HPG reported negative 3Q22 earnings

Negative impact from residential property

Vietnam’s residential property market has cooled down since 2Q22 following some tycoon arrests due to corporate bond issuance violations, limit ed credit room for property, and rising lending rates to dent the housing demand. The domestic steel industry has also been hit by other headwinds: (1) high input prices (including coking coal and steel scrap) and (2) persistent inflationary pressures have tightened financial conditions across a number of major economies, casting a shadow on global growth prospects.

As a result, global steel demand declined, causing difficulties for the export activities of Vietnamese steel companies. Despite the fact that public investment is expected to increase in the coming quarters, we expect total domestic steel demand to grow in the negative single digits in 2023.

Since late September, several production cuts have been announced: (1) Pomina Steel Corporation (POM VN, HOSE) has announced the closure of its BOF (blast furnace) at the POM 2 factory since 25 September 2022; (2) Southern Steel Company Limited has reduced the workload and production output during 4Q22; (3) other galvanized steel makers have partially halted their production; and (4) HPG plans to close two BFs (out of three) in its Hai Duong factory and two BFs (out of four) at the Dung Quat Steel Complex (DQSC) in November 2022. If demand continues to fall further towards the end of the year, HPG would consider shutting down one more (the fifth BF) in December 2022.

Mr. Tran Ba Trung, an analyst at VNDirect, said with massive shutdown plans for five out of seven BFs at two steel complexes, this sends a very negative message regarding HPG management’s view on steel demand in the short-term (maybe till the end of 2022 and 1Q23).

In 9M22, HPG maintains its leading position, holding a 35.8% market share, up from 32.6% in 2021. Notably, the gap between HPG and the 2nd largest player has expanded to 24.5% from the 19.9% seen in 2022. "We revise down our forecast for HPG's construction steel sales volume in 2023–24F, but it will still grow positively compared to 2022." We believe HPG is a beneficiary of the industry consolidation caused by the challenging environment. "This is mainly thanks to its effective distribution networks and competitive pricing strategy," said Mr. Tran Ba Trung.

>> Upbeat about the steel industry’s outlook in 4Q

Financial health has deteriorated

At the end of September 2022, the net debt position widened 91.6% ytd to VND26,589bn, bringing leverage to 0.27x from 0.18x at end-FY21. 80% of HPG’s total debt is short-term debt, so the sharp increase in net debt was due to financing working capital demands and constructing DQSC 2. The current leverage ratio is still manageable and healthier than the FY18-20 period when HPG developed DQSC 1 with an investment cost of VND52,000bn.

VNDirect expects HPG’s net debt at the end of FY22F will expand by 31.2% from the current level following the disbursement plan for DQSC 2 development. For FY23/24F, the company's net debt will continue to increase 28.4% yoy/11.1% yoy to VND 44,808bn/VND49,787bn, respectively. It also expects that after DQSC 2 goes into full commercial operation in FY26F, net debt and equity will fall to very low and healthy levels of 0.09x.

"We estimate HPG's 3Q22 cost of debt at 4.94%. With a net debt position, HPG's pre-tax profit will be affected in the current high interest rate environment. Thus, we adjusted the company's interest expense in FY22-23F by 19.0%–28.9% to VND3,099bn and VND3,192bn, respectively. "We estimate FY22F HPG's pre-tax profit will decrease by 1% if the cost of debt increases by 20 basis points," said Mr. Tran Ba Trung.

As a net importer of input materials, HPG has exposure to exchange rates, mostly in US$. In general, an appreciation of the USD will negatively impact the company's earnings due to (1) higher input material costs and (2) higher FX losses and interest rates for US$-dominated loans.

According to HPG’s management, the company is trying to reduce its US$-dominated short-term bank loans by cutting the inventory of input materials. As of end-2Q22, total short-term debt was VND56,576bn, including US$-dominated debt of VND27,477bn, equivalent to 49% of total short-term debt. The interest rate for these US$-dominated debts was in the range of 1.6–3.4%. VND depreciated by 9% ytd, so the US$-dominated debt will materially hurt HPG’s bottom line, especially in 4Q22.

As to long-term debt, HPG has a US$129.5 million loan with BNP Paribas and Woori Vietnam. However, HPG bought a currency swap contract (covering US$90 million) to protect itself against a weakening VND. Therefore, the impact of VND depreciation is much less for long-term debt, in VNDirect’s view.

In terms of cash flow forecasts, Mr. Tran Ba Trung assumes that FY22F net cash flow will fall from negative VND16,730bn to VND5,752bn due to huge capex disbursements for DQSC2. Meanwhile, FY23F net cash flow will turn positive again thanks to improved earnings growth at that time.

VNDirect’s valuation is based on an equal-weighted combination of its 10-year DCF valuation and P/B multiple. In DCF valuation, it rolls forward its valuation to FY23F and raises the risk-free rate assumption to 4.0% from 3.0% previously to reflect the rising interest rate environment globally. As a result, the DCF valuation decreased by 41.7% compared to our previous model following the FY23–FY24 EPS downgrade.

Given the current difficulties of the steel industry, VNDirect replaced the previous P/E valuation with a P/B valuation to better reflect the asset quality of cyclical industry companies.It applies a target P/B of 1.0x to FY23F book value, equivalent to the P/B level of regional peers with corresponding profitability. The gap between the two approaches is about 18% as it takes into account the contribution of DQSC2 to DCF valuation since FY24F, hence the P/B multiple valuation is lower.

“HPG is traded at 6.6x FY22F P/E and 5.3x FY23F P/E, not very attractive for short-term investment amid sector downtrend. We have no idea about the inflection point of steel manufacturing segment, however we still favor HPG for long-term investment”, said Mr. Tran Ba Trung.