NewOcean Energy (342.HK) Expansion Plans on Track

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1 Company Update Rating BUY Target price HK$1.63 Share price (4 Aug 2010) HK$1.35 Ticker HK NewOcean Share price vs HSI (HK$) (HK$m) Aug 09 Dec 09 Apr 10 Aug 10 Turnover Price HSI HSI 21, W high/low (HK$) 1.41/0.43 Shares in issue millions 1, Market cap HK$m 1, Sources: Bloomberg, CIRL Analyst: 信達國際研究部 Michael Yuk michael.yuk@cinda.com.hk research@cinda.com.hk (852) NewOcean Energy (342.HK) Expansion Plans on Track What s new? NewOcean has officially re-entered the bottled LPG market in Zhuhai, as well as penetrated the Macau LPG retail market after the commencement ceremony of its Zhuhai Terminal Filling Station and Hengqin Filling Station. We expect the new business will increase NewOcean s sales by 32,000tonnes (3% of FY09 sales) during its first full year of operation. We believe this small but significant milestone is evidence that NewOcean is able to successfully implement its expansion plans and raises the probability of success for completing the acquisition of Lianxin Energy ( 聯新能源 ), Guangzhou s largest Autogas supplier, by 4Q10. As a result of the significant progress that the company has made to achieve rapid volume growth through acquisition, we have increased our FY11E sales forecast to incorporate the accretive volume from Lianxin. Figure 1: Change in forecast HK$m FY11E (Old) FY11E (New) Sales volume ( 000 tonne) 1, ,528.8 Revenue 9, ,137.3 COGS (9,249.7) (10,469.0) Gross profit Gross margin % 6.0% 6.0% Operating profit Operating margin % 3.4% 3.4% PBT Tax (49.6) (60.6) Tax Rate % 25% 25% Net profit EPS HK Sources: CIRL Valuation Increasing our FY11E sales forecast has resulted in a 22% increase in our net income estimate. We have also conservatively added an additional 56m shares to our valuation model to take into account of the acquisition cost. Based on our revised EPS, the stock is currently trading at 9.0X FY11E earnings, which is below its mid-cycle valuation benchmark of 10.9X. We raise our target price to HK$1.63/share, inline with its historical benchmark and upgrade our recommendation from NEUTRAL to BUY. Page 1

2 Expansion projects reiterate NewOcean s competitive edge NewOcean has officially re-entered the bottled LPG market in Zhuhai as well as penetrated the Macau LPG retail market after the commencement ceremony of its Zhuhai Terminal Filling Station and Hengqin Filling Station. The Hengqin Filling Station will be mainly used to fill distributor-owned bottles of LPG used by retail customers, whereas the Zhuhai Filling Terminal will focus mainly on industrial customers near the Jiangmen area. Annual sales during the first year of operations are expected to reach over 90tonne/day. The next market that NewOcean will be targeting is the Hong Kong bottled LPG market, which is currently being dominated by 4 registered gas companies who are affiliates of Sinopec, ExxonMobil, Shell, and Caltex. NewOcean is currently setting up an LPG cylinder storage facility in Tuen Mun, which will act as a distribution centre for its bottled LPG. Once relevant governmental approval has been obtained, NewOcean is expected to import filled LPG cylinders from its Shenzhen filling station and store them in Tuen Mun for distribution into the Hong Kong market. Based on government statistics, Hong Kong consumed over 440,084tonnes of LPG in 2009, with 102,200tonnes or 280tonne/day being used for non-vehicle related use. We expect NewOcean will be able to undercut the selling price of its larger Hong Kong peers, who, being based in Hong Kong, are bogged down by higher operating costs. Initial sales volume during the first year is expected to reach 35tons/day. Figure 2: NewOcean s LPG cylinder expansion summary Location (Target market) Hengqin Filling Station (Zhuhai/ Macau) Zhuhai Terminal F/S (Zhuhai-Jiangmen Area) We are continually impressed by NewOcean s ability to leverage on its logistical and supply-chain prowess to increase its market share throughout the Pearl River Delta region. The company s track record shows that it currently enters one new city per year, while sales volume has persistently increased over the years. NewOcean s expansion into Zhuhai, Macau, and Hong Kong (expected to be completed by 4Q10) reiterates NewOcean s ability to succeed in an industry where others have found great difficulty. Xinao (2688.HK) and China Gas (384.HK) are well known players in the China s LPG market, each selling 357,000 and 944,000tonnes of LPG during their last financial period. Yet, Xinao recorded a segment loss of RMB54.6m and while China Gas posted an operating profit of HK$74.5m (after tax profit of HK$10m). This is due in part on their reliance on mainland refineries for LPG supplies as well as a higher proportion Shenzhen Filling Station (Hong Kong) Investment HK$ 3 million HK$ 20 million HK$60 million Target clients Residential Industrial Residential Market size 54tonne/day 150tonne/day 280tonne/day Initial sales target 18tonne/day 75tonne/day 30tonne/day Expected gross margins 13% 25% 42% Page 2

