Analysis of Top 4 China Power Producers (Part 2)

The author published the analysis report here is for his own reference only. It is not an indication of the author's business interests for companies being analyzed. It is definitely not an investment advice, please see the full disclaimer located at the bottom of the blog post.
 
In part 1, I look into Revenue, Net Profit and Net Profit Margin (NPM) of the top 4 China Power Producers such as Huaneng Power International, Inc. (hereafter called "Huaneng"), China Resources Power Holdings Co. Ltd. (hereafter called "CR Power"), China Power International Dev. Ltd. (hereafter called "China Power") and Datang Inter. Power Generational Co Ltd (hereafter called "Datang"). This time I will look into following items:

1. Why Huaneng's net profit of 2010 minus approximately 50% compared with 2006?
2. Why power generation industry experienced minimal profit or massive loss in 2008?

Down of Huaneng's Net Profit
In 2010, Huaneng's net profit declined 50% even operating revenue growth more than 100% compared with 2006. It is great the sales was double compared to 5 years ago, but I don't think the reduction of profit to the half of 2006 is a decent return.

By look into tabular data above, operation cost advance 168.41% and revenue advance 135.47%, operation cost grow more than 32.94% compared to revenue in 5 years period. The grow of operation cost mainly constituted by advancement of fuel cost, 200.3% in that period. Operating profit margin further narrow when ratio of operating cost to revenue achieved record level in 2010, 91.6%. Obviously, unpleasant outcome of Huaneng's operating results in 2010 was very much due to fuel and coal price hike. The fuel cost matter is not so much different compared to year 2008 when the company's management reported RMB4,551.83 millions loss. I believe the #1 challenge to the management of the company in near-term is -- fuel cost control, since it is the main dragging factor of company's performance. In my humble opinion, fuel cost control is much more critical than growing revenue to the company at this point of time.

Minimal Profit or Massive Loss in 2008
The minimal profitability for CR Power and Datang or massive loss for Huaneng and China Power in 2008 was caused by following factors:

1. Natural disaster: rainstorms and snowstorms in southern China, the severe earthquake in Wenchuan on 12 May
2. Drop of power demand due to global financial crisis
3. Continuous rise of coal price to record level historically
   
4. Significant increase in finance costs due to six interest rate hike

All things being equal, natural disaster and drop of power demand are non-controllable and unpredictable items that each company has more or less equal probability in occurrence. But I don't think so for fuel cost and finance cost. These two type of costs is very much related to efficiency of cost control of the company's manager. I believe cost control is important component to profitability especially in capital-intensive industry such as power generation. Let's see whether is this cost control factor keep CR Power and Datang remain profitability in 2008.

Looking into tabular data above, it was no doubt that fuel cost constitutes to large portion of operating cost, averagely 52% to 64% of revenue for these 4 companies. The best company in term of fuel cost efficiency is China Power, it's Compounded Annual Growth Rate (hereafter called "CAGR") of fuel cost is 28.15%, grow slightly less 0.92% than revenue, 29.06%. Next, the remaining three power companies have huge space of improvement in term of fuel cost control as all of them grow fuel cost faster relative to revenue in CAGR measure such as 5.62% for CR Power, 7.76% for Huaneng, 9.42% for Datang.

By refer to the table above, all companies grow finance cost greater than operating profit measured by CAGR, it was clear that power generation is capital-intensive industry which using financial leverages is a norm. However, it is common practices, doesn't means it is good. I believe if businesses can generate equals amount of operating profit, using lesser or no financial leverages is better, paying less finance cost means gain more in net profit. In finance cost control aspect, the previous fuel cost control winner -- China Power is the poorest performer among 4 companies, it's CAGR of finance cost is 83.52%, grow more than double of operating profit, 34.58%, different 48.93% relatively. The best company in term of finance cost efficiency is CR Power, it's CAGR of finance cost is 47% and operating profit is 34.1%, different 12.9% relatively. The 12.9% relative result is the smallest among 4 companies indicates CR Power using the least financial leverages relative to it's operating result. The second position measured by least uses of leverages is Datang, it's relative result is 29.68%, still more than double of CR Power. I believe it is combination of finance cost efficiency and fuel cost efficiency made CR Power has much wider profit margin comparing to it's peers.

That's all for the analysis of these four power producers, next blog post is devoted to analysis on CR Power including it's competitive advantages.

Analysis of Top 4 China Power Producers (Part 1)

The author published the analysis report here is for his own reference only. It is not an indication of the author's business interests for companies being analyzed. It is definitely not an investment advice, please see the full disclaimer located at the bottom of the blog post.

The analysis is perform based on 5 years revenue and net profit data of 4 China Power Producers such as Huaneng Power International, Inc. (hereafter called "Huaneng"), China Resources Power Holdings Co. Ltd. (hereafter called "CR Power"), China Power International Dev. Ltd. (hereafter called "China Power") and Datang Inter. Power Generational Co Ltd (hereafter called "Datang").

