Suchuang Gas launches IPO

City gas distributor hopes the prospect of tariff reform will propel IPO as sentiment towards the sector appears to be on the turn.

Suchuang Gas launches roadshows for a Hong Kong initial public offering on Friday, hoping to benefit from rumoured national tariff reforms that should tilt the pricing advantage back from oil to gas and re-energise the sector's stock market performance.

The Jiangsu-based city gas distributor is hoping to raise HK$416 million to HK$584 million ($53.6 million to $75.3 million) from the 200 million new share deal, which will have a 25% freefloat. The price range has been set at HK$2.08 to HK$2.92, which equates to a forward p/e range of 9.3 to 13 times earnings.

Syndicate analysts calculate that fair value for the company's market capitalisation spans a range of $230 million to $320 million, based on forecast 2015 net profit of Rmb143.6 million ($23 million). This equates to a p/e range of 10 to 15 times forward earnings and represents a 15% to 40% discount to the seven-year average forward trading level of the big four city gas distributors - China Gas, ENN Energy Holdings, China Resources Gas and Towngas China. 

Suchuang needs a big discount because it is small in scale. It is based in just one city, whereas China Gas has 184 city gas projects.

At the top end of the range, the valuation is in line with smaller city gas distributors such as Tian Lun and Zhongyu Gas, which are both trading in the 15 to 17 p/e range. 

Investors' main consideration will be whether the government reverses plans to implement gas tariff hikes now oil prices have fallen so far. If it does, the whole sector is likely to enjoy a positive re-rating.

City gas suppliers will see their input costs reduced, while the economics for end users will swing back firmly towards gas. 

Unintended consequences

Sentiment took a sharp turn south last summer after China's National Development Reform Commission (NDRC) announced a gas price hike of nearly 19%. The tariff increase was introduced to reduce the huge pricing advantage gas held over fuel oil but came just days before oil prices began their precipitous slide.

The government's intended pricing dynamics were, therefore, completely reversed as oil products became progressively cheaper. Retail prices for refinery products are adjusted every 10 days in China, whereas gas prices are only adjusted once a year enabling investors to arbitrage the difference between the two. 

In 2011, natural gas was being sold to end users at 50% to 60% discount to competing fuels. The government hoped to reduce this pricing advantage to about 15% through a series of tariff hikes in 2013, 2014 and 2015.

However, thanks to the oil price drop natural gas is now priced at a 14% to 20% premium to fuel oil, incentivising end users to switch to cheaper fossil fuels, never the government's intention given the pollution they cause. 

Unsurprisingly, the stock prices of city gas distributors led by China Gas and ENN Energy Holdings quickly sold off as investors realised revenue growth could be compromised. China's softening GDP growth also helped push the sector down, with natural gas consumption rising just 7.1% between January and October compared to 15.7% during 2013. 

China Gas consequently fell 30% between the end of June and the end of December, before recovering about 8% since then. The stock is currently trading at about 19 times forward earnings.

ENN Energy Holdings, meanwhile, slid 33% between mid-August and mid-February before jumping back up 3.11% during Thursday's trading. It is now trading at about 15 times forward earnings, the current sector average.

Signs that positive sentiment may be returning have been prompted by a number of analysts' reports. These suggest the NDRC will now implement a tariff cut of 5% to 20% rather than the proposed 15% hike, scheduled to take effect in the third quarter. 

Signs that a price cut may be in the offing have been further boosted by news that the Central Leading Group on Financial and Economic Affairs is proposing to unify gas prices in order to spur demand. 

However, the government is also under pressure from its three major oil majors, which are already suffering from the oil price decline and do not want their transmission business hit by cuts in prices they charge city distributors like Suchuang.  

Small but geographically well-positioned

Suchuang is based in the county-level city of Taicang under the jurisdiction of Suzhou, China's sixth richest city by GDP. The city, which is situated just north of Shanghai at the mouth of the Yangtze River, has a target of using 1.5 billion cubic metres of gas by 2020, implying a compound annual growth rate (CAGR) of 13%.

The company is 96% owned by the husband and wife team who founded it, while Shanghai-based private equity firm Prax Capital holds the remaining 4%. The sale of this strategic stake enabled the company to bring down its debt to equity ratio from 158% in 2013 to 13% in 2014. 

Suchuang has a 30-year operational lease, which expires in 2043 and a take-or-pay master agreement with its main supplier, Petrochina, which expires in 2023. For the past three years it has needed less than its contracted minimum of 240 million cubic metres of gas, but so far Petrochina has not enforced the obligation. 

In 2013, the company sold 186 million cubic metres of gas, of which 94.5% went to non-residential customers and enabled the company to achieve a net profit margin of 16.1%, higher than the 9.9% recorded by China Gas. 

During roadshows company officials are likely to argue the company has strong growth prospects given it only supplies 17% of the 1,913 industrial entities in its coverage area. Non-residential customers account for 74.7% of total gas sales. 

The company is also keen to scoop up smaller players in its area, which are not connected to Petrochina's pipeline. About 30% of IPO proceeds are being allocated for potential M&A.

The remaining proceeds are being used to fund the company's annual Rmb200 million capex plan. This includes acquiring three CNG and LNG re-fuelling stations from a related company owned by the owners' daughters and constructing nine combined CNG and LNG re-fuelling stations.

Company officials are likely to argue this will spur medium-term earnings growth given re-fuelling stations currently generate higher margins than end-users.  

BNP Paribas is sole sponsor for the IPO, with Haitong Securities and CIMB as joint bookrunners. Pricing is scheduled for March 4.

This article has been updated since first publication.

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