preface

Since 2019, we have written several reports “Leading Steel Structure Manufacturing Leaders, Enjoying Industry Growth Dividends - Honglu Steel (002541.SZ) Investment Value Analysis Report”, “From a Profit Statement Perspective, Further Discussing the Sources of Honglu Growth - Honglu Steel Structure (002541.SZ) In-depth Tracking Research 2”, “From the perspective of assets and cash flow, three discussions on Honglu Value - Honglu Steel (002541.SZ) In-depth Follow-up Research Series 3”, “Strengthening Competitiveness: Honglu Steel (002541.SZ) will continue to expand its leading edge in the new cycle - Honglu Steel Structure (002541.SZ) Structure (002541.SZ) depth “Follow-up Research Report 4” discusses Honglu's moat and competitive advantage: in labor-intensive industries with low profit margins, cost leadership brought about through scale effects and fine management, and eventually achieved leapfrog growth in production capacity and output. Since 2023, we have explained Honglu's firm investment in intelligent transformation in reports such as “Intelligent Transformation: The Moat Continues to Widen, and Production to the Next Level — Honglu Steel Structure (002541.SZ) In-depth Tracking Research Report 5”, and we are also optimistic that after intelligent transformation, Honglu's overall competitiveness (product quality optimization, improved delivery responsiveness, improved tonne profit, and effective production capacity increase) will be further strengthened.

Why is intelligent transformation a thorny path?

1) Currently, there are no mature solutions for the steel structure industry in the equipment industry, mainly due to the high degree of customization of steel structure products, diverse and complex product types, and differences in welding, cutting, and spraying standards for different delivery scenarios. For Honglu, building a “cutting-welding-transport-coating” intelligent production line for all kinds of steel structure products is a “path no one has walked”.

2) Since there is currently no optimal solution, the products of major equipment suppliers are still in the process of iteration, which means that intelligent transformation may face the dilemma of “loss of efficiency” at this stage, that is, loss of production efficiency and increase in production costs. At the same time, intelligent transformation requires reshaping the production process, and the production line layout needs to be adjusted, which in turn affects immediate production. In 24Q2, Honglu's production growth rate (1.19 million tons, +0.1% year over year) was significantly affected by the above factors.

3) In the context of weak demand, intelligent transformation requires courage and determination. Over the past 24 years, the overall steel structure industry has been under pressure due to weak demand for downstream manufacturing investment and infrastructure investment. Referring to the business data of Seiko Steel, another leader in the steel structure industry, its 24H1 steel structure sales volume was 0.57 million tons, -1% year over year; 24Q2 sales volume was 0.28 million tons, -15% year over year. For management, sacrificing short-term production and sales volume and profit requires great courage; after fully understanding the long-term significance of intelligent transformation, ignoring interference from the outside world also requires great determination.

Why is intelligent transformation the right path for the long term?

1) As a labor-intensive industry with low profit margins, steel structures are greatly affected by the supply of skilled jobs. The wages of welding workers are higher and personnel turnover is high, causing uncertainty in cost control, product quality, and delivery cycle. Intelligent transformation can effectively solve the above problems.

2) After the intelligent transformation is completed, product quality is optimized, and delivery response is improved. Stronger product pricing competitiveness will increase customer satisfaction, thereby increasing market share. Furthermore, the intelligent transformation will significantly increase the profit center of the tonne steel structure; in addition, its actual production capacity will rise to the next level (see “Intelligent Transformation: The Moat Continues to Widen, and Production Will Rise to the Next Level — Honglu Steel Structure (002541.SZ) In-depth Tracking Research Report 5”).

3) Intelligent production lines weaken management difficulties, break through industrial workers' restrictions on the layout of their production bases, and make it possible for the company to “go global” in the future.

4) Regardless of future needs, improving the overall competitiveness of enterprises is the right path: a) If demand improves, intelligent transformation drives actual production capacity increase, which will help the company rapidly increase its market share; b) if demand continues to decline, intelligent transformation will strengthen cost advantages and quality advantages, which will help the company to passively increase its market share during the market reshuffle period.

Why can Honglu Steel Structure implement intelligent transformation of steel structures as quickly as possible?

1) Honglu has a huge production capacity and has formed relatively standardized specialized production lines for different products.

