We view Shenhua as mispriced – seeing strong upside potential
Over the past decade, Shenhua has delivered an average ROE of 16%, 6% at itstrough in 2015. In the next three years, we expect Shenhua to deliver ROE ofbetween 13%-16% and FCF yield of 20% （RMB60bn of free cash per year）。 Atthe current implied PB multiple of 1x, we see strong reasons to argue thatmarket is not awarding Shenhua fair valuations. In this report, we provide anin-depth analysis of its strong track record and why we think its superiorperformance is sustainable. We raise our TP to HKD28.5, by applying a 1.5x PBmultiple to 2018 BVPS. Reiterating Buy.
Great asset quality across all segments
With a highly integrated business model, Shenhua is able to enjoy highefficiency throughout the value chain. It currently has c.300mt of low-cost coalproduction and high-quality coal reserves, c.54GW of installed capacity forthermal IPPs, c.350bt km of company-owned railway volume, and 200mt-plusof port turnover ability. Comparing horizontally with its peers and on astandalone basis, Shenhua’s assets outperform. Its ROIC in past years alsooutperformed peers by 3-8ppts for the most part. In our view, Shenhua’smanagement has performed reliably well in improving operational efficiencyand in the selection of assets to be loaded on to the listco.
What’s next?Potential upside has been underestimated
With the ability to generate RMB60bn of free cash flow per year, Shenhua’snet debt, at RMB6bn （as of end-1H17）， looks small. We believe Shenhua willrapidly build up cash, possibly choosing between a higher payout and assetacquisition. The merger between the Shenhua parentco and GD Power parentco enables the Shenhua listco to have a wide selection of assets foracquisition/injection. Our analysis suggests that even if Shenhua were to investin projects with ROIC at 2015 downturn levels, the acquisition would yieldaccretive returns for its shareholders. Note that Shenhua’s ROIC in past yearshas ranged from 7-19%. We believe its FCF upside potential has beenunderstated. We do not rule out upside surprises, considering potentialactivities by Shenhua to use its piles of free cash.
Reaffirming Buy; policy is a major risk
As mentioned in our previous note, Higher for longer, reiterate Buy on coalsector, published on 26 July, we believe that limited capex has been investedto increase coal supply in China. Thus, although the China government wantsto keep coal prices low, demand/supply tightness could keep prices high in thenext two years. Assuming an RMB600/t coal price in 2018, Shenhua wouldtrade at 6.5x 2018E PE and 1x 2018E PB. The company would yield 5% cash ifit maintains its payout at 40% （per historical practice）。 If it increases the payoutto 60%, yield could easily go above 7%. We believe Shenhua offers deep valueand we reaffirm our Buy call. We raise our target price by 7% to HKD28.5,adopting a consistent 1.5x PB, but rolling over to 2018E BVPS, implying 43%upside potential. We believe the market mispriced Shenhua due to acombination of concerns including the coal/thermal power industry’s outlookand Shenhua’s low beta nature. However, we believe earnings, dividends, andpotential asset injections will play out as catalysts to correct the misprice. Themajor risk to our thesis relates to China’s policies on SOE reform.