Hpg Valuation Report

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INVESTMENT HIGHTLIGHTS

I projected that in FY2015, Hoa Phat Group Joint Stock Company (HPG: HOSE) will achieve revenue of VND 26.396 bn (+ 3,4% YoY) and NPAT of VND 2.620 bn (-16,7% YoY). Real estate market is expected to recover strongly in 2015, boosting demand on construction materials (in 9M2015, sales volume of construction steel and steel pipe are 4,7 mil tons and 1 mil tons respectively). With FCFF valuation method, intrinsic value of HPG is VND 41.000/share, which is 36% higher than current market price in Nov 17, 2015. I recommended BUY for short-term and long-term investment purpose.

• In short-term, HPG will benefit from recovery of real estate market, which facilitates rapid increase of steel demand.
• In long-term, prospects of steel industry are not positive because: (1) World steel consumption is on downtrend as China’s economy is still weakened, while steel supply is excessive, (2) recent RMB devaluation makes Chinese steel cheaper and very competitive to local steel, (3) Vietnam steel companies are expanding their business, pushing the competition within industry.
• HPG is the leading company in Vietnam in construction material industry thanks to some advantages: (1) HPG is one of three steel companies (the others are TISCO and Viet Trung) applying BOF technology in steel production, (2) HPG has very strong brand, although they operate mainly in Northern region. However, thanks to large scale and well-known brand, they are able to expand to Southern market, (3) HPG have iron ore reserves of nearly 50 million tons, which help them self-supply the input materials.
• I suppose that despite difficult conditions within industry due to pressure from both local competition and steel import (mainly from China), long-term prospects of HPG is very positive.
• HPG plans to expand to new business segments, which are very potential to grow strongly in the future.

COMPANY ANALYSIS

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Overview

• Established in 1992 as a company specializing in construction manchinery trading, at present Hoa Phat has expanded their operations to various segments such as furniture (in 1995); steel pipe (1996), construction steel (2000), refridgeration (2001) and real estate development (2001)
• Currently, the company’s main segments are steel manufacturing, mining, coke production, real estate development, furniture and refridgeration, construction machinery. They possess many branches and factories located on different places such as Hanoi, Hung Yen, Hai Duong, Lao Cai, Yen Bai, Ha Giang, Ho Chi Minh City and Binh Duong. Of which, production of steel and input materials such as iron ore, coke are their core business, accounting for over 80% revenue.
• Steel production includes two sub-segments: (1) construction steel and (2) steel pipe. Detailed evaluation on each segment from input materials to finished products are as follows:

Input materials

• Coke: HPG need to use nearly 400.000 tons of coke annually. At present, their coke production capacity has exceeded their demand, and thus HPG also sell coke to domestic and foreign markets, mainly Japan. Input materials for coke production are imported coking coal (70%) and local Antracite coal (30%).

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Source: Bloomberg, author

• Iron ore – This is an important input material for steel production using BOF technology. After the Phase III of Steel Complex come in stream, total capacity of BOF steel production reached 950.000 tons p.a, accounting for 75% steel output of the company. Each year HPG consumes nearly 1,5 millions of iron ore tons. With total iron reserves of roughly 50 million tons, HPG’s current iron ore could supply sufficient materials to the company for over 20 years.

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Source: Bloomberg, author

• Steel scrap – This is critical input for EAF technology. The company’s EAF production capacity is about 300.000 tons p.a, contributing nearly 25% annual construction steel output. Currently HPG is importing 100% steel scrap for EAF production.

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Source: Bloomberg, author

Construction steel

This is one of the most important business area of the company. At the moment, HPG possesses 3 steel rolling mills with total capacity of 1,250,000 tons p.a. Their main production technologies are electric arc furnace (EAF) and blast oxygen furnace (BOF):

