China/Hong Kong China Gas

Kunlun Energy (135 HK) 23 August 2013

Company Rating: Outperform Buy on expected earnings miss (maintained)

• 1H13 earnings miss was expected; long-term growth story intact. Kunlun’s 1H13 earnings miss should not Price: HK$12.08 obscure the fact that its revenue streams are fundamentally sound given the gradual pickup in LNG plant and pipeline Target: HK$15.50 utilization and the rollout of LNG refilling stations over the (down from HK$16.00) medium term. 1H13 net profit rose 5% YoY to HK$3.68b, 11% below consensus. Earnings were negatively impacted Trading data by a 28% YoY decline in E&P pretax profit, despite higher-than-expected LNG midstream volume growth, 52-week range HK$11.40-17.32 downstream gas sales, and lower D&A expense. Market capitalization HK$97.7b/US$12.6b Shares outstanding (m) 8,063 • We still like the LNG market. As of 1H13, Kunlun had Free float (%) 38 developed 53,000 LNG vehicles versus our estimate of 3M average daily T/O (m share) 20 70,000 vehicles by the end of 2013F. Kunlun stands to 3M average daily T/O (US$ m) 34 benefit from LNG refilling stations built by other gas players Expected return (%) - 1 year 28 over the next two years as overall adoption of LNG vehicles Closing price on 22 August 2013 and LNG demand will rise accordingly. Despite uncertainty over a potential LNG source price hike and signs of a Stock price and HSCEI slowdown in downstream development, we believe the HK$ government will be able to fuel LNG vehicle development 18 through policies implemented over the next few years. 17 16 • Buy on temporary share price weakness. Kunlun’s recent 15 underperformance is due in part to widespread rumors of a 14 100%-plus LNG source price hike, lower-than-expected 13 Shaanjing pipeline volume growth and weak oil prices in 12 1H13. Over the medium term however, we expect earnings to 11 be underpinned by stronger transmission and gas sales 10 9 volume growth. After factoring in weaker E&P volume and 8 gas transmission volume in 1H13 balanced by improvement 1-Jan-12 26-Mar-12 19-Jun-12 12-Sep-12 6-Dec-12 1-Mar-13 25-May-13 18-Aug-13 in the mid-to-downstream gas business, we revise our Kunlun Energy HSCEI (rebased) 2013F/2014F earnings by -1%/+2%. Our new HK$15.50 Source: Bloomberg DCF-based SOTP target price suggests 28% upside.

Forecast and valuation Year to 31 Dec 2011 2012 2013F 2014F 2015F Revenue (HK$m) 25,915 32,953 40,027 50,077 61,362 Operating profit (HK$m) 8,137 11,154 12,766 15,718 19,399 Operating margin (%) 31.4 33.8 31.9 31.4 31.6 Net profit (HK$m) 5,621 6,518 7,282 8,512 10,001 EPS (HK$) 0.79 0.84 0.90 1.06 1.24 YoY change (%) 33.9 6.3 8.3 16.9 17.5 P/E (x) 15.4 14.5 13.4 11.4 9.7 Dividend yield (%) 1.8 1.9 2.2 2.6 3.1 Price/book value (x) 2.85 2.19 1.95 1.73 1.53 ROE (%) 19.6 17.4 15.4 16.1 16.7 Christeen So Net gearing (%) 35 19 34 37 33 (852) 2844 3609 Source: CCBIS estimates [email protected]

Please read the analyst certification and other important disclosures on last page Kunlun Energy (135 HK) 23 August 2013

Still following a good trajectory

We expect to see higher profit contribution from the mid-stream LNG and gas transmission business in 2014F-2015F. In 1H13 the company transmitted 12.3b m3 of natural gas, up a meager 0.3% YoY mainly on lower-than-expected utilization of the Shaanjing pipelines. However, looking towards 2H13-2014F, we believe a gradual pickup in Shaanjing pipeline volume and the fuel cost pass-through mechanism will lead to higher profit contribution from Kunlun’s transmission business. We also see strong 68% YoY volume growth from the company’s LNG terminal and processing plants, which accounted for 9.5% of 1H13 pretax profit, up from 3% in 1H12. Volume is likely to continue to rise given the rising contribution from Kunlun’s two new processing plants which commenced operations since the beginning of 2013. One of these was the sizable Xinjiang Hotan plant that boasts 5.78m m3/day capacity. There are also four other plants slated to begin operations in 2H13F-2014F.

LNG market still a structural growth story. ENN Energy plans to add 100 LNG refilling stations in 2013F while HKCG will add 50 stations by 2015F. These are but two examples of the rising number of downstream gas players aggressively tapping into the fledgling LNG refilling station market. Rapid vehicle infrastructure expansion coupled with favorable government policies is creating fertile ground for massive adoption of LNG vehicles. These trends should lend support to Kunlun Energy’s gas sales over the next few years. In preparation, the company developed 53,000 LNG vehicles in 1H13 and we expect it to double its LNG vehicle development to 70,000 by the end of 2013F. We conservatively forecast 36% YoY growth in gas sales volume for 2013F.

