Huaneng Power: A Mixed View

Summary

  • Huaneng Power’s sales volume recovery in 1Q 2021 was encouraging, but this was partially offset by a slight decline in the company’s average on-grid settlement price during the same period.
  • Higher coal prices led to a lower gross profit margin for Huaneng Power in the most recent quarter, and this remains the key risk factor for the company’s near-term profitability.
  • A successful pivot towards renewables, in the long run, will help to re-rate Huaneng Power’s shares, but this is partly constrained by the company’s relatively high financial leverage.
  • Huaneng Power is currently valued by the market at 0.30 times trailing P/B and 5.5 times consensus forward FY 2022 P/E, and it offers a consensus forward FY 2022 dividend yield of 9.2%.

Elevator Pitch

I retain my Neutral rating for Huaneng Power International (NYSE:HNP) [902:HK], as I have a mixed view of the company’s fundamentals and future prospects.

Huaneng Power’s stock price has been relatively flattish, since I published an article on the company earlier on April 23, 2021. Huaneng Power last traded at $14.22 at the close of July 7, 2021, as compared to its share price of $14.33 as of April 22, 2021 prior to the publication on my prior update on the stock. Huaneng Power is currently valued by the market at 0.30 times trailing P/B and 5.5 times consensus forward FY 2022 P/E, and it offers a consensus forward FY 2022 dividend yield of 9.2%.

Huaneng Power’s sales volume recovery in 1Q 2021 was encouraging, but this was partially offset by a slight decline in the company’s average on-grid settlement price during the same period. Higher coal prices led to a lower gross profit margin for Huaneng Power in the most recent quarter, and this remains the key risk factor for the company’s near-term profitability.

A successful pivot towards renewables in the long run will help to re-rate Huaneng Power’s shares, but this is partly constrained by the company’s relatively high financial leverage. Considering the stock’s undemanding valuations, I continue to rate Huaneng Power’s shares as Neutral.

Volume Recovery Partly Offset By Lower Settlement Price

Huaneng Power’s 1Q 2021 revenue increased by +24% YoY and +5% QoQ to RMB49.9 billion, which was also +9% higher than its pre-pandemic 1Q 2019 sales of RMB45.7 billion. The strong top-line growth in the first quarter of fiscal 2021 was mainly driven by both a +30% rise in power sales volume to 105 billion kWh. This implies that power demand in China has largely recovered from COVID-19 headwinds that began in the first quarter of last year, where there were lockdowns in parts of China to contain the coronavirus pandemic.

But Huaneng Power’s sales growth in the most recent quarter would have been even higher, if not a -0.6% YoY decline in the company’s average on-grid settlement electricity price to RMB420 per MWh in 1Q 2021. In the company’s FY 2020 annual report, Huaneng Power had cautioned that “the proportion of the company’s market transaction electricity will continue to expand, and there is a downside risk in the settlement of electricity prices.” Indeed, Huaneng Power’s percentage of power sold in the spot market in terms of sales volume increased from 33% in 1Q 2020 to 57% in 1Q 2021. This explains why Huaneng Power’s average on-grid settlement electricity price decreased in 1Q 2021, as spot prices are typically lower than contractual or benchmark prices.

Based on S&P Capital IQ data, sell-side analysts see Huaneng Power delivering a more moderate +6% revenue growth for full-year FY 2021. This is understandable as 1Q 2020 was a low base for Chinese independent power producers or IPPs due to the pandemic outbreak, so Huaneng Power’s YoY top-line expansion will slow in the remaining quarters of 2021. Furthermore, with Huaneng Power already guiding for a higher proportion of power sold in the spot market this year, there might be downward pressure on its average on-grid settlement electricity price for the current full-year.

Coal Prices Are The Key Risk Factor For Company’s Near-Term Profitability

Huaneng Power’s core net income attributable to shareholders (excluding one-offs like asset disposals) expanded by +39% YoY from RMB2,056 million in 1Q 2020 to RMB2,864 million in 1Q 2021. The robust bottom-line growth for Huaneng Power in the prior quarter masks the -230 basis points contraction in gross profit margin for the company from 18.9% in 1Q 2020 to 16.6% in 1Q 2021.

