China Utilities 23 June 2017

China Gas (384 HK) China Gas

Target price: HKD16.60 (from HKD14.00) Share price (22 Jun): HKD14.20 | Up/downside: +16.9%

Harvesting the rural, coal-to-gas and VAS crops

 Doubling of guidance for gas sales and connections in next 3 years … Dennis Ip, CFA (852) 2848 4068  … on strong rural connections and industrial coal-to-gas initiatives [email protected]  Reiterating Buy (1); VAS supports 25%+ YoY EPS growth for FY18E

What's new: After reporting a strong 20%+ YoY rise in FY17 recurring profit Forecast revisions (%) (1H FY17: -3% YoY) on 21 June, China Gas (CGHL) also guided for Year to 31 Mar 18E 19E 20E aggressive 25-30%+ YoY gas-sales volume growth for FY18-20E (our Revenue change 4.0 (0.3) n.a. Net profit change 20.9 17.0 n.a. forecast: up 20-25%; FY17: +16%) and a 3.5-5.0m annual residential Core EPS (FD) change 23.6 19.7 n.a. connection target (our forecast: 3.5-4.5m; FY17: 2.5m), on various new Source: Daiwa forecasts business contributions. Hence, we are raising our FY18-19 net-profit forecasts by 17-21% and introduce our FY20 net-profit forecast. Share price performance

(HKD) (%) What's the impact: Reaping the rural fruit. CGHL sees a 40m rural 14.5 110 household market in northern China (Beijing/Tianjin/Hebei [BTH], Shanxi, 13.4 101 Henan and Shandong) due to air pollution controls, and aims to have a 20% 12.3 93 market share (8m households) in FY18-22E. We see an incremental 1-2m 11.1 84 10.0 75 residential connections p.a. over FY18-20E, on top of the 2.5-3m city-gas Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 connections p.a., coming from rural projects. Management expects rural gas China Gas (LHS) Relative to HSI (RHS) sales, together with industrial coal-to-gas, contributing 10pp of its gas sales- volume growth for FY18-20E. China’s government plans to focus more on 12-month range 10.20-14.20 clean air, hence keeping the rural gas subsidies in place for at least the next Market cap (USDbn) 9.05 3 years, should benefit CGHL. We now factor CHGL’s rural gas potential into 3m avg daily turnover (USDm) 7.96 our assumptions. In our view, CGHL’s capex for rural projects can be paid Shares outstanding (m) 4,969 Major shareholder Beijing Enterprises Holdings (24.7%) back promptly with the receipt of connection fees.

Financial summary (HKD) Industrial coal-to-gas conversion a long-term gas sales driver. We Year to 31 Mar 18E 19E 20E upgraded CGHL to Buy (1) from Outperform (2) on 21 April 2016 as we Revenue (m) 41,842 51,331 62,750 viewed it as a winner in China’s industrial coal-to-gas initiatives. CGHL sees Operating profit (m) 7,385 8,348 9,613 Net profit (m) 5,516 6,305 7,340 Hebei’s coal-to-gas conversion accelerating with the government’s plan to Core EPS (fully-diluted) 1.111 1.270 1.479 eliminate all coal-fired boilers with capacity of less than 35t/h after having EPS change (%) 24.1 14.3 16.4 already shut down all 10t/h small boilers. On our estimates, 64bcm of gas will Daiwa vs Cons. EPS (%) 18.5 20.9 11.2 PER (x) 12.8 11.2 9.6 be required to replace 10t/h of coal. If the rest of China follows Hebei’s lead Dividend yield (%) 2.2 2.6 3.2 to convert more coal-fired boilers, gas sales volume growth for CGHL would DPS 0.316 0.374 0.450 remain robust post-2020. In our view, CGHL will be able to finance its rising PBR (x) 2.9 2.4 2.1 EV/EBITDA (x) 9.8 8.6 7.3 capex on new businesses (from HKD4.2bn in FY17 to HKD4.4-4.6bn in ROE (%) 24.5 23.6 23.3 FY18-20E) through HKD20bn of project funds. Source: FactSet, Daiwa forecasts

What we recommend: We reiterate our Buy (1) call and raise our 12-month DCF-derived TP to HKD16.6 from HKD14.0 after revising up our 2018-19E EPS by 20-24%, mainly as we are lifting our net-profit forecasts after trimming our LPG sales forecasts by 14-22% (with a thin c.11% gross-profit margin), based on latest guidance. Our upward revisions to gas sales and connections result in a lucrative 18% and 67% gross-profit margin, respectively. Key risk: retail gas tariff cuts.

How we differ: Our FY18-20E EPS are 11-21% above the consensus, likely as we have factored in CGHL’s latest company’s guidance.

See important disclosures, including any required research certifications, beginning on page 20

China Gas (384 HK): 23 June 2017

Table of contents

Heading towards a strong FY18-20E ...... 6 Rural connection market set to rise exponentially ...... 6 Resilient coal-to-gas boilers replacement programme ...... 9 Value-added service (VAS) for extra EPS growth ...... 11 Earnings revisions ...... 13 Risks ...... 14 Heavy reliance of rural connections on subsidies ...... 14 Industrial production slowdown ...... 14 Potential distribution tariff cut ...... 14 Gas sector reform ...... 16 Valuation ...... 17

China Gas (384 HK): 23 June 2017

How do we justify our view?

Growth outlook Valuation Earnings revisions

Growth outlook CGHL: retail natural gas sales volume

We are revising up our retail natural-gas sales-volume (mcm) growth assumption for CGHL for FY18, from 13% YoY to 18,000 30% 25% YoY, still lower than management’s bullish guidance 15,000 25% for 30% YoY growth. Also, we are raising our residential 12,000 20% connection volume forecasts for FY17-20 by 2-11% to 9,000 15% factor in additional revenue from new rural residential 6,000 10% customers. Since 26% of the company’s city-gas projects focus on northern China, CGHL believes it has first-mover 3,000 5% advantage in exploring the opportunities presented by 0 0% FY13 FY14 FY15 FY16 FY17 FY18E FY19E FY20E China’s “coal-free” policy, which is set to penetrate rural Residential Industrial (retail) areas. We are raising our gas sales volume and Commercial LNG/CNG YoY% connection forecasts after getting more clarity from Source: Company, Daiwa forecasts management during a recent analyst briefing. We are also revising up our long-term FY21-24E gas sales volume growth from 7-10% YoY to 15-19% YoY with our more bullish view on industrial coal-to-gas upside.

Valuation CGHL: 1-year forward PER

At our revised recurring EPS forecasts, CGHL is trading at PER (x) a 13x 1-year forward PER, 0.3SD below the stock’s past- 30 10-year 12-month-forward PER. We consider this multiple 25 to be attractive as we expect the company’s YoY gas sales 24.0x Avg+2SD volume growth and residential connections to accelerate 20 19.1x Avg+1SD further in FY18. However, we still see a distribution tariff 15 overhang in FY18E, despite management’s belief that the 14.1x Avg tariff will remain unchanged as its gas-sales ROA is only 10 3%, well below the 6% first proposed by the National 9.1x Avg-1SD Development and Reform Commission (NDRC) in May 5 4.1x Avg-2SD 2017. In terms of gas dollar margin defensiveness, we 0 believe ENN (2688 HK, HKD43.55, Buy [1]) would benefit Jan-09 Jan-11 Jan-13 Jan-15 Jan-17 more than CGHL with its cheaper gas, as ENN has relatively larger exposure to coastal provinces, which stand Source: Bloomberg, Daiwa forecasts to be more liberalised in the future with multi-gas sources.

