China power sector:Drowned by fuel,buoyed by quantamental

Conclusion

We cut our FY16/17earnings forecasts for coal-fired IPPs by 10%–36%,largely to factor in the surge in coal prices in 2016and our commodity team’slatest price forecasts (link). While fuel costs have receded from their Nov-16highs, we think IPP earnings will only rebound in 2H17at the earliest, giventhe base effect of low 2016fuel costs. Thus, we think it is too early to call aninflection point yet.

We downgrade Huadian (1071HK) to Neutral and Huaneng (902HK) to UPdue to our earnings and TP cuts. China Resources Power (836HK) is oursector pick on better yield visibility. We also have an OP rating on ChinaPower (2380HK) on its hydro exposure and undemanding valuation. Wemaintain our Neutral on Datang (991HK) and UP on Huaneng-A (600011CH), Huadian-A (600027CH) and Datang-A (601991CH).

We introduce our sector proprietary quant strategies (H shares), whichhave generated a total price return of 67.8% (Long-Only) and 80.2% (Long-Short pair), respectively, in the past ten years. During the same period, theHang Seng Index rose by only 18.6%.

Outlook

MacQ proprietary quant strategies on China IPPs (H shares). The MacQQuant team partners with the China IPP team to create a MQ ProprietaryQuantamental Signal for the sector. Based on the signal, we have constructed2quarterly-rebalanced products, a Long-Only (LO) portfolio and a Long-Short(LS) pair. In the past 10years, the LO portfolio generated 6.8% annualizedreturn while the LS pair generated an 8% annualized return. (See Pg. 6)

Earnings outlook: weighed down by coal. The spot coal price came in at>Rmb600/ton in Dec, 2016(vs. ~Rmb370in early 2016). The cost surge isweighing on coal-fired IPP earnings. We expect some IPPs to be loss-makingin 4Q16. While coal prices have already retreated from Nov’s high, we expectFY17’s avg. unit coal price to be higher than that in FY16. We factor in ourcommodity team’s coal price outlook (+9% YoY for 2017, link). However, ifthere is government intervention / strong seasonal movement, coal pricemovements in China can be different from international price movements.

Power demand growth to ease from >5% in 2016to 3.4% in 2017but 1Hlikely stronger than 2H. While strong power demand growth in 4Q16, drivenby secondary industry, was a positive surprise, we do not think this is asustainable trend. Our economists expect property investment growth to slowfrom FY16’s 7% to 2% in FY17(link). We also expect power demand growthto slow in 2017and expect 1H to be stronger than 2H due to base effect.

Structural challenges remain. We expect the discount for market powersales to narrow in 2017. However, the blended tariff impact will be offset by arising mix of market sales. For 2018, we expect a further rise in market salesto reduce the blended tariff for coal-fired IPPs. In terms of overcapacity, weexpect coal-fired IPP utilisation to continue to decline in 17/18E.

Coal-fired IPPs are our least preferred China gen exposure. We preferwind power-generating companies (see our China wind sector - Pitfallsremoved report by Patrick Dai).