Asia Pacific Equity Research 22 July 2020
China Gas Sector Primer National Pipeline Company - more than a pipe dream
China plans to restructure the midstream gas sector in 4Q20 with the transfer of Utilities and Environmental the country’s long-distance pipelines and LNG terminals into a single entity. AC Large downstream gas utilities will benefit under this backdrop from 1) improved Elaine Wu (852) 2800-8575 access to midstream pipelines and international gas supplies, 2) industry [email protected] consolidation and 3) lower gas prices for end-users. Kunlun Energy, China Bloomberg JPMA EWU
See page 25 for analyst certification and important disclosures, including non-US analyst disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
www.jpmorganmarkets.com Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Key charts/ tables
Table 1: JPM covered gas utilities comp sheet
Last Av g daily EPS growth Net JPM JPM PT price Upside Mkt cap liquidity (%) P/E (x) P/B (x) Yield (%) debt/equity RoE (%) EV/EBITDA (x) Company Ticker Rating (HK$) (HK$) (%) (US$mn) (US$mn) FY20E FY21E FY20E FY21E FY20E FY21E FY20E FY21E FY20E FY21E FY20E FY21E FY20E FY21E BJE 392 HK Neutral 32.0 27.6 16.2 4,485 6.6 4 5 4.3 4.1 0.4 0.4 4.1 4.3 50 51 9.8 9.4 5.5 5.1 China Gas* 384 HK Neutral 30.0 23.8 26.1 16,023 45.2 14 12 11.6 10.4 2.6 2.2 2.5 2.9 69 58 22.3 21.0 9.2 8.2 CR Gas 1193 HK OW 47.7 38.3 24.5 11,433 30.1 4 9 15.9 14.7 2.5 2.3 2.4 2.6 (16) (14) 15.8 15.6 8.8 7.9 ENN 2688 HK Neutral 102.5 93.2 10.0 13,537 25.1 14 12 15.7 14.0 3.2 2.8 2.2 2.6 47 46 20.2 19.8 9.9 8.6 Kunlun 135 HK OW 8.0 5.6 43.9 6,211 15.6 (5) 8 7.0 6.5 0.8 0.7 5.7 6.2 12 4 11.5 11.6 4.2 3.9 Average 6 9 10.9 9.9 1.9 1.7 3.4 3.7 32 29 15.9 15.5 7.5 6.8 Source: J.P. Morgan estimates, Bloomberg. *FY21/22 figures used for China Gas, fiscal year end 31 Mar. Table 1: Asset injection scenario analysis. Kunlun could get Table 2: Shaanjing line valuation and implied NAV. Kunlun’s shares Rmb13.4Bn in cash assuming 1.2x P/B on Shaanjing line and Dalian are undervalued as the current price level is ascribing almost no LNG terminal and 50% cash compensation value i.e. 0% cash compensation for Shaanjing line P/B (x) Assumed P/B Assumed Implied JPM Upside to current (Rmb MM) 1.0 1.2 1.5 multiple cash % PT (HKD) share price 25% 5,581 6,697 8,372 1.2 0% 5.4 -3% % of 50% 11,162 13,395 16,744 1.2 20% 6.0 8% cash 75% 16,744 20,092 25,115 1.2 40% 6.6 18% Source: Company reports and J.P. Morgan estimates. 1.2 60% 7.1 28% 1.2 80% 7.7 38% Source: J.P. Morgan estimates. Figure 3: Evolution of Kunlun’s operating earnings profile. Kunlun Figure 4: Kunlun’s free cash flow (after asset injection) vs. dividend will focus on its downstream gas sales business going forward payment. Kunlun will not need to cut dividend after asset injection 20,000 7,000 6,000 15,000 5,000 10,000 4,000 3,000 5,000 2,000 - 1,000 (Rmb MM) 2017 2018 2019 2020E 2021E - E&P Natural gas sales (Rmb MM) 2019 2020E 2021E 2022E 2023E LNG Processing and LNG Terminal Natural gas pipeline Original dividend forecast Kunlun free cash flow ex. pipeline and terminal
Source: Company reports and J.P. Morgan estimates. Source: Company reports, J.P. Morgan estimate. *assuming FCF starting 2020E will exclude Shaanjing line and Dalian LNG terminal
Figure 5: Major gas distributors' market share in 2019. Formation of Figure 6: After NPC formation, lower end-user prices will help the NPC is expected to accelerate sector consolidation stimulate gas use as China strives to meet its energy transition goal 700 ENN 600 CR Gas 7% 600 9% China Gas 500 5% 400 Kunlun 307 6% 300 193 Others BJE 200 5% 60% 100 HKCG - 8% 2015 2019 2030E China natural gas consumption (Bcm) Source: Company reports and J.P. Morgan estimates Source: State Council, NDRC, J.P. Morgan estimate
2 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Table of Contents Key charts/ tables...... 2 A closer look at the NPC...... 4 Development timeline ...... 4 “Control the middle, open up the two ends”...... 7 What’s next: asset injection ...... 9 Scenario analysis: Kunlun & Beijing Enterprises...... 11 Scenario analysis for Kunlun...... 12 Scenario analysis for BEH...... 13 Outlook and impacts on downstream...... 15 Near to medium-term ...... 15 I. Acceleration of sector consolidation ...... 15 II. More flexibility in sourcing for gas ...... 16 III. Lower transmission fee helps stimulate gas demand ...... 17 IV. Greater downstream presence of PetroChina/ Kunlun...... 19 Long-term...... 20 I. Continued reform to city gate prices ...... 20 II. Gas exchanges to play a greater role...... 21 III. Introduction of competition in the downstream/ cancellation of concession rights ...... 21 Stock preference ...... 22 Top idea: Kunlun Energy ...... 22
3 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
A closer look at the NPC
Development timeline Reasons for the establishment The National Development and Reform Committee (NDRC) first proposed the establishment of the National Pipeline Company (NPC) in 2010. The idea was to have a central government-controlled entity operate and own all the long-distance gas pipelines and LNG terminals in China, which are currently largely controlled and run by PetroChina, Sinopec and CNOOC. This process would involve asset injection of all long-distance/regional pipelines and terminals into the NPC in exchange for cash and/or equity. Thereafter, the NPC would open the access of these pipelines to all third parties, including downstream gas utilities. This would allow gas utilities to more easily and directly source gas from foreign suppliers in the future and use the pipelines to transport it to their projects in various parts of China. This contrasts with the current practice, whereby access of these pipelines are largely accessible by only PetroChina and Sinopec.
