Weekly A-Share Picks February 9, 2015 (Note: This is selected translation from the Chinese version of our A-share research notes) (1) Shenzhen Gas (601139.CH): Embracing the wind in gas industry (P.1) A-Share Market (2) Black Cattle Food (002387.CH): Breaking ceiling; fundamental bottoming (P.2) (3) Employee stock ownership is the breakthrough of mixed ownership reform (P.3) Shenzhen Gas (601139.CH): Embracing the wind in gas industry The company, based in Shenzhen, is a leading national player in the Chinese gas industry. Total assets of the company are over RMB12bn with revenue over RMB9.5bn. Through marketization, the company has successfully obtained franchise rights of pipeline natural gas projects in 20 cities in five provinces and two regions including Jiangxi, Anhui, Shandong, Jiangsu, Guangxi, Guangdong and Inner Mongolia. It now owns over 1.8m households of pipeline natural gas customers, covering over 10m people, with more than 7,500km pipelines. Pipeline gas as the lead and liquefied petroleum gas (LPG) wholesale and retail as two wings. Attaching great importance to expanding overseas gas source, the company has been actively managing gas source allocation. Its main gas sources are from Guangdong Dapeng LNG Company (from Australia) and the Second West-East Gas Pipeline from Turkmenistan. In addition, the company secures natural gas supply by purchasing liquefied natural gas (LNG) tank cars in China. By vigorously expanding natural gas power stations and industry and commerce customers, the company has realized the strategic transformation from an urban gas operator to an urban clean energy operator. Wong Chi Man Head of Research (852) 3698-6317 cmwong@chinastock.com.hk Great opportunities in the gas industry: Emergence of inflection point of natural gas prices. Since October 2014, international crude prices and LNG prices have dropped sharply, creating a rare favourable environment for China's natural gas price reform. Based on the "international crude+lng" price trend analysis, we forecast that in 1H15 the city-gate price of increment natural gas will be lowered, while that of stock gas will be raised slightly (lower than the previously expected rise) and the prices of the two gases will adopt a unified rate. If crude prices maintain between US$50-80/barrel, domestic city-gate prices of natural gas are expected to be lowered in general in 2H15. The fall in natural gas prices will stimulate end demand, thus improving the penetration rate of natural gas. Profitability improvement in gas distribution Gas distribution business encounters two great opportunities. First, with the release in demand, gas sales will increase. With the emergence of the price inflection point, natural gas demand will gradually release while business expansion of downstream distribution companies will accelerate. In particular, with the expected reduction of incremental gas price, expansion in new areas will accelerate. Second, with the cost improvement, the inflection point of stock gas business performance will emerge. City-gate prices of incremental and stock gas are expected to be unified in 1H15, but the stock gas price rise will be lower than market expectation. Gas companies will face less pressure in stock gas business. If crude prices maintain between US$50-80, city- 1
gate price of natural gas will be in a downward trend in 2H15, so gas distribution companies will see cost improvement and increased profitability. Inflection point of company performance will emerge. With the improvement on the upstream cost side and the expansion in downstream customers, the inflection point will emerge. Interest rate cut can improve company performance and valuation, while the catalyst is domestic natural gas price reform. We forecast that the company's EPS in 2014-16 will be RMB0.36, RMB0.42 and RMB0.55 respectively and the corresponding PER will be 27x, 24x and 18x. We give the company a "Recommend" rating. Black Cattle Food (002387.CH): Breaking ceiling; fundamental bottoming 1. Fundamentals showed signs of bottoming out and huge upside potential Traditional liquid and solid beverage business is backed by solid performance, creative premixed cocktail business provides re-rating potential, while O2O social networking platform provides room for imagination. Sales beat expectation just two months after the "new gift for lovers" mixed cocktail was launched, while sales of new product "No.33 Walnut Milk" beat expectation, and its rivals like Six Walnuts. Spring Festival demand has exceeded supply due to bottleneck in production capacity. Moreover, sales of its sour milk beverage are expected to double this year. Its liquid milk and soymilk powder also record stronger performance than its competitors as the company's market share significantly increased. It is expected to complete upstream and downstream M&A this year, which will fully support its whole industry chain. Investment opportunity in premixed cocktails is equivalent to that in the white spirit sector a decade ago. In the next five years the premixed cocktail market capacity will be about RMB40bn, up over 10 times than in 2014 and the company is the only cocktail play in the food and beverage sector. Sensitivity analysis shows that the company has great performance elasticity. When its revenue and gross profit margin are (RMB200m, 50%) and (RMB400m, 60%), the implied gross profits are RMB100m and RMB240m, about 40% and 100% that of the overall level of the company in 2013. Actual situation may exceed expectations. 