Buy Kunlun Energy

Kunlun Energy Deutsche Bank Markets Research Date 23 August 2017 Rating Company Buy Asia Kunlun Energy Results China Price at 21 Aug 2017 (HKD) Price target - 12mth (HKD) 52-week range (HKD) 7.45 8.50 Reuters 0135.HK Bloomberg 135 HK Exchange Ticker HSI 0135 Utilities Utilities 7.95 - 5.55 <ul style="display: flex;"><li style="flex:1">27,155 </li><li style="flex:1">HANG SENG INDEX </li></ul>Core profit growth in line; robust volume with slightly lower margin <a href="/goto?url=https://ger.gm.cib.intranet.db.com/ger/disclosure/Disclosure.eqsr?ricCode=0135.HK" target="_blank">Valuation & Risks </a><a href="mailto:[email protected]" target="_blank">Hanyu Zhang </a>Kunlun's 1H17 core net profit rose by 14% yoy to Rmb2.7bn, in line with our expectations and accounting for 58/62% of DBe/consensus full year forecast. Volume was as strong as expected with 12-184% yoy growth in four gas related segments. Similar with gas utilities peers, Kunlun recorded a Rmb2cents/cm yoy (flat hoh) decline in EBITDA margin for gas sales segment due to market competition and failure to pass through PetroChina's winter citygate price hike. Mgmt expect the volume momentum to continue and margins to recover a bit HoH in 2H17. Kunlun is the beneficiary of China's structural growth in both piped gas and the LNG value chain and is trading at an undemanding valuation of 11x 2018E P/E. Maintain Buy. Research Analyst +852-2203 6207 <a href="mailto:[email protected]" target="_blank">Michael </a><a href="mailto:[email protected]" target="_blank">T</a><a href="mailto:[email protected]" target="_blank">o</a><a href="mailto:[email protected]" target="_blank">ng, CFA </a>Research Analyst +852-2203 6167 Price/price relative 10 7.5 5By segment results review Kunlun's 1H17 reported net profit was flat yoy at Rmb2.4bn. If adding back 2.5 <ul style="display: flex;"><li style="flex:1">Jan '16 </li><li style="flex:1">Jul '16 </li><li style="flex:1">Jan '17 </li><li style="flex:1">Jul '17 </li></ul>Rmb325mn attributable impairment loss, core net profit rose by 14% yoy to Rmb2.7bn. On the positive side, transmission segment net profit increased by 9% yoy to Rmb1.9bn (accounting for 70% of total core profit) driven by 15% volume growth. E&P segment turned profitable with a Rmb161mn net profit (vs. Rmb188mn loss in 1H16). LNG terminal segment net profit more than doubled yoy to Rmb313mn. While on the negative side, gas sales segment core PBT declined by 15% yoy mainly dragged by higher financial cost and a Rmb2cents/ cm yoy (flat hoh) decline in EBITDA margin (excl. one-off impairment) despite a volume growth of 12%. LNG processing segment continued to make losses as expected. <ul style="display: flex;"><li style="flex:1">Kunlun Energy </li><li style="flex:1">HANG SENG INDEX (Rebased) </li></ul>Performance (%) Absolute 1m 3m 12m -3.1 5.8 22.9 <ul style="display: flex;"><li style="flex:1">1.7 7.9 18.4 </li><li style="flex:1">HANG SENG INDEX </li></ul>Source: Deutsche Bank Key indicators (FY1) <ul style="display: flex;"><li style="flex:1">ROE (%) </li><li style="flex:1">12.5 </li></ul>13.1 5.64 1.3 Net debt/equity (%) Book value/share (HKD) Price/book (x) SJ line tariff cut still in discussion and we believe the risks well priced in Kunlun's mgmt is actively bargaining with the central govt for a potential tariff <ul style="display: flex;"><li style="flex:1">Net interest cover (x) </li><li style="flex:1">53.6 </li></ul><ul style="display: flex;"><li style="flex:1">Operating profit margin (%) </li><li style="flex:1">13.1 </li></ul>cut of the SJ pipeline and will put Line IV into operations asap (target by end 2017) to ensure those assets are included in the ROA calculation. Kunlun's mgmt is confident about future volume growth and expects a better gas sales dollar margin for 2H17 vs. 1H17 with less impact from PetroChina's winter price hike. Kunlun has lower-than-peer dollar margins with Rmb0.54/cm for residential, Rmb0.41/cm for industrial and Rmb0.53/cm for commercial users, which makes it less vulnerable to potential dollar margin/return control by local govts. Source: Deutsche Bank Valuation and risks Our TP of HKD8.5 is based on SOTP (Fig.3). Key risks:lower-than-expected volume growth, a harsher-than-expected SJ tariff cut, and lower oil prices. Deutsche Bank AG/Hong Kong Distributed on: 23/08/2017 15:12:06 GMT Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, 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. