China Water Affairs Group Limited — Growth story continues

CWA, a mid-sized private water company, is a pioneer in the privatisation of water supply assets in China (the so-called TOO model: transfer, own and operate). Currently, the company has extensive and exclusive water supply coverage in over 50 cities (mostly Tier 3/4) in 13 provinces, connecting to 2.9 million users. CWA is a constituent of the FTSE Environmental Opportunities Asia Pacific Index and is included in Shenzhen-Hong Kong Stock Connect.

CWA posted 20% top-line growth in FY17 (vs restated revenue for FY16), driven by a 24% increase in its water supply segment (85% of the total revenue) and 67% growth in its sewage treatment segment (contributing 9% of the total revenue).

With acquisitions slowing down from HK$972m in FY16 to HK$286m in FY17, the company upped its capex by 50% to HK$1,910m to maintain its growth engine. Net debt increased by 48% to HK$6.2bn, bringing its net debt to equity ratio from 50% in FY16 to 70% in FY17.

The financial restatement regarding the reclassification of property, plant and equipment to intangible assets in FY17 aims to bring the reporting of concession rights in line with Hong Kong-listed peers to facilitate like-for-like comparisons. Previously, the assets operating under the TOO model were recognised as property, plant and equipment. Under the new accounting policy, these assets are recognised as intangible assets (concession rights).

We lower our fair value by 6% from HK$7.12/share to HK$6.71/share based on a sum-of-parts EV/EBITDA multiple. We think the sum-of-parts EV/EBITDA multiple can best reflect the immediate impact of our reduced revenue and hence EBITDA forecast and incorporate management’s guidance on capex/acquisitions and likely net debt positions. We lower our revenue forecasts for FY18 and FY19 by 6% and 7%, respectively, as CWA’s reported FY17 sales were 9% below our prior estimates. CWA exited FY17 with net debt of HK$6.2bn, almost 30% higher than our prior forecast, as a result of 50% higher capex and an HK$860m loan to China City Infrastructure Group (currently 7.3% owned by CWA). We derive the fair value of HK$6.71/share based on 7.0x EV/EBITDA multiples for its water business, at a discount of approximately 50% to HK-listed peers, plus 1.3x FY17 book value of its property development and other segments. We assume minorities increase 12.7% from HK$3.35bn to HK$3.77bn as CWA continues to make acquisitions. We model its net debt to decrease by 5% from HK$6.23bn to HK$5.90bn from FY17 to FY18e based on management’s guidance of approximately HK$2bn capex and acquisitions (vs HK$2.2bn in FY17) and likely recovery of the HK$860m loan to China City Infrastructure Group.

Investors in CWA should take heed of the following risk factors.

CWA is a listed company in Hong Kong offering pure equity exposure to tap water supply in China (with 87% of FY17 revenue from city water supply operation and construction). The company is a pioneer in the privatisation of water supply assets in China.

According to the National Statistics Bureau of the PRC, 98% of the city population was covered by the tap water supply network by the end of 2015. However, only 451 million people had access to tap water in 2015, slightly over 30% of the country’s entire population. In summary, tap water is under-penetrated especially in Tier 3/4 cities. CWA believes that these cities offer an attractive combination of growth potential and a lighter regulatory burden.

Management estimates that private enterprises account for only 20% of the water supply industry, and believes that the opportunity for privatisation remains significant. CWA prefers to have total control of its water networks, tariff negotiations and capital budgeting (the TOO model: transfer, own and operate). CWA seeks to acquire water networks at book value from often loss-making local governments, and create value with operational improvements and tariff negotiations. The basis for tariff determination is an ROE range of 8-12%, according to CWA. As a general rule, management hopes to make acquired assets accretive to earnings within two to three years.

Before founding Silver Dragon Group, the predecessor of CWA, in the 1990s, Chairman Duan Chuan Liang worked for the Ministry of Water Resources of the PRC for more than 10 years. The combination of his political connections and entrepreneurial approach was critical to the growth of the company, especially in the early days.

CWA indicates that its funding cost is approximately 2-3% offshore and 5-10% below benchmark borrowing rates onshore. Management seeks to create value for shareholders with a combination of competitive borrowing costs and, hopefully, a disciplined approach to capital deployment. For instance, CWA prioritises the project opportunities where it has existing customer service networks, to mitigate counterparty risks as a result of heavy leverage of local governments.

The majority of CWA’s water supply capacity is located in Tier 3/4 cities, under 30- to 50-year exclusive and renewable concession rights. It currently has daily capacity of 6.7m m3 for tap water. On top of its vertically integrated capabilities from raw water processing, tap water supply and sewage treatments, CWA is seeking to enter industrial wastewater treatment by targeting enterprise customers with specific technological requirements (evidenced by its long-term contract with China National Offshore Oil Corporation).

City water supply business is bread and butter for CWA, accounting for approximately 85% of the firm’s revenue.

