Hilong Holding is a Chinese private oil & gas company specialised in high-end oilfield equipmentmanufacturing and integrated petroleum and natural gas services. We expect the firm’s profitabilityto rise in coming years, on the back of increasing operational efficiency and an improving productmix. Moreover, we are positive on the sustainability of the current oil price recovery, which willbenefit upstream oil & gas companies, such as Hilong. We forecast diluted EPS of Rmb0.10 in 18E（+43% YoY）， Rmb0.14 in 19E （+40% YoY）， and Rmb0.18 in 20E （+29% YoY）。 We derive a target price ofHK$1.36 （11.0x 18E PE）。 With 14.3% upside, we initiate coverage with an Outperform rating.
Oil price support. After declining for two years, Brent futures reached US$60/bbl in end-October,catching the uptrend of global rotary rig count. As OPEC members adhered to a tight supply schedule,Brent futures have remained above US$60/bbl since the beginning of the year, topping US$80/bbl forthe first time since 2014, amid growing tensions in the Middle East. Oil price is one of the main triggersof Capex changes. As such, we see the current oil price recovery as a growth catalyst for the stock.
Strong drill pipe demand. Spears & Associates forecasts global drill pipe demand to grow 20.8% YoYto 320,000t in 2018F and expand at a Cagr of 11.5% over the next four years, against the backdrop ofincreasing drilling activity. As Hilong has already reached its full drill pipe capacity of 60,000t in 2017and management has not announced any plan to expand capacity, we expect the firm’s capacityutilisation to reach 100% in 2018-20E, given growing demand. We forecast oilfield equipment sales ofRmb1.4bn in 18E, Rmb1.5bn in 19E, and Rmb1.6bn in 20E （2017-20E Cagr: 6.5%）。
Product mix improvement. Management expects the proportion of higher-margin non-API drill pipesto gradually increase, given the rapid development of the non-conventional oil & gas sector, includingshale gas. According to our sensitivity analysis, a 1ppt increase in the proportion of non-API pipe saleswould have led to a 0.1ppt increase in gross margin for the firm’s oilfield equipment manufacturingsegment in 2017. We see the company’s improving product mix as a strong bottom-line growth driver.Based on our conservative estimates of non-API drill pipe sales, we expect the oilfield equipmentmanufacturing segment’s gross margin to reach 33% in 18E, 34% in 19E, and 35% in 20E.
Promising oilfield services segment. Hilong’s oilfield services revenue exhibited weak negativecorrelation with oil prices over the 2012-17 period （correlation: -0.49; R2: 24.5%）， vs a positivecorrelation of 0.62 （R2: 38.5%） for Anton Oilfield Service （3337:HK – BUY） and 0.64 （R2: 41.2%） for SPTEnergy （1251:HK – BUY）。 We attribute the weak correlation to Hilong’s long-term contracts with tieroneoil companies, such as Royal Dutch Shell （RDSA:NA）， whose production costs are sufficiently lowto sustain Capex despite oil downturns, thus reducing the impact of short-term oil price fluctuations.We are positive on the growth prospects of Hilong’s oilfield services and forecast segment revenue ofRmb1.1bn in 18E, Rmb1.4bn in 19E, and Rmb1.7bn in 20E （2017-20E Cagr: 23.9%）。
Initiate with an Outperform. We forecast diluted EPS of Rmb0.10 in 18E （+43% YoY）， Rmb0.14 in 19E（+40% YoY）， and Rmb0.18 in 20E （+29% YoY）。 We derive a target price of HK$1.36, representing 11.0x18E PE and 8.4x 19E PE. With 14.3% upside, we initiate coverage with an Outperform rating.