China Water Affairs Group Limited — Well positioned in a growing market

CWA is a one-stop water services solutions provider with operations encompassing the supply of raw and tap water, sewage treatment, network construction and maintenance and water resource management. Founded in 2003 and based in Beijing, CWA supplies water to over 58 cities in the People’s Republic of China (PRC) (under the transfer–own–operate model) and runs sewage treatment projects (under 25-year franchise agreements – build, operate, transfer (BOT)) spread across a number of provinces and regions. CWA also operates a number of other smaller businesses, including property development. The property business develops and sells land banks accumulated during the past 15 years. Proceeds are used for the development of the core water business. CWA seeks to grow its business both organically, via expansion of the network and tariff increases, and through the acquisition (privatisation) of existing assets.

Blended peer group multiples indicate a valuation for CWA of c HK$10.7/share. Applying only peer group P/E multiples (FY1 14.4x and FY2 12.7x) CWA’s valuation would rise to HK$11.7/share and HK$12.4/share, respectively. The two-year PEG ratios of 0.8x (at HK$10/share) and 0.9x (at HK$11/share) also appear undemanding for a company with CWA’s growth record. Our DCF valuation of HK$13.4 share is sensitive to assumptions on discount rates (we use 8%), terminal growth rates (we use 2%) and long-term EBIT growth rates (we assume 14% pa beyond 2021). Reducing our assumption for EBIT growth from 14% to 12% lowers the DCF valuation to HK$12.2/share (using discount rates of 8% and a terminal growth rate of 2%).

Regulation – CWA is allowed to earn returns of between 8% and 12%. Reductions in the allowed return, although unlikely in our view, could reduce the profitability.

CWA offers pure equity exposure to the Chinese water market and operates water supply assets across 58 Tier 3 and Tier 4 Chinese cities. The business expansion has delivered strong returns for shareholders, with CAGR in the DPS of 35.7% and 29.6% for EPS in the period 2013–18.

CWA is focused on the Chinese water supply market, with a supply capacity of 8.49m m3/day currently. In FY18, c. 0.7m m3/day of additional capacity was added by acquisitions and organic expansion. The water business accounted for 87% of group operating profits in 2018. CWA entered the sewage treatment sector in 2012 and this business has also grown rapidly in recent years and contributed c 10% of operating profits in 2018. Of the other businesses, property development is the most notable, generating c 3% of operating profits in 2018.

CWA‘s strategy is to continue to grow in its core Chinese market. Growth is targeted from expanding existing operations, through additional capex and improving profitability via tariff increases. CWA also seeks to acquire water networks (often loss-making) from local governments and as a result of operational improvements and tariff negotiations to improve profitability. Management targets earnings accretion from the acquisitions on a two- to three-year time frame.

The executive chairman, Mr Duan Chuan Liang, founded the predecessor company to CWA, Silver Dragon Group, in the 1990s. Prior to that, Mr Duan worked for the Ministry of Water Resources in the PRC for over 10 years. As a result of the implementation of its focused strategy, CWA has been able to achieve rapid growth for shareholders, with a CAGR in the period 2013–2018 of 26.1% for operating profits and 29.6% for EPS. The DPS has also been increased significantly (CWA’s policy is to pay at least 30% of basic EPS in DPS), achieving a CAGR of 35.7% in the period 2013–18.

The Chinese government has implemented significant changes to the Chinese water system in order to address the problems of scarce water resources, poor water quality and financially hard-pressed local governments. Water transfer projects and environmental legislation have begun to address some of the issues, but it is, in particular, the privatisation of water assets, encouraged by the central government, that provides a significant market opportunity for CWA.

Figures from the World Bank indicate that, in absolute terms, Chinese water resources, at 594.2bn m3 rank as the fifth most plentiful in the world, after Brazil, the Russian Federation, Canada and Indonesia. On a per-capita basis, the analysis appears less favourable, with China at approximately one-third of the global average, but nevertheless not out of line with some other major industrial economies. The headline figures do not, however, reveal the geographic disparity in terms of water resources between regions and the highly polluted nature of much of the water. According to the United Nations Food and Agriculture Organisation, some areas in the north of the country, such as the Huai and Hai-Luan river basins, possess resources of less than 500m3/year per inhabitant (below the level defined as ‘water scarce’ by the UN) versus c 25,000m3/year per inhabitant in the relatively sparsely populated south-west of the country. A total of 11 provinces in China fall below the 1,000m3 per capita level, defined by the World Bank as the ‘water poverty’ mark. Eight provinces are defined as suffering from ‘extreme scarcity’ with annual water resources below 500m3 per capita. According to CWA, over 400 out of 660 cities suffer from water shortages. With population and economic growth, and in the absence of intervention, the situation would worsen.

