Morningstar Advisor - December/January 2012 - (Page 44)

Spotlight Spotlight are the top first-tier names in the sector with the strongest pricing power. We think that their ex-factory prices (prices at the factory) will continue to grow at a moderate rate. The difference between ex-factory prices and retail prices for these firms is widening, indicating that demand still outstrips supply. Wuliangye is the sector’s largest company by revenue and production capacity. Although its focus is on high-end spirits, it offers a diverse set of products across the price spectrum. High-end spirits account for 80% of Wuliangye’s revenues. Its growth there will be dependent on how well it adjusts its distribution channels to adapt to fierce competition in the retail market. In the midprice market, growth will be dependent on distribution power. We see positive signs of distribution improvement from the company’s recent results. Top- and bottom-line revenues have grown this year by 39.8% and 49%, respectively. The company’s major midprice products recorded volume growth of more than 30%. Gross margins have declined a bit, but in September, Wuliangye announced it was raising ex-factory prices by 20% to 30%. We think that this will improve gross margins in the fourth quarter. As the most prestigious spirits brand in China, Kweichow Moutai is essentially the official drink of China’s political and military gatherings. More than half of its products are supplied to government, military, and big corporate groups through direct sales. Moutai’s demand story is best explained by its flying retail price. The price of a bottle of Moutai is more than CNY 1600 ($252), far exceeding its ex-factory price of CNY 619 ($97). In the first half of 2011, Moutai recorded volume growth around 20%, while top- and bottom-line revenues were up 49.2% and 57.8%, respectively. Gross margins stayed the same, and profit margins expanded by 2.9%. The company recently launched another brand, Hanjiang, which is priced at CNY 699 ($110), and it is likely to be another growth engine. We believe that Moutai’s pricing power will keep its margins stable and that 25% is an achievable revenue growth rate for the company. King Coal with small production capacities and allowed large coal miners to acquire smaller miners. State-owned coal companies have acquired the best-quality mines, crowding out private capital. Today, the major players in the coal sector are all state-owned enterprises. China Shenhua is the largest listed coal-mining Coal is very important to China’s energy security. Driven by economy’s fast growth, the production of coal, which makes up 70% of China’s primary energy resources, grew at a compound annual rate of 8% for the past five years. During the same period, the country’s GDP grew at an 11.2% rate, so 1 percentage point of coal-production growth brought about 1.4 percentage points of GDP growth. China’s coal production and consumption reached 3.24 and 3.18 billion tons, respectively, in 2010, making the country the largest coal producer and consumer in the world. More than 50% of China’s coal is burned to generate power. China’s coal supply and demand is balanced in terms of total volume, but not by regions. More than 60% of China’s coal is produced in its west, and most energy demand is along the coastal regions of south and east China. The country’s railway transportation capacity is insufficient, however, making it difficult to transport coal from west to east. Worries over a hard landing in the economy, which would drive down coal demand and prices, have investors fleeing the industry. The sector is trading at 13 times 2011 forward P/E and 3 times P/B, close to their historical lows. In the short term, we expect continuing pressure on the sector because of a gloomy economic outlook. But in the long term, investing in China’s major coal miners is still a good option, given the country’s reliance on coal and its positive long-term growth prospects. Under the direction of the Chinese government, the consolidation of the coal sector is intensifying. The government has closed mines company in China. We believe that Shenhua has formed a narrow moat. The company has created a distinctive, integrated business portfolio covering coal mining, power generation, and coal transportation. Its vast transportation network, composed of proprietary railways and ports, is the envy of its peers. Shenhua’s five railways connect major mining areas in Shanxi and Shaanxi, a pair of proprietary ports, and the Daqin Railway, China’s east-to-west coal transportation artery, forming a network that gives Shenhua direct access to China’s most developed regions. Coal produced by Shenhua is first shipped to its own ports and the Port of Qinhuangdao by railway, and then to eastern and southern China by sea. Meanwhile, Shenhua’s own power plants further leverage the core, competitive advantages conveyed by its transportation network, given the Chinese coal-mining sector’s transportation capacity shortage. The synergies created by Shenhua’s integrated business portfolio have helped reduce costs and boost coal sales, thereby translating into higher profitability. According to our models, Shenhua has a 2011 forward PE of 11.7, the lowest among all the A-share coal companies. We forecast the company’s 2011 revenue and EPS to grow by 29% and 15%, respectively, mainly driven by the fast growth of the company’s coal production and strong coal prices. The company’s strong cash flow and reasonable leverage lay down a solid base to weather any potential slowdown. K Zhao Hu, Iris Tan, Wei Men, and Hua Ye are equity analysts with Morningstar. 44 Morningstar Advisor December/January 2012

Table of Contents for the Digital Edition of Morningstar Advisor - December/January 2012

Morningstar Advisor - December/January 2012
Contents
Contributors
Letter From the Editor
Seduced by Complexity
Is China Exposure Important for a Portfolio?
A Niche Built on Trust
How to Find Your Client’s Investment Style
Taking the Long View
Consensus on Europe Elusive
Four Picks for the Present
Investment Briefs
Is Perception Reality for Active Managers?
Be Alert for Basic-Materials Bargains
Investment Boom Unsustainable
Digging Moats in China
Where China’s Domestic Companies Stand to Benefit
Arising Opportunities
China Strong Long Term
From Currency Manipulation to International Acceptance
The Keys to China’s Fortune
Wedgewood’s Lessons Pay Off
Reading the Evidence on Indexing
Scouting for Investments Abroad
Yield, Please (Hold the Europe)
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
China Fund Managers Eat Elsewhere

Morningstar Advisor - December/January 2012