China/Hong Kong China Gas Kunlun Energy (135 HK) 23 August 2013 Company Rating: Outperform Buy on expected earnings miss (maintained) • 1H13 earnings miss was expected; long-term growth story intact. Kunlun’s 1H13 earnings miss should not Price: HK$12.08 obscure the fact that its revenue streams are fundamentally sound given the gradual pickup in LNG plant and pipeline Target: HK$15.50 utilization and the rollout of LNG refilling stations over the (down from HK$16.00) medium term. 1H13 net profit rose 5% YoY to HK$3.68b, 11% below consensus. Earnings were negatively impacted Trading data by a 28% YoY decline in E&P pretax profit, despite higher-than-expected LNG midstream volume growth, 52-week range HK$11.40-17.32 downstream gas sales, and lower D&A expense. Market capitalization HK$97.7b/US$12.6b Shares outstanding (m) 8,063 • We still like the LNG market. As of 1H13, Kunlun had Free float (%) 38 developed 53,000 LNG vehicles versus our estimate of 3M average daily T/O (m share) 20 70,000 vehicles by the end of 2013F. Kunlun stands to 3M average daily T/O (US$ m) 34 benefit from LNG refilling stations built by other gas players Expected return (%) - 1 year 28 over the next two years as overall adoption of LNG vehicles Closing price on 22 August 2013 and LNG demand will rise accordingly. Despite uncertainty over a potential LNG source price hike and signs of a Stock price and HSCEI slowdown in downstream development, we believe the HK$ government will be able to fuel LNG vehicle development 18 through policies implemented over the next few years. 17 16 • Buy on temporary share price weakness. Kunlun’s recent 15 underperformance is due in part to widespread rumors of a 14 100%-plus LNG source price hike, lower-than-expected 13 Shaanjing pipeline volume growth and weak oil prices in 12 1H13. Over the medium term however, we expect earnings to 11 be underpinned by stronger transmission and gas sales 10 9 volume growth. After factoring in weaker E&P volume and 8 gas transmission volume in 1H13 balanced by improvement 1-Jan-12 26-Mar-12 19-Jun-12 12-Sep-12 6-Dec-12 1-Mar-13 25-May-13 18-Aug-13 in the mid-to-downstream gas business, we revise our Kunlun Energy HSCEI (rebased) 2013F/2014F earnings by -1%/+2%. Our new HK$15.50 Source: Bloomberg DCF-based SOTP target price suggests 28% upside. Forecast and valuation Year to 31 Dec 2011 2012 2013F 2014F 2015F Revenue (HK$m) 25,915 32,953 40,027 50,077 61,362 Operating profit (HK$m) 8,137 11,154 12,766 15,718 19,399 Operating margin (%) 31.4 33.8 31.9 31.4 31.6 Net profit (HK$m) 5,621 6,518 7,282 8,512 10,001 EPS (HK$) 0.79 0.84 0.90 1.06 1.24 YoY change (%) 33.9 6.3 8.3 16.9 17.5 P/E (x) 15.4 14.5 13.4 11.4 9.7 Dividend yield (%) 1.8 1.9 2.2 2.6 3.1 Price/book value (x) 2.85 2.19 1.95 1.73 1.53 ROE (%) 19.6 17.4 15.4 16.1 16.7 Christeen So Net gearing (%) 35 19 34 37 33 (852) 2844 3609 Source: CCBIS estimates [email protected] Please read the analyst certification and other important disclosures on last page Kunlun Energy (135 HK) 23 August 2013 Still following a good trajectory We expect to see higher profit contribution from the mid-stream LNG and gas transmission business in 2014F-2015F. In 1H13 the company transmitted 12.3b m3 of natural gas, up a meager 0.3% YoY mainly on lower-than-expected utilization of the Shaanjing pipelines. However, looking towards 2H13-2014F, we believe a gradual pickup in Shaanjing pipeline volume and the fuel cost pass-through mechanism will lead to higher profit contribution from Kunlun’s transmission business. We also see strong 68% YoY volume growth from the company’s LNG terminal and processing plants, which accounted for 9.5% of 1H13 pretax profit, up from 3% in 1H12. Volume is likely to continue to rise given the rising contribution from Kunlun’s two new processing plants which commenced operations since the beginning of 2013. One of these was the sizable Xinjiang Hotan plant that boasts 5.78m m3/day capacity. There are also four other plants slated to begin operations in 2H13F-2014F. LNG market still a structural growth story. ENN Energy plans to add 100 LNG refilling stations in 2013F while HKCG will add 50 stations by 2015F. These are but two examples of the rising number of downstream gas players aggressively tapping into the fledgling LNG refilling station market. Rapid vehicle infrastructure expansion coupled with favorable government policies is creating fertile ground for massive adoption of LNG vehicles. These trends should lend support to Kunlun Energy’s gas sales over the next few years. In preparation, the company developed 53,000 LNG vehicles in 1H13 and we expect it to double its LNG vehicle development to 70,000 by the end of 2013F. We conservatively forecast 36% YoY growth in gas sales volume for 2013F. Recent share