Earnings revisions CGHL: Bloomberg consensus earnings-forecast revisions

The Bloomberg consensus has revised up its FY18-19E (HKD) EPS by 5-6% for CGHL since the start of 2017, mainly to 1.6 factor in additional earnings from rural gas connection 1.5 projects secured in 7 northern cities, despite adopting a 1.4 1.3 more conservative stance. 1.2 1.1 However, the scope for further upward earnings revisions 1.0 were capped by market concerns about the impact of a 0.9 0.8 potential cut in distribution margins of all city-gas 0.7

distributors. But we expect the consensus forecasts for

Jul-16

Apr-16 Oct-16 Apr-17

Jan-16 Jun-16 Jan-17 Jun-17

Feb-16 Mar-16 Feb-17 Mar-17

Nov-16 Dec-16

Aug-16 Sep-16 May-17 CGHL to be adjusted up aggressively after the most recent May-16 2018E EPS 2019E EPS 2020E EPS update on gas sales and residential connection guidance from management presented during the analyst briefing of Source: Bloomberg the FY17 results on 21 June 2017.

China Gas (384 HK): 23 June 2017

Financial summary Key assumptions Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Natural gas sales volume (mn m3) 6,825 8,045 8,975 9,860 12,224 15,468 18,805 22,566 Gas ASP, incl tax (CNY/m3) 2.44 2.60 2.83 2.61 2.44 2.42 2.38 2.38 Gas purchase cost, incl tax (CNY/m3) 1.96 2.09 2.29 2.09 1.97 1.97 1.97 1.97 Residential gas connection ('000 1,226 1,662 1,921 2,100 2,565 3,500 4,000 4,500 houesholds) Gross profit contribution - connection 49 46 48 46 50 49 47 44 fee (%)

Profit and loss (HKDm) Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Sales of piped gas 7,352 10,169 12,929 12,996 13,779 17,738 21,686 26,615 Gas connection income 2,709 3,658 4,659 4,794 5,748 7,753 8,903 10,081 Other Revenue 7,895 12,182 14,078 11,708 12,466 16,351 20,743 26,054 Total Revenue 17,956 26,008 31,666 29,497 31,993 41,842 51,331 62,750 Other income 588 485 727 (472) 231 569 654 749 COGS (14,180) (20,722) (25,210) (22,283) (23,616) (31,143) (38,772) (47,813) SG&A (1,788) (2,071) (2,586) (2,649) (2,905) (3,883) (4,866) (6,074) Other op.expenses 0 0 0 0 0 0 0 0 Operating profit 2,576 3,699 4,597 4,092 5,703 7,385 8,348 9,613 Net-interest inc./(exp.) (691) (615) (554) (758) (705) (705) (698) (689) Assoc/forex/extraord./others 552 636 767 383 904 1,171 1,324 1,524 Pre-tax profit 2,437 3,721 4,810 3,718 5,902 7,851 8,974 10,448 Tax (400) (741) (940) (984) (1,208) (1,614) (1,854) (2,169) Min. int./pref. div./others (272) (404) (499) (460) (547) (720) (815) (940) Net profit (reported) 1,764 2,576 3,371 2,273 4,148 5,516 6,305 7,340 Net profit (adjusted) 1,671 2,569 3,320 3,716 4,397 5,516 6,305 7,340 EPS (reported)(HKD) 0.394 0.536 0.673 0.458 0.845 1.111 1.270 1.479 EPS (adjusted)(HKD) 0.373 0.534 0.663 0.749 0.896 1.111 1.270 1.479 EPS (adjusted fully-diluted)(HKD) 0.349 0.515 0.645 0.749 0.896 1.111 1.270 1.479 DPS (HKD) 0.079 0.121 0.162 0.195 0.250 0.316 0.374 0.450 EBIT 2,576 3,699 4,597 4,092 5,703 7,385 8,348 9,613 EBITDA 3,151 4,411 5,480 5,006 6,663 8,345 9,425 10,809

Cash flow (HKDm) Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Profit before tax 2,437 3,721 4,810 3,718 5,902 7,851 8,974 10,448 Depreciation and amortisation 575 711 883 914 960 960 1,077 1,196 Tax paid (400) (741) (940) (984) (1,208) (1,614) (1,854) (2,169) Change in working capital 269 287 262 1,845 (339) 720 652 861 Other operational CF items 16 (594) (363) 370 (199) (466) (626) (835) Cash flow from operations 2,896 3,383 4,653 5,862 5,117 7,451 8,223 9,501 Capex (2,511) (3,182) (4,003) (3,288) (4,195) (4,400) (4,600) (4,800) Net (acquisitions)/disposals (187) (1,215) (33) (358) 0 0 0 0 Other investing CF items 122 (744) (1,135) (355) (23) 0 0 0 Cash flow from investing (2,576) (5,141) (5,170) (4,001) (4,218) (4,400) (4,600) (4,800) Change in debt (33) 4,730 768 1,693 0 (1,000) (1,000) (1,000) Net share issues/(repurchases) 193 0 (233) (947) 0 0 0 0 Dividends paid (278) (411) (606) (942) (966) (1,227) (1,568) (1,855) Other financing CF items (858) (93) (638) (1,131) (705) (705) (698) (689) Cash flow from financing (976) 4,226 (708) (1,327) (1,671) (2,932) (3,266) (3,544) Forex effect/others 0 0 0 0 0 0 0 0 Change in cash (655) 2,468 (1,226) 533 (772) 118 357 1,158 Free cash flow 386 201 650 2,574 0 3,597 4,261 5,459 Source: FactSet, Daiwa forecasts

China Gas (384 HK): 23 June 2017

Financial summary continued … Balance sheet (HKDm) As at 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Cash & short-term investment 4,499 6,705 5,292 5,772 5,242 5,361 5,718 6,876 Inventory 952 1,207 1,199 1,213 1,679 1,963 2,288 2,653 Accounts receivable 3,347 4,737 5,328 5,094 6,067 7,413 9,375 11,633 Other current assets 555 1,284 1,149 1,567 2,375 2,375 2,375 2,375 Total current assets 9,354 13,932 12,968 13,647 15,363 17,111 19,756 23,536 Fixed assets 13,896 17,835 21,116 22,850 25,783 29,310 32,918 36,604 Goodwill & intangibles 1,752 4,322 5,570 5,540 6,358 6,271 6,186 6,104 Other non-current assets 7,493 9,176 10,971 11,497 12,483 12,863 13,333 13,827 Total assets 32,495 45,265 50,624 53,533 59,987 65,555 72,193 80,071 Short-term debt 3,640 2,783 2,581 10,324 10,873 10,373 9,873 9,373 Accounts payable 4,148 6,079 6,924 8,549 9,650 12,000 14,939 18,423 Other current liabilities 5,229 3,422 2,132 929 2,056 1,711 1,711 813 Total current liabilities 13,017 12,284 11,637 19,803 22,579 24,084 26,523 28,609 Long-term debt 6,356 14,192 16,817 12,010 12,745 12,245 11,745 11,245 Other non-current liabilities 379 631 735 756 735 629 62 308 Total liabilities 19,752 27,108 29,189 32,569 36,059 36,958 38,331 40,163 Share capital 46 50 50 49 50 50 50 50 Reserves/R.E./others 11,439 15,734 18,346 17,803 20,501 24,449 28,899 34,006 Shareholders' equity 11,485 15,783 18,396 17,853 20,550 24,499 28,949 34,055 Minority interests 1,258 2,374 3,039 3,112 3,377 4,098 4,913 5,853 Total equity & liabilities 32,495 45,265 50,624 53,533 59,987 65,555 72,193 80,071 EV 71,465 76,393 79,141 81,323 82,729 81,951 80,980 79,268 Net debt/(cash) 5,496 10,271 14,106 16,562 18,376 17,258 15,900 13,743 BVPS (HKD) 2.563 3.284 3.672 3.596 4.187 4.936 5.832 6.861

