Kunlun Energy Co.-In line with expectations:Still in transition mode

What surprised us.

Excluding one-off LNG processing plants impairment, Kunlun’s recurringprofits reached HK$4,392mn in 2016, relatively in line with our estimate (-4%).

Oil E&P division turned to profit (HK$14mn, pre-tax) from HK$3.9bn loss in2015, mainly due to the absence of exchange loss in Aktobe project(HK$3.1bn) and asset impairment loss (HK$1.6bn) in China booked in 2015. Onthe other hand, we saw slow pre-tax earnings growth in downstream gasdistribution (+4% yoy) and gas pipeline (+1% yoy) mainly due to 4% yoyincrease in natural gas sales to 2.35bn m3 and 2% yoy in transmission volumegrowth. Kunlun showed discipline in cost control as SG&A expenses declined11% yoy and employee compensation costs also slide 5%.

What to do with the stock.

We believe Kunlun is still in a transition period seeking the next growth driverwhile continuing to optimize its asset portfolio. (1) Kunlun identified gaspower and distributed generation power as a growing focus. The companyinvested in 8 gas power plants and 4 distributed generation projects in 2016,guiding for IRR in the range of 10-26%. Each project requires over 800mn m3annual gas demand. (2) Kunlun is in the process of divesting its upstream E&Passets and currently undergoing due diligence. Management said the assetsreturn to profitability is the prerequisite for the disposal. (3) The slow pipelinevolume growth is partly because the No.1-3 pipeline reached full utilization inthe winter season. The No.4 pipeline, which will commence operations in Oct2017, will resolve the bottleneck issue, according to management, but thetimetable for tariff cuts remains uncertain. We fine tune 2017-19 net profitestimates by +4.5%/-2.8%/+0.3% and revise up our SOTP-based 12m TP fromHK$6.8 to HK$7.0. Maintain Neutral. Risks: Higher LNG demand (+); tariff cut ingas pipeline (-).