A Big Chinese Power: Huaneng Power International
(Guest Commentary - October 5, 2006)
Dear Subscribers and Readers,
For those who had wanted to learn more about picking stocks and evaluating companies, I have again invited our regular guest commentator Mr. Bill Rempel for a quick mid-week discussion of an individual stock that he likes. As subscribers should know, Bill is a prolific writing on the stock market and individual stocks and is the midst of relocating his blog to: http://www.billakanodoodahs.com/
In this commentary, Bill is going to discuss Huaneng Power a Chinese large cap in the utility industry. This is again a value play given that Bill is a value investor at heart. Without further ado, following is biography of Bill:
Bill Rempel (aka nodoodahs) is an active poster on the MarketThoughts forum as well as a few others around the web. Bill is a regular, monthly guest commentator on our website (see A Fine Clothier that Bill Actually Likes: Hartmarx for his last guest commentary). Bill graduated from Caddo Magnet High School (a high school for nerds) back in 1985 and proceeded to learn the hard way when he drank his way out of a scholarship to Tulane later that year. After a few years of sweating for a living, he decided to go back to school, and graduated from LSU-Shreveport in 1995 with a Bachelors in Mathematics - all the while working the overnight shift stocking shelves in a grocery store.
Post-college, Bill has been in the P&C insurance industry as an actuary, product manager, and pricing manager. Bill and his wife Millie are amateur investors with a variety of holdings, but they prefer to buy and hold value investments. In typical "value" style, they live cheap, driving old cars and preferring to save or invest instead of buying fancy "stuff."
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
Let's talk about a large cap company this week. Make that a large cap utility company. Bored yet? How about a large cap utility company based in China. Huaneng Power International, Inc. (HNP) is headquartered in Beijing. I am long this stock from Friday's open, and actually started this write-up Tuesday night, but Henry says it's still OK even though it had a nice pop on Wednesday. The short ratio is only 3 days to cover, so I don't think the squeeze potential is very high. Per Yahoo!, the vital statistics are not deep value but are fairly enticing, and met the basic criteria of my value screener when it attracted my attention and when I bought.
Market Cap $9.2 billion
TTM P/E 12.3
Forward P/E 13.6
Here's the rub; while it looks cheap compared to electric utilities as a whole, it doesn't look cheap compared to the "foreign utilities" category. It's actually a pretty interesting comparison, check the charts below.
|Industry: Foreign Utilities
|Korea Electric Power Corp.
|Veolia Environnement SA
|Scottish Power plc
|Electricidade de Portugal SA
|Huaneng Power International In
|International Power plc
|Empresa Nacional de Electricid
|Companhia Energetica de Minas
|CPFL Energia S.A.
|Companhia de Saneamento Basico
|Transportadora de Gas Del Sur
|Consolidated Water Co. Ltd.
When digging a little deeper, I note that Enel and Endesa, the two largest "foreign utilities" by far, are both integrated utilities (not just electricity) and function primarily in Europe. Perhaps the lack of growth potential is what gives them and by extension, the sector a lower multiple?
Enel doesn't have a growth estimate available on Yahoo!, but as they're based in Italy, I would doubt they have significant room for growth. Endesa doesn't have a growth estimate, either, but their last five years have been a less than stellar 2.4% growth annually. For the record, Yahoo! includes no historic five-year number for Huaneng but does include an 8.8% estimate for the next five years.
Still trying to answer that question quickly, I turn to the "ten year summary" on MSN Money. Enel shows a little over 50% growth in revenues over seven years, with inconsistent earnings behavior. Endesa shows a more than doubling of revenues in nine years, but it's lumpy from an acquisition, and the earnings are similarly scattershot. The real kicker is looking at the ten year summary for Huaneng. It seems at this point the higher P/E is a growth premium compared to other foreign utilities.
Keep in mind that Huaneng (HNP) is not included in Yahoo!'s list of "electric utilities," but I prepared a table as if they were. It's plain that Huaneng's P/E is actually a discount to those comparable companies traded and based domestically. This is a "political risk" discount.
|Industry: Electric Utilities
|Duke Energy Corp.
|Dominion Resources Inc.
|FPL Group Inc.
|American Electric Power Co. In
|Progress Energy Inc.
|Constellation Energy Group Inc
|Huaneng Power International In
|Xcel Energy Inc.
|DTE Energy Co.
|Allegheny Energy Inc.
|NRG Energy Inc.