price weakness provides good entry point. We believe Kunlun Energy’s recent share price weakness reflects market speculation over a potential 100%-plus LNG source price hike from PetroChina (857 HK, Not Rated) earlier this quarter, lower-than-expected 1H13 volume growth from the Shaanjing pipelines, as well as the weak oil price in 1H13. We believe short-term pressure remains in the lead up to PetroChina’s final announcement of an LNG source price hike and an expected pickup in Shaanjing pipeline volume in 2H12, yet we believe Kunlun’s long-term growth story remains intact given (1) stronger demand after the commencement of new gas-fired plants along the Bohai Rim, (2) the massive rollout of LNG refilling stations, (3) more LNG processing plants becoming operational, and (4) the pickup in gas transmission volume over the medium term. We reiterate our Outperform rating and suggest investors buy on temporary share-price weakness. Kunlun Energy’s valuation looks inexpensive to us when the stock is trading at 13x and 11x on our 2013F-2014F EPS forecasts, compared with the past-three-year average of 18x. We marginally revise our earnings forecasts by -1% for 2013F and +2% in 2014F. We fine-tune our 2013F and 2014F earnings by -1% and +2% after taking into account weaker transmission volume and lower E&P sales volume for 1H13F balanced by improvement in the company’s gas midstream business in 2014F-2015F. Overall, we are still positive towards the mid-to-downstream gas business and like Kunlun as it is a leader within China’s LNG vehicle market with a compelling asset-injection story. Our new earnings forecasts are 1% and 6% above consensus for 2013F and 2014F. Our HK$15.5 new DCF-based SOTP target price based on 9-9.5% WACC suggests a 28% upside potential. 2 Kunlun Energy (135 HK) 23 August 2013 Absolute YTD share price performance in 2013 Relative YTD share price performance in 2013 Tianlun Gas Tianlun Gas China Gas China Gas ENN Energy ENN Energy Towngas China Towngas China CR Gas CR Gas Beijing Enterprises Beijing Enterprises Tianjin Jinran Gas Kunlun Energy Tianjin Jinran Gas HSCEI Index Kunlun Energy (40)% (20)% 0% 20% 40% 60% 80% (20)% 0% 20% 40% 60% 80% 100% Source: Bloomberg Source: Bloomberg WTI Crude oil price Kunlun’s YTD EPS revision US$/barrel HK$ 110 1.30 1.25 105 1.20 100 1.15 95 1.10 1.05 90 1.00 85 0.95 80 0.90 Jan Feb Apr Jun Jul Sep Nov Dec Jan-13 Jan-13 Mar-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 2012 2013 2013F 2014F Source: Bloomberg Source: Bloomberg China gas utilities peer valuation Share P/B Yield Net gearing Stock CCBIS Mkt cap price P/E (x) EPS growth (%) (x) (%) ROE (%) (%) Company code rating (HK$b) (HK$) 2013F 2014F 2015F 2013F 2014F 2015F 2013F 2013F 2013F 2014F 2015F 2013F Beijing Enterprises 392 HK O 60.12 51.40 15.9 12.9 10.6 12.7 23.4 21.5 1.4 1.7 9.0 10.5 12.0 35.8 China Gas 384 HK O 36.51 8.10 18.6 15.4 13.1 10.6 20.6 17.4 2.9 1.0 16.4 17.4 17.8 77.1 CR Gas 1193 HK O 42.66 17.90 19.6 14.9 11.9 11.8 31.1 25.6 3.0 1.1 16.3 18.6 20.0 15.6 ENN Energy 2688 HK O 44.97 39.25 18.2 13.6 10.8 24.9 33.6 26.6 3.3 1.4 19.5 22.3 23.8 42.1 Kunlun Energy 135 HK O 93.87 12.08 13.4 11.4 9.7 8.3 16.9 17.5 2.0 2.2 15.4 16.1 16.7 34.2 Tianjin Jinran 1265 HK N 3.73 1.83 19.2 15.1 11.9 17.6 27.6 26.8 1.6 1.3 8.9 10.5 12.1 (29.1) Tianlun Gas 1600 HK O 5.09 6.73 28.0 22.1 17.9 18.5 26.4 23.4 4.9 0.0 19.1 19.8 20.1 48.7 Towngas China 1083 HK N 2.39 7.25 18.5 15.8 13.8 14.5 17.6 14.3 1.5 1.1 9.0 9.4 10.0 31.7 Sector average 18.9 15.1 12.5 14.9 24.7 21.6 2.6 1.2 14.2 15.6 16.6 32.0 Source: Bloomberg, CCBIS Research Note: Share price as of 22 August 2013 3 Kunlun Energy (135 HK) 23 August 2013 Kunlun Energy – key assumptions 2011 2012 2013F 2014F 2015F Exploration and Production Subsidary + associates + JCEs Sales Volume ('000 barrel) 17,060 17,566 18,052 18,341 18,341 % change 4.1 3.0 2.8 1.6 0.0 ASP (US$/barrel) 105.1 104.1 100.3 95.4 96.4 % change 40.6 (1.0) (3.6) (4.8) 1.0 Natural Gas Distribution Natural gas sales Sales volume (m cm) 3,829 4,818 6,558 8,555 10,499 % change 72.4 25.8 36.1 30.4 22.7 ASP (HK$/cm) 2.3 2.8 2.9 3.0 3.2 % change 5.6 20.0 3.0 5.5 4.5 LNG terminal Sales volume (m cm) 1,638 5,078 6,602 8,912 12,032 % change NM 210.0 30.0 35.0 35.0 ASP (HK$/cm) 0.37 0.38 0.40 0.41 0.42 % change NM 2.7 5.0 4.0 3.0 Natural gas pipelines Sales volume (m cm) 20,786 23,833 26,216 30,411 34,973 % change 18.0 14.7 10.0 16.0 15.0 ASP (HK$/cm) 0.48 0.48 0.48 0.48 0.48 % change NM 0.1 0.0 0.0 0.0 Source: Company, CCBIS estimates 4 Kunlun Energy (135 HK) 23 August 2013 Kunlun Energy – consolidated income statement Year ended 31 December (HK$m) 2011 2012 2013F 2014F 2015F Revenue Exploration and production 6,189 6,076 5,796 5,545 5,600 Natural gas sales 8,633 12,734 17,692 24,068 30,254 LNG terminal