This High-Flying Utility Stock Is Still A Strong Buy

StreetAuthority Network

Investors rarely have the chance to use "highflier" and "utility stock" in the same sentence, but that description fits a utility stock I first recommended nearly three years ago to a tee.

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Since then, shares have climbed an impressive 67%. During the past three years, they've delivered an average annual return of 22.1%, besting the S&P 500's three-year return of 15.2% by nearly seven full percentage points.

I can almost hear you asking yourself, "What utility stock could possibly perform anywhere near that well? There certainly aren't any domestic utilities that can do it." And you'd probably be right.

To identify this high-flying utility, I had to look to emerging markets where economies and energy use are typically growing much faster than in the United States. The company I found was a leading independent coal-fired energy producer located in China. Because the firm was cranking up output to keep pace with China's economic expansion, sported a 4.7% dividend yield, and had a stock with below-average volatility, I thought every investor should know about it.

I'm referring to Huaneng Power International (NYSE: HNP), which owns and operates approximately 175 primarily coal-fired power plants in 19 Chinese provinces and Singapore.

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Don't worry if you missed out on owning this fast-rising stock the past few years. Even though China's economy probably won't expand like before, growth should still be more rapid than in developed countries. So I expect China's energy demand to remain strong and Huaneng Power to stay on a path to triple-digit returns, as I projected when I first profiled the company in 2011.  

Consider a recent U.S. Energy Information Administration (EIA) report projecting that China and India will continue to lead in world energy consumption -- and leave U.S. usage in the dust. As the EIA chart below shows, together these two countries accounted for 10% of global energy use in 1990 and 24% in 2010. By 2040, their combined use is expected to account for 34% of global consumption. "China, which recently became the world's largest energy consumer, is projected to consume more than twice as much energy as the United States in 2040," the EIA report adds.

Energy consumption in the U.S., China and India, 1990-2040

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Also consider that China is the world's top coal consumer, burning about 2.9 billion metric tons equivalent (BMTE) a year, and is projected to remain the No. 1 user for the foreseeable future despite trying to become less dependent on the fuel. According to the IEA, China's usage should hit 3.3 BMTE by 2018, nearly a 14% jump from today's levels. What's more, China generates about 80% of its electricity with coal and 96% of Huaneng Power's annual output (currently about 67,000 megawatts) comes from coal-fired power plants.

So to say China's energy usage trends bode well for Huaneng Power could be a huge understatement.

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The price of coal could be a big help, too, since Huaneng Power almost exclusively uses the fuel, which has dropped about 9% in price during the past year from $68 to $62 per metric ton. Lower prices could persist, perhaps even a few years or more, due to chronic global oversupply.

Another key advantage for Huaneng Power is most of its power plants are in eastern and southern China, more economically developed and affluent regions with robust energy demand and more predictable usage patterns. Plus, as I emphasized when I first profiled Huaneng Power, the company enjoys a close relationship with the Chinese government because it's controlled by a state-owned corporation. This means Huaneng Power typically has the inside track when seeking approval for new projects, making acquisitions, or applying for government-subsidized loans.

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Risks to Consider: Being close with the central government can be a double-edged sword. Consumer energy prices in China are regulated by the government, and the government is notoriously slow to react to coal price fluctuations. If the price were to spike, Huaneng Power could suffer losses in the hundreds of millions or even billions before the government got around to approving rate hikes to offset rising coal prices.

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Action to Take --> Because of projected energy use in China, the likelihood of favorable coal prices, and Huaneng Power's unique competitive advantages, I consider the stock a strong buy. Consensus growth estimates look reasonable and suggest earnings per share could rise from the current $4.72 to $9.37 by 2018, which would translate to an annualized growth rate of 14.7%. Such an increase could propel the stock price more than 80% higher from about $36 currently to nearly $66, and that's assuming the price-to-earnings (P/E) ratio remains at the present level of about 7.

Historically, though, investors have been willing to pay more like 12 times earnings for shares of Huaneng Power. If you apply that P/E ratio to 2018's projected earnings, you get a stock price of about $112 a share -- more than twice the current price.

Still, I'd lean toward the more conservative scenario since China's economy has noticeably downshifted and the central government is starting to move away from coal as a primary energy source. Either way, I expect shareholders will continue to enjoy a solid dividend yield similar to the 3.3% yield they're receiving now because of Huaneng Power's solid overall financial health, substantial cash position of $1.7 billion, and excellent prospects in coming years.

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