What was announced?Baosteel Group and Wuhan Iron and Steel (Group) (WISCO), two of China’slargest steelmakers, are planning to restructure, according to their listed units.

　　No details have been disclosed yet and the restructuring plans are subject toregulatory approval. We believe this could relate to a potential merger of thetwo steel groups at the parent level (and not listcos), in line with China's SOEreforms.

　　Who is WISCO?Based in Hubei, WISCO was established in 1958 and is fully owned by CentralSASAC. Its subsidiary, Wuhan Iron and Steel Co Ltd (600005.CH) was listed onthe main board of SHSE in 1999. In 2015, WISCO produced 25.78mt crudesteel, ranking #11 in the world and #6 in China by output, according to theWorld Steel Association. WISCO reported 2015 EBITDA of RMB894mn onrevenues of RMB101.7bn, resulting in an EBITDA margin of 0.9%. Gross debtfinished the year at RMB94.9bn, of which 81.7% was ST Debt. Cash balancewas RMB8.4bn, Gross leverage 106x and gross debt to total capital 67.5%.

　　What if two became one?If the merger goes through successfully, the combined entity will be the largeststeelmaker in China, and second largest in the world. While we appreciate amerger may prompt agencies to re-think the importance of the combinedentity to the central government, purely from a financial standpoint, we believea merger would be credit negative for Baosteel Group given WISCO has amuch higher leverage/gearing. Pro forma EBITDA in 2015 for the combinedentity was RMB14.8bn, on revenues of RMB331.7bn. EBITDA margin wouldfall to 4.5% vs. 6.0% for Baosteel Group. Gross debt and Cash would havebeen RMB236.4bn and RMB45.3bn respectively at YE15, implying grossleverage and gearing at 16.0x and 42.1% for the combined entity, compared to10.2x and 33.6% for Baosteel Group. We are obviously not factoring anypossible synergies and are assuming a simple combination of the two entities.

　　What's our view on bonds?As highlighted in our report, "China IG RV Series - Metals & Mining andPower” dated June 21, Baosteel bonds are among the widest trading in theirrating bucket in Asia IG. Assuming the credit can stay IG (and we think it will inthe near to medium term), a lot of downside already seems priced in. However,given our negative sector view and uncertainties relating to the merger, weretain our Hold recommendation. Between the two bonds though, we continueto prefer the 2018s (G+200bp) over 2020s (G+225bp). The 2018s are rated 1-notch higher by S&P and obviously shorter tenor, though they don’t benefitfrom the EMBIG eligibility as 2020s. The 2018s should also benefit from theonshore bid at some point. We don't expect the CoC put to be triggered ineither of the bonds in a base case scenario. Upside risks include steel pricerecovery, deleveraging post full operation of Zhanjiang plant, and downsiderisks are limited rating headroom, acquisitions of weaker steel companies, etc.