Figure 7: China natural gas value chain at present
Upstream gas suppliers
PetroChina, Sinopec, CNOOC
Midstream long-distance pipeline operators
PetroChina, Sinopec
Downstream gas utilities
China Gas, CR Gas, ENN, Towngas China, BJ Enterprises, Kunlun Energy, Tianlun Gas, Zhongyu Gas, etc
Source: J.P. Morgan
Sequence of events In 2014, the Department of Energy announced the draft version of "Regulatory Guidance on the Fair Open-up of Oil and Gas Pipeline Infrastructure." The final document published in May 2019 clearly outlines that the central government encourages greater inter-connection and open access of pipeline assets through centralized operation and management. Around the same time, the National Committee on Deepening Reform passed the “Implementation Advice on the Reform of Oil and Gas Pipeline System,” which formalized the establishment of NPC. The NPC was officially formed on Dec 9, 2019.
4 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Figure 8: National Pipeline Company timeline summary National Committee on Deepening Reform passed the resolution on “Implementation Advice National Pipeline Longkou LNG on the Oil and Gas Company terminal in Concept of Pipeline Reform” 《石油 formally Shandong begins the NPC first 天然气管网运营机制 established in construction proposed 改革实施意见》 Beijing under NPC
Mar May Dec Apr May June 2010 2014 2019 2019 2019 2020 2020 2020
Draft version of Final version of NPC signed Domestic news "Regulatory Guidance "Regulatory Guidance agreement with reported that NPC on the Fair Open-up of on the Fair Open-up of CNOOC to aims to start operation Oil and Gas Pipeline Oil and Gas Pipeline transfer operating after completing Infrastructure”《油气 Infrastructure” 《油气 rights of pipelines majority asset injection 管网设施公平开放 管网设施公平开放 assets by Sep 30 监管办法（试行）》 监管办法》 introduced published
Source: NDRC, J.P. Morgan
Ownership details of the NPC and potential IPO Since its formation in Dec 2019, minimal official details have been released on the NPC. However, various domestic news outlets have cited sources familiar with the matter and constructed a picture of how the NPC would look like, in terms of its organizational set-up, ownership structure, and assets included.
The ownership ratio of the NPC, after the asset injections, will be around 40% State- owned Assets Supervision and Administration Commission (SASAC), 30% PetroChina, 20% Sinopec and 10% CNOOC. The NPC is expected to be listed in the capital market via an IPO at a later date. The restructuring of these assets and the subsequent listing of the NPC will likely follow similar format as the creation of China Tower Corp in the telecom sector, according to state media.
First batch of injections by end-Sept Injection of the first batch of assets is expected to be completed by end-Sept, according to state media. While various parties are still negotiating on the valuation of the assets and methods of payment, a resolution could come as early as the end of this month. Thereafter, the remaining batches are expected to be injected by end- 2021. The NPC may be listed in an IPO in 2022-23.
Table 9: NPC organizational set-up NPC Details Official name PipeChina Nature State-owned Ownership SASAC (under State Council), PetroChina, Sinopec, and CNOOC, ownership ratio 4:3:2:1 Social capital will be introduced later after IPO Organization Led by Zhangwei, former Chairman of PetroChina; contains thirteen internal departments Assets Long-distance pipelines, LNG terminals, LNG storage facilities likely included in 1st batch (see below for details); provincial pipelines potentially injected in later batches Injection process Operating rights first, followed by ownership titles Timeline By 3Q 2020: completion of asset injection for the 1st batch; beginning of operation 2021: transfer of the remaining assets 2022-2023: potential IPO Source: J.P. Morgan
5 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Table 10: Assets for potential injection (latest list) Asset name (English) Asset name (Chinese) LNG terminals: PetroChina Dalian Terminal 中石油大连接收站 PetroChina Diefu North (Fujian) Terminal (under construction) 中石油迭福北接收站（在建） Sinopec Beihai Terminal 中石化广西北海接收站 CNOOC Tianjin Terminal 中海油天津浮式接收站 CNOOC Longkou Terminal (under construction) 中海油龙口接收站（在建） CNOOC Zhangzhou Terminal (under construction) 中海油漳州接收站（在建） CNOOC Yuedong Terminal (under construction) 中海油粤东接收站 CNOOC Diefu Terminal 中海油迭福接收站 CNOOC Fangchenggang Terminal 中海油防城港接收站 CNOOC Hainan Yangpu terminal 中海油海南洋浦接收站 Total 10 Pipelines: PetroChina Pipeline Company Limited 中石油管道有限责任公司 中国石油（601857.SH/00857.HK）北京油气 PetroChina Beijing Oil and Gas Control and Dispatch Center 调控中心 PetroChina Pipeline Company (branch) 中国石油管道分公司 PetroChina East-West Pipeline 中国石油西气东输管道分公司 中石油北京天然气管道有限公司(陕西北 PetroChina Beijing Pipeline Company (Shaanjing pipeline) 京线) PetroChina Western Pipeline Company 中石油西部管道公司 PetroChina Southwest Pipeline Company (Sino-Myarmar pipeline) 中国石油西南管道分公司（中缅线） PetroChina Pipeline and Engineering Company 中国石油天然气管道工程有限公司 Sinopec Pipeline and Storage Company 中国石化管道储运有限公司 Sinopec Sichuan-East China Pipeline 中石化川气东送管道有限公司 Sinopec Xinjiang Coal-bed Gas Pipeline Company 中国石化新疆煤制气管道有限公司 Sinopec Chongqing-Jinan Pipeline 中石化榆济管道有限公司 Sinopec Hebei Construction & Investment Natural Gas Company 中石化河北建投天然气有限公司 中国石化天然气分公司青宁输气管道公 Sinopec Qinghai-Ningxia pipeline 司 Sinopec Tianjin Natural Gas Pipeline Company 中石化天津天然气管道有限责任公司 CNOOC Pipeline Company 中海石油管道输气有限公司 CNOOC Central-North Pipeline Company 中海油华北天然气管道有限公司 Total 17 LNG storage facilities: Total Unspecified Source: Jiemian news, Sohu news, J.P. Morgan
6 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
“Control the middle, open up the two ends” China’s natural gas sector is divided into the upstream, midstream, and downstream. As the below chart illustrates, the three oil majors headed by PetroChina currently control both the upstream exploration & production (E&P) and midstream pipelines, meaning they are in charge of the production and transportation of gas, up until the point of city gate. The downstream gas companies buy gas from PetroChina et al. at city gate prices, and sell it to end-users including residential, commercial, and industrial customers. As the last-mile distributors, the gas companies earn a dollar margin, that’s the difference between the end-user gas tariff and gas input costs (which could go above or below city gate prices).