Recent share price weakness provides good entry point. We believe Kunlun Energy’s recent share price weakness reflects market speculation over a potential 100%-plus LNG source price hike from PetroChina (857 HK, Not Rated) earlier this quarter, lower-than-expected 1H13 volume growth from the Shaanjing pipelines, as well as the weak oil price in 1H13. We believe short-term pressure remains in the lead up to PetroChina’s final announcement of an LNG source price hike and an expected pickup in Shaanjing pipeline volume in 2H12, yet we believe Kunlun’s long-term growth story remains intact given (1) stronger demand after the commencement of new gas-fired plants along the Bohai Rim, (2) the massive rollout of LNG refilling stations, (3) more LNG processing plants becoming operational, and (4) the pickup in gas transmission volume over the medium term. We reiterate our Outperform rating and suggest investors buy on temporary share-price weakness. Kunlun Energy’s valuation looks inexpensive to us when the stock is trading at 13x and 11x on our 2013F-2014F EPS forecasts, compared with the past-three-year average of 18x.

We marginally revise our earnings forecasts by -1% for 2013F and +2% in 2014F. We fine-tune our 2013F and 2014F earnings by -1% and +2% after taking into account weaker transmission volume and lower E&P sales volume for 1H13F balanced by improvement in the company’s gas midstream business in 2014F-2015F. Overall, we are still positive towards the mid-to-downstream gas business and like Kunlun as it is a leader within China’s LNG vehicle market with a compelling asset-injection story. Our new earnings forecasts are 1% and 6% above consensus for 2013F and 2014F. Our HK$15.5 new DCF-based SOTP target price based on 9-9.5% WACC suggests a 28% upside potential.

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Kunlun Energy (135 HK) 23 August 2013

Absolute YTD share price performance in 2013 Relative YTD share price performance in 2013

Tianlun Gas Tianlun Gas

China Gas China Gas ENN Energy ENN Energy Towngas China Towngas China CR Gas CR Gas Beijing Enterprises Beijing Enterprises Tianjin Jinran Gas

Kunlun Energy Tianjin Jinran Gas

HSCEI Index Kunlun Energy

(40)% (20)% 0% 20% 40% 60% 80% (20)% 0% 20% 40% 60% 80% 100%

Source: Bloomberg Source: Bloomberg

WTI Crude oil price Kunlun’s YTD EPS revision

US$/barrel HK$ 110 1.30

1.25 105 1.20 100 1.15

95 1.10

1.05 90 1.00 85 0.95

80 0.90 Jan Feb Apr Jun Jul Sep Nov Dec Jan-13 Jan-13 Mar-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 2012 2013 2013F 2014F Source: Bloomberg Source: Bloomberg

China gas utilities peer valuation

Share P/B Yield Net gearing Stock CCBIS Mkt cap price P/E (x) EPS growth (%) (x) (%) ROE (%) (%) Company code rating (HK$b) (HK$) 2013F 2014F 2015F 2013F 2014F 2015F 2013F 2013F 2013F 2014F 2015F 2013F Beijing Enterprises 392 HK O 60.12 51.40 15.9 12.9 10.6 12.7 23.4 21.5 1.4 1.7 9.0 10.5 12.0 35.8 China Gas 384 HK O 36.51 8.10 18.6 15.4 13.1 10.6 20.6 17.4 2.9 1.0 16.4 17.4 17.8 77.1 CR Gas 1193 HK O 42.66 17.90 19.6 14.9 11.9 11.8 31.1 25.6 3.0 1.1 16.3 18.6 20.0 15.6 ENN Energy 2688 HK O 44.97 39.25 18.2 13.6 10.8 24.9 33.6 26.6 3.3 1.4 19.5 22.3 23.8 42.1 Kunlun Energy 135 HK O 93.87 12.08 13.4 11.4 9.7 8.3 16.9 17.5 2.0 2.2 15.4 16.1 16.7 34.2 Tianjin Jinran 1265 HK N 3.73 1.83 19.2 15.1 11.9 17.6 27.6 26.8 1.6 1.3 8.9 10.5 12.1 (29.1) Tianlun Gas 1600 HK O 5.09 6.73 28.0 22.1 17.9 18.5 26.4 23.4 4.9 0.0 19.1 19.8 20.1 48.7 Towngas China 1083 HK N 2.39 7.25 18.5 15.8 13.8 14.5 17.6 14.3 1.5 1.1 9.0 9.4 10.0 31.7 Sector average 18.9 15.1 12.5 14.9 24.7 21.6 2.6 1.2 14.2 15.6 16.6 32.0 Source: Bloomberg, CCBIS Research Note: Share price as of 22 August 2013