Key ratios (%) Year to 31 Mar 2013 2014 2015 2016 2017 2018E 2019E 2020E Sales (YoY) (5.2) 44.8 21.8 (6.9) 8.5 30.8 22.7 22.2 EBITDA (YoY) 3.2 40.0 24.2 (8.7) 33.1 25.2 12.9 14.7 Operating profit (YoY) 5.1 43.6 24.3 (11.0) 39.4 29.5 13.0 15.1 Net profit (YoY) 103.4 53.7 29.3 11.9 18.3 25.5 14.3 16.4 Core EPS (fully-diluted) (YoY) 97.2 47.5 25.3 16.1 19.7 24.1 14.3 16.4 Gross-profit margin 21.0 20.3 20.4 24.5 26.2 25.6 24.5 23.8 EBITDA margin 17.5 17.0 17.3 17.0 20.8 19.9 18.4 17.2 Operating-profit margin 14.3 14.2 14.5 13.9 17.8 17.6 16.3 15.3 Net profit margin 9.3 9.9 10.5 12.6 13.7 13.2 12.3 11.7 ROAE 15.7 18.8 19.4 20.5 22.9 24.5 23.6 23.3 ROAA 5.4 6.6 6.9 7.1 7.7 8.8 9.2 9.6 ROCE 12.0 12.8 12.1 9.7 12.6 15.0 15.6 16.6 ROIC 13.0 12.7 11.6 8.2 11.4 13.3 13.9 14.7 Net debt to equity 47.9 65.1 76.7 92.8 89.4 70.4 54.9 40.4 Effective tax rate 16.4 19.9 19.5 26.5 20.5 20.6 20.7 20.8 Accounts receivable (days) 61.7 56.7 58.0 64.5 63.7 58.8 59.7 61.1 Current ratio (x) 0.7 1.1 1.1 0.7 0.7 0.7 0.7 0.8 Net interest cover (x) 3.7 6.0 8.3 5.4 8.1 10.5 12.0 14.0 Net dividend payout 20.1 22.5 24.0 42.5 29.6 28.4 29.4 30.4 Free cash flow yield 0.5 0.3 0.9 3.6 0.0 5.1 6.0 7.7 Source: FactSet, Daiwa forecasts

Company profile

China Gas is one of the leading city-gas distributors in China, owning 330 projects (as of March 2017) with a geographical focus on northern provinces. It also owns LPG wholesale and distribution businesses.

China Gas (384 HK): 23 June 2017

Heading towards a strong FY18-20E

We are revising up our FY18-20E gas sales volume and residential connection forecasts for CGHL by 13-29% and 30-61%, respectively, after incorporating the latest management guidance, driven by 2 major new business initiatives since our rating upgrade to Buy (1) from Outperform (2) in April 2016.

Rural connection market set to rise exponentially CGHL has been discussing its rural gas project plan with investors since its 1H FY17 results at the end of November 2016. With a significant 26% exposure (in terms of the number of city-gas projects) to northern China, CGHL believes it has an advantage in exploring “coal-free” policy opportunities, which are also set to penetrate rural villages, to mitigate the regional air pollution surrounding Beijing.

Additional gas consumption from coal-to-gas conversion in northern China Rural counties in the Within China, the regions with the most severe air pollution and smog problems include the BTH area consume 40m BTH area and Shandong, mainly northern provinces with a high level of industrial activity. tonnes of bulk coal per While coal-to-gas conversion has been implemented in cities in order to reduce coal year, accounting for 10% usage, the focus has now expanded to rural areas, home to 50% of China’s population. of total consumption in The rural market has long been ignored, with the bulk of energy usage focused on the province (Hebei: 15% household heating, using bulk coal and other highly polluting low-grade fuels. According to of total coal media reports, rural counties in the BTH area consume 40m tonnes of bulk coal per year, consumption) accounting for 10% of total consumption in the BTH area (or Hebei: 15% of total coal consumption). Bulk coal produces more sulphur dioxide (SO2) and particulate matter (PM2.5) than clean coal used in urban areas, resulting in poorer air quality in surrounding cities.

Hebei: rural residential coal consumption and % of total coal consumption (ton th) 120,000 20%

100,000 15% 80,000

60,000 10%

40,000 5% 20,000

0 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Hebei total coal consumption Hebei rural residential coal consumption Rural consumption % of total (RHS)

Source: National Bureau of Statistics

In September 2016, Hebei introduced a “coal-free” zone for 18 cities/counties in Baoding and Langfang cities, where coal usage is prohibited and coal-to-gas substitutes are required to be implemented by October 2017. In late February 2017, a national policy released by the NDRC, namely the 2017 air pollution prevention plan for Hebei-Beijing- Tianjin (BTH), including Beijing, Tianjin, 8 cities in Hebei (including Shijiazhuang, Langfang, Handan), 4 cities in Shanxi, 7 cities in Shandong, and 7 cities in Henan, also emphasised the implementation of clean energy for winter heating and the full control of scattered coal among urban villages, rural-urban fringe zones and village areas.

China Gas (384 HK): 23 June 2017

Key policy targets from the 2017 air pollution prevention plan for HBT and surrounding areas Field Details Promoting clean energy heating during winter. Construct a “coal-free area” in Beijing, Tianjin, Langfang and Baoding. Winter clean energy Other cities should convert 50-100k households from coal to gas or electricity. heating Close down all coal-fired boilers smaller than 10 tonnes/hour. Prohibit the incineration of biomass and waste in the open. Restricting diesel vehicles carrying coal from entering ports in Hebei and Tianjin before end-July. By September, Tianjin, Others Hebei and surrounding areas will only be allowed to use railways for transportation of coal. Stricter regulation of diesel vehicles. The upstream suppliers are required to construct peak-shaving facilities, including underground gas storage facilities. The Measures notice also specifies that city gas projects must have certain reserve capacities. Source: NDRC, Daiwa

Since 2016, several provinces in northern China have introduced policies related to coal- to-gas conversion, with detailed financial subsidy policies. If all households in the BTH region converted to gas, the extra gas demand would reach 5bcm per year, on our estimates, representing one-third of the current consumption volume in the region, replacing the 16m tonnes of coal currently being used in the region.

Estimated additional gas consumption from the coal-to-gas conversion of rural households in northern China Total Beijing Tianjin Hebei Shanxi Shandong Henan Coal consumption of rural households (ktpa) 31,223 1,718 728 13,570 6,537 4,000 4,670 Additional gas consumption (m cm) 10,010 551 233 4,350 2,096 1,282 1,497 Gas consumption in 2015 (m cm) 50,983 14,688 6,398 7,297 6,492 8,232 7,877 % additional gas consumption 20% 4% 4% 60% 32% 16% 19% Source: National Bureau of Statistics, Daiwa estimates

Gas connection fee for new rural households CGHL currently has entered into clean energy strategic cooperation framework agreements with 9 cities in the BTH and Shanxi region. CGHL has committed to carry out the following work: coal-to-gas conversion in villages, transformation of coal-fired boilers into gas-fired boilers in urban areas, facilities for natural gas vehicles, distributed energy and natural gas storage.