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 083/04/2017. 0bed7b6cf11c 23 August 2017 Utilities Kunlun Energy Forecasts and ratios Year End Dec 31 Sales (HKDm) 2015A 41,641 12,448 137 2016A 81,882 12,915 659 2017E 87,355 17,810 5,418 0.671 0.671 23.4 2018E 87,832 15,628 5,394 0.668 0.668 -0.4 2019E 92,865 16,398 6,328 0.784 0.784 17.3 EBITDA (HKDm) Reported NPAT (HKDm) Reported EPS FD(HKD) DB EPS FD (HKD) DB EPS growth (%) PER (x) 0.017 0.463 -33.9 15.7 0.082 0.544 17.4 11.1 1.1 <ul style="display: flex;"><li style="flex:1">11.1 </li><li style="flex:1">11.2 </li><li style="flex:1">9.5 </li></ul><ul style="display: flex;"><li style="flex:1">Price/BV (x) </li><li style="flex:1">1.1 </li><li style="flex:1">1.3 </li><li style="flex:1">1.2 </li><li style="flex:1">1.1 </li></ul><ul style="display: flex;"><li style="flex:1">EV/EBITDA (x) </li><li style="flex:1">7.0 </li><li style="flex:1">6.3 </li><li style="flex:1">5.1 </li><li style="flex:1">6.0 </li><li style="flex:1">5.5 </li></ul>DPS (net) (HKD) Yield (net) (%) 0.200 2.8 0.060 1.0 0.074 1.0 0.101 1.4 0.134 1.8 <ul style="display: flex;"><li style="flex:1">ROE (%) </li><li style="flex:1">0.3 </li><li style="flex:1">1.5 </li><li style="flex:1">12.5 </li><li style="flex:1">11.3 </li><li style="flex:1">12.1 </li></ul>Source: Deutsche Bank estimates, company data Page 2 Deutsche Bank AG/Hong Kong 23 August 2017 Utilities Kunlun Energy 1H17 results review and by segment analysis Kunlun's 1H17 reported net profit was flat yoy at Rmb2.4bn. If adding back oneoff impairments (Rmb100 impairment in Zhaoqing plant and Rmb329 impairment on accounts receivables in gas sales segment, with a total of Rmb325mn loss on attributable basis), core net profit increased by 14% yoy to Rmb2.7bn. Adjusted EBITDA (after adding back impairment) increased by 18% yoy to Rm9.5bn, At profit before tax (PBT) level, we see positive growth momentum in transmission (+10% yoy), LNG terminal (+273% yoy) and E&P segment (turn profitable from loss). While on the other hand, gas sales segment PBT dropped by 15% yoy (excl. impairment) dragged down by lower margins and higher financial costs. LNG processing segment is still making losses as expected. See detailed analysis by segment below: Gas transmission segment: robust volume growth with tariff risks priced in In 1H17, Kunlun's total transmission volume increased by 15% yoy to 20.2bcm of which ShaanJing pipeline recorded a 13% volume growth to 18.7cm. The ASP edged down by Rmb2cents/cm yoy to Rmb0.31/cm mainly due to the mix change, i.e higher volume growth for short-distance gas sales. Kunlun aims to put the SJ pipeline IV into operation by end-2017, after which the total transmission capacity should expand to 50bcm from 35bcm. Mgmt expect Kunlun's transmission volume to continue to benefit from China's accelerating gas demand growth especially in Beijing-Tianjin-Hebei area. Mgmt is still in active negotiations with the central government about the magnitude and timing of the tariff cut and argues that the SJ IV pipeline asset should be included in the asset base calculation. We believe the share price has already priced in the potential ShaanJing tariff cut, which has been discussed by the market for more than a year. We assume a potential 27% tariff cut would occur in Oct 2017. Every RMB1cent/cm change in the tariff would affect 3.5% of Kunlun’s earnings. Gas sales segment: accelerating volume growth offset by weaker margins In 1H17, Kunlun's gas sales volume (incl.LPG) growth accelerates to 12% yoy (vs. 4% in 2016) and city gas segment recorded 18% yoy volume growth. However, similar with peers, Kunlun recorded a EBITDA margin squeeze of Rmb2cents/cm yoy (or flat hoh) in gas sales segment (after adding back Rmb329mn impairment on accounts receivables) , which is mainly due to the failure of pass-through of PetroChina winter citygate price hike (Nov 16-Mar 17). Dragged down by margin squeeze, higher financial costs and the impairment, gas sales segment PBT was down 35% yoy to Rmb1.0bn. If excl. impairment, core PBT was down 15% yoy (or up 20% hoh) to Rmb1.3bn. Gas sales segment profit is quite sensitive to EBITDA margins as it is very thin at Rmb0.18/cm. Every Rmb1cent/cm change in EBITDA margin impacts segment PBT by 12%. Mgmt expects margins to recover a bit HoH in 2H17, with less impact from seasonal citygate price hikes (2.5-3.0 months impact in 1H vs. at most 1.5 months impact in 2H). Kunlun has a lower-than-peer dollar margins with Rmb0.54/cm for residential, Rmb0.41/cm for industrial and Rmb0.53/cm for commercial users, Deutsche Bank AG/Hong Kong Page 3 23 August 2017 Utilities Kunlun Energy which makes it less vulnerable to potential dollar margin/return control by local govts. LNG receiving terminal: volume/profit growth accelerates meaningfully in 1H17, Kunlun's LNG terminal processing volume surged by 90% yoy to 3.6bcm, accelerating from 22% yoy growth in 2016. We believe the strong volume growth is driven by China's increasing gap of domestic production and demand growth, as well as the execution of long-term import contract signed by PetroChina in past few years. In the long run, Kunlun’s LNG terminals are also beneficiaries of the execution of third party access as it is positive for utilization. E&P segment turned profitable due to higher oil prices In 1H17, Kunlun's E&P segment turned profitable with a Rmb161mn net profit (vs. Rmb188mn net loss in 1H16) mainly due to recovery in oil prices (Brent +30% yoy to USD53/b). Production dropped by 22% yoy to 6.4mnbbl due to the termination of Xinjiang contract in 2016 LNG processing segment: still marking losses but recovery ahead In 1H17, Kunlun's LNG plant processing volume increased by 184% to 0.5bcm and the segment EBITDA is still negative at Rmb0.14/cm, partially due to the increasing per unit opex incurred by the 7 new LNG plants commencing operations in 1H17. We expect the margins of LNG plants to improve gradually, with increasing LNG demand and more disciplined capacity expansion: LNG demand should be boosted by 1) improving LNG vehicle station utilization with more vehicle willing to covert to LNG due to improved gas price competitiveness, 2) more peak shaving in demand from city-gas projects after coal-to-gas conversion, and 3) increasing LNG direct delivery demand from industrial users. Besides demand growth, we have witnessed a much slower capacity expansion (only 8% yoy) in 1H17, this compares to the 24%/23% yoy growth in 2015/16, which should also be helpful for the structural recovery of LNG sector. Financial costs rose by 147% yoy in 1H17 but the impact should mitigate in 2H In 1H17, financial costs rose strongly by 147% yoy and 26% hoh to Rmb481mn, due to the increase in total debt related to the Kunlun Gas acquisition and the commencement of new LNG plants that released the once-capitalized interest expense. We expect the negative impacts from higher financial cost to mitigate in 2H given high-base in 2H16 and potential debt repayment by Kunlun. Page 4 Deutsche Bank AG/Hong Kong 23 August 2017 Utilities Kunlun Energy Figure 1: 1H17 operational data summary <ul style="display: flex;"><li style="flex:1">yoy </li><li style="flex:1">yoy </li></ul>Key operating statistics Upstream E&P business: 1H16 <ul style="display: flex;"><li style="flex:1">Sales vol. (mil. bbl) </li><li style="flex:1">16.8 </li><li style="flex:1">15.2 </li></ul>34.7 <ul style="display: flex;"><li style="flex:1">-9% </li><li