HPG 28092016 MIRAE(TA)

From 2010 until early 2016, Hoa Phat supplied its own iron ore to produce steel, and has imported soft coal and hard coal for coke outsourcing, which account for an estimated 40% of the

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Hoa Phat Group (HPG VN) Low costs, steady profits

Hoa Phat Group (HPG VN) is Vietnam’s biggest maker of construction steel, with a highly efficient production chain We think Hoa Phat is attractive, in light of its: 1) low production costs; and 2) stable profits We initiate Hoa Phat with a BUY rating and target price of VND50,000

Sector-leading profitability, thanks to low costs

Hoa Phat began construction of an integrated steel mill in 2007, with the mill becoming operational in 2010 From 2010 until early 2016, Hoa Phat supplied its own iron ore to produce steel, and has imported soft coal and hard coal for coke outsourcing, which account for an estimated 40% of the cost of production of finished steel Thanks to current low global iron ore prices, the cost of outsourcing iron ore is below what it would be for Hoa Phat to produce its own In addition, iron ore and coke prices costs show less volatility than that of scrap iron As scrap iron accounts for 90% of the production costs of scrap-iron-derived steel, the input costs of steel produced from iron ore and coke are below that made from scrap iron This key competitive advantage has helped Hoa Phat to achieve growth above the industry average, even amid the steel sector’s stagnant growth period

of 2011-2013 Strong cost control has enabled Hoa Phat to increase its market share gradually and become Vietnam’s largest construction steelmaker

Stable profits

Fluctuations in the input prices of materials for steel production, such as iron ore, coking coal, and scrap, have a significant impact on the selling price of the finished product Investors tend to view steelmakers as unattractive investments, due to their earnings fluctuations However, even during the Vietnamese steel industry’s crisis of 2011-2013, amid a stagnant real estate market, Hoa Phat enjoyed stable net profits, while many other steel producers went bankrupt We expect Hoa Phat to continue to enjoy high net profit growth and stable operational cash flow going forward

Preview of 3Q16 earnings

We forecast 3Q16 revenue of VND7.5tn (+8.9% YoY) for Hoa Phat Revenue should increase on increased sales volume of construction steel (+23% YoY), thanks to completion of Phase 3 of the integrated mill operation However,

we expect ASP to continue to decline (-15% YoY) in 3Q16, as the third quarter is a low season for steel consumption, due to heavy rainfall in Vietnam We forecast gross margin and operating margin of 25.8% and 22%, respectively (3Q15: 23% and 19%, respectively)

Initiating with BUY and target price of VND50,000

We initiate coverage of Hoa Phat with a BUY recommendation and target price of VND50,000 (+10% upside) by using economic value added (EVA) model We believe the company, with its strong market position and stable operational cash flow, is undervalued Moreover, the company’s shares are currently trading at a 2016 P/B ratio of 2.0x, while the fair P/B ratio of 2.4x (2016 ROE of 32.3% and COE of 13.5%) Our target price is based on a 2016E P/E of 7.7x and P/B of 2.2x, while the company is currently trading at a 2016E P/E of 7.0x and P/B of 2.0x

Forecast earnings & valuation

Fiscal year ending Dec-15 Dec-16E Dec-17 E Dec-18 E

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Mirae Asset Securities

I Recommendation and valuation

Initiate with BUY and target price of VND50,000

We initiate coverage of Hoa Phat Group with a BUY recommendation and target price of VND50,000 (+10% upside) by using the economic value added (EVA) model to capture the long-term asset value of the steel manufacturer We believe that the company, with its strong market position and stable operational cash flow, is undervalued Moreover, the company’s shares are currently trading at 2016 P/B ratio of 2.0x while the fair P/B ratio of 2.4x (2016 ROE of 32.3% and COE of 13.5%) Our target price is based on a 2016E P/E of 7.7x and P/B of 2.2x, while the company is currently trading at a 2016E P/E of 7.0x and P/B of 2.0x

Figure 1 Hoa Phat’s EVA valuation

Present value of EVA 11,948

Source: Hoa Phat, Mirae Asset Research

Figure 2 Hoa Phat’s EVA valuation analysis

0 10,000 20,000 30,000 40,000 50,000 60,000

(VND bn)

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cap (VND bn)

Share price (VND)

Price Change (%) P/E (x) P/B (x) OPM (%) ROE (%) Debt ratio (%) Debt/EBITDA (%) growth (% YoY) growth (% YoY)

Source: Bloomberg, Mirae Asset Research

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Share price analysis

Hoa Phat’s share price has increased gradually from its January 2016 bottom of VND21,200 to the current level of VND42,000, following a downtrend from end-2014 to

2015, due to: 1) the impact of the temporary safeguard tariff in March and official safeguard tariff from August 2016; and 2) low raw-material (iron ore) input prices, which

helped the company increase its revenue by 6.5% YoY and net profit by a whopping 65%