CGHL has an early Our research shows that CGHL has secured a market size of around 4.8m rural mover advantage in a households from its strategic cooperation with the 9 cities. We view this number as market of 4.8m rural conservative, as we exclude the portion of households that we believe cannot be households with its connected to gas, as these households barely incur any energy consumption due to low strategic cooperation income levels. Notably, the company has so far signed contracts to convert 670k village with 9 cities users (in these 9 cities) from coal to natural gas, up from 500k at the beginning of April. From April to 10 June, the company had completed 310k village households, and expects to achieve a total 850k, 1.5m, 2m new village households in FY18E, FY19E and FY20E.

Management expects the market of the focused BTH, Shanxi, Shandong and Henan provinces to be 40m, and hence expects a further 35m village households to be ready to explore once the subsidy policy is confirmed. CGHL aims to acquire a 20% market share with 8m village household connections in FY18-22E, of which 5m will be completed over the next 3 years (FY18-20E).

Baoding and Langfang are the main focus for the rural conversion, due to their proximity to Beijing. The Hebei Government has also issued a proposal for a local subsidy for coal substitutes in Baoding and Langfang, aimed at eliminating the consumption of coal (other than for electricity-generation, centralised heating and raw material usage).

China Gas (384 HK): 23 June 2017

Potential confirmed rural households available for connection to gas District Total Baoding Langfang Zhangjiakou Cangzhou Xingtai Shijiazhuang Tianjin Taiyuan Yangquan Xinle City Gaocheng District Luquan District

No. of total population (m) 56.9 10.3 4.6 4.4 7.5 7.3 0.5 0.8 0.4 15.5 4.32 1.32 Year of statistics 2015 2015 2015 2015 2015 2010 2010 2010 2015 2015 2015

Rural 22.7 5.5 2.1 2.2 3.7 3.6 0.3 0.5 0.3 2.7 0.7 1.1 Urbanisation rate 40% 47% 54% 50% 51% 51% 40% 38% 25% 83% 84% 17% No. of rural household (m) 7.53 1.84 0.7 0.74 1.25 1.22 0.11 0.18 0.10 0.90 0.22 0.27 No. of super poor village 8 0 10 3 10 N/A N/A N/A N/A N/A N/A

Super poor village rate 40% 5% 80% 30% 50% 10% 10% 10% 10% 30% 70%

No. of rural household available 4.80 1.10 0.67 0.15 0.88 0.61 0.10 0.16 0.09 0.81 0.15 0.08 for connection (m)

Source: Daiwa research Note: Total village households market in Northern China (BTH, Shanxi, Henan and Shandong) is around 40m, according to management

Cities with a strategic cooperation framework agreement with CGHL

Source: Company

The local subsidy on coal-to-gas conversion is limited to the areas in the table above, where the upfront subsidy on installation varies between CNY2,700 and CNY3,000. Furthermore, since the cost of gas for heating is still priced at a 50-80% premium to coal, some local governments have also announced generous subsidies on gas tariffs of CNY500-1,200 per household during the heating season to encourage consumption.

Hebei: subsidy policy on rural coal to gas conversion in selected cities City Installation Operation (heating season)

Langfang, Baoding (Coal-free zone) 70% installation cost, not exceeding CNY2,700 per household; CNY4,000 CNY1/cm subsidy (limited to per household for pipeline connection 1,200cm), limited to 3 years

Cangzhou CNY3,600 per household subsidy: CNY2,600 for instalment, CNY1,000 for CNY500-1,000 per household equipment; additional CNY1,000/500 for household covert in 2015/16

Xingtai CNY3,000 per household for purchase of gas heater

Shijiazhuang CNY2,700 per household CNY900 per household Source: local governments, Daiwa

An additional 0.85-2.0m To calculate the net-profit impact from the additional rural household connections, we make of new connections from the following assumptions: 1) a connection fee of CNY2,700 per household, lower than the rural households could urban connection fee of c.CNY3,300. We view this as reasonable as the government could contribute 9-17% of offer a subsidy of CNY2,700, and 2) a lower gross-profit margin of 60%, as more CGHL’s net profit in construction materials will be used due to the lack of basic infrastructure, and higher FY18-20E expenses for the hiring of experienced labour. Our estimates imply an additional 9-17% overall gross profit for CGHL, or 19-36% of total connection fees in FY18-20E.

China Gas (384 HK): 23 June 2017

CGHL: estimated net profit upside from connection fee income in rural areas FY18E FY19E FY20E New connection (m) 0.85 1.5 2.0 Assumed connection fee (CNY) 2,700 2,700 2,700 Connection revenue (CNYm) 2,295 4,050 5,400 Assumed gross margin 60% 60% 60% Connection fee gross profit 1,377 2,430 3,240 Consolidated urban connection/ connection gross profit 19% 30% 36% Consolidated urban connection/ total gross profit 9% 15% 17% Source: Daiwa estimates

1. Resilient coal-to-gas boilers replacement programme Concerns over air pollution in China have intensified since 2015, and the China Government has been stepping up its efforts to replace coal with other clean energy sources, mainly natural gas. We see this initiative as a big opportunity for city-gas operators to increase their industrial gas sales, and in this context believe CGHL is well placed as a result of its geographical presence and industrial focus.

Potential for higher base of gas demand We estimate that new We estimate that the overall coal-to-gas initiative could lead to an additional 64bcm of gas demand arising from annual gas consumption in China by 2020E. According to the air pollution prevention the replacement of coal- policies set out by the central and provincial Ministries of Environmental Protection, China fired boilers will reach is targeting to eliminate all coal-fired boilers with a capacity of less than 10t/h by 2020, 64bcm by 2020E which in total account for 20% of capacity and coal consumption by coal-fired boilers in China, or c.380,000t/h. If 40% of the eliminated coal-fired boilers are converted to gas-fired equipment, around 64bcm pa of gas demand could be created, on our estimates.

On the other hand, the 13th FYP outline published in March 2016 highlights that the replacement of the 189,000t/h coal-fired boilers in the focused areas during 2016-20 should increase gas consumption by 45bcm. The aggressive target set by the State Council is in line with our estimates.

China: coal-fired boiler breakdown (2014) China: gas demand from coal-to-gas: over 64bcm by 2020E 100% 8% Unit Total capacity of coal-fired boilers in China m t/h a 1.90 80% Capacity % of boilers smaller than 10t/h % b 20% 52% 49% Total capacity to be eliminated m t/h c = a * b 0.38 % converted to gas boilers % d 40% 60% Total coal-to-gas capacity m t/h e = c * d 0.15 Daily gas consumption per t/h cm f 1500 40% Utilisation day per year Day g 280 67% Annual gas consumption per t/h mcm h = f * g 0.42 20% Annual gas consumption from coal-to-gas bcm i = e * h 64

20% 23% 0% Unit Capacity Coal consumption < 10 t/h 10-20 t/h 20-35 t/h > 35 t/h

Source: CAQSIQ, Daiwa estimate Source: MIIT, CAQSIQ, Daiwa estimate

CGHL: strong industrial focus In FY17, 61% of CGHL’s total gas sales volume was from industrial customers. Also, compared with its pure city-gas distributor peers, CGHL has a higher industrial and commercial (C&I) gas sales proportion (75% for FY17 vs. a peer average of 65% for calendar 2016). Hence, CGHL should be one of the major beneficiaries of the acceleration in coal-to-gas initiatives.

