30 November 2016 Asia Pacific/Hong Kong Equity Research Utilities HK and China Utilities Sector Research Analysts THEME Dave Dai, CFA 852 2101 7358 [email protected] When the clouds clear Gary Zhou, CFA 852 2101 6648 Figure 1: Macro/policy risk exposure of various sub-sectors [email protected] Low sensitivity to global risks Gloria Yan 852 2101 7369 IPPs Hydro Wind Nuclear [email protected] Solar Gas Shuwei Chen Lower earnings growth 852 2101 7728 [email protected] Higher earnings growth HK Util Thermal High sensitivity to global risks Source: Credit Suisse estimates ■ Prefer China to HK. After a year of external shocks (Brexit/US Election) and ten major domestic policy surprises, we expect utilities selection in 2017 to be easier for China amid a stabilising economy, clear earnings divergence and appealing valuations: prefer wind/gas/solar to hydro/nuclear/IPPs. HK counterparts could face volatile macro variables and regulatory risks. Top Outperforms: LYP/CRG/XYS/PAH; top Underperforms: HNP/HKCG/HKE/CGN. We adjust TPs for HNR/ HDF/ CRG/ ENN/ CLP/ HKE/CYP, upgrade ENN to OUTPERFORM and downgrade CYP to UNDERPERFORM. ■ Power: More divergent. In China, renewables are best positioned, with further curtailment relief driven by improving power demand and weaker hydro. Better demand-supply should support better market-based prices and reduce market concerns about renewables' expanding market-based sales. Despite better utilisation, IPPs could face a few quarters of losses with higher average coal prices, and the progress of carbon trade and green certificates that could transfer further earnings from IPPs to renewables. Wind (+40%) and solar (+39%) earnings growth in FY17E should clearly outpace other fuels. ■ Gas: Opportunity after bumps. The gas sector saw a bumpy year with policy shocks challenging margin sustainability. Our concerns about dollar margin downside are proven right with the recent local government intervention and winter price hikes. However, we calculate only 5-6% earnings impact despite the recent ~15% stock weakness. At only 9x sector P/E, we see valuations as being attractive with risks priced in and demand recovering next year (~10%), thanks to the various price-cutting efforts and new demand drivers. We like companies that are more likely to outgrow peers on volume growth. ■ Hong Kong: Challenges remain. The 4% average dividend yield is not attractive vs history and global peers. Plus, volatility of the long-term bond yield and USD's strength remain the key challenges. Hong Kong's next return reset could also kickstart in 2017; we stand by our forecast of a return cut from 9.99% to 8.00% (HKE and CLP most negatively exposed). Within the space, PAH is our top pick, given the likely special dividend if no acquisitions. DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, LEGAL ENTITY DISCLOSURE AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, 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. 30 November 2016 Focus charts Figure 2: Subsector valuation vs historical average Figure 3: Improving power demand-supply balance (%) 60 Avg + 2SD Total Thermal Hydro 50 Avg + 1SD 40 30 20 Average 10 0 Avg - 1SD (10) (20) Avg - 2SD (30) Jul-16 Wind Solar Gas Hydro IPPs NuclearHK Utilities Jul-12 Oct-11 Apr-13 Oct-15 Jun-11 Jun-15 Mar-12 Mar-16 Dec-13 Nov-12 Aug-13 Sep-14 May-14 Jan-Feb 15 Jan-Feb 11 Notes: dots = current valuation relative to history; stars/circles = expected ROE relative to Source: CEIC, Credit Suisse estimates history. Source: Bloomberg, Credit Suisse estimates Figure 4: Curtailment reduction could re-rate wind Figure 5: Gas demand is the key for city gas sector (x) Local control PetroChina (x) Gas tariff Gas tariff cut Gas tariff Transmission raised gas 1.9 14% 11% 10-12% 20.0% raised in Aug cut in Nov of gas regulation 17% 8% 15% in Mar 2015 pricing since price in Nov 20.0 2014 2015 since Aug 2016 25.0% 1.8x Avg+2SD 15.0% Apr 2016 2016 1.7 18.7x Avg+2SD 10.0% 18.0 20.0% 1.5x Avg+1SD 1.5 15.9x Avg+1SD 5.0% 16.0 15.0% 1.3 1.3x Avg 14.0 10.0% 0.0% 13.1x Avg 1.1 12.0 5.0% 1.0x Avg-1SD -5.0% 0.9 10.3x Avg-1SD 10.0 0.0% -10.0% 