Ferro China Research Report

by DMG & Partners (4 July)

JUST about a week or two ago, news was released about the finalisation of iron ore price discussions between Australian miners and Chinese steel mills. Brazilian miners had earlier this year set a 65-71 per cent increase in iron ore prices with Chinese steel mills, which were ignored by the Australian miners, arguing that their proximity to China reduced iron ore shipping costs.

That said, inflation fears among Chinese steelmakers appear to have deepened after they agreed to pay Anglo-Australian miner Rio Tinto up to 96.5 per cent more for their iron ore supplies this year.

This represents the largest ever annual increase and well above the 9.5 per cent increase paid last year. Baosteel then followed by releasing a statement saying that the deal would maintain pricing stability and encourage Rio Tinto's efforts to expand investments and increase production to ensure steady supply.

Such a highly priced new contract for iron ore will likely boost the cost of cars, machinery and other steel-related products.

Margins for giant steelmakers will definitely be maintained or perhaps even expand due to their ability to control prices and pass costs on to their ultimate customers, such as construction companies and car makers. Ferrochina, using hot-rolled steel coils as its raw material input, would appear to get squeezed as well.

However, according to the management, this is how the company has rectified the situation:

The news of the possibility of a 96.5 per cent increase in iron ore supplies from Australia had been floating around for a while, and hence already discounted into prevailing prices in the Chinese market, reducing any shocks.

Throughout the course of its business, Ferrochina has been successfully able to pass on the bulk of any raw material price increases to its customers as it is viewed as a steel processor. The passing on of costs, however, have a lagged effect, as its sales-order cycle is about four months. The selling price of a product is determined at the point of order, using a feedstock price plus a processing fee as its pricing formula. Almost all its products manufactured are backed with a matching order.

Management of Ferrochina has always seen rising steel prices as a threat, and hence started to expand its product offerings a while back, offering a wider range of thickness of galvanised steel gauges and different finishes of galvanising methods.

Management has also improved production efficiency through quicker maintenance works and increased the cold-rolling speeds to help raise utilisation.

We maintain our blended PE of 9; we view the current market weakness as an opportunity to start accumulation.

-Research Report by DMG & Partners (4 July)