23 August 2017 Utilities Kunlun Energy Deutsche Bank Markets Research Rating Company Date Buy Kunlun Energy 23 August 2017 Results Asia China Reuters Bloomberg Exchange Ticker Price at 21 Aug 2017 (HKD) 7.45 Utilities 0135.HK 135 HK HSI 0135 Price target - 12mth (HKD) 8.50 Utilities 52-week range (HKD) 7.95 - 5.55 HANG SENG INDEX 27,155 Core profit growth in line; robust volume with slightly lower margin Valuation & Risks Kunlun's 1H17 core net profit rose by 14% yoy to Rmb2.7bn, in line with our Hanyu Zhang expectations and accounting for 58/62% of DBe/consensus full year forecast. Research Analyst Volume was as strong as expected with 12-184% yoy growth in four gas related +852-2203 6207 segments. Similar with gas utilities peers, Kunlun recorded a Rmb2cents/cm Michael Tong, CFA 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. Research Analyst Mgmt expect the volume momentum to continue and margins to recover a bit +852-2203 6167 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 Price/price relative 2018E P/E. Maintain Buy. 10 7.5 By segment results review 5 Kunlun's 1H17 reported net profit was flat yoy at Rmb2.4bn. If adding back 2.5 Rmb325mn attributable impairment loss, core net profit rose by 14% yoy to Jan '16 Jul '16 Jan '17 Jul '17 Rmb2.7bn. On the positive side, transmission segment net profit increased by Kunlun Energy HANG SENG INDEX (Rebased) 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. Performance (%) 1m 3m 12m Rmb188mn loss in 1H16). LNG terminal segment net profit more than doubled Absolute -3.1 5.8 22.9 yoy to Rmb313mn. While on the negative side, gas sales segment core PBT HANG SENG INDEX 1.7 7.9 18.4 declined by 15% yoy mainly dragged by higher financial cost and a Rmb2cents/ Source: Deutsche Bank cm yoy (flat hoh) decline in EBITDA margin (excl. one-off impairment) despite a Key indicators (FY1) volume growth of 12%. LNG processing segment continued to make losses as ROE (%) 12.5 expected. Net debt/equity (%) 13.1 Book value/share (HKD) 5.64 SJ line tariff cut still in discussion and we believe the risks well priced in Price/book (x) 1.3 Kunlun's mgmt is actively bargaining with the central govt for a potential tariff Net interest cover (x) 53.6 cut of the SJ pipeline and will put Line IV into operations asap (target by end Operating profit margin (%) 13.1 2017) to ensure those assets are included in the ROA calculation. Kunlun's Source: Deutsche Bank 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. 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 2015A 2016A 2017E 2018E 2019E Sales (HKDm) 41,641 81,882 87,355 87,832 92,865 EBITDA (HKDm) 12,448 12,915 17,810 15,628 16,398 Reported NPAT (HKDm) 137 659 5,418 5,394 6,328 Reported EPS FD(HKD) 0.017 0.082 0.671 0.668 0.784 DB EPS FD (HKD) 0.463 0.544 0.671 0.668 0.784 DB EPS growth (%) -33.9 17.4 23.4 -0.4 17.3 PER (x) 15.7 11.1 11.1 11.2 9.5 Price/BV (x) 1.1 1.1 1.3 1.2 1.1 EV/EBITDA (x) 7.0 6.3 5.1 6.0 5.5 DPS (net) (HKD) 0.200 0.060 0.074 0.101 0.134 Yield (net) (%) 2.8 1.0 1.0 1.4 1.8 ROE (%) 0.3 1.5 12.5 11.3 12.1 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 one- off 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.