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Morningstar | Strong Power Demand and Tariff Hike Boosted Huaneng’s First Half; Shares Are Fairly Valued

No-moat Huaneng’s strong first-half 2018 result, with net profit rising 6 times year over year to CNY 1.7 billion, was within expectations, with 12% growth in power sales volume and a 2.7% increase in average selling tariff the key boosts. While Huaneng’s unit coal cost was up by 6% in first-half 2018, the recent decline in the QHD 5,500 Kcal spot coal price to around CNY 600/ton from over CNY 700/ton in early June reaffirms our bearish coal price outlook, and we expect coal price weakness to be the key growth driver for coal-fired power plants in the coming quarters. We maintain our full-year 2018 net profit forecast of CNY 3.6 billion, but we cut our fair value estimate slightly to HKD 6.00 per share from HKD 6.20, after taking into account the depreciation of the Chinese yuan against the Hong Kong dollar. We think the shares are fairly valued at the current level, close to our fair value estimate of 0.9 times price/book, which factors in the potential long-term positive cash flows under rationalized coal prices and a more comprehensive coal-power price linkage mechanism

Helped by the extreme weather conditions (cold winter and hot May) and pickups in property investment due to low inventory, nationwide power demand remained strong, rising 9.4% year over year in the first half. In addition, hydro power output increased only 2.6%, further boosting coal-fired power demand. This favors Huaneng, as coal-fired generation accounts for more than 90% of the company’s power output, driving its utilization to improve 7% to 2,051 hours in the first half. However, we think the U.S. trade war may lead to higher uncertainty for power demand growth, and our expectation of stronger hydro-water flows in the second half and China’s promotion of the use of gas to replace coal in power generation should mean coal-fired power growth will be less exciting. As such, we maintain our forecast of stable utilization of 4,200 hours for Huaneng in full-year 2018.

In addition, we also expect limited upside for the average tariff, given the National Development and Reform Commission's intention to decrease end-user power prices for industrial and commercial usage, as well as the expansion of the power trading scale. We maintain our forecast of CNY 420/MWh in 2018, representing a 1.4% rise from the average tariff of CNY 414/MWh in 2017.

Huaneng’s unit coal price rose 6% in the first half, and management revised up the company’s fuel cost guidance from down 4% to up 2% during the analyst briefing. However, our bearish outlook on coal prices is unchanged, and we project coal prices to continue weakening in second-half 2018, as we expect coal production to recover. In addition, China’s “Blue-sky Protection Campaign” should see continued expansion in coal-to-gas conversion amid winter heating, dampening coal demand. We’re confident that the coal price will fall to the preferred “Green Zone” range of CNY 500-CNY 570/ton, and we maintain our midcycle benchmark Bohai-Rim Steam-coal Price Index assumptions of CNY 565 per ton. This should drive a meaningful margin recovery for coal-fired power plants in the medium term.

Potential catalyst may come from the deepening power sector’s reform, which brings both opportunities and challenges for coal-fired independent power producers. We expect coal-fired IPPs to benefit from stable margins and healthy cash-flows in the long run, with reforms likely to allow the IPPs to better match fuel costs with power pricing. However, the sector's long-standing and deep-seated structural problems, along with the complexities and difficulties in balancing requirements for reliable energy supply, public affordability, environmental protection, and other factors, indicate that power sector reform is likely to remain a slow process. In addition, we think scientific and technological innovation will effectively reduce the costs for renewable power generation in the next five to 10 years. This will boost the competitiveness of renewable energy sources, leading to stronger growth that may vastly outpace coal-fired generation.