Energy 29 October 2019

Kunlun Energy (135 HK)

Target price: HKD9.30 (from HKD7.80) Share price (29 Oct): HKD7.16 | Up/downside: +29.9%

Additional upside from special dividend Tony Wu, CFA (852) 2848 4469  Overhang on pipeline spinoff looks overdone; attractive valuation [email protected]  Potential special dividend from pipeline spinoff Dennis Ip, CFA (852) 2848 4068  Reaffirming Buy (1) rating; TP lifted to HKD9.3, from HKD7.8 [email protected]

What's new: Kunlun’s share price is down 14% YTD vs. a 4% increase for Forecast revisions (%) the HSI, but has risen by 7% in the past one month. We see additional Year to 31 Dec 19E 20E 21E share-price upside from a potential special dividend post the pipeline Revenue change - - - spinoff. The overhang for the stock stems from the National Oil & Gas Net profit change - - - Core EPS (FD) change - - - Pipeline (NPC) reform and the spin-off of its SJ pipeline asset. Since the Source: Daiwa forecasts spinoff constitutes a major transaction that requires minority shareholders’ approval, we think a cash offer is more likely. Share price performance

(HKD) (%) What's the impact: Potential special dividend. The market is anticipating 10.0 110 an announcement on the setting up of the NPC in 4Q19 and as early as 31 9.0 98 October 2019. Our channel checks indicate that the government is in 8.0 85 discussions with different stakeholders at this stage, and we do not expect 7.0 73 6.0 60 the announcement to contain details on valuation as the deal would be Oct-18 Jan-19 Apr-19 Jul-19 Oct-19 complex to work through in a short period of time. Thus, details on the spinoff Kunlun En. (LHS) Relative to HSI (RHS) may take an additional few months to finalise in 1H20. Management stressed recently that it would look after the interests of minority shareholders. And in 12-month range 6.40-9.94 order to get minority shareholders’ approval, we believe a cash offer would be Market cap (USDbn) 7.37 possible. Assuming that the spin-off valuation is at a c.1.4x PBR to avoid 3m avg daily turnover (USDm) 15.45 impairment loss, the spin-off pipeline value arrives at c.HKD28bn Shares outstanding (m) 8,072 Major shareholder PetroChina (58.3%) (HKD3.5/share) based on 2018 book value. We believe it would be more desirable for Kunlun to utilise the cash received for expansion in the Financial summary (CNY) downstream business. If we assume an all-cash offer with c.30% paid as a Year to 31 Dec 19E 20E 21E special dividend, the cash dividend received would be HKD1.0/share. Revenue (m) 122,149 134,774 148,826 Operating profit (m) 15,068 16,265 16,125 Focus on downstream. After the payment of a special dividend, this would Net profit (m) 6,644 7,533 7,794 Core EPS (fully-diluted) 0.769 0.872 0.903 leave c.HKD7bn of cash (before spinoff: CNY11.2bn net debt) for Kunlun to EPS change (%) 12.9 13.4 3.5 expand its downstream business (peers’ PBR valuation: 3-4x). Kunlun has Daiwa vs Cons. EPS (%) 0.6 4.2 0.4 continued to expand its downstream business, having acquired 8 city-gas PER (x) 8.4 7.4 7.1 Dividend yield (%) 3.8 3.9 4.0 projects in 1H19 and 17 more projects from Jinhong during 2H19. As there DPS 0.247 0.252 0.261 are plenty of small gas distributors and with the opening up of the PBR (x) 1.1 1.0 0.9 downstream market to competition, we expect market consolidation by the EV/EBITDA (x) 4.2 3.8 3.7 large players. Kunlun seeks to cooperate with major gas distributors with ROE (%) 14.8 15.0 14.0 access to upstream supply in future project acquisitions. Source: FactSet, Daiwa forecasts

What we recommend: We reiterate our Buy (1) rating as we believe the stock is trading at an attractive valuation of a 1x 2020E PBR. We also raise our SOTP-based 12-month TP to HKD9.3, from HKD7.8, after rolling forward to 2020E book value and raising our target PBR to 1.3x (from 1.1x) as we now expect higher valuation for the pipeline spinoff. Key risk: pipeline spinoff at a valuation resulting in a disposal loss.

How we differ: We believe a further ramp-up of the gas distribution segment over 2020-21E could offset another potential transmission tariff cut in 4Q20E.

