The B-share listed company under the umbrella of Zhejiang Zheneng Electric Power (ZZEP) plans to return to the A-share market through merger by absorption. Zhejiang Southeast Electric Power (ZSEP) was incorporated in May 1997, and got listed on the Shanghai Stock Exchange (SSE) in Sep 1997 through offering B-shares. Its substantial shareholder ZZEP directly and indirectly holds a 40.0% stake in the Company; and the Company specializes in electric power production, which contributed ~96.4% of its total revenue in 2012. Installed capacity controlled by the Company is 3.95GW, and the attributable installed capacity is 5,337MW. Its generating units are distributed mainly in Zhejiang province. ZZEP plans to merge the Company by absorption, so as to list in the A-share market of SSE. After the merger, the surviving company will control installed capacity of ~20GW and have attributable installed capacity of ~21GW. Factoring in the nearly 5.9GW of attributable installed capacity under construction, the Company’s installed capacity will continue rising.

Zhejiang tops among thermal power markets in terms of earnings, and its power supply-demand landscape tends to be relaxed. Gross margin, net margin and ROE of thermal plants in Zhejiang stand at 18.7%, 12.5% and 22.2%, 5.3ppts, 6.3ppts and 10.1ppts higher than the country’s average levels; and profit per 1kWh of electricity was ~Rmb0.06/kWh in Zhejiang in 2012, ranking 3rd among other provinces and municipalities, which indicates robust profitability for the thermal plants in Zhejiang. Factoring in the supply and demand landscape, we expect the province’s utilization hours of thermal power capacity will decline 2.3%, 3.6%, and 2.7% YoY in 2013E/14E/15E, respectively, due to the impact of the continual operation of Liuheng Power Plant, Taizhou No.2 Power Plant and Cangnan 1GW generating units, as well as the supply of nuclear power and external hydropower. So the overall power supply and demand landscape will be relaxed.

Projects have entered an operation period, and profitability of ZZEP will grow stably. ZZEP’s generating units are distributed mainly in Zhejiang, and installed capacity mix characterized by a high proportion of large-capacity efficient generating units enables it to maintain significantly lower-than-average net coal consumption rate and strong profitability. Going ahead, ZZEP has a slew of projects in such fields as thermal power, gas turbine, and nuclear power, of which Liuheng Power Plant, Taizhou No.2 Power Plant, Fengtai Phase-II and Sanmen Nuclear Power Plant are all high quality assets with strong profitability, and the gas turbine and the expected acquisition of stake in Fangjiashan nuclear power are worth special attention. The downside of overall coal prices and capital cost in 2013E and decline in thermal power utilization hour in 2013-15E are important factors to affect ZZEP’s profit. We expect net profit attributable to the parent company of ZZEP to grow ~Rmb960mn, Rmb110mn and Rmb800mn, respectively in 2013/14/15E.

Reasonable range of offering prices and small free float. The forecasted range of offering prices at Rmb5.71-6.63 per share implies 14x-16x 2012E P/E, broadly close to the 14.8x median valuation of comparables, showing the range of offering prices is basically reasonable. Based on the current price range of Rmb5.71-6.63 per share, Zhejiang Energy Group, the substantial shareholder of the surviving company upon the completion of the merger will, directly and indirectly, hold an 85-86% stake in the surviving company. Factoring in the lockup arrangement for existing shareholders of ZZEP and the Company, the surviving company will have ~500mn-600mn shares of free float, representing ~6% of its total share capital after the merger.Potential risks: (i) Our earnings forecast and pricing are based on successful completion of the said merger by absorption, and the program is still subject to voting at the shareholders’ meeting; (ii) sharp swings of coal prices could affect the Company’s results; and (iii) projects under construction could be slower than expected.

Initiate “BUY”. Assuming the merger by absorption is completed in 2013E and the A-share offering price is Rmb6.17 per share, we expect the Company’s 2013E/14E/15E EPS to come in at Rmb0.55/0.56/0.65 (Rmb0.54/0.55/0.64 for core business of power generation, and Rmb0.01 from financial dividend), equivalent to 2013E/14E/15E P/E of 10.9x/10.7x/9.2x. Based on assumptions that the said merger by absorption is successfully completed in 2013E, and as Liuheng Power Plant, Taizhou No.2 Power Plant, Sanmen Nuclear Power Plant, Fengtai Phase-II, and gas turbine projects will be put into operation as of 2013, the Company’s installed capacity will continue growing. In view of the small free float of A shares after the completion of the merger, we assign 13x 2013E PE to its power generation business, implying target price at Rmb7.0 per share; and taking into account the Rmb0.4 per share or ~Rmb3.5bn worth of capitalization in banks, we set its target price at Rmb7.4 per share, equivalent to B-share target price of US$0.938 (A-share offering price of Rmb5.71/6.63 per share corresponds to B-share target price of US$1.005/0.879 per share). We initiate with a “BUY” rating.