China Oriental Group (581.HK)          BUY (TP: HK$3.90 (from HK$3.20))

More attractive valuation on improved fundamentals

We raised COG’s target price from HK$3.20 to HK$3.90, based on the industry average of 1.2x FY10 PBR (previously 1.0x PBR). We raised our target PBR because of 1) COG’s improved fundamentals -- JXJL is breakeven, and also rising steel prices to pass on rising cost; 2) strong earnings growth outlook -- up 91% and 22% in 2010 and 2011 due to capacity expansion and slight margin expansion; and 3) respectful ROE -- 5% in 1H09 when its peers were loss-making, and 11% and 18% ROE in 2010 and 2011. We raise our 2010 and 2011 earnings forecast by 3% and 4%, respectively, after factoring into a higher increase raw material and steel prices (a 38% and 19% YoY increase in iron ore and coke as well as a 23% YoY increase in COG’s average steel prices in 2010). As we observed in our trip on 27 Feb, JXJL is back on feet with capacity ramp-up and improved operating efficiency. JXJL contributes less than 5% of total revenue, but being breakeven should help overall margin expanded slightly. Our new gross margin forecasts for 2009 and 2010 are 8.6% and 10.4% respectively, up from 8.0% and 10.2% previously. We reiterate our BUY call.

Jinxi Jinlan (JXJL) stepped out of the wood. JXJL, COG’s cold-rolled steel plant with 81.5% interest, is located in Foshan of Guangdong, the production hub of home appliance/electronic products in China. The demand recovery (hence its restarts of idled capacity), product mix optimization and operation efficiency drive up JXJL’s productions and lead to slight profitability. COG sees production doubling to 0.4mt in 2010 in view of the monthly output of 37,000t in Jan and Feb. We expect JXJL’s unit cash profit to range Rmb0-100/t in Jan and Feb with operating cost cut from Rmb200/t to Rmb80-90/t.

Consolidating market presence by acquisitions. COG may add 3mt more crude steel capacity to 10mt by end 2010 by consolidating local mills near to its main production base in Jinxi of Hebei. COG has 30% of market share in China’s H-beam market. COG will continue to benefit from the demand for structural steel (composed mainly of H-beam) and other construction-related steel.

Undemanding valuation. Our target price of HK$3.90 (based on industry average of FY10 PBR), implies 7x FY10 PER, below industry average of 10x. We keep BUY.