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Kunlun Energy (135 HK) 23 August 2013

Kunlun Energy – key assumptions

2011 2012 2013F 2014F 2015F Exploration and Production Subsidary + associates + JCEs Sales Volume ('000 barrel) 17,060 17,566 18,052 18,341 18,341 % change 4.1 3.0 2.8 1.6 0.0 ASP (US$/barrel) 105.1 104.1 100.3 95.4 96.4 % change 40.6 (1.0) (3.6) (4.8) 1.0

Natural Gas Distribution Natural gas sales Sales volume (m cm) 3,829 4,818 6,558 8,555 10,499 % change 72.4 25.8 36.1 30.4 22.7 ASP (HK$/cm) 2.3 2.8 2.9 3.0 3.2 % change 5.6 20.0 3.0 5.5 4.5 LNG terminal Sales volume (m cm) 1,638 5,078 6,602 8,912 12,032 % change NM 210.0 30.0 35.0 35.0 ASP (HK$/cm) 0.37 0.38 0.40 0.41 0.42 % change NM 2.7 5.0 4.0 3.0 Natural gas pipelines Sales volume (m cm) 20,786 23,833 26,216 30,411 34,973 % change 18.0 14.7 10.0 16.0 15.0 ASP (HK$/cm) 0.48 0.48 0.48 0.48 0.48 % change NM 0.1 0.0 0.0 0.0 Source: Company, CCBIS estimates

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Kunlun Energy (135 HK) 23 August 2013

Kunlun Energy – consolidated income statement

Year ended 31 December (HK$m) 2011 2012 2013F 2014F 2015F Revenue Exploration and production 6,189 6,076 5,796 5,545 5,600 Natural gas sales 8,633 12,734 17,692 24,068 30,254 LNG terminal & processing 1,156 2,733 3,988 5,906 8,765 Natural gas pipelines 9,937 11,410 12,551 14,559 16,743 25,915 32,953 40,027 50,077 61,362 % change 49.5 27.2 21.5 25.1 22.5

Other net income 174 361 365 368 372 % change (14.3) 107.5 1.0 1.0 1.0

Less: Operating costs Purchases, services and others (9,307) (12,912) (17,007) (22,356) (28,127) Depreciation and amortization (4,090) (4,434) (4,851) (5,256) (5,611) Employee compensation costs (1,505) (1,684) (2,005) (2,459) (2,952) Selling, general and (1,607) (2,165) (2,590) (3,190) (3,847) administrative expenses Other (1,443) (965) (1,172) (1,466) (1,797) (17,952) (22,160) (27,625) (34,727) (42,334) % change 61.4 23.4 24.7 25.7 21.9

Operating profit (EBIT) 8,137 11,154 12,766 15,718 19,399 % change 26.8 37.1 14.5 23.1 23.4 Operating profit margin 31.4 33.8 31.9 31.4 31.6

Interest expenses (405) (661) (816) (1,037) (1,126) Interest income 178 172 182 148 145 Net interest expense (227) (489) (634) (889) (981) Share of associates 2,255 2,334 2,317 2,304 2,376 Share of JCEs 322 307 333 326 329 Exceptional item 0 0 0 0 0 Profit before taxation 10,487 13,306 14,782 17,459 21,124 Taxation (2,291) (3,392) (3,640) (4,226) (5,249) Profit after taxation 8,196 9,914 11,142 13,232 15,874 Non-controlling interests (2,575) (3,396) (3,860) (4,720) (5,873) Net profit 5,621 6,518 7,282 8,512 10,001 % change 34.0 16.0 11.7 16.9 17.5 Source: Company, CCBIS estimates

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Kunlun Energy (135 HK) 23 August 2013

Kunlun Energy – consolidated cash flow statement

Year ended 31 December (HK$m) 2011 2012 2013F 2014F 2015F Operating activities Net cash from operations 11,820 13,224 16,638 22,679 25,019 Taxation paid (2,222) (3,161) (3,640) (4,226) (5,249) 9,598 10,063 12,999 18,453 19,769

Investing activities (Increase)/decrease in fixed assets (16,350) (15,792) (23,396) (19,679) (13,928) (Increase)/decrease in associates and 1,895 2,784 2,385 2,366 2,435 JCEs Interest received 178 172 182 148 145 Other (8) (35) 0 0 0 (14,285) (12,871) (20,829) (17,165) (11,348)