• Construction steel in Pho Noi A Industrial Park (Hung Yen), whose total capacity of 300,000 tons p.a, applies EAF technology. In particular, HPG will import steel scrap to manufacture billets and roll them into finished steel. According to management, cost of steel production using EAF is lower by 5-6% than other companies and lower by USD25/ton compared to imported billet. The steel factory has been fully depreciated.
• Phase I and II of Steel Complex in Kinh Mon Industrial Park in Hai Duong, whose total capacity of 950,000 tons p.a, apply BOF technology. This complex use fully integrated production process with raw material processing factories, coke and thermal electricity manufacturing factories to steel rolling mills and other supporting zones. Input materials for this production process are iron ore and coke, which are mainly exploited and manufactured by HPG’s subsidiaries. This helps guarantee input supply for HPG and reduce production cost. According to HPG, cost of steel production using BOF technology is lower by 5% than EAF. The main reasons is that electricity consumption per ton of steel produced by BOF is lower by 10-15% compared to EAF. Besides, excess heat in BOF production process could be used to generate large amount of electricity equivalent to 40% of Steel Complex’s demand, helping HPG to be less exposed to negative effect of increase in electricity prices.

Output of this fully integrated progress is various steel products such as: steel coils with 6-8mm diameter, D8 ribbed steel wire coils, D10-D41 ribbed steel bars and many other steel bars with different types and standards. HPG is also one of few companies being able to produce high-grade D55 steel bars, which is commonly used in large-scale projects such as roads, bridges, high-storey building, etc. Thus, HPG has many customers which are leading constructor and real estate developers such as Vingroup, Hoa Binh, Coteccons, etc.

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Source: HPG

In 2014, sales volume of construction steel reached 1.001.017 tons (+ 43,3% YoY), equivalent to 19% market share. In 9M2015, sales volume was 1.015.000 tons (+ 48% YoY), equivalent to 21,7% market share.

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Source: VSA

Steel pipe

Hoa Phat Steel Pipe Co, LTD is responsible for steel pipe segment. Established in 1996, and this subsidiary has become leading steel pipe manufacturer. In 2014, steel pipe sales volume of HPG reached 300,000 tons, accounting for 20% market share and help HPG obtain the top position in Vietnam steel pipe market. The followers were Hoa  Sen group (18% market share) and SeAH Vietnam (12%). In 9M2015, HPG continued to be the largest steel pipe producer with market share of 29.2% In order to produce this product, HPG have to import hot rolled coil (HRC), mainly from some countries such as China, Russia, Ukraine, etc.

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Source: HPG, VSA

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Source: HPG, VSA

Energy and Mining

• Recently, HPG is permitted to exploit some mineral ores such as Tien Tien, Linh Thanh in Yen Bai province and Tung Ba, Sang Than in Ha Giang province with total iron ore reserves of more than 40 million tons. However, because most of those ores have low ferrous content, HPG have constructed some filtration factory near those ores to process them and create suitable materials for steel manufacturing. Total capacity of those factories are 800,000 tons p.a. In addition, in Steel Complex there is an iron ore processing factory with capacity of 300,000 tons p.a. According to HPG’s estimates, in order to manufacture 1 ton of construction steel by BOF technology, they would need 1.7 tons of processed iron ore; consequently, when the Phase III of Steel Complex commence operation in 2016, increasing capacity to 1.7 million tons p.a, HPG would demand roughly 3 million tons of processed iron ore p.a. Of which, HPG will self-supply about 40%- 50%, and they will purchase the remaining. Recently, as the world iron ore price is on downtrend, HPG has imported 55,000 tons and 300,000 tons of iron ore in order to diversify sources of supply and meet the demand of the Steel Complex.
• In respect of coke, thanks to large coke processing plant with 160 furnaces and total capacity of 700,000 tons p.a, HPG is able to self-supply and even sell some products to domestic and foreign market. In the 3Q2015 analyst meeting, management stated that coke production has reached 100% capacity, of which 75% output will be provided to Steel Complex and the other 25% will be sold. Another benefit is that the excess heat released from production process might be supplied to thermal electricity plant whose capacity is 37 MW, providing 100% electricity demand of coke processing plant and 40% demand of entire Steel Complex. Consequently, HPG could limit negative effect of increase in electricity prices thanks to cheap cost of electricity generated from coke production process (VND 450/kwh, according to HPG’s estimate).

Real Estate

For real estate business, HPG focused on residential property and industrial park segments. In 2014, HPG recorded VND700 bn net profit from Mandarin Garden project, accounting for 90% net profit from real estate segment. The remaining profit of this project is expected to be recorded in 2015. Mandarin Garden was built on 25,886 m2 area, including 4 high-storey towers with 1,008 apartments. This project was commenced in 2009 and completed in 2013. At present, HPG has launched a new project in 493 Truong Dinh, Hoang Mai, Ha Noi with total investment of VND 1,500 bn and expected to complete in 3 years and started to be sold in 1Q2016. This project was built on 13,728 m2 with 640 apartments in 4 high-storey blocks, each block has 26-30 floors. Besides residential property, real estate revenue is contributed regularly by industrial park business.

