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Morningstar | Huaneng Posts a Disappointing 3Q; FVE Lowered to HKD 5.60 on Near-Term Challenges

No-moat Huaneng’s net loss of CNY 140 million in the third quarter was a negative surprise, which should be largely attributable to a CNY 174 million impairment at Singapore Tuas, as well as a CNY 359 million foreign exchange loss from its investment in the Pakistan project. Core operation also missed slightly on higher-than-expected fuel cost, despite a decent 8% growth in power output and marginally improved power price. This indicates 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 30%-35% in 2018 and 2019 to CNY 2.5 billion and CNY 4.1 billion, respectively, after factoring in the one-off items and higher-than-expected fuel cost, as well as slower power consumption growth in 2019 given that the U.S.-China Trade War is likely to be more prolonged than we originally anticipated. Consequently, we lower our fair value estimate to HKD 5.60 per share, from HKD 6.00, but our long-term bearish coal price outlook is unchanged.

We think the shares are undervalued, trading at only 0.6 times price/book, compared with its 10-year average of 1.1 times and our valuation of 0.9 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 tonne suggests Huaneng will earn a sound operating margin of 12.1% compared with our estimated 8.7% in 2018, with robust free-cash flow of more than CNY 19 billion on an annual basis.

Huaneng’s unit coal price rose 7% year over year in the third-quarter. This is higher than our expectation, owing to larger proportion of spot market purchases, according to management. Driven by heating season restocking at power plants, the QHD 5500 kcal spot coal price surged up to about CNY 660 per tonne on Oct. 23, from the third-quarter average of CNY 633. 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. And Huaneng also saw a decent 8% power output growth, with utilization improving 5% to 1,129 hours in the third-quarter. However, the U.S.-China trade war appears to be more prolonged than we’ve anticipated, which may drive a higher uncertainty of power demand growth. We estimate if China GDP growth slows 1% in 2019, nationwide power demand would be likely to fall by 0.9%, and coal-fired power plants are worst positioned given China’s promotion of clean and renewable power sources. As such, we lower our 2019 utilization assumption to 4,200 hours from 4,250 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 85% growth in 2019 net profit to CNY 4.6 billion.