DME is a derivative of natural gas or coal that is increasingly being used as a non-renewable alternative fuel (and possibly will substitute for imported petroleum). DME can be used, stored and transported like LPG but is more cost competitive. DME is priced at a 5% discount to LPG, which is correlated to international oil prices.

Merrill Lynch Research

 

 

Expansion accelerated

Price S$1.61

Price Objective S$1.88 to S$2.28

? Expansion accelerated

China Energy is accelerating its DME capacity expansion by 30% to 3.2mn tpa by FY09. We view this latest development very positively, which also demonstrates management?s strong confidence in DME market growth. We raise our price objective to S$2.28 (from S$1.88) and reiterate our BUY recommendation.

DME capacity to expand 21x in three years

CEGY targets to complete its Zhangjiagang Phase II (700,000 tpa) a year ahead of schedule by end 08. It is also investing in two new DME sites (Ningbo and Tianjin), which will add another 600,000 tpa by end09. There are plans for further expansion at both sites which could lead to additional 1.4mn tpa DME capacity beyond 2009. Separately, CEGY plans to set up a procurement and marketing centre in Singapore for sourcing of methanol feedstock and potentially distribution of DME products to overseas markets such as Japan and Korea.

Additional debt to fund CAPEX

We estimate CEGY will require RMB3.3-3.6bn to fund its new plans over FY07- 09E. Based on its existing RMB1bn cash and projected cash flow generation, there could still be a funding gap of RMB1-1.5bn. Management indicated it is already in discussion with several banks to raise new debt to bridge the gap.

Price objective raised to S$2.28

We raise our FY09E earnings to RMB1.6bn (+30%) and consequently our DCF valuation to S$2.28. We understand the two new DME facilities in Shandong (250,000tpa) and Guangdong (200,000tpa) are in trial production and should be acquired by CEGY soon. Successful DME vehicle trials in China will also raise the likelihood of DME being used as a diesel substitute and benefit CEGY.

Our PO of S$2.28 is based on DCF valuation, which assumes WACC of 13% and terminal growth of 1%. This translates to a target multiple of 18xFY08E earnings, which is at PRC peers average P/E of 18x and still below Japanese alternative energy companies? forward PE of 27x. Price catalysts include favorable DME/LPG price environment leading to stronger than expected earnings and positive news flow on DME vehicle trials.

Risks are:

1. Lower than expected DME prices

2. Higher than expected Methanol costs

3. Coal supply risk

4. Execution risks related to DME capacity expansion

5. Retail consumers rejecting DME-blended LPG

6. Failure to develop new DME markets beyond 2010

7. Threat from new DME technology (based on one-step synthesis gas)

8 . Higher than expected acquisition prices from interested parties

Analyst Certification

I, Eddy Loh, CFA, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report

Price Objective Basis & Risk

24 May 2007

China Energy Ltd.