0.8x Avg-2SD 8.0 -5.0% 0.7 -15.0% 7.5x Avg-2SD 6.0 -10.0% 0.5 -20.0% Jan-14 May-14 Sep-14 Jan-15 May-15 Sep-15 Jan-16 May-16 Sep-16 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Monthly wind speed growth (YoY) LYP P/B Gas consumption volume growth YoY Gas sector P/E Source: NEA, Bloomberg, Credit Suisse estimates Source: NDRC, Bloomberg, Credit Suisse estimates Figure 6: IPPs will suffer a few quarters of losses Figure 7: HK's regulated return is unsustainable (Rmb mn) (%) 5,000 16 2-3 quarters of 2-3 quarters of 14 4,000 losses during losses likely this 2008-09 time 12 3,000 10 2,000 8 6 1,000 4 0 2 0 1Q09 4Q11 3Q14 2Q08 3Q08 4Q08 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 -1,000 1Q08 2Q17E 1Q17E 3Q17E 4Q17E 4Q16E -2 -2,000 -4 1964 1988 2012 1970 1973 1976 1979 1982 1985 1991 1994 1997 2000 2003 2006 2009 2015 HNP HDP DTP 1967 SOC return in HK Spread of SoC return over bond yield Historical mean of the spread Source: Company data, Credit Suisse estimates Source: Bloomberg, Credit Suisse estimates Figure 8: Valuation metrics—our top OUTPERFORM and UNDERPERFORM ideas Name Ticker Rating TP P/E P/B Name Ticker Rating TP P/E P/B 16E 17E 16E 17E 16E 17E 16E 17E LYP 0916.HK O 8.0 11.1 7.8 1.0 1.0 HNP 0902.HK U 3.5 8.4 19.6 0.7 0.7 CRG 1193.HK O 31.0 13.1 11.1 2.6 2.2 HKCG 0003.HK U 11.0 25.4 24.8 3.3 3.2 XYS 0968.HK O 4.0 9.4 6.8 2.7 2.2 HKE 2638.HK U 5.0 18.5 20.1 1.2 1.2 PAH 0006.HK O 81.0 20.8 20.9 1.2 1.2 CGN 1816.HK U 1.8 12.7 11.5 1.5 1.4 Source: Bloomberg, Credit Suisse estimates HK and China Utilities Sector 2 30 November 2016 When the clouds clear Prefer China to Hong Kong Needless to say, 2016 has not been an easy year to invest in HK/China utilities. Besides Prefer wind/gas/solar over the spillover effects from 2015 including the China GDP slowdown, lower oil prices and hydro/nuclear/IPPs in 2017 Rmb depreciation, low-probability (some call them 'black swan' events) external shocks (Brexit and Trump's victory) and a number of domestic policy surprises have turned a once stable sector into a very volatile one. After a year filled with external shocks and ten major domestic policy surprises, we expect utilities selection in 2017 to be easier for China amid a stabilising economy, clear earnings divergence and appealing valuations: We prefer wind/gas/solar over hydro/nuclear/IPPs. HK counterparts remain unattractive with volatile macro variables and return reset. Top Outperforms are LYP/CRG/XYS/PAH and top Underperforms are HNP/HKCG/HKE/CGN. Also, we upgrade ENN and downgrade CYP. Power: More divergent Following a sequential slowdown since 2013, China's total power output started to gain More balanced power momentum since July 2016. For 2017, we expect: (1) improving power demand and supply and demand may weaker hydro to reduce supply competition and improve renewable curtailment; (2) benefit renewables such as recovering market-based power prices as evidenced by the recent trend in Guangdong wind and solar… and reducing concerns for renewables' participation before reaching grid parity; (3) on a less bright spot, IPPs will face a few quarters of losses with higher average coal prices; and (4) progress of carbon trade and green certificates could transfer further earnings from IPPs to renewables. Wind (+40%) and solar's (+39%) earnings should clearly outpace …while IPPs could face a other fuels. Nuclear is likely to face pressures in 2017, with its output not fully protected by few quarters of losses with the proposed minimum utilisation scheme and tariff risks ahead (participation in low-tariff higher coal costs direct supply). Our top picks in the power sector are Longyuan Power and Xinyi Solar, and our top sells are Huaneng Power and CGN Power. Gas: Opportunity after bumps The gas sector saw a bumpy year in 2016 with policy shocks challenging margin Our key concerns for gas sustainability. In our recent sector report in September 2016, we highlighted near-term risk have been priced in, and of dollar margin squeeze due to local government intervention and winter price hikes, both current valuation seems of which are proved to be right.