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Morningstar | Huaneng’s Strong 1Q in Line; Falling Coal Price Will Continue to Drive Earnings’ Recovery

No-moat Huaneng’s strong first-quarter result, with net profit rising 114% to CNY 2.65 billion under PRC GAAP, was largely driven by falling coal prices, while its power output and average tariff remained largely flat from a year ago. This was well-expected, and an 8% fall in Huaneng’s unit coal cost drove its gross margin expansion of 4.8% in first-quarter 2019, to 18.3%, the best since third-quarter 2016. In addition, higher heating income, as well as the one-off noncash gains from the consolidation of its Pakistan project and reversal from a previous provision for its Singapore Tuas project, also helped to boost the bottom-line. We retain our bearish outlook on coal prices, and we expect QHD 5,500 kcal benchmark coal price to decline 8%-10% year over year in 2019, which will be the key growth driver for coal-fired power plants in the coming quarters. We maintain our full-year 2019 net profit forecast of CNY 4.4 billion (under IFRS), and our fair value estimate of HKD 5.20 per share. We think the shares are fairly valued, trading close to our fair value estimate.

Despite the strong earnings, we noticed that Huaneng’s power output volume fell slightly by 0.45%, lagging the 5.5% of nationwide power consumption and 2% of nationwide coal-fired power generation. Although Huaneng has been increasing the share of renewable energy sources, the coal-fired output still accounts for about 96% of the total output, and two thirds of these power plants are located in Northeast China and Eastern regions, which have stricter pollution controls that limit the use of coal. In addition, strong water flow since beginning of this year has led to sharp rising hydro-power outputs. This, along with government’s supporting policy in clean and renewable energy sources, should further dampen Huaneng’s power utilization hours in 2019. As such, we forecast Huaneng’s utilization to fall slightly to 4,400 hours in 2019, from 4,495 a year ago.

Huaneng’s average tariff remained largely flat at CNY 422/MWh in the first quarter, while unit coal cost fell 8% to CNY 220/MWh, which drove unit gross profit widening to CNY 202/MWh from CNY 185/MWh. This is in line with our expectations, and we think the lackluster coal demand and growth in supply will keep prices subdued. We think the high inventory level at six major power plants (26 days currently, versus a normalized 18-20 days), and more than 20% drop in import coal prices, further support our bearish outlook in coal prices. We maintain our assumption that coal price will fall 8%-10% in 2019, averaging at CNY 585-595 per tonne, and we expect Huaneng’s full-year unit profit to improve to CNY 198/MWh in 2019 from CNY 182/MWh in 2018. This will boost full-year 2019 net profit to CNY 4.4 billion, from CNY 0.4 billion in 2018. Our midcycle coal price assumption of CNY 565 per tonne is also unchanged, which suggests Huaneng will earn a sound operating margin of 16.6% (compared with the depressed 7% in 2018), with robust free-cash flow of more than CNY 20 billion on an annual basis.

Huaneng has been growing its renewable power capacity with a key focus on wind, while staying cautious on coal-fired expansion. According to management, Huaneng plans to add 2,350 MW, 2,400 MW and 2,000 MW installed capacity in wind over the three years in 2019, 2020 and 2021, equivalent to 7% of the total installed capacity at the end of first-quarter 2019. While this aligns 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 drive negative free cash flow. Despite the improving profit outlook, we estimate Huaneng’s net gearing will still be above 200% in 2019.