We believe industries that currently consume large amounts of coal and low amounts of gas have the greatest potential to create coal-to-gas demand. In this respect, we find that heavy industries, including ferrous metal, non-ferrous metal, non-metallic mineral products and paper-making, most closely match the above characteristics, as shown by the large gaps between their proportion of gas consumption and proportion of coal consumption.

China Gas (384 HK): 23 June 2017

Coal-to-gas: potential industries % to total China gas % to total China coal Accounting for total CGHL's Industry consumption consumption Top 4 provinces number of industrial customers Ferrous metal smelting and pressing 2.3% 8.4% Hebei, Jiangsu, Shandong, Tianjin 19% Non-ferrous metal smelting and pressing 2.3% 2.8% Shandong, Xinjiang, Henan, Gansu 18% Non-metallic mineral product (cement, glass, ceramics) 5.0% 8.0% Liaoning, Jiangsu, Shandong, Hebei 22% Paper making 0.3% 1.2% Shandong, Henan, Hainan, Guangxi 22%

Source: WIND, Company

CGHL: city-gas project breakdown vs. distribution of selected industries Province Proportion to CGHL total 2015 China production volume mix (%) Number of connected Number of city-gas industrial customers projects Steel Non-ferrous metal Glass Cement Paper Inner Mongolia 14% 4% 2% 7% 1% 2% 0% Henan 12% 8% 4% 10% 1% 7% 16% Anhui 12% 6% 3% 3% 3% 6% 1% Hubei 10% 7% 3% 2% 12% 0% 1% Fujian 8% 12% 2% 1% 7% 3% 2% Hebei 7% 14% 24% 0% 16% 4% 3% Shandong 6% 4% 9% 18% 10% 6% 35% Chongqing 6% 0% 1% 1% 2% 3% 1% Jiangsu 5% 5% 13% 1% 6% 8% 1% Shaanxi 5% 1% 1% 4% 2% 4% 0% Liaoning 4% 7% 6% 2% 2% 2% 0% Guangxi 3% 6% 3% 3% 1% 5% 8% Heilongjiang 3% 8% 0% 0% 1% 1% 0% Hunan 2% 2% 2% 5% 3% 5% 6% Zhejiang 1% 2% 3% 1% 6% 5% 1% Guangdong 1% 4% 3% 1% 9% 6% 8% Ningxia 0% 1% 0% 3% 0% 1% 0% Tianjin 0% 1% 8% 0% 4% 0% 0% Jiangxi 0% 2% 2% 3% 0% 4% 2% Shanxi 0% 0% 3% 2% 2% 2% 0% Jilin 0% 1% 1% 0% 1% 2% 0% Xinjiang 0% 1% 0% 12% 1% 2% 1% Gansu 0% 2% 1% 8% 0% 2% 0% Guizhou 0% 0% 0% 2% 1% 4% 1% Yunnan 0% 0% 2% 6% 1% 4% 2% Others 0% 0% 5% 6% 7% 13% 11% 100% 100% 100% 100% 100% 100% 100%

Source: Company, WIND, Daiwa estimates Note: Highlighted = top 5 provinces CGHL data as of 31 March 2015

Geographically, CGHL’s existing city-gas projects look to be closely aligned with the potential coal-to-gas industries, as evidenced by the fact that CGHL has c.20% of its connected industrial customers in the top 4 provinces for each selected industry. Also, the top 7 provinces in terms of CGHL’s number of connected industrial customers account for 29-57% of the production volume of the selected industries, which we believe underlines the concentration of CGHL’s presence in these high-potential provinces.

More balanced mix of new projects Compared with TCCL, Unlike Towngas China (1083 HK, HKD5.17, Outperform [2]) whose new projects largely CGHL’s projects in focus on industrial parks (8 out of 44 projects in 2010-15, or 18%), only 9 of CGHL’s new industrial cities are more projects since FY11 have been industrial parks (out of a total of 158 projects, or just 6%). established and hence Hence, in our view, CGHL focuses more on the established industrial demand from traditional more stable in terms of industrial cities or regions in developed cities (such as Jiangbei in Nanjing), rather than on gas sales volume growth new demand from newly built industrial parks. We believe this kind of project mix provides a more balanced and stable base of industrial demand for CGHL, whereas new industrial demand appears more susceptible to the ongoing economic slowdown in China.

Coal-to-gas boiler conversion is a long-term goal According to management, Hebei will replace more of its coal-fired boilers with capacity smaller than 35t/h after it eliminates all the 10t/h small-sized boilers, which could introduce a further c.100bcm gas sales market post 2020, should the whole of China follow Hebei to covert the medium-size coal-fired boilers to gas-fired. By 2030, it is likely that China government will retire half of the coal-fired boilers.

China Gas (384 HK): 23 June 2017

Value-added service (VAS) for extra EPS growth We forecast CGHL’s VAS Since FY15, CGHL has also been developing related services and products in order to earnings to rise at a generate new revenue streams. These include a wide variety of products and services, CAGR of 58% for FY17- such as gas appliances (being sold under the self-developed brand name GASBO, or 中燃 20E 宝), energy saving equipment, comprehensive gas insurance, e-commence services, etc. These products and services are being cross-sold via different channels including the offline retail stores as well as the self-developed mobile platform (Zhongran Smart Living, or 中燃慧生活).

According to management, on average these businesses post gross-profit margins of 40%, and the company is targeting to double the revenue from these value-added businesses in FY17-18. We forecast earnings CAGR of 58% for these businesses in FY17-20E and expect their contribution to CGHL’s gross profit to increase from 4% in FY17 to 9% in FY20E.

CGHL: gross profit from VAS businesses (FY17-20E) (HKDm)

1,400 8.7% 10% 1,200 7.5% 8% 1,000 5.6% 800 6% 3.9% 1,295 600 4% 942 400 603 2% 200 327 0 0% FY17 FY18E FY19E FY20E Gross profit (HKD m) Source: Company, Daiwa forecasts

CGHL: piped-gas customer service centre in Nanjing CGHL: GASBO display section in a China Gas customer service centre

Source: Daiwa research Source: Daiwa research

China Gas (384 HK): 23 June 2017

Examples of services provided by Zhongran Smart Living mobile app

Piped gas Staples & Overseas Securities LPG order Electricity Power retail sales services seafood shopping accounts

Smart-living Red Pocket Finance services

Home Gas Digital Air tickets Food products appliances products

Promotions Group-Buy

Source: Company, Daiwa research

China Gas (384 HK): 23 June 2017

Earnings revisions

Upward adjustment of We are revising up our gas sales volume and margin assumptions for CGHL (see table gas sales volume and below), given management’s guidance of strong retail gas sales volume and residential residential connection connections presented at its analyst briefing on 21 June 2017. We are raising our FY18-19 forecasts for FY18-19 gas sales-volume growth forecasts for CGHL by 7-12pp to 20-25% YoY, but trimming our FY17 unit dollar margin forecast by CNY2.5-6.6¢/m3 to reflect a potential distribution tariff cut for C&I gas sales, as fast-growing residential gas sales generally have a lower margin than C&I gas sales. Hence, the overall unit dollar margin could decline on a gas sales mix skewed more towards residential gas sales fuelled by rural projects.