Huaneng Power’s bottom line benefited from a -18% decrease in finance costs from RMB2,672 million in 1Q 2020 to RMB2,201 million in 1Q 2021, which helped to offset the negative impact of a lower gross profit margin. The company refinanced part of its borrowings with the issuance of new perpetual corporate bonds in 2020. It highlighted in its FY 2020 annual report that “any interests or dividends are discretionary. Interests or dividends on such instruments classified as equity (perpetual corporate bonds) are recognized as distributions within equity”, so that translated into lower finance costs for the company.

Apart from the lower average on-grid settlement electricity price on a YoY basis in 1Q 2021 as discussed earlier, higher coal prices were the key reason for Huaneng Power’s lower gross profit margin in the first quarter of the current year. The company’s fuel cost for its power plants in China on a per unit basis grew by +13% YoY to RMB236 per kWh, largely due to higher coal prices. It is clear that higher-than-expected coal prices pose the greatest risks to Huaneng Power’s earnings in the near term.

Given that it is challenging to predict commodity prices, including that of coal, there is significant uncertainty over Huaneng Power’s FY 2021 net income. Sell-side analysts are forecasting that Huaneng Power’s headline net profit and core adjusted net profit (excluding one-offs like asset disposals) to increase by +16% and +44%, respectively in FY 2021 based on S&P Capital IQ data, so there is room for earnings disappointments if coal prices turn out to be higher than expected.

On the positive side of things, the Chinese authorities are taking actions to cool coal prices in the country. China’s National Development and Reform Commission or NDRC has guided that “rising hydro and solar power output, together with higher coal production and imports, are expected to result in a ‘relatively large’ decline in China’s coal prices” in July 2021, according to a June 27, 2021 South China Morning Post news article. By sending a strong signal about increased coal supply, the Chinese regulators managed to drive a fall in coal futures in China at the end of June with their public statements.

Pivot Towards Renewables Is Key Re-Rating Catalyst In The Medium And Long Terms

China has set ambitious environmental targets, aiming to reach peak emissions in the next decade and be carbon-neutral by 2060. The current policy stance by China implies that Chinese coal-fired IPPs are trading at very low valuations (Huaneng Power’s valuations detailed in the next section), due to their relatively low exposure to alternative energy and renewables.

As of end-2020, renewable energy only accounted for approximately a fifth of Huaneng Power’s equity-based installed capacity of approximately 99GW. As part of the company’s pivot towards renewables in the medium to long term, Huaneng Power targets to allocate 56% and 18% of its planned capital expenditures in FY 2021 to new wind and solar power capacity additions, respectively.

However, do note that Huaneng Power’s gross debt-to-equity is relatively high at 186%, which means that it could require significant additional financing to execute on its long-term renewables targets.

Valuation And Risk Factors

Huaneng Power is valued by the market at 6.9 times consensus forward FY 2021 P/E and 5.5 times consensus forward FY 2022 P/E, according to the company’s stock price of $14.22 at the close of July 7, 2021. It also trades at a trailing P/B multiple of 0.30 times.

The market currently values the stock at levels significantly below its historical averages. Huaneng Power’s three- and five-year average consensus forward next twelve months’ P/E multiples were 9.0 times and 9.4 times, respectively; while its three- and five-year mean P/B ratios were 0.57 times and 0.69 times, respectively.

Although Huaneng Power looks cheap based on forward P/E and trailing P/B multiples, this is reasonable as the market is assigning a hefty valuation discount to Chinese IPPs with significant exposure to thermal or coal-fired power.

Huaneng Power also offers consensus forward FY 2021 and FY 2022 dividend yields of 6.3% and 9.2%, respectively.

I have sourced the forward-looking forecasts and valuation metrics used in the current article from S&P Capital IQ.

Huaneng Power’s key risks are a larger-than-expected decline in the company’s average on-grid settlement electricity price in the future, higher-than-expected coal prices going forward, and a longer-than-expected time taken for it to make a successful pivot towards renewables.

Author: The Value Pendulum, Seeking Alpha