3 of retail sales. The combination of these two factors leads to thin margins and higher business volatility. Even foreign enterprises are unable to match NewOcean s effectiveness and have had to pull out of the Chinese LPG market. BP has been looking to dispose of its Zhuhai LPG terminal (which is located adjacent to NewOcean s terminal) whereas Townsgas (1083.HK) disposed of its LPG distribution business in NewOcean s success is due in part to the company s focus on industrial clients and re-exports to nearby areas, including Hong Kong. These two segments made up 88% of the company s sales volume in FY09. Margins are not as high as the retail market but have remained steady at around 3%pa. Furthermore NewOcean has able to completely pass-through rising costs to end users, which is often difficult to for retail sales that need at least 1 to 2 months for price adjustments to catch up with rising supply costs. Figure 3: Industrial and re-export sales sustain steady margins and buffers against volatilities 2011E 2010E % 20% 40% 60% 80% 100% Industrial & Re-export Retail Figure 4: NewOcean has outperformed its peers with continual volume growth and stable margins ('000 tons) New Ocean Energy (LHS) Xinao (LHS) China Gas NewOcean LPG %margin (RHS) Xinao LPG %margin (RHS) China Gas LPG %margin 5% 4% 3% 2% 1% 0% -1% -2% -3% Page 3

4 Lianxin Energy acquisition should be close to completion Two month s after NewOcean announced its intentions of acquiring Lianxin Energy ( 聯新能源 ) our channel checks indicate that the acquisition timeline is on schedule and the deal could be completed as early as September. Lianxin is Guangzhou s leading auto-lpg (Autogas) provider with an estimated 60% market share. It operates LPG gas-filling stations, which fuels Autogas taxis and buses in Guangzhou. The 17 LPG fueling stations that NewOcean would obtain after acquiring Lianxin are strategically located along bus routes, which ensure that these stations will be highly utilized. Guangzhou currently has one of the biggest autogas programs in China with 85% of the city s buses and taxis (approximately 6,500 buses and 16,000 taxis) running on Autogas. The goal is to completely convert all buses and taxis to run on LPG by the end of 2010, as well as introduce more Autogas vehicles in preparation for the Guangzhou Asian Games. With the average bus consuming 120liter/day of Autogas and the average taxi requiring 60liter/day, Autogas demand in Guangzhou will remain strong reaching 400,000tonnes in FY10. Lianxin reported sales of RMB1.27billion during 2009 selling an estimated 240,000tonnes of Autogas (in comparison Hong Kong consumed 337,884tonnes of Autogas in 2009, which emphasizes the significant volume growth that would be obtained through the Lianxin acquisition). Applying an average 5% industry net profit margin, it s estimated that Lianxin would have contributed over RMB63.5million to NewOcean s bottom line, based on 2009 volumes and revenue. Figure 5: Lianxin s Autogas filling stations are conveniently located near and even adjacent to bus depots Source: CIRL Page 4

