OREANDA-NEWS. January 19, 2015. We hear three debates around Shanghai Electric: (1) Is the thermal power business stabilizing or deteriorating? (2) Is nuclear project really restarting in China? (3) Is nuclear business big enough to make a difference for Shanghai Electric?

- The first will remain an on-going debate, but at least the views from both sides – ours and the bears’ –are expressed in full. We wrote extensively about this in 2014, and most recently in the report: Asian Capital Goods: Chinese Power Generation Equipment in 2015; Preview of the 13th Energy Five Year Plan.

- The second debate, we think, is almost settled. The intention of the Chinese government to restart nuclear projects is by now well known. The timeline and magnitude is almost fixed given the clear 2020 target of 58GW operating plus 30-40GW under construction. The “degree of freedom”, which is very limited, boils down to which specific project will be the first restart in the next few months.

- We have heard the third challenge more and more frequently in the last few months, when SEG’s share price moved up. It is a good question, and we address it explicitly in this note.

Bears said it out loud: “Nuclear is only 3% of Shanghai Electric, it is not even meaningful.” We show, in two charts that this is not the case. In 2015-2018, nuclear island equipment alone will contribute 16-24% of EPS, and around 35% of EPS growth.

Speaking of earnings growth, nuclear is not only meaningful, but it is also the biggest driver in the next couple years. The 3% figure that bears quote is not imaginary; it is the revenue contribution from nuclear in 2014. So how does the 3% become 35%? And what have they missed? Three things:

- That the nuclear island equipment market size is tripling in four years.

- That nuclear equipment is a high margin business. Shanghai Electric has already gone through the nuclear equipment manufacturing learning curve to achieve +30% GP margin in the segment. We estimate that NP margin would be about 12%. Both numbers are much higher than the company’s overall business at 18-20% for GP margin, and 3-5% for NP margin.

- That the nuclear business is wholly owned by SEG. SEG has many joint ventures. On average, 35% of its net profit was attributable to non-controlling interest (therefore not attributable to shareholders of the company). In 2014, that number would reach 45% due to strong growth in JV businesses. Yet nuclear island business is almost wholly owned by the company. There is only one minor JV with KSB for nuclear valves, and the contribution is very small. At EPS level, the contribution from nuclear is further boosted by this factor.

Two additional factors make the nuclear business even more significant to SEG than we have calculated above

- Nuclear conventional island equipment(steam turbines and generators used in nuclear power plants) is an additional revenue stream for Shanghai Electric. It is reported under the High Efficiency and Clean Energy segment together with thermal power and T&D equipment. Given the nuclear construction cycle, the opportunity will kick in later than nuclear island equipment, but in 2017 the addressable market size in China would reach RMB10 billion and SEG can expect to capture 25-30% of it.

- The loss-making forging component business(under Shanghai Electric’s wholly owned subsidiary, Shanghai Heavy Machine Plant) is the upstream of nuclear island equipment. It is reported under the New Energy segment but separately from nuclear island business. Nuclear production will drive higher utilization and a strong turnaround there in 2015-2016. With a net loss of RMB1.1 billion in 2013, a full turnaround can drive 30-40% of earnings growth for SEG as a whole.

So, is the nuclear story already priced in for SEG? Not fully, in our view. The fact that a big part of the market still views nuclear as a sideline business for SEG and often quotes the 3% figure tells us the upside is yet underestimated.

Investment Conclusion

We continue to recommend SEG as the best play to capture China’s thermal and nuclear sector opportunities, with further upside from turning around previously unprofitable segments of wind and heavy machinery. We reiterate Outperform, TP HKD5.90.