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Gas Distribution | CHINA POWER AND UTILITIES NOMURA INTERNATIONAL (HK) LIMITED Joseph Lam, CFA +852 2252 2106 [email protected] Ivan Lee, CFA +852 2252 6213 [email protected] BULLISH ANCHOR REPORT Consolidation cooking Stocks for action With gas supply bottlenecks to ease and gas penetration to improve, we see the We prefer CR Gas and BJE for their ingredients coming together for a key investment theme for 2011 and beyond: large visible growth story, long-term market project M&A and industry consolidation. After years of development, many leader and consolidator positions in the downstream projects in second-tier cities with immediate piped gas sources and good gas distribution sector. economics have been taken. The most appetising future opportunities are likely to come from medium- to large-sized projects and new projects along W-to-E pipelines II Price Stock Ticker Rating Price target & III and other new gas sources. We expect strong competition for these from well- Pure China plays connected SOEs. We see increased potential for industry consolidation over the next CR Gas 1193 HK BUY 11.72 14.80 five years, during which large companies with strong balance sheets, better access to Beijing Enterprises 392 HK BUY 52.05 70.50 Kunlun Energy 135 HK BUY 10.08 13.50 gas sources, and strong government support should outperform. Our top picks, CR ENN Energy 2688 HK NEUTRAL 25.35 24.10 Gas and Beijing Enterprises, will likely be major consolidators, we believe. We also like Towngas China 1083 HK NEUTRAL 3.56 3.40 Kunlun Energy, for its hybrid business model and potential asset injections from its China Gas 384 HK REDUCE 4.42 3.70 parent. Our BUY ratings also flow from strong earnings outlooks over the next 3 years: Indirect plays HK and China Gas 3 HK REDUCE 19.02 16.50 a 30.7% CAGR for CR Gas, 21.4% for Beijing Enterprises and 44.9% for Kunlun Note: local currency; pricing as of 2 November, 2010 Energy. We see a neutral impact from potential gas price reform (dollar margin Upgrade from Reduce to Neutral; Downgrade from Neutral maintained) and believe gas connection fees will stay in one form or another. Analysts Remain Bullish on China’s gas distribution sector Joseph Lam, CFA th +852 2252 2106 12 FYP – Government’s supportive stance on gas demand [email protected] Prepare for industry consolidation in the long run Ivan Lee, CFA +852 2252 6213 BUY CR Gas, Beijing Enterprises and Kunlun Energy [email protected] Nomura Anchor Reports examine the key themes and value drivers that underpin our sector views and stock recommendations for the next 6 to 12 months. Any authors named on this report are research analysts unless otherwise indicated. See the important disclosures and analyst certifications on pages 133 to 136. Nomura 8 November 2010 Gas Distribution | CHINA POWER AND UTILITIES NOMURA INTERNATIONAL (HK) LIMITED Joseph Lam, CFA +852 2252 2106 [email protected] Ivan Lee, CFA +852 2252 6213 [email protected] BULLISH Action Stocks for action We are Bullish given stable dollar margin and strong pent-up gas demand. We We prefer CR Gas and BJE for their expect more gas supply to flow to China to meet the strong demand, driven by the visible growth story, long-term market th 12 FYP. Any potential price reform should be neutral to gas distributors. More leader and consolidator positions in the acquisition and cooperation will happen but in the long run, industry consolidation is gas distribution sector. inevitable. CR Gas and Beijing Enterprises are the likely winners, in our view. Price Catalysts Stock Ticker Rating Price target Pure China plays M&A, gas pricing reform and the government’s supportive policies on gas usage. CR Gas 1193 HK BUY 11.72 14.80 Beijing Enterprises 392 HK BUY 52.05 70.50 Anchor themes Kunlun Energy 135 HK BUY 10.08 13.50 ENN Energy 2688 HK NEUTRAL 25.35 24.10 We are upbeat on China’s gas distribution sector, considering: 1) favourable Towngas China 1083 HK NEUTRAL 3.56 3.40 government policies; 2) robust demand growth underpinned by the transition to China Gas 384 HK REDUCE 4.42 3.70 clean and low-cost energy; 3) stable margins attributable to strong cost pass- Indirect plays HK and China Gas 3 HK REDUCE 19.02 16.50 through capability; and 4) potential upside from the new energy initiatives. Note: local currency; pricing as of 2 November, 2010 Upgrade from Reduce to Neutral; Downgrade from Neutral Consolidation cooking Analysts Joseph Lam, CFA Remain Bullish on China’s gas distribution sector +852 2252 2106 On assumption of coverage, we reaffirm our Bullish view on China’s gas [email protected] distribution sector as we expect: 1) substituted demand to support clean and low cost energy; 2) gas supply outweighing demand in 2012F, we estimate; Ivan Lee, CFA 3) strong 20%-plus pa gas