China Gas Holdings: Regulatory Overhang Removed, But Positives Priced In

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About: China Gas Holdings Limited (CGHOF)
by: The Value Pendulum
Summary

Regulatory overhang over connection fee review is removed, with The National Development and Reform Commission's recent announcement on July 3, 2019.

The push for rural coal-to-gas conversion and demand growth in Northeast China driven by new gas imports from Russia are key growth drivers.

My suggested entry price is HK$27.90, pegged to its 5-year mean forward P/E of 15 times.

Elevator Pitch

China Gas Holdings (OTCPK:CGHOF) (OTCPK:CGHLY) [384:HK], a Hong Kong listed Chinese gas distribution company, has seen its share price rally by over 5% on Thursday July 4, 2019, following an announcement by The National Development and Reform Commission regarding connection fee review, which removed a key regulatory overhang on the stock.

China Gas has been the front runner among its peers in expanding its gas distribution business to the rural areas of China to build a meaningful customer base of 7 million households, which positions itself for future growth driven by rural coal-to-gas conversion. Furthermore, new upcoming gas supply from Russia in 2020 should be positive in alleviating the natural gas supply constraints and driving future demand in the Northeast region of China, where China Gas is the market leader.

Notwithstanding the positives mentioned above, China Gas's current valuation at 17.0 times forward P/E does not imply a wide margin of safety, which suggests waiting for a better entry price. China Gas also outperformed the Hang Seng index by 175 basis points year to date, as investors switched to more defensive sectors and stocks like gas utilities. I suggest an entry price of HK$27.90 for China Gas, pegged to its 5-year mean forward P/E of 15 times, versus its closing share price of HK$31.55 as of July 5, 2019.

Company Description

China Gas Holdings is a Hong Kong-listed Chinese gas distribution company, which builds and operates gas pipeline networks and distributes natural gas and liquefied petroleum gas to end users in China. The company generated 45.6%, 18.8%, 26.8%, 6.6%, and 2.2% of its FY2019 (YE March) revenue from natural gas sales, connection fees, liquefied petroleum gas sales, value-added services, and construction design & services, respectively.

Regulatory Overhang On Connection Fee Removed

The National Development and Reform Commission, or NDRC, released an announcement regarding its review of connection fees on July 3, 2019. In the policy document published by NDRC, the urban/city gas connection fee, the fee charged for covering gas equipment expenditure within building boundaries, will be determined by the local governments and capped on a cost-plus basis i.e. 10% on top of the cost of connection.

China Gas's share price rallied 5.5% on July 4, 2019, to HK$31.35 at market close, versus the July 3, 2019, share price of HK$29.70. China Gas's share price rose another 0.6% to close at HK$31.55 on July 5, 2019.

The market views the NDRC announcement positively for two key reasons.

Firstly, the NDRC announcement on the connection fee review is in line with market expectations.

China Gas's current connection margin is over 30%, but the decline in connection fees for gas distribution companies has already been priced in previously. Gas distribution companies have been guiding the same to investors, so there are no negative surprises for investors. At the FY2019 (YE March) results briefing on June 22, 2019, China Gas management already mentioned that "We can see in the future, the profit margin in connection fees will further go down."

The current cost-plus connection fee structure is also better than market fears of a complete cancellation of the gas connection fee in late-2018, when the Chongqing local government proposed to cancel the initial installation fee in October 2018. Although the initial installation fee (cost for connecting the area outside building boundaries to the main gas pipelines) is different from the connection fee (defined above and was not proposed to be cancelled by the Chongqing government), the Chongqing local government announcement sparked fears of a complete removal of the gas connection fee nationwide.

The July 3, 2019, NDRC announcement removes the regulatory overhang on connection fee review, and China Gas's share price has reacted positively as a result.

Secondly, local governments are given the authority to determine both the connection cost and connection fee cap. This gives gas distribution companies such as China Gas the leeway to negotiate with the local governments to possibly strike win-win deals. It is common for gas distribution companies to have joint ventures with local governments to promote local gas usage. More importantly, local governments have not reduced connection fees historically.