By nature, midstream pipelines tend to be operated as a natural monopoly. On the other hand, both the upstream and downstream have room for competition. The current set-up, which has the three oils control the midstream assets, essentially limits the possibility of competition since other upstream producers won't be able to use the pipelines, and downstream plyers have no choice but to buy gas supply from the three oils.
The government hence proposed the reform slogan of “control the middle, open up the two ends” for the sector. Formation of the NPC is the first step in the reform process. The NPC will centralize all midstream assets into one entity, and ideally will be in charge of the operation and coordination of all midstream pipelines and LNG terminals. One important mandate for the NPC is to open up the transmission capacity of long-distance pipelines for use by third parties including the downstream gas distributors.
In the long run, both the upstream and downstream space should see gradual open-up as more market participants come in. This will increase the diversity of gas supply, enhance operating efficiency of companies, and drive end-user prices down. Subsequently, there is potential for further liberalization of city gate prices until it becomes completely market-based (for more discussion on city gate prices, see section “long-term impacts” below).
Figure 11: China natural gas value chain reform: present, future, and longer-term
Before NPC… Upstream Midstream Downstream
Provincial PetroChina pipeline co. PetroChina City gate City gas co. End-user prices tariffs City gas co. End-users (Regulated (Regulated by Sinopec by NDRC) local govts) Sinopec City gas co. CNOOC CNOOC City gas co. Others Others
7 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
After NPC… Upstream Midstream Downstream
Provincial PetroChina pipeline co.
National City gate City gas co. End-user Pipeline Co. prices tariffs (long-distance City gas co. End-users pipelines) (Regulated (Regulated by by NDRC) local govts) Sinopec City gas co.
CNOOC City gas co. Others
Longer-term… Upstream Downstream Market-based price City gas co. Midstream PetroChina City gas co. National Pipeline City gas co. End-user Co. tariffs City gas co. Sinopec (long-distance End-users pipelines + City gas co. (Regulated by CNOOC provincial pipelines) local govts) City gas co. Others City gas co. Market-based price
Source: J.P. Morgan
8 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
What’s next: asset injection Chinese domestic news reported in early July that the NPC aims to complete the asset injection for the first batch of assets by Sep 30 this year. CNPC, Sinopec, and NPC have all appointed their respective financial advisors to work on the asset valuation. A potential announcement from the parties could come as early as late July, according to media sources. We believe the central government intends to have the NPC up and running as soon as possible, ideally before this year's heating season begins.
News flow earlier has pointed to a difficult negotiation process for asset injection between NPC and the three oil majors, and as a result, the focus may be on the transfer of operating rights first, before valuation details get ironed out. However, things seem to have picked up pace since summer, and an initial announcement with asset injection details could come soon, according to media sources. However, transfer of assets such as Kunlun’s Shaanjing line and some LNG receiving terminals could take longer to be completed due to involvement of minority stakeholders or joint venture partners. Nonetheless, the asset valuation plan for the three oils - once announced - could provide a reference point for other assets that will be injected later on.
China Tower model as reference Referencing the previous reform effort in the China telecom sector which involves the establishment of China Tower Corp and the subsequent injection of all tower assets from the telcos, we can see that it took more than a year (15 months) from the date of formation to the completion of asset injection plan.
Table 12: China Tower timeline Date Event July 2014 Establishment of China Tower Corporation Oct 2015 Tower asset injection from Chinese telcos to China Tower & announcement of valuation Aug 2018 Listing of China Tower on the Hong Kong Stock Exchange Source: J.P. Morgan
What could valuation look like? Taking reference to the China Tower transaction, we believe that the valuation multiple for asset injection could be in the range of 1.1x P/B to 1.3x P/B for the pipelines owned by the three oil majors. In principle, state-owned assets should not be sold at lower than 1x P/B, especially given that the pipelines in question are stable, profitable, and cash-generating assets. Valuation under 1x P/B is unlikely to garner support from shareholders.
In 2018, when China Mobile, China Unicom, and China Telecom injected their tower assets into the newly established China Tower company, the transaction was done at 1.0-1.1x P/B. We view this as the baseline for valuation multiple. Given the importance of pipeline assets to the earnings and cash flow of PetroChina etc., we believe the three oil companies will likely push for a higher valuation multiple as a form of compensation.
Cash-equity split is important Aside from valuation multiple, the allocation between cash and equity is equally if not more important, in our view. Referencing the asset injection model from China Tower transaction, a combination of cash and shares could be the likely outcome. On the one hand, the newly established National Pipeline Company does not have
9 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
sufficient cash to buy out the pipelines in one go. On the other hand, an all-equity transaction is unlikely to be approved by shareholders, in addition to causing the three oil majors to have majority ownership in the NPC which is an unwanted outcome. In the China Tower transaction, the asset transfer was done with 45/55 and 60/40 equity vs. cash split for China Mobile and China Unicom, respectively. We view a similar allocation as possible in the case of NPC.
Figure 13: China Tower asset spin-off details China Tower spin off (Rmb MM) China Mobile China Unicom China Telecom Total consideration 102.7 54.7 30.1 Consideration shares 45.2 33.3 33.1 Cash 57.6 21.3 (3.0) Book value of tower assets transferred 92.5 53.2 28.3 Implied P/B (x) 1.11 1.03 1.06 Current shareholding China Mobile 27.9% China Unicom 20.7% China Telecom 20.5% China Reform 4.4% H-shares 26.5% Source: company, J.P. Morgan
10 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Scenario analysis: Kunlun & Beijing Enterprises
Kunlun: Impact from potential disposal of Shaanjing line and Dalian terminal Shaanxi-Beijing pipeline, the major transportation line between the western province of Shaanxi and the capital city of Beijing, is owned 60% by Kunlun Energy and 40% by Beijing Enterprises Holdings. The current book value of the pipeline is Rmb31.9Bn at YE2019. The pipeline is expected to make up ~38% of Kunlun's earnings in 2020E.
Aside from the Shaanjing pipeline, Kunlun also currently owns three LNG terminals: Dalian, Jiangsu, and Tangshan. Dalian terminal has been reported to be potentially included among the first batch of injection. The three terminals, along with >20 LNG factories the company owns (which are currently money-losing), are expected to make up ~21% of Kunlun's total earnings in 2020.
Figure 14: Kunlun Energy operation earnings breakdown by segment, FY2020E
Natural gas E&P pipeline 6% 38%
Natural gas sales 35%
LNG Processing and LNG Terminal 21%
Source: Company reports.
