Beijing Enterprises Can Unlock Value With More Consistency And Execution

| About: Beijing Enterprises (BJINY)
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Beijing Enterprises has underperformed due to concerns about significant tariff reductions in part of its gas distribution business and management's decision to make a large investment in Russian upstream oil/gas.

BEH's core gas distribution business is still capable of generating attractive growth, as air quality pushes more coal-to-gas substitution; operations in water and waste also serve China's long-term pollution goals.

Beijing Enterprises isn't an outstanding buy candidate today, though a less onerous final tariff revision, improved economic growth and renewed confidence in management's capital discipline could all be positive drivers.

Not all investors are comfortable with state-owned conglomerates like Beijing Enterprises Holdings (OTCPK:BJINY) (0392.HK) and that's okay. These companies can be opaque and complex, and managements will make capital allocation decisions that, at a minimum, aren't in the short-term best interests of shareholders. That said, Beijing Enterprises Holdings (or BEH) may be worth a closer look, as the company's foundation in gas distribution should offer ongoing growth and cash flow potential, while the water and waste businesses likewise can benefit from utility demand growth in China.

Built Around Gas

While the contributions do fluctuate from period to period, BEH is basically built around its gas distribution operations. BEH owns 100% of Beijing Gas, 23% of China Gas (OTCPK:CGHLY), and 40% of the PetroChina (NYSE:PTR) BJ Pipeline that provides Northern China with significant amounts of natural gas. Collectively, these operations contribute about 70% of reported revenue and around 80% of pre-tax profits.

Beijing Gas is a relatively straightforward gas distribution business in the Beijing municipality, but the business generates about half of its sales from the power generation market. That has allowed for significant growth in recent years, as Beijing has moved to replace coal-fired utility plants with gas-fired plants. While the pace of coal-to-gas utility switching is going to slow for Beijing Gas, new opportunities are emerging in heating/cooling and industrial customers as clear air laws are pushing a switch from coal-fired boilers to gas-fired boilers in the municipality.

China Gas is a different kind of company, as it is an inter-regional gas transport/distribution company with operations in 24 provinces. Nevertheless, the company's operations are more focused on the north and central parts of China and the company recently moved forward with a government-supported venture to expand access to natural gas in rural areas in China's north. This will largely be for household and small-scale commercial heating, but still represents over 46 million households (most of which use coal or other highly-polluting energy sources) and gives the company a first-mover advantage relative to likely future rivals like ENN Energy (OTCPK:XNGSY) and CR Gas (OTCPK:CGASY).

The third part of the business is the most controversial at present. BEH's 40% ownership of the BJ Pipeline (Shaanxi to Beijing) gives it a meaningful stake in a primary source of natural gas that can currently transport close to 40bcm of natural gas, with a fourth line (and another 25bcm in capacity) coming on later this year. Unfortunately, Chinese regulators are looking to meaningfully alter the tariff structure; proposing tariffs based on 8% returns on assets when the BJ Pipeline has been generating mid-teens returns. Not surprisingly, that proposal hit the shares of BEH hard, but there are still details left to resolve that could moderate the negative impact (like the potential for including storage facilities in the asset base).

The Other Ops - Some Good, One Bad

Beyond the gas operations, BEH also operates in the solid waste treatment space, with a 50% stake in Beijing Development (an operator of solid waste treatment and waste-to-energy facilities), a 100% stake in BEH Environment Tech (an operator of solid waste treatment facilities) and ownership of Energy from Waste GMBH (or EWW), a German business that the company bought in 2016. While the business has 18 waste-to-energy facilities in and around Germany (with a high teens market share), the more significant long-term upside here is in technology and know-how transfers that help BEH build up its Chinese waste-to-energy operations. The solid waste operations are on pace to contribute close to 10% of revenue and a high single-digit percentage of pre-tax profit.

