, Coal, Steel Sector ANZ-China estimates that at the current Shanghai aluminum price of about USD2,35/t (USD1.7/lb.), roughly half of the smelters in China are operating at a cash loss. The government has been unable to materially alter supply growth, and many of the plants that have been closed were obsolete and not operating. Chinese smelters have been willing to tolerate low or negative profit levels because they have exceeded those from simply generating and selling electricity. Now that power plant profit margins have increased due to lower coal prices and smelter profitability remains low, this trend may change. So what is going to change the dynamics of the global aluminum industry? The developed world is also adding more capacity and despite the fact that the global surplus lies flatly at China s door, it too will be forced to do more in terms of capacity closures. In the next section, we lay out some of the key factors that could lead to a reversal of fortune for the aluminum market. Our forecast calls for a decreasing global market surplus, as capacity and production growth slows in China, with prices increasing about 5% from the current spot price during 213 (up 1.2% YoY), and a further 6% YoY increase during 215. Figure 32: Global and China Primary aluminum production/consumption in surplus The surplus in China is expected to decrease as supply growth slows due to decreasing industry profitability. The biggest near-term upside cost risk is Indonesia s ban on bauxite exports in ,5 2,5 1,5 5 (5) (1,5) World ex-china surplus (deficit) China surplus (deficit) ( LME aluminum price Surplus Deficit (2,5) A13E14E15E.4 Source: Wood Mackenzie, Bloomberg, Maybank Kim Eng estimates Figure 33: Global and China aluminum production and consumption summary ( t) A 213E 214E 215E Global prod./cons. Production 46,178 47,919 5,46 54,367 56,151 YoY chg. 9% 4% 5% 8% 3% Consumption 43,99 46,472 49,352 52,613 55,31 YoY chg. 8% 6% 6% 7% 5% Market surplus (deficit) 2,269 1,448 1,18 1, Total inventories 6,582 6,914 8,22 9,776 1,626 Weeks of supply Price (USD/t) $2,42 $2,22 $1,853 $1,929 $2,94 Price (USD/lb.) $1.9 $.92 $.84 $.88 $.95 China prod./cons. Capacity 25,67 27,67 3,87 34,37 36,37 YoY chg. 13% 8% 12% 11% 6% Production 19,8 22,22 24,5 26,4 27,8 YoY chg. 14% 12% 1% 8% 5% Operating rate 82% 83% 84% 81% 79% Consumption 19,167 21,43 23,3 25,659 27,322 YoY chg. 16% 1% 11% 1% 6% Surplus (deficit) Source: Wood Mackenzie, Bloomberg, Maybank Kim Eng estimates 25 September 213 Page 15 of 7

16 Metals, Mining, Coal, Steel Sector Aluminum market conditions and current prices Chinese aluminum production has increased about 1% thus far in 213, which is roughly equivalent to our full-year forecast of 1.3%, and slightly below forecast consumption growth of 1.7%. Supply side cuts continued to help aid in the process of de-stocking China s inventory of aluminum. Inventory on the Shanghai exchange has decreased 38% from the April high this year. However, the stockpile of metal in Shanghai pales in comparison to that on the LME, which reached a new high in mid-july this year. Aluminum prices on both the LME and Shanghai exchanges peaked in early Sep 211 at USD2,431/t and USD2,793/t, respectively (the difference largely reflects the 17% VAT in China). The Shanghai price has outperformed the LME price, falling 16% vs. the latter s 26% decline. The outperformance indicates continued healthy demand growth in China. The graph below depicts the pricing and inventory levels on the LME and Shanghai exchanges. The LME inventory overhang is a negative factor for the market, particularly as warehousing rules are reformed, allowing for more rapid outflows, and carrying costs rise. Figure 34: Aluminum prices and inventories Inventory (tonnes ') 5,6 4,8 4, 3,2 2,4 1,6 8 - LME Inventories Comex Inventories LME Spot Price Shanghai Inventories (LHS) Shanghai Spot Price (RHS) Jan Jun Nov Apr 1 Sep 1 Feb 2 Jul 2 Dec 2 May 3 Oct 3 Mar 4 Aug 4 Jan 5 Jun 5 Nov 5 Apr 6 Sep 6 Feb 7 Jul 7 Dec 7 May 8 Oct 8 Mar 9 Aug 9 Jan 1 Jun 1 Nov 1 Apr 11 Sep 11 Feb 12 Jul 12 Dec 12 May 13 Oct P Source: Bloomberg. Note: the Shanghai price includes the 17% VAT China s production of aluminum has increased strongly in line with demand, supported by upstream integration into alumina. The country is now nearly selfsufficient in alumina, utilising domestic and increasingly imported bauxite. Looking ahead, alumina production is likely to take a hit starting in 214 for those refineries which have not made adequate business recovery plans to procure bauxite in advance of the changes in Indonesia s raw materials export policy starting next year (more below). Figure 35: Chinese aluminum production and YoY change ' t 25, 2, 15, 1, 5, Source: IAI Annualized production (LHS) Yoy chg (RHS) YoY Chg. 7% Jan 5 May 5 Sep 5 Jan 6 May 6 Sep 6 Jan 7 May 7 Sep 7 Jan 8 May 8 Sep 8 Jan 9 May 9 Sep 9 Jan 1 May 1 Sep 1 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 Sep 13 5% 3% 1% -1% -3% Figure 36: Chinese alumina production and YoY change ' t Annualized production (LHS) YoY chg (RHS) 6, 5, 4, 3, 2, 1, Source: IAI Jan 5 May 5 Sep 5 Jan 6 May 6 Sep 6 Jan 7 May 7 Sep 7 Jan 8 May 8 Sep 8 Jan 9 May 9 Sep 9 Jan 1 May 1 Sep 1 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 Sep 13 YoY Chg. 1% 8% 6% 4% 2% % -2% 25 September 213 Page 16 of 7

17 Metals, Mining, Coal, Steel Sector What could help lift or lower aluminum prices? We see four key supporting factors for China s primary aluminum production growth: ample and cheap raw materials (bauxite and electricity), subsidised demand from the aluminum fabrication sector (exports receive VAT rebates), local government support (subsidies, and low but rising environmental costs), and until recently, cheap financing. For reference, alumina and electricity each contribute roughly a third of aluminum production cost. China s bauxite vulnerability. China on average imports about 5% of its bauxite requirement to produce alumina (4t bauxite/2t alumina/1t aluminum), most of which comes from Indonesia. This has fuelled the rapid growth of China s alumina production to the point where it is nearly self-sufficient. China s self-sufficiency in both aluminum and alumina production have eliminated the country as an upside catalyst for the global prices of both. Action. Under the Mining Law of 29, Indonesia will ban the export of unprocessed ores from Jan 214. Those exporters within Indonesia who do not have their processing capacity (bauxite to alumina) running in time may be allowed to continue exporting under a quota, but at an export tax of 5%, up from 25% previously, with some exceptions. As mentioned earlier, we anticipate some slippage in the ban/tax increase depending upon the exporter/importer s progress on adding refining capacity. Impact. Based on our rough calculations, the increased tax will add 15% and 5% to the production cost of alumina and aluminum respectively, for those refineries/smelters wholly reliant on imported bauxite. Regional bauxite prices will most likely rise to the level of the new tax-inclusive price from Indonesia. Impact. With respect to the ban, the regional prices of bauxite and alumina will most likely increase depending on how much the Chinese can diversify their import sources (for instance, bauxite from Australia, some from India, Africa, which has great long-term potential). Chinese companies are rapidly building stockpiles in advance of the ban, which should help get them through most of 214. Chinese bauxite is generally high in silica and, if relied on, will further raise costs. For example, if the Chinese return as large net importers of alumina due to a shortage of bauxite, and regional alumina prices increase by USD1/t to about USD42/t, the cost increase to a Chinese smelter wholly reliant on imported alumina would be approximately 1%. Conclusion. Some importers of Indonesian bauxite that have not taken steps to build refinery capacity in Indonesia will face higher costs as regional prices increase. Some may import more alumina, favourably impacting prices. The impact on aluminum is positive but less than for bauxite and alumina, depending on how much of the cost can be absorbed by profitable Chinese smelters, but marginal capacity may close. We reflect this trend in our aluminum forecast of a slower rate of growth in China s production and in higher aluminum prices. The biggest beneficiaries are regional suppliers of bauxite and alumina as prices rise, and Indonesian companies that are moving up the value chain. Aluminum consumption, mainly from aluminum fabricators in China, is growing very rapidly at about 1% per year, but this is still less than supply growth. Nearly 15% of China s primary aluminum production is exported through the manufacture of fabricated aluminum products, much to the consternation of its trading partners in Asia. The annualised figure through Jul 213 is about 3mt, which is about 4x the level in 25. The increase is due to China putting an export tax on primary aluminum because of its energy intensity, but leaving a loophole in exempting the fabrication 25 September 213 Page 17 of 7

18 Metals, Mining, Coal, Steel Sector sector. If China is serious about reducing the energy intensity of its economy, it will restrict the exports of fabricated products mainly to only those that are higher value-added and meet the needs of domestic industry. If China s primary aluminum production falls more rapidly than we forecast and prices rise, aluminum fabrication capacity could enter a period of consolidation or be forced to import more aluminum. The aluminum market would be more balanced, helping to support prices (there is still a large global inventory that would need to be worked down). Chinese fabricators would lose market share to international competitors. China does not need to produce as much primary aluminum as it currently does because a lot of it is being exported via fabricated products. Electricity vulnerability. The cost of making aluminum is likely to marginally increase. Aluminum is one of the most energy-intensive materials to produce (about 13.5MW/t), with electricity accounting for about 3% of total production costs. In China, the outlook for power availability is quite good, as discussed earlier. If generating electricity ever becomes more profitable than selling aluminum, then production of the latter will slow. This may not happen over the near term. Costs are likely to rise for industry longer term, in line with the government s plan to restructure the economy. Local subsidies slowly diminishing, but exist for a small portion of the aluminum smelters. During times of economic crisis (GFC and the 212 downturn), local governments have subsidised power costs, waived taxes, and even purchased aluminum to help ease the burden of low prices on the sector and keep the engine of GDP running. This demonstrates the historical tension between the local and central government in China. Environmental costs will take years to be rolled into the cost structure of industry but should help restrain supply growth. We are referring to resource taxes, carbon taxes, environmental remediation and other measures to help the environment. Beijing is getting tougher on egregious violations, particularly when exposed by local opposition. The old adage, build first and permit later, seems to be rapidly fading as a business practice, as enforcement is stepped up. We also reflect this trend in our estimate of slower rates of capacity and production build. Government-mandated capacity closures. Our expectations are low, of the order of mt (about 3% of total capacity) for 213. But as mentioned earlier, new capacity is coming in at a higher rate. One regulation on the sector is that pots that operate under 16, amps (typical average worldwide is 18, amps) will be subject to compulsory shutdowns. But our industry sources indicate that based on a sample of smelters that have closed, most were either already idle or never started operation. Therefore it seems that the impact will be on marginal loss-making smelters who cannot maintain adequate profitability. Where the government can have an impact is on continuing to move the industry to real-world costing over time (energy, environment, health, safety, etc.) to force out marginal producers. Impact of new warehousing rules on metal premiums. Despite the oversupply of aluminum, global premiums for delivery from warehouses to customers are high. Consumers have complained about the problem and measures are being taken to alleviate the bottleneck, such as the LME accelerating delivery times. The profitable metals warehousing business has attracted financial institutions (large banks) and also traders. The US Congress has put pressure on banks to sell non-core speculative businesses, and a few have sold warehouses. Over time, higher interest rates and an easier flow of material to consumers will lower premiums and bring more offexchange supply onto the market. This would be a net negative for aluminum prices at some point in the future. 25 September 213 Page 18 of 7

19 Metals, Mining, Coal, Steel Sector Figure 37: Aluminum ingot trade (' mt) slight exports Figure 38: Aluminum semi trade (' mt) high exports 2 import export net export 36 import export net export (1) (2) (3) - (4) 2 1 (1) (2) (3) (4) (12) (12) Jan 5 May 5 Sep 5 Jan 6 May 6 Sep 6 Jan 7 May 7 Sep 7 Jan 8 May 8 Sep 8 Jan 9 May 9 Sep 9 Jan 1 May 1 Sep 1 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 Jan 5 May 5 Sep 5 Jan 6 May 6 Sep 6 Jan 7 May 7 Sep 7 Jan 8 May 8 Sep 8 Jan 9 May 9 Sep 9 Jan 1 May 1 Sep 1 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 Source: China NBS Source: China NBS Figure 39: Alumina trade (' mt) largely self-sufficient Figure 4: Bauxite trade (' mt) stockpiling for (1) (2) (3) (4) (5) (6) (7) (8) Source: China NBS import export net export Jan 5 May 5 Sep 5 Jan 6 May 6 Sep 6 Jan 7 May 7 Sep 7 Jan 8 May 8 Sep 8 Jan 9 May 9 Sep 9 Jan 1 May 1 Sep 1 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 1 (1) (2) (3) (4) (5) (6) (7) (8) 7 - (7) (1,4) (2,1) (2,8) (3,5) (4,2) (4,9) (5,6) (6,3) (7,) Source: China NBS import export net export Jan 5 May 5 Sep 5 Jan 6 May 6 Sep 6 Jan 7 May 7 Sep 7 Jan 8 May 8 Sep 8 Jan 9 May 9 Sep 9 Jan 1 May 1 Sep 1 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 7 (7) (1,4) (2,1) (2,8) (3,5) (4,2) (4,9) (5,6) (6,3) (7,) Copper outlook: Upside from improving near-term demand The tight supply of copper concentrate and scrap is expected to ease later in 214, leading to a slower rate of growth in China s refined copper imports. Copper scrap availability usually tightens during periods of low prices, and China s new green fence policy has impacted the import supply as well. We look for the copper price to improve over the next six months, in line with the recovery of China s industrial economy and as supply remains tight. Longer term, increasing copper supply growth is expected to lead to a widening oversupply of refined copper starting in the second half of 214. Much of the growth in mine supply of copper concentrate is being matched by double-digit increases in China s copper smelting/refinery capacity, which, in addition to easier scrap availability, should reduce the growth rate of refined copper imports. The global copper market turned to surplus in 212from a deficit in 21 and 211, and we forecast it to remain in moderate surplus through to 215. The demand for refined copper has benefitted from strong consumption in China as well as tight scrap availability, which is normally consumed as a less expensive alternative by copper fabricators. In addition, the Chinese customs department has enforced a green fence policy, which has led to a build-up of scrap inventories at ports as substandard shipments are returned to the country of origin. Copper scrap accounts for more than half of China s total copper supply and 85% of its scrap is imported from outside the country, mainly the US and Europe. Primary copper scrap generation and secondary scrap gathering typically slow during manufacturing downturns because of low prices. The gap between primary copper and scrap narrows at the bottom of the economic cycle, and widens during the recovery phase of the cycle. Chinese refined copper demand has been very strong thus far in 213, as shown in the graph below. China s apparent consumption has been supported by inventory de-stocking, as well as a pickup in refined copper imports, from April of this year. As a result, we are assuming very strong consumption growth of 1.5% 25 September 213 Page 19 of 7

20 Metals, Mining, Coal, Steel Sector YoY in 213 vs. our expectation of about 8% earlier. We believe that China s core refined copper consumption annual growth rate will be in the 5-6% range going forward. The growth rate has often been impacted by speculative refined copper imports (arbitrage of Shanghai vs. LME copper prices). Currently, the arbitrage favours importing copper to China. Figure 41: China apparent refined copper consumption increasing strongly China s apparent consumption has been supported by inventory destocking, as well as a pickup in refined copper imports from April of this year. As a result we forecast very strong consumption growth of 1.5% YoY in , Jan 8 Apr 8 Jul 8 Oct 8 Jan 9 Apparent consumption (' t) YoY Change YoY chg (1) (2) Apr 9 Jul 9 Oct 9 Jan 1 Apr 1 Jul 1 Oct 1 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13 Jul 13 Source: China NBS, Bloomberg, Maybank Kim Eng Were it not for China s strong re-stocking demand growth this year, our forecast copper market surplus would be higher. For example, if Chinese growth were 8% during 213 and not 1.5% as we now forecast, the market surplus during 214 would be 4% higher (758kt vs. 539kt). Despite the surplus, we see the copper prices being supported above the current level until late 214 by improving economic activity worldwide and in China. This is reflected in our copper supply and demand model, with the surplus becoming more evident during 2H14. Figure 42: Global refined copper production/consumption surplus later in 214 We look for the global copper market to be in moderate surplus, but for the price to be supported well above USD3.25/lb. as long as the market has a positive view on economic growth, and US monetary policy is supportive. (USD/t) Market balance (RHS) Copper Price (LHS) 1,5 Surplus 8, 5,5 Deficit 3, A13E14E15E (' t) 1,2 6 (6) (1,2) Source: Wood Mackenzie, Bloomberg, Maybank Kim Eng estimates The most risky call is our forecast for China s refined copper imports to peak this year and decline in 214 and 215. The main reason is our expectation of a large increase in refined copper output in 214 due to new capacity and a large increase in mine concentrate supply. Our historical analysis of copper inventory and prices shows that unless the market is awash in supply, which is not our assumption, prices will be supported if expectations of global demand growth are positive. In the end, copper prices will take their cue from China s imports of refined copper, which are the most visible, though not the most accurate, manifestation of its real demand. The table below provides the details of our outlook for the refined copper market worldwide and in China. The most interesting and perhaps risky call is our forecast for China s refined copper imports to peak this year before declining in 214 and 215. This is a result of the rapid growth in China s refinery capacity, which will be fed from rising copper mine concentrate supply (domestic and imported), and copper scrap imports. Even with our assumption of declining refined copper imports, the domestic market is in surplus, as shown in the last line of the table. This surplus 25 September 213 Page 2 of 7