Financing activities Shares issues/(repurchases) 96 10,605 0 0 0 Capital contributions from equity 0 0 0 0 0 owners Capital contributions from 1,358 3,249 1,840 920 0 non-controlling interest Increase/(Decrease) in borrowings 9,647 3,701 6,000 5,000 0 Dividends paid to MI (837) (2,310) (2,625) (3,211) (3,995) Dividends paid to equity owners (684) (1,766) (1,852) (2,185) (2,554) Interest paid (1,267) (1,418) (1,660) (1,923) (2,043) Other (397) (1,636) 0 0 0 7,916 10,425 1,703 (1,398) (8,591)

Increase/(decrease) in cash 3,229 7,617 (6,128) (110) (171) Cash at beginning of year 8,203 11,718 19,592 13,464 13,354 Effect on FX change 286 257 0 0 0 Cash at end of year 11,718 19,592 13,464 13,354 13,183

Add: Pledged bank deposits 0 0 0 0 0 Cash balance at bal sheet 11,718 19,592 13,464 13,354 13,183 Source: Company, CCBIS estimates

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Kunlun Energy (135 HK) 23 August 2013

Kunlun Energy – consolidated balance sheet

Year ended 31 December (HK$m) 2011 2012 2013F 2014F 2015F Current assets Inventories 563 717 944 1,241 1,562 Accounts receivables 736 1,367 1,660 2,077 2,545 Prepaid expenses and other current assets 3,594 5,575 6,772 8,472 10,381 Time deposits with maturities >3mths 0 0 0 0 0 Cash and cash equivalents 11,718 19,592 13,464 13,354 13,183 16,611 27,251 22,841 25,145 27,672 Non-current assets Property, plant & equipment 56,677 69,225 87,683 102,010 110,222 Advanced operating lease payments 1,218 2,199 2,292 2,394 2,505 Investments in associates 6,158 5,606 5,838 6,068 6,306 Investments in JCE 1,732 1,541 1,574 1,607 1,640 Other non-current assets 1,811 2,720 2,720 2,720 2,720 67,596 81,291 100,107 114,799 123,392

Total assets 84,207 108,542 122,948 139,944 151,064

Current liabilities Short-term borrowings 2,611 5,111 5,111 6,886 6,886 Account payable and accrued liabilities 8,913 12,438 12,743 14,283 15,295 Other payables 1,048 814 1,015 1,276 1,555 12,572 18,363 18,869 22,444 23,736 Non-current liabilities Long-term borrowings 24,964 26,562 31,594 35,787 35,787 Other non-current liabilities 1,013 1,439 1,794 2,255 2,749 25,977 28,001 33,388 38,042 38,536

Non-controlling Interests 15,275 17,756 20,830 23,260 25,138 Equity and reserves 30,383 44,422 49,861 56,198 63,654 Total equity & liabilities 84,207 108,542 122,948 139,944 151,064 Source: Company, CCBIS estimates

Kunlun Energy – key financial ratios Year ended 31 December 2011 2012 2013F 2014F 2015F EPS (HK$) 0.79 0.84 0.90 1.06 1.24 EPS growth (%) 33.9 6.3 8.3 16.9 17.5 P/E (x) 15.4 14.5 13.4 11.4 9.7 DPS (HK$) 0.22 0.23 0.27 0.32 0.37 DPS growth (%) 59.3 4.6 18.0 16.9 17.5 Yield (%) 1.8 1.9 2.2 2.6 3.1 Cash earnings/share (HK$) 1.36 1.40 1.51 1.71 1.94 P/CE (x) 8.9 8.6 8.0 7.1 6.2 BV/share (HK$) 4.2 5.5 6.2 7.0 7.9 P/B (x) 2.9 2.2 2.0 1.7 1.5 EV (HK$m) 102,477 109,331 121,459 126,569 126,740 EBITDA (HK$m) 14,804 18,229 20,267 23,604 27,716 EV/EBITDA (x) 6.9 6.0 6.0 5.4 4.6 Net debt/(cash) (HK$m) 15,857 12,081 24,209 29,319 29,490 Net debt/equity (%) 34.7 19.4 34.2 36.9 33.2 Interest cover (x) 35.8 22.8 20.1 17.7 19.8 ROE (%) 19.6 17.4 15.4 16.1 16.7 ROA (%) 14.8 14.5 13.5 14.1 15.3 Source: Company data, CCBIS estimates

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Kunlun Energy (135 HK) 23 August 2013

Rating definitions Outperform (O) – expected return > 10% over the next twelve months Neutral (N) – expected return between -10% and 10% over the next twelve months Underperform (U) – expected return < -10% over the next twelve months Analyst Certification: The authors of this report, hereby declare that: (i) all of the views expressed in this report accurately reflect their personal views about any and all of the subject securities or issuers; and (ii) no part of any of their compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed in this report; and (iii) they receive no insider information/non-public price-sensitive information in relation to the subject securities or issuers which may influence the recommendations made by them. 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