Utility/Renewable/Environmental:2018outlook and top picks

Less of a beneficiary of cyclical recovery but clean and green theme intact

    Except natural gas, our coverage universe has largely underperformed in 2017.Heading into 2018, we are generally positive on most subsectors: 1) wind -clear of green certificate overhang and with accelerated earnings growth;

    2) environmental - stronger enforcement and improving cashflows/earningsquality; 3) gas - continued strong volume growth; and 4) IPPs - earningsrecovery on tariff hike/coal price fall plus potential SOE reforms. Despite beingless geared to a cyclical recovery, we prefer wind and environmental as theirlong-term clean and green theme remains intact. Our top Buys includeLongyuan, Huadian Fuxin, CEI, ENN, CR Gas, CR Power and CPI.

    Wind: policy overhang to dissipate in 2018

    We believe the green certificate (GC) mechanism, a key overhang for thesector in 2017, could turn out better than expected when it is finalized in 2018.Stress-testing of GC’s NAV impact suggests current share prices have priced invery bearish scenarios, while we expect the sector to see accelerated earningsgrowth from continuing curtailment reduction and improving cashflow in 2018.

    Environmental: stronger enforcement with improving cashflow

    We expect this laggard sector to benefit from China strengtheningenvironmental enforcement during the last three years of Five-Year Planperiods (i.e. from 2018), especially as China plans to set up a "National NaturalResources and Ecology Administration" soon. We also see potential earningsbeats, rising proportions of earnings from operations and improving cashflowprofiles over the next few years.

    Gas: sector growth story sustainable

    Sustainable volume growth, manageable margin risks and improving free cashflows should support the gas sector’s growth story over 2018-19. We expectsustainable coal-to-gas momentum to support a 15% gas demand CAGR over2017-20. Gas sales margins, on the other hand, may decline over 2018-19E ata tolerable rate. We also see increasing visibility on rural coal-to-gasconversions, providing connection fee income upside for gas distributors.

    Thermal IPP: recovery on tariff hike and lower coal price

    We expect IPPs’ earnings to turn around in 2018-19, primarily on a tariff hike atyear-end and potentially lower coal prices. We expect IPPs’ ROE to recover toc.9% in 2018, making current valuations attractive (8x 2018E P/E and 0.75xP/B, 5-8% dividend yield). Meanwhile, the sector is one of the key potentialbeneficiaries of the SOE reform, with corporate restructurings likely.HK Utilities: sector fully valued amid rising yield environmentWe still think the sector is fully valued, with a rising outlook for the US treasuryyield and the stocks only offering a dividend yield ~1.5% above the US yield.Among the Hold-rated stocks, our relative preference is for CKI on earningspotentially benefiting from rising UK inflation and M&A.

    Valuation and risks

    We use DCF as the major valuation tool for utilities, given their visible cashflow profile, except for some multi-business players (for which we use SOTP).Industry risks include demand variance causing top-line volatility, changes ininput costs without a pass-through, interest rate hikes and policy risk.