21 Metals, Mining, Coal, Steel Sector is needed to support the increasing capacity and need for inventory (working capital) of the copper fabricated products industry. Where we could be wrong is if China s scrap supply remains tight and/or demand growth remains closer to 1%, compared with our forecast of around 6.5% in 214 and 215. We could be wrong if China s consumption growth remains close to 1% vs. our assumption of 6.5% for the next few years, or if refined copper production growth does not accelerate due to construction delays or disruptions to the feed of copper mine concentrate or scrap. Figure 43: Global and China copper production and consumption summary ( t) A 213E 214E 215E Global prod./cons. Production 18,271 18,934 19,675 2,131 21,23 22,237 22,939 YoY change %.1% 3.6% 3.9% 2.3% 4.4% 5.8% 3.2% Consumption 17,362 19,36 19,747 19,697 2,719 21,698 22,67 YoY change % -3.2% 11.2% 2.3% -.3% 5.2% 4.7% 4.5% Balance: surplus (deficit) 91 (373) (72) Total inventories 3,214 2,841 2,769 3,23 3,57 4,47 4,315 Weeks of supply Price (USD/t) $5,162 $7,536 $8,835 $7,957 $7,385 $7,716 $6,68 Price (USD/lb.) $2.34 $3.42 $4.1 $3.61 $3.35 $3.5 $3.3 China prod./cons. Production 4,19 4,534 5,197 5,828 6,29 8,195 9,645 YoY change % 8.3% 1.3% 14.6% 12.2% 6.5% 32.% 17.7% Consumption 6,5 7,24 7,815 8,24 9,65 9,677 1,34 YoY change % 27.5% 1.8% 8.5% 5.% 1.5% 6.7% 6.5% Net exports (imports) (3,165) (2,942) (2,718) (3,181) (3,186) (2,231) (1,561) YoY change % 124.5% -7.% -7.6% 17.%.2% -3.% -3.% Balance (prod. - net exp. - cons.) Source: Wood Mackenzie, Bloomberg, Maybank Kim Eng estimates Figure 44: China's refined copper production and YoY change ' t Refined Copper YoY Change YoY Chg Jan 8 Apr 8 Jul 8 Oct 8 Jan 9 Apr 9 Jul 9 Oct 9 Jan 1 Apr 1 Jul 1 Oct 1 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13 Jul 13 (1) Source: China NBS Copper market conditions and current prices The LME copper price has continued to move sideways, in a range of USD /lb, since April of this year. The price is currently at the upper end of this range, caught in a tug-of-war between those expecting continued US monetary expansion (positive) and those expecting its removal (negative). We think it more likely that fiscal stimulus will be slowly tapered and the economy allowed to stand on its own at some point during the next 12 months. Over the near term, the positive arbitrage favours continued Chinese imports of copper from overseas, based on the lower price of the LME vs. Shanghai copper prices after adjusting for the 17% VAT in China. 25 September 213 Page 21 of 7

22 Metals, Mining, Coal, Steel Sector Copper price and inventories on the metals exchanges Figure 45: Copper price and inventories The LME copper price has been range-bound since April at between USD3-3.3/lb. The arbitrage continues to favour exporting copper to China after adjusting for the 17% VAT. Inventory (tonnes ') 1, LME Inventories Shanghai Inventories Comex Inventories Shanghai Spot Price LME Spot Price Comex Spot Price Jan Jun Nov Apr 1 Sep 1 Feb 2 Jul 2 Dec 2 May Oct 3 Mar 4 Aug 4 Jan 5 Jun 5 Nov 5 Apr 6 Sep 6 Feb 7 Jul 7 Dec 7 May Oct 8 Mar 9 Aug 9 Jan 1 Jun 1 Nov 1 Apr 11 Sep 11 Feb 12 Jul 12 Dec 12 May Oct P Source: Bloomberg. Note: the Shanghai price includes the 17% VAT Imports of refined and concentrate copper bottomed out in March of this year and have increased strongly since on consumer re-stocking and arbitrage-driven speculative buying. The refined copper trade is a source of trade finance and has been boosted by those seeking access to cheap credit. This makes interpreting the trade data as much or more about credit flows than the demand for copper. Figure 46: Refined copper trade (' mt) Figure 47: Concentrate copper trade (' mt) 5 - (5) (1) (15) (2) (25) (3) (35) (4) import export net export 4 Mos. 14 Mos. 16 Mos. 5 (5) (1) (15) (2) (25) (3) (35) (4) 5 - (5) (1) (15) (2) (25) (3) (35) (4) import export net export 5 (5) (1) (15) (2) (25) (3) (35) (4) Jan 5 May 5 Sep 5 Jan 6 May 6 Sep 6 Jan 7 May 7 Sep 7 Jan 8 May 8 Sep 8 Jan 9 May 9 Sep 9 Jan 1 May 1 Sep 1 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 Jan 5 May 5 Sep 5 Jan 6 May 6 Sep 6 Jan 7 May 7 Sep 7 Jan 8 May 8 Sep 8 Jan 9 May 9 Sep 9 Jan 1 May 1 Sep 1 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 Source: China NBS Source: China NBS Copper scrap imports have not materially improved and remain about 25% below the high in Nov 212. China s trade of copper semi-fabricated products remains well balanced, as opposed to aluminum where exports far exceed imports. But over the past eight years China has cut its copper semis imports by half, while its exports have been flat. We look for continued growth in China s copper fabrication sector to meet growing domestic demand. Figure 48: Copper scrap trade (' mt) Figure 49: Copper semi trade (' mt) 155 import export net export import export net export (155) (155) - (31) (31) (5) (5) (465) (465) (1) (1) (62) (62) (15) (15) Jan 5 May 5 Sep 5 Jan 6 May 6 Sep 6 Jan 7 May 7 Sep 7 Jan 8 May 8 Sep 8 Jan 9 May 9 Sep 9 Jan 1 May 1 Sep 1 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 Jan 5 May 5 Sep 5 Jan 6 May 6 Sep 6 Jan 7 May 7 Sep 7 Jan 8 May 8 Sep 8 Jan 9 May 9 Sep 9 Jan 1 May 1 Sep 1 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 Source: China NBS Source: China NBS 25 September 213 Page 22 of 7

23 Metals, Mining, Coal, Steel Sector Steel outlook: Woes to continue due to excess capacity Our forecast calls for the steel sector to remain highly seasonal with steel prices recovering during the first half of the year and falling during the second half. We see this sector as one to trade based on the trend in steel prices and earnings, buying in when losses deepen, and selling out when conditions improve. Capacity additions in the past several years, on top of high raw material costs, have nearly eliminated pricing power and squeezed profit margins. In 212, the average operating profit margin of the steel sector was.4%, the lowest of all industries, with about 4% of the companies in the sector making losses. We have taken a relatively optimistic view from 215, forecasting some improvement in industry fundamentals as low profitability, tight credit availability and government restrictions limit the pace of expansion. We forecast capacity growth slowing to about 2% per year from 214 compared to high single digits in the past several years, with operating rates rising from 78% in 212 to 82% during 215 (based on average year-end capacity). What is likely to change or not in the near term to relieve some of the pressure on the sector? Hebei local government released its final target for steelmaking capacity closures the next five years, setting this at 6million metric tonnes or over 2% of existing capacity. Achieving that target would be impressive. We are forecasting lower iron ore prices the next few years due to rising new supply amid slowing Chinese demand. The big question is how much of the cost benefit can Chinese mills retain in terms of profit margins. Historically, as profit margins widen, steel production rises. Given the current excess capacity, we see no reason for this to change over the medium term. We have forecast that Chinese steel prices fall slightly less relative to decreasing iron ore prices. Government restrictions on capacity additions have tightened, but past efforts have had mixed success. From , crude steel capacity was reduced by 76mt mainly from obsolete plants, but new capacity was 44mt. The State Council's cancellation of a batch of approval rights is a positive signal. Future reduction targets are quite ambitious, for example Hebei Province is targeting a 2% reduction in three years. Chinese steel exports have increased 17% YoY through August and are on track to reach 68mt this year (+22% YoY), very close to the record high. Korea and Latin America were the two largest export destinations. Exports will not have a material impact on the problem of excess capacity in terms of supporting domestic Chinese prices. And already, weaker regional currencies (India, Japan, and Korea) are eroding the cost competitiveness of Chinese steel exports. M&A at the state level has been active, but overall industry consolidation remains slow and ineffective in consolidating capacity. A large number of local steel mills refuse to be acquired by larger steel companies, state-owned or otherwise. The steel mills are the backbone of local economies, contributing to GDP, providing large-scale employment, and paying taxes. Some progress has been made on agreements to ease the burden locally, such as through transfer payments from the central government. 25 September 213 Page 23 of 7

24 Metals, Mining, Coal, Steel Sector Figure 5: Finished steel trade (mt) 1 import export net export 1 China s trade in finished steel shows increasing net exports. We see this topping out as overseas market demand slows and weaker regional currencies erode its export competitiveness (2) (2) (4) (4) Jan 5 Jul 5 Jan 6 Jul 6 Jan 7 Jul 7 Jan 8 Jul 8 Jan 9 Jul 9 Jan 1 Jul 1 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Source: China NBS Steel and raw material price assumptions The following table shows our forecast for Chinese steel prices and steelmaking raw materials. We have assumed that steel prices fall less than raw material prices. For the correct comparison, note that iron ore makes up only about onethird of steelmaking costs, as does coking coal. So an accurate comparison of the impact of changing raw material prices on the cost of steel would involve taking a third of the iron ore and coking coal price change vs. our steel price forecast, as shown in Figure 52. Figure 51: Chinese steel and raw materials price assumptions (VAT incl.) Steel price forecast E 214E 215E 216E 217E Flat steel Benchmark (2.75mm HRC, Rmb/t) 4,413 4,838 4,177 3,836 3,777 3,649 3,447 3,275 YoYchg. 16% 1% -14% -8% -2% -3% -6% -5% Benchmark (2.75mm HRC, USD/t) YoYchg. 17% 15% -12% -6% -1% -2% -6% -5% Long Steel Benchmark (ψ12 rebar, Rmb/t) 4,23 4,783 4,54 3,648 3,51 3,315 3,68 2,914 YoYchg. 13% 13% -15% -1% -4% -5% -7% -5% Benchmark (ψ12 rebar, USD/t) YoYchg. 14% 18% -13% -8% -3% -4% -7% -5% Raw material price forecast ($US/t, VAT not applied): Iron ore fines (62% CIF China) YoYchg. 81% 17% -22% 4% -8% -1% -11% -19% Hard coking coal contract (FOB Australia) YoYchg. 11% 51% -26% -26% % -2% -3% % Source: Custeel, Steelhome, Maybank Kim Eng We forecast a continued decrease in iron ore prices as supply growth accelerates the next few years. But thus far, steel companies have not been able to materially expand profit margins. Steel prices to make up some ground lost to iron ore prices longer term Steel prices have failed to keep pace with the volatile cost of steelmaking raw materials (iron ore and coking coal), as shown in the graph below. US steel prices have performed better in this regard than those in China due to consolidation and import duties. US steel companies have suffered volatile swings in earnings, including losses, but not to the extent of Chinese steel companies. The graph shows our forecast for lower raw material prices and a lesser decrease in China s steel prices longer term. The graph only includes the cost of raw materials (1.6t iron ore and about.5t coking coal per tonne of raw steel). 25 September 213 Page 24 of 7

25 Metals, Mining, Coal, Steel Sector Figure 52: Raw material costs (iron, coking coal) vs. US and China HRC prices Longer term, we forecast some profit margin improvement as iron ore and coking coal prices fall slightly more relative to steel prices, aided by slowing steel production growth. USD/t 1,3 1,2 1,1 1, Raw materials cost ex-freight (RHS) US HRC price (LHS) China HRC 2.75mm, VAT excl. (LHS) USD/t Q'6 2Q'6 3Q'6 4Q'6 1Q'7 2Q'7 3Q'7 4Q'7 1Q'8 2Q'8 3Q'8 4Q'8 1Q'9 2Q'9 3Q'9 4Q'9 1Q'1 2Q'1 3Q'1 4Q'1 1Q'11 2Q'11 3Q'11 4Q'11 1Q'12 2Q'12 3Q'12 4Q'12 1Q'13 2Q13 3Q'13E 4Q'13E 1Q'14E 2Q14E 3Q'14E 4Q'14E 1Q'15E 2Q15E 3Q'15E 4Q'15E Source: AMM, SBB, Custeel, Steelhome, Maybank Kim Eng Figure 53: China steel supply/demand model (mt) capacity growth forecast to slow E 214E 215E 216E 217E Capacity yr. end ,8 1,33 1,59 1,85 1,11 Capacity yr. avg ,2 1,46 1,72 1,93 Utilization 82% 82% 78% 8% 81% 82% 83% 84% Crude steel production* Finished steel production** ,51 1,18 1,15 1,193 1,231 Flat Share of total finished prod. 45% 45% 43% 43% 45% 46% 46% 47% Long Net export (incl. semis) Import Export Apparent cons. (reported)** ,65 1,15 1,146 1,183 Apparent cons. (adjusted) YoY Change Capacity yr. end 11% 9% 8% 6% 2% 2% 2% 2% *Crude steel production 11% 1% 3% 1% 5% 4% 4% 3% Finished steel production** 16% 1% 8% 1% 5% 4% 4% 3% Apparent consumption** 13% 1% 7% 9% 7% 4% 4% 3% Apparent consumption adjusted*** 11% 9% 2% 9% 7% 4% 4% 3% * Crude steel production in 211 could be understated by 1-2Mt due to statistical error between parent/subsidiary producers in Hebei Province. **Includes double counted tonnes from downstream processing found in the reported figures ***Adjusted consumption is our estimate excluding the double counting of finished steel from further downstream processing. Source: CEIC, CMIPRI, CBI, Kim Eng forecasts Figure 54: China s crude steel production, capacity, and operating rate If China is successful in at least slowing the rate of capacity additions, operating rates should slowly improve over the next few years. m tonnes 1,2 1, % 94% Steel production (LHS) Steel capacity (LHS) Utilization rate (RHS) 1% 96% 93% 94% 91% 87% 79% 82%82%82%78% 8%81%82%83% 84% 15% 1% 95% 9% 85% 8% E 214E 215E 216E 217E 75% Source: CEIC, CMIPRI, CBI, Maybank Kim Eng China s steel production surged 33% from Nov 211 to May 213 just as credit policy was being tightened to slow the economy. The impact squelched the seasonal 1H rally in prices. This is a pattern that has been repeated over the last several years. 25 September 213 Page 25 of 7

26 Metals, Mining, Coal, Steel Sector Figure 55: China s crude steel production growth history and forecast Just as China was tightening credit, crude steel production accelerated, increasing 33% from the Nov 211 trough to the peak in May 213. Though slightly off the peak, production remains at high levels. m tonnes GFC Peak to Trough: -25% from June to Nov., 28 Monthly crude production (LHS) GFC Trough to Peak: +49% from Nov., 28 to Aug., 29 Peak to Trough: -17% from May, 211 to Nov., 211 YoY growth (RHS) YoY chg. 9% 8% 7% 6% Trough to Peak: 5% +33% Nov., 211 4% to May, 213 3% (Est.) 2% 1% % -1% -2% Jan 6 May 6 Sep 6 Jan 7 May 7 Sep 7 Jan 8 May 8 Sep 8 Jan 9 May 9 Sep 9 Jan 1 May 1 Sep 1 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 Sep 13 Source: Custeel; Steelhome, Maybank Kim Eng forecast Steel market conditions and current prices Steel prices have been trending lower since the fourth quarter of 211 when China began its credit tightening. The pace of price declines slowed in the fall of last year, and prices rallied during the seasonally strong late first and early second quarters of this year. Accompanied by lower raw material costs and a seasonal pickup in demand, steel mill profitability improved during the second quarter. During July, CISA reported that its members returned to profit with average operating profit margins of.77%, the highest so far in 213, and well above the margin of.4% for all of 212. Profits increased to USD474m for the 86 members comprising tier one and two steel mills, from losses of USD114m in June. CISA attributed the improvement to higher demand and prices. Figure 56: Steel market prices (CNY/t incl. VAT) Steel prices in China staged a seasonal recovery in 1H13, boosting profits, but a surge in production and a flattening of demand has pushed prices lower in September. 8, 7, 6, 5, 4, 3, 2, Rebar ψ12 Plate 2mm HRC 2.75mm CR sheet 1mm HDG.5mm Jan 4 Jun 4 Nov 4 Apr 5 Sep 5 Feb 6 Jul 6 Dec 6 May 7 Oct 7 Mar 8 Aug 8 Jan 9 Jun 9 Nov 9 Apr 1 Sep 1 Feb 11 Jul 11 Dec 11 May 12 Oct 12 Mar 13 Aug 13 Source: Custeel, Steelhome Since the spring price rally, steel prices have weakened 1-2% due to a flattening out of demand and excess production brought on in response to the improvement in profit margins. Industry sources report that there was no widespread improvement in buying, which was the main reason behind the price corrections. In an attempt to stabilise the market, Baosteel announced that it would keep its September HRC price unchanged, but is eliminating the CNY1/t discount it was offering earlier. Steel company pricing appears to be out of line with market pricing (the average is being boosted by Baosteel s pricing), raising the risk that if the market does not improve, steel mills will have to capitulate. The graph below indicates average company and market HRC prices (ex-vat). The bars illustrate company price premium to the market price, which has widened to over 2% the past few months. Since the GFC, the steel mills, led by Baosteel, have been trying to push 25 September 213 Page 26 of 7