See important disclosures, including any required research certifications, beginning on page 5

Kunlun Energy (135 HK): 29 October 2019

Kunlun: pipeline spin-off case Kunlun vs. national city-gas distributors: 12-month forward PER CNY PER (x) 2020E 2021E 30 80% Pre-spinoff Post-spinoff Pre-spinoff Post-spinoff 25 60% Net profit (m) 7,533 4,923 7,794 6,085 20 40% EPS 0.87 0.57 0.90 0.71 DPS 0.25 0.25 0.26 0.26 15 20% Payout ratio 29% 45% 29% 37% 10 0% PBR(x) 1.06 1.12 0.96 1.04 5 -20% PER(x) 7.4 11.5 7.1 9.3 ROE 15% 10% 14% 12% 0 -40%

Jul-11 Jul-18

Oct-09 Oct-16 Apr-13

Jun-14 Jan-08 Jan-15

Mar-09 Mar-16

Feb-12 Feb-19

Aug-08 Dec-10 Sep-12 Nov-13 Aug-15 Dec-17 Sep-19

May-10 May-17 Kunlun PER (LHS) National city-gas distributors PER (RHS) Kunlun PER discount/ (premium) (RHS) Source: Bloomberg and Daiwa forecasts Source: Bloomberg and Daiwa forecasts

China transmission and distribution gas players: PER trend PER (x) 20 3 18 5 2 4 6 16 1 14 7 12 14 10 8 6 8 10 12 13 4 9 11 2 0 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19 Jul-19 Jan-20 Transmission player Distribution player Transmission player (forecast) Distribution player (forecast) Kunlun (post-spinoff) Source: Bloomberg and Daiwa forecasts Note: # Segment Event 1 Distribution Concern on inclusion of connection income in 7% RoA 2 Distribution Confirmation of connection income excluded from 7% RoA 3 Distribution Concerns on connection fee regulations 4 Distribution 6-7% summer city-gate tariff hike for non-residential customers 5 Distribution NDRC’s policy for gas connection fee confirmed 6 Distribution Slow 1H19 results 7 Distribution NOC setup 8 Transmission Transmission tariff cut (28%) 9 Transmission New transmission fee implemented with no near-term overhang until Sept-2020 10 Transmission Delay of NOC setup 11 Transmission Slow 1H19 results was less than expected 12 Transmission NOC setup 13 Transmission Concern on transmission tariffs review in Sept-2020 14 Kunlun Follows uptrend of gas distributors

Kunlun: EBIT proportion Kunlun: net profit breakdown by segment Segments Book value Target PBR Target book value Proportion 100% Oil & Gas E&P 320 0.50x 160 0.2% 27% Natural gas sales 21,422 1.30x 27,848 40.5% 80% 41% 43% 39% LNG terminal and processing 9,575 1.30x 12,447 18.1% 60% Natural gas pipeline 21,765 1.30x 28,295 41.2% 38% Total book value 53,081 1.30x 68,750 100.0% 31% 40% 36% 31% No. of shares 8,072 20% 32% Target price (CNY) 8.52 19% 22% 25% HKD/CNY currency 1.10 4% 4% 4% 4% 0% Target price (HKD) 9.3 2018 2019E 2020E 2021E

E&P Natural gas sales LNG processing and terminal Natural gas transmission

Source: Bloomberg, Daiwa forecasts Source: Bloomberg, Daiwa estimates

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Kunlun Energy (135 HK): 29 October 2019

Financial summary Key assumptions Year to 31 Dec 2014 2015 2016 2017 2018 2019E 2020E 2021E Oil & Gas E&P - sales volume ('000 16,877 16,747 15,223 13,060 13,270 13,483 13,700 13,921 barrels) Total distribution gas sales (mcm) 6,845 6,577 15,189 18,772 21,994 24,794 28,058 31,784 City-gas and LPG sales (mcm) 4,141 4,556 10,061 12,372 15,154 17,944 21,198 24,914 Vehicular gas sales (mcm) 2,704 2,021 5,128 6,400 6,840 6,850 6,860 6,870 LNG terminal (mcm) 5,181 3,968 6,567 14,902 21,230 22,024 22,555 25,967 LNG processing (mcm) 912 679 522 1,093 1,545 1,625 1,705 1,785 Total transmission gas sales (mcm) 30,693 33,978 35,731 41,689 52,945 57,885 62,338 64,883

