Upgrading CR Gas, also prefer BEHL and ENN
We attended a reverse roadshow held by PetroChina (857:HK – N-R) in Xinjiang Province last week. Weexpect gas demand to remain strong and believe limited piped gas supply will lead to higher liquefiednatural gas (LNG) price and volume in the coming winter heating season and in
Sustainable volume growth, manageable margin risks and improving free cashflows will support the gas sector’s growth story over 2017-19. Looking into2018, valuations are not demanding at an average 12x P/E. Specifically, wenow upgrade CR Gas, a high-quality laggard, to Buy, as we believe the marketunderestimates its coal-to-gas potential, is overly concerned about margin risksand ignores its best-among-peers balance sheet and FCFs. At currentvaluations, we also prefer BEHL (deeply discounted value play) and ENN (keycoal-to-gas beneficiary with cheap valuation).
Sustainable volume growth story supported by coal-to-gas conversions
Strong gas demand. We note 1H17 interim earnings of downstream gas distributors are largely in line withmarket expectations as higher-than-expected gas sales have offset lower-than-expected gas sales margins.
We estimate an additional 69bcm/year volume upside from coal-to-gasconversions by 2020, contributing nearly half of China’s total incremental gasdemand. We now expect a 15% gas volume CAGR in 2017-20E in China,achieving 10% energy mix by 2020. Historically, the volume growth of leadinggas players is usually 5-10ppt higher than the national average and we expectthe trend to continue. Besides ENN (Hebei and coastal focus) and China Gas(North China focus), which have been recognized by the market as key coal-togasbeneficiaries, CR Gas also looks well-positioned with the largest exposure(14projects) to 2+26cities and more big city projects, where governments aremore active and able to afford subsidies.
ENN Energy (2688:HK – BUY) recorded the highest retail gas sales growth among peers in 1H17, at 26.8%YoY (residential: +25% YoY; commercial & industrial: +34% YoY), while China Resources Gas (1193:HK – N-R)reported a 22% YoY growth (residential: +12% YoY; commercial & industrial: +29% YoY) and Towngas China(1083:HK – N-R) an 18% YoY expansion (industrial: +23% YoY; commercial: +19%). According to gasdistributors, the strong commercial & industrial gas demand was mainly due to coal-to-gas conversions andChina’s economic recovery. According to the National Development and Reform Commission (NDRC), China’sapparent gas consumption grew 30.4% YoY in August 2017, at a significantly higher pace than in 1H17(+15.2% YoY). Given stronger-than-expected gas sales due to coal-to-gas conversions in northern China andcoastal provinces, and the relatively stable economic growth outlook, we expect China’s gas sales growth toreach 25% YoY in 2H17E, leading to +20% YoY in 17E and +15% YoY in 18E.
Margin risks manageable, winter gas shortage is a double-edged sword
Limited margin pressure. ENN Energy’s gas sales margin fell to Rmb0.66/m3 in 1H17 (vs Rmb0.74/m3 in1H16), while China Resources Gas’ dropped to Rmb0.64/m3 (vs Rmb0.75/m3 in 1H16). We note investorconcerns about further gas sales margin pressure, as a result of increasing competition in point-to-point LNGsupply and direct-gas sales. In contrast to market consensus, we see limited potential for further marginsqueeze in point-to-point gas supply in 17-18E, as the average commercial & industrial retail gas price ofRmb2.70/m3 is only 7% higher than the current LNG price. We also see little incentive for end-consumers toswitch from piped gas to LNG, with LNG less than Rmb0.30/m3 cheaper than piped gas.
In this report, we dive deeper into gas sales margin trends by analyzing fourfactors that could affect margins. Overall, we expect margins to trend downgradually but at a tolerable rate (Rmb4-12cents/cm over three years). Potentialwinter non-residential city-gate price hikes (likely 15-20%) is another round ofstress test but we believe the risks are manageable. On the positive side,winter gas shortage has pushed up domestic LNG prices to a two-year high,helping eliminate the threat from LNG direct delivery, the price advantages ofwhich have diminished sharply in recent months.
Potential winter gas shortage. Given the upcoming potential winter gas shortage, following the increasedgas demand from coal-to-gas conversion and limited upstream piped gas supply, we expect PetroChina toraise by 10-15% its benchmark non-residential city-gate price, prior to the upcoming winter. We note theprice of LNG rallied by Rmb390/t to Rmb3,519/t in September (vs Rmb2,820/t in September 2016 andRmb3,030/t in 16A), as a result of the recent LNG supply shortage. With the potential winter gas shortage,we expect average LNG price to remain high at Rmb4,500-5,000/t in 4Q17E and Rmb4200/t in 18E,benefiting upstream LNG suppliers, such as PetroChina, CNOOC, Sinopec, Kunlun Energy (135:HK – N-R), andENN Energy, which signed overseas LNG supply contracts for 1.4mt at an all-in cost of Rmb2,200-2,400/t (itsZhoushan LNG terminal project is scheduled to commence operation in June 2018). However, we areconcerned about the profitability of residential gas sales in rural areas, due to higher gas costs as we expect60-70% of the supply for winter heating to rely on LNG. According to our sensitivity analysis, for every pricehike of Rmb100/t of LNG, China Gas (384:HK – Outperform) will see its FY18E EPS reduced by 0.7%.
Rural opportunities: connection visibility vs. gas sales uncertainties
Remain Overweight. Given expected strong gas sales in 17-18E (two-year Cagr of 18%) and limited marginpressure, we think the sector’s average valuation of 14x 18E PE remains attractive. Thus, we remainOverweight the sector. Our top pick is ENN Energy, given its strong earnings growth (15%) and attractivevaluation of 13x 18E PE. By contrast, we remain cautious on China Gas given the increasing margin pressureon rural residential gas sales and its relatively high valuation of 17x 18E PE.
We see increasing visibility of new connection growth in rural areas due tostronger pushes from local government; therefore, we believe China Gasshould be able to meet its aggressive connection target. Our typical ruralproject model suggests a 8%/11% project IRR/equity IRR but at the same timewe notice the IRR is very sensitive to many moving parts, including actual gasusage, dollar margin, capex and opex, all of which is debatable due to lack ofmature projects as benchmark. Variance of risk appetite might explain gasdistributors’ differing attitude towards rural opportunities. We respect ChinaGas’s pioneer spirit in rural areas and meanwhile agree with ENN and CR Gasabout their discretion and more disciplined return requirements.
Valuations and risks
We use DCF (WACC of 7.6-8.3%) and SOTP to derive target prices. Key risksinclude weaker demand growth, harsher margin squeeze, policy uncertainties.
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