Description

Kunlun Energy will pay a 34% dividend by the end of July 2021 funded by a major asset disposal. The remaining natural gas and LNG distribution business is trading at only 10x P/E with an unlevered balance sheet and double-digit growth. Comparable natural gas distribution companies in China trade at 13-17x P/E with levered balance sheets so this stock has plenty of room to re-rate.

Description

Kunlun Energy is a Hong Kong-listed, 57.6% owned subsidiary of state-owned PetroChina. Kunlun started out as an oil & gas exploration and development company, but in 2009 it began to diversify into natural gas and LNG businesses which now account for the majority of sales and profits.

Asset Disposal

In December 2020, Kunlun announced the sale of its 60% stake in the Shaanxi-Beijing pipeline and its 75% stake in the Dalian LNG terminal to its parent company, PetroChina for RMB 40.9b in cash ($6.3b). The disposal is part of PetroChina’s restructuring of its gas business, which will consolidate ownership of pipelines and midstream gas assets under PipeChina and make Kunlun the group’s main platform for expansion in downstream gas distribution. This disposal price values the assets at 1.9x P/B and 16.5x 2020 P/E, which seems very reasonable and is higher than sell side analysts were expecting. Although it was a related-party transaction, it does not appear that minority shareholders are being taken advantage of.

Kunlun management has confirmed that the company will pay out 50% of the net proceeds in the form of a special dividend, which equals RMB 2.1366 per share, on top of a regular dividend of RMB 0.2101 per share. This equates to approximately HK$2.80 per share which is a 34.2% dividend yield on the current share price. The ex-dividend date for both the special and regular dividend is May 31 and the pay date is July 30.

The other 50% of net proceeds will be used to acquire new city gas projects, invest in renewable power projects such as solar or wind, and pay down some existing debt.

Pro Forma Business post disposal

Natural Gas downstream distribution (FY20 pro forma 80% of sales and 61% of EBIT): Kunlun operates 414 city gas projects across 31 provinces in China with 12.35 million customers. FY20 natural gas sales volume grew +20.5% y/y via organic growth and newly acquired projects. Management expects volume growth of at least 15% in 2021. As a significant portion of the disposal proceeds are expected to be deployed into this business, higher growth might be possible in late 2021 and 2022 as capital is deployed.

LNG Processing Plants and Terminals (FY20 pro forma 6% of sales and 35% of EBIT): Overall profitability is strong for this division, but it is actually a combination of one profitable business (LNG terminals) and one loss-making business (LNG Processing Plants). Kunlun owns and operates two LNG terminals in Jingtang and Jiangsu with a total capacity of 13 million tonnes per year. These terminals operated at a 79% utilization rate and generate stable returns according to management. Kunlun also has 15 LNG processing plants which operated at a 44% utilization rate the past two years. The processing plants are loss making and structurally challenged due to cheap LNG imports compared to the relatively high cost of domestic gas. Management is implementing a cost reduction program and has stated that they may exit some of the plants if profitability cannot be achieved within two years.

LPG product sales (FY20 pro forma 13% of sales and 7% of EBIT): Kunlun sold 5.2 million tons of LPG in 2020, which was down 14% due to Covid. Two-thirds of sales are wholesale and one-third is retail.

E&P (FY20 pro forma 1% of sales and -3% of EBIT): Kunlun has oil & gas projects in China, Kazakhstan, Oman, Peru, Thailand, and Azerbaijan with a total crude production of 12.2 m barrels in 2020. This division swung to a small loss in 2020 due to low oil prices but profitability should improve this year. The E&P business is no longer a focus and it will gradually be exited as its existing E&P contracts expire in the coming years.

Valuation

Kunlun trades at a significant discount to Chinese gas distribution peers. As the majority of Kunlun’s profits will now come from city gas distribution, we think there is a compelling reason for the stock to rerate closer to peer multiples. This is especially true when considering that most peers have 1-2x net debt to EBITDA but Kunlun will be net cash post disposal. The valuation disparity of Kunlun at 7x EV/EBIT vs. peers at 11-13x is even more glaring.

Management’s plan to redeploy capital into the city gas business could drive faster earnings growth and gradually regear the balance sheet to a more appropriate level for this stable, cash generative business. Excluding any possible M&A, we estimate that the stock is trading at an 8% free cash flow yield post payment of the special dividend.

Risks

Regulatory: Gas distribution is a regulated industry in China and the government could reduce retail gas prices or connection fees for new customers. If this were to happen, Kunlun could face margin pressure.

M&A: Kulun has about RMB 20 billion to spend on acquisitions of city gas distribution assets and renewable power projects. The company might make bad acquisitions with low returns. Alternatively, Kunlun’s close relationship with Petrochina might give them better access to quality city gas assets relative to competitors.

SOE: Kunlun is a state-owned company so the government is inevitably involved in decision making and the management team should not be considered exceptional. However, the company is in the process of implementing a stock incentive program which might increase management’s focus on the stock price.

OFAC List: Trump signed an executive order in November 2020 which added a number of Chinese companies with alleged ties to the Chinese Military to the U.S. Treasury Department’s Office of Foreign Asset Control (OFAC) list. Kunlun Energy and Petrochina were not added to the OFAC list. However, it is conceivable that the Biden administration could expand the list and add Petrochina and its subsidiaries to the list if relations between the two countries deteriorates further. If this were to happen, U.S. investors or investment managers managing funds with underlying U.S. investors might be forced to quickly sell the stock. Index providers such as MSCI and FTSE might also delete the stock from indices, which could create further short-term technical selling by index tracking funds.

Catalyst

Payment of special dividend, increased awareness of undervaluation vs. peers, organic and inorganic growth of the core gas distribution business