Revenue

In 2006, it is very clear that Huaneng is the biggest power producer in the country, 52.69% of total revenue out of four companies concentrated to this single company. 5 years later, it's market coverage declined to 45.75% as it's Compound Annual Growth Rate (CAGR) only achieved 23.88%, lowest among the four companies. CR Power achieved highest and impressive CAGR of revenue 49.44%, it's market coverage improves from 11.58% in 2006 to 21.31% in 2010, close to double in 2006 to 2010 period.

Net Profit

In 2010, Huaneng performance was far from satisfaction (if not crying) as it only achieve plus 3,323 millions given the revenue of 104,318 millions compare to year 2007 with less than half of the revenue of 2010, 49,767 millions which gain close to double the net profit of 2010, 6,481 millions. It is worth detail investigation what happened to Huaneng in 2010. In 2006 to 2010, Huaneng achieve year-on-year negative growth in net profit except 2009. It is obvious that 2008 was a difficult year for the energy industry as all four companies had negative growth in net profit where CR Power and Datang remain profitable, Huaneng and China Power experienced massive loss.

Net Profit Margin (NPM)

By looking into the tabular data above, it is no doubt that CR Power poses certain competitive advantages over it's peers. From 2006 to 2010, it's enjoy very wide net profit margin compare to others, approximately double it's competitors averages.

What's Next...
I will look into following items:

1. Why Huaneng's net profit of 2010 minus approximately 50% compared with 2006?
2. Why energy industry experienced minimal profit or massive loss in 2008?
3. What is the competitive advantages of CR Power, is it durable?

I'd look to hear your comments as usual.

Edited on 22-Jun-2011: Correction of Huaneng's Net Profits, update related description, update Net Profit Margin (NPM) table.

Reading the Letter to Partners of Buffett Partnership 18 Jan 1965

In 1964, the overall result for the Buffett Partnership was plus 27.8% compared to an overall plus 18.7% for the Dow. The advantage of 9.1% on a partnership basis were the poorest since 1959.

Buffett's opinion for 2 largest open-end funds and 2 largest close-end investment companies underperform the Dow, an unmanaged index:

1. group decision - my perhaps jaundiced view is that it is close to impossible for outstanding investment management to come from a group of any size with all parties really participating in decisions;
2. a desire to conform to the policies and (to an extent) the portfolios of other large well-regarded organizations;
3. an institutional framework whereby average is "safe" and the personal rewards for independent action are in no way commensurate with the general risk attached to such action;
4. an adherence to certain diversification practices which are irrational; and finally and importantly
5. inertia.

Buffett's view of conservatism:
It is unquestionably true that the investment companies have their money more conventionally invested than we do. To many people conventionally is indistinguishable from conservatism. In my view, this represents erroneous thinking. Neither a conventional nor an unconventional approach, per se, is conservative. Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy. We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don't. A public opinion poll is no substitute for thought. When we really sit back with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action obvious. In that case - whether conventional or unconventional - whether others agree or disagree - we feel we are progressing in a conservative manner.

According to Buffett, to achieve an outstanding investment results, you need:

1. A long life, and
2. A high compound rate

Buffett's advice to newcomer of stock investment:
If a 20% or 30% drop in the market value of your equity holdings is going to produce emotional and financial distress, you should simply avoid common stock type investments.

Buffett's opinion on seeking third party for money management:
Any investment manager, whether operating as broker, investment counselor, trust department, investment company, etc., should be willing to state unequivocally what he is going to attempt to accomplish and how he proposes to measure the extent to which he gets the job done.

In "Our Method of Operations" section, Buffett added a new category known as "Generals - Relatively Undervalued", totally four categories. Below is the description of two categories of "Generals":

1. "Generals - Private Owner Basis" - a category of generally undervalued stocks, determined by quantitative standards, but with considerable attention also paid to the qualitative factor. There is often little or nothing to indicate immediate market improvement. The issues lack of glamour or market sponsorship. Their main qualification is a bargain price; that is, an overall valuation of the enterprise substantially below what careful analyzes indicates its value to a private owner to be. Many times in this category we have the desirable "two strings to our box" situation where we should either achieve appreciation of market prices from external factors or from the acquisition of controlling position in a business at a bargain price. While the former happens in the overwhelming majority of cases, the latter represents an insurance policy most investment operations don't have.
2. "Generals - Relatively Undervalued" - this category consists of securities selling at price relatively cheap compared to securities of the same general quality. We demand substantial discrepancies from current valuation standards, but (usually because of large size) do not feel value to a private owner to be a meaningful concept. We have recently begun to implement a technique which gives promise of very substantially reducing the risk from an overall change in valuation standards; e.g., we buy something at 12 times earnings when comparable or poorer quality companies sell at 20 times earnings, but then a major revaluation takes place so the latter only sell at 10 times.