Table 15: Pipeline and Dalian LNG terminal book value Pipeline and LNG terminal book value (Rmb MM) Shaanjing Pipeline Total net assets 31,897 Dalian LNG terminal Total net assets 4,249 Total pipeline + Dalian terminal 36,146 % of Kunlun total consolidated net assets 46% Source: J.P. Morgan *net asset of Dalian LNG terminal is estimated by taking 1/3 of total segment net assets.
In our SOTP valuation for Kunlun, we currently value Shaanjing line using a 10-year DCF and apply a 30% discount in the overall SOTP. As a result, the pipeline represents an NAV per share of Rmb2.4 (after minority interests) out of total company value per share of Rmb7.4, on our estimates.
On the other hand, we value the LNG terminal and processing segment using 1.0x P/B multiple, and the total segment NAV per share is Rmb1.5. For simplicity, we estimate Dalian terminal to be 1/3 of segment assets, and with Kunlun’s 75% stake, that would mean Rmb0.38 for NAV per share.
11 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Together, Shaanjing pipeline and Dalian LNG terminal represent ~Rmb2.8 NAV per share, 38% of Kunlun's total NAV per share based on our PT of HKD8 (Rmb7.4).
Table 16: Kunlun’s SOTP valuation Exit multiple/ terminal Valuation Valuation NAV per share Sum-of-the-parts valuation Discount rate % of total growth rate methodology (RmbMM) (Rmb) E&P 0.5 P/B multiple 1,328 0.2 1.3% Natural gas sales 8.3% 1.2% DCF 56,010 6.5 53.4% LNG terminal and processing 1.0 P/B multiple 12,746 1.5 12.2% Natural gas pipeline 8.3% 0.0% DCF w/ 30% discount 34,816 4.0 33.2% Net debt 25 0.0 Minority interests (41,162) (4.8) Total 63,763 7.4 100.0% Source: Companies, J.P. Morgan
Scenario analysis for Kunlun Our analysis below lists out the potential outcomes for Kunlun assuming a range of valuation multiples and cash vs. equity split. Based on our analysis, Kunlun could get between Rmb5Bn to Rmb25Bn of cash (depending on where it ends up on the spectrum), which it can use to invest in downstream gas projects or pay out special dividend to shareholders.
Table 17: Potential cash payable to Kunlun from injection of Shaanjing line & Dalian terminal P/B (x) (Rmb MM) 1.0 1.2 1.5 % of cash 25% 5,581 6,697 8,372 50% 11,162 13,395 16,744 75% 16,744 20,092 25,115 Source: J.P. Morgan
Table 18: Potential cash payable to Kunlun from injection of Shaanjing line alone P/B (x) (Rmb MM) 1.0 1.2 1.5 % of cash 25% 4,785 5,741 7,177 50% 9,569 11,483 14,354 75% 14,354 17,224 21,530 Source: J.P. Morgan
Assume a 1.2x P/B injection multiple and a 50/50 cash vs. equity split that Kunlun gets from the asset injection - which we think is reasonable considering the precedent of China Tower and the quality of the assets in question, the company could get Rmb13.4Bn of cash (including Rmb11.5Bn from Shaanjing line alone), which it can use to pay out a special dividend and/or invest into additional city gas projects. Although the company would lose ~45% of its earnings as a result of the pipeline and LNG terminal being taken away, some of this will be made up over time by additional earnings contribution from natural gas segment. While the ROA of city gas distribution business (we assume 5%) is lower than pipelines (~10% on our estimate), gas distribution has a higher growth rate of ~10-15% p.a. vs. relatively flat growth of the pipeline. In the long run, we believe that the company will benefit from simplification of its business model and a clearer focus on the downstream. Note that all our analyses assume that Kunlun will not receive any dividend from the NPC in the near term.
12 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Table 19: Scenario analysis for pipeline & LNG terminal injection (assume 1.2x P/B) Scenario 1: 75% Scenario 2: 50% Scenario 3: 25% cash 25% equity cash, 50% equity cash, 75% equity Option 1: pay out special dividend Rmb2.32 per share Rmb1.55 per share Rmb0.77 per share Option 2: invest in city gas projects Additional Rmb1Bn Additional Additional (assume 5% ROA) earnings Rmb670MM earnings Rmb335MM earnings
Pro forma FY2021E earnings* Rmb4,626MM Rmb4,291MM Rmb3,956MM % change vs. before -31% -36% -41%
Source: J.P. Morgan. *Assuming no dividend payment from NPC.
Kunlun scenario analysis shows upside to a cash/ equity deal Our scenario analysis assumes Kunlun Energy would sell its 60% stake in Shaanxi- Beijing Pipeline to the National Pipeline Company. The current price of HKD5.6 assumes Kunlun would receive 100% equity for the transaction, on our estimates, which is unlikely. Taking reference to the China Tower transaction, the deal was settled with ~50% equity/cash at ~1.1 P/B. If we assume Kunlun gets a similar deal for its pipeline disposal, 1.2x P/B and 50% cash, this would result in 23% upside to current share price, on our estimates.
Table 20: Kunlun’s pipeline valuation and implied NAV per share NAV per share NAV per share Implied JPM PT Upside to current Assumed P/B multiple Assumed cash % NAV (Rmb mn) (Rmb) (HKD) (HKD) share price 0.8 50% 7,655 0.88 0.95 6.4 14% 1.0 50% 9,569 1.11 1.19 6.6 19% 1.2 50% 11,483 1.33 1.43 6.8 23% 1.4 50% 13,397 1.55 1.67 7.1 27% 1.6 50% 15,311 1.77 1.91 7.3 32%
1.2 0% - - - 5.4 -3% 1.2 20% 4,593 0.53 0.57 6.0 8% 1.2 40% 9,186 1.06 1.15 6.6 18% 1.2 60% 13,780 1.59 1.72 7.1 28% 1.2 80% 18,373 2.12 2.29 7.7 38% Source: J.P. Morgan estimates
Scenario analysis for BEH With Beijing Enterprises Holdings, it’s unclear whether its 40% ownership of the Shaanjing line will be injected. Given that it is only a minority stake, and that the Shaanjing line has strategic importance to Beijing City, we think there’s a good chance that it could be kept by Beijing Enterprises Holdings. However, in the case of injection, our scenario analysis below shows that similar to Kunlun, BEH is also expected to be compensated by some cash/ equity combination. The cash it could receive falls in a range of Rmb3.2-Rmb14.4Bn. Compared to Kunlun, BEH has ~20% of its earnings coming from the pipeline, and hence the relative earnings impact is smaller.