China Gas management expressed similar views at the recent FY2019 results briefing on June 22, 2019, prior to the July 3, 2019 NDRC announcement (my emphasis):

On top of that, we may look at connection fees. They are rather stable in both cities and countryside. As for city projects, it's 205 - it's 2,508; as for township projects, 3,010, but they are in line with our range in the guidelines. I believe in 2018, 2019 fiscal year, connection fees have attracted a lot of attention. This is the first time for us to report the number in Chongqing, and the figure is 3,000. Guangxi has remained the level of 2018, while Yunnan sees 10% increase of cost. In Guizhou, it's 100 - RMB 800 in Guiyang; but in Shaanxi, RMB 3,000 is too high, so we need to monitor the risk and costs. There is no province which sees price decrease...Secondly, our central government will not take a one size fit all approach, it's not the policy of NDRC. Rather than that, different provinces will adopt different prices, and this will be the new normal in the future which is also line with our expectation. The average connection fee is RMB 2,500, which is in the lower range.

Notably, China Gas's connection fee of RMB 2,500 per household is the lowest among listed companies. Peers China Resources Gas (OTCPK:CGASY) (OTC:CRGGF) [1193:HK], China Tian Lun Gas [1600:HK], ENN Energy (OTCPK:XNGSF) (OTCPK:XNGSY) [2688:HK] and Towngas China (OTCPK:TGASF) (OTC:TGASY) [1083:HK] charge relatively higher average connection fees of RMB 2,892, RMB 2,958, RMB 2,598, and RMB 3,900, respectively. This could be a positive factor for China Gas, as it bargains with local governments on the determination of the connection cost and the connection fee cap. NDRC's latest announcement has highlighted that the gas connection fee should be lowered if the current fee level is too high.

Another potential positive for China Gas is that larger and listed gas distribution companies could potentially consolidate the market through acquisitions, as private sub-scale gas distribution companies which charge higher connection fees and still earn lower margins (due to lack of scale and high fixed costs) go out of business due to the decline in connection fees.

With the regulatory overhang over the connection fee removed, investors can focus on the fundamentals and investment merits of China Gas.

Rural Residential Coal-To-Gas Conversion Driving Growth In New Connections

China's push for rural residential coal-to-gas conversion to combat air pollution in the country is a significant growth driver for China Gas.

In October 2018, an additional 1.18 million households in 11 cities in Fenwei Plain (Shanxi, Shaanxi and Henan provinces) switched from coal to natural gas for heating, as part of the Chinese central government's financial subsidy plan for coal-to-gas consumption. This follows on from the inaugural "2+26" clean winter heating plan, which provided government subsidies amounting to RMB 15.8 billion for 4 million households in 28 cities in Beijing, Tianjin and Hebei to convert from coal to natural gas plan for heating between 2017 and 2019. Shanxi and Shaanxi are the country's two largest provinces producing coal; and Linfen in Shanxi was the worst Chinese city with respect to air quality for 1Q19, according to a survey of 168 cities by the environment ministry.

In the past year or so, China Gas has been aggressively extending the reach of the company's natural gas distribution business into rural areas to benefit from China's push for rural coal-to-gas conversion.

As of end-FY2019, China Gas has secured a total of 542 piped gas projects with concession rights, which includes 365 city piped gas projects and 177 township coal-to-gas conversion projects with over 7 million rural residential households of which 3.54 million households for which the connection works have been completed by March 2019. For FY2019, China Gas completed new connections for 5.1 million households versus company guidance of 4.7 million, representing a 30.1% increase. In terms of residential customer break-down, rural coal-to-gas projects were the main driver, growing 108.1% from 1.1 million connections in FY2018 to 2.4 million in FY2019, which exceeded the company's expectations by over 20%. In contrast, the number of new connections for city households declined marginally by 2.2% YoY to 2.7 million for FY2019.