A lot of work so far, and all we've got to show for it is that Huaneng is cheap enough to hit my value screener, has a growth premium to other foreign utilities, and has a political risk discount to comparable domestic companies. It remains to be seen if the price is justifiable.
To do a quick check, I ran some DCF evaluations. The parameters include the 8.8% growth projection in a two-stage model, with ten years of high growth and subsequent lower growth. The discount rates used are 11.5% (long-term S&P 500 return) and 15% (my ultra-conservative rate based on long-term interest rates and M3 growth).
Ten years @ 8.8%, subsequent 4%, discount = 11.5% yields P/E of 19.2.
Ten years @ 8.8%, subsequent 4%, discount = 15.0% yields P/E of 12.7.
Ten years @ 8.8%, subsequent 2%, discount = 11.5% yields P/E of 17.0.
Ten years @ 8.8%, subsequent 2%, discount = 15.0% yields P/E of 11.9.
The current TTM P/E is in the low 12's, meaning that Huaneng is arguably at a discount, or fairly priced if you're conservative on your discount rate. I think it's time to dig still deeper. I downloaded the statistics into my handy-dandy spreadsheet, and was a little disappointed. Since HNP trades as an ADR in the U.S., the interim cash flow statements are unreliable. We have two quarters of data in Fiscal 2006, but I don't trust those measurements that involve the cash flow statement for 2006, so I omitted them.
There's certainly not much to worry about on the growth metrics. There are three discomforting issues in the financials. The main issue I have in the per share measurements is the lack of Free Cash Flow, but considering the company is in a capital-intensive industry and is growing rapidly, it may be forgivable. It certainly is something I'd keep an eye on. Debt and LT Debt to Equity are moving higher and not lower. Lastly, the earnings quality as shown by cash generating power and reliance on financing cash show the movement towards increased use of debt. All of these are related to the rapid expansion, and this strikes at the heart of the issue. If you can forgive some poor metrics during a growth phase, you forgive it and move on. If you can't, if you demand your value stocks be pristine, this is a company to pass on.
Another disappointment is that, as a foreign issuer and an ADR, the SEC filing requirements are different and there's generally less frequent information to review. There's the usual risk information about macro events such as regulation, fuel costs, climate change claptrap, Renminbi exchange rate fluctuations, and Sarbanes-Urkel. Pretty much this is the stuff in a filing that I find myself paying little attention to. The meaty stuff is more in the details.
A plurality of shares is owned by a parent conglomerate, and this could create some movement if they ever decide to monetize that ownership. The parent conglomerate is run by the "government" and includes interests in transportation, like some of the wharves where the coal needed by the plants is unloaded, and possibly some of the rails that the coal is transported on. Definitely some potential for conflicts of interest. Matter of fact, they don't even attempt to list all of them, simply stating that there is 40% ownership by the group and there are related party transactions. Nice.
There is plenty of construction to power future growth. The filing is rife with lists of plants under construction and the status thereof. I didn't know that utilities in China don't carry business interruption insurance. Biz interrupt is a major source of loss dollars for commercial lines and would put the company's earnings at risk in the event of some catastrophe. Fuel costs were 40% higher in 2005 than they were in 2006. If we are, for now at least, in a time of decreasing oil prices, one would expect coal prices to fall and utility profits to rise. About 70% of the shares (including the 40% owned by the parent) are institutional Chinese owned or insider owned. The history makes for interesting reading, but the growth through acquisition is disconcerting; it complicates the books and creates opportunities for surprises.
All in all, the filing documents make me want to set a close trailing stop under this thing before I go on vacation.
A couple of charts may be illustrative:
In the larger timeframe we can see how significant the current price level is. In the shorter time frame, the technical indicators are lining up with powerful trends in the indicators, good alignment of the moving averages, higher highs and higher lows, and penetration of the levels with volume confirmation. Actually, last week got me interested, although this has been on the watch list for many weeks. Tuesday gave us a volume spike with an umbrella; Wednesday gave us a bullish belt hold; on Thursday we had a gap up, bullish candle, and volume; I bought Friday at the open.
My conclusion? Well, I'm already long. It's not a stock that I'd go to the Bahamas while I owned it (unless I had a well-thought-out trailing stop order placed on it), but it's got good valuations, good macro prospects, growth at a reasonable price, and nice technicals. It's also the largest-cap stock I've reviewed for Henry in quite a while!