China Gas Distributors:The Return of Structural Growth

We initiate coverage on the China gas distributors sector with a positive view.

We think the current five-year-low valuation has overlooked some positives:1) we forecast China gas demand growth to rebound to 10/11% in 2016/17efrom 5/6% in 2014/15; 2) sector margins are subject to limited tariff cut risks andconnection fee headwinds; and, 3) we like BEH and CGH for their ability todeliver higher ROE and growth at more attractive valuations, justified by theirhigher exposures to our preferred Central and North China regions.

Structural consumption growth re-affirmed

We forecast anti-pollution (coal-to-gas substitution) and continuing urbanizationefforts will drive a gas consumption growth rebound to 10/11% in 2016/17e anda more structural 8% CAGR until 2020e, driven by our modelled growth fromPower Generation (CAGR 13%), Transportation (CAGR 13%), Residential(CAGR 10%) and Industrial (CAGR 5%). Jan-Mar have already seen demandrise 14% YoY, following the last price cut versus the 10% organic volume growthcompanies expect in 2016e.

Margin outlook better than you might think

Sector margins are subject to tariff cut risks and connection fee headwinds, butthese are not as bad as implied by current valuations, in our view. Chances offurther tariff cuts are slim, and we see Zhejiang as a special case. Connectionfee fears also ignore the still-low overall penetration rate (below 40% vs maturelevel of 75%) and the likely new connection growth in lower-tier cities withloosening property policies.

BEH & CGH best positioned for regional growth

Our regional screening of demand growth and connection fee upside reveals theCentral and North China regions are best positioned to witness the fastestdistributor income growth. BEH and CGH have the largest exposure to theseregions.

Sector valuation to rebound from multi-year lows

The gas sector is now trading at five-year low P/E, P/B and EV/EBITDA,depressed by concerns over lower growth prospects and margin contraction. Ourwork on DCF, PE and PB valuation suggests that the derating is overdone, andwe expect the sector valuation to rebound ~22% together with our structuralgrowth outlook and low tariff cut risks. Our top picks are BEH and CGH.