Buffett's additional comments about "Controls": Controls in the buying stage move largely in sympathy with the Dow. In the later stages their behavior is geared more to that of workouts.

In my opinion, below is how the equity interests evolves over a period of time:

Generals - Relatively Undervalued (Minority Interest) -> Generals - Private Owner Basis (Largest Shareholder) -> Controls (Controlling Interest)

I'd love to hear your comments as usual.

Reading the Letter to Partners of Buffett Partnership 8 Jul 1964

During the first half of 1964, the Dow advanced from 762.95 to 831.5, plus 10.9% (including dividends received), where Buffett Partnership results will differ only insignificantly from those of the Dow.

Regarding relative result of investment performance, Buffett commented:
I would feel much better reporting to you that the Dow had broken even, and we had been plus 5% or better still, that the Dow had been minus 10%, and we had broken even.

For partnership's performance beating the Dow, Buffett commented:
I have always pointed out however, that gaining an edge on the Dow is more difficult for us in advancing markets than in static or declining ones.

For important of investment performance measurement and objective evaluation, Buffett said:
All investment managements (including self-management) should be subjected to objective tests, and that the standards should be selected a priori rather than conveniently chose retrospectively. We feel it is essential that investors and investment managements establish standards of performance and, regularly and objectively study their own results just as carefully as they study their investments.

Did you chosen a good yardstick to measure your own investment performance? Yes, I did.

Reading the Letter to Partners of Buffett Partnership 18 Jan 1964

In 1963, the Dow achieved plus 20.7% (including dividends received), where Buffett Partnership achieved plus 38.7%, different 18%, an extraordinary result.

As usual, Buffett compares performance of the partnership to the Dow and 2 largest open-end funds and 2 largest close-end investment companies. Buffett partnership achieved 22.3% Annual Compounded Rates where the Dow is 10% and the 4 investment companies under-perform the Dow in the period of 1957 to 1963.

In the "Our Method of Operation" section, Buffett further elaborates more about the partnership's three investment categories such as "Generals", "Workouts" and "Controls" which first mentioned in letter of 24 Jan 1962. In my opinion, this piece of information and it's examples in appendix section is an outstanding investment materials, I urge you to go through it (Buffett Partnership Letter on 18 Jan 1964) yourself again and again.

Establishing Investment Yardstick for US and Hong Kong Market

I am firm believer of active investing (a.k.a. active portfolio management). I believe intelligent investors able to beat the investment performance of market averages over long-term, albeit they are minority. This strong belief not an idea pop-up from my head while I wake up this morning, but instead it was based on facts.

Even an intelligent investor able to beat the investment performance of market averages over long-term, the rational question come to mind is "Am I the able intelligent investor?" So, I created the following 4 lean indexes based on open market price of 1 June 2011 to measure my investment performance of US and Hong Kong Market over any reasonable period of time (with such a period including both advancing and declining markets):

US Market
Dow Jones 15

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The initial investment capital of this index is US$100,000, which invested into top 15 US companies (top 15 index components of Dow Jones Industrial Average). It's weighting is equals to 73.91% of Dow Jones Industrial Average.  Please see the corresponding spreadsheet for detail of creation of this index.

Fortune 10

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The initial investment capital of this index is US$100,000, which invested into top 10 World's Most Admired Companies published by Fortune Magazine. The idea is originated from the book titled Getting Started in Value Investing, in page 62. Please see the corresponding spreadsheet for detail of creation of this index.


Hong Kong Market
Hang Seng HK 15

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The initial investment capital of this index is HK$1,300,000 (minimum amount), which invested into top 15 Hong Kong companies (top 15 index components of Hang Seng HK 35). It's weighting is equals to 77.58% of Hang Seng HK 35. Please see the corresponding spreadsheet for detail of creation of this index.

Hang Seng Mainland 12

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The initial investment capital of this index is HK$750,000 (minimum amount), which invested into top 12 China companies listed in Hong Kong Stock Exchange (top 12 index components of Hang Seng Mainland 25). It's weighting is equals to 80.71% of Hang Seng Mainland 25. Please see the corresponding spreadsheet for detail of creation of this index. 

Annual review will be performed in January for 4 lean indexes above. Components of Dow Jones 15, Hang Seng HK 15 and Hang Seng Mainland 12 will not change unless the stock removed from the corresponding index of stock exchange, when there is any changes to weighting of the lean index components, it will based on open market price of first market day of the year. Fortune 10 will be updated annually. If Fortune Magazine published the top 10 World's Most Admired Companies of the year after the annual review, the Fortune 10 will be updated whenever the news published.

Read till this far, you may curious "Why the author take the hassle of creating his own indexes instead of just use the general indexes defined by stock exchange for his investment performance yardstick?". The motivation is simple: If being prove that my investment performance cannot beat the market average over a reasonable period, I better as well re-allocate my investment capital to these lean indexes.

I'd love to hear you comments as usual.