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Morningstar | Datang’s 3Q Missed on Lower Generation Volume; Cut FVE to HKD 2.50, but Shares Remain Undervalued

Datang’s third-quarter performance missed our expectation, with net profit falling 52% year-over-year to CNY 398 million under PRC GAAP. Despite a strong 8% nationwide power consumption growth, Datang’s third-quarter power sales volume remained largely flat from a year ago. While this is disappointing, we think this probably suggests rising tariff pressure amid the expansion of power trading activities, and the company’s priority to maintain unit profitability at the expense of volume. Fuel cost was also higher than we expected, indicating that coal-fired IPPs have little bargaining power over coal miners, and there is little flexibility to pass on the higher coal costs. We cut our near-term earnings forecasts by 25%-30% in 2018 and 2019 to CNY 2.5 billion and CNY 3.7 billion, respectively, after factoring the lower volume and high fuel cost assumptions in 2018, as well as slower power demand growth in 2019 given that the US-China trade war is likely to be prolonged than we anticipated. Consequently, we lower our fair value estimate to HKD 2.50 per share from HKD 2.72, but our long-term bearish coal price outlook remains unchanged.

We think the shares are undervalued, trading at only 0.5 times price/book, compared with its 10-year average of 0.9 times and our valuation of 0.7 times. We think this reflects only the current weak profitability, while the potential long-term positive 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 forecast of CNY 565 per metric ton suggest Datang should be able to earn a sound operation margin of 19.1% compared with our estimated 13.2% in 2018, with robust free-cash flow of more than CNY 5 billion on an annual basis.

Datang’s unit coal price rose about 9% year over year in the third quarter. This is higher than our expectation and we think the company should have increased the proportion of spot market purchases. Due to seasonal restocking by power plants and the government’s intention to limit coal imports, the QHD 5500 kcal spot coal price surged to about CNY 644 per metric ton on Oct. 26, from the recent low of CNY 592 per metric ton on Aug. 3. However, with coal inventory at the six major power plants rising to over 30 days, compared with 14-16 days last year and a normalized 18-20 days, we think the further coal price upside should be limited. We maintain our bearish long-term coal price outlook and our midcycle assumption of CNY 565 per ton. This should drive a meaningful margin recovery for coal-fired power plants in midterm. Key drivers of lower prices are capacity expansions in China, with a repeal of the 276-day production constraints, growth in supply from Inner Mongolia, and loosening coal import restrictions. In addition, we think the improving coal rail-transport infrastructure, with the new rail corridor Menghua line commencing service in 2020, will also help to reduce bottlenecks and flatten the cost curve. In the long term, we think the decline in electricity-intensity of the Chinese economy and the shift toward an anything-but-coal energy policy will continue to dent coal demand and limit any material price increase.

Helped by rising demand from service sector and residential usage, nationwide power consumption rose 8% year over year in the third-quarter. However, Datang posted a flat power output growth in the third quarter. We think this probably indicates Datang’s priority to maintain unit profitability at the expense of volume, as the company saw its unit profit improving to CNY 72/MWh from CNY 67/MWh in the second quarter. In addition, we think the US-China trade war is likely to be prolonged, which could weaken China’s activity levels and cut power demand growth. Our supply/demand model suggests, if China’s GDP growth slows 1% in 2019, nationwide power demand would be likely to fall by 0.9%. Coal-fired power plants are worst positioned given China’s current policy to prioritize use of clean and renewable power sources. As such, we lower our 2019 utilization assumption to 4,600 hours from 4,650 hours. In addition, we also expect a 1% lower in average power prices in 2019, given the NDRC’s intention to lower end-user power prices for industrial and commercial usage, as well as the expansion of power trading scale. However, we expect these negatives to be offset by lower coal prices, leading to 46% growth in 2019 net profit to CNY 3.7 billion.