5 Valuation As a result of the significant progress that the company has made to achieve rapid volume growth through acquisition, we have increased our FY11E sales forecast to incorporate the accretive volume from Lianxin Energy resulting in a 22% increase in our FY11E net income estimate. As stated in the company s circular, total consideration for the Lianxin acquisition is RMB60,000,000 (HK$68,400,000). Although, the company had over HK$194m in cash, as of the latest balance sheet date, we have conservatively assumed that the acquisition will be fully funded by additional shares priced at a 10% discount to yesterday s closing price of HK$1.35/share. Hence, an additional 56m shares has been incorporated into our valuation model. As a result of our assumptions, our FY11E EPS has been increased by 16% to HK$0.15/share. Based on our revised EPS, the stock is currently trading at 9.0X FY11E earnings, which is below its mid-cycle valuation benchmark of 10.9X. We raise our target price to HK$1.63/share, inline with its historical benchmark and upgrade our recommendation from NEUTRAL to BUY. Figure 6: Change in forecast HK$m FY11E (Old) FY11E (New) Sales volume ( 000 tonne) Revenue 9, ,137.3 COGS (9,249.7) (10,469.0) Gross profit Gross margin % 6.0% 6.0% Operating profit Operating margin % 3.4% 3.4% PBT Tax (49.6) (60.6) Tax Rate % 25% 25% Net profit EPS HK Source: CIRL Page 5

6 Figure 7: 12-month P/E band (X) M Rolling Forward PE Mean +1 Standard Deviation -1 Standard Deviation Source: CIRL Figure 8: Peer comparison Company Stock Code Share price (HK$) Market cap (HK$m) Gross margin Operating margin Net margin ROAA ROAE Xinao Gas Holdings 2688 HK , Towngas China Co 1083 HK , China Gas Holdings 384 HK , China Resource Gas Group HK , China Oil and Gas Group 603 HK , Average Hong Kong & China Gas 3 HK ,912 N/A NewOcean Energy Holdings 342 HK , Div.- payout ratio Div. yield FY1 P/E (X) FY2 P/E (X) FY2 EPS growth 2-yr forward EPS CAGR Company Free cash flow per share P/B (X) Xinao Gas Holdings (5.2) Towngas China Co China Gas Holdings (0.2) China Resource Gas Group China Oil and Gas Group N/A Average Hong Kong & China Gas NewOcean Energy Holdings (0.1) Source: CIRL Page 6

7 Risk Rising crude oil prices. A spike in crude oil prices poses a risk for NewOcean, since downstream price adjustments usually lag upstream price volatility. However, we have noted that LPG price, or more specifically Propane and Butane prices have not increased at the same pace as crude oil during In fact, although crude oil price for the year has increased 1%ytd, propane and butane prices and have actually declined 21%ytd and 18%ytd, respectively. This is mainly due to the large increases in gas supply from mega-gas projects in the Middle East like the Qatargas2 project. Since butane and propane are often expelled from a natural gas stream, increasing supplies of these two gases will be available over the next 2-3years. As a result, we believe that NewOcean will be insulated from dramatic price fluctuations related to crude oil price. Figure 9: Arab Gulf Propane & Butane Spot Price vs. Brent Crude Oil (USD/tonne) 900 (USD/bbl) Mar09 May09 09 Sep09 Nov09 10 Mar10 May Arab Gulf Propane (Spot) Arab Gulf Butane (Spot) Brent Crude Oil (Spot) - RHS Source: Bloomberg and CIRL High gearing. The company s net debt-to-equity is over 200%. However, this is because NewOcean borrows foreign currencies (mainly USD), while keeping the bulk of its RMB denominated cash in pledged deposits. The company s management believes that they can lock-in and capitalize on low-interest rate financing using this method. Based on the latest balance sheet, after incorporating pledged deposits into net debt, net gearing is approximately 48%. Low net margins. NewOcean s net margins have averaged 1.4% over the past years. However, we note that even under the worse conditions i.e. in FY08 when crude oil prices rose to over US$130/bbl, NewOcean still remained profitable. Possible new shares issuance. The company issued an additional 192.5m shares (approximately 20% of the previous share capital) at the end of FY09 to finance the expansion of its Zhuhai gas terminal. We have assumed that the company will need to raise RMB60,000,000 for the Lianxin acquisition via additional share placement. However, the actual amount of funds that the company may need to raise may exceed our forecast. Page 7

