Kunlun Energy：N： Strategic shift to gas is a long road; cut TP to HKD12.9

abcGlobal Research Kunlun’s strategic direction is clear, but the timing of growth kickers has slipped. The company has a three-pronged gas strategy to develop: pipelines; domestic liquefaction and distribution; and imported LNG regas terminals. It operates a 60:40 joint venture with Beijing Enterprises Holdings (BJE) (392 HK – CP HKD68.6; Neutral, TP HKD72) which holds the Shaanxi-Beijing pipeline assets. Kunlun now operates nine LNG liquefaction plants (all land-based units located in northeastern and central China) and 600 LNG fuelling stations, and plans to be a major LNG importer via its port terminals. Risks. Kunlun shares peaked in January 2013 after doubling over the previous 12 months. Over the next nine months, the shares fell 40% in a straight line, hurt by China’s gas pricing reform in July 2013 (which raised feedstock costs) and the oil and gas industry corruption scandals in China, along with Kunlun-specific governance concerns related to management changes. The company and its investors are now re-focusing on the longer-term corporate strategy and industry fundamentals. Management consistency remains a concern. Kunlun has lost two successive chairmen, both of whom were investigated by the government for disciplinary violations (Xinhua, 18 December 2013). Operations have not been materially affected, but the resignation of two successive chairmen in August and December 2013 impacted the shares. Management stability and corporate governance merit continued monitoring. Remain Neutral with new target price of HKD12.9 (previously HKD13.3). Our target price is derived via a sum-of-the-parts methodology. We use DCF to value Kunlun’s E&P business and apply a 16x PE (previously 18.3x) to 2014e gas segment earnings. Upside and downside risks to our investment case include policy changes on LNG vehicle adoption (which may be supportive or unsupportive); higher- or lower-than-expected oil prices; higher or lower pipeline and LNG terminal volumes than we are now forecasting; higher- or lower-than-expected source gas price increases, and corporate governance issues. Kunlun Energy(135 HK) N: Strategic shift to gas is a long road; cut TP to HKD12.9 Much work remains for Kunlun to implement PetroChina’s downstream gas strategy  Cut 2014e and 2015e earnings by 4% and 12%, respectively, to reflect new oil prices and gas transmission volume  Remain Neutral, cutting target price to HKD12.9 from HKD13.3 after rolling valuation, trimming segment multiples to reflect slower development of LNG plants and gas pipelines Natural Resources & Energy Oil & Gas Equity – China Company report Neutral Target price (HKD) 12.90 Share price (HKD) 11.90 Forecast dividend yield (%) 2.3 Potential return (%) 10.7 Note: Potential return equals the percentage difference between the current share price and the target price, plus the forecast dividend yield Dec 2013a 2014e 2015e HSBC EPS 0.85 1.00 1.02 HSBC PE 14.0 11.9 11.7 Performance 1M 3M 12M Absolute (%) -9.3 -8.3 -22.2 Relative^ (%) -6.7 -8.8 -17.6 9 May 2014 Thomas Hilboldt* Head of Oil, Gas and Petrochemical Research, Asia Pacific The Hongkong and Shanghai Banking Corporation Limited +852 2822 2922 thomaschilboldt@hsbc.com.hk Tingting Si* Analyst The Hongkong and Shanghai Banking Corporation Limited +852 2996 6590 tingtingsi@hsbc.com.hk View HSBC Global Research at: http://www.research.hsbc.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations Issuer of report: The Hongkong and Shanghai Banking Corporation Limited Disclaimer & Disclosures This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it ^Index Hang Seng IndexIndex level 21,746RIC 0135.HKBloomberg 135 HKSource: HSBC Enterprise value (HKDm) 137,253Free float (%) 100Market cap (USDm) 12,392Market cap (HKDm) 96,061Source: HSBC 2 Kunlun Energy (135 HK) Oil & Gas 9 May 2014 abc Valuation and earnings 4 Investment thesis 4 Valuation methodology and risks to our view 5 Kunlun share price performance 6 Earnings forecast revisions 7 2013 revenue and pricing 8 Company background 8 Kunlun segment financials 10 Corporate developments 11 Management changes and corporate governance 11 Business fundamentals 11 Asset injections 18 Asset injection not off the table; valuation discounts likely to narrow or disappear 18 Kunlun’s LNG terminals 20 Background 20 China LNG import volumes by source, 2011-13 22 China LNG import volumes by terminal, 2011-13 23 Disclo