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Summary

  • Energy demand in China crashed when their export driven economy met the global financial crisis.
  • China’s growth path puts it on track to become the world’s largest economy by 2019.
  • Economic growth and a rising standard of living require electricity to sustain them.
  • Huaneng Power is priced as if it were an American company due to lowered expectations for China’s economy.
  • Rapidly growing private wealth and an emerging middle class will light up demand for electricity in the country.

The Creation Of The Opportunity

Just a few short years ago, the center of focus in the investing world was China. It seemed, everywhere you turned for any type of financial news, China was the main topic. Everyone agreed that you had to invest in China if you wanted to make real money and be considered a serious investor. Asset prices soared. Then came the global financial crisis and the world quickly discovered that an economy built on an export driven platform will fall hard when global demand collapses. Along with a serious slowdown in economic growth, asset prices in China fell sharply as well.

As most of us know, investors have a relatively short attention span when it comes to assets that are no longer the primary topic of discussion on CNBC. The global financial collapse absolutely devastated power demand in China and crushed the profitability of Huaneng Power Intl. (NYSE:HNP). Huaneng's earnings plummeted 81%, from $6.16 billion in 2007 to $1.18 billion in 2011, as the global economy sputtered along with weak demand for China's exports.

As energy demand softened and operating profits fell, the share price of the stock fell as well. From a high of $55.46 in September of 2007 the share price fell all the way to $15.67 in September of 2011. Since that time however, the share price has nearly tripled to the current level of $44.06.

Value Investing Does Not Always Mean Buying Near The Bottom

I am often asked by people how I know, as a value investor and contrarian, when a stock is at a bottom and it is time to buy. The simple answer is that I do not have any idea when a stock is at a bottom or near a top. I analyze value and sentiment and try to find businesses trading at attractive valuations based upon current conditions and with positive or improving sentiment. But, can a business selling within 20% of its 10-year high price actually offer a compelling value that would attract a value oriented contrarian? Yes, it can.

According to an April 30, 2014 Bloomberg article, China is expected to surpass the U.S. and become the world's largest economy before 2019. Despite the well-publicized problems they have had, they are a manufacturing powerhouse and manufacturing creates wealth through value-added processes. Wealth creates higher standards of living and higher standards of living tend to create more demand for electricity. If you want electricity in China or Singapore, it will likely originate form Huaneng Power. A business that provides a critical product or service to what will soon be the largest economy in the world certainly deserves, at the very least, serious consideration.

Now, what about the current price being so close to the price at which the stock was trading when it reached its high in 2007? In 2007, when the share price of Huaneng reached $55.46, the company reported net income of $6.16 billion. In 2013, the business reported net income of $10.43 billion, 72% higher than it was six years earlier and yet the share price today is approximately 20% below that previous high. Value investing is not about buying at a price that is lower today than it was before, it is about buying at a better price to value ratio than what was previously available and one that offers exceptional future value with a business that is sustainable over the long-term and one that would be difficult to replace.

How Large Is The Downside Risk In Huaneng Power?

All investors should give a high priority to the assessment of downside risk; but rarely do you find investors who scrutinize it with the fervor of value investors. Huaneng is the primary source of electricity for China and Singapore. The first question to ask is whether the company's product can be replaced or made obsolete in the foreseeable future? The answer is obviously a resounding "No". I can't even begin to conceive of what might one day replace our need for electricity so Huaneng is pretty safe in regard to the sustainable nature of its business and the need for its product.

Does it have a competitive advantage that is almost impervious to potential competitors? Yes, it owns the power plants that produce the electricity. These facilities take years to construct and are so costly as to make it prohibitive for anyone contemplating entry into this market. Without the existing revenue stream and distribution network, it is impossible to acquire the capital required to construct a new facility. This business is more insulated against potential competitors than just about any you could ever hope to find.

The primary production source of that electricity is coal fired generators. As coal has become more and more denigrated in the western world, the price has fallen to the point that it is the cheapest source of fuel available for power plants. It is also the cheapest and most convenient fuel to transport across an ocean. The fact that coal usage is being pushed to the back burner by American politicians and regulators simply means more and cheaper supplies of fuel for Huaneng.