8 Figure 10: NewOcean Energy Holdings Profit and Loss Statement Year ending 31 Dec., HK$m FY06 FY07 FY08 FY09 FY10E FY11E CAGR Revenue 2, , , , , , COGS (2,261.6) (3,719.2) (5,931.2) (6,087.8) (8,041.3) (10,469.0) 41.2 Gross profit Operating expenses (75.3) (132.3) (202.8) (180.3) (233.4) (313.5) 30.5 Other operating income Operating profit Finance expenses (37.3) (53.7) (108.0) (47.8) (124.9) (131.4) 49.8 PBT Tax (0.2) (2.1) (1.2) (42.6) (40.0) (60.6) 84.7 Net profit EPS HK Figure 11: NewOcean Energy Holdings Profit and Loss Statement (Year on Year Growth) Year ending 31 Dec., % FY06 FY07 FY08 FY09 FY10E FY11E CAGR Revenue COGS Gross profit Operating expenses (11.1) Other operating income (60.1) (12.6) 21.5 (17.7) 20.2 Operating profit (7.2) (41.1) Finance expenses (55.8) PBT Tax (95.1) 1,076.0 (42.5) 3, Net profit EPS (7.4) Figure 12: NewOcean Energy Holdings Profit and Loss Statement (Common Size) Year ending 31 Dec., % FY06 FY07 FY08 FY09 FY10E FY11E Average Revenue COGS (94.8) (95.6) (96.3) (93.9) (94.2) (94.0) (95.2) Gross profit Operating expenses (3.2) (3.4) (3.3) (2.8) (2.7) (2.8) (3.2) Other operating income Operating profit Finance expenses (1.6) (1.4) (1.8) (0.7) (1.5) (1.2) (1.4) PBT Tax (0.0) (0.1) (0.0) (0.7) (0.5) (0.5) (0.2) Net profit Page 8

9 Figure 13: NewOcean Energy Holdings Balance Sheet As at 31 Dec., HK$m FY06 FY07 FY08 FY09 FY10E FY11E CAGR Cash and securities Accounts receivable , Inventory Other current assets , , , , Total current assets , , , , , Net fixed assets Other long-term assets Total assets 1, , , , , , Short-term debt , , , , , Accounts payable , , Other current liabilities Total current liabilities , , , , , Long-term debt N/A Other long-term liabilities Total liabilities 1, , , , , , Shareholders equity , , , Minorities (0.1) Total equity and liabilities 1, , , , , , Figure 14: NewOcean Energy Holdings Balance Sheet (Common Size) As at 31 Dec., % FY06 FY07 FY08 FY09 FY10E FY11E CAGR Total assets Cash and securities Accounts receivable Inventory Other current assets Total current assets Net fixed assets Other long-term assets Total assets Total equity and liabilities Short-term debt Accounts payable Other current liabilities Total current liabilities Long-term debt Other long-term liabilities Total liabilities Shareholders equity Minorities Total equity and liabilities Page 9

