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Morningstar | Recent Pullback on Gas Utilities Presents a Good Opportunity to Accumulate Undervalued Stocks

The share prices of China Gas Holdings, or CGH; China Resources Gas, or CRG; and ENN Energy, or ENN, have fallen by close to 30% or more from their recent peaks following the announcement of the Chongqing People’s Congress proposal to abolish up-front construction fees in the city gas sector. However, we do not expect the policy will lead to cancellation of connection fees nationwide, and we believe the recent correction is overdone. CRG is the only operator with meaningful exposure to Chongqing through its 22.5% stake in Chongqing Gas Group, but we expect less than 2% earnings impact. Our narrow moat ratings and respective fair value estimates of HKD 25.50, HKD 36.50, and HKD 83 for CGH, CRG, and ENN are intact. We think city gas distributors’ shares are undervalued at current levels. Our preferred pick is ENN, given the company’s ability to source LNG at competitive prices and its potential in the fast-growing integrated energy business.

Since 2000, the Chongqing municipality has allowed city gas distributors to charge gas users a one-off total connection fee of CNY 2,150 per household, which comprises an up-front construction fee of CNY 1,150 and an installation fee of CNY 1,000. It has been proposed that the up-front construction fee should be abolished while the installation fee will remain. We think there is some confusion here that has triggered the market sell-down on concerns of removal of connection fees for city gas operators, which contribute about half of their earnings. In our view, it is important to differentiate between the two fees. The up-front construction fee refers to the fee collected for the construction of infrastructures such as gas pipelines and gas storage, as a measure to subsidize the initial investment costs of city gas operators when the penetration rate of city gas is low. Meanwhile, the installation fee is a fee charged to customers for engineering services to connect their properties to gas supply.

We believe Chongqing plans to abolish the up-front construction fee, as the municipality has already achieved a high gas penetration rate of close to 70%. However, China’s gas penetration rate is only about 50% and is still far behind the 80%-plus for developed countries. We would also highlight that gas users may not need to use gas even if their properties are connected to gas supply. As such, we think connection fees will remain important to encourage investment by city gas operators to connect new users, given China’s ambition to increase the gas penetration rate to 57% by 2020. In the longer run, we think a monthly maintenance fee may be introduced if the government intends to abolish the connection fee. Furthermore, many local governments have discontinued up-front construction fees, and only a few cities are still charging both fees. Hence, we do not expect a nationwide impact, and cities with a still-low gas penetration rate may continue to allow up-front construction fees until their gas penetration rate increases.