Profit and loss (CNYm) Year to 31 Dec 2014 2015 2016 2017 2018 2019E 2020E 2021E Natural gas sales revenue 26,291 77,097 54,581 71,203 86,087 100,047 113,220 128,256 Natural gas transmission revenue 12,679 14,031 11,683 10,746 9,690 11,162 10,444 8,304 Other Revenue 9,074 5,207 5,478 6,757 9,693 10,940 11,110 12,266 Total Revenue 48,044 96,335 71,742 88,706 105,470 122,149 134,774 148,826 Other income 1,056 1,093 974 1,546 36 775 767 797 COGS (28,722) (74,422) (52,159) (68,474) (83,094) (97,456) (107,394) (118,443) SG&A (2,777) (3,821) (2,912) (3,448) (3,389) (3,803) (4,061) (4,336) Other op.expenses (6,131) (9,111) (11,470) (6,696) (7,077) (6,597) (7,821) (10,719) Operating profit 11,470 10,074 6,175 11,634 11,946 15,068 16,265 16,125 Net-interest inc./(exp.) (486) (673) (651) (1,145) (1,130) (1,187) (1,019) (819) Assoc/forex/extraord./others 972 (1,846) 767 991 1,169 1,211 1,265 1,327 Pre-tax profit 11,956 7,555 6,291 11,480 11,985 15,093 16,511 16,633 Tax (3,080) (3,325) (3,200) (3,531) (3,772) (4,400) (4,609) (4,546) Min. int./pref. div./others (3,266) (2,739) (2,425) (3,189) (3,579) (4,048) (4,369) (4,293) Net profit (reported) 5,610 1,491 666 4,760 4,634 6,644 7,533 7,794 Net profit (adjusted) 5,720 3,316 3,938 4,894 5,885 6,644 7,533 7,794 EPS (reported)(CNY) 0.695 0.185 0.083 0.590 0.574 0.823 0.933 0.966 EPS (adjusted)(CNY) 0.709 0.411 0.488 0.606 0.729 0.823 0.933 0.966 EPS (adjusted fully-diluted)(CNY) 0.709 0.411 0.488 0.568 0.682 0.769 0.872 0.903 DPS (CNY) 0.200 0.060 0.065 0.210 0.230 0.247 0.252 0.261 EBIT 11,470 10,074 6,175 11,634 11,946 15,068 16,265 16,125 EBITDA 16,862 16,764 11,865 17,285 18,135 20,723 21,947 21,853

Cash flow (CNYm) Year to 31 Dec 2014 2015 2016 2017 2018 2019E 2020E 2021E Profit before tax 11,956 7,555 6,291 11,480 11,985 15,093 16,511 16,633 Depreciation and amortisation 5,392 6,690 5,690 5,651 6,189 5,654 5,682 5,728 Tax paid (3,080) (3,325) (3,200) (3,531) (3,772) (4,400) (4,609) (4,546) Change in working capital (2,863) (12,775) 1,705 (362) (86) (708) (63) (172) Other operational CF items 2,293 18,590 3,645 49 2,702 (1,050) (1,104) (1,166) Cash flow from operations 13,698 16,735 14,131 13,287 17,018 14,589 16,417 16,477 Capex (9,553) (7,375) (9,231) (12,330) (8,458) (9,950) (9,009) (8,009) Net (acquisitions)/disposals 158 372 (14,914) (976) 788 0 0 0 Other investing CF items 1,794 (414) 3,813 (187) 670 755 789 827 Cash flow from investing (7,601) (7,417) (20,332) (13,493) (7,000) (9,195) (8,220) (7,182) Change in debt (6,209) (1,209) 9,415 9,195 (6,537) (4,000) (4,000) (4,000) Net share issues/(repurchases) 32 0 0 0 0 0 0 0 Dividends paid (5,722) (4,496) (1,118) (5,727) (4,542) (1,993) (2,034) (2,104) Other financing CF items 1,750 (1,207) 2,527 (191) (276) 0 0 0 Cash flow from financing (10,149) (6,912) 10,824 3,277 (11,355) (5,993) (6,034) (6,104) Forex effect/others (116) (1,201) 162 (386) (39) 0 0 0 Change in cash (4,168) 1,205 4,785 2,685 (1,376) (599) 2,163 3,190 Free cash flow 4,145 9,366 20,481 2,504 8,560 4,640 7,408 8,467 Source: FactSet, Daiwa forecasts

