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Eric Ng

Parent's injection of two units may mean earnings are near their peak

Dongfang Electrical Machinery's move to buy two of its  parent's subsidiaries at a low valuation sent investors piling into the stock last week but analysts warned that the deal  may mean its earnings are peaking.

The cheapness of the assets to be injected might indicate that the favourable industry cycle is near or even past its peak, they said.

'Why choose to do the restructuring in 2007? Does management see all three companies' earnings peaking in 2007?' said a Morgan Stanley research report. 'Does it expect a significant earnings decline after 2008 as power equipment demand begins to slow?'

Dongfang Electrical's H shares shot up 14 per cent last week on the news, ending at HK$34 on Friday. Since the start of the year the shares have soared 63 per cent.

The Sichuan province-based company has enjoyed a strong resurgence since suffering losses between 1999 and 2001.

Dongfang Electrical, the second-largest producer of coal-fired power generation equipment in a market dominated by three state-controlled companies, was hit hard by a 1998 moratorium on new power project approvals imposed because of oversupply.

The halt on new orders exacerbated management and product quality problems, while provisions for inventories and deposits that it failed to recoup from mainland financial institutions also weighed heavily on earnings.

The shares traded at less than HK$1 when the company said early in 2003 that it expected to return to the black in 2002.

Profit jumped to 534.69 million yuan in 2005 from 18.61 million yuan in 2003, boosted by a binge in power plant construction on the back of faster than expected economic growth and power shortages.

Profit may have grown 52.3 per cent to 814.42 million yuan last year, according to Thomson First Call's consensus estimate in a survey of 11 brokerages.

The company last week said it would buy from parent Dongfang Electric Corp a 68.05 per cent stake in Shanghai-listed Dongfang Boiler and all of unlisted Dongfang Turbine for 11.9 billion yuan.

The deal will complete Dongfang Electrical's product line, which at present consists primarily of generators and put its structure in line with rivals Shanghai Electric Group and Harbin Power Equipment, based in northeast China.

The purchase price valued the assets at 5.9 to 7.3 times their net profit last year, CLSA estimated in a research report, much lower than the company's own multiple of 11.64 times ahead of the asset purchase announcement.

The result is a 50 per cent enhancement in earnings per share, the brokerage said, justifying the spectacular share price performance.

However, analysts said neither Dongfang Boiler nor Dongfang Turbine appeared to have bright short-term earnings prospects.

A-share company Dongfang Boiler posted a 22.1 per cent year-on-year drop in net profit for the first nine months of last year, as its gross profit margin was squeezed by falling product prices, higher raw materials costs and a shifting product mix, despite higher output.

BNP Paribas, in a research report, forecast that net profit would be flat this year and might fall 10 per cent next year.

Unlisted Dongfang Turbine's profit surged to 800 million yuan in 2005 from 466 million yuan in 2004, according to BNP, citing figures from the China Electrical Equipment Industry Yearbook. The brokerage projected profit would rise 10 per cent this year to 880 million yuan, before dropping 10 per cent to 792 million yuan next year.

Both Dongfang Boiler and Dongfang Turbine are expected to see greater profit declines next year than  Dongfang Electrical due to their higher exposure to the coal-fired power equipment segment.

Dongfang Electrical also has substantial sales in the hydro segment, BNP said.

After demand growth exceeded supply growth for five years, China's power market has reversed the trend since 2005, as producers raced to expand capacity.  State Grid Corp, the nation's largest power distributor, has forecast this year's growth to slow to 15.3 per cent.

Analysts expect capacity addition to fall substantially next year, as the central government's clampdown on unauthorised plant construction takes effect.

In the meantime, analysts are asking whether Dongfang Electrical can reap cost savings and efficiency gains after merging the three operations.

'The three companies had operated under one group in previous years, and there is no change in management,' Morgan Stanley said in a research report.

BNP is more sanguine. It said integration of sales and marketing operations may create better cross-selling of products and lower selling costs while centralisation of procurement will also help cut costs.

Dongfang Electrical's spokesman has been meeting investors overseas and was unavailable for comments. Deputy chairman Han Zhiqiao declined to comment, citing regulatory sensitivity as the deal had not been completed.



Dongfang asset deal draws analysts' warning