Hong Kong Utilities 21 April 2016 Towngas China (1083 HK) Towng as C hina Target price: HKD5.00 (from HKD7.50) Share price (20 Apr): HKD4.40 | Up/downside: +13.6% Would now be a good time to privatise? Dennis Ip, CFA (852) 2848 4068 Weak 2016E guidance and greenfield projects lag expectations [email protected] But current trough valuation may be a privatisation opportunity Marco Lai (852) 2848 4465 Cutting TP to HKD5.0 and downgrading to Outperform (2) [email protected] What's new: We believe Towngas China’s (TCCL) greenfield projects pose Forecast revisions (%) a risk to its gas sales volume growth, and that the company’s annual Year to 31 Dec 16E 17E 18E incremental 4.5bcm gas sales volume target for its 2010-15 greenfield Revenue change (17.2) (20.9) n.a. projects may be hard to achieve. At the same time, we think the stock’s Net profit change (6.8) (11.3) n.a. Core EPS (FD) change (7.7) (12.1) n.a. valuations (9.2x 2016E PER, 0.8x PBR) could make the case for a Source: Daiwa forecasts privatisation, which TCCL has said it could consider at the right price. Share price performance What's the impact: Greenfield projects lacking growth momentum. (HKD) (%) TCCL missed its gas sales volume targets for its greenfield projects by over 9 105 80% in 2013-15, and we estimate that around 40% of the projects acquired 8 94 over 2010-15 are loss-making. As TCCL’s greenfield projects focus on new 6 83 industrial demand, we expect the ongoing slowdown in new industrial park 5 71 3 60 expansion to hinder their sales volume growth. Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Towngas Ch (LHS) Relative to HSI (RHS) Widespread regulatory margin cut unlikely. The impact of Zhejiang’s proposed 20% distribution tariff cut will be small, on our estimates, as Zhejiang 12-month range 3.48-8.73 accounts for only 5% of TCCL’s total project investment. While we believe the Market cap (USDbn) 1.51 proposed cut is unlikely to be copied nationwide, we do see some provinces 3m avg daily turnover (USDm) 2.56 having a higher chance of adopting a similar tariff cut, which we estimate Shares outstanding (m) 2,665 Major shareholder The Hong Kong and China Gas (60.8%) altogether would reduce TCCL’s 2017E gross profit by 4.3%. Financial summary (HKD) Possible case for privatisation. TCCL is currently trading at an attractive Year to 31 Dec 16E 17E 18E 9.2x 2016E PER, a 58% discount to the 22x PER of parent Hong Kong and Revenue (m) 7,518 8,345 9,372 China Gas (HKCG; 3 HK, not rated). It is also trading at 0.8x 2016E PBR Operating profit (m) 1,258 1,311 1,410 Net profit (m) 1,279 1,342 1,412 vs. 2.8x for HKCG. We can see grounds for HKCG to consider privatising Core EPS (fully-diluted) 0.480 0.504 0.530 TCCL at a 30-50% premium to TCCL’s current share price, as we attribute EPS change (%) 6.3 4.9 5.2 its valuation discount to peers (at 12-15x 2016E PER) to the immaturity of Daiwa vs Cons. EPS (%) (3.8) (0.9) 2.3 PER (x) 9.2 8.7 8.3 its newly acquired projects, which saw flat YoY gas sales volume growth in Dividend yield (%) 3.7 3.9 4.2 2015, vs. 2% YoY for HKCG. It may take a few years for TCCL to realise DPS 0.161 0.172 0.184 the value of its 2010-15 city-gas projects, as