My Concerns Around China Shenhua Energy Company Limited (HKG:1088)

China Shenhua Energy Company Limited (SEHK:1088) is a company I've been following for a while, and the biggest I see is around the sustainability of the business going forward. Although 1088 seems to be managing its financials well, and appears to be currently undervalued, meaning we can buy its shares at a good price, I would rather buy an outstanding business at an OK price. My problem is, 1088 doesn't seem to be an outstanding business, and here's why.

Firstly, a quick intro on the company - China Shenhua Energy Company Limited, together with its subsidiaries, engages in coal, power, railway, port, shipping, and coal chemical businesses in the People’s Republic of China and internationally. Since starting in 2004 in China, the company has now grown to a market cap of HK$496.26B.

The first thing that struck me was the pessimistic outlook for 1088. A consensus of 11 HK oil, gas and consumable fuels analysts covering the stock indicates that its revenue level is expected to decline by -4.27% by 2021, negatively impacting earnings, with a bottom-line annual growth rate of -1.16%, on average, over the same time period. With top line and bottom line expected to decline over the next couple of years, there is high uncertainty around the sustainability of its current operations.

Investors tend to get swept up by a company's growth prospects and promises, but a key element to always look at is its financial health in order to minimize the downside risk of investing. China Shenhua Energyhas an enviable balance sheet, with high levels of cash generated from its core operating activities (1x debt) able to service its borrowings. Furthermore, 1088's debt level is at an appropriate 25.02% of equity, though it has been increasing over the past five years from 23.70%. 1088 also generates a sufficient level of earnings which amply covers its annual interest payment 22.11x. The company shows the ability to manage its capital requirements well, which somwehat alleviates my doubts around the sustainability of the business going forward. 1088 has high near term liquidity, with short term assets (cash and other liquid assets) amply covering upcoming one-year liabilities, as well as long-term commitments. 1088 has managed its cash well at a current level of CN¥73.79B. However, more than a fifth of its total assets are physical assets and inventory, which means that in the worst case scenario, such as a downturn or bankruptcy, a significant portion of assets will be hard to liquidate and redistribute back to investors.

1088 currently trades at HK$19.50 per share. With 19.89 billion shares, that's a HK$496.26B market cap - quite low for a business that has an upcoming 2018 free cash flow figure of CN¥63.73B. Even with an expected negative FCF growth rate of -7.54% (source: analyst consensus), the target price for 1088 of CN¥34.81 is still above its share price. Therefore, the stock is trading at a discount. Moreover, comparing 1088's current share price to its peers based on its industry and earnings level, it's undervalued by 100.60%, with a PE ratio of 6.49x vs. the industry average of 13.02x.

What initially drew me into 1088 was its robust balance sheet and the possibility that it's undervalued. However, after looking at the prospects of the business, I'm not jumping with joy. Like above, I would rather invest in a company that checks all the boxes - an outstanding business - than a mediocre one. For all the charts illustrating this analysis, take a look at the Simply Wall St platform, which is where I've taken my data from.

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.