The quality of water has also been a major concern. According to the UN, FAO ‘Water Report 37 2012’, 80% of the 50,000km of major rivers in China are so polluted that they can no longer support fish. In addition, around urban areas 90% of rivers are said to be seriously polluted, especially in the industrial north of the country. According to the National Development and Reform Commission (NDRC), in 2015 over 30% of China’s seven major river systems fell below the expected standard (below grade III).

The Chinese government has taken a number of initiatives to address issues of water scarcity and pollution.

The South-to-North Water Diversion Project involves drawing water from southern rivers and supplying it to the north and thereby reducing water abstraction in the relatively dry Northern provinces. The project will link China’s four main rivers and will involve the construction of three diversion routes, across the eastern, central and western parts of China. Planned for completion in 2050, it is estimated the project will cost $62bn and, when complete, will facilitate the diversion of 44.8bn cubic metres of water annually.

As we have already noted, a significant proportion of China’s water resources are polluted. To tackle the problems of pollution the authorities have devised a regime of increased supervision and punishment. The revised Water Pollution Prevention and Control Law came into effect on 1 January 2018 with increasing government responsibility and supervision. Over 900,000 river chiefs have been appointed, who will in turn have their performance assessed by public bodies based on the quality of rivers and lakes in their jurisdiction. The river chief system is designed to improve the co-ordination of trans-jurisdictional matters. Stronger enforcement also forms a key part of the law and fines can reach as much as RMB1m with the potential for criminal punishment for significant violations. The Ministry of Ecological Environment, in its recently published 2017 ‘State of Ecology & Environment Review’, revealed that RMB11.6bn of violation fines were levied in 2017. While the changes have begun to bear fruit in terms of river quality (in 2017, rivers meeting grades I–III rose to 71.8% (from 71.2% in 2016) versus the target of 70%), the picture remains mixed, with groundwater and lakes and reservoirs showing a deterioration.

The 13th Five Year Plan for the Construction of Urban Wastewater Treatment and Recycling Facilities (issued 2017) has set out a number of objectives for increasing the rate of urban sewage treatment, sludge treatment and expansion of the sewage pipe network. In total, investment is expected to reach RMB560bn, c 31% higher than the expenditure envisaged in the 12th Five Year Plan.

The rapid rate of urbanisation in China and the weak financial state of the local governments’ balance sheets have also led to the Chinese authorities to encourage the participation of private capital in the provision of water services and this has created a significant business opportunity for CWA and allowed it to grow its business strongly in recent years. In addition, the recent economic policy document (943 – June 2017) from the NDRC called for, among other issues, more stringent discharge standards for sewage, competitive bidding for sewage treatment contracts and the introduction of a pricing mechanism for sewage treatment and sludge. Most importantly for CWA, in our view, NDRC 943 advocates the establishment of a price-adjustment mechanism that fully reflects the costs of the water supplied, so that the residential water price is no longer below cost level and prices in the non-residential section of the market allow for a reasonable profit level to be earned.

The underlying Chinese water market has been growing modestly over the longer term, at a rate of c 1%, although domestic usage has been growing more rapidly, at almost 3%, over the same period. However, the percentage of the market that has been privatised remains small (c 15% of the water market is currently in private hands), allowing significant scope for expansion.

Despite recent rises, water tariffs in China remain low. A comparison of international water tariffs shows clearly that China remains well below international averages for industrialised nations. Tariffs correspond to c 1% of average disposable income compared to a world average of c 3–5%, providing potential for upward revision over time.