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Kunlun Energy (135 HK): 29 October 2019

Financial summary continued … Balance sheet (CNYm) Year to 31 Dec 2014 2015 2016 2017 2018 2019E 2020E 2021E Cash & short-term investment 10,729 17,145 19,165 21,850 20,474 19,875 22,038 25,229 Inventory 1,157 1,518 1,242 1,559 1,865 2,008 2,213 2,440 Accounts receivable 1,988 3,280 2,958 2,846 2,459 3,072 3,389 3,743 Other current assets 5,741 10,406 5,858 6,640 5,859 0 0 0 Total current assets 19,615 32,349 29,223 32,895 30,657 24,955 27,641 31,412 Fixed assets 86,442 98,878 87,859 95,735 95,933 100,337 103,770 106,155 Goodwill & intangibles 1,509 1,540 2,424 1,173 1,889 0 0 0 Other non-current assets 10,144 10,419 9,428 10,755 12,108 11,765 12,721 13,742 Total assets 117,710 143,186 128,934 140,558 140,587 137,057 144,132 151,308 Short-term debt 8,465 8,076 16,585 11,805 7,072 7,072 7,072 7,072 Accounts payable 14,776 24,539 26,784 26,569 27,355 28,819 29,403 30,157 Other current liabilities 1,261 1,725 1,571 1,077 4,714 4,714 4,714 4,714 Total current liabilities 24,502 34,340 44,940 39,451 39,141 40,605 41,189 41,943 Long-term debt 16,224 16,414 15,920 29,296 28,163 24,163 20,163 16,163 Other non-current liabilities 2,670 3,813 6,179 6,186 3,189 (6,503) (5,882) (5,441) Total liabilities 43,396 54,567 67,039 74,933 70,493 58,264 55,471 52,665 Share capital 81 81 65 65 65 65 65 65 Reserves/R.E./others 52,807 61,680 37,787 39,960 42,639 47,290 52,789 58,479 Shareholders' equity 52,888 61,761 37,852 40,025 42,704 47,355 52,854 58,544 Minority interests 21,426 26,858 24,043 25,600 27,390 31,438 35,807 40,099 Total equity & liabilities 117,710 143,186 128,934 140,558 140,587 137,057 144,132 151,308 EV 81,217 82,075 85,352 91,475 87,214 86,853 83,997 79,975 Net debt/(cash) 13,960 7,345 13,340 19,251 14,761 11,360 5,197 (1,994) BVPS (CNY) 6.552 7.652 4.690 4.959 5.291 5.867 6.548 7.253

Key ratios (%) Year to 31 Dec 2014 2015 2016 2017 2018 2019E 2020E 2021E Sales (YoY) 10.6 100.5 (25.5) 23.6 18.9 15.8 10.3 10.4 EBITDA (YoY) (3.3) (0.6) (29.2) 45.7 4.9 14.3 5.9 (0.4) Operating profit (YoY) (11.2) (12.2) (38.7) 88.4 2.7 26.1 7.9 (0.9) Net profit (YoY) (16.8) (42.0) 18.8 24.3 20.2 12.9 13.4 3.5 Core EPS (fully-diluted) (YoY) (16.8) (42.0) 18.8 16.4 20.0 12.9 13.4 3.5 Gross-profit margin 40.2 22.7 27.3 22.8 21.2 20.2 20.3 20.4 EBITDA margin 35.1 17.4 16.5 19.5 17.2 17.0 16.3 14.7 Operating-profit margin 23.9 10.5 8.6 13.1 11.3 12.3 12.1 10.8 Net profit margin 11.9 3.4 5.5 5.5 5.6 5.4 5.6 5.2 ROAE 11.1 5.8 7.9 12.6 14.2 14.8 15.0 14.0 ROAA 4.8 2.5 2.9 3.6 4.2 4.8 5.4 5.3 ROCE 11.3 9.5 6.0 11.6 11.3 14.0 14.4 13.6 ROIC 9.6 6.1 3.5 10.1 9.6 12.2 12.7 12.3 Net debt to equity 26.4 11.9 35.2 48.1 34.6 24.0 9.8 n.a. Effective tax rate 25.8 44.0 50.9 30.8 31.5 29.2 27.9 27.3 Accounts receivable (days) 14.7 10.0 15.9 11.9 9.2 8.3 8.7 8.7 Current ratio (x) 0.8 0.9 0.7 0.8 0.8 0.6 0.7 0.7 Net interest cover (x) 23.6 15.0 9.5 10.2 10.6 12.7 16.0 19.7 Net dividend payout 28.8 32.5 78.4 35.6 40.1 30.0 27.0 27.0 Free cash flow yield 8.0 18.0 39.3 4.8 16.4 8.9 14.2 16.3 Source: FactSet, Daiwa forecasts

