Diversification to Weather Thermal Downturn; EW

We are EW on SHE because we see it as fairly valued amid flat growth and believe the challenges for coal-fired power capacity growth amid air pollution controls and lower coal consumption will have less of an effect on SHE than on peers because of its diverse segments and share of high-end business. 　　Competitive edge from technology innovation: SHE had a 60% new order market share in 1H13 in the air-coolant coal-fired power equipment market in China. It can tap the market in central and western China for such equipment as new coal-fired power plants move inland from coastal areas, and use air rather than water to cool, because of capacity restrictions under air pollution controls. SHE’s high market share and edge in the high-end market will limit the effect of lower revenue growth and gross margin contraction, in our view. 　　Low exposure to coal-fired business: SHE derived 30% of gross profit from thermal power in 1H13, against 51% at Dongfang Electric and 58% at Harbin Electric. We estimate this will decline to 26% in 2015, with more contribution from power transmission and distribution (T&D) and higher-margin industrial products. 　　Stock catalysts likely to emerge only in 2H14/2015: These could include: commissioning of the world’s first AP1000 nuclear power generation unit; China raising its nuclear power capacity target; acceleration of power demand growth; and SHE’s new product development. 　　Contrary to the market, we expect no growth in coal-fired power capacity in China despite the improvement in IPPs’ profitability since 2H12, as air pollution controls may limit new project approval. SHE is trading close to its trough valuation from 2008, while industry fundamentals may be worse, given low visibility on power demand and economic growth. We believe the current valuation at 10x 2014 P/E, on our estimates, is fair, given our estimates for low single-digit profit growth.