Potential supply cuts will boost earnings - upgrade Chalco to Buy

Deutsche Bank Markets Research Asia China Resources Metals & Mining Industry China Aluminium Industry Date 28 February 2017 Recommendation Change Potential supply cuts will boost earnings - upgrade Chalco to Buy A small cut can make a huge difference; upgrading Chalco ________________________________________________________________________________________________________________ Deutsche Bank AG/Hong Kong Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 057/04/2016. Sharon Ding Research Analyst - sharon.ding@db.com James Kan Research Analyst (+852 ) 2203 6146 james.kan@db.com Grant Sporre Research Analyst (+44) 20 754-58170 grant.sporre@db.com Key Changes Company Target Price Rating 1378.HK 7.80 to 9.50(HKD) - 2600.HK 3.00 to 5.40(HKD) Hold to Buy Source: Deutsche Bank Companies Featured China Hongqiao Group Ltd. (1378.HK),HKD7.80 Buy 2015A 2016E 2017E P/E (x) 7.4 7.2 4.7 EV/EBITDA (x) 5.5 5.0 4.1 Price/book (x) 0.8 1.2 1.0 Chalco (2600.HK),HKD3.87 Buy 2015A 2016E 2017E P/E (x) 190.4 134.6 18.0 EV/EBITDA (x) 9.5 10.3 7.7 Price/book (x) 0.8 1.3 1.2 Source: Deutsche Bank From the coal, steel and power sectors, China will extend supply-side reforms to aluminium. Unlike the other sectors, aluminium and alumina production are already running at decent utilization rates of 85% and 90%+. Thus, even a small capacity cut, especially in alumina, would make a huge difference to the industry balance. Tighter environmental standards would also steepen the cost curve, meaning that overseas players would be the true beneficiaries. Domestic smelters and refineries with decent environmental protection facilities and alumina capacity would also benefit. Therefore, we upgrade Chalco to Buy. MoEP proposal impractical for aluminium, but may affect carbon anode and likely alumina to a lesser extent In a draft of the report, 2017 Air Pollution Prevention and Control Plans for Beijing, Tianjin, Hebei and Surrounding Areas, the Ministry of Environmental Protection (MoEP) proposes to cut 30%, 50% and 50% of capacities for aluminum, alumina and carbon anode during the heating season in 26 cities across Hebei, Shandong, Henan and Shanxi. Aluminium and alumina capacities in those areas account for 30%+ and 40%+ of the China total. A full shut-down during the heating season would result in 4% and 7% capacity cuts in aluminium and alumina (on a full-year basis). We see the main polluting culprits in the aluminium supply chain as carbon anodes, followed by power generating units, alumina, and primary aluminium production lines. We think production halts in aluminium are impractical, simply because it is too costly to restart smelters (it costs c.RMB100m to restart a 200kt production line). Carbon anode, which uses raw materials petroleum coke and asphalt, has been the primary focus of environmental inspections. Alumina is less polluting but more flexible in shutdowns/restarts. What can the NDRC do to aluminium capacity? Although we don’t think that the environment proposals meaningfully lower aluminium capacity in isolation, a combination of edicts from the MoEP and NDRC could limit Chinese supply growth by delaying or cutting new capacity, or by phasing out inefficiency capacities (e.g. operating smelters below 240kA, 7%+ of the China total). According to our research, new capacity for aluminium is about 4mt+ in 2017E and 3mt+ in 2018E. Most of these have provincial government approvals, but not official approvals from the NDRC, indicating potential risks. We thus expect lower new capacity ramp-ups in late 2017 and 2018. Even with existing capacities, there is a gap between the NDRC’s official approval list of 30mt vs. operating capacities of 42mt. Upgrading Chalco from Hold to Buy; China policy is the major risk Despite near-term pressure from rising aluminium inventory, we expect smelters’ and refineries’ utilization rates to continue to improve in the medium term. Following 8.2% and 6.6% rises in DB global aluminium price forecasts, we increase Chalco’s bottom line by 50% / 9% for 2017 / 2018 and Hongqiao’s by 12.5% / 9.5% for the same periods, and raise their target prices respectively by 70% and 18%. Chalco-H’s historical average PB since listing is 1.37x with a 5.4% ROE, and with a 7%/9% ROE in 2017/18, we set Chalco’s TP at HKD5.4 via 1.8x 2017DBe BVPS. With 30% upside, we upgrade Chalco to Buy. Hongqiao’s target price is based on DCF wit