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Morningstar | BEH’s First Half Beats on Robust Gas Demand and Improving Tariffs; Shares Remain Undervalued. See Updated Analyst Note from 31 Aug 2018

Narrow-moat Beijing Enterprises Holdings', or BEH’s, 13% year-over-year growth in first-half net profit was encouraging, with decent growth across all segments. The result was slightly ahead of our expectations, with stronger-than-expected gas demand and higher tariffs being the key drivers. Along with a 19% jump in contribution from 25%-owned associated China Gas, the improved gas sales more than offset the 37% tariff cut on the Shaanxi-Beijing gas transmission pipeline, or SJ pipeline, and drove gas segment recurring profit up 4.8%. In addition, revenue from Yanjing Brewery expanded 9%, a nice turnaround following four consecutive years of decline. This is a positive sign that BEH’s brewery business is benefiting from expanded premium offerings. We expect BEH to extend the strong growth momentum into the second half and we raise our 2018 earnings forecasts slightly by 3% to HKD 7.3 billion. We anticipate little change to our midcycle assumptions and maintain our fair value estimate of HKD 58.00 per share, which has incorporated a weaker Chinese yuan against the Hong Kong dollar.

BEH remains one of our Best Ideas, and we think the market does not currently appreciate its decent growth outlook and robust cash flows. The shares are currently trading at only 0.6 times price/book, well below our valuation of 1 times price/book and its 10-year average of 1.4 times. With the finalized tariff cuts on SJ pipelines and stabilizing profit at Yanjing Brewery, overhanging concerns are alleviating. We expect the company’s net profit to grow at a CAGR of 8% over the next five years, which is decent and underpinned by China’s long-term promotion of the use of natural gas over coal as a cleaner fuel source. Although the growth rate is lower than our forecast 10%-15% for major gas distributors we cover, we think BEH’s low valuation, compared with the 3-4 times price/book for its peers, represents an attractive risk-reward tradeoff for BEH.

Driven by coal-to-gas conversion projects in Beijing’s outer suburbs, BEH’s gas distribution volume rose 23% year over year. This is fairly impressive, compared with the lackluster 1.4% growth in full-year 2017, and is also higher than management’s earlier guidance of 17% for full-year 2018. Gross margin widened to 12.6% from 11.0% with a rise in distribution tariff to CNY 0.223 per cubic meter of gas from CNY 0.219. We expect full-year gas distribution volume to rise 20%, with margins largely stable.

SJ pipeline IV came ongrid in November 2017, further lifting the total gas transmission volume by 31.5% year over year to 246 million cubic meters, an uptick in growth versus 14.8% in 2017. The transmission tariff rose to CNY 0.201 per cubic meter from CNY 0.18 per cubic meter, benefiting from a better mix of gas sales. We think the winter heating demand in Northern China will continue to drive robust gas demand in the second half, and we expect full-year gas transmission volume to grow 30% in 2018.

Driven by higher oil prices, BEH’s 20% investment in Russian oil and gas company Verkhnechonskneftegaz, or VCNG, contributed HKD 660 million in profit to the company, compared with HKD 421 million in second-half 2017. However, we expect crude oil prices to pull back and Brent to average USD 60 per barrel in the midcycle with ample shale oil supply and slower demand growth. We maintain our view that the profit contribution from VCNG will stabilize at HKD 0.8 billion-HKD 1 billion over the medium term.

BEH’s water and waste segments were both on track, with first-half profit contribution up 20% and 94%, respectively. BEH’s brewery business also improved in first-half 2018, with revenue and profit before tax rising 8.9% and 6.7% from a year ago. We think this suggests Yanjing’s efforts in product premiumization are paying off, and signals BEH’s brewery business has turned the corner under its strategy to introduce more premium products. While the contribution from Yanjing Brewery is small, accounting for only 4%-5% of group earnings, we think the improving profit will remove a key sentiment dampener for BEH.