BEH's involvement in water treatments comes through its 44% stake in Beijing Enterprises Water (OTC:BJWTY), a company that operates over 300 sewage treatment and water distribution plants throughout China and 40 more outside of China. Given the relevant accounting treatments, BEH's water investments don't factor into revenue, but they do contribute a little more than 20% of pre-tax profits.

Last and least is company's 46% stake in Yangjing Brewery (by way of an 80% stake in Yangjing Beer). The Chinese beer market is still surprisingly regional (establishing national brands has proven to be a long and difficult process), and though this company is the dominant beer brand in Beijing, it has only about 10% or so national share, trailing the likes of China Resources Beer Holdings (OTCPK:CRHKY) (with close to one-quarter share), Tsingtao (OTCPK:TSGTY), and Anheuser-Busch InBev (NYSE:BUD). I say "last and least" because the brewery business chips in about 20% of revenue, but a low single-digit percentage of pre-tax profits.

Challenges To Address, And Some Are Self-Inflicted

Those significant tariff reductions in the pipeline business will create a double-digit earnings headwind for BEH, unless the final proposals are significantly different. I personally believe that operators like BEH will be allowed to include a wider base of assets in the calculation, but it's still going to be a big headwind. Future volume growth can at least partially compensate - coal-to-gas is a significant volume-stimulating driver (for power gen, heating/cooling, and industrial use) and the adoption of more gas-powered vehicles will likewise stimulate more demand. They won't completely make up for the reduced tariff in volume, but I still believe double-digit FCF growth is possible even with the steep tariff cut.

A bigger concern for me was the company's announcement in late 2016 of a $1.1 billion investment in Verkhnechonskneftegaz (aka V-Gaz or "VERK") for a 20% stake. This company is a Rosneft (OTCPK:RNFTF) subsidiary with licenses to develop the Verkhnechonskoye field in eastern Siberia. BEH paid a pretty hefty premium for this minority stake and diversification upstream hasn't often gone well for utility-type companies. That said, it should help secure gas supplies through the East Siberia Pipeline to Beijing, and the gas will be meaningfully cheaper than that transported all the way from Central Asia. What's more, VERK is already producing oil and cash flow and appears to have clean financials; reducing the risk for BEH and suggesting a decent flow of dividends in the not too-distant future. While I can understand some of the logic of this deal (cheaper gas supplies), the market really didn't like the move and I can't claim that a minority interest in a Russian E&P is a good use of shareholder capital.

Another concern is the brewery business. Yanjing has been losing share for a few years now and I frankly don't think current management is up to the job. Among management's recent proposals for improving performance has been "easy open" packaging; seemingly ignoring the fact that the real problem is not that people find it hard to open a Yanjing, but that they don't want to drink it in the first place. A sale of this business would be a welcome move, and I think BEH would find many interested buyers despite the underperformance of the business in recent years.

The Opportunity

As China continues to grow and continues to take more serious measures against pollution, I believe BEH will see strong demand in its core markets. Gas demand should be supported throughout the next decade by ongoing coal-to-gas substitution, with increased demand for water and waste treatment also playing an important role in controlling/reducing/improving pollution within China.

I'm looking for mid-single-digit revenue growth, with high single-digit earnings growth on the back of ongoing growth in the gas business (even after the tariff cut) and expansion of the water and waste businesses (particularly energy-to-waste facilities). Future capital allocation decisions could certainly alter those expectations; I don't believe VERK will be a major value-creator, but I could be wrong and management could find more promising investment opportunities closer to its core competencies. A more favorable final tariff determination would also be a significant positive for the company.

The Bottom Line

Discounted back, the cash flows I model suggest that Beijing Enterprises is slightly undervalued today. Sentiment is still pretty sour on this name, though, so multiples could expand if and when management can reassure investors regarding the long-term plan. If readers are interested in the name, I'd suggest the Hong Kong-listed shares, as the U.S. ADRs don't offer an attractive level of liquidity.

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