Chinese Energy Firm Poised to Gain 30%

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Huaneng Power International Inc.
Moat: Narrow | Risk: Above Average | Price/Fair Value Ratio*: 0.57 | Three-Year Expected Annual Return*: 33.9%

What It Does: Huaneng Power International  develops, constructs, operates, and manages power plants in China, with generation capacity of more than 28,000 megawatts on an equity basis. The company wholly owns 16 operating power plants, has controlling interests in 13 operating power companies, and has minority interests in four operating power companies. It is the largest listed power producer in China. Huaneng International Power Development Corporation (HIPDC) has a 42% economic interest in Huaneng Power but controls 70% of voting rights.

What Gives It an Edge: Morningstar analyst Paul Justice credits Huaneng with a narrow economic moat. According to Justice, Huaneng has a privileged relationship with the Chinese government, which it has levered to acquire some of the nation's most efficient and well located power plants. Both Huaneng Power and its state-owned parent company, HIPDC, are run by Li Xiaopeng, the son of former prime minister Li Peng. Given China's strong growth prospects and current power shortages, Justice believes Huaneng is likely to see demand outstrip supply for several years to come.

What the Risks Are: Huaneng is being challenged by domestic coal shortages and skyrocketing costs for imported coal. Due to an unusually harsh winter and the closure of several unsafe coal mines over the past year, Chinese power producers are facing critically low supplies of coal currently. The rising cost of coal has driven costs up substantially, and the problem has been particularly painful for electric generators since the government has frozen electricity rates in order to curb inflation. Should this situation continue indefinitely, Huaneng's profits would disappear.

What the Market Is Missing: While the market remains focused on these short-term risks, Justice points out that coal problems have surfaced at Huaneng before, and the government eventually capitulated with higher electricity rates. Justice thinks Huaneng's pain today is temporary. Within the next year, Justice expects the government to enforce the coal and electricity price linkage mechanism, much like it did in both 2005 and 2006. The government both recognizes the risks of keeping rates frozen too long and is acting aggressively to correct the nation's rail and coal-production problems. Given the robust domestic reserves of coal and the country's constant thirst for more power, Justice believes the future of coal power generation remains bright in China.

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, March 14, 2008.