China Shenhua 1088 HK S
December 15, 2011 - 12:17pm EST by
2011 2012
Price: 32.85 EPS $2.25 $2.00
Shares Out. (in M): 20 P/E 12.5x 14.0x
Market Cap (in $M): 90 P/FCF 0.0x 0.0x
Net Debt (in $M): -10 EBIT 0 0
TEV ($): 80 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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Shenhua is the largest and lowest cost producer of thermal coal in China.  It has an integrated model where it owns transportation infrastructure and utilties that give it exposure to the entire coal supply chain.  However, thermal coal production is the largest piece of its business, representing over 60% of gross profits.  There are three key drivers to the cash flow generated by teh coal business: (1) the price of spot market coal, (2) the mix of coal sold on a contract basis on price regulated by the governemnt, and (3) the quality of the caol they sell. Contract prices are far lower than spot prices and so a mix shift to spot coal has been a big driver to cash flow for the company as has the increases in spot prices that have begun to roll over. 

I believe that (1) due to supply/demand dynamcis the price of spot coal will be secularly challenged from here, the mix to contract coal and plateaued, and the quality of coal produced has deteriorated.  So recenty, the NDRC has announced that they will cap the price of spot coal at 800RMB for the benchmark grade (spot was north of 900Rmb when this was announced). While clearly a negative, many have said that given the extremely fragmented nature of the industry, this will never be enforced. I agree except that Shenhua is an SOE  and so will be tough to report violations of the policy in print.  Second, I believe market dynamics will impari the price of coal anyway. The price of contract coal was also raised by 5% for various reasons and while this is a positive and received attention, a second comment was made that received little attention: i.e. that more strict enforcement of fulfillment of contract volumes will be enforced.  This will be a headwind that people are not acknowledging.  Finally, if we look at the gross profit per ton on the contract coal business in 2011, we see clear deterioration in price suggesting that the quality of the firm's prodution has been deteriorating.

In short, I think consensus estimate of Rmb2.60 will be more like Rmb2.00 next year and the multiple will contract to 8-10x as the market realizes the secular issues with the coal indsutry.  Why pay more for chinese coal, albeit low cost coal, if the upside to the commodity is capped and the downside is steep due to issues I address below. So targert price is HKD is 2.00 x 9 x 1.22 or lows 20s HKD (must convert RMB EPS to HKD).

Key points of the thesis is below.

Chinese coal supply is growing well in excess of demand

  • Chinese coal companies have very high relative margins and returns so they have little reason to curtail production and the gov't which already caps the price on a good portion of their output has little incentive to raise caps (if anything will lower them)
  • Costs of operating mines are increasing which will impact the otherwise healthy margins
  • Coal rail capacity has and will continue to surge removing a bottleneck that has existed for years resulting in ever-increasing supply going forward

Chinese language report noted that 1 billion tons of coal production capacity is currently under construction in China. To put that in context, total coal production in Australia, Indonesia, Mozambique, and South Africa combined in 2009 was ~950 million tons, according to the EIA.

  • Production was up 15% in 2009 based on NBS statistics. For China's 50 largest coal mining companies, production was up 14.2% in 2010 and is running at about 10-12% in 2011.  Fixed asset investment in the coal mining sector continues to increase at an even faster rate that production and this is the leading indicator for future production capacity. As such I think we can expect low double digit to high single digit produciton increases in supply.
  • Robust growth in coal production has been absorbed by mid-teens growth in electricity production. The power sector consumes roughly half of Chinese coal production. However, over the past few montsh there has been an noticeable drop in power consumption and in November on a year-on-year basis it was 7.1%.
  • What's interesting is the implied relationship between GDP growth and electricity production growth in 2011. The "power multiplier" (power consumption growth / real GDP growth) of 1.05x suggests that since 2004, this metric has fallen by one-third in China. So lets assume it hovers around 1%. That implies we will have 7-9% power consumption growth overall.
  • The point is that Chinese power consumption growth is likely to track GDP growth while coal production capacity growth could be >1.2x or more for some time.
  • The industry is set to be over-supplied beginning pretty much now.
  • With hydro, nuclear, wind and natural gas gaining share, the coal power multiplier problaby drops below 1.0x: i.e. cylical and structural issues onthe supply and demand sides.
  • Based either on gross margins or return on capital, Chinese coal miners are operating well above global, normalized margins and returns. For example, returns on capital for the larger coal producers in China are north or 10% while for the rest of teh coal world they are half of that. Similarly gross margins are about 50% again meaningfully above most coal or other commodity producers globally. The implication is that we will see robust supply at much lower coal prices.
  • An increase in coal mining investment is one thing but without the rail infrastructure to move the coal, the increase in production capacity does not impact the demand-supply profile or pricing. Bernstein analysis suggests that China is on track to commission 2,699 km of coal dedicated rail facilities in 2010 and almost 10,000 km by the end of 2014.
  • The top 50 producers are all grwoing comfortably in the mid teens giving some credibiltiy to supply forecasts.
In short, I believe demand will growth 6-8%, supply will grow 10-13% and transporation bottlenecks incrementally ease pretty much every day. As such the industry is cyclically and structurally over-earning.



coal price falling
earnings misses beginning in Q112
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