Animal feed and husbandry

HPG has established 2 subsidiaries operating in animal feed segment:

• Hoa Phat Animal Feed Production and Trading Co., LTD in Pho Noi A Industrial Park in 1Q2015 with chartered capital of VND 300 bn
• Hoa Phat Dong Nai Animal Feed Co., LTD in Jul 2015 with chartered capital of VND 200 bn.

At present, HPG only operate in animal feed trading so as to search customer and gain market share. As a result, although 3Q2015 revenue was VND 500 bn, net profit was negligible.

HPG has invested in two projects related to animal feed manufacturing. The first one was animal feed plant in Hung Yen with total invested capital of VND 300 bn and capacity of 300,000 tons p.a, planned to commence operation in 1Q2016. The second one was animal feed plant in Dong Nai with with total invested capital of VND 200 bn and capacity of 200,000 tons p.a. HPG’s management confirmed that this project would be commenced soon, although timeline was not clear.

Furthermore, HPG is planning to find land bank for hog farming. Nevertheless, they are facing difficulties as local governments concern about pollution in husbandry farms. To solve that issue, first and foremost HPG intends to acquire 2 state-owned firms which have available husbandry farm.

Animal Feed and Husbandry segment is very potential, however competition within industry is very intense. Due to no detailed information, I will not release any evaluation on this segment yet.

FINANCIAL ANALYSIS

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Revenue and segment performance

Revenue

In 2010-2014 period, HPG’s revenue CAGR reached 12.3%. In 2014, revenue increased significantly by 35% YoY. The main catalysts for this impressive growth are:

• Steel manufacturing continues to grow strongly - Contrary to decrease in average selling prices (-5,2% YoY), sales volume rocketed. In particular, sales of construction steel and steel pipe reached 1.001.017 tons and 300.000 tons respectively, increasing by 43,3% YoY and 40% YoY. This impressive growth was thanks to recovery of macro conditions, as 2014 GDP growth was 5,98% (compared to 5,43% in 2013). Of which, growth in industrial and construction segments were 7,14% (compared to 5,42% in 2013). Besides, HPG upgraded BOF of Phase 1, improving capacity from 350.000 to 450.000 tons p.a, and acquire a steel plant in Da Nang, increasing steel pipe capacity to 236.000 tons p.a.
• Remarkable contribution from Mandarin Garden project – In 2014, HPG recorded VND 2,566 bn sales of apartments from this project (+150% YoY), compared to nearly VND 1.000 bn revenue booked in 2013.

In 9M2015, HPG’s revenue was VND 20.331 bn (+7,3% YoY). Main reasons for slow growth are as follows:

• Iron ore price is on downtrend, making average selling prices decrease – In 9M2015, world iron ore price has decreased 44% YoY on average due to the fact that supply surged significantly as some large producers such as Rio Tinto, BHP Vale has exploited new mines, whereas demand from some major markets such as China has weakened. This leads to remarkable decrease in construction steel prices. At present, domestic construction steel prices is only VND 9,5mn/ton, dropping by 8% compared to last 3 months and 20% compared to end of 2014.
• Mandarin Garden recognized only VND 425 bn revenue, compared to nearly VND 2.490bn in 9M2014.  

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Source: HPG, author

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Source: HPG, author

Gross profit

In 2010-2014, gross profit of HPG often fluctuated in range of 14%-20%, which is high relative to peers in steel industry. This is thanks to advanced BOF techonology that HPG is applying, and in fact there are not many companies using this technology (the others are TISCO and Viet-Trung). Meanwhile, most steel manufacturers still use EAF technology which has higher production costs, leading to lower gross margin and they have to shut down some factories.

