Investment summary
We believe most of the bad news is already priced into IPP stocks.
Given increasing government concern about IPP earnings, which
affect their capacity expansion, we expect tariff hikes in 4Q08 (7%
versus consensus forecast of 4-5% increase in 4Q08-1Q09) after
inflation starts to ease. This should relieve margin pressure and
improve IPP earnings in 2009. We prefer CR Power and Datang as
their vertical integration into the coal business could alleviate the
impact of higher coal prices and substantially enhance earnings.

Value starting to emerge
We believe most of the bad news for independent power producer (IPP) stocks – the surge in coal costs
and the delay in tariff hikes – are already priced in as their share prices have dropped 34-59% from the
peak in October 2007. Although coal prices should stay high and put pressure on IPP margins, we believe
that downside for IPPs is limited, especially since most are trading well below the average of their
historical PER and PBV.
Margin pressure to recede after expected tariff hike in 4Q08
With the surge in coal prices and delay in tariff hikes, earnings for the China IPP industry dropped 71% in
January-February 2008. In our recent discussion with the National Development and Reform Commission
(NDRC), we note that keeping the CPI under control is a higher priority for the government, but there is
an urgent need to raise the IPPs’ tariff as the sharp earnings decline may affect their expansion plans,
which would eventually result in a nation-wide power shortage. We believe that inflation in China will
stay high in 1H08 but may drop in 3Q08 due to a higher base in 2H07 and a significant decline in food
prices. Therefore, we expect the tariff hike to take place in 4Q08. Since power grid companies are wholly
owned by the government, to minimize the impact on inflation, the government could delay passing on
the increase in the power grid company’s tariff to end-users until 2009.

We have factored in a 7% tariff hike for IPPs in 4Q08 (versus the consensus forecast of 4-5% increase in
4Q08-1Q09). Although IPPs are only allowed to pass on 70% of the coal price increase to power grid
companies, it could improve IPPs’ earnings significantly compared to 1H08. As we expect the domestic
coal price to stabilise in 2009 and the tariff hike for IPPs to have a full-year impact next year, IPP
operating margins should improve next year. We forecast earnings for the IPP sector will rebound 53% in
2009.

Vertical integration – the only way to maintain competitiveness
CR Power and Datang are the first China IPPs to invest substantially in the coal business. We believe this
move will not only help mitigate the risk of higher coal prices but also improve margin significantly. We
estimate that after the full commissioning of their coal mines in 2012-13, CR Power could save costs of
RMB5-7bn pa and Datang RMB8-11bn pa, resulting in a high operating margin of above 35% versus
11-13% for the peers. Compared to consensus, our 2010 earnings forecast for CR Power and Datang is
38% and 19% higher, respectively, since market estimates have not factored in this potential vertical
integration enhancement.
Following our company visits with Huaneng, Huadian and China Power, we note that their parent
companies also have investments in coal mines. Although they have not formulated plans to acquire these
assets from their parents, we believe they will do so in order to maintain their competitiveness in the
industry. The finalising of plans to expand could become a catalyst to their stocks.
How to play the sector? Buy the first movers in coal business
Within the sector, we prefer CR Power and Datang as they are the only IPPs with substantial vertical
integration plans for the coal business; we think their stocks do not yet reflect this potential. Once their
coal output becomes substantial, we expect the profit margin to expand significantly and drive earnings
(2009-11e EPS CAGR of 30-45% versus peers’ 2-8%). In all, we believe the higher premiums the stocks
are trading at to peers are justified (10.9-11.4x 2009e PER versus CR Power’s 14.6x and Datang’s 13.1x).
Our target prices of HKD29.03 and HKD9.22 for CR Power and Datang, respectively, suggest potential
upside of 51% and 86%. We initiate coverage of these stocks with Overweight (V) ratings. CR Power’s
reward/risk profile looks more attractive given its track record of maintaining high earnings growth, with
room to enhance this further, versus Datang’s EPS dilution from new share issuance.
For Huaneng, Huadian and China Power, we initiate with Neutral (V) ratings and respective target prices
of HKD7.06, HKD3.00 and HKD2.95, suggesting 20% potential upside. Given the high earnings
sensitivity of these stocks, we expect their share prices to be driven by news flow on a tariff hike and coal
prices in the near term.

Upside and downside risks
The key downside risks to the sector include: 1) further delay in tariff hikes if the government continues
to have concerns about high inflation, 2) slowdown in capacity expansion if the low profitability of IPPs
cannot be improved, 3) further surge in coal prices, and 4) more interest rate hikes.
Upside risks to the sector include: 1) an earlier-than-expected tariff hike if CPI falls faster than expected,
2) decline in coal prices after the easing of supply constraints, 3) more IPPs expanding into the coal
business, and 4) increase in plant utilisation for the HK-listed IPPs due to their lower coal consumption
rate.

目录

Valuation & risks 9
Reasonable risk adjusted reward 9
DCF-based valuation 9
HSBC versus consensus 10
Ratio-based valuation 10
Top picks: CR Power and Datang 12
Risks 13
Earnings growth outlook 14
Earnings to decline substantially in 2008 14
IPPs’ earnings should rebound in 2009 14
Capacity expansion to continue 15
Vertical expansion key to drive earnings in long term 16
Earnings sensitivity 16
Margin pressure to recede 18
Coal price increase to slow in 2009-10 18
Lowering coal consumption rate 18
Rise in unit fuel cost to ease in 2009 19
Tariff hike cannot be delayed 19

Vertical integration – the only
way to survive 22
The first movers – CR Power & Datang 22
Substantial cost savings 23
Trend for other IPPs to follow 24
Company highlights 25
CR Power 26
Datang Power 36
Huaneng Power 46
China Power International 55
Huadian Power 63
Appendices 73
Appendix 1: PE band charts 74
Appendix 2: PBV band charts 75
Appendix 3: Yield band charts 76
Appendix 4: Winner and loser 77
Disclosure appendix 79
Disclaimer 84