Table 21: Potential cash payable to BEH from injection of Shaanjing line P/B (x) (Rmb MM) 1.0 1.2 1.5 % of cash 25% 3,190 3,828 4,785 50% 6,379 7,655 9,569 75% 9,569 11,483 14,354 Source: J.P. Morgan
13 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Figure 22: Beijing Enterprises Holdings operation earnings breakdown by segment, FY2020E Solid waste treatment 9% China Gas 24%
Water 24%
Brewery NG transmission 0% 20% Other piped gas sales VCNG 15% 8%
Source: J.P. Morgan
14 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Outlook and impacts on downstream
Near to medium-term I. Acceleration of sector consolidation In recent years, the central government has stepped up its regulation of the downstream gas distribution sector, as seen from the successive roll-out of policy guidance and codification of rate-making mechanisms in the past 2-3 years, with the major policies listed below:
Table 23: Major policy directives for gas distribution Year Area Ruling 2016 Long-distance transmission Regulated ROA of 8% (utilization rate not lower than 75%) 2017 Gas distribution Regulated ROA of 7%, accompanied by regular cost audits 2019 Connection fee Margin not higher than 10% 2020 Gas distribution Reiteration of 2017 policy, regulated ROA not higher than 7% Source: NDRC, J.P. Morgan
China’s downstream gas sector is still rather fragmented at the moment, as we estimate the six biggest city gas operators have less than 50% of market share (by volume of gas sold). The remainder are small city gas companies that operate on a local level, some with only a few projects. Faced with the uncertainty from the formation of the NPC as well as increasing pressure from downstream expansion of PetroChina/ Kunlun, some smaller players could be looking to sell, especially as their profit margin is being squeezed by stricter government regulation. Last year we’ve already seen several big M&A deals announced or completed, including Kunlun’s Jinhong purchase and CR Gas’ Ningbo acquisition. With COVID-19 this year, greater cost concerns and cash flow pressure should continue to facilitate sector consolidation. As a result, we believe the trend will likely continue in the next 1-2 years, and we expect the leading market players including the gas distributors under our coverage to ramp up their M&A capex significantly in the turf battle for high- quality city gas projects.
Figure 24: Major gas distributors' market share vs. total gas consumption in China (2019)
ENN CR Gas 7% 9% China Gas 5% Kunlun 6% Others BJE 5% 60% HKCG 8%
Source: Companies, J.P. Morgan *numbers shown are rough estimates, given some companies report volume numbers that include non-consolidated projects and hence may be over-stating
15 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Table 25: Capex distribution for major gas companies in 2020E (in Bn) CRG (HKD) ENN (Rmb) Kunlun (Rmb) China Gas (HKD) Existing gas projects 4 4-5 5-6 6 M&A 3.5 2 not included not included Other N/A 2 2.5 3 Total 7.5 8-9 8 9-10 Source: Companies, J.P. Morgan
Table 26: Recently announced M&A deals Date of Name Company announcement Completed Total value P/E Jinhong gas projects Kunlun 2019 Y 1.7Bn Rmb 11x Ningbo CR Gas 2019 N 2-3Bn HKD 20-25x Taiyuan CR Gas 2020 N NA NA Source: Companies, J.P. Morgan
II. More flexibility in sourcing for gas Currently downstream city gas companies obtain 80-90% of their gas supply from piped gas, including those supplied by PetroChina and Sinopec. In recent years, prices of imported LNG have come down significantly along with oil prices. However, downstream city gas companies under the current scenario can hardly take advantage of the cheap LNG, since none of them except ENN has access to LNG terminals, and pipeline access (which is controlled by the three oils) is needed for transportation of huge quantity of LNG especially to areas further away from the coastal region.
Table 27: Comparison of LNG prices vs. city gate prices for coastal region in 1H20 Type of gas Price (Rmb/cm3) Note LNG long-term contract 1.3-1.5 Indexed to oil prices LNG spot 1.0 Available from spot market/ exchanges Piped gas (non-peak season) 1.7 Average city gate prices Piped gas (peak season) 2.0 Average city gate prices +20% Source: ENN, J.P. Morgan
In the future, with the opening-up of LNG terminals and pipeline networks, downstream city gas companies will have the option to enter into long-term contracts with overseas LNG suppliers themselves, or simply buy spot cargos when price is attractive. This should help them maintain and potentially lower gas procurement costs through leveraging on resources from the international market.
We note that the central government is also encouraging the building of more LNG terminals especially by private enterprises in recent years. Below is a table of China's existing LNG terminals, including those under planning and construction. In the medium to long run, we believe that greater availability of imported LNG and related infrastructure will also help drive down the price of piped gas. In fact, we have already seen PetroChina lowering the price of piped gas it sells to downstream starting June this year by 5-10% because of competition from cheap LNG resources.
16 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Table 28: China’s LNG terminals (in operation + under construction) Name Province Main stakeholder In operation? Dapeng Guangdong CNOOC, BP, SZ Gas, etc Y Wuhaogou Shanghai Shanghai Shenergy Y Putian Fujian CNOOC Y Yangshan Shanghai Shanghai Shenergy, CNOOC, etc Y Dalian Liaoning PetroChina Y Ningbo Zhejiang CNOOC Y Jiufeng Guangdong Jovo Group Y Rudong Jiangsu PetroChina Y Tangshan Hebei PetroChina Y Zhuhai Guangdong CNOOC Y Tianjin Tianjin CNOOC Y yangpu Hainan CNOOC Y Qingdao Shandong Sinopec Y Beihai Guangxi Sinopec Y Yuedong Guangdong CNOOC Y Qidong Jiangsu Guanghui Energy Y Diefu Guangdong CNOOC Y Tianjin Tianjin Sinopec Y Zhoushan Zhejiang ENN Group Y Minyue Guangdong SinoEnergy, Huafeng Group Y Fanggangcheng Guangxi CNOOC Y Dushan Zhejiang GCL Power, Hangzhou Gas, etc N Jiangyin Jiangsu SinoEnergy N Gangxi Shandong Kunlun Energy N Binhai Jiangsu CNOOC N Wenzhou Jiangsu Sinopec N Caofeidian Hebei Jingneng N Suizhong Liaoning Bestsun Energy N Zhangzhou Fujian CNOOC N Ganyu Jiangsu Huadian N Longkou Shandong Nanshan Group N Tianjin Tianjin Beijing Gas N Source: J.P. Morgan
Timeline: While fair opening-up of pipeline network is a key concept behind the establishment of the NPC, the implementation of it will likely take some time and happen in phases. We believe that the NPC will likely take reference after the recent model set by Zhejiang province, where the provincial pipelines will open up 20% of its capacity in the beginning for fair use by third parties. It will be difficult for the NPC to open up the entire long-distance pipeline network in one go, given that the majority of capacity still needs to be reserved for the import contracts of the three oil companies. We think a realistic timeline could be a gradual opening-up of capacity (e.g. starting from 20%) in 2021/2022.