While one can never truly know what emotional turns the market and its investors might take. This is a business with a serious level of protection against new competition and a product its customers absolutely must have.

What Will Drive The Price Higher?

As mentioned earlier in this article, the share price has almost tripled since September 2011 which is an incredible move higher for an electric company, even in China. However, the net income of the business has increased 10-fold during that same period as it skyrocketed from $1.18 billion in 2011 to 10.43 billion in 2013. This means that, even though the share price has already tripled, the stock is actually cheaper in relationship to its present value than it was at the actual bottom of its price range.

China has been out of favor for all sorts of reasons for the past few years but the growing wealth of the nation and its population is undeniable. The fact that energy consumption rates rise as wealth increases in a country is also undeniable.

Just as businesses can be priced well above fair value when they are popular, once they fall from favor, the share price can seriously lag fundamentals when conditions begin to improve, as it can take time for the market to notice the value. This is especially true if investors were badly burned in the shares previously. That appears to be the case with Huaneng.

Right now, the stock is trading at a very reasonable P/E of around 8.1 times 2014 projected earnings and has just announced an annual dividend of $2.44 that produces a yield of 4.97% based on the current share price. Furthermore, it is trading at a price to cash flow ratio of just under 5 and projected annual earnings growth of about 15% for the next 5 years.

All of the fundamentals are in place for a higher share price. At this point in the cycle, the fact that the earnings have been rising far faster than the share price is having the same effect as plugging up a water line, as the earnings continue to grow faster than the share price rises, the pressure continues to build. At some point in time, the market will notice the inequity of the relationship between the two and the share price will explode higher.

How Large Is The Opportunity?

As investors, we can never really know with any degree of certainty when the market will correct a disparity between price and value. As a value investor, all I need to know with certainty is that the disparity will be corrected at some point. The longer it takes, the more sudden and violent it is likely to be when it occurs. Value and contrarian investors are usually used to waiting and do not object given the magnitude of the eventual rewards.

How large will the opportunity with Huaneng Power be when the stock begins to move? That will depend upon how long it takes the market to discover the misalignment between the value and the price. What we can determine today is what amounts to a reasonable assessment of current fair value. If we can buy today at a substantial discount to the current fair value, all of the future growth of the business just becomes gravy for later.

Right now, Huaneng trades at a price to book value of 1.47 compared to the industry average of 1.75; this represents a 19% discount to the industry. On a price to cash flow basis, Huaneng trades at a multiple of 4.1 compared to the industry average of a 6.77 multiple. This is an astounding discount of 39% to the industry. As if these numbers are not enough proof as to the value offered by this opportunity, the current industry average P/E multiple at this time is 18.21 compared to Huaneng's 8.3.

So, we have the largest supplier of electricity in the country that is soon to become the world's largest economy trading at discounts to its industry averages that range from 19% in price to book value to 54.4% in terms of the P/E multiple.

I believe it is very reasonable, and most likely overly conservative, to value Huaneng at the industry average. Based on simply reaching a price to book valuation of 1.75, the current fair value of Huaneng would be $52.45/share and represent a 19% gain from the current price while exposing shareholder to all of the future growth for free.

If the shares are considered to be worth the industry average P/E multiple, the price would have to rise to $96.67/share for an increase of 119%. This might sound unlikely, but that would only be valuing this business at the industry average P/E which does not really seem unreasonable given the micro and macroeconomic factors involved.

Closing Thoughts And Actionable Conclusions

Regular readers of my analysis will already be aware of my fondness for suggesting multiple ways to open new positions in a stock that range from selling uncovered put options to selling covered calls. In the case on Huaneng, I was unable to come up with anything quite so variant and can only say this stock is a compelling opportunity that can be purchased today and handed down to your children on a very profitable basis. Buy these shares and stick them in your safety deposit box for the next 20 or 30 years.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in HNP over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Generate Electrifying Profits With Huaneng Power