The company’s shares are currently trading at 2.0x 2016E P/B, versus an average of 1.5x for its global peers, a level that reflects the company’s strong market position, stable operational cash flow, and solid earnings, amid a difficult environment for the steel sector, both in Vietnam and globally

Figure 4 Hoa Phat’s historical EV/EBITDA band chart Figure 5 Hoa Phat’s 12-month forward EV/EBITDA

2.1x

1.3x

0 1 2 3 4 5 6 7 8 9

(x)

+2 std +1 std

2 3 4 5 6 7 8

2010 2011 2012 2013 2014 2015 2016

(x)

+2 std +1 std

5 yr avg -1 std -2 std

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Figure 8 Hoa Phat’s historical P/B band chart Figure 9 Hoa Phat’s 12-month forward P/B

Figure 10 Hoa Phat’s event chart

0.5x (VND)

0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8

HPG surpasses

34% of full-year

plan in 7 months Strong 1Q09 earnings

results and increase in dividend

VN Index declining amid stagnant real estate market

YoY drop in net profit, due to low steel demand

VinaCapital announces purchase of 4m HPG shares

Market share of construction steel increases from 10-14%, and gross margin improves, thanks to low prices of input materials

1H14 net revenue and profit

up +58% YoY and +85% YoY

Bank Invest fund divests all of its stake

of 3.5%

Temporary safeguard tariff in March and official safeguard tariff from August

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Figure 11 Hoa Phat’s peer comparison

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II Investment thesis

Sector-leading profitability, thanks to low costs

Figure 12 Cost of steel production in Vietnam (2Q16)

Source: Vietnam Steel Association (VSA), Mirae Asset Research

As a developing country, Vietnam’s steel industry is in the early stages of development, with most steel companies being small-scale mills that manufacture low-value rebar steel (concrete-reinforcing bars) Vietnam’s steel industry still uses small smelting chambers and heavy input of scrap metal (83%), which results in high costs and inefficient use of energy As a result, Vietnam’s steelmakers are faced with difficulties, especially in terms of production costs, compared with developed nations, which have large-scale production from integrated mills

Currently, there are only three steel producers in Vietnam that operate integrated mills with blast furnaces: Hoa Phat Group (HPG VN), Thai Nguyen Iron and Steel JSC (TIS VN), and Viet–Trung Metallurgy and Mineral Co Ltd (Viet–Trung) Of the three, Hoa Phat has the largest total capacityfor construction steel, at over 2m tonnes per year, versus 1m tonnes for Thai Nguyen Iron and Steel JSC and 500,000 tonnes for Viet–Trung

Hoa Phat is the largest producer of construction steel in Vietnam, in terms of both capacity and market share (22%, as of June 2016) Unlike other steel producers in Vietnam, Hoa Phat operates an integrated mill (capacity of 1.7m tonnes) that produces steel bar from the first stage of the value chain, iron ore Thanks to low costs, the company enjoys the highest profitability in Vietnam’s steel sector

We estimate the average cost of steel production of Hoa Phat’s complex at approximately VND7.9m/tonne in 2016, based on: 1)operation of the integrated mill at 90- 100% of capacity; and 2) the currently low global prices of raw materials (coal, iron ore, scrap, billet) The average cost of steel from the company’s complex is equivalent to 85% of the cost of steel produced from scrap (VND9.0m/tonne) and 81% of the cost of steel produced from purchased billets (VND9.2m/tonne)

-20% -10% 0% 10% 20% 30% 40% 50% 60% 70%

1,000 2,000 3,000 4,000 5,000 6,000 7,000

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As a result, at the current selling price of around VND10m/tonne, Hoa Phat’s gross margin1 for steel made from iron ore, steel scrap, and purchased billet is 22%, 10%, and 8%, respectively This shows that steel made from iron ore provides a higher margin than steel made from other materials The current selling price provides the company with a significant competitive advantage, based on our estimation

Figure 13 Cost of steel production in Vietnam at 2Q16

Figure 14 Construction steelmaker comparison

Company Name

Ticker

Market cap (VND bn)

Share price (VND)

Hoa Phat began construction of an integrated steel mill in 2007, with the mill becoming operational in 2010 From 2010 until the beginning of 2016, excluding soft coal (imports) and hard coal for coke (which account for an estimated 40% of the production costs for finished steel), raw materials, such as iron ore, were provided by Hoa Phat’s subsidiaries Although the company currently outsources its iron ore, the cost is below what it would

be for Hoa Phat to produce its own, thanks to low global iron ore prices

In addition, iron ore and coke prices costs show less volatility than that of scrap iron As scrap iron account for 90% of production costs, the input costs of steel produced from iron ore and coke are below that made from scrap iron This key competitive advantage

