Thursday, February 28, 2008

A look at the Power Companies - part ii


Tariff hike: $758m
Fuel cost hike: $1.1b

Tariff hike: $1.4b*
Fuel cost hike: $1b*
* not disclosed so I had to calculate myself which could be very wrong

Huaneng is better at managing its fuel, remember it generated 50% more power than Datang yet its incremental fuel cost (from price increase) was lower. On the other hand, Huaneng’s higher revenue from tariff hike was only the logical result of its larger scale.

Huaneng dealt with the coal problem by entering into long term contracts with miners to ensure supply and probably lock-in purchase price ahead too. The last annual report showed it had secured $5.5b of coal supply a year, about ¼ of 2006 requirement, up to 2009. So Huaneng should continue to have a cost advantage over Datang in the short run.

Datang is more ambitious and is prepared is spend $10b in developing coal mines in Inner Mongolia. Part of the output will also be used to generate natural gas of some sort (I’m no scientist).

Because of their expansion, Datang and Huaneng have so far hung out alright even past tariff hike lagged, both in time and dollar terms, behind the increase in coal price.

But now as further tariff hike is uncertain, I tried to estimate how much negative impact that will cause. To start I’d assume further fuel cost increase to be $1b for every 6 months, which is the same as 1st half of 2007, for Datang and Huaneng.

To put things in perspective $1b is about 1/3 of interim EBT for both Datang and Huaneng.

With an EBT margin of 19.3% and 13.3% respectively, it’d suggest a further $5.2b and $7.5b of turnover are needed to produce enough margin to offset the additional fuel charges of $1b. These mean a 6-month-growth rate of 30%+ for both, much higher than the full year growth of 42% for Datang and 21% for Huaneng. (Note: actually the EBT margin going forward should be lower because of higher fuel cost but I recken the new capacities will probably come with some tax concessions and the two will cancel out to a certain extent.)


The answer to the 1st question is no: neither can withstand a tariff freeze for very long without seeing a decline in profit. Datang however is slightly more resilient because (i) it has a higher turnover growth, and (ii) it pays higher taxes and MI which means the net effect to bottom line will be relatively smaller.

The bigger question is how long will this price control be in place? If it’s like the petroleum market then the outlook is indeed very dim. Sinopec has been running losses 3 years in a row but the price reform is still nowhere in sight. But the picture here is slightly more complicated as the total industry profit is shared between the power grids and the power plants, i.e. the power plants sell power to the grids who then resell it to end consumers. As the power grids are said to be very profitable, the government should have some space to maneuver if it so wishes. However, whether anything will be done when the grid companies are themselves preparing for listing is another question mark. If the grid companies are squeezed too tight then their ability to raise funds to build/revamp the power network is compromised.

Valuation wise it'd seem the market has assumed that price control will go away in the not too distant future. Datang at $5.6 has a capitalization of $65b and Huaneng at $6.6 had a capitalization of $80b. Both have a recurring p/e of 17x or thereabout according to my estimation, seems not justifiable if continuing results are seen to be flat or declining. (Note: the ongoing p/e will go lower as RMB appreciates)

Since the results are shortly due there's no need to guess. If the price cap does go away then profit of both should go in tandem with the pace of expansion, and Datang should have the upper hand. It's the preferred choice between the two.

DISCLOSURE: I don't hold 991 or 902 at time of writing.

Wednesday, February 27, 2008

A Look at the Power Companies - part i

I've always had good impressions about power companies, especially those in China where demand seems to be growing with no end in sight. Selling power is an easy business, all is needed is a growing population and fair regulatory environment for it to prosper. Buying power companies is more like making a country bet. The higher growth is the country, the better return is for the power companies.

But the problem with China now is the government wants higher growth but without a rising electricity bill. Since it majority owns all the power assets in the country, it manages to ban all tariff hike at the moment. Power companies, faced with rising coal price (60+% of their operating cost) but unable to pass it on, can only pursue volume, i.e. to sell more electricity via expansion. They are also diversifying into alternative power but that's more a strategic move than an economical one, as this won't have material impact on the results until in the medium term.

The critical questions one needs to consider are:

(1) Can the expansion and increased turnover make up for the loss from the rising coal price?
(2) How long will the price control stay in place?

I've focused only on Datang (991) and Huaneng (902). This part will only deal with the 07 interim data and I will tackle the final results later. I'll try to answer the two questions as I go along.


Asset size: $100b
Power generated: 56b kwh, up 35%
Revenue: $15.5b, up 42%
Commitment: $15b

Asset size: $110b
Power generated: 81b kwh, up 14%
Revenue: $23b, up 21%
Commitment: $10b

Hueneng appears more efficient as it generates close to 50% more power and revenue from the same asset base. But it's a distorted scene because of Datang's high growth in recent years (look at growth in power generated and revenue instead). Datang actually has doubled its asset base since 12/04 (I tracked 3-yr data) whereas Huaneng has only increased its assets by about 50% over the same period. Once those new capacities are up and running, Datang will probably produce just as much turnover or may even surpass Huaneng. Another point to note is Datang has 50% more capital commitment in new capacities than Huaneng, indicating strong growth prospect.


Recurring profit: $1.8b, up 42%
EBIT margin: 25.3%
EBT margin: 19.3%
Net margin: 14.6%
Net margin after MI: 11.7%
2006 ROE: 14.6% (excluding A-share issue in Dec)
Gearing: 1.72x

Recurring profit: $2.3b, up 7%
EBIT margin: 15%
EBT margin: 13.3%
Net margin: 10.9%
Net margin after MI: 10%
2006 ROE: 13.9%
Gearing: 1.43x

On each dollar of revenue, Datang had much higher margin (25.3% vs 15%), even before leverage. This has been another consistent trend since 12/04. So Datang seems to have done something very right (which I don't know). After paying out financing costs which were twice as much in proportion to sales, since Datang was more heavily geared, the margin gap was still very wide (19.3% vs 13.3%).