III. Lower transmission fee helps stimulate gas demand As the NPC takes control of midstream assets in China, potential adjustment to transmission fee becomes the key focus. Chinese domestic media reported that it is also currently a main point of disagreement between PetroChina and the NPC. PetroChina would like to see the transmission fee lowered to help share some of its burden from gas import loss. The NPC, however, is hesitant to adjust down transmission fee in the near term given that it needs cash for new pipeline investment.
Tracing the history of transmission fee regulation in China, in 2016 the NDRC issued the main policy document that set an allowed ROA of 8% for long-distance gas transmission. Subsequently in 2017, it conducted the first round of cost audit for 13 midstream pipelines, including the Shaanjing pipeline co-owned by Kunlun and BEH, and cut the transmission tariff by an average of 15% (while simultaneously
17 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
announcing a 6% reduction to city gate prices). Below table outlines the current transmission fee for the major long-distance pipelines.
Table 29: Current transmission fee of major long-distance pipelines Unit price (Rmb per m3 * 1000 Entity name Main pipelines km) Ownership PetroChina Beijing Pipeline Company Shaanjing pipeline 0.2805 PetroChina PetroChina Pipeline United Company Western sections of Western Pipelines I and II, Seninglan Line 0.1416 PetroChina PetroChina Northwest United Pipeline Company Western Pipelines III 0.1202 PetroChina PetroChina Eastern Pipeline Company Eastern section of Western Pipeline I and II, Zhongwu Pipeline, and Changning Pipeline 0.2386 PetroChina PetroChina Pipeline Branch Company Qinshen Line, Dashen Line, Hashen Line, Zhongcang Line 0.4594 PetroChina PetroChina Southwestern Pipeline Branch Company Zhonggui Line, South Guangzhou section of Western Pipeline II 0.389 PetroChina PetroChina Southwestern Pipeline Ltd. Sino-Myarmar Line 0.4035 PetroChina PetroChina Southwestern Gas Field Branch Company Surrounding pipelines of Southwestern gas field 0.14* PetroChina Sinopec Sichuan to East China Gas Pipeline Company Sichuan to East China Pipeline 0.3824 Sinopec Sinopec Yuji Pipeline Company Chongqing-Jinan Line 0.4363 Sinopec Canton Inner Mongolia Datang International coal gas pipeline company Inner Mongolia to Beijing Coal Gas Line 0.9611 Datang, BJ Gas Shanxi Tongyu Coalbed Methane Transmission Company Shanxi Coalbed Methane Line 3.4416 Shanxi govt Zhangjiakou Yingzhang Natural Gas Company Yingzhang Line 1.9938 Jinhong holdings Source: NDRC, J.P. Morgan *unit price is in Rmb yuan/m3
Table 30: Estimated ROA for selected major pipelines in China, FY2019 Total assets Net profit Estimated Company Entity name Assets (Rmb MM) (Rmb MM) ROA Kunlun PetroChina Beijing Gas Pipeline Co Shaanjing Pipeline 44,349 4,257 9.6% PetroChina Trans-Asia Pipeline Co Trans-Asia pipeline 45,938 4,070 8.9% PetroChina PetroChina Pipelines Co. PetroChina Eastern Pipeline 232,929 18,911 8.1% PetroChina Northwest United Pipeline PetroChina United Pipelines Sinopec Kantons Yuji Pipeline Yuji Pipeline (Chongqing-Jinan) 4,545* 266* 5.8% Sinopec Sichuan to East China Gas Pipeline Co Sichuan To East China Gas Pipeline 51,087 2,191 4.3% Source: Company annual reports, J.P. Morgan *number is in HKD MM
Based on the current available financial disclosure, we found that the actual earned ROA of major pipelines in China can vary quite considerably. Assets including Shaanjing pipeline and Western pipelines (PetroChina) are earning at or above 8%. The Sichuan to East pipeline (Sinopec) and Yuji pipeline (Kantons), however, seem to be earning below 8%, mainly due to lower utilization rate and shorter distance of gas travelled in recent years.
We believe that in the medium to longer term, lowering of transmission fee is likely to be the trend, due to several reasons: 1) better capacity planning and coordination of operation will likely improve the utilization rate of existing pipelines, hence lowering unit costs, and 2) building and construction of more pipelines and expansion of network will naturally drive costs down. We believe that realization of potential cost savings from asset consolidation is one of the major objectives behind the government’s initiative to set up the NPC. These cost savings will likely be fully passed on to end-users to stimulate demand. This is not only consistent with the central government’s policy objective to lower end-user gas and electricity tariff for businesses, but is also crucial to China realizing its long-term gas consumption target as part of its energy transition plan. China aims to increase the share of natural gas in its primary energy mix to 15% in 2030 from ~10% currently. This entails a consumption CAGR of ~6% from 2019 to 2030, based on our estimates.
18 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Figure 31: China gas demand growth plan, in order for natural gas to reach 15% of primary energy mix by 2030E 700 600 600
500
400 307 300 193 200
100
- 2015 2019 2030E China natural gas consumption (Bcm)
Source: NDRC, State Council, J.P. Morgan
In the short run (next 6-12 months), however, it is likely that transmission tariffs will remain unchanged while the asset merger is underway. This is both to avoid complication to the on-going valuation assessment, and also due to the fact that the NPC will likely need more cash at the initial stage of its operation to purchase assets and to initiate additional pipeline investment. Note that the NDRC is due to initiate another round of pipeline tariff review later this year based on the 3-year cycle (last review was done in 2017), but so far has not taken any actions. In the short run, therefore, any drastic change is unlikely.
IV. Greater downstream presence of PetroChina/ Kunlun PetroChina has started to accelerate its expansion efforts into the downstream space in the recent 1-2 years, faced with the impending injection of its profitable midstream assets into the NPC and import contract loss at its upstream business. Its downstream expansion is mainly done through its 57.6% ownership in Kunlun Energy, its only retail gas sales platform, and this has resulted in direct competition with existing city gas companies at times.