As a pioneer of the public–private partnership in the water supply business in China and integrated across the entire water supply value chain (using the TOO model), CWA has been able to expand more rapidly than some of its competitors and has established an extensive network of contacts with local governments. The network, covering 58 cities (operated using 30–50-year contracts) allows CWA to ensure that it is not overly exposed to adverse regulatory/political outcomes in any one specific area. The direct collection of tariffs from the end user also provides for a stable income and cash flow. Although international water companies have made some inroads into the Chinese market, recent history (since the financial crash) would suggest that they have pulled back from the market. We believe that CWA’s local knowledge, Chinese credentials, experienced management team and proven track record have made it a trusted partner of local governments and place it in a strong position to grow the business.

CWA’s strategy is to exploit the growth opportunity in the Chinese water market. As we have already seen, the water business remains the core component of profitability and has grown rapidly in recent years, with the principal profit drivers being price increases and volume growth (organic and acquisitive). In the case of acquisitions, CWA will buy water assets (often loss-making) from local authorities, and improve and expand the system while applying for tariff increases. The regulation allows for an 8–12% (post-tax) return on equity.

Exhibits 5 and 6 show that in 2018 acquired projects accounted for c 64% of the total increase in capacity, with organic growth accounting for the other 36%. In total, the capacity additions of 702,000 m3/day represent an increase of c 9% in capacity. Customer numbers increased from 2.9m at year-end FY17 to 3.3m at FY18 (+c 14%). In FY18, CWA was also successful in negotiating tariff increases in 16 cities (versus seven in each of the previous two years). Since the year-end, a further eight cities have agreed tariff increases. We believe the scale of the tariff increases varies significantly, from as little as 2% in some cases, up to a maximum of 20%.

CWA entered the sewage market in 2012 and this business has grown quickly too (2013–18 CAGR in operating profit: 66.5%) to a point where it contributes c 10% of operating profits. An additional 205,00m3/day of sewage treatment capacity was added as a result of organic growth in 2018 and four cities agreed tariff increases (one each in the previous two years).

Increasingly, CWA will also seek to explore the provision of value-added water services and the development of a direct drinking water business (not regulated and not subject to return caps). Growth is targeted by both organic and acquisitive routes with the continuing disposal of non-core assets used, in part, to fund the expansion.

CWA now serves 58 cities in the east and north of China, spread over 13 provinces and three independent municipalities. Most of the cities served are small to medium-sized (Tier III or IV). The distribution network is over 135,000km in length. In total, CWA serves 3.3m people and its assets have a total designed capacity of 13.91m m3/day. The current capacity of 8.49m m3/day will be supplemented by 1.85m m3/day of assets currently under construction and 3.57m m3/day of plans for future expansion (Exhibit 7).

The growth is, in part, funded by the disposal of non-core assets and this forms a key part of CWA’s strategy. In 2018, CWA disposed of assets worth HK$833m and plans to increase the rate of disposals to over HK$1,000m in 2019. A significant proportion of the disposal proceeds are generated by the profits on property development and investment. Unwanted water assets (eg water treatment plants) are either developed by CWA’s own property development business or sold on to other developers for cash.

The increased capacity (illustrated graphically but unfortunately not quantified by CWA) has been accompanied by rising revenues and profitability as shown in Exhibit 11. Over the period since 2008, CWA has achieved CAGR of 32.8% in revenues and 39.8% in operating profits. The operating margin for the core water business has remained in the range of 36–41% since 2011, and in 2018 was 38%, marking an improvement over the 37% margin recorded in 2017. Over the past five years, revenues and segmental profits in the key water business have grown at a CAGR of 31.5% and 33.3%, respectively.

CWA posted continuing year-on-year growth in group revenue (HK$7,580m, +32.8%), recurring operating profit (HK$2,718m, +37.5%) and EPS (71.8c, +29.6%). The growth reported exceeded our expectations for both revenue (HK$7,069m) and EPS (64.9c). The performance was aided by property profits, tariff hikes, acquisitions and an improvement in the cost-to-income ratio. It is worth noting that, excluding fair value gains on investment properties and a change in the fair value of derivative financial assets, CWA’s growth in operating profit was 37.5%. The DPS was increased to 23.0c (Edison FY18e: 19.6c) and represented c 32% of basic EPS, in line with CWA’s policy of paying at least 30% of basic EPS as a DPS. The headline numbers can be seen in Exhibit 12.

