Improvements at Kangda International

China Water Affairs Group 28 April 2020 Update
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China Water Affairs Group

Improvements at Kangda International

Additional investment

Utilities

28 April 2020

Price

HK$6.15

Market cap

HK$9,865m

Net debt (HK$bn) at 30 September 2019

11.0

Shares in issue

1,604m

Free float

66%

Code

855

Primary exchange

HK

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

6.1

(7.7)

(26.3)

Rel (local)

2.6

6.3

(10.1)

52-week high/low

HK$8.18

HK$5.29

Business description

China Water Affairs (CWA) is a pioneer in the privatisation of water supply assets in China. The company seeks to create growth via volume/price increases

Next events

FY20 results

June 2020

Analyst

Graeme Moyse

+44 (0)20 3077 5700

China Water Affairs Group is a research client of Edison Investment Research Limited

FY19 results from Kangda International Environmental (KIE) showed an improvement in profitability and China Water Affairs (CWA) has put in place a deal to increase its holding in its associate company. While the precise financial impact of the COVID-19 pandemic has yet to be clarified, we have left our FY20 forecasts unchanged, but CWA’s current rating appears modest for such a defensive company.

Year end

Revenue (HK$m)

PBT*
(HK$m)

EPS*
(c)

DPS
(c)

P/E
(x)

Yield
(%)

03/18

7,580

2,462

71.8

23.0

8.6

3.7

03/19

8,302

2,772

85.1

28.0

7.2

4.6

03/20e

8,757

3,169

98.2

33.0

6.3

5.4

03/21e

9,894

3,417

106.1

38.0

5.8

6.2

Note: *PBT and EPS are normalised, excluding amortisation of acquired intangibles, exceptional items and share-based payments.

CWA increases holding in Kangda International

KIE (CWA holds c 29.5%) recently released its results for the year ending December 2019. The headline numbers showed good progress, with PBT +12% and EPS +25%, which will feed into CWA’s FY20 results. CWA subsequently announced that it had entered into an agreement to subscribe to an issue of exchangeable bonds in KIE (HK$361.3m and convertible into 344.13m KIE shares). In a related transaction, an issue of convertible bonds (into CWA shares) allowed CWA to fund the purchase of the exchangeable bonds in KIE. Assuming full conversion (after July 2022), CWA will hold 46.5% of KIE. In our view, the deal represents an attractive opportunity for CWA to consolidate its position as KIE’s largest shareholder. The effective price of HK$1.05/share stands at a 56.6% discount to KIE’s book value of HK$2.42 and represents c 5.2x FY19 EPS.

COVID-19

We have not attempted to estimate the financial effect of the spread of COVID-19 in our (unchanged) FY20 and (modestly revised) FY21 forecasts. We anticipate that there will have been delays to some capital projects because of the COVID-19-related extension of the New Year holiday in China. We would expect to see some reduction in industrial and commercial water volumes, although higher domestic and municipal volumes may compensate for this shortfall. Our model assumes c 15% growth in water supply revenue in FY20 (+13.4% in H120 vs H119) and FY21. A theoretical increase of only 8% in water revenues in FY21 would lead to a c 5% reduction in our operating profit estimate, from HK$3,785m to HK$3,610m.

Valuation: Rating remains modest despite rebound

At the current price of c HK$6.15/share, CWA is trading on a modest 6.3x our FY20e EPS of 98.2c and 5.8x our FY21e EPS of 106.1c (peer group averages are 13.3x and 13.5x respectively). Although uncertainty persists as to the financial impact of COVID-19, CWA remains a defensive play in a sector where we see a secular trend of improvement in the quality of water providing continuing growth opportunities for CWA.

Focus on Kangda International Environmental

CWA’s initial investment in KIE

In April 2019, CWA acquired 29.52% of Kangda International Environmental (HKSE: 06136) from Kangda Holdings for HK$1.2bn (600m shares at a price of HK$2/share), implicitly valuing the entire business at HK$4.1bn. Post the acquisition, CWA became the largest single shareholder in KIE, taking control of KIE’s board. CWA treats its holding in KIE as an equity investment.

