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. The stock trades at a price-to-book of 0.9 times,
which reflects 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 about the ongoing restructuring of
the business and its ability to extract maximum value from the sale
of non-core assets. 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
Subscribe to WSJ: http://online.wsj.com?mod=djnwires