HONG_KONG_UTILITIES：EVENTFUL_2013_MAY_OFFER_CATALYSTS_FOR_OTHERWISE_FAIR_VALUATION-2012-11-08.ppt

november 7, 2012 hong kong: utilities equity research eventful 2013 may offer catalysts for otherwise fair valuation catalysts abound for the hong kong utilities in 2013,power utilities: 1) tariff discussion would be the highlight in december and we expect about 4%-5% yoy increase for 2013e tariffs. 2) the next five- year development plan would be key to driving scheme of control (soc) earnings in hong kong in the medium term. 3) with limited local organic growth, overseas profits, via acquisitions or restructuring, would continue to be a key driver for earnings growth. with the above in mind, we prefer power assets holdings (pah) to clp because: 1) it may face less political/ social resistance in tariff hikes as its user mix and fuel cost structure may allow for easier acceptance on smaller hikes; 2) it may see more upside in capex off a lower base via potential new plant construction for purpose of emission reduction; 3) overseas business has been a key source of profit growth for pah but earnings volatility for clp; and 4) it may have upside risks to dividend per share sooner based on rising associate dividends. hong kong and china gas (hkcg): we think with rising market competition and gradually maturing gas demand growth in china, hkcg would count on its ability to optimize its customer mix in terms of sources and volumes of gas consumption. its execution in the coal/chemical and new energy businesses would also be key to sustaining its valuation premium vs. peers.,three key catalysts for clp, pah - tariff hikes in 2013. - five-year development plan capex. - overseas profits growth. stock ideas - prefer pah to clp based on the above three catalysts and relative upside performance though we think both of them (neutral-rated) are close to fair valuation. - maintain sell rating for hkcg as we think its relative p/e valuation premium vs. peers has more than priced in its growth potential in its china business. - 2012e dividend yields for clp, pah, and hkcg are 3.8%, 3.5%, and 1.9%, respectively. we see upside risks to their dividends per share based on our projected improvements to their cash flows. valuation summary,12-month,price,potential,p/e (x),raising earnings estimates for pah but lowering estimates for clp pah: we raise our 2012-2014 eps estimates by an average 5% mostly to reflect 4% hike (0% before) in 2013 tariff in hong kong and higher overseas,company pah clp hkcg,ticker 6.hk 2.hk 3.hk,rating neutral neutral sell,tp hk$ 67.8 hk$ 65.0 hk$ 18.0,5-nov-2012 66.9 66.1 20.6,up/downside 1% (2%) (13%),2013 14 14 23,(associate) income based on efficiency gain. hence, we raise our 12-month p/e- based target price (tp) by 4% to hk$67.8 (same 14x 2013 target p/e multiple). clp: we cut our 2012-2014 eps estimates by an average 13% mostly to reflect 5% hike (4% before) in 2013 tariff in hong kong and a reduced 2012 base of australian profits (reported 1h12 charges). we roll over our target multiple to 2013 (14x) from 2012 (14.5x). hence, we cut our tp by 6% to hk$65.0. key risks for clp/pah: tariff and overseas profits vary from our forecasts. hkcg (sell) valuation remains our key reservation we raise our 2012-2014 eps estimates by an average 10% mostly to reflect better returns from investments in china. we roll over our target multiple to 2013 (20.0x) from 2012 (18.5x). hence, we raise our tp by 28% to hk$18.0. key risks: higher-than-expected earnings growth in china.,source: datastream, goldman sachs research estimates. key risks to our 12-month target prices: higher/lower-than- expected domestic sales and overseas profits.,franklin chow, cfa +852-2978-0790 goldman sachs (asia) l.l.c. viola zhang +852-2978-7215 goldman sachs (asia) l.l.c. the goldman sachs group, inc.,goldman sachs 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. for reg ac certification and other important disclosures, see the disclosure appendix, or go to /research/hedge.html. analysts employed by non- us affiliates are not registered/qualified as research analysts with finra in the u.s. global investment research,2,november 7, 2012,hong kong: utilities,prefer power assets to clp: tariff, soc capex, and overseas earning while we think both are well-managed hong kong utilities, we prefer power assets to clp on the three upcoming industry catalysts. i) power tariff discussion