We also assume 1.5-2.0m new connections from rural households in FY18-19. Consequently, we raise our FY18-19E EPS by 17-21%, and introduce our FY20 net-profit forecast.

CGHL: changes to Daiwa’s forecasts Previous New Change Comment FY18 Gas sales volume growth (YoY%) 13.0% 25.0% 12.0pp Coal-to-gas industrial boiler replacement and rural-gas sales. CGHL’s guidance: 30%+ FY19 Gas sales volume growth (YoY%) 13.0% 20.0% 7.0pp Coal-to-gas industrial boiler replacement and rural-gas sales. CGHL’s guidance: 25%+ FY18 Unit dollar margin (CNY/m3) 0.48 0.46 -2.5cent Distribution tariff cut for C&I gas sales. FY19 Unit dollar margin (CNY/m3) 0.48 0.41 -6.6cent Distribution tariff cut for C&I gas sales FY18 New residential households (m) 2.7 3.5 30% New connections from rural households. CGHL’s guidance: 3.5m FY19 New residential households (m) 3.0 4.0 33% New connections from rural households. CGHL’s guidance: 4.5m FY18 SG&A cost (HKDm) 3,786 3,883 3% Rural connections and LPG retail FY19 SG&A cost (HKDm) 4,849 4,866 0% Rural connections and LPG retail FY18 Finance cost (HKDm) 804 705 -12% Capex partly financed by HKD20bn energy fund, less borrowing burden FY19 Finance cost (HKDm) 696 698 0% FY18 Recurring net profit (HKDm) 4,563 5,516 20.90% Surge in the SG&A costs for the huge upfront costs for rural construction FY19 Recurring net profit (HKDm) 5,387 6,305 17.04% Surge in the SG&A costs for the huge upfront costs for rural construction Source: Daiwa forecasts

China Gas (384 HK): 23 June 2017

Risks Heavy reliance of rural connections on subsidies Rural connections are China’s rural areas lack infrastructure, thus we believe that building long-distance pipelines policy-driven and as is not economically feasible. In our recent discussions with management, CGHL has such any changes in indicated that it plans to leverage on its existing LNG wholesale logistics system to provide policy impact the LNG to rural areas via trucks, similar to the spot supply of LNG. The urban gas network is economics of rural run on a concession agreement system, where operators are granted the exclusive right to consumption supply gas in a given region for 25-30 years. We understand that CGHL has entered into strategic cooperation framework agreements with the 9 cities, but since the framework agreements do not prohibit other operators from supplying gas in these regions, we believe other listed major gas operators or small firms which supply spot LNG could compete for supply to these 7 cities.

Furthermore, the gas cost per energy content is still at a 50% premium to coal in China. Hence, even if rural households are connected to gas resources, we think subsidies to boost consumption would be required, or households may switch back to older sources of energy. Currently, most cities have only introduced limited-period subsidies on operations. According to management, coal prices currently in the “coal-free zones” have skyrocketed to CNY800/tonne, given a restriction on coal usage. Therefore, we believe the success of rural connections is primarily policy-driven for the whole of China, and any changes in the policy might negatively affect the economics of rural gas consumption. This constitutes the primary risk to our call.

Revenue dependent on government subsidies; receivables might be a concern Given low household incomes in rural areas, around 70-100% of connection revenue comes from subsidies, on our estimates. After reviewing the local government proposals on how the subsidies could be raised (released to the public from 4Q16-1Q17), we believe around 30-60% of the subsidy burden will falls on city governments and even lower-class county governments. As such, there could be a risk of subsidy delays, resulting in increased receivables.

Industrial production slowdown Lower-than-expected growth of industrial production in China, especially for high-gas- consuming heavy industries such as glass and non-ferrous metal, would negatively impact the country’s overall industrial gas demand and thus reduce CGHL’s total gas sales volume, of which 61% was from industrial customers in FY17.

Although we expect new industrial gas demand created by the coal-to-gas initiatives to outweigh the decline in gas demand resulting from the production slowdown in these industries, lower-than-expected growth in industrial production may drive down gas demand to an extent that outweighs coal-to-gas demand, leading to an overall decline in industrial gas demand. We consider this possibility a secondary risk to our call.

Potential distribution tariff cut On 22 June, the NDRC announced a 7% ROA regulation for city-gas distributors, with the new distribution tariff to be set by 30 June 2018. The document clearly states that connection fees will not be included in the calculation of ROA formula to determine the distribution tariff, and hence would have an insignificant impact on earnings as the company’s average gas-sales ROA for CGHL is around 3%, lower than the permitted 7% ROA. However, we do not rule out the possibility that the local provinces could lower the distribution tariff for C&I gas to relieve the cost burden of enterprises, similar to the 15% distribution tariff cut proposed by Zhejiang in April 2016. Our stress test shows that CGHL’s gross profit will see a decline of 5.5% if all provinces follow the city-gate tariff cut of

China Gas (384 HK): 23 June 2017

Zhejiang, much lower than peers’ 5.9-7.8%, thanks to its more diversified earnings stream such as rural-gas and VAS businesses. According to management, currently none have CGHL’s projects have reached a 7% ROA.

China gas distributors: gas sales as % of gross profit / segment profit (%) 2016E 2017E 2018E Gas sales as % of gross profit / segment profit (%) ENN Energy 56% 57% 57% Towngas China 40% 43% 44% China Gas 38% 38% 39% China Resources Gas 63% 64% 66% Source: NDRC, companies, Daiwa estimates

