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XinAo Gas Holdings Limited (2688.HK) - Government policy bolsters growth

Friday, December 12, 2008

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XinAo Gas Holdings Limited(2688)

Recommendation on 12 December 2008
Recommendation	Buy
Price on Recommendation Date	$7.740
Target Price	$9.580

Weekly Special - 2333 Great Wall Motor

Summary

In the first half of 2008, XinAo Gas reported its revenue increased 53.2% to RMB3.53 billion from RMB2.31 billion over the same period last year. Net profit for the period increased 50.5% from RMB251 million to RMB378 million. Although gross profit margin dropped from 33.16% to 26.78%, net profit still kept soaring. The rise in net profit is mainly attributable to the successful cost control which leads to a drop in the proportion of administrative expense over revenue. Also, the company did not record any non recurring items in the first half of 2008. In the same period last year, fair value changes on derivative financial instruments and convertible bonds and impairment loss on goodwill were incurred.

Gas market benefited from the government policy

As the economy of China continues to grow, energy demand is the stable factor to ensure ongoing development of the economy. The PRC government now pays efforts on changing the fuel consumption into a more environmental-friendly way. The Eleventh Five-Year plan aims at reducing 20% of energy consumption per 10000 RMB GDP, and increasing the overall energy consumption of natural gas to 5.3%. According to CEIC, 3.5% of total energy consumption was natural gas in 2007. Also, the PRC government will devote more resources on the pipeline construction up to 50,000 km, from currently about 30,000 km.

Strong gas sales growth

In the first half of 2008, piped gas sales revenue reached RMB1.48 billion, indicating a 20.7% increase over the same period last year. At the same time, the sales volume of piped gas reached 1.10 billion cubic meters, representing a 21.8% increase. Since 2005, the CAGR of the sales volume of the gas is 31.1%.

Besides piped gas, the company also distributes bottled liquefied petroleum gas (LPG) and vehicle gas. The growth of bottled LPG is very strong, increased 468% over the same period last year. The company has adjusted its development strategy to boost the sales of LPG. The continuous expansion of LPG network further strengthens the customer base.

The decrease in proportion of gas connection indicates that the company now replies on the organic growth and has a more stable and long term revenue base.

New projects

The company has secured 5 new projects which were located in Zhejiang, Anhui, Henan and Fujian. The number of urban gas project increased to 71 till now. Projects secured this year were located in areas which the concentration of industrial and commercial users is higher. The orders are larger and the profit margins are larger than those of the residential users. This will support the growth of gas sale of the company in the future.

The company also invested in upstream operations. The project is in Inner Mongolia in the northern part of China. The company expects the project will be finished and the production will start next year, delivering 400,000 tons of dimethyl ether (DME), an alternative energy to replace LPG.

The Second West-to-East Pipeline and Sichuan-East Pipeline are now under construction. With the completion of these 2 major projects, the gas sources will be secured. With less transportation by truck, the company reduces the transportation cost, thus increasing the profitability.

Penetration rate

Currently the company has an overall penetration rate of 24.6%. According to its past experience, the penetration rate can reach to as high as 70%. So there is high potential to expand its business.

Peer comparison

Due to the continuing acquiring other companies to boost up its customer base, the debt ratio is a bit higher than its peers. However, we expect the company will enjoy its organic growth as new urban projects start near its existing projects. With the constant supply of gas source, from its investment in Inner Mongolia and future completion of the two major pipeline projects, will satisfy its customer base.

Risk factors

Decline in gas price significantly

Government policy

Economic slowdown in China which lowers the gas demand growth

Delay in any major projects

Valuation

Unlike China Gas, XinAo Gas is now enjoying the organic growth of the customer base. Also with the favorable government policies, the usage of natural gas will be greatly increased in the coming years. We expect the sales of gas will further increase as there are many ongoing projects, which some of them are close to its existing projects, thus lowering the cost.

We use DCF methodology to valuate XinAo Gas. Our WACC for XinAo Gas is 10.88%, assuming 3% terminal growth rate, 9.5% market risk premium, 1.65% risk free rate, 0.974 equity beta from Bloomberg, 8.5% cost of debt, 35% debt to equity ratio, implying our target price is HK$9.58. We affirm our Buy rating on XinAo Gas as there is 23.8% potential upside. The company will trade at 2009E PE of 12.13.

Company Description

XinAo Gas Holdings Limited is a clean energy distributor in China. The company is mainly engaged the clean energy distribution including the city pipeline natural gas, liquefied petroleum gas, vehicle refueling gas and dimethyl ether, the non-pipeline energy delivery, and other value added services on the basis of energy distribution.