China Everbright Water - DBS Research 2020-02-28: Higher IRR, Higher ROE

CHINA EVERBRIGHT WATER LIMITED (SGX:U9E)

China Everbright Water - Higher IRR, Higher ROE

China Everbright Water's FY19 net profit was above expectations due to higher gross margin.
Higher IRR of new projects to lift ROE further.
Diversifying into water supply through SOE reform.
FY20/21 earnings revised up by 10-12%; maintain BUY with new Target Price of HK$2.40 (HKSE) and S$0.49 (SGX).

We maintain our BUY rating on China Everbright Water (SGX:U9E). Thanks to rising demand for higher quality ecological services and products, we expect China Everbright Water will continue to secure new projects with higher IRR of > 10%, up from 8% in the past. We estimate this would lead to higher ROE of 10.7% in FY21, up from just 5.1% in FY16 or 10.2% in FY19.
In addition, SOE reform allows China Everbright Water to step into the water supply market and develop further along the value chain. With continuous uptrend in treatment tariff and treatment capacity, China Everbright Water should be able to deliver earnings growth in mid-to-high teens.

China Everbright Water reported 23% growth in FY19 net profit to HK$833.5m, 12% and 5% higher than our and market estimates respectively. The major variance was higher-than-expected gross margin of 34% (vs 33% estimate), following 25.8% growth in revenue from operation services.
During the period, China Everbright Water won 18 new projects and an expansion project, with an aggregate investment of Rmb4.7bn, up from Rmb3.6bn in FY18. Pursuing its asset light strategy, it also secured O&M and EPC contracts with a total contract value of Rmb146m. Net debt-equity ratio was up 12ppts to 73.5%, higher than our projected 66%.
Final DPS of 3.74HKcents (or 0.67Scents) was declared, bringing the total DPS to 7.48HKcents (or 1.32Scents). Total dividend payout ratio was up 3ppts to 25.5%.

During the period, 10 projects enjoyed tariff hike ranging from 4% to 61%, due to upgrade of treatment standard to grade 1A. This raised average tariff by around 5%. Coupled with additional revenue from overdue tariff hikes, operational service revenue climbed 25% in FY19.
Although 90% of China Everbright Water’s plants are already operating under grade 1A standard, the company is negotiating with many local governments for further upgrades. We believe that continuous enhancement in waste water treatment standards is an irreversible trend.
We have projected a 5% increase in average treatment tariff p.a. in the next two years.

After adding 1.34m tons of new daily capacity in FY19, China Everbright Water currently has 6.2m tons of daily treatment capacity under its portfolio. We estimate around 74% of these capacities are currently operational. Having projected an addition of 0.4m and 0.6m tons of new operational capacity in FY20 and FY21 respectively, we estimate waste water treatment volume to climb 10% p.a. to 1.58bn and 1.73bn tons in the corresponding period.

Increasing demand for higher quality of ecological services and products has allowed China Everbright Water to be more stringent in project selection. This is echoed by the fact that the average equity IRR of newly secured projects in FY19 is > 10%, higher than 8% in the past years. Thus, profitability of China Everbright Water is expected to climb.
Apart from the sewage treatment market, the recent SOE reform, which allows strategic investors to invest in SOEs, gives rise to more investment opportunities for China Everbright Water. In particular, the marketisation of water supply market is very low with poor efficiency. Hence, China Everbright Water is in a good position to bring in synergies after it becomes a strategic shareholder of these SOEs.

The COVID-19 outbreak has minimum impact on China Everbright Water’s operations.
- Firstly, it only has two projects in Hubei. One project is operating normally despite some hiccups in logistic arrangement. Although construction of one project is currently suspended, it is close to completion and investment amount is small. Thus, impact of the delay on the whole group is not significant.
- Secondly, out of 31 projects currently under construction, 8 have resumed construction. Except for the plant in Hubei, management expects the remaining projects will resume construction soon as China Everbright Water is proactively communicating with various local governments for such arrangement.
- Thirdly, while management has noticed a decline in volumes at some of industrial treatment plants after CNY, the impact is expected to be < 1% for the full year.
Fourthly, operating cost for treating medical waste water has increased due to higher treatment standards required by the government. However, the cost increase was not significant as a relatively high standard is already in place. All-in, the outbreak has not had a significant negative impact on China Everbright Water’s operation.

To reflect the better-than-expected performance from operational service, we have raised our turnover and earnings estimates by 9-10% and 11-12% for FY20/21 respectively.
See China Everbright Water Share Price; China Everbright Water Target Price; China Everbright Water Analyst Reports; China Everbright Water Dividend History; China Everbright Water Announcements; China Everbright Water Latest News.
China Everbright Water has traded at an average PE of around 6x since listing on the Hong Kong Stock Exchange and we estimate the valuation is higher at around 6.5-7x if construction revenue is stripped out.
We reckon China Everbright Water deserves to trade at the average historical PE given its stable cashflows, healthy balance sheet and improving ROE. Our new Target Price is set at HK$2.40, based on 7x 12-month rolling adjusted PE (stripping out construction revenue).

Patricia YEUNG DBS Group Research | https://www.dbsvickers.com/ 2020-02-28

SGX Stock Analyst Report BUY MAINTAIN BUY 0.490 SAME 0.490