Beijing Enterprises Holdings (北京控股) - Growth at A Reasonable Price

Summary

· Natural gas will grab an increasing share of China’s growing energy mix. Favorable government policy as well as coming supply glut will speed adoption. Chinese gas distributors will benefit and Beijing Enterprises Holdings Limited (BEHL) is well positioned to capture that trend.

· I expect 35-45% upside in 2 year time frame, likely more due to multiples expansion. Ultimately I hope to hold this over the next decade.

Introduction

Beijing Enterprises Holding Limited ("BEHL", 0392.HK) is a conglomerate with ~80% of its net profit coming from natural gas distribution and transmission. The other 20% of profit comes from a mix of water treatment, waste treatment, and beer businesses. The company has many opportunities to deploy cash into various projects and grow. 

Other than the beer business, the rest of BEHL fits neatly into an environmental theme. The integrated theme gives them synergy in acquiring new customers outside of Beijing, since decisions regarding natural gas, water, and waste treatments are often made through the same political relationships.

The Industry Opportunity

The growth runway for natural gas in China is long and strong. Natural gas contributed only 5% of China’s total energy use in 2012, but the government targets that number to be 10% by 2020 due to environmental reasons. In 2013 natural gas demand was 168 billion cubic meters (bcm), by 2020 the target is estimated to be 360 bcm. Even by CNPC’s lower estimate of 310 bcm, that is a strong 9% CAGR from 2013 levels.

A wave of gas supplies coming to China over the next decade will help demand growth by holding prices down. Over the next decade, China is expected to grow its unconventional production (shale, coal bed methane…etc). Meanwhile, global LNG supply (including American LNG) is set to increase, and China has pipeline deals with Central Asia suppliers as well as Russia. Taking these sources together, one broker project that total supply will reach 334 bcm by 2020, outpacing demand growth. This would in turn contain prices and speed up the adoption of natural gas.

Chinese gas distributors will be beneficiaries, as they benefit from higher volume while still taking a steady spread between city gate prices and end user prices.

In the intermediate term however, gas is facing some headwinds from the recent drop in oil prices. First, low oil prices have made natural gas less competitive versus alternatives such as LPG. Second is property exposure. For many Chinese distributors, “connection fees” contribute half of overall gross margins. These are one-off fees charged set up new customers. With China's slowing property market this revenue source will face some headwinds.

Why BEHL?

BEHL has the least exposure to these near term headwinds, yet will still benefit from long term industry upside. In terms of price competition with other substitutes, BEHL’s customer base is mostly power generation and heating, with very little industrial exposure which is arguably the most price sensitive. Demand is mostly mandated by the government as the city of Beijing actively shifts away from coal and toward natural gas. BEHL also has low exposure to property slow down. Natural gas use in Beijing is already highly penetrated, and it does not make money from connection revenues.

Management guidance is for gas volumes to increase by a cumulative 40-60% by 2016E (from 2014). This is mostly due to gas fired power plants coming online in 2015 and 2016. However, one reason BEHL is cheaper than its peers is the perception that it has limited growth prospects beyond 2016E, as natural gas is already > 70% penetrated in Beijing.

I would argue otherwise. BEHL has a long growth runway with a plethora of growth opportunities. Just to list a few:

• As the gas supplier of the country’s capital, BEHL is in a prime position to grow as China executes its strategic integration of Beijing, Tianjin, and Hebei (京津冀一體).
• Expansion into suburban areas around Beijing.
• BEHL owns over 20% of China Gas, which has gas operations all over China. This relationship provides BEHL further investment opportunities across the country. 
• Shaanxi-Beijing Pipeline 4 to come online over the next 2 years. Future gas imports from Russia could provide more growth opportunities in the midstream sector.
• LNG/CNG could take off in the longer term, especially a few years down the line when gas supplies flood the market.
• Water treatment and solid waste management are fast growing areas. For example, revenue at subsidiary BE Water grew 39% in 2014. 

Now, growth opportunities are good only if new investments can earn a return that exceeds cost of capital or some minimum hurdle. As a rough proxy, I looked at historical return on new invested capital (RONIC). I estimated historical RONIC to be about 7-8.5%. But much of capex and acquisitions were funded with cheap debt, so return on incremental equity is more like 9-11%. Given the stability and growth runway of this business, I consider that adequate.

Implied Valuation for the Core Gas Business

Typical of Asian companies, BEHL has a messy corporate structure with ownership of multiple listed subsidiaries. What I like to do is use market prices for the main publicly listed subsidiaries, and then back out the implied valuations for the rest of the business. 

Corporate structure and segment profit breakouts are shown below. 

There are two publicly traded subsidiaries that directly correspond to BEHL’s segment reporting. Beijing Enterprise Water Group Limited (371.HK), and Yanjing Brewery (000729.CH) maps to the water treatment segment and brewery segment, respectively. Using the public market value for those segments, we can back into the implied valuation for the gas and corporate segments (conservatively allocate all debt and corporate expenses to the remaining operations, which includes Beijing Gas, shares of PetroChina Beijing Pipelines, China Gas, and other listed but immaterial subs). 

As seen below, BEHL’s publicly traded water and brewery businesses alone worth $27 HKD per share. That implies ~34 HKD / share, or ~44bn market value for the core natural gas business and corporate. With ~3.7bn HKD of net income in 2014, the market is valuing the core natural gas business at 12x 2014 earnings.

Implied valuations for main segments (excluding water and beer segments)

Even If I were to be super conservatively and 1) subtract any suspected non-recurring items out of those earnings, 2) attribute all of them to gas & corporate, the implied valuation for the gas business would be ~15.5x 2014 earnings. 

Peers such as China Gas (which BEHL has a stake in), China Resources Gas, and TownGas trade at 15-20x consensus 2015E earnings and 13-16.5x 2016 earnings. Thus BEHL’s gas operation appears outright cheap.

Peer comparison of price/earning ratios 

Expected Returns and Holding Period

For me this one is more about controlling the downside and let the upside take care of itself. Aside from short term market technicals, the biggest risk is potential tariff cuts, particularly around pipelines. But overall downside is limited given high visibilities around volumes and gas distribution gross margins, as well as the low valuation multiple. 

Although the upside is not my focus, it’s worthwhile to do a quick back-of-the-envelope calculation using management guidance. Volume is expected to grow 26% and 16% in 2015E & 2016E, if it grows even 5% in 2017 then that’s 53% more volume from 2014 levels. Gross Margins will lower by RMB 0.02/cubic meter, an -8% drop. Take the higher volume with lower margin, 2017E net income would easily be 35%-45% higher from 2014 levels, even assuming no further margin gains from SG&A leverage (for reference, current street consensus expects 2017 EPS to be 50% higher from 2014 levels). This 35-45% is my expected return. Multiple expansion can provide further upside, given BEHL trades at 2016 forward P/E of ~11.5x, a big discount to peer average of 15x.

More importantly though, I’m trying to buy a company that, 10 years down the line, will most likely have higher per share earnings and cash flows. I believe BEHL’s stock offers that at a good price