in december could remain controversial the question is more on how much rather than why. we expect power tariffs in hong kong to rise again in 2013 and then in 2014. while the magnitude can be managed with operational efficiency subject to fuel cost trend, the need for tariff increases in accordance with the scheme of control (soc) as agreed between the hong kong utilities and hong kong government seems difficult to avoid. we are not advocates for tariff hikes but we recognize the reality of striking a difficult balance between environmental protection (fuel emission and fuel mix diversity) and immediate cost increases. we now assume 3%-6% annual tariff hikes in 2013 and 2014. for 2012, pah raised more in tariffs than clp off its already higher base. for 2013, we expect the tariff hike amounts to be lower than what the market has previously expected given the milder fuel cost during 2012, especially on coal. exhibit 1: we expect further power tariff hikes for 2013 and 2014 in hong kong tariff, actual and projected, for clp and power assets, 2012, 2013e, 2014e,clp,pah,2012,2013e,2014e,2012,2013e,2014e,tariff (hk$ cents),basic tariff fuel clause surcharge/rebate others net total yoy change (%),84.2 17.8 (3.3) 98.7 4.9%,84.2 20.8 (1.6) 103.4 4.8%,84.2 25.0 0.0 109.2 5.6%,94.1 37.0 0.0 131.1 6.5%,94.1 42.0 0.0 136.1 3.8%,94.1 46.0 0.0 140.1 2.9%,source: company data, goldman sachs research estimates. we expect the two utilities to both raise power tariffs by about 5% each. however, we think clp may again face more political pressure like last year due to its customer base (exhibit 2); for example: 1) clp reported that it served 80% of the population in hong kong in 2011. it accounted for 74% of total power consumption in hong kong in 2011, along with pah; 2) among residential users, average income level for pah customers is likely higher than clp customers; and 3) among commercial users, we believe the service area of pah (majority in hong kong island) has a much higher concentration of large and global corporations than that of clp. while we think these factors should not change how we ascertain the fairness of power tariff hikes, relative affordability would still matter within the political process and for media attention. exhibit 2: power assets has a much larger mix of commercial customers than clp does 2011 customer mix (%) based on power generation,clp (local power sold in 2011: 31,168gwh) infrastructure and public services,pah (local power sold in 2011: 10,897gwh) industrial (3%),(26%) industrial (6%) residential (28%),commercial (41%),residential (23%),commercial (74%),source: company data, goldman sachs research. goldman sachs global investment research,3,november 7, 2012,hong kong: utilities,downside risk to 9.99% permitted return is too early to quantify now. there have been voices in the public in recent months about whether the permitted return allowed for clp and pah would seem too high and suggestions to consider reforming the power supply market. we, however, would not anticipate any changes to the 9.99% return profile unless due to unforeseen extreme scenarios. key aspects of the current agreement as reached between the two utilities and the hong kong government include: in 2013, the hong kong government is scheduled to make an interim review of the soc agreement. before 2016, the government will also review the regulatory framework for electricity supply, potentially covering market liberalization and power grid interconnectivity. in 2018 (the 10th year of the current agreement), the government has an option to change the current regulatory framework or extend the current agreement for five more years to a total of 15 years which will be equivalent to the prior agreement period. we think any subsequent potential changes to the framework would at least be contingent on the following: 1) economic growth and income equality in hong kong, which would shape public opinion and perception of the need and “acceptable” degree of tariff hikes. 2) governments comprehensive policy in environmental protection and accompanying monetary incentives, e.g. support to curb pollutant emission of power plants via emission reduction equipment installation as well as construction of new and cleaner power plants. 3) transparency and accountability of the public policy and business contracts (i.e. soc) undertaken by the government regarding a stable and reasonably priced power supply. 