27 Metals, Mining, Coal, Steel Sector market prices higher. This is indicated by the majority of the bars in the graph above the % line ever since the GFC vs. more of a balance of bars in the negative/positive territory before. Figure 57: Market price tension of company vs. market prices Company steel prices have moved out of line with lower market prices, posing the risk of a price cut during 4Q13. Prices (Rmb/t) 6, 5,5 5, 4,5 4, 3,5 3, 2,5 Co. vs. Market premium (discount); (RHS, bars) Co. avg. HRC price (VAT excl.) Market price (2.75mm, VAT excl.) Jan 4 Jun 4 Nov 4 Apr 5 Sep 5 Feb 6 Jul 6 Dec 6 May 7 Oct 7 Mar 8 Aug 8 Jan 9 Jun 9 Nov 9 Apr 1 Sep 1 Feb 11 Jul 11 Dec 11 May 12 Oct 12 Mar 13 Aug 13 Company vs. market premium (discount) 36% 29% 22% 15% 7% % -7% -15% Source: Custeel; Steelhome, Maybank Kim Eng Inventory levels do not appear excessive Inventory of long and flat products in China do not appear excessive based on the small sample provided in our data series (source: Steelhome). The data continue to follow a seasonal pattern for long products, which are typically accumulated during 1Q and de-stocked during 2Q. The inventory of HRC (flat products) shows a longer-term trend of de-stocking from the peak in early 21 and 211 of just below 6mt to the trough earlier this year of about 3mt. HRC inventory has increased by a third since then. Figure 58: China flat product inventory at traders/distributors (mt) May 9 Aug 9 Nov 9 Feb 1 Source: Steelhome Hot rolled coil Cold rolled coil Medium plate May 1 Aug 1 Nov 1 Feb 11 May 11 Aug 11 Nov 11 Feb 12 May 12 Aug 12 Nov 12 Feb 13 May 13 Aug 13 Figure 59: China long product inventory at traders/distributors (mt) May 9 Source: Steelhome Rebar Wire rod Aug 9 Nov 9 Feb 1 May 1 Aug 1 Nov 1 Feb 11 May 11 Aug 11 Nov 11 Feb 12 May 12 Aug 12 Nov 12 Feb 13 May 13 Aug 13 Figure 6: China non-iron ore steelmaking raw material prices (VAT incl.) USD/t Jan 7 May 7 Sep 7 Jan 8 Tangshan coke Shanxi coking coal Nanjing scrap (6mm) Newcastle Premium HCC (FOB Australia, VAT not applied) May 8 Sep 8 Jan 9 May 9 Sep 9 Jan 1 May 1 Sep 1 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 Sep 13 Source: Custeel, Bloomberg, Steelhome 25 September 213 Page 27 of 7

28 Hong Kong Initiating Coverage 25 September 213 Buy Share price: Target price: HKD25.5 HKD29. Alexander LATZER (852) Stock Information Description: China Shenhua Energy Company Limited (China Shenhua) is the largest coal producer in China, with production mainly thermal coal totaling 34m tonnes and sales of 464.6m tonnes in 212. The companyis headquartered in Beijing and is 73.1% owned by the State.Shenhua is fully integrated from coal mining, railway transportation, ports, shipping, and coal-fired power plants. The majority of the company's business is conducted within China. Ticker: 188 HK Shares Issued (m): 19, Market Cap (USDm): 65,24 3-mth AvgDaily Turnover (USDm): 64.5 HSI: 23,371.5 Free Float (%): Major Shareholders: % JP Morgan Blackrock 7.88 Walter Scott Partners 5.2 Vanguard Group Inc Key Indicators (June 3, 213) ROE annualised (%) 19 Net debt (Rmbm): 17,64 NTA/shr (HKD): Interest cover (x): 27.8 Historical Chart Sep 12 Nov 12 Jan 13 Mar 13 May 13 Jul 13 Sep 13 PRICE Performance: 52-week High/Low (HKD) 35.45/18.1 PRICE REL. TO HANG SENG INDEX Source: Bloomberg 1-mth 3-mth 6-mth 1-yr YTD Absolute (%) (1.1) (15.1) (24.9) Relative (%) (2.6) (2.) (15.7) (27.9) (28.) China Shenhua Energy The One To Own In The Coal Sector Steady growth, strong balance sheet and healthy cash flows. We initiate coverage with a BUY and target price of HKD29. Catalysts are improving macro and seasonal factors, and higher earnings powered by strong coal sales growth. We see upside to consensus EPS in 213/14. Anticipating slowing coal consumption in China, Shenhua has ramped up capex spending in 212 and 213 to expand its delivery systems (rail, port, shipping), and power plant capacity (supplied 86% with its own coa). Coal mine capex continues, but at a lower rate. The benefits of this sensible strategy are yet to come, and include rapid sales growth through consolidation of regional coal supply via its delivery network, and raising productivity to offset higher industry costs. We assume volume growth of 5-7% in sales and 3.5% in production in Strong sales volumes YTD support our 213 target. We forecast a 5% increase in thermal coal prices by end-213 from current levels, in line with the average for the same period in , backed by recovering thermal power generation, lower inventory at power plants, and maintenance on China s largest coal railway in September. We forecast a 5% YoY coal price hike in 214 and a 2.5% power tariff rate cut later with segmental margins lower thereafter. We forecast rising cash flows as Shenhua tapers its capex spending from the peak of nearly USD1b in 213, with the company returning to a net cash position in 215. The strong balance sheet offers flexibility for future growth and continued strong dividends. Our valuation is based on a DCF methodology. Our target price of HKD29 represents a 1% discount to our DCF valuation of HKD32/sh (WACC 11.2% and long-term growth 2.75%). Our TP translates to a PBR of 1.4x and EV/EBITDA of 5.1x our 214 estimates. We see this as fair given Shenhua s strong industry position, leading profit margins, and cash flows supporting a healthy 39% payout to shareholders. China Shenhua Energy Summary Earnings Table FYE Dec (CNYm) 212A 213A 214F 215F Revenue 25,26 253, , ,61 EBITDA 86,41 88,692 9,537 93,22 Recurring Net Profit 48,858 46,362 47,31 48,19 Recurring Basic EPS (CNY) EPS growth (%) 6.6 (5.1) DPS (CNY) PER (x) 8.4x 8.6x 8.4x 8.1x EV/EBITDA (x) 4.9x 4.8x 4.5x 3.9x Div. Yield (%) P/BV (x) 1.6x 1.4x 1.3x 1.1x Net Gearing (%) net cash ROE (%) ROA (%) Consensus EPS (CNY) N.A Source: Shenhua, Bloomberg Consensus, Maybank Kim Eng SEE APPENDIX I FOR IMPORTANT DISCLOSURES AND ANALYST CERTIFICATIONS

29 China Shenhua Energy Company Limited How do we justify our positive view on the shares? Positive earnings and cash flow growth forecast in 214/15 We forecast profits to trough in 213, with moderate increases in 214/215 due to slightly higher coal prices and coal sales volumes. The lower ROE in 213 was mainly driven by lower coal prices and during 214 is due to our assumption of a power tariff rate cut and higher unit costs. The decrease in ROE is also a direct result of the defensive strategy of the company to adjust the business to the changing market environment. Figure 61: ROE and net profit and coal volumes Coal produced and purchased CNY 26.6bn 31.7 Coal produced Coal purchased ROE in %; ROE Net profit (CNY b) Net Profit in CNY b % E 214E 215E 1 Source: Shenhua, Maybank Kim Eng estimates Shenhua has emerged from a market downturn with only a forecast 5% fall in net profit for 213F, and with capex remaining at high levels to further improve the business. This shows the strong cash generating power of the business. Free cash flows are expected to increase on lower capex and rising profitability. Assuming 213 was the peak in capex spending, we see Shenhua returning to a net cash position in 215. Its business is highly cash generative, which gives the company the financial flexibility to pursue bolt-on acquisitions and maintain a healthy dividend policy (39% payout). Shenhua indicated during its interim results briefing that capex for 213 is likely to come in below its earlier forecast of CNY67.45b. Our forecasts assume a cut of 12% from the initial guidance. The company recently acquired the coal-to-chemicals business of its parentco Shenhua Group. We also think it remains in the running to be part of a consortium to acquire the Tavan Tolgoi East block. With respect to M&A, management has specifically stated that it will stick to its core competencies. It uses a variety of evaluation criteria, including an IRR of greater than or equal to 1%, cash flows of the business, and how it complements the existing asset base. Figure 62: Free cash flow outlook CNYb CAPEX Dividends Operating cash flows Free Cash Flows (2) (6) (1) E 214E 215E Source: Shenhua, Maybank Kim Eng estimates 25 September 213 Page 29 of 7

30 China Shenhua Energy Company Limited Figure 63: Operating profit by business segment CNY b Coal Power Other (Rail, Port, Shipping, other) E 214E 215E Source: Shenhua, Maybank Kim Eng estimates Figure 64: Capital spending by business segment CNY b Coal Power Railway Others E 214E 215E Source: Shenhua, Maybank Kim Eng estimates Business strategy the right one at this point in the cycle From , Shenhua s profit grew rapidly due to rising volumes from its own mines, and stable to slightly higher returns as rising coal prices more than offset increasing costs. As the operating environment changed, management rapidly adjusted its business strategy to focus on higher productivity to cope with slower volume growth amid stable coal prices. This is a sensible move at this point in the cycle and one that is possible due to its strategic portfolio of mines, power plants and coal delivery systems (rails, ports and shipping). During 213, this strategy paid off. The company saw increased sales volumes from third parties, was able to prioritise higher-margin mines and expanded its coal delivery systems, which helped lower costs (-3% YoY our 213 estimate) amid significantly lower selling prices (Qinhuangdao -17% YoY and Shenhua average -1% YoY in 213F in CNY terms). As a result, we forecast the company will experience only a 5% decrease in profitability this year, which is far better than most of its peers in any of the materials sectors. Looking ahead, we forecast Shenhua s profitability will grow more slowly coming out of the 213 trough than in the period before based on our assumptions. During 214, we have assumed slower market demand growth, higher total unit costs (+4% YoY), a power tariff rate cut (-2.5%), partially offset by higher sales volumes, though with a less profitable product mix (increasing sales of third-party coal vs. self-owned coal). The graph below illustrates our assumptions on costs and selling prices and Figure 61 our assumptions on coal sales volumes. Figure 65: Average realised coal selling price and unit costs Cost, CNY/t 4 Own mines Transport Purchased coal Avg. coal price (RHS) Price, CNY/t E 214E 215E Source: Shenhua, Maybank Kim Eng estimates 25 September 213 Page 3 of 7

31 China Shenhua Energy Company Limited Valuation Our target price is supported by our DCF and an analysis of its PBR and ROE. In addition, there are few companies in the materials sector generating comparable returns. Our valuation is based on an examination of Shenhua s PBR relative to its ROE, as well as our DCF analysis. Our DCF value is HKD32/sh from the beginning of 214 to which our target price of HKD29/sh represents a 1% discount. The indicated DCF valuation from the start of 215 is HKD35/sh, reflecting the winding down of the capex programme and closer to higher cash flows in our forecast period. We are using a WACC of 11.2% and perpetual growth rate of 2.75%. Our terminal year is 217 in which we have assumed a regional coal price of USD8/t (Newcastle high CV 6,kcal), up 2% from the current level, and Qinhuangdao of CNY585/t (high CV 5,8kcal), which is flat with the current level. We have assumed Shenhua s total delivered coal costs rise 3% from 1H13 actual to CNY318/t in 217 (USD53/t), with coal production of 355mt (+12% vs. 213F), and coal sales of 592mt (+21% from 213F). With respect to the other segments, we have assumed moderate growth in volume of about 3% per year from 213 to 217, but have taken down the profit margins. For the power segment, we have assumed a lower profit margin of 18% in 217 compared to 22% in 213 and 2% in 214 (we assume a 2.5% tariff rate cut), which we think is conservative. Our profit margin for the railway segment is down slightly from 47% in 213F to 45% in 217, shipping is flat, and ports down from 34% in 213F to 25% in 217. Our sustaining capex assumption is CNY28b. Under this scenario, Shenhua s earnings would be flat with those estimated in 213F, and the EBIT margin would be 23%, down from 27%. The company would be generating free cash flow of CNY29b/yr and have accumulated a total cash balance of about HKD9.5/sh (CNY146b) from 213 to 217 vs. about HKD2.25/sh (CNY36b) in 213F. We assume no M&A and the sustaining capital of CNY3b in 216 and CNY28b in 217. The PBR has fallen in line with the ROE and that makes sense, but we see it having bottomed and below the ratio implicit in a Gordon Growth style analysis. The level of the ROE when compared to the required return on capital still implies that a large premium to book value is justified. We compare the ROEs in 213, 214 and 215 to the required return of 11% and arrive at book value premiums of 55%, 45%, and 35%, respectively, which on the year-end book value equates to a share price of HKD28-29/sh. Our forecast for Shenhua s 214F ROE is 15.8%, which is the same level as the latest point in the one-year forward rolling ROE in the graph below. At this level, the market is valuing the shares at 1.3x. This compares to the 1.4x implied in our target price and the 1.2x using the current share price. Figure 66:Shenhua ROE vs. PBR The PBR has fallen in line with the ROE, which we forecast is bottoming, and remains at a level where a 35-45% premium to book value should apply. ROE ROE (LHS) PBR (RHS) 3% 27% 24% 21% 18% 15% 12% Jul 5 Oct 5 Jan 6 Apr 6 Jul 6 Nov 6 Feb 7 May 7 Aug 7 Nov 7 Mar 8 Jun 8 Sep 8 Dec 8 Apr 9 Jul 9 Oct 9 Jan 1 Apr 1 Aug 1 Nov 1 Feb 11 May 11 Sep 11 Dec 11 Mar 12 Jun 12 Sep 12 Jan 13 Apr 13 Jul 13 PBV 7.8x 6.5x 5.2x 3.9x 2.6x 1.3x.x Source: Bloomberg, Shenhua, Maybank Kim Eng estimates 25 September 213 Page 31 of 7

32 China Shenhua Energy Company Limited The PBR remains below the GFC low, reflecting in part a lower ROE, but also a China de-rating. This seems unjustified as Shenhua s business and returns are among the best worldwide among nearly all materials companies. Figure 67:Shenhua PBR bands HKD Jan-6 May-6 Sep-6 Jan-7 May-7 Sep-7 Jan-8 May-8 Sep-8 Jan-9 May-9 Sep-9 Jan-1 May-1 Sep-1 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep x Avg +2SD 2.6x Avg Source: Bloomberg, Shenhua, Maybank Kim Eng estimates Shenhua s PBR band analysis using one-year forward rolling estimates indicates the shares remain well below the average PBR since 26, as well as that since 29. The PBR is actually below that during the trough of the GFC in late 28 and early 29. The shares have not only been de-rated due to the falling ROE, but also the China market de-rating. While we do not argue that ROE is falling, we find that Shenhua remains a world-class company supported by its returns, which we point out further below. What is priced into the shares? Since early July, Shenhua s share price has moved much higher as expectations of macro growth in China improved. The shares have pulled back slightly since on industry-specific concerns regarding government policy towards the coal sector. We believe that policy risk is not fully priced in with respect to a potential tariff rate cut and a resource tax, though we have tried to price some of this into our estimates. The market appears to be pricing in a flat coal price and some policy risk based on our analysis below. The market appears to be pricing in lower than consensus earnings of about CNY2./sh, which would be pricing in a flat coal price in 214 YoY and a tariff rate cut of about 2.5%. We see the tariff rate hike as being more impactful of the two policies and have factored in a 2.5% cut in 214, and lower power segment profit margins in the out years as well. The resource tax could take many forms but is likely to be on the value of the product rather than the volume produced. This could imply a tax of 1-3% on the price of coal for example, but we don t know if other taxes at the local level would be deducted. We have also factored in rising total delivered coal costs in future years. The table below provides a sensitivity analysis of Shenhua s earnings to changes in power tariffs and coal prices. Our 214F EPS of CNY2.37/sh (bolded) assumes a 2.5% tariff rate cut and a 5.% coal price increase (full-year average realided price CNY47/t). The company s earnings are more sensitive to changes in the coal price than to changes in the power tariff rate. The consensus 214 EPS estimate of CNY2.29/sh (MBKE: CNY2.37/sh) appears to be pricing in either a lower coal price increase (2.5% YoY) or the same coal price increase of 5.% but a 5% tariff rate cut. The market seems to be pricing in 214 earnings of closer to CNY2./sh, assuming the market PBR of 1.2x the current price. This implies the market has priced in flat coal prices in 214 YoY and a tariff rate cut of about 2.5%. 25 September 213 Page 32 of 7