1 Our estimates are based on the average market prices of global coke, pig iron, and steel billet (the price

of hard coking coal price is around USD90/tonne; anthracite coal at USD80/tonne; steel scrap

~USD210/tonne; and steel billet ~USD330/tonne)

7.40 7.60 7.80 8.00 8.20 8.40 8.60 8.80 9.00 9.20 9.40

Cost of steel from iron ore using Blast Furnace

Cost of steel produced from

scrap

Cost of steel produced from purchased billets VNDmn/tonne

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has helped Hoa Phat to achieve growth above the industry average, even amid the steel sector’s stagnant growth period of 2011–2013 Strong cost control has enabled Hoa Phat

to increase its market share gradually and become the largest construction steelmaker

in Vietnam Moreover, it enables Hoa Phat to offer high commissions for sales agencies,

to compete with domestic and Chinese competitors

Figure 15 Hoa Phat’s spread between COGS of construction steel and ASP

Financial strength

Figure 16 Construction steel market size in Vietnam

Source: VSA, Mirae Asset Research

In 2011 and 2012, both the production and consumption of construction steel among members of the Vietnam Steel Association, or VSA (which represents 90% of total steel production in Vietnam) saw negative growth, due to weak demand Construction steel makes up the largest portion (40%) of total steel demand in Vietnam From 2011 to 2013, sales of construction steel remained at around 4.6 to 4.7m tonnes (CAGR of -1.5%), with Hoa Phat the only steel producer to see consistent earnings results during this period (see Figure 17)

We compared cash flow from operating activities (CFO) between Hoa Phat and other steel producers in Vietnam Fluctuations in the input prices of materials for steel production, such as iron ore, coking coal, and scrap, have a significant impact on the selling price of the finished product Investors tend to view steelmakers as unattractive investments, due to their earnings fluctuations However, even during the Vietnamese

500,000 1,000,000 1,500,000 2,000,000 2,500,000 3,000,000 3,500,000

0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000

(% YoY)

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steel industry’s crisis of 2011-2013, amid a stagnant real estate market, Hoa Phat enjoyed stable net profits, while many of Vietnam’s steel producers went bankrupt We expect the company to continue to enjoy high net profit growth and stable operational

cash flow going forward Unlike other steelmakers, which have suffered from unstable,

or even negative, cash flow over the past five years, Hoa Phat has enjoyed steady growth

in operational cash flow during the same period

Figure 17 Hoa Phat’s CFO

Figure 18 Comparison of steelmakers’ CFO

Figure 19 CFO comparison: Hoa Phat Group (HPG) vs Hoa Sen Group (HSG)

(VND bn)

(2,000) (1,000) - 1,000 2,000 3,000 4,000 5,000

(1,000) - 1,000 2,000 3,000 4,000 5,000

(VND bn)

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III DuPont analysis

In order to carry out a DuPont analysis for Hoa Phat, we broke down its ROE into three parts: 1) net profit margin (net profit/sales); 2) asset turnover (sales/total assets); and 3) financial leverage (total assets/shareholders' equity) By employing a DuPont analysis,

we can assess how well the company is leveraging its assets, compared with global peers In 2015, the company indeed outperformed global peers, in terms of net margin, asset turnover (0.15x vs 0.92x global average), and even financial leverage (1.81x versus

a 4.04x global average)

In terms of net margin, we believe the high levels of 2016 and 2017 will be difficult to maintain, as we do not expect the favorable trend of raw material prices to continue long term

Figure 20 Hoa Phat’s DuPont analysis

Net margin (%) 5.9 10.3 12.3 12.7 18.0 18.7 16.1 14.8 Asset turnover (x) 0.9 0.8 1.2 1.1 1.0 1.0 1.0 1.0 Financial leverage (x) 2.2 2.4 1.8 1.8 1.5 1.4 1.3 1.3

Figure 21 Hoa Phat vs global peers: DuPont analysis (2015)

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IV Financial analysis

Short receivable period

Steel is a key input material of capital goods industries; these industries do not consume input material within a single year, so steel manufacturers often have to provide credit in the form of receivables for their customers, in order to retain client's loyalty However, Hoa Phat has a low receivable period figure, reflecting the high quality of the company’s sales, as well as its customers Moreover, the company’s receivable period decreased to

22 days in FY15 from 32 days in FY13, and continues on a downtrend

It should be noted that the inventory turnover of Hoa Phat is quite low We believe that this is the result of the company’s raw material stocking policy, which aims to optimize profitability This policy has enjoyed positive results, thanks to the company’s solid brand name, high market share, and good bargain-sales policy However, unexpected changes

in raw material price trends could have a negative effect on Hoa Phat’s earnings results

Figure 22 Hoa Phat’s operating ratio

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