China Oriental

China Oriental (‘group’) is in the business of manufacturing steel products (68% of revenues) as well as trading steel/iron ore and real estate development.

It is a relatively large concern – ranked in the top 300 largest firms in China – and holds a leading position in H-section steel products since 2009 (41% of revenues).

Other sales are: steel strip products (37%) and billets, sheet piling, and cold rolled sheets among others (22%). It also has 387m RMB of properties under development in inventory.

Though it’s a large entity with presumed efficiencies of scale, it generates a sub-par return on capital (~7.5%). Part of this is due to the heavy capex typical of the steel industry. The group has also made large investments in railway transportation, which should enhance efficiencies (and carbon footprint) when it becomes operational within the next year.

Certain loans and advances were made on an interest-free basis – facilitated by the “government department concerned” (348m RMB). This is likely part of entrenched government intrusion that directs the steel industry in China from permissible capacity to carbon emissions. (In fact, no additional steel capacity is permitted currently, which bodes well for the group’s earning power.)

There are also certain less than ideal governance issues like the lack of an independent internal audit function; and temporary director appointments not subject to a shareholder vote for over a year.

The financial performance is relatively steady over the years. The most recent results were bolstered by a nearly 40% rise in steel prices (with almost as much rise in iron ore costs). These have since fallen by almost a third after the half year results to June 30th were released.

Nevertheless, average revenues since 2017 have amounted to over 42b RMB. Applying average EBITDA margins of 11% (4.6b RMB) and deducting depreciation and taxes yields 2.6b RMB in after-tax earning power.

The balance sheet does have net debt of 8.7b yen (cash net of working capital requirements), which is just under 2x average ebitda. Though not super-comfortable, current assets exceed gross debt; and the group has access to an additional 7.5b RMB of borrowing capacity.

The equity sells for 6.5b RMB, which is 2.5x average earning power. Despite the issues above, this stock seems particularly cheap. Dividend payouts are reasonable and the most recent batch of interim, special, and final dividends yielded just under 10% at market.