33 China Shenhua Energy Company Limited Figure 68: Shenhua sensitivity table on 214 EPS (CNY/sh). Changes YoY Power tariff (%) change YoY Coal price % chg. YoY Source: Maybank Kim Eng. *Base case EPS is CNY2.37/sh, assuming a 2.5% tariff rate cut and a coal price increase of 5.% (average realised price CNY47/t) Earnings revisions trend has bottomed and should improve The consensus forecast of Shenhua s 213 and 214 earnings has been in a continuous downward trend since late 211 in line with the Chinese economy and other materials stocks taking the share price with it. We see this trend bottoming and look for the consensus to raise their forecast more in line with ours. We have noticed that the consensus 213 estimate has moved higher by a few percentage points since late August. Figure 69: Consensus forecast for Shenhua s earnings in 213 and 214 HKD Jan 1 Mar 1 May 1 Jul 1 Share price (LHS) Consensus EPS adjusted 213 (RHS) Consensus EPS adjusted 214 (RHS) Sep 1 Nov 1 Jan 11 Mar 11 May 11 Jul 11 Sep 11 Nov 11 Jan 12 Mar 12 May 12 Jul 12 Sep 12 Nov 12 Jan 13 Mar 13 May 13 Jul 13 CNY Source: Bloomberg consensus 25 September 213 Page 33 of 7

34 China Shenhua Energy Company Limited Figure 7: Global coal company market capitalisation (USDm) 3, 22,5 Global coal company valuation graphs 29,228 64,131 15, 7, ,372 1,41 1,88 2,29 2,376 2,4 2,659 2,689 4,848 11,145 7,192 7,735 Source: Bloomberg consensus Figure 71: Global coal companies EV/EBITDA 214 Figure 72: Global coal companies Dividend Yield Berau Coal Harum Energy Shenhua Borneo Lumbung Fushan Energy Adaro Coal India China Coal Peabody Energy Bumi Resources Consol Energy Banpu Pcl Mechel PT Bukit Asam Walter Energy Alpha Natural White Haven Yanzhou Coal Arch Coal Mongolian Mining Hidili Southgobi Winsway Winsway Walter Energy Hidili White Haven Consol Energy Mechel Yanzhou Coal Peabody Energy Adaro Arch Coal China Coal Fushan Energy PT Bukit Asam Banpu Pcl Shenhua Harum Energy Coal India Borneo Lumbung Source: Bloomberg consensus Source: Bloomberg consensus Figure 73: Global coal companies ROE 214 Figure 74: Global coal companies PBR 214 (2) (1) Tigers Realm Alpha Natural Walter Energy Arch Coal Winsway Southgobi Mechel Mongolian Mining Hidili Raspadskaya White Haven Peabody Energy Yanzhou Coal Fushan Energy China Coal Consol Energy Banpu Pcl Adaro Borneo Lumbung Shenhua Bayan Resources Harum Energy Berau Coal PT Bukit Asam Coal India (12.8) (12.4) (12.3) (1.5) (8.5) (6.7) (4.) (1.5) Hidili Alpha Natural Arch Coal Southgobi Mechel Borneo Lumbung Winsway China Coal White Haven Yanzhou Coal Fushan Energy Banpu Pcl Adaro Peabody Energy Mongolian Mining Walter Energy Tigers Realm Shenhua Consol Energy Harum Energy Berau Coal PT Bukit Asam Coal India Source: Bloomberg consensus Source: Bloomberg consensus 25 September 213 Page 34 of 7

35 China Shenhua Energy Company Limited INCOME STATEMENT BALANCE SHEET FYE Dec (CNYm) 212A 213F 214F 215F FYE Dec (CNYm) 212A 213F 214F 215F Revenues 25,26 253, , ,61 Cash & equivalents 51,627 29,994 43,747 75,86 Coal 165, ,97 178, ,2 Time and restricted deposits 1,54 1, 1, 1, Power 71,96 73,761 76,762 79,449 Inventories 15,171 18,759 2,879 22,588 Others 13,175 18,318 19,314 19,592 Accounts receivable 2,28 24,129 26,96 27,746 COGS (15,957) (156,327) (173,992) (188,232) Other 14,48 2,319 19,228 17,524 Gross Profit 99,33 97,66 1,7 13,829 Total current assets 111,36 13,21 119,95 152,944 SG&A (12,95) (8,593) (9,614) (1,222) PPE 236,48 275, ,922 33,564 Other operating expense 48 (376) (549) (584) Construction in progress 61,142 6, 5, 4, EBITDA 86,41 88,692 9,537 93,22 Other non-current assets 48,817 52,22 58,215 64,254 DD&A (16,797) (19,421) (2,3) (2,23) Total non-current assets 346,7 388,23 4,137 47,818 Operating Profit (EBIT) 69,64 69,271 7,533 72,819 Total Assets 457, ,44 52,88 56,762 Net financing cost (2,71) (2,384) (2,9) (1,557) S. term borrowings & current 28,93 28, 28, 28, Associates Accounts and bills payable 31,72 31,265 34,798 37,646 Other inc. (exp) Other current liabilities 46,392 54,714 52,198 56,47 Pre-tax profit 68,11 67,78 68,944 71,762 Total current liabilities 15, ,98 114, ,116 Income tax (1,965) (12,475) (12,919) (14,175) Long term borrowings 39,624 33,151 28,151 28,151 Minority interests (8,188) (8,87) (8,963) (9,329) Other non-current liabilities 5,629 5,5 5,5 5,5 Net Profit 48,858 46,362 47,62 48,258 Total non-current liabilities 45,253 38,651 33,651 33,651 EPS Total liabilities 15,81 152, , ,767 Div/sh Minority interests 49,968 54,43 58,882 63,54 Avg. shares out. 19,89 19,89 19,89 19,89 Share capital 19,89 19,89 19,89 19,89 Reserves 236, ,48 292, ,565 Revenue Growth % Shareholders' Equity 256, ,37 312, ,455 EBITDA Growth (%) Total Liabilities & Sh. Equity 457, ,44 52,88 56,762 EBIT Growth (%) 1.3 (.5) Net Profit Growth (%) 6.6 (5.1) Gross Debt/(Cash) 67,717 61,151 56,151 56,151 Tax Rate % Net Debt/(Cash) 16,9 31,157 12,44 (18,935) Working Capital 5,83 (1,779) 4,954 3,828 CASH FLOW RATES & RATIOS FYE Dec (CNYm) 212A 213F 214F 215F FYE Dec 212A 213F 214F 215F Profit before taxation 68,11 67,78 68,899 71,66 EBITDA Margin % Depreciation 18,15 19,421 2,3 2,23 Op. Profit Margin % Net interest expense 3,315 3,177 2,87 2,88 Net Profit Margin % Working capital change (1,394) (5,12) (1,98) 5,466 ROE % Cash tax paid (14,689) (12,475) (12,91) (14,155) ROA % Others (4,338) (1,434) (1,235) (1,648) Dividend Cover (x) Cash flow from operations 69,55 71,384 75,646 84,334 Interest Cover (x) Capex (52,256) (59,356) (35,942) (31,845) Asset Turnover (x) Disposal/(purchase) Asset / Equity (x) Others (9,894) (4,366) Asset/Debt (x) Cash flow from investing (61,93) (63,449) (35,942) (31,845) Receivables Turn (days) Debt raised/(repaid) 1,565 (6,566) (5,) Payables Turn (days) Equity raised/(repaid) Inventory Turn (days) Dividends (paid) (17,91) (19,94) (18,81) (18,342) Net Gearing % Net cash Others (incl. int. paid) (817) (3,98) (2,87) (2,88) Gross Debt/ EBITDA (x) Cash flow from financing (17,153) (29,568) (25,951) (21,15) Gross Debt/ Market Cap (x) Change in cash (1,28) (21,633) 13,753 31,339 PER SHARE DATA FYE Dec 212A 213F 214F 215F EPS EBITDA/share DPS Oper. CFPS Free CFPS (.6) (.36) BVPS Source: Shenhua, Maybank Kim Eng 25 September 213 Page 35 of 7

36 Hong Kong Initiating Coverage 25 September 213 Hold Share price: Target price: HKD4.99 HKD5.5 Alexander LATZER (852) Stock Information Description: China Coal Energy Co. Ltd. (China Coal) mines and markets primarily thermal, but also coking coals. The company also manufactures coal mining equipment and offers coal mine design services. The company, which is 58.2% State held, is headquartered in Beijing, with principal operations located in Shanxi Province in northern China. During 212, raw coal production totaled 145.4m tonnes,and sales of self-produced coal 111.1m tonnes, of which 98.6% was thermal coal. Ticker: 1898 HK Shares Issued (m): 13,259 Market Cap (USDm): 8,482 3-mth AvgDaily Turnover (USDm): 28.8 HSI: 23,371.5 Free Float (%): 41.8 Major Shareholders: % Blackrock 7.1 JP Morgan 6.6 Citigroup Inc. 4.8 Government of Singapore 4.4 Key Indicators (June 3, 213) ROE annualised (%) 6.3 Net debt (Rmbm): 33,895 NTA/shr (HKD): 9.8 Interest cover (x): 6.9 Historical Chart Sep 12 Nov 12 Jan 13 Mar 13 May 13 Jul 13 Sep 13 PRICE Performance: 52-week High/Low 9.4/3.66 PRICE REL. TO HSI Index Source: Bloomberg 1-mth 3-mth 6-mth 1-yr YTD Absolute (%) 13. (1.5) (37.2) (29.2) (45.4) Relative (%) 14.2 (7.) (33.3) (38.9) (41.2) China Coal Energy Hold For Recovery In Coal Price Leverage to higher coal prices. We recommend holding the shares for the seasonal recovery in coal prices later this and early next year. Looking further ahead, we forecast profitability to flatten out, capex spending to rise, free cash flow to turn negative, and debt levels to increase as the company builds a new growth engine in coal/chemicals. Coal/chemicals spending to remain high. Management has doubled coke/chemicals business Capex each year since 21. In 213, we forecast Capex on the business at CNY17.4b, (53% of the total spend), and remaining high at CNY15b in 214, and CNY11b in 215. We look for the business to turn profitable late 214 and improve thereafter, but remain small vs. coal based on our projections. Coal business will drive profitability over the medium term. Given the long lead time to ramp up the coal/chemicals business, profitability will still be driven by the coal segment where volumes are growing nicely in the mid-single digits. During 214, we forecast a 7% increase in EPS to CNY.44/sh, which is about 1% above consensus. We forecast a 5% increase in thermal coal prices by end-213 from the current level, in line with the average of the same period in , supported by recovering thermal power generation, lower inventory at power plants, and maintenance on China s largest coal railway. During 214, we assume a 5.5% YoY increase in coal sales volumes mainly due to higher coal production (+4% YoY), a 3% YoY increase in unit costs, and a 5% YoY increase in the coal price. Our valuation is based on the one-year forward (214) PBR/ROE. Our target price of HKD5.5 is based on.6x PBR, which is in line with the current market multiple, and appears consistent with the discount commensurate with the ROE vs. the required return. On EV/EBITDA, the valuation is 7.8x, a bit high vs. its peers given its low profit margin, indicating to us that the rally in the shares is nearing an end, unless coal prices move materially higher than our forecast. China Coal Summary Earnings Table FYE Dec (CNYm) 212A 213A 214F 215F Revenue 87,292 8,97 87,399 93,13 EBITDA 17,414 14,349 15,86 17,388 Recurring Net Profit 8,842 5,491 5,855 6,149 Recurring Basic EPS (CNY) EPS growth (%) (11.2) (37.9) DPS (CNY) PER (x) 6.1x 9.5x 8.8x 8.3x EV/EBITDA (x) 4.3x 7.2x 7.5x 7.4x Div Yield (%) P/BV (x).6x.6x.5x.5x Net Gearing (%) ROE (%) ROA (%) Consensus EPS (CNY) N.A Source: China Coal, Bloomberg Consensus, Maybank Kim Eng SEE APPENDIX I FOR IMPORTANT DISCLOSURES AND ANALYST CERTIFICATIONS

37 China Coal Energy Company Limited How do we justify our view on the shares? We justify our view by a combination of factors, primarily our forecast for a mild increase in thermal coal prices (5% to year-end and 5% in 214 YoY), the nearly full valuation, the lack of other growth drivers in the medium term, and the stepup in capex causing negative free cash flow and rising debt levels. Overall, given our coal price forecast calling for a mid-single digit increase in 214 YoY, we see the upside as limited, while the business risk is rising if the company spends as much as we have forecast. Based on our earnings forecasts, the valuation appears to offer limited upside longer term. Given the approaching seasonally strong period, we believe it is worth holding current positions to participate, before taking profits. Figure 75: ROE and net profit and coal volume Coal self-produced and traded, mt % 15 Sales of self-produced coal Proprietary coal trading ROE Net profit ROE in %; Net Profit in CNY b % CNY 7.7bn 7.4bn 9.1% 7.5bn 1.9% 1.bn 8.9% 8.8bn 5.5bn 5.9bn 6.1bn 5.3% 5.4% 5.5% E 214E 215E Source: China Coal, Maybank Kim Eng estimates Figure 76: Average realised coal selling price and unit costs Cost, CNY/t Taxes and fees Transportation cost Production cost Selling price of self-produced coal (RHS) E 214E 215E Price, CNY/t Source: China Coal,Maybank Kim Eng estimates Looking beyond 214, we have made some big assumptions on the coke/chemicals business, despite the lack of specific data points from management other than its expressed goal of shifting the focus from coal to coke/chemicals/energy. For example, our capex and profit margin assumptions are likely to change as the business plan is disclosed in more detail. We have kept our assumptions modest in terms of profitability because the segment has been loss making in all but two interim periods from 2H8 through 1H September 213 Page 37 of 7

38 China Coal Energy Company Limited Figure 77: Free cash flow outlook CNY b (1) (2) (3) (4) Operating cash flow CAPEX Dividends Free Cash Flow E 214E 215E 216E Source: China Coal, Maybank Kim Eng estimates All in all, this company will continue to be driven by the coal segment and the ability of management to continue to raise productivity to stabilise returns if coal price volatility remains low on a historical basis, as we forecast. Figure 78: Operating profit by business segment Figure 79: Capital spending by business segment CNY b 15 Coal Mining Equipment Coke/Chemicals Other eliminations CNY b 4 Coal Coke/Chemicals Mining Equipment Power Generation Others (5) E 214E 215E 216E E 214E 215E 216E Source: China Coal, Maybank Kim Eng estimates Source: China Coal, Maybank Kim Eng estimates Valuation We have valued China Coal using PBR and ROE analysis because cash flows remain weak relative to debt levels to generate a meaningful DCF valuation. Our target price of HKD5.5 is based on.6x PBR on our 214 estimates, which is in line with the current market multiple, and appears consistent with the discount commensurate with the ROE vs. the required return. Our forecast for the ROE is about 5.5% the next two years, which is slightly greater than half the required return. The graph below shows the relationship between China Coal s ROE and PBR ratio on a one-year forward moving average basis. 25 September 213 Page 38 of 7

39 China Coal Energy Company Limited A discount to PBR is justified given the outlook for profitability (ROE) to remain low. Figure 8: China Coal ROE and PBR chart ROE ROE (LHS) PBR (RHS) 25% 22% 19% 16% 13% 1% 7% 4% Jan 7 Mar 7 Jun 7 Sep 7 Dec 7 Feb 8 May 8 Aug 8 Nov 8 Jan 9 Apr 9 Jul 9 Oct 9 Jan 1 Mar 1 Jun 1 Sep 1 Dec 1 Feb 11 May 11 Aug 11 Nov 11 Jan 12 Apr 12 Jul 12 Oct 12 Dec 12 Mar 13 Jun 13 Sep 13 PBV 7.x 6.x 5.x 4.x 3.x 2.x 1.x.x Source: Bloomberg, China Coal, Maybank Kim Eng estimates The PBR is low on a historical basis as well (see graph below), trading at a level similar to that during the GFC. However, our 214 forecast compared to 29 calls for EPS 2% lower and ROE about half. Figure 81: China Coal PBR bands While the PBR is low on a historical basis, profitability is forecast to be worse in 214 than during the GFC (29). HKD Jan-7 May-7 Sep-7 Jan-8 May-8 Sep-8 Jan-9 May-9 Sep-9 Jan-1 May-1 Sep-1 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep x Avg +2SD 3.x Avg +1SD 1.8x Avg.7x Avg -1SD Source: Bloomberg, China Coal, Maybank Kim Eng estimates What is priced into the shares? Based on the table, it appears that the current share price is discounting a zero to 2% increase in the coal price YoY during 214. As shown, China Coal has high operating leverage to coal prices and as a result, high earnings volatility. If the coal price exceeds our forecast, the shares will move higher, all other factors unchanged. The table below provides an estimate of the impact of the change of the coal price on the earnings, ROE and share price of China Coal. We have derived the share price using the ratio of the ROE to the required return on capital of 9% times the book value. 25 September 213 Page 39 of 7

