Downgrade Huaneng Power (902) to neutral amid tariff cut speculation

Huaneng Power (902, $7.94) slumped most since 2008. Comment: Five power companies including Huaneng Power (902), Datang Power (991), China Resources Power (836), China Power Int’l (2380) and Huadian Power (1071) lost 14% on average in past three days with exceptionally high trading volume. The correction is not stand alone for power counters, as we notice similar moves among shale gas related counters, smartphone plays and renewable energy sector. Since these sectors are those massively outperforming Hang Seng Index year-to-date, a quick answer to the share price corrections is profit taking.

However, the magnitude of correction among power companies is the largest since 2011, the year that power tariff started hiking for several rounds and coal prices peaking out, we could not rule out a possibility of paradigm shift of market expectation on the sector’s fundamental. Up to mid-May this year, analysts generally adopted three basic assumptions in their earnings model of power counters: (1) coal prices remain weaknesses and the risk is on downside in the rest of 2013; (2) on-grid tariff remains stable in the rest of 2013; and (3) slowdown in electricity output this year given weaker-than-expected economic activity acceleration. Recent news flow posed uncertainty on the first two assumptions.

Firstly, National Energy Administration has drafted new regulations on banning low-quality coal imports. This aroused concern on unit fuel cost assumption as import coal is an important source of coal procurement for coal fired IPPs. Secondly, there is rumor about tariff cut in coming peak season. This will reduce revenue growth of IPPs and hence drag down their earnings in 2013.

In our view, the impact of proposed banning on import coal is insignificant to earnings of China IPPs because only those imported thermal coal with net calorific value below 4,544 Kcal per kg will be subject to the proposed restriction. Most of the thermal coal imported by China IPPs are above this threshold. We also did not notice any excitement in physical market to endorse this speculation. In past one week, China Bohai Rim Steam Coal Price Index fell 0.2% to RMB610 per ton.

The impact of tariff cut, if any, is more significant as it will directly cut China IPP’s revenue growth and earnings growth in 2013 and 2014. Assuming tariff cut effective in 3Q13 and holding other factors constant, net profit of the five listed China IPPs in 2013 will decrease by an average 1.6% for every 1% cut in tariff. Among which, Huaneng Power’s (902) sensitivity to tariff cut is above industry average. We estimate that the counter’s net profit will be reduced by 3.0% in 2013 and 4.4% in 2014.

We tentatively maintain our assumptions of flattish tariff growth, 5% of unit fuel cost saving and 10% increment of utilization hours for Huaneng Power. Our earnings forecast for 2013 is RMB9.0bn implying the counter is presently trading at 9.8x PER in 2013 with EPS growth of 53%. This set of assumptions and estimates is subject to downside risk if tariff cut is materialized. As we lower valuation benchmark amid growing earnings risk, we have downgraded Huaneng Power to “Neutral” with revised 6-month target price of $8.05, equivalent to 10x 2013 PER. Since most of the analysts have not incorporated tariff cut assumption into their models, consensus target price is $9.53. Technically, the counter’s 9-day RSI dipped below 50 in three trading days and closed at 22 yesterday. This signaled a bearish trend ahead but a short term rebound is likely in near term. We recommend investors to reduce weighting on Huaneng Power in coming rebound.