The core water business (c 82% of group revenues) saw revenues and operating profits increase by 25.1% (to HK$6,204m) and 30.1% (to HK$2,401.9m), respectively. The profit growth resulted from tariff increases, capacity expansion (acquisitive and organic) and a strong performance from construction and connection. The sewage business saw year-on-year growth in revenues of 47.1% and 30.4% in profits. Once again, tariff hikes and capacity expansion fuelled growth along with construction and connection work. The relative contributions of each of CWA’s divisions can be seen in Exhibit 13.

As CWA continues to expand the scope of its operations, net debt rose to HK$7,801m, but the balance sheet remains healthy and the ratio of total liabilities to total assets reduced from 65% to 61%, helped by the recovery of HK$833m from the sale of non-core assets. The returns on capital employed, according to our calculations, were 10.3%

The 13th Five Year Plan and the recent opinion issued by the NDRC (934) show that the government remains committed to an improvement in environmental standards and accepts the idea that improved standards will require tariffs to be placed on an economic footing. This political direction of travel is clearly a positive for CWA. The reform of the water supply market in China is at an early stage and the implementation of the public–private partnership model is expected to accelerate. CWA’s competitive position is strong and its financial position remains sound, with cash inflow and disposal proceeds underpinning growth. CWA is a stable (cash flow is relatively immune from economic fluctuations) but growing utility business with the opportunity to offer additional services, such as the provision of hazardous waste services and direct drinking water (unregulated with the potential for significantly higher margins). We believe the outlook for CWA remains favourable.

Executive chairman Mr Duan Chuan Liang: Mr Duan worked in the Ministry of Water Resources of the PRC for more than 10 years, before founding the Silver Dragon Group in the 1990s. Mr Duan has over 30 years’ experience of the water industry and he has a bachelor’s degree in water conservation and hydro power from North China College of Water Conservation and Hydro Power. Mr Duan is also is the chairman and non-executive director of China City Infrastructure Group.

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

Executive director Ms Liu Yu Jie: Ms Liu Yu Jie has been working in Hong Kong, Singapore and the PRC for over 20 years in total. She graduated from the University of International Business and Economics in Beijing and is also the executive director of New Universe Environmental Group.

Executive director Mr Li Zhong: graduating from St Mary’s University of Canada with a master’s degree in business administration, Mr Li Zhong is a member of the Standing Committee of the Shenzhen Municipal Committee of the Chinese People’s Political Consultative Conference, as well as being the director of Shenzhen Bus Group and the honorary chairman of the Hong Kong Volunteers Association. He has served in large state-owned enterprises and US-based corporations for over 20 years.

We use peer valuation multiples cross-referenced to a DCF to arrive at a suggested valuation for CWA.

For the comparable valuation analysis, we have selected a range of mid-sized to large Chinese and international water companies and tabulated the P/E, EV/EBITDA, Yield and P/B multiples (for FY1 and FY2) to obtain sector averages. An average of peer group multiples indicate a valuation for CWA of c HK$10.7/share. Applying only peer group P/E multiples (FY1 14.4x and FY2 12.7x) CWA’s valuation would rise to HK$11.7/share and HK$12.4/share, respectively. The two-year PEG ratios of 0.8x (at HK$10/share) and 0.9 x (at HK$11/share) also appear undemanding for a company with CWA’s growth record (sector average of 1.2x).

We have also constructed a DCF, valuing cash flow to 2024 assuming capex of HK$2,200m pa and using as a base-case long-term EBIT growth of 14%, a discount rate of 8% and a terminal growth rate of 2%. The valuation is sensitive to assumptions on discount rates and long-term EBIT margins, but as can be seen from Exhibit 16, using our base case assumptions a valuation of HK$13.4/share is obtained. Reducing the long-term growth assumption for EBIT, from 14% to 12% or raising the discount rate to 9% would reduce the valuation to HK$12.2/share or HK$10.8/share respectively. Exhibit 15 shows the sensitivity of the DCF valuation to changes in discount rate and terminal growth assumptions, while Exhibit 16 shows the impact of variations to assumptions on long-term EBIT growth.