40 China Coal Energy Company Limited Figure 82: China Coal sensitivity table on 214 EPS (CNY/sh). Changes YoY Coal price(% chg. YoY) EPS (Rmb) ROE (%) Share Price (HKD) Source: Kim Eng estimates. The share price is generated using the ratio of ROE to the required return times the book value. Earnings revisions The momentum in the consensus earnings for China Coal continued to decrease the past month since the company reported a weak interim results, albeit at a slower rate than earlier. The upturn in the share price implies the market sees the earnings stabilising based on the interpretation of recent positive macroeconomic data. We have indicated earlier in our analysis of the coal market that the macro trend turned a corner earlier this year but the coal price continued to remain weak, reflecting ample supply and de-stocking. Projecting the trend would indicate some level of re-stocking in a couple of months by power producers, which we think is largely priced into the shares. The recent very strong electricity data may be a result of the summer heat wave or a shift higher in sustaining demand. We will know more over the next month or two. Our forecast calls for an improving but historically slower rate of consumption growth and for supply to remain adequate to meet demand compared to the surplus earlier this year. If aluminum output is any guide, China is an electricity intensive economy and more coal supply will be needed ahead. Figure 83: Consensus forecast for China Coal s earnings in 213 and 214 HKD Share price (LHS) Consensus EPS adjusted 213 (RHS) Consensus EPS adjusted 214 (RHS) CNY Jan 1 Mar 1 May 1 Jul 1 Sep 1 Nov 1 Jan 11 Mar 11 May 11 Jul 11 Sep 11 Nov 11 Jan 12 Mar 12 May 12 Jul 12 Sep 12 Nov 12 Jan 13 Mar 13 May 13 Jul 13 Sep 13 Source: Bloomberg consensus 25 September 213 Page 4 of 7

41 China Coal Energy Company Limited INCOME STATEMENT BALANCE SHEET FYE Dec (CNYm) 212A 213A 214F 215F FYE Dec (CNYm) 212A 213A 214F 215F Revenue 87,292 8,97 87,399 93,13 Cash & equivalents 13,91 6,216 6,745 6,12 COGS (65,291) (61,728) (67,223) (7,974) Time and restricted deposits 9,471 8,65 8,65 8,65 Gross Profit 22, 18,369 2,176 22,39 Inventories 6,697 7,527 7,99 8,481 SG&A (4,586) (4,2) (4,37) (4,651) Accounts receivable 11,394 12,74 11,16 12,177 EBITDA 17,414 14,349 15,86 17,388 Other 7,918 8,649 9,197 9,862 DD&A (4,697) (5,671) (6,75) (7,75) Total current assets 49,381 43,746 43,661 45,289 Operating profit (EBIT) 12,717 8,679 9,56 9,638 PPE 85,51 18,2 126, ,689 Other income (loss) (32) Mining and land use rights 32,479 33, 33, 33, Net financing cost (254) (419) (7) (85) Other non-current assets 18,317 23,93 23,577 27,813 Associates Total non-current assets 136,36 165,13 183,171 2,52 Other gains (losses) Total Assets 185,688 28, , ,791 Pre-tax profit 12,789 8,56 8,673 9,19 S. term borrowings & current 6,541 7,9 7,9 7,9 Income tax (3,214) (2,141) (2,168) (2,277) Accounts and bills payable 16,12 16,936 15,16 14,843 Minority interests (733) (928) (651) (683) Other current liabilities 11,483 1,199 1,677 11,392 Net Profit 8,842 5,491 5,855 6,149 Total current liabilities 34,126 35,35 33,736 34,134 EPS Long term borrowings 4,77 6,447 75,447 86,447 Div/sh Other non-current liabilities 1,64 7,5 7,5 1,594 Avg. shares out. 13,259 13,259 13,259 13,259 Total non-current liabilities 5,141 67,947 82,947 97,41 Total liabilities 84,267 12, , ,175 Minority interests 14,694 15,75 15,75 15,75 Share capital 13,259 13,259 13,259 13,259 Reserves (incl. ret. earnings) 73,468 76,858 81,141 85,68 Shareholders' Equity 86,726 9,117 94,399 98,866 Revenue Growth % (3.9) (8.2) Total Liabilities & Sh. Equity 185,688 28, , ,791 EBITDA Growth (%) (7.3) (17.6) EBIT Growth (%) (9.5) (31.8) Gross Debt/(Cash) 46,619 68,347 83,347 94,347 Net Profit Growth (%) (11.2) (37.9) Net Debt/(Cash) 32,718 62,131 76,62 88,227 Tax Rate % Working Capital 15,255 8,711 9,925 11,155 CASH FLOW RATES & RATIOS FYE Dec (CNYm) 212A 213A 214F 215F FYE Dec 212A 213A 214F 215F Profit before taxation 12,789 8,541 8,673 9,19 EBITDA Margin % Depreciation 4,697 5,671 6,75 7,75 Op. Profit Margin % Net interest expense 1,119 1,65 2, 2,3 Net Profit Margin % Working capital change (2,82) (2,218) (685) (1,856) ROE % Cash tax paid (3,52) (2,141) (2,168) (2,277) ROA % Others (incl. int. paid) (2,133) (593) (2,25) (2,55) Dividend Cover (x) Cash flow from operations 1,888 1,91 12,32 12,476 Interest Cover (x) Capex (24,934) (32,889) (25,144) (2,845) Asset Turnover (x) Disposal/(purchase) (4,67) Asset / Equity (x) Others (2,889) (1,921) Asset/Debt (x) Cash flow from investing (31,889) (34,81) (25,144) (2,845) Receivables Turn (days) Debt raised/(repaid) 12,272 19, 15, 9,5 Payables Turn (days) Equity raised/(repaid) Inventory Turn (days) Dividends (paid) (3,157) (2,784) (1,647) (1,756) Net Gearing % Others (incl. int. paid) 4,196 Gross Debt/ EBITDA (x) Cash flow from financing 13,311 16,216 13,353 7,744 Gross Debt/ Market Cap (x) Change in cash (7,691) (7,685) 529 (626) PER SHARE DATA FYE Dec (CNY) 212A 213A 214F 215F EPS EBITDA/share DPS Oper. CFPS Free CFPS (1.3) (1.87) (1.9) (.76) BVPS Source: China Coal, Maybank Kim Eng 25 September 213 Page 41 of 7

42 Hong Kong Initiating Coverage 25 September 213 Buy Share price: Target price: HKD16.28 HKD2. Alexander LATZER (852) Stock Information Description: Jiangxi Copper Company Limited (Jiangxi) is China's largest copper producer with business activities mainly in the PRC and headquarters in Jiangxi Province. Its ADR shares are listed in New York (JIXAY), and its ordinary shares on the main stock exchanges in Hong Kong and Shanghai. Jiangxi Copper Corp, a Chinese SOE, owns 4.4% of Jiangxi. Jiangxi and its subsidiaries are engaged in copper mining, smelting, refining, and manufacturing, with byproduct output from copper smelting of precious metals and sulphur. It also produces rare earth metals and chemical products. Ticker: 358 HK Shares Issued (m): 3,463 Market Cap (USDm): 7,227 3-mth AvgDaily Turnover (USDm): 29.1 HSI: 23,371.5 Free Float (%): 59.6 Major Shareholders: % Blackrock 6.8 JP Morgan 4.6 Vanguard 2.9 Franklin Resources 2.5 Key Indicators (June 3, 213) ROE annualised (%) 6. Net debt (Rmbm): 2,593 NTA/shr (HKD): 5.74 Interest cover (x): 3.4 Historical Chart Sep 12 Nov 12 Jan 13 Mar 13 May 13 Jul 13 Sep 13 PRICE Performance: 52-week High/Low 21.95/11.52 PRICE REL. TO HANG SENG INDEX Source: Bloomberg 1-mth 3-mth 6-mth 1-yr YTD Absolute (%) 14.4 (.5) (18.1) (11.8) (26.1) Relative (%) (14.3) (21.5) (21.9) Jiangxi Copper Ride The Copper Price One Last Time We initiate coverage of Jiangxi with a BUY rating based on our forecast recovery in the copper price over the next six months on improving global demand growth and rising Chinese imports. We forecast EPS to improve from the trough in 1H13 on rising copper prices and metals sales volumes through mid-214 with full-year 214 EPS up 19% YoY. We see this as a trading call given our forecast copper price peak in mid-214 after which supply overtakes demand. The near-term earnings trend to remain weak, which could later provide an even more attractive entry point. Jiangxi s 1H13 earnings were weak, down 49% YoY due to lower metals prices and higher raw material costs. The company has warned to expect more of the same in its nine-month results due next month. While our 213 EPS is below consensus, our 2H13 EPS estimate is up from the 1H13 trough. Our 214 EPS estimate is in line with consensus, while 215 is below. Improving financial flexibility on healthy cash flows and low/negative net debt. Rising cash flows are forecast to drive the company to a net cash position during mid-214, which should allow for increasing capex to pursue growth initiatives. Jiangxi has a couple of overseas copper projects (Peru and Afghanistan). When more details are provided, we will incorporate them into our model. Our valuation methodology utilises DCF, to which we apply a premium based on our forecast peak in the copper price above our long-term assumption. Our target price of HKD2/sh is based on a 25% premium to our DCF value of HKD16/sh, reflecting a mid-214 LME copper price peak of USD8,157/t (USD3.8/lb) compared to our longterm forecast of USD5,842/t (USD2.65/lb). The EPS run rate at our peak copper price is CNY1.22 vs. our 214 estimate of CNY.98. Using the current PER of 13x, the peak EPS equals our target of HKD2. Jiangxi Copper Summary Earnings Table FYE Dec (CNYm) 212A 213A 214F 215F Revenue 158,6 18,389 19,47 165,965 EBITDA 6,924 5,157 5,821 5,249 Recurring Net Profit 5,17 2,861 3,42 2,991 Recurring Basic EPS (CNY) EPS growth (%) (21.5) (44.7) 18.9 (12.1) DPS (CNY) PER (x) 8.8x 15.6x 13.x 14.5x EV/EBITDA (x) 6.9x 9.x 7.3x 6.8x Div Yield (%) P/BV (x) 1.1x 1.x.9x.9x Net Gearing (%) Net cash Net cash ROE (%) ROA (%) Consensus EPS (CNY) Source: Jiangxi Copper, Bloomberg Consensus, Maybank Kim Eng SEE APPENDIX I FOR IMPORTANT DISCLOSURES AND ANALYST CERTIFICATIONS

43 Jiangxi Copper Company Limited How do we justify our view? Our BUY rating is predicated on a recovery in the copper price during the seasonally strong periods of 2Q and 3Q of 214. Jiangxi s share price is highly correlated with the price, as shown in the graph below. Depicted is our monthly copper price forecast through end-214 and the expected trend in the share price to our HKD2 target. The share price has underperformed vs. the copper price since earlier this year, reflecting cautious market sentiment on global growth (copper price expected to fall rather than share price rise). We discussed the copper market in detail earlier in this report and how the growth rate in Chinese apparent copper consumption has exceeded our expectation. The risk to our call is that China effectively re-stocks during 2H13 and borrows demand growth from our estimate for 214. However, we see the copper price moving more on headline macro growth fundamentals, which we see as increasingly positive, while US monetary policy remains accommodative. Figure 84: Jiangxi Copper share price and LME copper price highly correlated Jiangxi s share price is highly correlated with the copper price. We see room for the share price to increase to catch up with the current and forecast higher copper price. HKD/sh Share price (LHS) LME copper price (RHS) Estimate Jan-2 Jun-2 Dec-2 May-3 Nov-3 Apr-4 Oct-4 Mar-5 Sep-5 Feb-6 Aug-6 Jan-7 Jul-7 Dec-7 Jun-8 Nov-8 May-9 Oct-9 Apr-1 Oct-1 Mar-11 Sep-11 Feb-12 Aug-12 Jan-13 Jul-13 Dec-13 Jun-14 Nov-14 USD/t 14, 12, 1, 8, 6, 4, 2, - Source: Bloomberg, Maybank Kim Eng estimates Our longer-term forecast of LME and Shanghai copper prices is illustrated in the graph below. The copper price in Shanghai (ex-vat) increased relative to the LME price during 211, reflecting strong demand growth in China relative to that outside the country. We look for the gap to slightly narrow starting in 215 as demand growth in China slows on a relative basis. Figure 85: Copper price history and forecast LME vs Shanghai (ex. 17% VAT) USD/t LME copper price Shanghai copper price (excl. 17% VAT) 1, 9, 8,744 8, 7, 6, 5, 6,776 5,941 5,213 7,435 6,441 7,551 7,776 7,468 7,81 6,81 6,315 6,595 6,735 5,7 4, 4,412 3, E 214E 215E Source: Jiangxi Copper, Maybank Kim Eng estimates Profit outlook forecast to improve on higher prices and sales volumes. Our forecast 19% YoY increase in 214 profits (CNY3.4b vs. CNY2.86b) is based on a 5% increase in the Shanghai copper price, 3% higher sales volumes and lower costs. Jiangxi mentioned in its interim results not only lower metals prices but 25 September 213 Page 43 of 7

44 Jiangxi Copper Company Limited also higher input costs. We believe this reflects the tightness in the supply of copper units (concentrate and scrap) during the early part of the year due to disruptions of copper mines and from tight scrap availability. We look for the supply of the materials that Jiangxi feeds into its smelters (copper scrap and concentrate) to improve during 214. We also look for tolling and refining rates to improve as the tightness in the copper concentrate market eases. Like most of China s copper smelters, Jiangxi is long smelting, requiring that it purchase copper units in much greater quantities than it self-supplies from its own mines (copper concentrate). This is shown in the graph below where copper cathode production from its smelters exceeds the copper concentrate production from its mines. Copper smelting offers lower but more stable returns than that from copper mining. Despite being long smelting capacity, Jiangxi s earnings are mainly driven by the copper price and to a lesser extent the byproduct gold, other metals, and sulfur credits produced from the smelting of copper. Jiangxi is also China s largest copper concentrate producer, though other Chinese companies with overseas growth projects are catching up (Chinalco Mining, 3668 HK, HKD1.11, Not Rated). Figure 86: ROE and net profit and coal volumes We look for net profit to increase during 214 on higher metals prices and sales volumes, as well as lower input costs of copper units. Production, ' t 1,5 1,25 1, 11.7% 1.9% CNY 2.3bn 2.4bn 17.5% 5.bn Copper concentrate production Copper cathode production ROE 17.9% 6.6bn 12.6% 5.2bn 6.6% 7.4% 2.9bn 3.4bn ROE in %; Net Profit in CNY b % 3.bn E 214E 215E. Source: Jiangxi Copper, Maybank Kim Eng estimates Looking longer term, we forecast modest volume growth of about 3% per year in Jiangxi s copper smelting and mine production. A step-up to our assumptions would occur if the Galeno copper project were to come on-stream sometime during late 214 or 215. However, the project has repeatedly been pushed back and we refrain from adding it to our numbers until management provides more clarity on the volume and cost. The only mention of the project in the company s 212 annual report is the development plan for the mine is under demonstration. We take this to mean that the project is in the test phase of development with construction largely completed. The Galeno project is jointly controlled 4% share each with China Minmetals Non-ferrous Metals Company Limited through the 1% equity interest in Northern Peru Copper Corp. The value of the investment is shown in Jiangxi s annual report at CNY3.25b (USD533m). Free cash flow has been consistently positive reflecting the favourable copper price the past few years. We look for free cash flow to remain stable in 214 and improve in 215, mainly as working capital turns positive to CNY2.4b vs. a negative CNY1.b during 214. This reflects our forecast decrease in copper prices during 215, which will result in lower inventory valuation and sales values. As mentioned above, Jiangxi purchases large volumes of copper concentrate to feed its smelters, resulting in large swings in working capital related to movements in the copper price. We have left our capex forecast stable with prior periods at CNY2.b (USD33m). 25 September 213 Page 44 of 7

45 Jiangxi Copper Company Limited Figure 87: Free cash flow outlook Cash flow generation has been healthy and stable since 211 despite continual buildup of working capital. As metals prices decrease in 215, we look for cash flows to improve as the working capital requirement decreases despite lower profitability. CNY b (5) (1) (15) OCF excl. chg. WC CAPEX Working Capital (WC) Dividends Free Cash Flow E 214E 215E Source: Jiangxi Copper, Maybank Kim Eng estimates Valuation Our valuation methodology utilizes DCF, to which we apply a premium based on our forecast peak in the copper price above our long-term assumption. Our target price of HKD2/sh is based on a 25% premium to our DCF value of HKD16/sh, reflecting a mid-214 LME copper price peak of USD8,157/t (USD3.8/lb) compared to our long-term forecast of USD5,842/t (USD2.65/lb). Our DCF assumptions include a WACC of 11.25% and long-term growth rate of 4.25%, a bit higher than we normally use to make up for the lack of our forecasts including Jiangxi s overseas growth projects. The EPS run rate at our peak copper price would be about CNY1.22 vs. our 214 estimate of CNY.98. Using the current PER of 13x, the peak EPS would equal our target of HKD2. We illustrate in the graph below Jiangxi s one-year forward rolling PBR and ROE. Based on our 214 estimates, the shares are currently trading equal to book value and at an ROE of 7.2% rolling towards our 214 full-year estimate of 7.4%. The ROE high of 37% in 26 was due to the impact on net profit of a doubling in the copper price YoY to USD3.2/lb while book value was quite low. Our target price of HKD2/sh represents a PBR of 1.1x, compared to the current 1.x the book value of HKD17.5/sh we forecast for year-end 214. Figure 88: Jiangxi Copper ROE and PBR chart ROE 5% ROE (LHS) PBR (RHS) PBV 5.x Jiangxi s shares are trading at the book value of its assets. Our target price assumes this will increase to 1.1x. 4% 3% 2% 1% % Jan Jun Nov Apr 1 Sep 1 Feb 2 Jul 2 Dec 2 May 3 Oct 3 Mar 4 Aug 4 Jan 5 Jul 5 Dec 5 May 6 Oct 6 Mar 7 Aug 7 Jan 8 Jun 8 Nov 8 Apr 9 Sep 9 Feb 1 Jul 1 Dec 1 May 11 Oct 11 Mar 12 Aug 12 Feb 13 Jul 13 4.x 3.x 2.x 1.x.x Source: Bloomberg, Jiangxi Copper, Maybank Kim Eng estimates 25 September 213 Page 45 of 7