KIE’s business encompasses urban water treatment, water remediation and rural water improvements. Urban water treatment includes design construction and operation of waste treatment plants, among other activities, while water environment remediation is focused on harnessing and improving rivers, pipeline network projects and pipe tunnel construction. Rural water improvement involves construction and operation in the areas of pipeline and waste water treatment, designed to aid the construction of ‘beautiful villages’. In the future, CWA will focus the business on the urban water treatment segment.

KIE’s results show progress

On 27 March 2020, KIE released its FY19 results, the first set of annual figures since CWA acquired its holding. The headline numbers showed revenue -7%, PBT +12% and EPS +25%.

For the major part, the decline in revenue resulted from a decrease in construction revenues (RMB341.3m), particularly in the urban water treatment division, which more than offsets the increase in operational revenue (RMB74.3m) generated by the commencement of new build-operate-transfer (BOT) upgrade projects. However, gross profit rose by 12% to RMB1,163m, thanks to a higher margin on completed engineering, procurement and construction (EPC) projects. Stringent control of selling and distribution expenses (-65%), and administrative (-14%) and other costs (-40%) also helped produce an overall increase in PBT to RMB509.8m, despite an increase (+12%) in financing costs, to RMB557.5m, due to higher levels of indebtedness and a higher rate of interest in H219. A lower tax rate of 25% (32%) contributed to the increase in EPS to RMB18.54c (+25%). Overall, the gearing ratio (net debt divided by capital and net debt) of the business remained static at 70%. Reducing KIE’s level of gearing will constitute an important part of CWA’s strategy for improving the performance of KIE over the next two years.

CWA increases its holding in KIE

Subsequent to KIE’s results (on 1 April 2020), CWA announced that it had entered into an agreement to subscribe to an issue, by Baring Private Equity Asia (BPEA), of exchangeable bonds in respect of its share in KIE. In turn, the issue of convertible bonds (into CWA shares) to BPEA allowed CWA to fund the acquisition of the exchangeable bonds in KIE from BPEA.

For its part, CWA agreed to subscribe to the exchangeable bonds issued by BPEA, amounting to HK$361.3m, entitling it to convert the bonds (not before August 2022) into 344.13m KIE shares (equivalent to 16.93% of KIE’s capital) at an effective price of HK$1.05/share. The price represents a premium of 38.2% over the closing price for KIE’s shares on 1 April, but a significant discount (56.6%) to KIE’s net assets of HK$2.42/share (at 31 December 2019). The price is substantially below the acquisition cost of the first tranche of shares (HK$2/share) and reduces CWA’s overall ‘in’ cost to c HK$1.65/share. The HK$1.05 price also represents c 5.2x KIE’s FY19 EPS of RMB0.1854 equivalent to HK$0.230. Sharp Profit, a wholly owned subsidiary of CWA, which currently holds CWA’s 29.52% stake in KIE, will hold the bonds and, assuming full conversion of the bonds and no issuance of further capital by KIE, will eventually hold 46.45% of KIE.

The issue of a convertible bond to BPEA has provided the consideration of HK$361m. On conversion (after July 2022), the bond will convert into 44.9m CWA shares (equivalent to approximately 2.80% of the existing issued share capital of the company). The conversion price of HK$8.05 represents a premium of c 42% to the share price prevailing immediately before the announcement of the deal and a significant premium (c 63%) to CWA’s FY19 NAV of HK$4.95/ share. HK$8.05 is also equivalent to c 9.5x CWA’s FY19 EPS of 85.1c and c 8.2x FY20e EPS of 98.2c.

Deal rationale

The directors of CWA are optimistic about the prospects for KIE and point to an improving financial performance in FY19, helped by a significant reduction in costs and an optimised tax rate, which we have detailed above. CWA considers the subscription an opportunity to increase its holding in KIE and consolidate its position as KIE’s largest shareholder without any adverse impact on cash flow. The deal has been struck on attractive terms, which should allow CWA to capture a greater share of the improvement expected in KIE’s business over the next two years without having to consolidate KIEs significant debt on the balance sheet.