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Source: Companies’ FS, author

Financial activities

In the period 2011-2014, financial income of the company fell dramatically (except for 2013 since HPG receive profit from its subsidiary divestment from Duc Tien ltd). The main cause was due to continuously drop in deposit interest rate. Meanwhile, loan interest expense of HPG also decreased thanks to decrease in borrowing interest rate, on average. However, foreign exchange loss surged due to depreciation of VND relative to USD, especially in 2015 when the government devalue VND by 3% and extended the band from 1% to 3%. In 2014, around 80% loan of the company are denominated in USD.

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Source: HPG’s FS

Assets

Current asset normally takes up 53-54% total asset in 2009-2014, in which HPG usually keep a high proportionate of cash for its working capital demand. Moreover, with a high amount of cash, HPG can easily extend its business to animal feed segment

Inventory increased remarkably and always take a significant proportion in 2009-2014 mainly due to 257 Giai Phong project launch in 2010 and Mandarin Garden project launch in 2011. I predict that inventory balance of HPG will remain high in the future since the company has launched 493 Truong Dinh project.

Non-current asset also accounted for large proportion and tends to enhance as HPG operates Phase II of Steel complex with VND3,300 billion in 2011 and 2012 and Phase III of Steel Complex with VND3,800 billion in 2014, respectively. In the near future, the company will invest in 2 animal feed plants in Hung Yen and Dong Nai, worth VND300 and VND200 billion respectively. This would maintain high proportion of non-current asset in the future.

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Source: HPG, author

Capital Structure

In HPG capital structure, total debt (both long and short-term) usually makes up 30-40% of total capital. Of which, short-term debt dominates since the company needs working capital (especially to raw material). Long-term debt proportion increased during 2010-2012 to support Phase II of Steel complex project and other real estate projects.

Even though debt ratio is high, we believe that HPG’s capital structure is currently safe and their interest coverage shows improvement recently

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Source: HPG, author

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Source: HPG, author

Net profit, ROE and EPS

In 2010-2012, profit after tax of Hòa Phát fell due to the fact that real estate market went into recession, brought down both the steel price and profit margin. In the meantime, interest rate was at a high level. However, in 2013 and 2014, PAT grew impressively thanks to Phase II of Steel Complex went into operation, reducing production cost and improving gross margin. Moreover, net profit from real estate, especially Mandarin Garden project, contributed significantly. Therefore, ROE and EPS were significantly enhanced.

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Source: HPG, author

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Source: HPG, author

FINANCIAL PROJECTION FOR 2015-2019 PERIOD

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Operating results:

Steel manufacturing will continue to be the most important business segment in revenue structure of HPG. In particular, according to my estimate, it will account for 85%-90% revenue due to the fact that HPG’s direction is focusing on steel production, and they will activate the Phase III of Steel Complex in 1Q2016, increasing total steel rolling capacity to 2 million tons p.a. Some of my critical assumptions are as follows

Construction steel

• 2015-2018 period:

• Sales volume will show strong growth thanks to good macroeconomic conditions (ADB forecast Vietnam GDP to be 6.5%) and the recovery of real estate market. In addition, TPP agreement which might be officially enacted in next two years will enhance FDI flows into Vietnam and foreign trade activities, boosting infrastructure demand. Also, Phase III of Steel Complex which will be activated in 1Q2016 will facilitate rapid increase in sales volume of construction steel in 2016 compared to 2015 and  this strong growth will remain until 2018 when Phase 3 reach full capacity.
• Average selling price will be on downtrend – Main reasons are weak domestic demand in China due to poor performance of real estate market, leading to excess supply of construction steel. Therefore, many Chinese steel companies have to lower selling price and increase steel export to boost sales volume. According to BMI, Chinese steel export in 8M2015 reached 71.8 million tons (+28.4% YoY). BMI forecast that Chinese steel export will peak in 2016 and then decline. Thus, I project that average selling price will go down in 2015 and 2016 before rebounding in 2017.

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Source: HPG, author

• However, HPG is able to maintain high gross margin owing to the fact that their sources of input supply is stable and input prices are reducing – Two essential materials for steel production are iron ore and coke. At present, HPG is able to self-supply 100% coke; they only import coking coal (mainly from Australia) to manufacture coke. However, coking coal price is on downtrend, and BMO estimate that it will go down to USD103 and USD 97 per ton in 2015 and 2016, respectively. In respect of iron ore, HPG is flexible in using iron ore with high ferrous content (over 62% Fe) via both self-supply and import, depending on performance of iron ore price. As a result, I projected that HPG will maintain gross margin over 20% in the future.