Company profile

Kunlun Energy is a major midstream and downstream natural gas company of PetroChina. It owns an integrated LNG business, which includes 3 terminals in Jiangsu, Dalian and Caofeidian, 12 LNG processing plants, and around 1,200 LNG/CNG vehicles refuelling stations. It also owns 2 mid-stream transmission gas pipelines and over 150 city-gas projects. Away from natural gas, Kunlun also has legacy oil and gas fields in China, Asia, and South America.

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Kunlun Energy (135 HK): 29 October 2019

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Kunlun Energy (135 HK): 29 October 2019

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Ownership of Securities For “Ownership of Securities” information please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. Investment Banking Relationships For “Investment Banking Relationships” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. DCMA Market Making For “DCMA Market Making” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action.

Research Analyst Conflicts For updates on “Research Analyst Conflicts” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. The principal research analysts who prepared this report have no financial interest in securities of the issuers covered in the report, are not (nor are any members of their household) an officer, director or advisory board member of the issuer(s) covered in the report, and are not aware of any material relevant conflict of interest involving the analyst or DCMA, and did not receive any compensation from the issuer during the past 12 months except as noted: no exceptions.

Research Analyst Certification For updates on “Research Analyst Certification” and “Rating System” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. The views about any and all of the subject securities and issuers expressed in this Research Report accurately reflect the personal views of the research analyst(s) primarily responsible for this report (or the views of the firm producing the report if no individual analyst is named on the report); and no part of the compensation of such analyst (or no part of the compensation of the firm if no individual analyst is named on the report) was, is, or will be directly or indirectly related to the specific recommendations or views contained in this Research Report.

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* 69.11% Hold** 23.76% Sell*** 7.13% Source: Daiwa Notes: data is for single-branded Daiwa research in Asia (ex Japan) and correct as of 30 September 2019. * comprised of Daiwa’s Buy and Outperform ratings. ** comprised of Daiwa’s Hold ratings. *** comprised of Daiwa’s Underperform and Sell ratings.

Additional information may be available upon request.

Japan - additional notification items pursuant to Article 37 of the Financial Instruments and Exchange Law (This Notification is only applicable where report is distributed by Daiwa Securities Co. Ltd.)

If you decide to enter into a business arrangement with us based on the information described in materials presented along with this document, we ask you to pay close attention to the following items.  In addition to the purchase price of a financial instrument, we will collect a trading commission* for each transaction as agreed beforehand with you. Since commissions may be included in the purchase price or may not be charged for certain transactions, we recommend that you confirm the commission for each transaction.  In some cases, we may also charge a maximum of ¥ 2 million (including tax) per year as a standing proxy fee for our deposit of your securities, if you are a non-resident of Japan.  For derivative and margin transactions etc., we may require collateral or margin requirements in accordance with an agreement made beforehand with you. Ordinarily in such cases, the amount of the transaction will be in excess of the required collateral or margin requirements.  There is a risk that you will incur losses on your transactions due to changes in the market price of financial instruments based on fluctuations in interest rates, exchange rates, stock prices, real estate prices, commodity prices, and others. In addition, depending on the content of the transaction, the loss could exceed the amount of the collateral or margin requirements.  There may be a difference between bid price etc. and ask price etc. of OTC derivatives handled by us.  Before engaging in any trading, please thoroughly confirm accounting and tax treatments regarding your trading in financial instruments with such experts as certified public accountants. *The amount of the trading commission cannot be stated here in advance because it will be determined between our company and you based on current market conditions and the content of each transaction etc.

When making an actual transaction, please be sure to carefully read the materials presented to you prior to the execution of agreement, and to take responsibility for your own decisions regarding the signing of the agreement with us. Corporate Name: Daiwa Securities Co. Ltd. Financial instruments firm: chief of Kanto Local Finance Bureau (Kin-sho) No.108 Memberships: Japan Securities Dealers Association, The Financial Futures Association of Japan Japan Securities Investment Advisers Association Type II Financial Instruments Firms Association

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