46 Jiangxi Copper Company Limited Jiangxi s PBR (one-year forward rolling average) is close to the average for the period post the 28 peak, and well above the trough of.4x in Aug 28. We forecast the company s net profit in 213 to be about 24% higher than in 28 and 29, but our ROE estimate is 6.6%, which is well below the 11.7% in 28 and 1.9% in 29. Either the market is fixated on the level of earnings rather than that relative to the book value, or the stock price is overreaching. We continue to believe that the copper price drives the share price, but are mindful that the shares will be vulnerable to a sharp correction once copper prices peak. The PBR has recovered vs. the GFC low but the ROE was higher in 28 and 29 than in 213F. We take this to mean either the market is fixated on PER or the shares will be vulnerable to a sharp correction once copper prices peak. Figure 89: Jiangxi Copper PBR bands Price HKD Jan- Oct- Jul-1 Apr-2 Jan-3 Oct-3 Jul-4 Apr-5 Jan-6 Oct-6 Jul-7 Apr-8 Jan-9 Oct-9 Jul-1 Apr-11 Jan-12 Oct-12 Jul x Avg+2SD 2.x Avg+1SD 1.5x Avg.9x Avg-1SD.4x Avg-2SD Source: Bloomberg, Jiangxi Copper, Maybank Kim Eng estimates What is priced into the shares? In the table below, we have provided a sensitivity analysis with various copper price scenarios and the impact on Jiangxi s EPS, ROE, EBITDA and hypothetical share price at various PERs. Based on our estimates, the share price appears to be already factoring in a copper price of USD3.5/lb, which is higher than the current market price of USD3.35/lb. In the course of a few weeks from early September, the market has gone from factoring in the current copper price at that time of about USD3.25/lb to factoring in the higher than current price of USD3.5/lb. This tells us that it will take a higher copper price of USD3.8/lb for the shares to move to our target price. In addition, as the copper price moves higher than USD3.8/lb, the market will increasingly anticipate the peak in EPS based on even higher copper prices and apply a lower PER. Our table factors this in as best as we can estimate for both the upside (PER compression) and the downside in EPS at lower copper price (PER expansion). We note that Jiangxi s cost structure appears to have moved materially higher from as recently as 211, given the higher copper price necessary to generate a similar earnings level based on our estimates. We noted this in our discussion of ROE vs. prior periods as well. This also indicates that the stock will face a hard correction after copper prices peak unless management can restore the level of earnings relative to the copper price from a few years ago. 25 September 213 Page 46 of 7

47 Jiangxi Copper Company Limited Figure 9: Jiangxi Copper 214 earnings sensitivity to changes in copper price Copper (USD/lb) EPS (Rmb/sh) ROE (%) EBITDA (bn) Shpr (HKD) PER 2.6 (.28) (2.2) N/A Source: Jiangxi Copper, Maybank Kim Eng estimates Earnings revisions Consensus earnings for 213 and 214 have been in a continuous downward trend, particularly after the company s disappointing 213 interim profit report. The share price is anticipating that EPS has troughed and will recover on higher copper prices along the lines of what we discussed in the previous section. Our 213 EPS forecast of CNY.83/sh is below the consensus of CNY.9/sh, in line for 214 at CNY.98/sh vs. consensus CNY.99/sh. Figure 91: Consensus forecasts for Jiangxi s earnings in 213 and 214 HKD Share Price (LHS) Consensus EPS adjusted 213 (RHS) Consensus EPS adjusted 214 (RHS) CNY Jan 11 Mar 11 May 11 Jul 11 Sep 11 Nov 11 Jan 12 Mar 12 May 12 Jul 12 Sep 12 Nov 12 Jan 13 Mar 13 May 13 Jul 13 Sep 13 Source: Bloomberg consensus 25 September 213 Page 47 of 7

48 Jiangxi Copper Company Limited Global metals company valuation graphs Figure 92: Global metals company market capitalisation (USDm) 2, 18, 16, 14, 12, 1, 8, 6, 4, 2, In this section we provide graphs of global metals companies for comparison to those in China (Jiangxi and Chalco). 95,95 83,122 72,28 34,87 35, ,235 1,33 1,3331,3361,355 2,433 2,741 2,782 3,26 3,317 3,197 3,366 4,448 4,876 5,658 9,145 8,33 9,432 13,338 15,856 23,927 35,153 3,56 4,598 4,765,137 7,96 8,486 8,479 8,8678,98 12,149 13,437 18, ,192 Source: Bloomberg consensus Figure 93: Global metals company EV/EBITDA (x) 214 Figure 94: Global metals company PBR (x) 214 Sesa Goa China Vanadium Titano African Minerals Hongqiao Sterlite Inds. Vedanta Energy Resource Australia Vale (Brazil) Freeport McMoRan Anglo American Antofagasta Rio Tinto Paladin Energy Pan Aust Korea Zinc Barrick Gold Teck Resources Buenaventura PT Inco BHP Billiton Minmetal Alcoa Nickel Asia Aneka Tambang Hindalco Glencore Xstrata Fortescue Metals Cliffs Natural Res. Norsk Hydro Lynas Iluka Philex Lonmin Jiangxi Copper Molycorp Zhaojin Mining Zijin Mining Lingbao Gold Anglo American Platinum Newcrest Mining United Co Rusal China Molybdenum Mitsubishi Chalco Source: Bloomberg consensus Haranga United Co Rusal Sterlite Inds. China Vanadium Titano Lingbao Gold Hindalco Paladin Energy Cliffs Natural Res. Minmetal Hongqiao Alcoa Sesa Goa Mitsubishi African Minerals Glencore Xstrata Norsk Hydro Buenaventura Chalco Energy Resource Australia Anglo American Lonmin Alumina Teck Resources Vale (Brazil) Jiangxi Copper China Molybdenum Molycorp Aneka Tambang Vedanta Zijin Mining Barrick Gold Lynas Pan Aust Korea Zinc PT Inco Nickel Asia Philex Freeport McMoRan Zhaojin Mining Norilsk Nickel Antofagasta Anglo American Platinum Newcrest Mining Rio Tinto Iluka BHP Billiton Fortescue Metals Source: Bloomberg consensus September 213 Page 48 of 7

49 Jiangxi Copper Company Limited Figure 95: Global metals company ROE (%) 214 Figure 96: Global metals company dividend yield (%) 214 Energy Resource Australia Chalco Haranga Lingbao Gold Alumina Molycorp Norsk Hydro Alcoa Cliffs Natural Res. Lonmin United Co Rusal Newcrest Mining Teck Resources Hindalco Jiangxi Copper Anglo American Anglo American Platinum Paladin Energy Buenaventura Nalco Zijin Mining PT Inco Aneka Tambang Mitsubishi China Molybdenum Glencore Xstrata Pan Aust China Vanadium Titano Philex Minmetal Zhaojin Mining Sterlite Inds. Barrick Gold Antofagasta Vedanta Korea Zinc Vale (Brazil) Sesa Goa Freeport McMoRan Nickel Asia Iluka Lynas BHP Billiton African Minerals Rio Tinto Norilsk Nickel Hongqiao Fortescue Metals (2) (1) Minmetal Chalco Energy Resource Australia United Co Rusal Lingbao Gold African Minerals Paladin Energy Lonmin Lynas Newcrest Mining Anglo American Platinum Hindalco Sesa Goa Alcoa Barrick Gold Korea Zinc Philex Alumina Zhaojin Mining Jiangxi Copper Antofagasta Aneka Tambang Cliffs Natural Res. Sterlite Inds. Hindustan Zinc Buenaventura Zijin Mining PT Inco Teck Resources Pan Aust Glencore Xstrata Mitsubishi Norsk Hydro Rio Tinto Nalco Anglo American Vedanta Freeport McMoRan BHP Billiton China Molybdenum Iluka China Vanadium Titano Fortescue Metals Vale (Brazil) Nickel Asia Hongqiao Norilsk Nickel Source: Bloomberg consensus Source: Bloomberg consensus 25 September 213 Page 49 of 7

50 Jiangxi Copper Company Limited INCOME STATEMENT BALANCE SHEET FYE Dec (CNYm) 212A 213A 214F 215F FYE Dec (CNYm) 212A 213A 214F 215F Revenue 158,6 18,389 19,47 165,965 Cash & equivalents 16,678 16,436 17,893 22,2 COGS (149,28) (173,326) (182,325) (159,56) Time and restricted deposits 3,631 6,5 6,5 6,5 Gross Profit 8,726 7,63 7,722 6,99 Inventories 15,936 12,999 13,674 11,929 SG&A (1,82) (1,96) (1,9) (1,66) Accounts receivable 14,156 2,294 21,38 18,671 EBITDA 6,924 5,157 5,821 5,249 Other 2,53 2,65 2,65 2,65 DD&A (1,29) (1,372) (1,42) (1,436) Total current assets 52,456 58,879 62,98 61,95 Operating profit (EBIT) 5,634 3,785 4,419 3,813 PPE 19,934 2,65 21,243 21,847 Other income (loss) Intangible assets Net financing cost (832) (95) (82) (733) Other non-current assets 4,881 4,913 3,779 3,779 Associates 9 7 (4) (4) Total non-current assets 25,632 26,318 25,822 26,426 Other gains (losses) Total Assets 78,88 85,197 87,92 88,377 Pre-tax profit 6,273 3,53 4,295 3,777 S. term borrowings & current 12,417 14, 14, 14, Income tax (1,26) (77) (859) (755) Accounts and bills payable 11,647 15,599 16,49 14,315 Minority interests (78) 38 (34) (3) Other current liabilities 3,173 5,15 5,15 5,15 Net Profit 5,17 2,861 3,42 2,991 Total current liabilities 27,238 34,749 35,559 33,465 EPS Long term borrowings 6,299 4,15 2,4 65 Div/sh Other non-current liabilities ,473 3,355 Avg. shares out. 3,463 3,463 3,463 3,463 Total non-current liabilities 6,988 5,14 3,873 4,5 Total liabilities 34,226 39,763 39,432 37,47 Minority interests 1,88 1,1 1,1 1,1 Share capital 3,463 3,463 3,463 3,463 Reserves (incl. ret. earnings) 39,312 4,871 43,925 46,344 Shareholders' Equity 42,775 44,334 47,388 49,87 Revenue Growth % (12.7) Total Liabilities & Sh. Equity 78,88 85,197 87,92 88,377 EBITDA Growth (%) (2.) (25.5) 12.9 (9.8) EBIT Growth (%) (24.5) (32.8) 16.8 (13.7) Gross Debt/(Cash) 18,716 18,15 16,4 14,65 Net Profit Growth (%) (21.5) (44.7) 18.9 (12.1) Net Debt/(Cash) 2,38 1,714 (1,493) (7,55) Tax Rate % Working Capital 25,218 24,13 26,539 28,485 CASH FLOW RATES & RATIOS FYE Dec (CNYm) 212A 213A 214F 215F FYE Dec 212A 213A 214F 215F Profit before taxation 6,273 3,53 4,295 3,777 EBITDA Margin % Depreciation 1,29 1,372 1,42 1,436 Op. Profit Margin % Working capital change (1,29) 752 (952) 2,36 Net Profit Margin % Cash tax paid (1,229) (77) (859) (755) ROE % Others (incl. int. paid) 271 (19) ROA % Cash flow from operations 5,316 4,838 3,887 6,818 Dividend Cover (x) Capex (2,154) (2,) (2,) (2,) Interest Cover (x) Disposal/(purchase) (2,158) (825) Asset Turnover (x) Others 3,613 (2,343) Asset / Equity (x) Cash flow from investing (7) (5,167) (2,) (2,) Asset/Debt (x) Debt raised/(repaid) 3,52 1,315 Receivables Turn (days) Equity raised/(repaid) Payables Turn (days) Dividends (paid) (1,731) (1,731) (429) (51) Inventory Turn (days) Others (incl. int. paid) (253) 59 Net Gearing % N.A. N.A. Cash flow from financing 1,67 93 (429) (51) Gross Debt/ EBITDA (x) Change in cash 5,684 (237) 1,458 4,37 Gross Debt/ Market Cap (x) PER SHARE DATA FYE Dec (CNY) 212A 213A 214F 215F EPS EBITDA/share DPS Oper. CFPS Free CFPS BVPS Source: Jiangxi Copper, Maybank Kim Eng 25 September 213 Page 5 of 7

51 Hong Kong Initiating Coverage 25 September 213 Buy Share price: Target price: HKD2.79 HKD3.5 Alexander LATZER (852) Stock Information Description: Aluminum Corporation of China Limited (Chalco) is the largest producer of aluminum in China. The company is owned 42% by Chinalco, an SOE, and is headquartered in Beijing, with business activities mainly in the PRC. Its ADR shares are listed in New York (ACH), and its ordinary shares on the main stock exchanges in Hong Kong and Shanghai. The company and its subsidiaries are engaged mainly in the aluminum industry with growing businesses in materials trading and energy. Ticker: 26 HK Shares Issued (m): 13,524 Market Cap (USDm): 4,838 3-mth AvgDaily Turnover (USDm): 6.1 HSI: 23,371.5 Free Float (%): 55.3 Major Shareholders: % Franklin Resources 31.4 J.P. Morgan 4.7 Blackrock 3.5 Vanguard 3. Key Indicators (June 3, 213) ROE annualised (%) (4.) Net debt (Rmbm): 11,875 NTA/shr (HKD): 9.32 Interest cover (x): (.3) Historical Chart Sep 12 Nov 12 Jan 13 Mar 13 May 13 Jul 13 Sep 13 PRICE Performance: 52-week High/Low 4.21/2.2 PRICE REL. TO HANG SENG INDEX Source: Bloomberg 1-mth 3-mth 6-mth 1-yr YTD Absolute (%) 5.7 (17.1) (2.9) (15.) (26.5) Relative (%) 6.8 (13.7) (17.) (24.7) (22.3) Chalco Speculative Buy On Aluminum Price Rise We initiate coverage of Chalco with a BUY rating, reflecting our view that the shares represent a low cost option on higher aluminum prices. We forecast a modest recovery in prices next year on the positive impact on market sentiment of Indonesia s restrictions on bauxite exports from 214, and as rising raw materials costs result in slowing aluminum supply growth from later in the year in China. Management is making progress in improving the business. Aluminum costs fell 6% YoY in 1H13 and we look for further improvement as the aluminum business is resized to more profitable facilities. The company is also increasing self-owned energy and bauxite supplies (imported ores account for only 25% of Chalco s total), and is constructing an alumina refinery with its JV partner in Indonesia. Despite the improvements, the company will continue to face challenges even with higher forecast prices and lower costs. We forecast losses to decrease from CNY.36/sh in 213F (excl. gains) to CNY.23/sh in 214F. Borrowing will continue to be necessary to fund the business, assuming capex is largely flat with 213. Our aluminum price forecast is below consensus (though the rating is non-consensus). As an SOE, Chalco does not have the same bankruptcy risk as a private company. Nonetheless, the nature of this call makes it a Speculative Buy, suitable for only certain investors. The main risks are continued strong aluminum supply growth in China causing prices to remain low, and increasing funding costs given Chalco s high gearing. Our target price of HKD3.5/sh is based on a DCF valuation (WACC 12.3% and LT growth 2.75%) with 217 our terminal year, and an LME aluminum price of USD.95/lb (USD2,94/t). Our target price implies a PBR of 1.x and EV/EBITDA of 1.x our 213 estimates vs..8x and 8.1x currently. Chalco s earnings are sensitive to changes in metals prices. Each USD.1/lb change in aluminum (USD1/t change in alumina) impacts EPS by CNY.27/sh (CNY.32/sh). Chalco Summary Earnings Table FYE Dec (CNYm) 212A 213F 214F 215F Revenue 149, ,4 145, ,657 EBITDA 825 1,235 16,218 21,7 Recurring Net Profit (8,247) (4,865) (3,93) (1,285) Recurring Basic EPS (CNY) (.61) (.36) (.23) (.1) EPS growth (%) N.A. N.A. N.A. N.A. DPS (CNY) PER (x) N.A. N.A. N.A. N.A. EV/EBITDA (x) 151.x 14.4x 9.4x 7.3x Div Yield (%) P/BV (x).7x.7x.8x.8x Net Gearing (%) ROE (%) (17.2) (11.5) (7.9) (3.5) ROA (%) (5.) (2.6) (1.5) (.6) Consensus EPS (CNY) N.A. (.27) (.19) (.9) Source: Chalco, Bloomberg Consensus, Maybank Kim Eng SEE APPENDIX I FOR IMPORTANT DISCLOSURES AND ANALYST CERTIFICATIONS