4) if fuel costs remain a key driver for near-term power tariff hikes (especially for clp), clear communication from the government on its policy which limits, if any, the fuel mix and fuel supply options (e.g. long-term gas supply from china for clp) for power utilities would also be important for the public to understand the tariff hike mechanism. 5) candid communication from power suppliers to the public on their balance between shareholder returns and affordable/stable power supply in hong kong. 6) cost and benefits of introducing new competition to the power supply market as well as the criteria to measure qualification and reliability of potential new entrants. ii) capex discussion could boost permitted return we believe the next five-year capex plan would be key to driving scheme of control (soc) earnings in hong kong for the two power utilities. under the current five-year development plans as approved by the hong kong government, clp is allowed a capital expenditure in hong kong power-related infrastructure of hk$39.9bn over october 2008 to december 2013 while power assets is allowed hk$12.3bn over 2009 to 2013. since the 9.99% permitted return is applied to companies net fixed asset values to derive allowable soc profits in hong kong, upside to their next five-year (2014-2018) development plan capex budgets could result in upside to their permitted returns. we think such upside may include government supports to build new power plants to replace older ones. we expect clp to still have a bit faster growth in its permitted return than pah (exhibit 3) based on its larger annual approved development plan capex. however, given the smaller base of pahs current capex plan, we think it may see more upside risks if new power plant construction is approved, notwithstanding a potentially lengthy process. goldman sachs global investment research,4,november 7, 2012,hong kong: utilities exhibit 3: clp has seen stronger growth in its permitted return than pah in recent years permitted return of clp and pah, 2006 2014e permitted return (%),5% 0%,clp pah,(5%) (10%) (15%) (20%) (25%) (30%) 2006 2007 2008 2009 2010 2011 2012e 2013e 2014e note: the declines in 2009 reflected the change of permitted return from 13.5% to 9.99%, effective october 1, 2008 for clp and january 1, 2009 for pah. source: company data, goldman sachs research estimates. iii) overseas profits, via acquisitions or restructuring, may signify differentiation different outcomes on overseas investments. seeking growth outside hong kong has been a strategy for the hong kong utilities given their mature low-growth local businesses. strong cash flows from these local businesses tend to help fund overseas growth. as shown in exhibit 4, the portion of overseas profits has been generally rising since 2007 for clp and pah. however, we notice that the track record of pah on its overseas earnings growth seems to be better than clp in recent years (exhibit 5). key observations: 1) earnings profile: clp: its overseas units are scattered across very different geographic markets in terms of growth and regulation, e.g. australia, china, india, and southeast asia. its overseas profits tend to be more volatile than pahs and include more non-recurring charges. power assets: we believe its overseas assets tend to be more defensive and regulated as well as concentrated in relatively similar markets (e.g. uk, australia, new zealand) at least in terms of regulatory and legal framework. 2) growth profile: clp: we expect it to focus on optimizing/restructuring its current portfolio of assets rather than on new acquisitions. we believe its key focus market is currently australia as it continues to restructure its recently re-branded energyaustralia and prepares for the potential initial public offering of that unit (previously reported by clp). we think they would continue to focus on fangchenggang power plant in china and look for exit opportunities for certain existing coal-fired power joint ventures. we do not expect much new investment in india and southeast asia from clp. power assets: we expect it will remain committed to jointly invest along cheung kong infrastructure in power utilities assets with inflation-adjusted returns in markets they are already active in. we think these acquired growth plus efficiency gains on existing assets may offer earnings growth upside. goldman sachs global