China gas distributors: impact of tariff cuts by province (2018E) ENN CRG CGHL TCCL Non- Non-residential Installed designed residential retail tariff Unit dollar Unit dollar Max. margin 2015 Industrial daily capacity Number of Industrial Project city-gate (provincial margin for distribution squeeze under industrial proportion as for C&I customers projects customers investment tariff capital) T&D margin assumed cuts GDP growth a % of GDP % % % % Zhejiang 2.29 3.60 1.31 1.00 0.15 5.4% 48% 8% 10% 7% 5% Guangdong 2.18 4.36 2.18 1.60 - 6.8% 46% 13% 12% 2% 5% Hebei 1.98 3.02 1.04 0.73 0.11 4.7% 51% 10% 3% 8% 4% Jiangsu 2.16 3.10 0.94 0.63 0.03 8.4% 47% 11% 7% 6% 2% Jiangxi 1.96 2.92 0.96 0.65 0.05 9.4% 52% 0% 5% 0% 5% Shanghai 2.18 3.17 0.99 0.68 0.12 1.2% 35% 0% 0% 0% 0% Shanxi 1.91 3.20 1.29 0.98 0.15 -1.1% 49% 0% 4% 0% 0% Liaoning 1.98 3.20 1.22 0.91 0.14 -0.2% 50% 1% 7% 4% 21% Jilin 1.76 3.15 1.39 1.08 0.16 5.6% 53% 0% 4% 0% 7% Heilongjiang 1.76 3.60 1.84 1.53 0.23 1.1% 37% 0% 1% 2% 2% Shandong 1.98 3.70 1.72 1.41 0.21 7.4% 48% 15% 9% 7% 21% Guangxi 2.01 4.18 2.17 1.86 0.28 8.1% 47% 0% 0% 4% 2% Sichuan 1.65 3.25 1.60 1.29 0.19 7.8% 49% 0% 7% 0% 13% Inner Mongolia 1.34 2.67 1.33 1.02 0.15 8.0% 51% 0% 0% 14% 1% Hunan 1.96 3.18 1.22 0.91 0.14 7.4% 46% 13% 5% 1% 2% Beijing 2.00 3.16 1.16 0.85 0.13 3.3% 21% 1% 0% 0% 0% Tianjin 2.00 2.77 0.77 0.46 0.07 9.2% 49% 0% 0% 0% 0% Xinjiang 1.15 2.39 1.24 0.93 0.14 6.9% 43% 0% 0% 0% 0% Anhui 2.09 3.30 1.21 0.90 0.14 8.5% 53% 5% 5% 12% 10% Henan 2.01 2.90 0.89 0.58 0.09 8.0% 51% 9% 6% 11% 0% Hubei 2.31 3.49 1.19 0.88 0.13 8.3% 47% 0% 7% 9% 0% Hainan 1.64 2.62 0.98 0.67 0.10 6.5% 25% 0% 0% 0% 0% Chongqing 1.64 2.14 0.50 0.19 0.03 11.3% 46% 0% 0% 1% 0% Guizhou 1.71 3.30 1.59 1.28 0.19 11.4% 42% 0% 1% 0% 1% Yunnan 1.71 3.42 1.71 1.40 0.21 8.6% 41% 0% 3% 0% 1% Shaanxi 1.34 2.39 1.05 0.74 0.11 7.3% 54% 0% 0% 5% 0% Gansu 1.43 1.99 0.56 0.25 0.04 7.4% 43% 0% 0% 0% 0% Weighted average max. C&I dollar margin 0.83 1.03 0.88 1.11 Exposure - Proposed provinces 44% 34% 23% 20% - High-risk provinces 28% 40% 32% 68% Max. negative impact on C&I unit dollar margin if: - Only the proposed provinces cut distribution margins (based on the announced plan) 3.5% 2.4% 2.5% 1.7% - Only the proposed & high-risk provinces cut distribution margins (adopt the Zhejiang plan) 7.7% 8.4% 7.3% 11.9% - All provinces cut (adopt the Zhejiang plan) 10.5% 11.8% 14.0% 13.7% 2018E gross profit % derived from gas sales (assume residential gas sales contribute minimal gross profit) 57% 66% 39% 44% Max. estimated negative impact on 2018E gross profit if: - Only the proposed provinces cut distribution margins (based on the announced plan) 2.0% 1.6% 1.0% 0.8% - Only the proposed & high-risk provinces cut distribution margins (adopt the Zhejiang plan) 4.4% 5.5% 2.9% 5.3% - All provinces cut (adopt the Zhejiang plan) 5.9% 7.8% 5.5% 6.0% Max. estimated negative impact on 2018E net profit attributable to shareholders if: - Only the proposed provinces cut distribution margins (based on the announced plan) 3.0% 3.0% 1.4% 0.8% - Only the proposed & high-risk provinces cut distribution margins (adopt the Zhejiang plan) 6.5% 10.3% 3.9% 5.8% - All provinces cut (adopt the Zhejiang plan) 8.8% 14.5% 7.4% 6.6% 2018E RoE if: - No gas tariff cut at all 21.0% 19.3% 24.6% 8.4% - Only the proposed provinces cut distribution margins (based on the announced plan) 20.4% 18.7% 24.3% 8.4% - Only the proposed & high-risk provinces cut distribution margins (adopt the Zhejiang plan) 19.9% 17.6% 23.6% 7.9% - All provinces cut (adopt the Zhejiang plan) 18.5% 15.3% 22.2% 7.5%

Source: NDRC, companies, Daiwa estimates Note: (1) Provinces highlighted in blue = already proposed gas-price related measures to boost local economy (2) Cells highlighted in grey = higher-than-average unit dollar margin / lower-than-average industrial GDP growth / larger-than-average industrial GDP proportion (3) Text highlighted in red = high-risk provinces that have at least 2 cells highlighted in grey (4) Different proxies used depending on data availability for the provincial exposure of each gas distributor (5) Assume no change in the gas sales volume (6) Unless specified by measures proposed by government, assume all provinces to cut distribution margin by 15%, same as in Zhejiang

China Gas (384 HK): 23 June 2017

Gas sector reform On 21 May, Xinhua News announced that the NDRC had issued its oil & gas reform guidance, which focuses on industry liberalisation and pricing mechanisms. The document highlighted 8 major missions of oil & gas reform:

1. To open up oil & gas exploration and production (E&P) to ensure continuous resource production 2. To finalise the oil & gas import & export system 3. To reform oil & gas pipe networks to ensure third-party access, and aims for pipeline asset spin-offs from oil & gas majors to ensure independent operations 4. To introduce competition to the oil & gas downstream segment 5. To liberalise oil & gas prices by deregulating the city-gate gas tariff through oil & gas exchanges while regulating the transmission and distribution with a reasonable ROA 6. To further proceed with SOE reforms and corporate restructuring 7. To ensure oil & gas reserves, and establish peak-shaving mechanisms to ensure sustainable oil & gas supplies during the peak winter season 8. To establish a health, safety and environmental (HSE) system

We see the missions mainly focusing on “regulating midstream while liberalising the upstream/downstream”. We see both opportunities and threats to our covered China gas distributors; please refer to our note dated on 22nd May 2017 for our further comments.

China Gas (384 HK): 23 June 2017

Valuation

Reiterating our Buy (1) We reiterate our Buy (1) rating on CGHL and raise our 12-month DCF-derived TP to rating following our HKD16.60 (from HKD14.0). The stock is trading currently at a 12.8x FY18E PER on our upward earnings revised recurring EPS forecast. We believe this multiple is appealing, given our view that forecasts revisions CGHL’s gas sales volume growth is likely to accelerate due to rapid coal-to-gas conversion and a ramp-up of its recently acquired industrial gas projects in FY18-19E.

We value CGHL using DCF methodology to reflect the stable long-term income generated by the company from its gas sales volume and residential connections. We assume an unchanged WACC of 9.3% with a terminal growth rate of 2%. Our DCF-based valuation yields a fair value of HKD16.60, implying a 2018E PER of 15.0x.

CGHL: DCF valuation Forecast 12 months to 31 Mar, all figures in HKDm FY18E FY19E FY20E FY21E FY22E FY23E FY24E Terminal Valuation Date 22-Jun-17 31-Mar-18 31-Mar-19 31-Mar-20 31-Mar-21 31-Mar-22 31-Mar-23 31-Mar-24 31-Mar-24 Next Balance Date 31-Mar-18 First Year Cash Flow Adjustment 0.91

Free Cash Flow EBITDA 8,345 9,425 10,809 11,714 12,608 13,538 8,186

Less: Other Non Cash 451 508 584 636 684 737 954

Less: Cash Tax Payable on EBIT (1,518) (1,725) (1,995) (2,168) (2,345) (2,536) (1,404)

Plus: Decrease in Working Capital 720 652 861 1,346 1,605 1,875 3,441

Less: Capital Expenditure (4,400) (4,600) (4,800) (4,250) (3,700) (3,150) (2,500)

Free Cash Flow 3,597 4,261 5,459 7,278 8,852 10,463 8,677 8,851

Free Cash Flow for Valuation Purposes 3,597 4,261 5,459 7,278 8,852 10,463 8,677 8,851