the projects do not yet have PBR (x) 0.8 0.8 0.7 EV/EBITDA (x) 7.5 6.7 5.7 the requisite economies of scale. Thus, we expect TCCL to remain cheap ROE (%) 9.2 9.1 9.0 compared with peers ENN (2688 HK, HKD41.85, Buy [1]) and CR Gas Source: FactSet, Daiwa forecasts (1193 HK, HKD21.80, Buy [1]). Moreover, an asset injection from HKCG to TCCL seems unlikely due to the wide valuation gap between the two. What we recommend: We trim our 2016-17E revenue and EPS by 17-21% and 8-12%, respectively, after adjusting for its weak gas sales volume in 2015, the Nov 2015 tariff cut, and our expectation of weak industrial gas sales for new projects. We cut our 12-month DCF-derived TP (basis unchanged) from HKD7.5 to HKD5.0 and downgrade TCCL from Buy (1) to Outperform (2). How we differ: Our 2016-17E EPS forecasts are 1-4% below the consensus on our more conservative gas sales growth assumptions. See important disclosures, including any required research certifications, beginning on page 18 Towngas China (1083 HK): 21 April 2016 How do we justify our view? Growth outlook Valuation Earnings revisions Growth outlook TCCL: gas sales, connection, revenue and profit growth rates We forecast TCCL’s gas sales volume growth to be stable 60% for 2016-18E (11-14% YoY). Although we forecast 0.4-0.5m 50% new connections a year for 2016-18E, we expect 40% connection fee revenue to decline by a 1% CAGR due to 30% declining connection margins (42% in 2015 vs. 34-39% in 20% 2016-18E). Our forecasts call for recurring net profit to see a 5% CAGR over 2016-18, supported by gas sales volume 10% growth. 0% (10%) 2011 2012 2013 2014 2015 2016E 2017E 2018E Gas sales volume YoY% New connection YoY% Total revenue YoY% Recurring net profit YoY% Source: Company, Daiwa forecasts Valuation TCCL: 12-month forward PER TCCL is currently trading at 9.2x 2016E PER, 1.5SD below (x) its past-7-year 12-month forward PER average of 16.3x 30 and well below the 11-15x range of its pure city-gas 25.7x Avg+2SD 25 distributor peers. At these levels, we can see the grounds 21.0x Avg+1SD for HKCG to privatise TCCL, since TCCL’s PER discount to 20 HKCG stands at a high of 58%. 16.3x Avg 15 11.7x Avg-1SD 10 7.0x Avg-2SD 5 Jul-11 Apr-10 Oct-12 Apr-15 Jan-09 Jun-09 Jan-14 Jun-14 Feb-11 Mar-13 Feb-16 Nov-09 Dec-11 Nov-14 Sep-10 Aug-13 Sep-15 May-12 Source: Bloomberg, Daiwa forecasts Earnings revisions TCCL: Bloomberg consensus EPS forecast The Bloomberg consensus for TCCL’s 2016-17E EPS has (HKD) steadily declined over the past 2 years, likely due to the 0.75 low gas sales volume achieved by its newly acquired 0.70 projects against the backdrop of the oil-price slump and the 0.65 industrial production slowdown in 2015. 0.60 Our 2016-17E EPS forecasts are 1-4% lower than the 0.55 consensus forecasts, due to our more conservative gas 0.50 sales growth assumptions, especially for industrial gas 0.45 sales from TCCL’s greenfield projects. Jul-14 Jul-15 Jan-14 Jan-15 Jan-16 Mar-14 Mar-15 Mar-16 Sep-15 Sep-14 Nov-14 Nov-15 May-14 May-15 2016E EPS 2017E EPS Source: Bloomberg 2 Towngas China (1083 HK): 21 April 2016 Financial summary Key assumptions Year to 31 Dec 2011 2012 2013 2014 2015 2016E 2017E 2018E Total