investment research,clp,5,november 7, 2012,hong kong: utilities,3) dividend profile: clp: we believe the mandate for clp management is to deliver stable dividends with occasional growth; acquisitions are not necessarily top priority. we assume its dividend per share to remain at hk$2.52 until 2014. this implies the payout ratio would fall from 65% in 2012 to 49% in 2014. we think stabilization in its australia business earnings may position clp to pay a higher dividend per share before 2014 as the payout ratio has not been below 50% since our review from 1999. power assets: we believe the mandate for pah is to: 1) deliver stable dividends from its local business. we assume its dividend per share to remain at hk$2.32 until 2014. this implies payout ratio to fall from 51% in 2012 to 46% in 2014. we see upside risks to its dividends given its growing cash dividends from associates and that its dividend payout ratio has not been below 50% since our review from 1999; and 2) invest some of its abundant cash from its hong kong unit to fund investments in overseas power utility assets with inflation-adjusted returns with an objective of obtaining long-term dividend growth. dividends received from associates were hk$1.4bn (up 82% yoy) in 2011 and we expect those to grow to hk$2.8bn and hk$3.3bn in 2012 and 2013. exhibit 4: rising profit contribution from non-hong-kong businesses profit from hong kong businesses vs. non-hong kong businesses (profit before interest/tax for clp and net profit for pah), 2006-2011, 1h12,clp: 23% in 1h12 (36% in 2011),pah: 60% in 1h12 (50% in 2011),outside hong kong profit before interest and tax (hk$ mn) 20,000,total,proportion (%) 40%,pah net profit (hk$ mn) 10,000,outside hong kong,total,proportion (%) 60%,60%,36%,50%,16,000,32%,8,000,48%,12,000 8,000 4,000,21%,23%,24% 16% 8%,6,000 4,000 2,000,10%,36% 24% 12%,0,2006,2007,2008,2009,2010,2011,1h2012,0%,0,2006,2007,2008,2009,2010,2011,1h2012,0%,note: for clp, we use its profit before interest and tax including associate/jointly controlled entity (jce) income as segment net profit is not reported for the time series. unallocated profit is excluded from both sources (hong kong and overseas) of profit. source: company data, goldman sachs research. goldman sachs global investment research,120%,49%,6,november 7, 2012 exhibit 5: overseas earnings growth for pah seems to be stronger than that of clp overseas and local earnings growth (operating profit for clp and net profit for pah), 2006 2011 note that the y-axis scales are different for clp and pah for their different growth rates.,hong kong: utilities,clp,pah,net profit yoy changes (%) profit before interest and tax yoy changes (%),50% 40%,100% 80%,overseas,30% 20% 10% 0% (10%) (20%) (30%),overseas hong kong,60% 40% 20% 0% (20%) (40%) (60%) (80%) (100%),hong kong,2006,2007,2008,2009,2010,2011,2006,2007,2008,2009,2010,2011,notes: 1) for clp, we use its profit before interest and tax including associate/jce income as segment net profit is not reported for the time series. unallocated profit is excluded from both sources (hong kong and overseas) of profit. 2) for pah, the yoy decline in 2006 net profit was mostly due to the discontinued income after disposal of an associate in australia. source: company data, goldman sachs research. hkcg: p/e valuation premium conundrum persists appealing fundamentals but expensive valuation. our investment thesis remains though we recognize the appeal of the steady execution, brand name, and management experience of hkcg, we could not fully explain its significant p/e valuation premium over its peers. our revised 12-month p/e-based target price of hk$18.0 implies 13% downside potential. overseas growth strategy executed. exhibit 6 shows that the company has been steadily executing its stated strategy of raising its non-hong kong earnings to 50%. with a much larger asset and profit base, we think it is to be expected that its annual profit growth rate will gradually decline, in addition to the impact of a slower economy in 2009 and now. exhibit 6: non-hong kong earnings are now close to 50% of total, with far higher annual earnings growth profit contribution from hong kong and overseas businesses, earnings yoy growth (%), 2006-2011, 1h12 hkcg: 49% in 1h12 (46% in 2011),hkcg adjusted ebit (hk$ mn) 8,000 6,000,outside hong kong,total 46%,proportion (%) 50% 40%,adjusted ebit yoy changes (%) 100% 80% 60%,30%