Then two unusual items caught my attention - tax and MI. Somehow Huaneng paid profits tax at a much lower rate whereas Datang had a much higher MI payout ratio. Stange isn't it given the two are running the same business? The net effect is such that the net margin after tax and ROE of the two were very close, with slight edge went to Datang (whose figure was distorted by its faster expansion). I checked past figures and found this pretty much has been a consistent trend for the past 3 years.

I have some speculative reasons for these differences, like Huaneng's plants are younger, or some of Datang's lucrative deals had to be compensated by a bigger minority stake. But much time will need to be spent to gain a better insight.

For now, let's just say both are very well-oiled machines, with one running at a faster speed.

DISCLOSURE: I don't hold 991 or 902 at time of writing.

Thursday, February 14, 2008

Xinhua Bookstore (811)

I found Xinhua bookstore an interesting stock when it was listed last year, simply because I enjoy reading books and naturally I was attracted to buying a bookstore share. But the price took off far too early and by too much. It's only very recent that I found the price worthwhile to 'read' the prospectus.

The stock has quite some attractions. Xinhua is the largest bookstore chain in Sichuan and it distributes textbooks for all primary and secondary schools in the province. I don't know the details but I always hear complains about those HK bookstores distributing textbooks making too much profit, so I reckon it may be a good business too in China. And most Chinese parents are willing to mortgage anything if they can to finance education of their children. They never skim on education. In addition, Xinhua, if properly managed, may expand to become a nationwide bookstore chain like those in North America.

But the facts turn out a little different.

1st, the retail operation, i.e. its 190+ bookstores, makes up less than 20% of turnover and doesn't make profit. The management has put it nicely that it generates plenty of cash flow. This in fact is 100% true. The arrangement with book suppliers is that no settlement is made until the books are sold. And nearly all of the books purchased can be returned if not sold after a certain period. On the sales side of course it's COD. So no inventory risk, cash received upfront, and suppliers settled in months. Yet the business still barely breakevens. What's wrong?

I think the tough terms with suppliers are out of necessities, i.e. nobody is buying books, or more precisely, nobody is paying for books. Books are intellectual properties, which in chinese term means 'trash' and nobody cares. Like CDs and DVDs, I can imagine a huge supply of pirated books in the market driving down prices of all books. Worse, there's electronic books all over the internet and younger generations may never need to touch a book, let alone pay for one. Sharing is all wonderful, isn't it? Why pay for anything if it's free on internet?

One direction Xinhua can take to like go asset light but strong on logistics like Amazon. But I bet even Amazon will have a tough time in China with this level of piracy.

Nevermind, the bread and butter business of Xinhua is textbook distribution. This made up more than 80% of sales and all the profit for the IPO track record period. Segment profit was quite high at 20% given what Xinhua did was to pass the books from suppliers to schools and students. However, there's no competition because this area is heavily controlled by the central government (no surprise) and only selected bookstores are granted exclusive distribution right. Xinhua thus has been the sole distributor in Sichuan for decades. Monopoly leads to excess profit, although it's probably true that the bookstore network also functions as distribution points which are now cost-free to the distribution business, i.e. real margin should be lower.

Xinhua also has got another sweetener: it's not required to pay any VAT nor profits tax (from 2006), as the central government wants to encourage the good habit of reading to increase the quality of its citizens. So it has to be sure no bookstores will go belly up.

With all the help Xinhua's net margin grew from 10% in 2005 to 13.5% in 2006. Profit in 2006 was $300m with sales of $2.2b (marginally up from $2b in 2004).

So far so good even if Xinhua has to bear the unprofitable bookstore operation. But the government's policy is changing and it's trying to open up the distribution market for competition in all provinces. The distribution right will go through a tendering process like any government contract would. In fact, Sichuan was a trial province and Xinhua won the last tender which will last till spring term 2008, which is now.

Now comes the perplexing part. Will Xinhua win the next distribution right? It should since it has the most established infrastructure in place already. But what's the point of the reform if it's the same old Xinhua over and over again? Xinhua also states in its prospectus that it will try to bid for neighbouring province's distribution right. This is more interesting as other provinces' Xinhua (it's a common trademark shared nationally by all state owned or ex-state owned bookstores) will have no choice but to bid in Sichuan as well, just in case it loses in its home turf. And it helps neither of them if they end up winning the other's right, in which case they might just swap back the right!

So it doesn't look to me that this reform is going anywhere. One thing for sure though is that all these biddings will drive down the margin of all future right!

A more likely development is for Xinhua to expand by M&A, issuing shares and taking over neighbouring Xinhua one by one. If policy allows this seems a better expansion route. But the current low share price will be hard to appeal to others.

In fact the Xinhua management seemed to concur and found more creative use of its IPO proceeds (~1/8) in investing in Chengdu City Commercial Bank as a strategic investor. A bookstore can be a strategic investor of a bank? You bet. I remember even if one sells in the 1st month of IPO, he's still a strategic investor, and his sale is considered a strategic sale!

Because of all these confusions about Xinhua's future I won't bother even it's cheap. Plus I try to avoid any business that can prosper only because of status, privilige, or government protection.

DISCLOSURE: I don't hold 811 at time of writing.

p.s. i apologize for there may be a lot of typos as somehow the spellchecker isn't working.

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