gas sales volume (mn m3) 4,670 5,320 5,945 6,511 6,562 7,016 7,647 8,419 Subsidary gas sales volume (mn m3) 1,200 1,310 1,570 1,726 1,719 1,908 2,156 2,458 Gas ASP, incl tax (HKD/m3) 2.74 3.03 3.35 3.60 3.50 2.99 2.99 3.00 Gas purchase cost, incl tax (HKD/m3) 2.55 2.80 3.08 3.32 3.23 2.73 2.73 2.73 Segment profit contribution - connection 66 64 60 61 61 59 55 50 fee (%) Profit and loss (HKDm) Year to 31 Dec 2011 2012 2013 2014 2015 2016E 2017E 2018E Sales of gas 3,288 3,972 5,265 6,205 6,011 5,702 6,444 7,382 Gas connection 1,034 1,211 1,451 1,677 1,708 1,816 1,901 1,989 Other Revenue 0 0 0 0 0 0 0 0 Total Revenue 4,321 5,183 6,716 7,882 7,719 7,518 8,345 9,372 Other income 195 160 246 14 (162) 200 203 206 COGS (3,634) (4,324) (5,650) (6,664) (6,549) (6,320) (7,089) (8,011) SG&A 0 0 0 0 0 0 0 0 Other op.expenses (101) (116) (140) (151) (152) (140) (147) (156) Operating profit 782 904 1,171 1,080 856 1,258 1,311 1,410 Net-interest inc./(exp.) (142) (148) (164) (174) (181) (181) (135) (126) Assoc/forex/extraord./others 394 480 601 625 593 680 683 691 Pre-tax profit 1,034 1,236 1,609 1,531 1,269 1,757 1,860 1,975 Tax (257) (299) (383) (350) (344) (351) (387) (427) Min. int./pref. div./others (68) (95) (120) (127) (117) (127) (131) (136) Net profit (reported) 709 841 1,106 1,054 808 1,279 1,342 1,412 Net profit (adjusted) 592 796 946 1,195 1,203 1,279 1,342 1,412 EPS (reported)(HKD) 0.289 0.342 0.424 0.402 0.305 0.480 0.504 0.530 EPS (adjusted)(HKD) 0.241 0.323 0.363 0.456 0.454 0.480 0.504 0.530 EPS (adjusted fully-diluted)(HKD) 0.241 0.323 0.362 0.454 0.451 0.480 0.504 0.530 DPS (HKD) 0.050 0.064 0.080 0.100 0.100 0.161 0.172 0.184 EBIT 782 904 1,171 1,080 856 1,258 1,311 1,410 EBITDA 1,019 1,179 1,502 1,482 1,295 1,722 1,800 1,922 Cash flow (HKDm) Year to 31 Dec 2011 2012 2013 2014 2015 2016E 2017E 2018E Profit before tax 1,034 1,236 1,609 1,531 1,269 1,757 1,860 1,975 Depreciation and amortisation 237 276 331 402 439 464 488 512 Tax paid (257) (299) (383) (350) (344) (351) (387) (427) Change in working capital 48 524 436 (201) 312 (316) 266 318 Other operational CF items (433) (661) (942) (124) (177) (680) (683) (691) Cash flow from operations 628 1,075 1,051 1,258 1,500 874 1,544 1,687 Capex (894) (1,610) (1,685) (2,005) (800) (770) (740) (710) Net (acquisitions)/disposals (170) (136) (317) (318) (130) 0 0 0 Other investing CF items 33 96 (981) (272) (836) 0 0 0 Cash flow from investing (1,031) (1,651) (2,983) (2,595) (1,766) (770) (740) (710) Change in debt 1,044 670 788 681 1,217 (400) (400) (400) Net share issues/(repurchases) 40 0 940 10 0 0 0 0 Dividends paid (97) (147) (191) (121) (263) (267) (430) (459) Other financing CF items 37 567 70 73 0 0 0 0 Cash flow from financing 1,025 1,089 1,607 643 953 (667) (830) (859) Forex effect/others 0 0 0 0 0 0 0 0 Change in cash 622 513 (326) (694) 687 (562) (25) 118 Free cash flow (266) (536) (634) (746) 700 104 804 977 Source: FactSet, Daiwa forecasts 3 Towngas China (1083 HK): 21 April 2016 Financial summary continued … Balance sheet (HKDm) As at 31 Dec 2011 2012 2013 2014 2015 2016E 2017E 2018E Cash & short-term investment 2,071 2,699 2,605 1,797 2,376 1,814 1,788 1,907 Inventory 388 395 588 566