One way to go on the defensive

There’s one industry that is a defensive investment in volatile markets: electricity. Huaneng Power (HNP or 902.HK) is the largest independent power producer (IPP) in China with a heavy presence along the wealthier eastern seaboard. The company just reported 2007 full year earnings of HK$6.8 billion, or EPS of HK$0.56 a share (for the Hong-Kong listed shares). That puts the shares at a P/E of about 10X, based on a recent share price of HK$5.84. More compelling is the company’s cash flow multiple. Depreciation for 2007 was roughly HK$0.60 a share. Add this back to earnings and the company is trading at a rough cash flow multiple, excluding new capital expenditures, of about 5X. A further plus is that the dividend yield is now running over 5%. For a rock-solid business like electricity generation, the shares don’t look expensive.

However, there are aspects of Huaneng Power that the market doesn’t like. For one, earnings were just about flat with 2006, so investors looking for growth are likely to steer clear. The company also just announced a large acquisition of power plant assets in Singapore and many find the price to be a bit high, especially since Huaneng Power is likely to take on more debt to finance the purchase. Finally, the biggest input for Huaneng’s power plants is coal. With commodity prices running high, it is likely that coal input prices are going to rise by a double-digit percentage in 2008, despite the fact that a lot of Huaneng’s coal supply is in long-term contracts. In theory, Huaneng Power should be able to recoup at least part of the cost of higher coal prices with higher electricity tariffs. However, China’s government remains concerned about the impact of inflation on its residents so it is not clear how much electricity prices will be allowed to adjust.

Despite all of the potential negatives, the risk/reward looks favorable for Huaneng Power, especially over the long run. It makes a product that will always be in demand. Higher construction costs for new plants are likely to mean the real value of the company’s assets are much higher than their accounting value. And, over the long run, the Chinese government should allow Huaneng Power to make adequate returns with fair electricity pricing. Over time, coal supply should increase and coal price rises should level off. If you believe that coal prices might even fall, then Huaneng Power would make even more sense as its margins could see a large expansion.