52 Aluminum Corporation of China Limited How do we justify our view? Chalco is making progress in adding more self-owned energy, bauxite, and alumina supply both in China and in Indonesia. It is also building up its two new business units in Energy and Trading to provide a more stable earnings base. It has also sold its aluminum fabrication business. Our forecasts do not include the Simandou iron ore JV in Guinea with Rio Tinto which has been delayed to 218. We see Chalco shares as a low cost option on higher aluminum prices. We forecast a modest recovery in prices next year on the positive impact on market sentiment of Indonesia s restrictions on bauxite exports from 214, and as rising raw materials costs result in slowing aluminum supply growth later in the year in China. We see this as a Speculative Buy recommendation based on the market impact of the changes to export policy in Indonesia. Chalco is also making progress on addressing competitive weaknesses and to restore profitability medium-term. The impact of its initiatives will take time and as such, we are not long-term buyers of the stock given the challenges and in light of its stretched balance sheet. We will assess its progress as they develop but are keeping our expectations low evident in our earnings projections. Chalco is making progress to address competitive weaknesses in energy, selfowned bauxite supply, and in the productivity of its plants. We forecast further improvement in productivity based on a resizing of its aluminum production facilities. Management has indicated that loss making plants will be suspended, merged, or the work transferred. We forecast a 5% decrease in aluminum unit operating costs in 213 and a 3% decrease in 214 YoY. The company is also increasing its energy exposure through purchasing coal and power plants. In January of this year Chalco purchased a 7.82% equity interest Ningxia Energy with 2.38 billion tonnes of coal and other power assets and is targeting further improvement in self-generated energy requirement from 21% now by 215. With respect to bauxite, the company has and continues to expand its self-owned supply, which is currently 5%. The sources of its bauxite and our forecast are shown in the graph below. During 212, self-owned bauxite production was 17.3mt, up from 13mt in 21, and should account for 5% of its total requirement by year-end 213 on a run rate basis. We forecast the run rate of self-supply to increase to 65% at the end of 214 and 72% at the end of 215. The company is also diversifying its import sources, but given its increasing alumina capacity both domestic and in Indonesia, we anticipate its total bauxite requirement will decrease. Chalco s exposure to imported bauxite is only 25%, and we forecast it to reach 14% by year-end 214. Figure 97: Chalco's sources of bauxite supply (%) 1. Self mined Domestic purchases Imports Chalco s exposure to imported bauxite is only 25% and we forecast it to reach 14% by year-end 214, and lower thereafter E 214E 215E Source: Chalco, Maybank Kim Eng estimates 25 September 213 Page 52 of 7

53 Aluminum Corporation of China Limited The push to develop bauxite and alumina capacity has taken on a new urgency with the situation in Indonesia. Chalco disclosed that new taxes on bauxite exports imposed by the Indonesian government caused its cost of alumina in212 to increase by approximately 4% YoY. The table below provides the sources of Chalco s bauxite and the costs during the interim periods of 213, 212 and 211. Bauxite costs have increased about 1% on average per year (see table below). Figure 98: Cost of bauxite (CNY/t) 1H'13 1H'12 213/12% chg. 1H'11 212/11% chg. Self-operated mines Domestic purchased Imports Blended average Blended avg. (USD/t) Source: Chalco A new JV in bauxite, and one in an alumina refinery in Indonesia by the end of 214 to address supply constraints and rising costs brought on by new export policies. In April this year Chalco acquired a 7% equity interest in PTNP, a company incorporated in Indonesia, which holds several bauxite exploration and development permits at a total cost of CNY32.5m (USD5.25m). The company is also collaborating with an Indonesian company in controlling bauxite resources and accelerated the development of mines and is targeting annual production capacity of 1.8mt. Chalco is also accelerating the construction of a JV alumina refinery in West Kalimantan, Indonesia, which should be completed by the end of 215. Total capacity is estimated at about 2mt per annum and we are awaiting further updates once construction begins. Chalco s alumina cost increased about 1% during 212 due to higher bauxite and consumables costs, but is expected to decrease 5% in 213 due to lower energy and consumables costs. During 1H13, Chalco s cash alumina cost was CNY2,173/t (USD353/t) according to the company. Figure 99: China alumina price and Chalco's alumina cost Source: Chalco, Maybank Kim Eng estimates Chalco has made progress in lowering its cost of aluminum thanks to lower energy prices during 213. During 1H13, its aluminum cash cost was CNY13,143/t (USD2,137/t), approximately 6% lower YoY. For the year as a whole, we forecast a 5% YoY decrease and a further 3% YoY decrease in 215. The graph below compares the pricing trend in China for aluminum, which fell below Chalco s costs and led to large losses in its aluminum division in 212 and 213. We look for a combination of higher selling prices and lower costs to gradually return the business to breakeven longer term. 25 September 213 Page 53 of 7

54 Aluminum Corporation of China Limited Figure 1: China s aluminum price and Chalco's aluminum cost USD/t 2,4 Total aluminum unit cost Shanghai aluminum price (excl. 17% VAT) 2,2 2, 1,8 1, E 214E 215E Source: Chalco, Maybank Kim Eng estimates Financials: Outlook for profitability and cash flows to improve Stemming the losses in the aluminum business will take time, but we think the worst from 212 is in the past. We look for Chalco s profitability to improve the next few years from the trough in 212 due to higher selling prices and lower operating costs. Our projections for profits, ROE, and sales volumes are all in the graph below. Our profit forecasts deduct non-recurring items, such as the CNY1.741b gain during 1H13. While improvement is evident the net profit remains in the red. Non-cash charges, mainly DD&A, remain high so EBITDA is actually relatively strong. We have forecast lower volumes of alumina and aluminum, reflecting management s comments that it will rationalise the businesses to improve profitability. The projections are our own and could be subject to change when more details of the plan are disclosed. Figure 11: ROE and net profit and aluminium/alumina volumes We have forecast lower metals sales volumes and lower costs reflecting management targets to rationalise the businesses to improve profitability. Alumina and aluminum sales, mt (.19bn) (.3%) (4.41bn) (8.4%) Alumina sales ROE (RHS) 1.4%.71bn (.44bn) (.8%) (8.25bn) (17.2%) Aluminum sales Net profit (RHS) (4.86bn) (11.5%) (3.9bn) (7.9%) (1.29bn) (3.5%) E 214E 215E ROE in %; Net Profit in CNY b 5.. (5.) (1.) (15.) (2.) Source: Chalco, Maybank Kim Eng estimates The graph below details the improvements by business segment with the largest changes simply reducing the losses in aluminum and alumna, which we think can be accomplished by closing underperforming facilities. Business segment data prior to 21 may be misleading when compared to more recent periods because of the changes in the businesses and changes in financial reporting. 25 September 213 Page 54 of 7

55 Aluminum Corporation of China Limited Figure 12: Operating profit by business segment CNY b Aluminum Alumina Fabricated Products Energy Trading 4, We forecast business segment profits to improve as losses in aluminum and alumina decrease and contributions from new businesses increase. 2, - (2,) (4,) (6,) (8,) (1,) E 214E 215E 216E Source: Chalco, Maybank Kim Eng estimates Free cash flow is forecast to steadily improve the next few years on improving profitability (operating cash flows), and slightly lower capex. Free cash flow has been on a negative trend since 21 due to falling profitability and volatile swings in working capital. During 1H13, the draw in working capital was a net negative CNY6.3b, mainly due to a negative CNY4.3b in accounts receivable and a negative CNY9.7b in other assets, partially offset by a positive CNY6.6b in accounts payable. We have assumed a net negative CNY6.6b for the full-year 213. Figure 13: Free cash flow outlook Weak operating profits and negative working capital have led to deteriorating free cash flow. We forecast these measures to turn more favourable ahead. CNY b (5) (1) (15) (2) OCF excl. chg. WC CAPEX Working Capital (WC) Dividends Free Cash Flow E 214E 215E 216E Source: Chalco, Maybank Kim Eng estimates 25 September 213 Page 55 of 7

56 Aluminum Corporation of China Limited Valuation Our target price of HKD3.5/sh is based on a DCF valuation, assuming a WACC of 12.3%, long-term growth rate of 2.75% and 217 as our terminal year in which we forecast an LME aluminum price of USD.95/lb (USD2,94/t). Our target price implies a PBR of 1.x and EV/EBITDA of 1.x our 213 estimates vs..8x and 8.1x currently. The PBR ratio has fallen in line with the ROE and is at the GFC low of.8x. The losses have also returned to the GFC low but improved from the blowout loss during 212. The ROE is much lower (more negative) because the book value has decreased after the period of net losses forecast at a negative 11.5% vs. negative 8.4% during 29. We note that the valuation has remained stable at about.8-1.x since late 211 despite the significant losses over the following period. We believe the valuation fully reflects the negative sentiment and the poor earnings performance. Hence, we see some upside potential in the valuation back to book value on positive news, which we expect as a result of the changes we have forecast. Figure 14: Chalco PBR bands Price HKD 25 The PBR valuation has been stable at.8-1.x since late 211 despite the losses over the ensuing period indicating that the negative factors are now factored into the shares Jan-2 Jul-2 Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Jan-8 Jul-8 Jan-9 Jul-9 Jan-1 Jul-1 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13.8x Avg-1SD Source: Bloomberg, Chalco, Maybank Kim Eng estimates Figure 15: Chalco ROE and P/BVPS chart We look for ROE trend to improve and the PBR to follow on a lag basis. ROE ROE (LHS) PBR (RHS) 4% 32% 24% 16% 8% % -8% -16% -24% PBV 8.x 7.x 6.x 5.x 4.x 3.x 2.x 1.x.x Jan 2 Oct 2 Jul 3 Apr 4 Jan 5 Nov 5 Aug 6 May 7 Feb 8 Nov 8 Sep 9 Jun 1 Mar 11 Dec 11 Sep 12 Jul 13 Source: Bloomberg, Chalco, Maybank Kim Eng estimates The PBR and ROE trends are shown in the graph above on a one-year forward rolling basis. Our one-year forward forecast of ROE calls for it to improve from a negative 11.5% in 213 (-17.2% in 212) to a negative 7.9% in 214. This is shown in the graph where the line is moving higher while the current PBR trend remains lower. 25 September 213 Page 56 of 7

57 Aluminum Corporation of China Limited What is priced into the shares? The table below illustrates Chalco s earnings sensitivity to changes in the aluminum price and indirectly the alumina price since our model links that latter to the former at a ratio of 17.5% in 214. We also provide an estimate of the share price but have used book value since PER is not relevant due to the negative EPS. We have assumed the PBR remains at 1.x though the shares should trade at a PBR discount at lower aluminum prices and a premium at higher prices which we conclude it does. Our estimate is shown bolded in the table. The table indicates that the current share price is factoring in an aluminum price of between USD.65-7/lb, which appears low compared to the current market price of USD.8/lb. Looking at it another way, if we assume the market is using the current aluminum price of USD.8/lb, then the shares are trading at a 15% discount to book value of HKD3.25/sh. If using the consensus forecast of USD.92/lb, then the market is applying a 25% discount to book value. We believe the market is factoring in an aluminum price of USD.85/lb, which is halfway between the current market price of USD.8/lb and the 214 consensus. Our view is that the market usually factors a materials price somewhere in between the spot price and consensus. This would imply that the market is discounting the shares by 2% and using an aluminum price of about USD.85/lb, which is slightly below our forecast of USD.88/lb on average for 214. We believe that for the share price to achieve our target, the spot aluminum price needs to reach USD.95/lb, which we forecast to occur during late 214. Figure 16: Chalco 214 earnings sensitivity to change in aluminum price Aluminum (USD/lb) EPS (Rmb/sh) ROE (%) EBITDA (bn) Shpr (HKD)* BV (Rmb/sh).65 (.98) (38.5) (8.9) (.64) (23.9) (.48) (17.2) (.31) (1.9) (.23) (7.9) (.15) (4.9) Source: Maybank Kim Eng estimates. *Share price assumes shares trade at book value in HKD. We also have linked the alumina price to the aluminium price at a ratio of 17.5% for 214. So the EPS changes include the change shown in the aluminium price and the change in alumina price. Earnings revisions The trend in earnings revisions has been downwards on a steel trajectory for both the 213 and 214 consensus EPS estimates. More recently, consensus EPS has turned higher for 213 and 214. This is a positive indicator and the shares are a bit off the lows as well. We are maintain our cautious outlook on 214 EPS at a loss of CNY.23/sh vs. the consensus of CNY.19/sh, which is based on a higher aluminum price forecast than ours. We forecast the run rate of Chalco s earnings to materially improve during 2H14 to the consensus figure as profitability is impacted by our forecast higher market prices. 25 September 213 Page 57 of 7

58 Aluminum Corporation of China Limited Figure 17: Consensus forecasts for Chalco s earnings in 213 and 214 HKD Share Price (LHS) Consensus EPS adjusted 213 (RHS) Consensus EPS adjusted 214 (RHS) CNY (.2) (.4) (.6) Aug 1 Oct 1 Dec 1 Feb 11 Apr 11 Jun 11 Aug 11 Oct 11 Dec 11 Feb 12 Apr 12 Jun 12 Aug 12 Oct 12 Dec 12 Feb 13 Apr 13 Jun 13 Aug 13 Source: Bloomberg consensus 25 September 213 Page 58 of 7

59 Aluminum Corporation of China Limited INCOME STATEMENT BALANCE SHEET FYE Dec (CNYm) 212A 213A 214F 215F FYE Dec (CNYm) 212A 213A 214F 215F Revenue 149, ,4 145, ,657 Cash & equivalents 9,219 9,382 9,441 8,858 Cost of sales (143,493) (134,894) (133,222) (134,543) Time and restricted deposits 1, Gross profit 5,985 9,56 12,57 15,115 Inventories 25,596 25,293 24,979 25,227 Selling & dist. exp. (1,968) (1,727) (1,75) (1,796) Accounts receivable 2,616 7,329 7,333 7,482 General & admin. (2,993) (2,576) (2,624) (2,694) Other 1,456 2,234 19,983 2,181 EBITDA 1,24 5,23 8,197 1,625 Total current assets 49,16 62,78 62,28 62,291 DD&A (6,39) (6,71) (7,4) (7,14) PPE 96,248 11,77 13,87 14,87 Research & dev. (199) (17) (175) (18) Intangible assets 4,26 1,7 1,7 1,7 Operating profit (EBIT) (5,484) (1,669) 982 3,35 Other non-current assets 25,493 28,874 28,734 28,594 Net financial expense (4,599) (4,931) (5,562) (5,647) Total non-current assets 126,1 141,28 143,24 144,1 Other income Total Assets 175,17 24,6 25,52 26,391 Gains (losses) (45) 1,741 S. term borrowings & current 67,915 7, 7, 7, Associates Accounts and bills payable 7,59 13,489 13,322 13,454 Pre-tax income (9,92) (3,817) (3,83) (1,592) Other current liabilities 8,879 9,443 9,326 9,418 Income tax Total current liabilities 83,853 92,932 92,648 92,872 Profit from continuing ops. (8,644) (3,344) (3,256) (1,353) Long term borrowings 36,636 57,826 62,826 64,826 Profit from discontinued ops. 27 Other non-current liabilities 757 1,1 1,1 1,1 Minority interest (41) (174) (163) (68) Total non-current liabilities 37,392 58,926 63,926 65,926 Net to shareholders (8,234) (2,962) (3,93) (1,285) Total liabilities 121, , , ,798 Recurring net from cont. ops. (8,247) (4,865) (3,93) (1,285) Minority interests 9,963 11,287 11,124 11,56 Share capital 13,524 13,524 13,524 13,524 Revenue Growth % 2.5 (3.4) Reserves (incl. ret. earnings) 3,283 27,391 24,298 23,13 EBITDA Growth (%) (88.8) Shareholders' Equity 43,88 4,916 37,822 36,537 EBIT Growth (%) (274.5) (69.6) (158.8) Total Liabilities & Sh. Equity 175,17 24,6 25,52 26,391 Net Profit Growth (%) (3,559.9) (64.) 4.4 (58.4) Recurring Net Profit Growth (%) 1,793.3 (41.) (36.4) (58.4) Gross Debt/(Cash) 14, , , ,826 Tax Rate % Net Debt/(Cash) 95, , , ,968 Working Capital (34,837) (3,152) (3,368) (3,581) CASH FLOW RATES & RATIOS FYE Dec (CNYm) 212A 213A 214F 215F FYE Dec 212A 213A 214F 215F Profit before taxation (9,92) (3,817) (3,83) (1,592) EBITDA Margin % Depreciation 6,39 6,71 7,4 7,14 Op. Profit Margin % (3.7) (1.2) Net interest expense 4,864 4,931 5,562 5,647 Recurring Net Profit Margin % (5.5) (3.4) (2.1) (.9) Working capital change (569) (6,567) 276 (37) ROE % (17.2) (11.5) (7.9) (3.5) Cash tax paid (171) ROA % (5.) (2.6) (1.5) (.6) Others (incl. int. paid) (218) (2,261) (5,562) (5,647) Dividend Cover (x) N.A. N.A. N.A. N.A. Cash flow from operations 1,122 (539) 4,6 5,417 Interest Cover (x) (1.2) (.3).2.6 Capex (9,148) (9,) (9,) (8,) Asset Turnover (x) Disposal/(purchase) (13,477) (1,8) Asset/Equity (x) Others (9,676) (1,25) (9,) (8,) Asset/Debt (x) Cash flow from investing (23,153) (11,331) (9,) (8,) Receivables Turn (days) Debt raised/(repaid) 21,869 14,588 5, 2, Payables Turn (days) Equity raised/(repaid) Inventory Turn (days) Dividends (paid) (53) (43) Net Gearing % Others (incl. int. paid) (1,387) (2,594) Gross Debt/ EBITDA (x) Cash flow from financing 2,429 11,951 5, 2, Gross Debt/ Market Cap (x) Change in cash (1,62) 81 6 (583) PER SHARE DATA FYE Dec (CNY) 212A 213A 214F 215F Shares outstanding 13,524 13,524 13,524 13,524 Reported EPS (.61) (.22) (.23) (.1) Recurring EPS from cont. ops. (.61) (.36) (.23) (.1) DPS EBITDA/share Oper. CFPS.8 (.4).3.4 Free CFPS (.6) (.71) (.37) (.19) BVPS Source: Chalco, Maybank Kim Eng 25 September 213 Page 59 of 7

