2023 results miss our and market expectations

Honglu Steel Construction announced its 2023 results: Revenue rose 18.6% YoY to Rmb23.54bn, and attributable net profit grew 1.4% YoY to Rmb1.18bn. In 4Q23, revenue rose 21.2% YoY to Rmb6.57bn, and attributable net profit grew 0.4% YoY to Rmb290mn. The firm’s 2023 results slightly missed our expectations, mainly due to slightly higher-than- expected R&D expenses in 4Q23. Our comments are as follows:

Output and sales volume continue rapid growth. The firm's output and sales volume rose 28.4% and 30.6% YoY to 4.49mnt and 4.26mnt in 2023, and its full-year capacity utilization rate grew 14ppt YoY to 91.6%. In 4Q23, the firm’s output increased 21% YoY and 11% QoQ to 1.26mnt, thanks to ramp-up of new capacity and smart transformation.

Net profit per tonne under short-term pressure; full-year R&D expenses rose 52% YoY to Rmb700mn. We estimate the firm’s net profit per tonne of steel structure at Rmb209 (-Rmb82 YoY) in 2023, and at Rmb158 (-Rmb50 YoY and -Rmb43 QoQ) in 4Q23. In 2023, the firm accelerated its smart transformation, and amortization expenses of equipment as well as R&D expenses per tonne have been rising. In 4Q23, R&D expense per tonne climbed Rmb94 YoY and Rmb20 QoQ to Rmb218. We believe the firm's smart transformation is still in its infancy, and expect its R&D expenses to remain elevated in 2024-2025.

Cash flow improves. Net operating cash inflow grew 93% YoY to Rmb1.10bn in 2023, mainly due to a lower cash-flow-to-payment ratio. Its cash-flow-to-payment ratio and cash-flow-to-revenue ratio stood at 88% and 100%. Liability-to-asset ratio grew 0.63ppt YoY to 60.5%.

Trends to watch

Production capacity rising steadily; market share gains to continue. According to corporate filings, the firm’s production capacity reached 5mnt by end-2023, up about 4% YoY. In 2023, China's investment in manufacturing and infrastructure rose 6.5% and 5.9% YoY. The firm’s new　　orders increased 18% YoY to Rmb29.7bn in 2023. We expect the firm to continue its market share gains. The CICC macro economy team estimates that fixed asset investment in manufacturing and infrastructure may grow 7.8% and 10% YoY in 2024, implying resilient demand and clear advantages of leading names. We do not think investors should be overly pessimistic about demand from leading names in the near term.

In the medium-to-long term, we expect the firm's capacity utilization rate to exceed 120% in some mature production bases, as it surpassed 90% in 2023. In addition, given the firm’s ample land on hand, we think the firm will likely obtain high-quality orders and optimize costs in the near term. We believe the firm may expand production capacity in the medium and long term.

Smart transformation boosts long-term growth, but weighs on net profit per tonne in near term. Our survey shows that with the current technology, welding robots are likely to be applied in 30% of the welding process. We believe that smart transformation means higher R&D investment in the near term. Looking ahead, however, we expect the pressure from shortage of welders and rising labor costs in the steel structure industry to ease. We think the firm may enhance its cost advantages in the medium and long term (we roughly estimate that with a 40% replacement rate, the manufacturing cost per tonne for leading players may fall by a few dozens of yuan). We are optimistic that the firm will likely enjoy its cost advantages as a frontrunner in smart transformation.

Financials and valuation

Given the high per-tonne expenses amid smart transformation, we lower our 2024 and 2025 net profit forecasts by 11% and 9% to Rmb1.29bn and Rmb1.49bn. The stock is trading at 8x 2024e and 7x 2025e P/E. We maintain OUTPERFORM, as the firm continues to gain market share and enjoy cost advantages as a top player in the steel structure industry. Given falling risk appetite in the sector, we cut our target price by 33% to Rmb20, implying 11x 2024e and 9x 2025e P/E with 34% upside.

Risks

Weaker-than-expected demand; sharp fluctuations in steel prices; disappointing smart transformation.