When it comes to downstream expansion, PetroChina has significant resource advantage with its ~70% market share in the upstream and midstream space. It currently holds ~70% of China’s gas supply through both domestic production and imports, and owns ~70% of long-distance pipelines across the country. There are two ways through which PetroChina could expand in the downstream:
1) Direct supply of gas to end-users. Direct gas sales to end-users ("Zhigong" 直供) is not a new idea, and in recent years has been supported by the central government based on the “Proposal to accelerate use of natural gas” policy document issued in 2017. The rationale behind is that, for industrial customers that have a significant volume commitment and are hence sensitive to gas prices, having upstream suppliers such as PetroChina directly supplying gas could help achieve cost savings and ensure greater supply stability. However, this tends to run counter to the prevailing “concession rights" arrangement for downstream distribution companies, which states that once concession right is awarded to a city gas operator, only the said operator can sell gas in a certain area.
19 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Since 2017, several provinces including Shandong, Anhui, Guangdong, etc. have announced policy support for direct gas supply to big industrial users. As PetroChina expands direct gas sales, it at times runs into conflict with city gas distributors. For example, news reported that in June this year, one of the big industrial customers in Jiaozuo City, Henan Province, was involved in a disagreement with Zhongyu Gas, its designated city gas distributor, as the former was allegedly building pipelines to self-connect to Kunlun’s gas supply station in the neighboring village.
Advances by PetroChina to develop direct gas sales within big industrial customers will pose challenges to downstream city gas distributors, especially since industrial customers tend to have higher margin vs residential. We see the impacts likely to be greater for smaller gas distributors than for the bigger players, since the latter tend to have better supply visibility and are more difficult to challenge.
2) Develop more pipeline openings (管道开口). The other technique used by PetroChina more recently is to take advantage of its current ownership of long-distance pipelines and to develop more branch-line openings at major intersection points. This is a relatively new phenomenon. Media news reported that since the beginning of the year, PetroChina has sped up the pace of developing new pipeline openings - against the wish of the NPC - before it has to hand over the operating rights of these pipelines to the latter in 2H. Having new pipeline openings is the pre-condition to expanding in the downstream since it allows one to secure gas supply before one can start connecting to new city gas projects. We see this effort by PetroChina as pre- empting its continued expansion in the downstream space in the future.
Long-term I. Continued reform to city gate prices City gate prices are benchmark prices that upstream gas producers currently use to sell gas to downstream city gas operators. It varies by province and serves as a benchmark price, as starting 2015, upstream sellers and downstream buyers are allowed to negotiate prices for up to 20% above city gate prices (with no lower limit) at normal times. Price hikes usually happen during winter as supply tends to be tight. 2019 was the first time that prices were hiked during non-peak season (Apr-Oct) as upstream gas producers raised selling prices to downstream. City gate prices are hence often used as the main reference point for input costs for downstream gas distributors.
Historically, city gate prices were set by the central government by taking a 15% discount on the average price of LPG and fuel oil. In reality, city gate prices were rarely adjusted when prices of LPG and fuel oil move; instead, it has been employed more as a policy tool by the central government to monitor and adjust demand due to the substitution effect with other fuels. However, as part of the government’s attempt to reform the gas value chain, some efforts have been made to liberalize city gate prices in recent years, with a timeline summary below.
20 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Table 32: On-going reform to city gate prices Year Development 2013 City gate prices established and regulated by the NDRC as “maximum selling prices” 2014 Implementation of “ladder prices” for residential end-user gas tariff 2015 Prices of direct gas sales between upstream and end-users are relaxed and can be negotiated between parties 2015 Establishment of Shanghai Petroleum and Gas Exchange 2015 City gate prices for non-residential users changed from “maximum selling prices” to “benchmark prices” (up to 20% above, no lower limit) 2017 Establishment of Chongqing Petroleum and Gas Exchange; gas traded on the exchanges are not subject to city gate prices 2018 City gate prices for residential users changed from “maximum selling prices” to “benchmark prices”; unification of residential and non-residential prices Source: Companies, J.P. Morgan
A key component and major goal of the gas sector reform is to make prices more market-driven. With the establishment of the NPC and future opening-up of pipelines, direct transaction between the upstream and downstream will be possible. There are two ways this could be done: 1) downstream gas companies sign direct contracts with the upstream producers (just as what they do now) at a mutually agreed price, or 2) gas companies can buy gas from the gas exchanges, which act as the middlemen for such transactions.
II. Gas exchanges to play a greater role Currently there are two exchanges set up in China to facilitate gas trading: Shanghai Petroleum and Gas Exchange (SHPGX) and Chongqing Petroleum and Gas Exchange (CQPGX). The third one, Shenzhen Gas Exchange (SZPGX), has recently received regulatory approval and is expected to start operation soon. Given the locational difference, the three exchanges could play different roles in the future and yet complement each other, with SHPGX and SZPGX potentially focusing on LNG while CQPGX dealing more with ex-contract piped gas/ non-conventional gas. As such, in the long run, city gate prices will likely be further relaxed, until it eventually becomes irrelevant, although the process could take a while.
III. Introduction of competition in the downstream/ cancellation of concession rights Concession right is the basic business model underlying the downstream gas distribution sector. According to this model, the local government (on a city or county level) will award concession right to a city gas company that covers a certain area so that the latter can start laying down pipes and supplying gas. Once the concession right is awarded, no other city gas distributor can come in and supply gas to the same area. Note that this only applies to piped gas while LNG is excluded. In addition, some big industrial customers may opt for direct purchase of gas from the upstream suppliers (refer to “direct supply of gas” section above).
Since the 1990s, leading city gas companies have acquired hundreds of city gas projects based on the concession right concept, with the average remaining life of their concession rights ranging from 15-20 years at the moment. There is no visibility currently on what the next step will be once the concession rights expire. A possible scenario could be for the gradual shortening of concession rights period, given the government’s intent to introduce more competition into the downstream sector.
However, we believe that despite the long-term prospect of a more open downstream sector, the incumbents already have certain competitive advantages to help it maintain and expand market share. These include cost advantage from bigger
21 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
economies of scale, relationship advantage from its existing connections with local governments, as well as a track record of operational efficiency. As a result, we remain positive on the long-term outlook for downstream gas distributors and view it as potentially favoring the bigger market players.
Stock preference
In order of potential benefits from NPC: Kunlun > CR Gas, ENN > China Gas, Beijing Enterprises We prefer Kunlun Energy on the upcoming overhang removal from asset injection clarity. In the long run, as the only downstream subsidiary of PetroChina, we believe Kunlun is strategically well-positioned to gain market share through both M&A and organic growth. As a result, it should be able to continue increasing dividend and shareholder return through strong cash flow generation.