Compared with the general-purpose flexible production lines of other companies, the intelligent transformation of dedicated lines is relatively less difficult, and the transformation progress is faster.

2) The huge internal market makes it possible to be self-reliant: a) A team of experienced workers provides “knowledge base” training for the algorithm team; b) The practical application of steel structures in various scenarios is conducive to rapid iteration of equipment and algorithms.

3) Company management's deep understanding and firm determination for intelligent transformation.

In the current situation of weak demand, why are we still firmly promoting intelligent transformation?

1) With the technological upgrading of the equipment industry and the continuous optimization of algorithms, the intelligent transformation of the steel structure industry already has the technical conditions. Currently, many equipment manufacturers have launched corresponding solutions. Honglu also purchased some equipment from such enterprises in the early stages and cooperated accordingly, but the equipment manufacturer's solutions are not yet mature. Therefore, the company decided to take the lead in setting up a R&D team and carry out long-term cooperation with external intelligence to carry out research and development. For companies, technological progress can create deeper barriers to competition, ultimately achieve stronger competitiveness, and lead the entire industry.

2) Honglu's intelligent transformation began in 2021. In the early stages, it was more about expanding the management radius and improving efficiency through digital informatization and other means, thereby solving the hidden risk of “uncontrolled management” that may be encountered during the scale expansion process. The transformation of intelligent production lines is also aimed at solving real problems in the current production process. If they give up trying to upgrade the industry due to low demand for steel structures at this stage, it may cause R&D personnel and early R&D experience to be lost, making a wedding dress for others.

3) For Honglu, although the intelligent transformation has a short-term impact on its income statement, the pressure on its cash flow and balance sheet is not significant. In 2017-2023, Honglu reached an average annual capital expenditure of 1.4 billion yuan and a cumulative investment of about 10 billion yuan, eventually achieving an annual production capacity leap from 1.02 million tons to 5 million tons. In the next phase, Honglu's production capacity expansion will shift from “building a new base” to “intelligent transformation,” while the investment intensity required for “intelligent transformation” is far lower than the former. As capital expenses for the new base are reduced, the time is right for an intelligent transformation.

Investment advice: If the road is long, it will come; even if it is difficult, it will be achieved

1) Short-term apparent data is under some pressure. Honglu will still be at the peak of intelligent investment in 24-25. Considering that production and profit will be affected by intelligent transformation and iterative upgrades, and that high R&D investment puts pressure on the company's profit side, we lowered our 24-26 net profit forecast to 1.24/1.3/1.65 billion yuan, respectively, to a corresponding reduction of 19%/28% 25%. The current price corresponds to a 24-year dynamic price-earnings ratio of 8x.

2) It has been underestimated from a long-term perspective. Profit center: Under the pessimistic assumption, the intelligent transformation did not bring about an increase in effective production capacity (see 5 million tons of production capacity at the end of 2023; production capacity will maintain this value after the pessimistic assumption), and the current low ton profit level is used as the long-term profit center (see 2023 tons minus non-net profit of 205 yuan, year-on-year - 79 yuan/ton, and factors such as high R&D investment have lowered the profit level), corresponding to annual profit of about 1 billion yuan; the current market value corresponds to the pessimistic PE valuation of about 9x, which is at an extremely low level in history. Free cash flow perspective: Production capacity expansion was achieved in 2017-2023 through the construction of a new base, with an annual capital expenditure of about 1.4 billion yuan; the capital expenditure intensity of intelligent transformation is lower than that of a newly built plant, and capital expenditure will also drop drastically after the renovation is completed; it is expected that its free cash flow will improve, which will also support its long-term valuation.

3) Maintain a “buy” rating. Honglu's solutions in intelligent cutting and intelligent welding have gradually matured, and have now entered the large-scale deployment stage. The production line transformation process has an adverse impact on current production and profit, but in the long term, it will further enhance the company's competitiveness and increase market share; high R&D expenses affect current profits, but it can reduce investment in equipment capital expenses and accelerate the iteration and upgrading of intelligent production lines. If you go a long way, you will come; if something is difficult to do, it will always be possible. We maintain a “buy” rating for the company.

Risk warning: demand fell beyond expectations, steel prices fluctuated sharply, and the effects of intelligent transformation fell short of expectations.