• From 2019 to beyond – Construction steel will grow stably at 5% as Phase III of Steel Complex reach full capacity. Currently HPG does not have any plan to expand capacity in the future.

Steel pipe

• I forecast steel pipe sales volume will reach 400.000 tons p.a, meaning that total capacity of HPG will be fully utilized (currently HPG does not have any plan to expand capacity). However, revenue will decline slightly in 2016 due to decrease in steel pipe selling prices. This could be explained by the fact that HRC price is on downward trend and is expected to drop continually in 2015 and 2016 (according to GE Capital). Then, HRC price will recover and maintain stable. Hence, I forecast that average selling price of steel pipe will decline by 18% and 10% in 2015 and 2016, before rebounding in the future

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         Source: HPG, author

Other Segments

Real Estate

• For residential segment, revenue from Mandarin Garden will be fully recorded VND 700 bn in 2015, 3 times lower than FY2014 revenue of nearly VND 2.490 bn. This make real estate revenue drop significantly. HPG announced that they will start selling apartments in 493 Truong Dinh project in 1Q2016; however, I do not include this project in my forecast due to no detailed information. In addition, management confirm that they will not develop this segment in long-term.
• For industrial park segment, Pho Noi A and Hoa Mac IP are nearly fully-occupied. Plus with the fact that there are not many new leasing contracts, I estimate that growth potential of this segment is quite low and its growth will remain stable in the future

Animal feed and husbandry

• Besides two animal feed plant projects in Hung Yen and Dong Nai, I do not have much detailed information about this business segment. According to management, they do not expect highly positive operating result in early years from animal feed and husbandry. As a result, I do not include this segment in my forecasting model.

Others

• In terms of energy and mining, because its main purpose is to provide input materials for steel production (according to management, 75% of sales volume is used for steel production, and the rest will be sold locally and exported), I expect that this segment will maintain stable growth. For construction machinery and furniture and refridgeration, I forecast that their business result will not move rapidly.  

Net profit, ROE and EPS

• Net profit and ROE is expected to reduce in 2015 because revenue will growth slowly, while HPG’s current plants are reaching full capacity and Phase III of Steel Complex is still idle. Meanwhile, average selling price of steel products are expected to go down due to steel import pressure from China. EPS is also projected  to decline strongly in 2015 because HPG has paid stock dividend at 10:2 ratio, plus with aforementioned reasons. However, from 2016, as Phase III of Steel Complex commence operation and steel prices recoveries when world supply and demand conditions are better, net profit, ROE and EPS will show improvement.

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• FY 2015 ROE reduced due to the fact that net profit declined by 16.67% compared to 2014, while shareholders’ equity increase, making ROE go down to 21% in FY2015. However, ROE will recover in the future.

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Balance Sheet

• Current asset will rise rapidly because of strong increase in cash and cash equivalent as well as inventory, when HPG will enhance cash reserves to prepare for working capital demand in the future and raw material reserves for maintaining and expanding business, as Phase III will come in stream in 2016

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Source: HPG, author

• Non-current asset will increase in short-term but remain stable in long-term – Since HPG invested VND 100 bn to upgrade Phase 1 BOF in 2014 and VND 3.800 bn to construct Phase III of Steel Complex, as well as VND 500 bn to build two animal feed plants in Hung Yen and Dong Nai, Non-current asset will rise remarkably in 2015-2017. However, after that period, non-current asset will remain stable and even decrease owing to the fact that HPG has no new investment plan, while depreciation expense will surge.

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Source: HPG, author

• Liabilities grow gradually, while shareholder’s equity rise significantly thanks to high retained earnings – I suppose that borrowing debt will maintain stably with ratios of short-term and long-term debt to revenue are 15% and 9% respectively. In terms of shareholders’ equity, assuming that HPG will pay cash dividend of 15% annually, this item will rise significantly on high retained earnings, as net margin will remain at 10% in the future

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Source: HPG, author

Valuation approach

To estimate value of HPG, I use Free Cash Flow to Firm (FCFF) method and EV/EBITDA comparable approaches for short-term valuation. In the FCFF method, intrinsic value for HPG share was estimated t be 41,000 VND per share. Key information for HPG valuation using FCFF method is as follows: