Summary: Although the company's stock price surged 17.8% yesterday due to earnings forecasts for the first quarter, the company's valuation is still very low. It is only 5.4 times the 2017 E price-earnings ratio, far lower than 14.5 times Angang Steel (0347.HK) and 11.2 times Ma Steel (0323.HK). We see potential for the valuation gap to narrow: (i) trading volume soared to HK$45 million due to yesterday's profit forecast, indicating that more investors are paying attention to the company again; (ii) if Qixing Group's financial problems are resolved in the coming months, investors' concerns about the parent company's financial situation will be greatly reduced.

Company Background: Xiwang Special Steel is a steel producer, and about 75% of its revenue in 2016 came from Shandong. The company also produces general steel and special steel. Last year, the company sold 2.8 million tons of steel products (compared to Angang Steel's sales volume of 19.9 million tons in 2016). Xiwang Investment holds 74.75% of the company's shares.

Gross profit in tonnes rebounded markedly in 2016. The company's gross gross profit rebounded after falling to a low of 99 yuan in the second half of 2015. It rebounded to 346 yuan and 396 yuan respectively in the first half and second half of 2016, mainly benefiting from supply-side reforms and improved demand from the infrastructure and real estate industries.

The recovery in earnings in 2016 was hampered by rising financial costs. The company's net profit in 2016 increased 97% year-on-year to 333 million yuan. In fact, operating profit surged 170% year over year to 762 million yuan. The lower increase in net profit was due to a 269% increase in financial expenses to RMB 336 million. In the past, interest on shareholder loans (RMB 2.88 billion at the end of 2016) did not have to follow market interest rates. However, according to the regulator's latest requirements, the controlling shareholder finance company's loans should charge market interest rates (around 6% last year), which has caused the company's financial costs to rise.

Change the way depreciation is calculated. In 2016, the company changed the depreciation period for properties from 30 years to 40 years, and also changed the depreciation period for machinery and equipment from 15 years to 20 years. As a result, the company's net profit increased by about 100 million yuan in 2016, but we found that the new depreciation calculation method is similar to Angang Steel.

Gross profit per ton continued to expand in the first quarter of 2017. The company announced a profit forecast for the first quarter yesterday. Net profit is expected to increase 344% year-on-year to 185 million yuan. The gross tonnage profit of the steel production business further increased to 610 yuan year-on-year, up from 396 yuan in the second half of 2016.

The goal is to increase the revenue contribution of specialty steel this year. In 2016, due to strong demand from infrastructure and real estate, Pu Steel's revenue share rose from 51.9% to 54.9%, and the contribution of specialty steel fell from 30.3% to 23.9%. The company aims to increase its specialty steel revenue ratio to 40% or more this year. We believe this should help mitigate the risks associated with a slowdown in the real estate market, because the company's specialty steel products are mainly used in high-speed railways, ships, automobiles, machine tools, wind power, petrochemicals, etc. The Chinese Academy of Sciences (CAS) is the company's strategic R&D partner. The Institute of Metals of the Chinese Academy of Sciences and some technicians own 100 million shares of Xiwang Special Steel, with a purchase price of HK$1.22 per share.

The new production line will drive growth in 2018 and beyond. The company announced that it will invest 2.55 billion yuan to establish a new production line, which can produce 700,000 tons of steel rails, 150,000 tons of railway axles, and 150,000 tons of steel profiles every year. According to management estimates, the production line's annual revenue contribution is about 5 billion to 6 billion yuan. The first phase is expected to be completed by the end of 2018, while the second phase will be completed in 2020.

Capital expenditure is manageable. If maintenance capital expenses are included, we think the company's capital expenditure this year is about 1 billion to 1.1 billion yuan. According to rough estimates, the company's EBITDA should exceed RMB 1.3 billion this year. Thus, it is anticipated that the demand for capital expenditure will be manageable. As of the end of 2016, the company's net debt-to-equity ratio was 120%. Excluding shareholder loans, the net debt-to-equity ratio at the end of 2016 would be significantly lower, at just 48%.

Qi Xing Group's financial problems have yet to be resolved. Qi Xing Group is a company that focuses on aluminum products. The company is currently in a difficult financial situation due to its high debt ratio. Xiwang Group, the parent company of Xiwang Special Steel, participated in some joint guarantees; if it were to fulfill its guarantee responsibilities, the potential net burden would be about 870 million yuan. As of the end of September 2016, the net asset value of Xiwang Group was approximately RMB 147 billion, and the cash and bank balance was approximately RMB 2.7 billion. This means that even in the worst case scenario, Xiwang Group's financial position is still stable. Meanwhile, according to media reports, Xiwang Group is cooperating with local governments, and the former will take over Qixing Group's business for three months. Therefore, if a restructuring plan can be formulated within three months with the help of the local government, the uncertainty of the Xiwang Group will be greatly eliminated. This would greatly mitigate the potential indirect impact on Xiwang Special Steel.

A relatively conservative average forecast for the market. Since the company has no new production lines this year, its 2017 sales target is relatively conservative, at only 2.9 million tons, slightly higher than the 2.8 million tons in 2016. Due to seasonal fluctuations, management maintained a target of 450-500 yuan in gross gross profit per ton in 2017. Compared with RMB 610 in the first quarter of 2017, this target is not very aggressive. Based on the gross profit calculation of 450 yuan per ton, we estimate that the company's net profit this year is about 490 million yuan, which is roughly in line with the average market forecast.

Valuation concessions have great potential for narrowing. The company's current price-earnings ratio in 2017 is 5.4 times, far lower than 14.5 times that of Angang Steel and 11.2 times that of Ma Steel, with a valuation discount of more than 50%. We see that the valuation gap has potential to narrow: (i) trading volume soared to HK$45 million due to yesterday's profit forecast, indicating that more investors are paying attention to the company again; (ii) if Qixing Group's financial issues are resolved in the coming months, investors' concerns about the parent company's financial situation will be greatly reduced.