China thermal power equities to grow in the next three years

Contrary to current depictions.

Slowing capacity additions, changing generation mix in favour of renewable power, and potential tariff cuts are the current major newsflow items related to the thermal power sector and do not appear to give positive outlook.

According to a research note from Barclays, however, it believes the thermal power equities in China under its coverage (CR Power, Huaneng,Datang, CPI and Huadian)are likely to deliver an altogether different story in the next three years.

It noted taht 2008 to 2012 was a period when the thermal power sector in China saw a sharp deterioration in financial performance while the coal sector reaped most of the benefits of stronger market dynamics.

Net profit margins for the thermal power sector averaged 2.3% in the period, while average ROEs were 4.1%. Meanwhile, the coal sector earned an ROE of 23.9%.

The government’s intended policy framework for the next phase of China economic growth has initiated a change of cycle for the coal-to-power sector.

Barclays believes the new growth dynamics and consequent policy direction will help the thermal power generation sector to recover its profitability and repair its balance sheet between 2013 and 2016E.

Here's more from Barclays:

Profitability in 2013 was the first full year of earnings recovery for the sector, and we see this continuing in the next three years, although we expect policy adjustments (both explicit and implicit) to prevent the earnings recovery from reaching supernormal levels.

The key summary of our positive base case view on thermal power sector equities is:

1) earnings should continue to recover on a y/y basis in 2014;

2) sustainability of earnings recovery should be established in 2015 and 2016, despite potential tariff cuts; and

3) strong free cash flow should help with deleveraging, thus leading the convergence of the sector from earnings growth to an EV rebalancing story.

In that context, we expect sector average earnings growth at c25% in 2014, while earnings should moderately decline in 2015 and 2016 by 5-10% due to our assumption for additional tariff cuts.

FCF for the sector should increase to RMB24bn in 2014, and then increase further in 2015 to RMB32.1bn annualised, implying an average FCF yield of 11.3%.

We factor in a potential tariff cut of RMBc3.5/kWh in 2015-16 for thermal power, while a QHD coal price over RMB500/t is used to arrive at a fuel cost in 2015 that is c5% higher than the current spot coal price.