10 Figure 15: NewOcean Energy Holdings Key Ratios Year ending 31 Dec. FY06 FY07 FY08 FY09 FY10E FY11E CAGR Profitability ratios Gross margin % Operating margin % Net margin % ROAA % ROAE % Liquidity ratios Current assets / current liabilities X Liquid assets / current liabilities X Cash and securities / current assets % Cash flow from oper. / curr. liabilities % 27.1 (12.5) (8.2) (1.9) Other ratios Capex / sales % Capex / depreciation % 1, Operating expenses / sales % (3.2) (3.4) (3.3) (2.8) (2.7) (2.8) (3.2) Net debt (cash) / equity % Inventory / sales % Effective tax rate % Cash-conversion cycle days ROAA component analysis Revenue / average assets % COGS / average assets % (197.1) (196.7) (236.3) (175.8) (166.9) (190.0) (201.5) Gross profit / average assets % Operating expenses / average assets % (6.6) (7.0) (8.1) (5.2) (4.8) (5.7) (6.7) Other operating income/ average assets % Operating profit / average assets % Finance expenses / average assets % (3.2) (2.8) (4.3) (1.4) (2.6) (2.4) (2.9) PBT / average assets % Tax / average assets % (0.0) (0.1) (0.0) (1.2) (0.8) (1.1) (0.4) Net profit / average assets % ROAE component analysis Revenue / average equity % COGS / average equity % (539.8) (765.8) (955.5) (702.2) (679.3) (766.9) (740.8) Gross profit / average equity % Operating expenses / average equity % (18.0) (27.2) (32.7) (20.8) (19.7) (23.0) (24.7) Other operating income / average equity % Operating profit / average equity % Finance expenses / average equity % (8.9) (11.1) (17.4) (5.5) (10.7) (9.6) (10.7) PBT / average equity % Tax / average equity % (0.0) (0.4) (0.2) (4.9) (3.3) (4.4) (1.4) Net profit / average equity % Page 10

11 Rating Policy Rating Definition Buy Outperform HSI by 15% Stock Rating Neutral Between -15% ~ 15% of the HSI Sell Underperform HSI by -15% Accumulate Outperform HSI by 10% Sector Rating Neutral Between -10% ~ 10% of the HSI Reduce Underperform HSI by -10% Analysts List Castor Pang Research Director (852) castor.pang@cinda.com.hk Christina Ngai Research Analyst (852) christina.ngai@cinda.com.hk Michael Yuk Research Analyst (852) michael.yuk@cinda.com.hk Hayman Chiu Research Analyst (852) hayman.chiu@cinda.com.hk Lewis Pang Research Assistant (852) lewis.pang@cinda.com.hk Frankie Chan Research Assistant (852) frankie.chan@cinda.com.hk Barry Chan - (852) barry.chan@cinda.com.hk Analyst Certification I / We Michael Yuk hereby certify that all of the views expressed in this report accurately reflect my / our personal views about the subject company or companies and its or their securities. I / We also certify that no part of my / our compensation was / were, is / are or will be directly or indirectly, related to the specific recommendations or views expressed in this report / note. Disclaimer This report has been prepared by Cinda International Research Limited. Although the information and opinions contained in this report have been compiled or arrived at from sources believed to be reliable, Cinda International Research Limited cannot and does not warrant the accuracy or completeness of any such information and analysis. The report should not be regarded by recipients as a substitute for the exercise of their own judgment. Recipients should understand and comprehend the investment objectives and its related risks, and where necessary consult their own financial advisers prior to any investment decision. The report may contain some forward-looking estimates and forecasts derived from the assumptions of the future political and economic conditions with inherently unpredictable and mutable situation, so uncertainty may contain. Any opinions expressed in this report are subject to change without notice. The report is published solely for information purposes, it does not constitute any advertisement and should not be construed as an offer to buy or sell securities. Cinda International Research Limited will not accept any liability whatsoever for any direct or consequential loss arising from any use of the materials contained in this report. This document is for the use of intended recipients only, the whole or a part of this report should not be reproduced to others. Page 11