Coking-Coal Firms Offer a Way To Play China's New Price Caps

By YVONNE LEEJuly 28, 2008

HONG KONG -- Despite a near doubling in global spot-coal prices in the first half, listed coal producers in China -- the world's biggest coal consumer -- have been market laggards as a result of price caps imposed by the state to regulate supply.
The Hong Kong shares of China Shenhua Energy, the country's largest integrated coal producer by output, have slumped 38% so far this year, while industry No. 2 China Coal Energy lost 43% amid concerns of the price-control risks.
Analysts say these stocks may be susceptible to further near-term losses following measures the government announced Thursday to cool red-hot domestic thermal-coal prices by artificially capping spot prices at major ports.
The new steps affect producers of thermal coal, used mainly for electricity production. However, producers of coking coal -- the key ingredient for metals processing -- aren't affected.
Shares of Hong Kong-listed coking-coal maker Hidili Industry International Development have outperformed both its thermal-coal peers and the Hang Seng Index, which is down 18% this year.
Sichuan-based Hidili, which listed last September, is down 10% in 2008. But many analysts say now is a good time to accumulate the stock, thanks to expectations coking-coal prices will continue to rise and to attractive valuations.
Four analysts that cover the company have an average price target for the stock of 18.69 Hong Kong dollars (US$2.40), or 74% above its Friday close of HK$10.76.
"We are bullish on China's coking-coal sector because of the current tight-market-supply situation," says UOB KayHian analyst Karen Li. "We believe HK$11 or below is a good entry point to gain exposure to this booming industry."
Hidili, which raised US$525.4 million from its initial public offering, supplies coal to steelmakers in southern and western China, including Panzhihua Iron & Steel Group and Liuzhou Iron & Steel Group. Analysts say Hidili is attractive because of rising coking-coal prices, which have almost doubled in the first half on strong demand both in domestic and global markets.
Xu Hui, Hidili's company secretary, says its coking-coal prices in the first half jumped 90% from the previous year and reached 1,500 to 1,600 yuan (US$220 to US$235) a metric ton at the end of June. He didn't give any forecast for prices in the second half.
Liu Jianzhong, deputy general manager of Shanxi Coking Coal Group, China's biggest coking-coal producer by output, told state media earlier this month that he expects coking-coal prices in the second half to rise 200 to 300 yuan a metric ton.
Coal prices will also likely be supported by the government's effort to crack down on smaller mines in hopes of reducing the number of deaths from accidents.
The government plans to shut more than 4,000 small coal mines and reduce their numbers to below 10,000 by 2010, from about 16,000 currently, the Xinhua News Agency reported this month. Of the total, 90% of the coking-coal mines are considered small ones, with much lower safety standards than larger, more established operations, Xinhua said.
Goldman Sachs says Hidili's share weakness, and its differentiation from thermal-coal producers, provide a good opportunity for investors to buy into the stock.
"The key advantage of coking coal verses thermal coal is a better demand profile and lower risk of government price control," Goldman analyst Song Shen wrote in late June. "We believe Hidili shares have been weak given the higher risk premium due to government price controls on thermal coal."
Analysts say the Chinese government won't likely intervene in the coking-coal industry, given the nature of the domestic metals market.
"The setting of power tariffs is regulated by the government in order to curb the country's rising inflation," says Nomura analyst Donovan Huang. "As China's steel prices are largely market-driven, coking-coal producers have lower government price-control risks."
Beijing last month imposed temporary price ceilings on thermal coal to protect the profitability of power producers using it. China's thermal-coal mines can't sell at prices higher than those reached June 19.
Aside from the booming market for coking coal, Hidili's shares are also attractive because of the company's acquisition plans, analysts say. Hidili intends to raise its reserves by acquiring mines in western Guizhou province.
The company said it aims to boost coal output to eight million metric tons by 2011, more than twice this year's target of 3.2 million tons. In 2007, it produced 2.27 million tons.
Given those projections, analysts are generally upbeat on Hidili's earnings for the next two years. Goldman Sachs said it expects the company's net profit to more than double this year, followed by a 75% increase in 2009, due by higher sales volume and prices.
In 2007, Hidili's net profit jumped more than sixfold to 570.3 million yuan from a year earlier.
Hidili's valuations are lower than those of peers. According to Thomson Reuters, the stock is trading at about 16.11 times projected 2008 earnings, compared with 18.95 times for Shenhua Energy and 17.08 times for China Coal.
Nonetheless, concerns that growth in China's steel industry could slow amid rising prices for raw materials might hurt Hidili's near-term share performance, analysts say.
"If steel-production growth slows down sharply, we could see coking-coal prices coming down," Goldman Sachs says.
Citigroup projects Chinese steel production at 640 million tons next year, up 16% from its 2008 forecast of 553 million tons. The nation accounts for slightly more than one-third of the world's demand for steel.
Mr. Xu, Hidili's company secretary, says he expects China's steel production will grow strongly until 2010 as "we have confidence Beijing will maintain sound economic growth over next two years."
Write to Yvonne Lee at yvonne.lee@wsj.com