A. Significant rebounding output in China with steady global production

After experiencing a sharp depression in the second half of 2008,the production of international steel industry have appeared to be stable. The output of non-Chinese steel industry increased from 43.02 million tons in last December to 49.13 million tons in May, Year-on-year decline also slowed from 38% to 33.6% . Then we come to China, after the 5%-16% fall in the second half of 2008, the production maintained a positive growth in most time of 2009. Of which the crude steel production was 46.46 million tons in May, amount to annual 550 million tons, only below to last June's level, which was 570 million tons. Meanwhile, Chinese crude steel output has accounted for 49 of global production, much higher than the year of 2000's 17%.

In the aspect of capacity utilization, China also improved greatly. The lowest point in last year was less than 70%, however , it got to 85% in May , of which types of long product even got to more than 90%. On the contrary the lowest utilization rate of 2009 in the US was 40.4%, currently is 49%. China's iron and steel industry has rebounded the most fast, mainly benefiting from the 4 trillion stimulation policy and the driving force of investment in infrastructure.

Steel industry suffers absolute over-supply both domestic and abroad, yet steel price has bottomed up in the last three months supported by production reduce and policy stimulus. The global steel price index has rebounded c. 6% from the bottom, and the momentum is stronger in China with long products rebounded c. 16%, and plate products c. 10% after the second bottom in early April.

B. Abundant demand will drive price up

1. Domestic demand will further improve

The main driving force in China's economic growth in the first half of this year is the fixed assets investment, which increased substantially 33.5%, ranking the highest in the last ten years, mainly attributing to the infrastructure investment growth, for example, railway investment grew 110%, road 52%, city transportation 60%. These are the key elements which drove iron and steel consumption increasing.

Looking forward, given the continuing support of stimulus plan, apparent consumption of steel in 2009 will amount to 490million tons, 7.4%y/y, assuming FIA growth of 35% and 24,500 tons consumption per billion RMB investment.

Specifically, we believe that steel demand for infrastructure will continue, because the majority of infrastructure projects will last 2 to 3 years. Therefore, infrastructure project can drive the demand for iron &steel for a period.

More importantly, real estate recovery are the biggest drive for steel demand in 2H09 with consumption contribution of 40% while the infrastructure consumption we mentioned above only account for 13% in this sector. Since the end of 2008, domestic real estate has increased above 50% in 1H09 from -30% y/y of 2H08 measured by sales area. New projects construction start-out in 3Q09 is expected to accelerate given general 6 months lag in building behind the sales area. Therefore, demand of long products is estimated to be stronger than plate products.

2. Net export will not get worse

Due to cost advantages, net export of Chinese steel in the past three years averaged 40 million tons, which gave the domestic market a big support. However, abroad market weakness led some foreign currencies depreciation sharply (Won depreciated over 70% in a year, take an example), which greatly hurt the competitiveness of Chinese steel price and resulted net import in April and May of about one million tons.

We think, however, export & import of steel will not impact domestic market as major foreign economies become stable and Chinese government has taken proactive measures to stimulate economy. Following the export tariff abolishment at the end of 2008, China adjusted tariff policy for three times up till now in 2009. Export tax rebate of steel once reached as high as 17% in the history, which suggests room to adjust for the current policy.

It is worthwhile to mention that in May, steel products net import of America from China was 148,000 tons, 48.7% increase m/m, and the first positive growth in 2009. And major manufacturers such as Angang Steel and Baosteel got sharply added export order in June.

3. Supply pressure may be smaller than expected

As far as the supply pressure is concerned, we can account from stocking level and production increase.

First is the stocking level. Big and medium manufactures still have high stocks which yet dropped 27% from the peak. This situation is basically in line with the market which stocks declined 25%. So it gives evidence that domestic production growth in 1H09 is supported by real demand.

Furthermore, production increase is general based on an expectation of price up. But two factors can offset the concerns of production added in a degree. First, utilization in May has reached 85% suggesting narrow room for further production growth. Second, it is planned to eliminate out-of-date capacity of 10million tons for iron and 6million tons for steel in 2009 and 72millions tons for iron and 25million tons for steel in 2011 which will materially narrow the gap of over-supply.

4. Steel price is expected to rebound further

Spot steel price has stably rebounded from April followed by delivery price increase by major manufacturers, which still continues up till now. Despite of supply pressure, we are cautiously optimistic to steel price given the improving demand and inflation expectation. At present the largest steel manufacturer Baosteel Group has begun looking for measures to answer for the possible inflation. Benefiting from its resources factor, we think there is large proportion of upwards steel price than downwards possibility.

The 2H09 demand will mainly be from investment construction. As steel bars utilization has already reached over 90%, or even near to 100%, we prefer long products most.

As far as region is concerned, middle and west area has more room for urbanization and industrialization. Steel price also varied by geographic region in long products especially steel bars whose price is RMB200 higher in Chongqing than that in Shanghai though plate products are on similar price. We expect this gap of price in different areas will last.

C. Profitability will improve

Major steel manufacturers experienced continuous loss entering 2009 with profit from January to April of RMB-1.06billion, RMB-0.451billion, RMB-1.797billion, RMB-1.871billion. But in May, it turned positive of RMB0.761billion supported by price rebound and cost per ton depreciation declines with high cost ore stocks run out and sustained production growth. As long-term contract ore price is set to drop, cost per ton will probably cut about RMB300 with ore cost decline obviously, and higher profit margin will be certain.

In fact, China has obvious advantages in recent negotiation of ore price. First, as the biggest demander of iron ore, China should enjoy more price power. Recently, China is taking serious measures to punish inner traitors to assemble its whole negotiating power. Second, China enjoys rich steel resources and ore growth in the past three years, which is higher than crude steel increase. And a huge steel minor of 3billion tons reserve is recently declared to discover in Benxi. Furthermore, ore stock imported is enough for next three months use. In a conclusion, we believe the negotiation will end up more positive to China though there may be a compromise. Combined with steel price up trend, profit margin of steel manufacturers is expected to improve.

D. Value of manufacturers will draw attraction

Based on the positive outlook, we still prefer steel stocks though it has rebounded four to five times from the bottom. We recommend long products players especially those with resources, cost and region advantages. Measured by company historical PB versus HSI PB, the three major companies are still at low level value, especially Angang Steel, followed by Chongqing Steel, but the latter enjoys more advantages with lower market value per ton and higher value discount to the share price in A-share market.

Angang Steel (0347.HK): cost drop in 2H09

Iron ore price will cut down in 2H09. Though Angang Steel Group has a high ore self-sufficiency of 70%, the company may still record loss at 2Q given a price scheme based on half a year. However, self-sufficient iron ore concentrate price will drop to RMB650 per ton from RMB860 per ton in the 2H09, leading crude steel cost cut by RMB300 per ton at least.

Silicon iron launch will improve its product structure. Following WIsco and Baosteel, the company will launch into operation its self-developed silicon iron production line with annual capacity of 100,000 tons, thus improve its product structure.

Capacity expansion still goes on with Bayuquan project of 5million tons annual capacity fully launched into operation. The plant area is only 3 kilometres away from the port and highway resulting low transportation cost. Iron cost of the two blast furnace operated is only RMB1800 per ton, far lower than average level in this sector. This project spares investment cost of RMB 1,500 per ton than the average, greatly deduced its depreciation expense.

Chongqing Steel (1053.HK): sound production & sales

The company recorded better than average performance in 2008 and 1Q09. Without scale advantage, it has sound production and sales with stable operation.

First, the RMB4trillion stimulus plan has set one quarter investment on the post-earthquake reconstruction which is expected to add steel consumption of ten million tons per year in this region. Chongqing Steel will directly benefit from this with its location near to this region.

Second, industrialization in China has showed a trend of transfer to middle and west area. Chongqing, the fourth automobile production base and the No. 1 motorcycle cradle, was approved to be the third comprehensive reform plot area, and will fast develop its secondary industry represented by industry and construction. According to the development plan in Chongqing, steel consumption in 2010 will amount to ten million tons. Versus the capacity of 3.5million tons of Chongqing Steel, the main supplier in this area, a big gap of supply is obvious.

So the company has no concern of excess production capacity in the next two years, which is the clearest advantage versus other manufacturers.

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