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China Everbright Water - DBS Research 2016-04-12: Sustainable and reasonable returns

China Everbright Water - DBS Research 2016-04-12: Sustainable and reasonable returns CHINA EVERBRIGHT WATER LIMITED U9E.SI 

China Everbright Water - Sustainable and reasonable returns 

  • Strong competitive edge to gain market share amid keen competition 
  • Target to become top 3 player with total treatment capacity of at least 10m tons per day 
  • Balance sheet remains strong 
  • Maintain BUY with TP of S$0.64 

Positive reception from European investors 

  • The major takeaway from China Everbright Water’s (CEWL SP) (CEW) NDR in Europe was that CEW is optimistic in earning reasonable and sustainable returns amid the keen competition within China's water sector. This is appreciated by the European investors who are optimistic about the enormous growth potential of China water sector, as well as CEW’s earnings growth outlook. 
  • In general, investors were keen to learn more about 
    1. the competitive landscape; 
    2. CEW’s growth strategy and return; and 
    3. stock liquidity. 

How is the competitive landscape? 

  • Following the release of the Water Ten Plan, the water sector has become more competitive on the back of more new players. In fact, small private companies, which used to dominate the water market, have been gradually replaced by some SOE players or listed water companies through market consolidation. 
  • Investors are wondering how such a trend would affect the IRR trend. 
  • In view of the keener competition, CEW has indeed lowered its IRR yardstick by c.2ppts to 8-10% for new projects. However, management will not win projects through pricing strategy, as evidenced by the fact that its secured projects were not the lowest priced within the tender. 
  • While we should not expect a lucrative margin to be earned in the water sector, CEW is optimistic on maintaining a reasonable and sustainable return as it has competitive advantages over its peers. 
  • CEW, with 13 years of experience, has built a solid foundation and reputation, technical expertise and management experience. In fact, the management team has a strong background in financing and working experience in government institutions. 
  • In addition, its ultimate parent company, China Everbright Group, has an investment arm in the financial sector with banking and securities operations in various municipals, which is positive for building solid relationships with local governments. 
  • Its major shareholder, China Everbright International (CEI) (257 HK), is also one of the major operators in waste-to-energy and a leading environmental player in China. 
  • Co-operation with CEI in negotiation with local government for provision of comprehensive environmental service will create synergy. 
  • Furthermore, CEW has a sound track record in corporate governance. 
  • These competitive advantages will allow CEW to win more market share. 

What is CEW’s development plan? 

  • In the medium term, CEW targets to become a top three player in China, in terms of operating scale and efficiency, by expanding its daily total treatment capacity from 4.6m tons to at least 10m tons within the coming three to five years. The new daily capacity target is 1-2m tons for FY16. 
  • Management believes that these targets will translate into a top-line growth of 30-50% p.a. 
  • These plans will be achieved through M&A, extension of existing projects, technical upgrade, participation in PPP projects and diversification into new areas, such as watershed treatment, construction of sponge cities and other comprehensive water environmental treatment services. 
  • In terms of geographical coverage, it will gradually extend into coastal regions or nearby regions from existing markets to minimise A/R risk and management cost. New markets include Zhejiang and Guangdong provinces. 
  • In the long run, it targets to venture beyond China to become a global player. Management understands the risks involved. Thus, there is no timetable for its long-term target and the company will be very careful in making its first step. 
  • Management is confident of achieving the medium targets because there are enormous opportunities in the water sector. For instance, the investment amount required under the Water Ten Plan is estimated to be a few trillion Rmb while that of construction of sponge cities to be at least Rmb6tn by 2030. 
  • Additional investments are also required to tackle the issue of black and stinky water body which is currently affecting at least 1,860 rivers in China. 

How effective was M&A strategy? 

  • Some investors are keen to know the impact of M&A strategy on CEW’s returns given the acquired assets, i.e. Hankore and Dalian Dongda, had lower IRR than the water plants originating from CEI. 
  • Management assured investors that the integration of Hankore was successful, evidenced by the turnaround of its bottom line from loss-making to a profit of c.HK$100m in FY15. This was done by re-initiating the construction of new plants, upgrading facilities and treatment standards, increasing sewage treatment volume through better connectivity and tariff hike. 
  • Although the current average utilization rates of Hankore and Dalian Dongda of c.70% and 87% respectively are still lower than 93% achieved by CEI water plants, management is confident that further improvement in utilization can be achieved in Hankore and Dalian Dongda. 
  • CEW is optimistic about its M&A strategy because it has stringent criteria for M&A targets, including: 
    1. Location in affluent or coastal areas to avoid A/R risk; 
    2. Synergy or strategic impact on the existing operations; 
    3. Room for improvement in turnover or efficiency, such as capacity expansion or tariff hike. 

How does tariff adjustment mechanism work? 

  • Many investors are concerned that CEW may face difficulties in adjusting its treatment tariff as tariff hike is the key to enhancing returns. Under each concession agreement, there are terms to regulate tariff adjustments which are done according to certain formulas and parameters, such as investment cost, operating cost, treatment standard, etc. The adjustment is usually done every two years. So far, CEW has not experienced any difficulties in tariff adjustment negotiation. 
  • In fact, it enjoyed tariff hikes for 10 projects in FY15 with a tariff increase ranging between 3.5% and > 50%. 

How stretched can the balance sheet be? 

  • To finance the above development plan, CEW will seek financing through various channels. 
  • Given its net debt/equity ratio of just 42% in FY15, there is ample room for more bank borrowing or bonds before reaching its targeted upper limit of 70-80%. 
  • Given the environmental sector is strongly supported by the government, coupled with its SOE background, CEW has no difficulties in seeking support from banks. 
  • In addition, CEW can also finance its projects, particularly large-scale PPP projects, through industry development funds or PPP funds. 
  • Management understands investors’ concerns on currency risk. Thus, it will maintain the percentage of foreign debt at around 30%. 
  • Current cost of debt is around 3.5% and 4.5-5.0% for foreign debt and Rmb loans respectively. 

How to improve stock liquidity? 

  • Poor stock liquidity is a major concern for many European investors who wonder whether CEW will increase its free float or consider listing in other stock exchanges. 
  • CEW's management has no intention to switch to another stock exchange currently. Much consideration will be given as such an exercise will incur extra expenses. 
  • Nevertheless, management reckons that as CEW grows larger, it will need more support from the equity market through share placements which could improve stock liquidity. 

Valuation 

  • Our current estimations project earnings growth of 20-25% p.a. for FY16 and FY17. If management’s expansion plans materialise, we reckon there could be upside on our earnings forecasts. 
  • Nevertheless, we keep our conservative projections for now and maintain our TP at S$0.64, which is based on 25x 12-month rolling PE (adjusted for construction revenue). 
  • Maintain BUY.



Patricia YEUNG DBS Vickers | Tony WU CFA DBS Vickers | http://www.dbsvickers.com/ 2016-04-12
DBS Vickers SGX Stock Analyst Report BUY Maintain BUY 0.64 Same 0.64


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