Next to Kunlun, we see NPC benefiting CR Gas and ENN due to the two companies’ concentration of projects in the eastern and coastal regions of China. With easy access to LNG terminals and increasing abundance of imported LNG over time, the two companies are set to enjoy cheaper gas prices and greater diversity of gas supply earlier than peers. ENN specifically has an edge given its stake in Zhoushan LNG terminal. Once the Zhejiang provincial pipelines are opened up, transportation of gas will be cheaper and easier, providing upside to the company’s dollar margin.
Lastly, we see the impacts of the NPC as relatively muted for China Gas and Beijing Enterprises Holdings in the near to medium term. For Beijing Enterprises Holdings, while it could be a short-term positive if it gets to keep the 40% stake in Shaanjing Pipeline, we think that in the long run there could be downside risks to earnings if transmission tariff gets adjusted down, as Shaanjing line is currently earning above the regulated return based on our estimates.
Top idea: Kunlun Energy
Direct subsidiary of PetroChina with a focus on the downstream Kunlun is set to benefit in the long run from its position as PetroChina’s only downstream gas distribution subsidiary. After the recent two times of internal restructuring/ optimization within PetroChina which took place in 2018 and 2020, PetroChina has made it a priority to guarantee gas supply to Kunlun and to help the latter accelerate its development in the downstream market. This will become increasingly important after PetroChina gives its midstream pipelines to the NPC.
Given that in the near term, PetroChina will still control ~70% of China's gas supply, having PetroChina’s support will be essential to Kunlun's expansion. In fact, we’ve seen Kunlun's volume growth quickly picking up and outstripping peers in 2019 after the internal restructuring. In 2019, Kunlun’s retail gas sales volume grew by 25% vs. 10-15% peer average. Management expects to sustain at least 15% annual volume growth in the next 2-3 years.
Potential M&A
22 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Kunlun currently has low net gearings of 20%. With Rmb18Bn cash on hand, we see the company as ready to embark on M&A deals as a way to expand quickly in the downstream market. After the Rmb1.7Bn Jinhong deal it completed last year, management indicated that it will continue to study other M&A proposals. Any M&A announcement could be a catalyst for the stock.
Figure 33: Evolution of Kunlun's operating earnings profile Figure 34: Kunlun Energy’s operating earnings breakdown by 20,000 segment, FY2020E
Natural gas E&P 15,000 pipeline 6% 38% 10,000 Natural gas 5,000 sales 35% - (Rmb MM) 2017 2018 2019 2020E 2021E E&P Natural gas sales LNG Processing and LNG Terminal Natural gas pipeline LNG Processing and LNG Terminal Source: Company reports and J.P. Morgan estimates. 21%
Source: Company reports.
Clarity from NPC provides re-rating opportunity We see several positive catalysts in the next 6-12 months for Kunlun. First, clarity from NPC asset injection should help remove the long-term overhang on the stock and provide a re-rating opportunity. Since late 2018 when the news of NPC formation first surfaced, Kunlun’s shares have underperformed peers by 55%. Current share price is implying that Kunlun gets close to zero value for its Shaanjing pipeline i.e. the transaction will be done in all equity, which we believe is too pessimistic (see details on valuation on pages11-13).
In the long run, as Kunlun continues to expand its downstream business and transitions into more of a conventional, pure-play downstream gas utility, we believe that it should begin to trade more like the pure-play peers. Currently Kunlun is trading at a 6.5x 1-year forward P/E, while the pure-play peers (China Gas, CR Gas, and ENN) are trading at 13x. The multiple expansion is likely to come gradually, in our view.
Strong free cash flow to support rising dividend Before asset injection: In our current valuation which includes the pipeline segment, we estimate that Kunlun’s net operating cash flow will be rising from Rmb16Bn to Rmb20Bn in 2022, with the growth of natural gas sales at its city-gas business, margins improvement, and steady growth in LNG terminal utilization rate. This would result in rising free cash flow and the ability for the company to keep growing its dividend payment. Kunlun’s 2019A annual DPS was Rmb26c, and the payout ratio (on core earnings) was 36%. We currently model its dividend to grow by on average 8% in the next five years, based on 40% payout on our earnings estimates (which include earnings from the pipeline).
23 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
Figure 35: Kunlun Energy’s cash flow outlook (with pipeline) Figure 36: Kunlun Energy’s dividend outlook (Rmb MM) (Rmb MM) 25,000 3,500 50% 3,081 2,689 2,877 45% 3,000 20,000 40% 2,481 2,500 2,277 35% 15,000 2,000 30% 25% 10,000 1,500 20% 1,000 15% 5,000 10% 500 5% - - 0% 2019 2020E 2021E 2022E 2023E 2019 2020E 2021E 2022E 2023E Net operating cash flow Capex Free cash flow Dividend payment Payout ratio Source: Company reports and J.P. Morgan estimates Source: Company reports and J.P. Morgan estimates
After asset injection: The more likely scenario is that Kunlun will lose part or all of the cash flow from the pipeline after its injection into the NPC sometime in the future. While the NPC may pay out some cash dividends, the prospect and timeline are unclear at the moment. As a result, we’ve looked at how taking away the pipeline and Dalian LNG terminal could affect Kunlun’s dividend. In fact, we believe that Kunlun’s dividend should not be affected by the NPC formation and asset injection. Based on our analysis, Kunlun will still be able to generate Rmb3-6Bn of free cash flow per year for 2020E-2022E after the asset injection, which will be more than sufficient to cover its original annual dividend payment of Rmb2.3-2.7Bn. Therefore, we don’t think the company would need to cut dividend after the pipeline and Dalian terminal are sold to NPC. Note that as cash flow contribution from Kunlun’s natural gas sales business rises over time, the relative contribution of pipeline will gradually decline.
Figure 37: Kunlun’s cash flow and dividend situation after pipeline & Dalian terminal injection
7,000 6,153 6,155 6,000 5,292 5,000 4,573 4,000 2,977 2,877 3,081 3,000 2,689 2,277 2,481 2,000 1,000 - (Rmb MM) 2019 2020E 2021E 2022E 2023E Original dividend forecast Kunlun free cash flow ex. pipeline and terminal Source: Company reports, J.P. Morgan. *assuming free cash flow starting 2020E will exclude Shaanjing line and Dalian LNG terminal
24 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
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25 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
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26 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
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27 Elaine Wu Asia Pacific Equity Research (852) 2800-8575 22 July 2020 [email protected]
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28 Completed 22 Jul 2020 01:55 AM HKT Disseminated 22 Jul 2020 03:17 AM HKT