Survival of the fittest - the worst has yet to come
Ahead of prolonged margin pressure and rising funding costs, IPPs with
stronger cost control and margin protection remain our favorite, i.e. CRP.
Despite marked recent share price correction, we downgrade our sector
stance to Cautious from Neutral as we believe 1Q/2Q08 results could
reveal even more troubles for IPPs, further pressuring share prices.
Escalating coal prices; elusive tariff increases; uncertain utilization
IPPs have yet again raised their guidance on 2008 yoy increases in unit
coal costs, up to 18%. We forecast 10% for CRP and 15%-18% for others.
We still do not assume tariff increases as timing remains vague. We share
our Goldman Sachs China Economist’s view that inflation remains the key
obstacle against tariff increases. Yet, recent price increases allowed in
other sectors and further discussions by NDRC make the market’s estimate
of a 3Q/4Q08 increase more probable now. On utilization, we think macro
tightening and IPPs’ weakening profit margin expose it to higher risks.
Declining profits prompt alternative investments; risks abound
The lack of a complete power reform yet renders many IPPs ill-equipped to
cope with margin compression. We think “one-off” remedies (ad-hoc tariff
increases) and monopolistic customers (power distribution) dampen IPP’s
investment in capacity growth. Many resort to non-core ventures in coal,
transportation, and private equity to boost return but with more new risks.
Consensus estimates still too bullish - P/E convergence to come
We think consensus estimates for 2008 and beyond remain excessively
high and that the P/E gap among H-share IPPs will therefore shrink. We cut
DCF-based 12-month target prices for our coverage by up to 34%, and cut
2008E-2009E EPS by up to 50% mostly on higher coal prices. We see
coverage EPS declining by 6% over 2008E-2009E vs. up 16% in 2006.
Pair trade: long CRP (Buy), short Huaneng (Sell, Conviction List)
CRP remains our top pick for its stronger earnings growth and ROE. We
downgrade Huaneng (A and H) to Sell from Neutral as we think the market
has not fully priced in higher coal costs and debt burden, and downside
risk to dividend yield. We downgrade Datang (H) to Neutral from Buy, and
Datang (A) and Huadian (A) to Sell from Neutral on valuation. Key risks are
the sudden tariff increases and plummeting coal prices.