2. The soymilk (powder) market ceiling is open, and strategy transformation is on the way Over 1,050 nationwide dealers, over 80,000 points of sales (POS) for solid beverage and over 100,000 POS for liquid beverage that the company has accumulated for years have begun to bear fruits since the company successfully completed a strategic adjustment of its production and marketing channel system. Through launching a new series such as "No.33 Walnut Milk", the company's traditional liquid and solid beverage product market ceiling has been opened for a huge sales potential in future. The company will continue to look for health products with high technological content and promising outlook in the health market. 3. CAGR 2013-16 as high as 169%, approaching turning point The company has adopted equity incentive scheme for its senior management. New president and concurrently vice chairman of board has become the second biggest shareholder through block trade with a lockup period of two years. We are optimistic about the improvement in the company value brought by the new management team (including original middle-level and senior management from Master Kong, Tsingtao Beer, Jianlibao Group, Yinlu and Bacchus), as well as the high upside potential of its premixed cocktail business and the diversification of its traditional business in future. The performance is about to rebound from the bottom and getting on a high-growth path. We are bullish about its Q1 performance. We forecast that its EPS in 2014-2016 will be RMB0.06, RMB0.40 and 2
RMB0.91 respectively (PER of 279x, 42x and 18x). We maintain our Recommend rating, as detailed in our in-depth reports Black Cattle Food (002387.CH): Focus on the No.1 Youth and Fashion Stock, Develop Great Health Drink Strategy released on 26 May and 5 September. Employee stock ownership is the breakthrough of mixed ownership reform Recently the Leading Group for Comprehensively Deepening Reform of the State-owned Assets Supervision and Administration Commission of the State Council (SASAC) held the 18th plenary session, at which the Suggestions on Carrying out Pilot Schemes of Employee Stock Ownership (the Suggestions ) were reviewed. The Suggestions, as one of the "N" supporting policies of the top level plan in state-owned assets reform in the "1+N" top level design plan, are expected to be launched together with the top level plan before the Lunar New Year after its suspension in central state-owned enterprises (SOEs) 11 years ago. In the last decade or so, even state-owned assets were in a relative controlling position, operation and management cadres in relevant SOEs were still assigned by the government department. Therefore, the SOEs management were not professional managers, but officials. This special model has its own advantages when enterprises are in market competition. In particular, after the financial crisis, it has directly led to the state advancement at the expense of private sector. But the fatal flaw of this model lies in expansion: because there is no separation from government functions to enterprise management, there is no risk control in the process of assets expansion, and officials attach great importance to their achievements without taking risks for failure. The goal of mixed ownership reform is to establish a general manager responsibility system led by the board of directors. That is also the corporate governance reform with Chinese characteristics. We have also introduced such thinking when designing board of directors and senior management shareholding plans for private enterprises, which has successfully solved the relationship issue between the founders of private enterprises and their professional managers, providing a system guarantee for the sustainable development. The thinking is similar to the "principal accountability system led by the Party" in universities. The "corporate governance structure reform" of Chinese SOEs is doomed to be a process full of twists and turns. In the last round of state-owned assets reform, most of the radical MBOs were thrown into jail. In the last decade or so, there have been unceasing disputes and doubts about senior management stock ownership. Today employee stock ownership plan has undoubtedly solved the systemic problem. The employee stock ownership plan can not only guarantee the core interests of senior management, but also fully motivate backbone cadres. The key lies in the unchanged controlling stake of original major shareholders. To state-owned assets, it will not shake up the controlling of state-owned assets; while to private enterprises, it will not shake up the equity holding position of their founders. We believe that in the process of the mixed ownership reform of state-owned assets, stock ownership plan design based on business strategy will decide if the reform is successful, and whether the new management and backbone employees will make positive contributions to corporate business strategy. The mixed ownership reform gives rise to corporate governance. The general manager responsibility system led by the board of directors is a necessary model of mixed ownership reform. 3
What stocks can we buy? First, pick sectors/companies which have largely rectified corruption problems, where mixed ownership reform can be implemented smoothly. Second, pick the sector and region with relatively good quality state-owned assets and less complicated equity relationships. 4
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Explanation on Equity Ratings BUY SELL HOLD : : share price will increase by >20% within 12 months in absolute terms share price will decrease by >20% within 12 months in absolute terms : no clear catalyst, and downgraded from BUY pending clearer signal to reinstate BUY or further downgrade to outright SELL Copyright Reserved No part of this material may be reproduced or redistributed without the prior written consent of China Galaxy International Securities (Hong Kong) Co., Limited. China Galaxy International Securities (Hong Kong) Co. Limited, CE No.AXM459 Room 3501-3507, 35/F, Cosco Tower, Grand Millennium Plaza, 183 Queen s Road Central, Sheung Wan, Hong Kong. General line: 3698-6888. 5