60 Hong Kong Initiating Coverage 25 September 213 Sell Share price: Target price: HKD5.1 HKD4.25 Alexander LATZER (852) Stock Information Description: Angang Steel Company Limited (Angang Steel) is one of China s largest steel producers and is based in Anshan in in northeast China. The company mainly produces flat rolled steel, such as hot-rolled sheets, cold-rolled sheets, galvanized steel sheets, color-coated plates, silicon steel and medium plates, as well as wire rods and steel pipes. Its products are widely used in industries such as automobile, construction, ship-building, home electrical appliances, railway construction and the manufacture of pipelines. Ticker: 347 HK Shares Issued (m): 7,235 Market Cap (USDm): 4,731 3-mth AvgDaily Turnover (USDm): 9.2 HSI: 23,371.5 Free Float (%): Major Shareholders: % Citigroup Inc. 5.2 J.P. Morgan 5.1 Government of Singapore 4.9 Wellington Management 4.8 Key Indicators (June 3, 213) ROE annualised (%) 3. Net debt (Rmbm): 17,81 NTA/shr (HKD): 7.16 Interest cover (x): 2.6 Historical Chart Sep 12 Nov 12 Jan 13 Mar 13 May 13 Jul 13 Sep 13 PRICE Performance: 52-week High/Low 6.78/3.49 PRICE REL. TO HANG SENG INDEX Source: Bloomberg 1-mth 3-mth 6-mth 1-yr YTD Absolute (%) (3.6) 27.4 (14.8) Relative (%) (1.6) Angang Steel Sell Before Fall And Buy In Spring We initiate coverage with a SELL rating based on our forecast for eroding profitability on lower steel prices through year-end 213 and flat earnings in 214 YoY. We see the unfolding industry trend as a repeat of prior ones, where modest industry profitability earlier in the year brings on excess supply later in the year eroding prices and margins. The 1H13 profit improvement could prove illusory. Angang reported a profit in 1H13 after three consecutive HoH losses, boosted by higher selling prices and lower input costs, as well as an accounting change that lowered DD&A. We forecast 2H13 EPS to fall near breakeven based on lower profit margins due a 6% HoH fall in steel prices, eroding earlier cost gains, partially offset by higher sales volumes. Profitability expected to stall in 214. We look for flat 214 EPS YoY (12% below consensus) as lower steel prices erode much of the decrease in input costs. We also note a decline in earnings quality as cash flows lag the profit trend after being boosted in 1H13 by a jump in payables. In 215, we forecast rising profits as supply side discipline helps margins widen as prices for steel fall less than for raw materials. Been here before, this time may be a bit different. Bold measures to close capacity have been announced in the past, but in the end have amounted to a few percent at most and been more than offset by new capacity additions. While new targets are more aggressive, we believe it will take a few years to have an impact. In the meantime, as industry profitability remains marginal, we believe steel prices will continue to chase raw material prices downhill while demand growth slows. Our target price of HKD4.25 is based on a 1% discount to our DCF valuation (12.5% WACC and long-term growth 2.75%) due to the current weak ROE vs. our long-term assumption. Our target price implies 214F PBR of.5x and EV/EBITDA of 4.5x, which appears generous compared to 2 to mid-23 when ROE was 2-3x higher. Angang Steel Summary Earnings Table FYE Dec (CNYm) 212A 212A 214F 215F Revenue 77,748 73,735 75,954 75,217 EBITDA 3,265 9,217 9,599 1,428 Recurring Net Profit (4,157) 1,26 1,93 1,79 Recurring Basic EPS (CNY) (.57) EPS growth (%) 93.7 N.A DPS (CNY) PER (x) N.A. 28.8x 26.6x 16.7x EV/EBITDA (x) 18.1x 5.1x 4.9x 4.4x Div Yield (%) P/BV (x).6x.6x.6x.6x Net Gearing (%) ROE (%) (8.5) ROA (%) (4.1) Consensus EPS (CNY) N.A Source: Angang Steel, Bloomberg Consensus, Maybank Kim Eng SEE APPENDIX I FOR IMPORTANT DISCLOSURES AND ANALYST CERTIFICATIONS

61 Angang Steel Company Limited How do we justify our view? We are concerned by the weak trend in steel prices and the potential for the same in 214 pushing our estimates lower and further below consensus. In addition, the quality of earnings appears to have fallen as cash flows lag the recovery in 1H13 profit. Working capital benefitted from a large increase in payables in 1H13. Our main near-term concern is the weak trend in steel prices and the downside risk to profitability in 2H13. Looking to 214, we believe that the level of profitability does not support a higher share price, and the trend in EPS could turn negative YoY vs. our flat assumption if steel prices or volumes disappoint. In addition, free cash flow is not improving as rapidly as reported net profit, implying the quality of earnings has decreased, partly due to the accounting change for depreciation (more below), but also the stretching out of payables, which during 1H13 helped fund a reduction in short-term debt and the working capital deficit. Steel prices have fallen 3% in north China on average the past few weeks and the outlook for further decreases during the fourth quarter due to slowing demand and continued high steel production remains high. Specifically for Angang, we project EPS to decrease during the next two reporting periods (2H13F, 1H14F) relative to 1H13 EPS of CNY.97/sh. If Angang s product sales volumes do not increase 4% HoH to offset lower prices, 2H13F EPS could come in near breakeven, which is well below our and the consensus estimates. In the graph below we have provided Angang s operating profit/t of finished steel sales vs. the HoH change in unit costs and revenues. Operating profit has significantly decreased from the level in 26 and 27 because of a loss of pricing power due to slower demand growth and weak customer profitability. The steel industry and Angang s losses reached a deep level in 212 as steel prices fell faster than raw materials cost. There is some cause for optimism as lower input costs and less volatility should help steel companies and their customers manage profit margins more effectively. However, pricing power remains weak and that is a function of industry overcapacity. Looking at Angang s profit trend, our two main concerns are can the bump up in 1H13 be sustained, and if it is, then the level of future profitability appears uninspiring due to competitive pressures limiting profit margin expansion. Figure 18: Angang operating profit/t and changes in costs and revenues HoH Oper. Profit/t (LHS) HoH chg. in Cost/t (RHS) USD/t HoH chg % HoH chg. Rev/t (RHS) (1) (25) (2) (5) (3) (75) (4) 1H'6 2H'6 1H'7 2H'7 1H'8 2H'8 1H'9 2H'9 1H'1 2H'1 1H'11 2H'11 1H'12 2H'12 1H'13 2H'13E 1H'14E 2H'14E 1H'15E 2H'15E Source: Angang, Maybank Kim Eng estimates The graph below shows Angang s net profit and ROE vs. its crude steel production and finished steel sales volumes. Our steel production growth forecast is 1.5% in 214 and 2.5% in 215, while for finished steel sales it is 5% in 214 and 2.5% in 215 as Angang works down its inventory after sales weakened this year relative to plan. Angang has not altered its steel volume targets for 213, at least not publically, so we have assumed a pickup in 2H13 after a weak 1H13. The stronger 2H vs. 1H sales is a typical pattern but this year 1H was a bit weaker relative to production than usual. 25 September 213 Page 61 of 7

62 Angang Steel Company Limited Figure 19: ROE and net profit and coal volumes We look for the volume of steel sales to outpace steel production in 214 to make up for the imbalance during 213 as steel demand remained sluggish. We think Angang may miss its 213 steel volume targets. Production and sales, mn t % bn % 1.4%.7bn 2.1bn (2.1bn) -4.1% Crude steel production Finished product sales ROE (4.2bn) -8.5% 2.2% 2.3% 1.bn 1.1bn E 214E 215E ROE in %; Net Profit in CNY b % bn. (3.) (6.) (9.) (12.) Source: Angang Steel, Maybank Kim Eng estimates Despite our forecast for a YoY increase in pre-tax profit in 214 (CNY1.4b vs. CNY1.1b), free cash flow is expected to decrease YoY. This is due to lower operating cash flow and the cash drain from working capital vs. the cash generation in 213. Angang stretched its accounts payables during 1H13, which increased to CNY1.7b at the end of the period from CNY5.8b at end-212. This was matched by a similar decrease in short-term debt to CNY9.99b from CNY15.1b. Angang s balance sheet had become heavy on short-term debt, which was nearly double long-term debt of CNY8.4b at end-212. The increase in payables also helped reduce the working capital deficit to CNY8b at end-jun 213 from CNY17bn at end-212. Figure 11: Free cash flow outlook An increase in payables boosted working capital during 1H13 allowing for the pay down of short-term debt and funding of the working capital deficit. CNY b (5) (1) (15) (2) OCF excl. chg. WC CAPEX Working Capital (WC) Dividends Free Cash Flow E 214E 215E Source: Angang Steel, Maybank Kim Eng estimates Valuation Our target price of HKD4.25 is based on a 1% discount to our DCF valuation (12.5% WACC and long-term growth rate of 2.75%) due to the current weak ROE vs. our higher long-term assumption of 6.5%. Our target price implies 214F PBR of.5x and EV/EBITDA of 4.5x, compared to the current value of.6x and 5.x. The graph below shows Angang s one-year forward rolling PBR and ROE. The jump in ROE during Nov 211 reflects the rolling in of our full-year 213 ROE of 2.2% vs. the negative 8.5% in 212. Historically, we have seen the PBR 25 September 213 Page 62 of 7

63 Angang Steel Company Limited improve slowly to changes in ROE that were sustained. For example, in 2, ROE dipped to 5% and then improved over the subsequent two years to over 1% before the PBR followed rising to a high of 1.1x. We believe the current period is different in that the ROE has moved from negative to positive low single digits. Assuming the improvement in ROE in 1H13 is sustained, the low level we forecast for 214 of 2.3% and for that matter our optimistic 3.5% in 215 support at most a PBR of.4-.5x, similar to that during the period from 2 to mid-23. It appears the market will not allow the valuation to fall lower, such as to a level of.25x PBR unless there is a major economic downturn or earnings collapse, though this level would be more in line with the current ROE. The bounce in ROE reflects the improvement from a negative 8.5%to the positive 2.3% we forecast for 214. Despite the improvement, we see no reason why the PBR should be more than.4-.5x equal to or lower than what it was from 2 to mid-23 when the ROE was significantly higher. Figure 111: Angang Steel ROE and PBR chart ROE 25% 2% 15% 1% 5% % -5% -1% -15% ROE (LHS) PBR (RHS) Jan Jun Nov Apr 1 Sep 1 Feb 2 Jul 2 Dec 2 May 3 Oct 3 Mar 4 Aug 4 Jan 5 Jul 5 Dec 5 May 6 Oct 6 Mar 7 Aug 7 Jan 8 Jun 8 Nov 8 Apr 9 Sep 9 Feb 1 Jul 1 Dec 1 May 11 Oct 11 Mar 12 Aug 12 Feb 13 Jul 13 PBV 6.4x 5.6x 4.8x 4.x 3.2x 2.4x 1.6x.8x.x Source: Bloomberg, Angang Steel, Maybank Kim Eng estimates The PBR bands may no longer be relevant calculated over a period when the business was generating a higher ROE. Figure 112: Angang Steel PBR bands Price HKD Jan-6 May-6 Sep-6 Jan-7 May-7 Sep-7 Jan-8 May-8 Sep-8 Jan-9 May-9 Sep-9 Jan-1 May-1 Sep-1 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Jan-13 May-13 Sep x Avg+2SD 1.9x Avg+1SD 1.2x Avg.6x Avg-1SD Source: Bloomberg, Angang Steel, Maybank Kim Eng estimates What is priced into the shares? It is difficult to calculate a reasonable sensitivity analysis fixing one variable like steel price while leaving the input costs unchanged. This is because of the linkage between the two ever since the market moved to short term iron ore pricing vs. the previous one-year and then quarterly contract. It is more instructive to look at how earnings are impacted by changes in the profit margin. Suffice it to say that small changes in profit margin lead to large changes in absolute profits because the impact of prices and raw materials costs flow straight through to the bottom line. For example, our forecast 214 net profit is CNY1.1b (CNY.15/sh) and net margin is 1.4%. If we were to double our profit margin to 2.8%, Angang s net profit would also double to CNY2.2b (CNY.3/sh). 25 September 213 Page 63 of 7

64 Angang Steel Company Limited Earnings revisions The consensus earnings for 213 and 214 have been moving sideways since earlier this year, which has helped put a floor under the share price valuation as we discussed earlier looking at the PBR. We see some scope for small downward revisions more in line with our 214 estimate. Also, the quality of earnings implies that cash flows may not be as strong as the trend in earnings and further funding (debt) may be required, which would raise the interest expense and adversely impact net profit. Figure 113: Consensus forecasts for Angang s earnings in 213 and 214 HKD Share price (LHS) Consensus EPS adjusted 213 (RHS) Consensus EPS adjusted 214 (RHS) CNY (.25) Aug 1 Oct 1 Dec 1 Feb 11 Apr 11 Jun 11 Aug 11 Oct 11 Dec 11 Feb 12 Apr 12 Jun 12 Aug 12 Oct 12 Dec 12 Feb 13 Apr 13 Jun 13 Aug 13 Source: Bloomberg consensus Global steel company valuation graphs Figure 114: Global steel companies market capitalisation (USDm) In this section we provide graphs of global steel companies for comparison to those in China (Angang, Baosteel, Maanshan, Shougang and Wuhan). 4, 35, 3, 25, 2, 15, 1, 5, 12,17 16,2716,93 11,679 13, ,761 2,227 2,556 2,884 2,968 3,22 3,346 3,917 5,613 7,57 3,467 3,5473,73 3,9354,4 6,628 4,682 23,424 33,385 26,626 Source: Bloomberg consensus 25 September 213 Page 64 of 7

65 Angang Steel Company Limited Figure 115: Steel EV/EBITDA (x) 214 Figure 116: Steel PBR (x) JSW Steel Angang Steel Authority Tata Steel Thyssen Krupp (Germany) U.S. Steel Severstal (Russia) Arcelor Mittal (Luxembourg) Evraz (London) AK Steel Jindal Steel & Power Wuhan Baosteel Steel Dynamics Hyundai Hysco Bluescope Steel POSCO JFE Holding Maanshan Nucor Bhushan Steel Kobe Steel Allengheny Technology Nippon Steel Dongkuk Steel Dongkuk Steel Arcelor Mittal (Luxembourg) Shougang Steel Authority Maanshan Angang Evraz (London) Baosteel Bluescope Steel POSCO Wuhan Hyundai Steel Tata Steel JSW Steel JFE Holding U.S. Steel Kobe Steel Severstal (Russia) Bhushan Steel Jindal Steel & Power Nippon Steel China Steel Allengheny Technology Steel Dynamics Hyundai Hysco Nucor Thyssen Krupp (Germany) Source: Bloomberg consensus Source: Bloomberg consensus Figure 117: Steel ROE (%) 214 Figure 118: Steel dividend yield (%) 214 Shougang Dongkuk Steel Evraz (London) Maanshan Angang Arcelor Mittal (Luxembourg) Wuhan U.S. Steel Allengheny Technology Bluescope Steel Hyundai Steel POSCO China Steel Steel Authority Kobe Steel Baosteel Tata Steel JFE Holding Severstal (Russia) Nippon Steel JSW Steel Steel Dynamics Nucor Bhushan Steel Jindal Steel & Power Hyundai Hysco Thyssen Krupp (Germany) Source: Bloomberg consensus Shougang Bhushan Steel AK Steel Hyundai Hysco Hyundai Steel Jindal Steel & Power Maanshan U.S. Steel Evraz (London) Kobe Steel Angang JSW Steel Nippon Steel Thyssen Krupp (Germany) Arcelor Mittal (Luxembourg) JFE Holding Severstal (Russia) Allengheny Technology POSCO Wuhan Steel Dynamics Nucor Bluescope Steel China Steel Dongkuk Steel Tata Steel Steel Authority Baosteel Source: Bloomberg consensus September 213 Page 65 of 7