WACC 9.3% 9.3% 9.3% 9.3% 9.3% 9.3% 9.3% 9.3% 9.3%

NPV of Free Cash Flow 3,358 3,639 4,265 5,202 5,789 6,261 4,749 66,368

Source: Daiwa forecasts and estimates

CGHL: DCF calculation CGHL: DCF sensitivity analysis Target gearing (debt/capital) (%) 35% Discount NPV of Enterprise Equity Equity Value Per Share

Market risk premium (%) 10.0% Rate FCF Value Value (HKD)

Beta 0.95 6.8% 36,613 154,693 137,435 27.69 Risk-free rate (%) 3.5% 7.3% 35,906 139,511 122,254 24.63

Cost of debt (%) 3.2% 7.8% 35,218 126,954 109,696 22.10 8.3% 34,548 116,395 99,138 19.97 Cost of equity (%) 13.0% 8.8% 33,898 107,395 90,137 18.16 WACC (%) 9.3% 9.3% 33,264 99,632 82,374 16.60

9.8% 32,648 92,869 75,612 15.23 Terminal Value 10.3% 32,049 86,925 69,668 14.04 Terminal Growth Rate 2.00% 10.8% 31,465 81,661 64,403 12.98 Terminal WACC 9.30% 11.3% 30,897 76,966 59,708 12.03 11.8% 30,344 72,754 55,496 11.18 Estimated Terminal Free Cash Flow 8,851 NPV of Terminal Value (as at 31 Mar 2024) 121,257 NPV of Terminal Value (as at 22 June 2017) 66,368 DCF Valuation

NPV of Forecasts (HKDm) 33,264 NPV of Terminal Value (HKDm) 66,368 Enterprise Value (HKDm) 99,632 Less: Net Debt (as at 31 Mar 2018) -17,258 Equity Value (HKDm) 82,374 No. Shares (m) 4,963 Per Share Equity Value HK$16.60

Source: Daiwa forecasts and estimates Source: Daiwa forecasts and estimates

China Gas (384 HK): 23 June 2017

Daiwa’s Asia Pacific Research Directory

HONG KONG SOUTH KOREA Takashi FUJIKURA (852) 2848 4051 [email protected] Sung Yop CHUNG (82) 2 787 9157 [email protected] Regional Research Head Pan-Asia Co-head/Regional Head of Automobiles and Components; Automobiles; Jiro IOKIBE (852) 2773 8702 [email protected] Shipbuilding; Steel Co-head of Asia Pacific Research Mike OH (82) 2 787 9179 [email protected] John HETHERINGTON (852) 2773 8787 [email protected] Banking; Capital Goods (Construction and Machinery) Co-head of Asia Pacific Research Iris PARK (82) 2 787 9165 [email protected] Kevin LAI (852) 2848 4926 [email protected] Consumer/Retail Chief Economist for Asia ex-Japan; Macro Economics (Regional) SK KIM (82) 2 787 9173 [email protected] Olivia XIA (852) 2773 8736 [email protected] IT/Electronics – Semiconductor/Display and Tech Hardware Macro Economics (Hong Kong/China) Thomas Y KWON (82) 2 787 9181 [email protected] Kelvin LAU (852) 2848 4467 [email protected] Pan-Asia Head of Internet & Telecommunications; Software – Internet/On-line Games Head of Automobiles; Transportation and Industrial (Hong Kong/China) Leon QI (852) 2532 4381 [email protected] TAIWAN Banking; Diversified financials; Insurance (Hong Kong/China) Rick HSU (886) 2 8758 6261 [email protected] Yan LI (852) 2773 8822 [email protected] Head of Regional Technology; Head of Taiwan Research; Semiconductor/IC Design (Regional) Banking (China) Nora HOU (886) 2 8758 6249 [email protected] Anson CHAN (852) 2532 4350 [email protected] Banking; Diversified financials; Insurance Consumer (Hong Kong/China) Steven TSENG (886) 2 8758 6252 [email protected] Adrian CHAN (852) 2848 4427 [email protected] IT/Technology Hardware (PC Hardware) Consumer (Hong Kong/China) Kylie HUANG (886) 2 8758 6248 [email protected] Jamie SOO (852) 2773 8529 [email protected] IT/Technology Hardware (Handsets and Components) Gaming and Leisure (Hong Kong/China) Helen CHIEN (886) 2 8758 6254 [email protected] John CHOI (852) 2773 8730 [email protected] Small/Mid Cap Head of Hong Kong and China Internet; Regional Head of Small/Mid Cap

Alex LIU (852) 2848 4976 [email protected] INDIA Internet (Hong Kong/China) Punit SRIVASTAVA (91) 22 6622 1013 [email protected] Carlton LAI (852) 2532 4349 [email protected] Head of India Research; Strategy; Banking/Finance Small/Mid Cap (Hong Kong/China) Saurabh MEHTA (91) 22 6622 1009 [email protected] Dennis IP (852) 2848 4068 [email protected] Capital Goods; Utilities Power; Utilities; Renewables and Environment (Hong Kong/China) Jonas KAN (852) 2848 4439 [email protected] SINGAPORE Head of Hong Kong and China Property Ramakrishna MARUVADA (65) 6499 6543 [email protected] Cynthia CHAN (852) 2773 8243 [email protected] Head of Singapore Research; Telecommunications (China/ASEAN/India) Property (China) David LUM (65) 6329 2102 [email protected] Thomas HO (852) 2773 8716 [email protected] Banking; Property and REITs Custom Products Group Royston TAN (65) 6321 3086 [email protected] Oil and Gas; Capital Goods PHILIPPINES Shane GOH (65) 64996546 [email protected] Micaela ABAQUITA (63) 2 737 3021 [email protected] Property and REITs; Small/Mid Cap (Singapore) Property Jame OSMAN (65) 6321 3092 [email protected]

Transportation – Road and Rail; Pharmaceuticals and Healthcare; Consumer (Singapore)

China Gas (384 HK): 23 June 2017

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China Gas (384 HK): 23 June 2017

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China Gas (384 HK): 23 June 2017

Markets Europe Limited is authorised and regulated by The Financial Conduct Authority (“FCA”) and is a member of the London Stock Exchange and Eurex. This publication is intended for investors who are not Retail Clients in the United Kingdom within the meaning of the Rules of the FCA and should not therefore be distributed to such Retail Clients in the United Kingdom. Should you enter into investment business with Daiwa Capital Markets Europe’s affiliates outside the United Kingdom, we are obliged to advise that the protection afforded by the United Kingdom regulatory system may not apply; in particular, the benefits of the Financial Services Compensation Scheme may not be available.

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The following explains the rating system in the report as compared to relevant local indices, unless otherwise stated, based on the beliefs of the author of the report. "1": the security could outperform the local index by more than 15% over the next 12 months. "2": the security is expected to outperform the local index by 5-15% over the next 12 months. "3": the security is expected to perform within 5% of the local index (better or worse) over the next 12 months. "4": the security is expected to underperform the local index by 5-15% over the next 12 months. "5": the security could underperform the local index by more than 15% over the next 12 months.

Disclosure of investment ratings Rating Percentage of total Buy* 66.8% Hold** 20.9% Sell*** 12.2% Source: Daiwa Notes: data is for single-branded Daiwa research in Asia (ex Japan) and correct as of 31 March 2017. * comprised of Daiwa’s Buy and Outperform ratings. ** comprised of Daiwa’s Hold ratings. *** comprised of Daiwa’s Underperform and Sell ratings.

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