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Morningstar | Huaneng Posts a Disappointing 2018 Result; Cutting FVE to HKD 5.20 on Worsening Balance Sheet. See Updated Analyst Note from 20 Mar 2019

No-moat Huaneng’s disappointing 2018 full-year result, with net profit falling 54% to CNY 734 million, was largely driven by a CNY 1.6 billion impairment. Core operations also missed slightly on higher-than-expected fuel cost, despite a decent 9% 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. However, we retain our bearish outlook on coal prices, which should drive a material profit recovery for coal-fired IPPs. Huaneng’s guidance on 2019 capital expenditure exceeded our expectation, with two thirds spending on wind power. While this is aligning with the government’s long-term energy plan and supports Huaneng’s long-term growth outlook, we think the sharp rising capital needs, along with the company’s highly geared balance sheet, and approaching debt payment peak in 2019, should keep interest expense elevated in 2019, as well as a negative free cash flow. As such, we cut our 2019 recurring net profit forecast slightly by 5% to CNY 4.4 billion and lower our fair value estimate to HKD 5.20 per share from HKD 5.60 per share.

We think the shares are slightly undervalued, trading at only 0.6 times price/book, compared with its 10-year average of 1.1 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 tonne suggests Huaneng will earn a sound operating margin of 16% compared with the depressed 7% in 2018, with robust free-cash flow of more than CNY 20 billion on an annual basis.

Despite the weak earnings, it’s worth highlighting that Huaneng’s utilization and average tariff continued to improve from a year ago. The company added 301 hours in its coal-fired power plants’ utilization, to 4,495 hours in 2018, which, along with a 2% generation capacity growth, drove the company’s power sales volume up by 9% from a year ago. We think slowdown in industrial activities and the US-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 Huaneng’s utilization to fall slightly to 4,400 hours in 2019. Huaneng’s average tariff also increased CNY 4 /MWh to CNY 418 /MWh. We think this also implies a rationalizing trend in power trading prices and suggests limited downside for unit margin at coal-fired IPPs. Our valuation assumes the average tariff for Huaneng will fall slightly to CNY 416/MWh, while we expect unit profit to improve to CNY 198/MWh in 2019 from CNY 182/MWh in 2018.

Huaneng’s unit coal price rose 4% year over year in 2018. This is higher-than our expectation, and the 1% rise in QHD 5,500 kcal spot coal price, which we think should be largely attributed to a low base in 2017 and larger proportion of peak season restocking. The QHD 5,500 kcal benchmark coal price weakened to CNY 623 per tonne as of March 15, 2019, from its recent peak of CNY 638 on March 8. 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 Huaneng’s profitability, and we forecast the company’s recurring net profit at CNY 4.4 billion and CNY 5.9 billion, respectively, in 2019 and 2020.

Huaneng has been growing its renewable power capacity with a key focus on wind, while staying cautious on coal-fired expansion. This has sent the company’s capital expenditure averaging at CNY 22 billion between 2016 and 2018. However, the deteriorating profitability over the past three years has driven the company’s net gearing up to 203% in 2018 from 156% in 2016. Despite the improving profit outlook, we think Huaneng’s plan to further raise its capital spending in 2019 to over CNY 30 billion should keep its net gearing above 200% in 2019 and lead to further capital-raising requirements for the company in 2019, following its A-share issuance in 2018.