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Morningstar | Datang’s 2018 Result Slightly Missed; Our FVE Remains Intact on Bearish Coal Price Outlook.

In line with industrywide deteriorating profitability, Datang’s full-year 2018 result missed our expectations, due to higher-than-expected fuel cost. Net profit fall 18% year over year to CNY 1.2 billion, with unit fuel cost rising 4% year over year. We think this, compared with only 1% growth in QHD 5,500kcal spot coal price, indicates that coal-fired IPPs have little flexibility to pass on the higher coal costs. Although Datang’s full-year result implies a net loss in the fourth quarter, we think this was largely due to a CNY 0.5 billion impairment and other one-off items that are not sustainable. Core operations in the fourth quarter improved slightly, with gross margin expanded by 0.5% to 15.3% from the prior quarter, as coal prices fell. Our long-term bearish coal price outlook remains unchanged and we think the firm should be able to benefit from this in the long run. We make little change to our full-year 2019 earnings forecast of CNY 3.7 billion, and we maintain our fair value estimate of HKD 2.50 per share.

We think the shares are slightly undervalued, trading at 0.6 times price/book, which is lower than our valuation and its 10-year average of 0.8 times price/book. We think the potential improvement in long-term cash flows under rationalized coal prices and a more comprehensive coal-power price linkage mechanism should drive the valuation close to our fair value estimate. Our midcycle coal price assumption of CNY 565 per tonne suggests Datang should be able to earn a sound operating margin of 14.5% compared with 10.0% in 2018, with robust annual free cash flow of more than CNY 10 billion. In addition, Datang’s proposed dividend payout of CNY 0.1 per share implies 5.5% dividend yield, which is more attractive than the 1.8%-2.5% for its major peers Huaneng and China Resources Power.

Despite weak earnings, Datang’s utilization hours and average tariff continued to improve from a year ago. The company added 73 hours in its coal-fired power plants’ utilization while archiving 4% rise in average tariff, despite 46% increase in power trading volume from a year ago. We think slowdown in industrial activities and the U.S.-China trade impasse should mean greater uncertainty for power demand in 2019, and our expectation of improving curtailment at renewable energy sources and China’s promotion of the use of gas to replace coal in power generation should mean coal-fired power growth will lag. As such, we forecast Datang’s utilization for coal-fired power generation to fall slightly to 4,650 hours in 2019 from 4,728 hours. We also expect a rationalizing trend in power trading prices and our valuation assumes the average tariff for Datang will fall slightly to CNY 305/MWh from CNY 310/MWh, while we expect unit profit to improve to CNY 89/MWh in 2019 from CNY 84/MWh in 2018.

Datang’s unit coal price rose about 4% year over year in 2018, similar to its peer Huaneng. This, however, is higher than our expectation and the 1% rise in QHD 5,500kcal spot coal price, which we think should be largely attributable to a low base in 2017 and larger proportion of peak season restocking. The QHD 5,500 kcal benchmark coal price weakened to CNY 618 per tonne as of March 29, 2019, from its recent peak of CNY 638 in early March. This is in line with our expectations. We think the recent coal price rally was primarily driven by tight supply, due to stricter safety controls during the two sessions of National People’s Congress and Chinese People’s Political Consultative Conference, following a few coal mine disasters in Shanxi, Shaanxi and Inner Mongolia. We expect coal production to gradually recover from late March, and demand to fall amid the end of heating season. Along with a slowing economy in China and the U.S.-China trade impasse, coal prices are likely to remain constrained. We maintain our bearish long-term coal price outlook and our midcycle assumption of CNY 565 per ton. We expect the softening coal prices to drive a strong rebound in Datang’s profitability, and we forecast the company’s recurring net profit at CNY 3.7 billion and CNY 4.5 billion, respectively, in 2019 and 2020.

Unlike Huaneng and China Resources Power, who are rapidly growing their wind power capacity in recent years, Datang’s clean and renewable generation sources are more focused on hydropower. We expect hydropower to maintain stable profitability over a mid-cycle, and without an aggressive capital expenditures plan, we expect Datang’s free cash flow to remain robust. The Chinese government plans to implement a grid-parity policy on wind power gradually from 2021, which will remove the subsidies and lower the wind tariffs to be at the same level as coal-fired generations. This implies about a 15%-20% cut in wind tariffs, but it’s only for the new capacity commissioning from 2021, while the capacity commencing before 2021 will still attract the current on-grid tariffs. This has encouraged Chinese independent power producers to accelerate the construction and commissioning of wind projects, and we expect the aggressive capital expenditure plans at Huaneng and China Resources Power to lead to negative free cash flows in 2019. In addition, we expect capacity expansion for wind power to remain strong over the coming two years, which will exacerbate the wind sector’s oversupplied situation. Although the government’s promotion of renewable energy sources and the launch of spot power trading market will help to digest some excess capacity, we expect the overall curtailment rate to stay high through 2019-20. We expect CRP’s utilization hours for wind power to be around 1,850-1,950 hours over the next three years, compared with 2,095 hours in 2018.