demand growth; 4) neutral impact from potential gas +852 2252 6213 price reforms (dollar margin maintained); and 5) sustainable gas connection fees. [email protected] th 12 FYP – Government’s supportive stance on gas demand With the government’s targets to reduce carbon emissions by 40-45% by 2020, as depicted under the 12th Five-Year Plan (FYP), China plans to raise the natural gas proportion in the primary energy mix from 3.9% in 2009 to 8.3% in 2015F, representing a demand CAGR of 19.4%. This shows the government’s supportive stance in utilizing natural gas as a major clean energy source. Prepare for industry consolidation in the long run After 10 years of development, the majority of downstream projects at second-tier cities with immediate piped gas sources and good economics have been taken. We expect opportunities to come from medium- to large-sized projects and new projects along W-to-E pipelines II & III and other new gas sources; these are expected to see strong competition from well-connected SOEs. We see increased potential of industry consolidation over the next five years, during which large size companies with strong balance sheets, better access to gas sources and strong government support should outperform, in our view. BUY CR Gas, Beijing Enterprises and Kunlun Energy CR Gas and Beijing Enterprises will be major consolidators, in our view. CR Gas and Beijing Enterprises are our top picks. We also like Kunlun Energy for its hybrid (E&P and natural gas) business model and potential asset injections from parent. We downgrade China Gas to REDUCE, due to margin volatility on its LPG business, limited growth from its piped gas business and options dilution risk. We upgrade Towngas China to NEUTRAL due to fair valuation. HK & China Gas remains a REDUCE on demanding valuation. ENN is a NEUTRAL given rising new project risks. We also provide updates on 12 not rated listed gas plays in China. Nomura 1 8 November 2010 Gas Distribution | China Joseph Lam, CFA Contents Road to consolidation 4 Positive on China’s gas distribution sector 4 12th Five-Year Plan (FYP) to support growth 5 Road to consolidation 5 Phase II: Road to consolidation 6 Macro headwinds 6 The potential winners and losers are … 7 Natural gas – rising star in China’s energy pie 12 More gas supply flowing to China 13 Gas reserves in China 13 Future natural gas supply trend 13 Future sources of gas supply 14 New gas pipelines coming online 15 LNG terminals – ambitious construction plan 16 CBM – next source of gas supply 17 What is CBM? 17 Prospects 17 Shale gas – early stage of development; not main source in near future 18 What is shale gas? 18 Prospects 18 LPG – limited room for growth 19 Who will benefit more from improved gas supply? 20 Strong gas demand growth ahead 21 Primary energy consumption: world vs China 21 China gas demand growth: a 9.7% CAGR over 1990-2009 21 Strong gas demand growth ahead 22 More potential upside to our forecasts? 23 Adverse effects of cold winter – positive or negative? 23 Pricing – cost pass through to be maintained 24 June wellhead price hike – mostly passed through to end users 24 Expected upward trend for gas prices 25 New development in Hebei province 25 Potential gas pricing reform? 26 Connection fee? Construction fee? Capacity fee? 27 Connection fee: still in place in the next few years, to be abolished in the long run 27 Changes in accounting treatment; no significant impact to cash flow 28 Nomura 2 8 November 2010 Gas Distribution | China Joseph Lam, CFA Policy support for gas demand 29 12th Five-Year Plan (FYP) expectations 29 Size does matter 30 Phase I: Project acquisition / cooperation 30 Phase II: Road to consolidation 31 Macro headwinds to the gas sector 32 CPI concern – Difficulty in wellhead cost pass through? 32 Slowing GDP and industrial production growth 32 Interest rate hike risks? 32 BUY CR Gas, BJE and Kunlun Energy 33 Why has the sector underperformed in FY10 YTD? 33 Latest company views China Resources Gas 34 Beijing Enterprises Holdings 48 Kunlun Energy 56 ENN Energy Holdings 59 Towngas China 72 China Gas 81 Hong Kong and China Gas 93 Nuggets Sino Gas 96 China Oil and Gas 99 Pearl Oriental Innovation 102 Sino Oil and Gas 104 Suntien Green Energy 107 Tian Lun Gas 110 Zhengzhou Gas 112 Also see our Anchor Report: Asia Zhongyu Gas 115 Pacific Natural gas — Reaching for the blue sky (13 October, 2010) Enviro Energy 117 Tianjin Tianlian 119 China Energy 121 Green Dragon Gas 123 Sector valuation I 128 Sector valuation II 129 Sector valuation III 130 Nomura 3 8 November 2010 Gas Distribution | China Joseph Lam, CFA Executive summary Road to consolidation We have been Bullish on China’s gas distribution sector since 2008 (report “Sweet when ripe”, dated 27 November 2008).
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