Towngas Smart Energy reported FY22 revenue of HK$20.07bn (+17% YoY) and earnings of HK$965m (-23% YoY), missing our expectation. The company proposed to pay a final dividend of HK$0.15 per share. Towngas has signed a memorandum of understanding with Shenergy Group to withdraw from the equity investment of a 25% stake in Shanghai Gas.
　　Higher revenue vs. lower margin. In 2022, the company added seven new urban gas projects and brought the total to 183. The number of customers swelled by 0.84m to a total of 15.93m. The growing number of projects and a stronger user base lifted the company’s gas sales to 15.25bnm3 (+5% YoY), gas and energy sales delivered a combined revenue of HK$16.66bn (+19.4% YoY), while gross profit slid to 715m (-34.2% YoY), which we ascribe to the following reasons. 1) Elevated upstream gas prices pushed up purchase prices, which failed to be passed on to household customers, hence dragging down the gross margin. 2) Renewable energy business remains in the early stage, which coupled with the Covid impact, slowed down PV installation.
　　Non-operating breakeven. Due to the high gas price and the Covid outbreaks in Shanghai, the company suffered losses from its 25% stake in Shanghai Gas, which amounted to HK$589m in 2022. At end-2022, the company’s share price stood at HK $3.92, significantly lower than the conversion price of convertible bonds issued to Affinity at HK$6.33 per share, resulting in an income of HK $531m from fair value changes. Regardless of the gains and losses mentioned above, the attributable net profit resided at HK $1.02bn (-36.5% YoY).
　　Diversified gas sources to widen margin. The company plans to increase the proportion of gas purchased from sources other than "three barrels of oil" (Sinopec (600028:CH - N-R), PetroChina (601857:CH - BUY) and CNOOC (600938:CH - BUY)) to diversify the source structure through acquiring coalbed methane in inland areas and importing LNG in coastal areas to bring down the overall cost. By end-2023, the company’s self-operated gas source will reach 2bnm3, slashing overall purchase cost by Rmb0.1/m3. In 2022, the company’s gross margin reached Rmb0.50/m3(-Rmb0.01/m3 QoQ). According to the company’s guidance, the gross margin will rebound to Rmb0.52/m3 in 23E.
　　Growth potential of PV business. In 2022, the company signed a total installed capacity of 1.37GW, including 0.55GW connected to the power grid and 0.3GW still under construction. The Covid impact has started to wane since end-2022, the company’s installed PV capacity has shot up, and we expect the cumulative grid-connected PV capacity to surpass 1GW by the end of 1Q23. With smooth logistics nationwide and the downward price pressure on PV modules, Towngas aims for a cumulative installed capacity of 3GW in 23E. Given the management synergy for large-scale PV projects in the smart park, we expect the PV projects to achieve a higher IRR than the market average and continue to bolster profitability from 2023 onwards.
　　Maintain BUY. Considering the exclusion of Shanghai Gas’s investment income from the company’s financial statements, the expectation of lower gas purchase prices, and the increase in planned renewable energy grid-connected capacity expansion, we trim our earnings forecast from HK$1.42bn to HK$1.35bn in 23E, from HK$1.67bn to HK$1.79bn in 24E, and introduce forecast HK$2.01bn for 25E(not considering gains or losses from fair value changes of convertible bonds). The stock is trading at 9.2x 23E PE, 7.2x 24E PE and 6.2x 25E PE. We maintain our BUY rating.
　　Risks. Sharp rise of gas purchase price; slower-than-expected grid-connected capacity ramp-up.