Hong Kong Power Utilities
Sector
ASSUMING COVERAGE
Focus remains domestic
Aggregate Hong Kong power sector’s forward P/E premium/discount to market
0
20
40
60
80
100
120
140
160
Jan 88 Jan 90 Jan 92 Jan 94 Jan 96 Jan 98 Jan 00 Jan 02 Jan 04 Jan 06 Jan 08
-2x SD
-1x SD
+1x SD
+2x SD
Avg
Market already pricing in EPS benefit of sector
leveraging up HK$19-20bn for M&A at 15% ROE
(%)
Source: Company data, Credit Suisse estimates
■ The sector’s 33% outperformance over the market (12 months) was due
to mainly to: 1) defensive SOC (scheme of control) earnings, 2) low net
gearing and 3) stable Hong Kong dollar dividend (versus 2007).
■ The current forward P/E premium to the market (26% for CLP and 20%
for HKE) against historical average discounts of 4% and 20%,
respectively, has to be justified by expectations that their balance
sheet can be leveraged for earnings growth to narrow this premium.
■ That said, we highlight that: 1) the M&A related execution risks,
2) inherent earnings volatility and returns of overseas earnings and
3) share prices have discounted the earnings accretion on HK$19-
20 bn worth of M&A at a 15% ROE.
■ We believe HKE could benefit more if the full acquisition amount
(HK$20 bn) is realised, as it is a smaller entity. We do not doubt its
parent’s access to deals, but we believe caution (cash preservation)
within the group may prevail unless the acquisition is inexpensive.
CLP has stronger prospects for future SOC asset growth, while still
retaining the capacity for leverage.
■ Our new discounted cash flow (DCF) based target price for CLP is
HK$60.6 (HK$75 previously) (17% potential upside) and for HKE
HK$49.1 (HK$53 previously) (10%). The share of SOC enterprise value
in our DCF is 85% for CLP and 70% for HKE. Against market upside of
30%, we assume coverage of HKE with an UNDERPERFORM rating
(formerly Neutral) and of CLP with a NEUTRAL rating. As we prefer to
focus on domestic assets rather than M&A, we prefer CLP to HKE.

Focus remains domestic
Finalisation of the new scheme of control (SOC) terms provides earnings visibility and
enhances the sector’s hedge against the market. Furthermore, we believe leveraging undergeared
balance sheets for growth is an option. However, execution risk (on valuations and
target returns) is high and we believe share prices have discounted possible earnings
accretion. We prefer to focus on the visible domestic business versus M&A options and
prefer CLP to HKE. We discuss in Appendix IV the Australian carbon cost issue.
CLP has a stronger case for domestic SOC capex
Domestic SOC returns, driven by capex growth, are set for 2009-13E. Following the SOC
earnings decline in 2009 from lower SOC returns, we see an SOC earnings CAGR over
2009-13E of 4.2% for CLP and 0.1% for HKE. Beyond that, we believe CLP has a better
case for incremental capex growth. First, the reserve margin risk should fall to 14% by
2013 (from 32% in 2008) on 3% maximum demand growth (the CAGR for 2004-08 was
2.8%). Second, CLP is a direct beneficiary of the government’s domestic infrastructure
plans given its wider coverage area. Third, stricter environment targets point to upgrading
capex or new gas-fired gencos. Lastly, CLP has historically met (or surpassed) capex
guidance, while HKE has come in below. Cross-border power access plans are also a risk,
in our view. That said, we assume 18% and 14% respective capex falls for CLP and HKE
over 2014-19E.
We believe that having a positive development fund account (a deferred liability) provides
CLP with the incentive (given that interest is chargeable) to accept a lower tariff in the next
review. This is more acceptable to the public in a weak economy. HKE may have to ask
for a tariff increase in 2010, as it has a HK$1 bn fuel clause deficit (deferred receivable) on
its books. This should be settled eventually, but it is a drag on HKE’s cash flow.
Overseas M&A: unlikely to be any easier or cheaper
We expect a 2009-12E overseas earnings CAGR of 8.4% for CLP and 9.6% for HKE from
their existing assets. We estimate that raising gearing to 70% would provide incremental
capital of HK$20 bn for HKE and HK$19 bn for CLP; this would add HK$1.4/share for HKE
and HK$1.2/share for CLP if their 15% equity return target were met and would represent
44% of HKE’s and 33% of CLP’s 2010E earnings. HKE, as such, leads on this angle.
Despite CLP’s and HKE’s strong financial positions in a weak credit environment, deals
remain either competitive or fraught with uncertainty. Growth markets (like China and
India) have regulatory risks, and foreign technology or capital are not bargaining chips.
Returns sought are unlikely to be met, in our view. Stable and mature markets (Singapore,
Australia and the UK) are likely see lower returns (i.e., environmental costs) and still face
competitive bidders (e.g., Singapore). This compares to a pure SOC ROIC of 13-15%.
M&A fully discounted but not the execution
Our base-case DCF-based target price is HK$60.6 (17% potential upside) for CLP and
HK$49.1 (10%) for HKE. The DCF sensitivity to changes in SOC capex beyond 2013 is
limited compared with the weighted average cost of capital (WACC at 6.6%) (a 0.5%
change impacts our DCF by 10-12% for CLP and 7-9% for HKE). CLP and HKE trade at
26% and 20% premiums to the market (based on forward P/E). Adding the full EPS benefit
of the acquisition optionality (i.e., leverage to 70%) returns them to their long-term
historical discounts to the market (4% for CLP and 20% for HKE). Post-HKE’s China
acquisition, CLP is trading at a 5% premium to HKE (its historical average is 9%). The
share of SOC enterprise value in our DCF is 85% for CLP and 70% for HKE. We believe
the potential volatility of overseas earnings and execution risk suggests that the market
should (historically it did) continue to focus on the domestic assets. Against market upside
of 30%, we prefer CLP (NEUTRAL) to HKE (UNDERPERFORM).