The volume of city water supply in China grew from 60bn tonnes in 2010 to 66.8bn tonnes in 2015, at a CAGR of 2.2% according to the data from the Ministry of Housing and Urban-Rural Development. Frost & Sullivan forecasts a CAGR of 2.2% for 2016-20e for the market to increase to 74.4bn tonnes by 2020.

CWA entered the sewage water treatment market in 2012. This segment reports a CAGR of 82% in FY13-17 in terms of top-line growth from a small base.

The city sewage treatment market has been growing in size rapidly in China since the 1980s, with the city sewage treatment volume up from 35.5bn tonnes in 2010 to 50.7bn tonnes in 2015. The residential waste water processing fee went up from RMB0.76 per tonne in 2010 to RMB0.85 per tonne in 2015, and the industrial waste water processing fee increased from RMB1.08 per tonne to RMB1.16 per tonne during the same period.

As CWA does not disclose outputs, utilisation or average selling prices, we forecast its revenue based on the Chinese water market growth (in terms of volume and price), CWA’s current capacity and plans to continue with a similar rate of capex and acquisition. We forecast CWA’s water supply segment to grow 30% in FY18e and 22% in FY19e (vs the CAGR of 30% in FY13-17). We assume only 5% growth for the sewage business as the TOO model (ie asset acquisition) is generally not applicable. We also factor in potential valuation gains and profit realisation of CWA’s property development business, reported in ‘other’ segments. We are conservative about the profitability of the water supply segment in the mid-term as we think the competition in the secondary market may eventually increase acquisition costs for CWA (vs the acquisitions at book value in the past).

We model CWA’s revenue to grow 25% in FY18 and 20% in FY19 (vs consensus of 19% and 14%, respectively) and operating margins to be 34% in FY18 and 33% in FY19 (vs 40% in FY17), after stripping out the HK$185m non-cash valuation gain in H117 and factoring in an increase in amortisation of concession rights due to higher capex in FY17. Management guides its FY18e revenue should increase by 20-30% year-on-year. In the absence of CWA’s disclosure on outputs and average selling prices, our assumptions for its revenue growth are based on the following:

We view CWA’s acquisitions and capital expenditures as an integrated vehicle for growth. In FY14 and FY15, the company’s capex was close to HK$800m pa and acquisition cash outflows totalled HK$165m and HK$95m, respectively. The combined cash outflows for capex and acquisitions more than doubled in FY16/17 from the FY14/15 level. Understandably, the net debt to equity ratio also went up, from 57% in FY14 to 78% in FY17. CWA’s effective interest rate for borrowing also increased from 3.5% to 4.8% during this period, although its funding cost remains competitive in the industry.

Executive Chairman Mr Duan Chuan Liang: After working for the Ministry of Water Resources of the PRC for more than 10 years, Mr Duan founded Silver Dragon Group in the 1990s, the predecessor of China Water Affairs. He is also the chairman and non-executive director of China City Infrastructure Group (2349.HK). He has a bachelor’s degree in water conservation and hydro power from the North China College.

Executive Director Ms Ding Bin: Ms Ding Bin has over 10 years of experience in financial management and tax planning. She graduated from Zhengzhou University of Technology in finance and computer management and is a certified public accountant in the PRC.

Executive Director Ms Liu Yu Jie: Ms Liu Yu Jie started her career in investment banking and progressed to corporate management roles. Prior to CWA, she was an executive director of Shanghai Industrial Investment (Holdings) Co and sat on the board of several environmental and resource management companies. She graduated from the University of International Business and Economics with a master’s degree in business administration.

Executive Director Mr Li Zhong: Mr Li Zhong is a member of the Standing Committee of the Shenzhen Municipal Committee of the Chinese People’s Political Consultative Conference. For more than 20 years, he has served in large state-owned enterprises and US-based corporations. He graduated from Saint Mary’s University of Canada with a master’s degree in business administration.

Investors in CWA should be mindful of the following risk factors:

For instance, local governments are required to steer away from hiding debts via guaranteed purchases, because PPP projects are capped at 10% of the annual budgets for local governments and project development process is long and tedious. This could open up more opportunities for CWA, if more local governments are forced to divest loss-making assets in order to free up their balance sheets.