COVID-19 update

CWA will report its results for the 12 months ending 31 March towards the end of June. The results will include the first quarter of 2020, which coincided with the peak of COVID-19 in China. CWA has not publicly quantified the impact of the epidemic on its business and we have not altered our forecasts to attempt to estimate the financial effect of the spread of the disease. However, we believe it is worth noting some of the potential effects of the virus. We expect there will have been delays to some capital projects, for example plant construction, as a result of the extension of the New Year holiday in China in an attempt to contain the spread of the coronavirus. We would also expect some reduction in industrial and commercial water volumes, although higher domestic and municipal volumes may compensate for this shortfall. Our model assumes c 15% growth in water supply revenue in FY20 (H120: 13.4%) and FY21. An 8% increase in water revenues in FY21 would lead to a c 5% reduction in our operating profit estimate, from HK$3,785m to HK$3,610m. However, CWA may have also been able to take advantage of some of the government’s schemes (reduction in VAT, cheap loans, reduced electricity prices) introduced to combat the economic impact of the virus. We remain confident that the long-term growth opportunity remains.

Forecasts and valuation

Our forecasts for FY20 remain unchanged and we have made only a small revision to our FY21 estimates (EPS +0.5% from 105.6c to 106.1c). At the current price of c HK$6.15/share, CWA is trading on a modest 6.3x our FY20e EPS of 98.2c and 5.8x our FY21e EPS of 106.1c (averages for selected Hong Kong- and China-listed peers are 13.3x and 13.5x respectively). Although considerable uncertainty persists as to the extent of the financial impact of COVID-19, CWA remains a relatively defensive play in a sector where we expect the secular trend towards improvements in the quality and availability of water in China to provide continuing growth opportunities.

Exhibit 1: Financial summary

HK$m

2017

2018

2019

2020e

2021e

31-March

HKFRS

HKFRS

HKFRS

HKFRS

HKFRS

PROFIT & LOSS

Water supply revenue

4,874

6,204

6,376

7,268

8,330

Environmental Protection

531

814

1522

1065

1119

Other segments

303

562

404

424

445

Revenue TOTAL

 

 

5,708

7,580

8,302

8,757

9,894

EBITDA

 

 

2,646

3,097

3,507

3,899

4,473

Operating Profit

 

 

2,271

2,691

3,022

3,289

3,785

Amortization

315

334

404

480

528

Depreciation

60

71

81

130

160

Net Interest expense

(251)

(289)

(319)

(493)

(555)

Profit Before Tax

 

 

1,963

2,462

2,772

3,169

3,417

Tax

(583)

(701)

(642)

(729)

(786)

Profit After Tax

1,379

1,762

2,130

2,440

2,631

Net profits contributable to shareholders

853

1,141

1,369

1,586

1,710

Average Number of Shares Outstanding (m)

1,505

1,571

1,609

1,606

1,604

EPS - fully diluted (c)

 

 

55.4

71.8

85.1

98.2

106.1

Dividend per share (c)

20.0

23.0

28.0

33.0

38.0

EBITDA Margin (%)

46.4

40.9

42.2

44.5

45.2

Operating Margin (%)

39.8

35.5

36.4

37.6

38.3

BALANCE SHEET

Fixed Assets

 

 

15,689

19,581

24,493

28,666

31,922

Intangible Assets

10,316

13,499

16,514

19,534

22,506

Plant, property and equipment

1,127

1,695

2,020

1,990

1,930

Investment properties

1,173

909

912

915

918

Investment in associates

635

661

676

1,483

1,637

Other

2,438

2,817

4,371

4,744

4,931

Current Assets

 

 

9,942

9,008

11,332

11,911

9,911

Properties Under Development

 

 

690

1,370

1,274

1,274

1,274

Properties Held for Sale

 

 

289

597

816

816

816

Inventory

 

 

285

348

531

560

633

Trade and Bills Receivables

 

 

872

1,055

1,243

1,311

1,481

Due from Non-controlling Equity Holders of Subsidiaries

251

260

288

323

349

Due from Associates

409

563

227

227

227

Prepayments, Deposits and Other Receivables

1,743

1,293

1,550

1,635

1,847

Pledged Deposits

 

 

783

570

645

645

645

Deposits and cash

4,314

2,511

3,973

4,335

1,855

Other

307

440

785

784

784

Current Liabilities

 

 

7,393

8,649

10,019

11,616

9,991

Trade and Bills Payables

 

 