style="flex:1">8.4 </li><li style="flex:1">8.3 </li><li style="flex:1">8.1 </li><li style="flex:1">7.1 </li><li style="flex:1">6.4 </li><li style="flex:1">-22% </li></ul><ul style="display: flex;"><li style="flex:1">56% </li><li style="flex:1">Realized oil price (US$/bbl) </li><li style="flex:1">43.0 </li><li style="flex:1">-19% </li><li style="flex:1">47.0 </li><li style="flex:1">39.0 </li><li style="flex:1">29.3 </li><li style="flex:1">40.9 </li><li style="flex:1">45.6 </li></ul>Mid-/downstream gas vol (mn cm): NG (ex. LNG processing) LNG processing 22,280 679 23,233 522 4% -23% 22% 5% 11,059 246 11,221 433 11,533 178 11,700 344 12,878 506 12% 184% 90% <ul style="display: flex;"><li style="flex:1">LNG terminal re-gasification </li><li style="flex:1">3,968 </li><li style="flex:1">4,859 </li><li style="flex:1">2,217 </li><li style="flex:1">1,751 </li><li style="flex:1">1,908 </li><li style="flex:1">2,951 </li></ul>18,164 3,630 <ul style="display: flex;"><li style="flex:1">Pipeline transmission </li><li style="flex:1">33,978 </li><li style="flex:1">35,731 </li><li style="flex:1">16,634 </li><li style="flex:1">17,344 </li><li style="flex:1">17,567 </li><li style="flex:1">20,160 </li><li style="flex:1">15% </li></ul>EBITDA dollar margin (Rmb/cm): <ul style="display: flex;"><li style="flex:1">Natural gas </li><li style="flex:1">0.21 </li></ul>(0.28) 0.23 0.19 0.12 0.24 0.27 0.25 (0.60) 0.25 0.20 (0.05) 0.24 0.18 (0.14) 0.27 (0.03) 0.39 0.17 (0.09) 0.21 0.17 0.20 0.24 0.26 (0.03) (0.09) 0.03 LNG processing LNG terminal re-gasification Pipeline transmission EBIT dollar margin (Rmb/cm): Natural gas 0.01 <ul style="display: flex;"><li style="flex:1">0.28 </li><li style="flex:1">(0.00) </li><li style="flex:1">0.28 </li><li style="flex:1">0.27 </li><li style="flex:1">0.28 </li><li style="flex:1">0.27 </li><li style="flex:1">(0.01) </li></ul>0.10 (0.60) 0.09 0.09 (0.56) 0.12 (0.01) 0.04 0.15 (1.00) 0.12 0.06 (0.37) 0.05 0.11 (0.92) 0.09 0.08 (0.37) 0.14 0.09 (0.56) 0.19 (0.02) <ul style="display: flex;"><li style="flex:1">0.37 </li><li style="flex:1">LNG processing </li></ul>LNG terminal re-gasification Pipeline transmission <ul style="display: flex;"><li style="flex:1">0.03 </li><li style="flex:1">0.09 </li></ul><ul style="display: flex;"><li style="flex:1">0.23 </li><li style="flex:1">0.22 </li><li style="flex:1">(0.00) </li><li style="flex:1">0.23 </li><li style="flex:1">0.22 </li><li style="flex:1">0.23 </li><li style="flex:1">0.22 </li><li style="flex:1">0.22 </li><li style="flex:1">(0.01) </li></ul>Source: Company data *note: EBITDA/EBIT margin excludes impairments Deutsche Bank AG/Hong Kong Page 5 23 August 2017 Utilities Kunlun Energy Figure 2: 1H17 P&L by-segment summary <ul style="display: flex;"><li style="flex:1">yoy </li><li style="flex:1">yoy </li></ul><ul style="display: flex;"><li style="flex:1">Summary P&L (Rmb mn) </li><li style="flex:1">1H16 </li></ul>33,659 493 <ul style="display: flex;"><li style="flex:1">Revenue </li><li style="flex:1">77,839 </li></ul>561 69,027 668 -11% 19% -15% -1% 39,467 492 38,372 68 35,368 175 40,078 563 Other gain/(loss) 14% 22% 3% Purchases, services & others Employee compensation SG&A (56,304) (3,829) (3,087) (563) (47,783) (3,777) (2,865) (502) (28,390) (1,880) (1,339) (266) - (27,914) (1,949) (1,749) (297) (23,148) (1,783) (1,182) (260) (24,635) (1,994) (1,683) (242) (28,271) (1,839) (1,664) (215) (100) 8,552 (2,665) 5,887 22 <ul style="display: flex;"><li style="flex:1">-7% </li><li style="flex:1">41% </li></ul><ul style="display: flex;"><li style="flex:1">-17% </li><li style="flex:1">Tax other than income taxes </li></ul>Impariment -11% 179% -18% -1% (1,393) 13,223 (5,406) 7,817 (1,599) 2,326 (407) (3,879) 10,887 (5,366) 5,522 (513) (1,393) 5,139 (2,485) 2,654 (1,361) 681 <ul style="display: flex;"><li style="flex:1">-</li><li style="flex:1">(3,879) </li></ul><ul style="display: flex;"><li style="flex:1">3,108 </li><li style="flex:1">EBITDA </li><li style="flex:1">8,084 </li></ul>(2,920) 5,164 (238) 1,645 (245) 277 7,779 (2,725) 5,054 (267) Depreciation and amortisation Profit from operation E&P business <ul style="display: flex;"><li style="flex:1">(2,641) </li><li style="flex:1">-2% </li></ul>-29% -68% -5% (246) 914 -108% -34% 69% Natural gas sales LNG processing 2,203 (4,175) 603 1,289 (166) 851 925% 63% 4% <ul style="display: flex;"><li style="flex:1">(162) </li><li style="flex:1">(4,009) </li></ul>424 (281) <ul style="display: flex;"><li style="flex:1">674 </li><li style="flex:1">LNG terminal </li><li style="flex:1">371 </li><li style="flex:1">94 </li><li style="flex:1">179 </li><li style="flex:1">277% </li></ul><ul style="display: flex;"><li style="flex:1">10% </li><li style="flex:1">Natural gas pipeline </li><li style="flex:1">7,654 </li></ul>(528) 7,984 (580) 3,763 (39) 3,891 (488) 4,075 (56) 3,909 (524) 4,465 <ul style="display: flex;"><li style="flex:1">156 </li><li style="flex:1">Others </li><li style="flex:1">10% </li></ul>-9% -379% -40% Interest income <ul style="display: flex;"><li style="flex:1">Finance costs </li><li style="flex:1">(544) </li><li style="flex:1">(577) </li><li style="flex:1">(235) </li><li style="flex:1">(308) </li><li style="flex:1">(195) </li><li style="flex:1">(382) </li><li style="flex:1">(481) </li></ul>Share of profits from JCs Share of profits from associates Profit before tax E&P business 196 (1,687) 6,104 (3,134) 2,519 (701) 161 599 -18% -135% -2% 98 (62) <ul style="display: flex;"><li style="flex:1">97 </li><li style="flex:1">73 </li></ul>185 <ul style="display: flex;"><li style="flex:1">88 </li><li style="flex:1">112 </li></ul>402 53% <ul style="display: flex;"><li style="flex:1">(1,625) </li><li style="flex:1">414 </li><li style="flex:1">117% </li></ul>5,998 12 5,124 (127) 1,701 (388) 246 5,325 (151) 1,595 (286) 180 6,045 <ul style="display: flex;"><li style="flex:1">416 </li><li style="flex:1">-100% </li></ul>8% (3,007) 819 163 1,135 (4,200) 413 -375% -35% 40% Natural gas sales LNG processing 2,730 (4,486) 593 1,029 (400) 672 540% 82% 5% (313) <ul style="display: flex;"><li style="flex:1">81 </li><li style="flex:1">LNG terminal </li><li style="flex:1">326 </li><li style="flex:1">273% </li></ul><ul style="display: flex;"><li style="flex:1">10% </li><li style="flex:1">Natural gas pipeline </li></ul>Others 7,579 (485) 7,976 (826) (3,120) 2,878 (2,322) 3,705 (12) 3,874 (473) (1,288) (307) (713) (1,020) (2,242) 18 4,062 (75) 3,914 (751) (1,746) (1,073) (780) (1,853) 8 4,452 (124) (1,878) 4,167 (1,748) 2,419 161 70% 16% -16% 5% 65% <ul style="display: flex;"><li style="flex:1">Tax </li><li style="flex:1">(2,687) </li></ul>3,418 (2,213) 1,205 (2,348) 625 (1,399) 3,725 (1,501) 2,224 (106) 608 (1,374) 3,951 (1,542) 2,409 (188) 833 37% Profit after tax <ul style="display: flex;"><li style="flex:1">Minority interest </li><li style="flex:1">13% </li></ul><ul style="display: flex;"><li style="flex:1">Net profit </li><li style="flex:1">-54% </li></ul>-92% -439% 65% 10% 100% <ul style="display: flex;"><li style="flex:1">E&P business </li><li style="flex:1">(180) </li></ul>(2,120) 287 -186% -78% 233% 9% NG sales (incl. LNG processing) LNG terminal (2,953) 193 180 <ul style="display: flex;"><li style="flex:1">175 </li><li style="flex:1">115 </li><li style="flex:1">59 </li><li style="flex:1">94 </li><li style="flex:1">313 </li></ul>Natural gas pipeline Others 3,256 (503) 3,573 (1,005) 1,611 (3) 1,645 (500) 1,755 (85) 1,818 (920) 1,913 <ul style="display: flex;"><li style="flex:1">(148) </li><li style="flex:1">74% </li></ul>Adding back one-off items: Attributable impairment Attributable Fx loss of Actobe project Recurring Net profit 1,393 1,520 4,118 3,147 0 126% -100% -10% 00 1,393 1,520 1,893 00 3,147 0 325 0<ul style="display: flex;"><li style="flex:1">3,702 </li><li style="flex:1">2,224 </li><li style="flex:1">2,409 </li><li style="flex:1">1,293 </li><li style="flex:1">2,744 </li></ul>

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