We lower our fair value by 6% from HK$7.12/share to HK$6.71/share based on a sum-of-the-parts EV/EBITDA multiple, as we think this method can reflect the immediate impact of our reduced revenue forecast and the likely net debt positions based on guidance. We lower our revenue forecasts for FY18 and FY19 by 6% and 7%, respectively, as CWA’s reported FY17 sales were 9% below our prior estimates. CWA exited FY17 with net debt of HK$6.2bn, almost 30% higher than our prior forecast, as a result of 50% higher capex and an HK$860m loan to China City Infrastructure Group (currently 7.3% owned by CWA). We derive the fair value of HK$6.71/share based on 7.0x EV/EBITDA multiples for its water business, at a discount of approximately 50% to HK-listed peers, plus 1.3x FY17 book value of its property development and other segments. We assume minorities increase 12.7% from HK$3.35bn to HK$3.77bn as CWA continues to make acquisitions and the original shareholders of the acquired assets typically retain 30-40% of the stakes. We model its net debt to decrease by 5% from HK$6.23bn to HK$5.90bn from FY17 to FY18e based on management’s guidance of approximately HK$2bn capex and acquisitions (vs HK$2.2bn in FY17e) and likely recovery of the HK$860m loan to China City Infrastructure Group.

Management seeks to create value for shareholders with a combination of competitive borrowing costs and a disciplined approach to capital deployment.

CWA indicates that its funding cost is approximately 2-3% offshore (outside China) and 5-10% below benchmark rates onshore (in China). In January 2017, the company issued a US$300m five-year senior note at face value and a coupon rate of 5.25% due in 2022.

Compared to Beijing Enterprises Water Group (371.HK), a Beijing government-owned water utility focusing on sewage water treatment, and Luzhou Xinglu Water (2281.HK), a Sichuan-based regional water company with a business model similar to CWA, CWA’s effective interest rates for bank loans look competitive. Among the three companies, Luzhou Xinglu Water is the least levered, but its borrowing cost is the highest, possibly due to a smaller scale. Luzhou Xinglu Water also prefers to have ownership of water supply assets. It is currently serving 0.26 million users vs 2.9 million users covered by CWA’s networks.

It is worth noting that CWA holds the view that the quality of the currently available PPP projects in China is not consistent. While it is the intention of the central government to encourage local municipals to use JV/hybrid ownership structures in order to deleverage their own balance sheets and improve the operating efficiency of existing assets, the majority of PPP projects in water and sewage on the market are for new infrastructure, and the repayments primarily come from local governments. CWA indicates that it prioritises on the opportunities where it has existing customer care networks, to mitigate counterparty risks.

Economic value added (EVA) spread, the delta between WACC (weighted cost of capital) and ROIC (return on invested capital) is a good metric for shareholder value. We think CWA’s competitive borrowing cost is a key contributor to its low WACC. Even compared to state-owned enterprises such as Beijing Enterprises Water Group (43.6% owned by Beijing Enterprises, essentially the Beijing city government), CWA’s borrowing cost looks competitive. We believe this is the result of CWA’s quality assets and stable cash flows. On the other hand, CWA’s cost discipline seems to pay off, reflected in a higher ROIC compared to Beijing Enterprises Water Group.

We lower our revenue forecasts for FY18 and FY19 by 6% and 7%, respectively, as CWA’s reported FY17 sales were 9% below our prior estimates. We also revise EBITDA downward for FY18 and FY19 by 1% and 4%, respectively. We assume a certain degree of operating leverage.

The quality of its earnings in FY17 is comparable to FY16, both with net operating cash flows as approximately 25% of revenues (vs 9% in FY15). CWA generated net operating cash flows of HK$1.45bn, 25% up year-over-year.

However, CWA’s net debt and leverage are at a historical high, with a net debt up 48% to HK$6.23bn in FY17 as a result of a 50% increase in capex to HK$1,910m and the HK$860m loan to China City Infrastructure Group (currently 7.3% owned by CWA). So far, the short-term debts remain at 30% or lower of the total interest-bearing debts.

A major change in CWA’s financial reporting in FY17 is the reclassification of the water supply infrastructure under the TOO model from property, plant and equipment to other intangible assets. Management indicates that this restatement is to bring its reporting in line with peers in Hong Kong, as recommended by its new auditor PwC, to facilitate like-for-like comparisons. This restatement has no retroactive impact on operating expenses or operating cash flows.

In FY17, CWA restated its financials for FY15 and FY16 to bring its accounting policy in line with peers regarding the revenue and asset recognition of concession agreements. This restatement has no retroactive impact on operating expenses or operating cash flows.

On the income statement, a major change is a non-cash HK$700m increase in FY16 revenue, as a result of estimates on a cost-plus basis for construction services (vs percentage of costs incurred to date and a gross margin assumption). CWA believes that the gross margin assumption used for its estimates at 10.7% is lower than the 20% typically seen among its peers. Management also thinks that the non-cash HK$700m increase in FY16 revenue is evidence of its prior conservative revenue recognition policy.

The water supply infrastructure previously classified as property, plant and equipment is now reclassified to intangible assets, as the amount to be received from end-users is uncertain. These intangible assets are amortised on a straight-line basis over the terms of remaining service concession periods.

Management indicates that its previous accounting policy should in theory result in a lower EBIT number (all else being equal) because depreciation of fixed assets is typically over 10-15 years (vs amortisation of intangible assets under concession contracts typically over 25-30 years of the contract period).