1,097

1,626

2,410

1,400

1,500

Accrued Liabilities, Deposits and Other Payables

2,102

2,306

1,979

2,529

2,822

Short-term Borrowings

3,206

3,450

3,437

5,295

3,144

Other

988

1,267

2,192

2,392

2,525

Long Term Liabilities

 

 

9,275

8,786

12,903

14,026

15,107

Long-term Borrowings

8,123

7,432

11,494

12,494

13,494

Other long term liabilities

1,152

1,354

1,409

1,532

1,613

Shareholders' Equity

 

 

8,963

11,154

12,902

14,934

16,735

CASH FLOW

Net Cash Flows from Operating Activities

1,452

1,632

1,429

2,554

3,299

Purchase of property, plant and equipment

(92)

(100)

(100)

(100)

(100)

Increase in concession rights for water supply and sewage processing

(1,808)

(2,500)

(2,500)

(3,500)

(3,500)

Acquisitions/disposals

(283)

0

0

(1,200)

(361)

Increase in prepayments and other receivables

(1,226)

0

0

0

0

Others

(134)

(171)

(708)

159

164

Net Cash Flows from Investing Activities

(3,543)

(2,771)

(3,308)

(4,641)

(3,797)

Dividends

(135)

(369)

(450)

(530)

(610)

Shares issue and/or options exercised

(38)

301

0

(34)

0

Other

245

(362)

(183)

(205)

(221)

Net Cash Flow

(2,020)

(1,569)

(2,513)

(2,857)

(1,329)

Opening net debt (CWA definition)

 

4,213

6,232

7,801

10,313

13,170

Closing net debt/(cash)

 

6,232

7,801

10,313

13,170

14,499

Net debt to equity ratio (CWA definition)

 

70%

70%

80%

88%

87%

Source: Company accounts, Edison Investment Research

General disclaimer and copyright

This report has been commissioned by China Water Affairs Group and prepared and issued by Edison, in consideration of a fee payable by China Water Affairs Group. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

No personalised advice: The information that we provide should not be construed in any manner whatsoever as, personalised advice. Also, the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The securities described in the report may not be eligible for sale in all jurisdictions or to certain categories of investors.

Investment in securities mentioned: Edison has a restrictive policy relating to personal dealing and conflicts of interest. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report, subject to Edison's policies on personal dealing and conflicts of interest.

Copyright: Copyright 2020 Edison Investment Research Limited (Edison).

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New Zealand

The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (i.e. without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision.

United Kingdom

This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.

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London +44 (0)20 3077 5700

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London, WC1V 7EE

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New York +1 646 653 7026

1,185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

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Level 4, Office 1205

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General disclaimer and copyright

This report has been commissioned by China Water Affairs Group and prepared and issued by Edison, in consideration of a fee payable by China Water Affairs Group. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

No personalised advice: The information that we provide should not be construed in any manner whatsoever as, personalised advice. Also, the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The securities described in the report may not be eligible for sale in all jurisdictions or to certain categories of investors.

Investment in securities mentioned: Edison has a restrictive policy relating to personal dealing and conflicts of interest. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report, subject to Edison's policies on personal dealing and conflicts of interest.

Copyright: Copyright 2020 Edison Investment Research Limited (Edison).

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Edison Investment Research Pty Ltd (Edison AU) is the Australian subsidiary of Edison. Edison AU is a Corporate Authorised Representative (1252501) of Crown Wealth Group Pty Ltd who holds an Australian Financial Services Licence (Number: 494274). This research is issued in Australia by Edison AU and any access to it, is intended only for "wholesale clients" within the meaning of the Corporations Act 2001 of Australia. Any advice given by Edison AU is general advice only and does not take into account your personal circumstances, needs or objectives. You should, before acting on this advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If our advice relates to the acquisition, or possible acquisition, of a particular financial product you should read any relevant Product Disclosure Statement or like instrument.

New Zealand

The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (i.e. without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision.

United Kingdom

This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.

This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.

United States

Edison relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. This report is a bona fide publication of general and regular circulation offering impersonal investment-related advice, not tailored to a specific investment portfolio or the needs of current and/or prospective subscribers. As such, Edison does not offer or provide personal advice and the research provided is for informational purposes only. No mention of a particular security in this report constitutes a recommendation to buy, sell or hold that or any security, or that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1,185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1,185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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