By Thomas Streater

China's major power producers hope to embrace the market's invisible hand sooner rather than later.

The Chinese government's ambition to allow market forces to play a 'decisive' role in the world's second largest economy could be a boon for the industry, as electricity prices are freed from the iron grip of official diktat and power producers focus on delivering better returns from their generation assets.

While utility stocks in developed markets like the US are viewed as yield plays, China's power producers offer investors an alluring mix of yield and growth. Some investors have questioned whether the yields offered by China's utility stocks are sustainable, but those juicy returns to shareholders should be underwritten as companies focus on sweating their existing assets harder rather than just blindly adding new, but unprofitable, capacity.

China's power producers have received a boost from the decline in the prices for thermal coal, the fossil fuel that provides more than 70% of the country's electricity. But Goldman Sachs analyst Franklin Chow says there are more compelling reasons to own the sector than it just being a bet akin to taking a short position in coal. He highlights what he calls the three Cs as key to the industry's prospects; affordable coal, disciplined capital expenditure, and improved free cash flow.

It is a more disciplined approach to capital expenditure that could significantly improve the profitability of China's power producers. China's once red hot pace of growth had encouraged the industry to build additional capacity, but that capacity is being underutilized as economic growth has cooled to slowest pace in five years. While this is not great news for the industry in the short term, it should encourage power producers to refrain from adding additional capacity.

Waiting for the installed capacity to be fully utilized would not only boost the firm's returns on capital, but also allow the government to raise electricity prices. The Chinese government is keen to allow market forces to play a more prominent role in the setting of electricity prices, rather than maintaining them at heavily subsidized levels. Not only would higher electricity prices help the government in its fight against pollution, it would allow the power producers to bolster their earnings.

There are five Hong Kong-listed independent power producers. Goldman's Chow has buy ratings on Huadian ( 1071.HK), China Resources Power ( 836.HK), and China Power International ( 2380.HK) because he believes they are cheaply valued and well positioned to benefit from improved operating conditions over coming years.

Chow likes Huadian because its expected growth in free cash flow should allow it to pay down its debt. Net debt-to-equity could fall to 226% in 2015, well down from the eye watering 430% recorded in 2011. The company has about 70% of its generation assets based in Northeast China and could also benefit from plans for its state-backed parent company to inject additional assets. The stock trades at a projected price-earnings multiple of around seven times and yields just under 5%.

China Resources Power has been in the headlines for all the wrong reasons. The resignation of its president on corruption charges doesn't present the company in the best light, but investors can take comfort from the company's relatively low net-to-debt position of 102%. The company is viewed as fairly well sheltered against tightening credit conditions in China. Not as cheap as Huadian at nine times earnings, China Resources Power has a solid return on equity of 19% underwritten by robust net margins. The stock yields just above 3%.

China Power International is different from the other coal-based power producers as one-fifth of its revenue comes from hydro power. Nearly all of its power is generated in the eastern provinces. The stock is the cheapest on a forward price-earnings multiple of under seven times and a price to book of 0.9 times. It boasts a healthy dividend yield of around 6%.

Datang International Power Generation ( 991.HK) gets the nod from Credit Suisse analyst Dave Dai, who has an overweight rating on the stock on the stock due to a low book value of 0.9 times and thanks to its limited exposure to China's coastal regions. The company's nuclear power plants provide an advantage at a time when the government is seeking to cut pollution. Dai argues that coal-fired generation in coastal regions will face increasing competitive pressure from nuclear power. Goldman's Chow, who rates Datang as neutral, has concerns over the announced sale of its coal chemical business that could see a valuation discount from the buyer. Datang's dividend yield is 3.7%.

Finally, the largest player by market cap and power generation capacity is Huaneng Power International ( 902.HK, HNP). The company is a national operator, though 30% of its generation comes from Jiangsu and Shandong provinces, and has some generating assets in Singapore. Most of its generation is coal fired. Barclays analyst Ephrem Ravi, who has an overweight rating, argues the stock's yield of more than 5% can be increased over coming years. He also believes the injection of additional assets from its state-controlled parent company could provide an additional boost to earnings in 2015. The stock trades at a forward P/E of eight and yields just over 5%.

China's major power producers are poised to benefit from the government's desire to see greater market pricing in energy markets. These reforms could lift see the stocks re-rated, with price-earnings multiples expanding from single digits to double digits, similar to their peers in developed markets. Just as investors in developed markets are willing to pay up for predictable earnings, so too could investors in China power producers if the companies make the most of the reforms and focus on profitable capacity growth.

Email: thomas.streater@barrons.com

Comments? E-mail us at asiaeditors@barrons.com

 
 
 

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