Why China's Gas Stocks Are Rising

Shares in China's gas distributors soared after the government announced higher-than-expected limits on investment returns.

The National Development and Reform Commission (NDRC) announced on Thursday the return cap (ROA cap) for downstream gas transmission assets will be set at 7%, higher than the expected 6%. The news boosted distributors such as ENN Energy (2688.HK), which jumped 6%; China Gas Holdings (384.HK) rose 5% to its highest in three years; and CIMC Enric (3899.HK) was up almost 4%. Jefferies analyst Laban Yu doesn't believe this will have any impact on gas distributors earnings in the medium term:

Now, with the newly published document indicating a higher return cap, and a clear explanation from gas companies in the past month on why the connection fee should not be included, concerns over margin compression have been allayed, in our view. The ROA (excluding connection fee) among gas distributors is currently less than 4%. Thus, with a 7% return cap, there should be limited earnings impact on the downstream gas projects in the medium term.

Daiwa analyst Dennis Ip believes the distribution tariff will benefit ENN Energy, which has a plan to import its own low-cost LNG. Here's his take:

The policy clearly states that the distribution tariff would be focused only on the gas distribution business, without mentioning gas connection fees and customer retail service fees. Therefore, city-gas companies would likely spin off their gas distribution business to other entities to be regulated, while gas connection and retail gas profit would not be affected. In addition, gas distributors might exercise various cost savings measures, including sourcing cheaper gas and by-passing oil majors to earn additional return. ENN Energy should be able to enjoy an additional 10-15% dollar margin with its 1.5mtpa LNG contract once the parent's owned Zhoushan LNG terminal is commissioned in 2H18E.

Shares in China Gas have rallied more than 40% so far this year, but the stock shows no signs of running out of energy as the Chinese government pushes towards the use of gas instead of coal.

After reporting an 83% year-on-year jump in net profit after tax (NPAT) for 2017, the gas distributor guided for gas sales of 30% in the current year to March, and 25% growth for the following two years. The company is also looking to add 13 million new residential connections over the next three years, mainly driven by coal to gas conversion demand.

Jefferies analysts Howard Lau and Laban Yu say China Gas is in strong position to benefit from the China government's efforts to switch to gas instead of coal. China Gas has signed framework agreements with with nine major cities year-to date to develop coal to gas projects and secured contracts to convert 0.67 million households in rural areas:

Among our coverage, we believe China Gas will be the fastest growing distributors, thanks to its distinctive rural development strategy and exposure in the Northern China, benefiting from the strong demand growth from coal to gas conversion.

Jefferies has a buy rating on China Gas with a price target of HKD15.40 a share and remains the brokers top pick in the gas sector.

Deutsche Bank analyst Hanyu Zhang, who has a buy rating on the stock, raised his earnings estimates for FY18/19 earnings by 10% and 8%, respectively, to reflect stronger volume growth and new connection assumptions and increased his target price to HKD15.80 a share.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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