One key concern regarding China Gas's plans to drive growth from rural coal-to-gas projects is delayed subsidy payments relating to coal-to-gas conversion by the government which could hurt China Gas's cash flows. This is not a problem specific to China Gas or gas distribution companies, but a common issue for companies which do business with the state. A China Daily news article titled "Private firms get postponed payments" published on February 26, 2019, quoted Xin Guobin, vice-minister of industry and information technology saying that "Delayed payments by governments or SOEs (state owned enterprises) to private, small enterprises had negative impacts on cash flows and operations." But things are changing for the better. In March 2019, Chinese Premier Li Keqiang delivered the government work report at the second session of the 13th National People's Congress of the People's Republic of China and commented directly on this issue:

The government must set an example in acting in good faith and honoring contracts; new officials must not be allowed to get away with ignoring obligations undertaken by predecessors. Over 50 percent of overdue payments to enterprises must be made by the end of the year, and new arrears are impermissible.

This should alleviate any issues or concerns relating to delayed subsidy payments for China Gas.

Annual new connections are an indicator of the company's organic growth. In other words, coal-to-gas conversion projects are driving the growth in new connections, while the growth for city gas projects is more muted. Going forward, China Gas is guiding for annual new residential connections/households of 5.5 million and 6.3 million in FY2020 and FY2021, respectively. It also expects a minimum 25% per annum growth in gas volume for city and township projects combined both for FY2020 and FY2021.

The annual 25% gas sales volume growth target for the next two years will be driven by rural coal-to-gas conversion projects and also demand growth in Northeast China, which I elaborate on in the next section.

Northeast China Gas Market To Benefit From New Russia Supply

In May 2014, the China National Petroleum Corporation and Gazprom (OTCPK:OGZPY) (OTCQX:GZPFY) signed a $400 billion 30-year gas supply contract with a capacity of 38 billion cu m/year, equivalent to one-seventh of China's total gas consumption in 2018. Construction of the middle section of the China-Russia natural gas pipeline starting at Northeast China's Jilin Province and ending in North China's Hebei Province, commenced construction on July 4, 2019, and is expected to ease natural gas shortages in Northeast China.

The new natural gas import from Russia starting 2020 is significant for the Northeast China region, because Northeast China's historical gas demand has been hurt by a shortage of gas supply despite having a longer winter period. This is primarily because Northeast China is the only region in China where there is no natural gas trunk pipeline servicing the area. Northeast China currently imports only a very limited quantity of natural gas from Qatar and relies largely on the Heilongjiang province's gas fields to meet demand.

At the post-FY2019 results analyst briefing, China Gas communicated to analysts that it expects total gas sales (including both China Gas and its competitors) in the three Northeast China provinces to grow from 3.7 billion cu m in 2018 to 20 billion cu m and over 30 billion cu m by 2025 and 2030, respectively, with the China-Russia Eastern Route pipeline starting operations in December 2019. China Gas Holdings is dominant in the Northeast China region and expects to grab at least half the market share of the gas market in Northeast China.

Valuation

China Gas Holdings trades at 19.6 times FY2019 historical P/E and 17.0 times consensus FY2020 forward P/E based on its share price of HK$31.55 as of July 5, 2019. China Gas is currently trading close to its 17.5 times forward P/E level, representing one positive standard deviation from its historical mean of 15 times, suggesting that most of the positives mentioned have been priced in.

With respect to relative share price performance, China Gas is up 13.08% year to date, outperforming the benchmark Hang Seng index by 175 basis points over the same period. This is also partially due to the fact that investors have rotated from cyclicals to defensive utilities such as China Gas in a volatile, uncertain market environment.

In terms of peer valuation, China Gas trades at parity with China Resources Gas and ENN Energy valued at 16-17 times forward P/E, but at a premium to China Tian Lun Gas and Towngas China, which are trading at 11.0 times and 9.5 times forward P/E, respectively. The disparity in valuations between the two groups of China gas companies is largely due to market capitalization and scale, China Tian Lun Gas and Towngas China have market capitalizations of below $2 billion, while China Gas, China Resources Gas and ENN Energy have a market capitalization in excess of $10 billion. China Gas is valued by the market at valuation multiples in line with its large-cap peers China Resources Gas and ENN Energy.

My recommended entry price of HK$27.90 for China Gas is pegged to its 5-year mean forward P/E of 15 times.

Variant View

The key risk factors for China Gas Holdings include a reduction in or eventual cancellation of subsidies relating to rural coal-to-gas conversion policy over time and poor-than-expected GDP growth for China leading to slower overall gas demand growth.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.