Yuexiu Transport Infrastructure Ltd. BUY: HKD 6.74 (+25.3%)

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1 Analysts Crystal Zhuang Huijin Lead Analyst, Equity Research Chin Zhiren Analyst, Equity Research Gao Zhixuan Analyst, Equity Research Sia Kexun Analyst Equity Research Basic Information Last Closed Price HKD M Target Price HKD /- Potential +25.3% Bloomberg Ticker 1052:HK GICS Sector Industrials GICS Sub-Industry Expressway and Toll svcs 1Y Price v Relative Index Company Description Yuexiu Transport Infrastructure Limited is principally engaged in investment, operation and management of toll expressways and bridges in the People s Republic of China. As at 31 December 2015, the Group had a total of 13 investments in its operating expressways and bridge projects, spanning across 6 different locations. Key Financials Market Cap HKD M Basic Shares O/S 1,673.16M 52-Wk High-Low HKD HKD5.63 Fiscal Year End 31-Dec-15 (RMB mil) FY14A FY15A FY16E FY17E Revenue Gr Rate (%) - 19% 8% 2% EBITDA 1, Margin (%) 92% 90% 91% 94% Net Income Margin (%) 43% 32% 35% 25% ROA (%) 4% 3% 5% 4% ROE (%) 7% 6% 9% 8% EV/EBITDA P/E Ratio D/E Ratio Key Executives Zhu Chun Xiu Liu Yong Jie He Baiqing 1052.HK Close HangSeng Index Rebased Chairman & CEO Deputy Chairman General Manager Yuexiu Transport Infrastructure Ltd. BUY: HKD 6.74 (+25.3%) Equity Research Department 23 October 2016 Highway to Paradise with Yuexiu We are recommending Yuexiu Transport Infrastructure Ltd with a BUY rating. Our rating reflects our confidence in the company's prudent operating system and is further accentuated by the strong industry outlook for expressway infrastructure construction in China. 2Q16 Earnings Review Total income from operations up 33.7% yoy; GNSR Expressway, Yuexiu s main source of revenue, saw a rise of 16.6% yoy in operating income, contributing to 40.2% of Yuexiu s 1H2016 income The growth in income from operations, net of tax in the 1H2016 was mainly due to GNSR Expressway, Changzhu Expressway and the newly acquired SuiYueNan Expressway (consolidated to the Group since 21 July2015) in the toll operation side. 1H16 gross profit increased 36.5% yoy, and gross margins improving from 68.7% to 70.1% Net profit from controlled projects of RMB405.2 million represented growth of 29.7 percent or RMB92.9 million higher than same period in 2015; of which net profit from toll operation increased 27.5 percent to RMB411.8million. Investment Thesis Steady stream of revenue with long-term revenue generating model, geographic diversity of assets provides protection against adverse developments in traffic/toll standards in a particular area. Traffic volume at Yuexiu Transport s subsidiaries increased 7% despite China s slower economic growth, change to charging toll by vehicle weight increased average toll rate received in 2015, toll revenue increased by 20% to RMB 2.2bn in Catalysts Shenzhen-HK Stock Connect will trigger an immediate rise in the value of Yuexiu Transport Stock as mainland investors are able to purchase, increasing demand for the stock Acquisition of SuiYueNan Expressway expected to grow revenue streams by 9.6%, EPS to go up to RMB 0.62 in 2016E from RMB 0.39 in The boom in online sales in China (11.7% of total) in Q32016, up 10.4% yoy, has led to a surge in demand for delivery services. Rise in distribution logistics will raise road usage and thus higher toll revenue for Yuexiu. Valuations Our 12-month price target from date of coverage is HKD 6.47, reflecting 17.02x our 2017E EPS of HKD We believe that Yuexiu Transport s price of HKD 5.38 is significantly underpriced considering immediate catalysts not factored in that will raise its value, its prudent strategies and continued acquisition growth model. Low emphasis was also placed on its long-term revenue models, with low risks. Investment Risks Development of new roads that can disrupt existing expressways and divert traffic. Bad weather and natural disasters can deter consumers from driving, reducing toll usage and severe disasters could cause road damage that increase revenue.

2 Figure 1. Revenue by Expressway/Bridge, FY15 GNSR XiAn CangYu JinBao HanXiao Changzhu Weixu SuiYueNan GNSR Joint Humen Bridge Northern Ring Shantou Bay QingLian Source: Yuexiu Transport Annual Report 2015 Figure 2. Revenue by Operation, FY15 Source: Yuexiu Transport Annual Report 2015 Company Overview Yuexiu Transport Infrastructure Limited and its subsidiaries are principally engaged in investment, operation and management of toll expressways and bridges in the People s Republic of China. The Company s major shareholder, Guangzhou Yue Xiu Holdings Limited is a state-owned enterprise under the supervision of the State-owned Assets Supervision and Administration Commission ( SASAC ) of the Guangzhou Municipal People s Government. As at 31 December 2015, the Group had a total of 13 investments in its operating expressways and bridge projects, spanning across 6 different locations. Guangzhou Northern Second Ring Expressway ( GNSR Expressway ), Guangzhou Western Second Ring Expressway ( GWSR Expressway ), Guangzhou Northern Ring Road ( Northern Ring Road ), Guangdong Humen Bridge ( Humen Bridge ), Shantou Bay Bridge and Qinglian Expressway, all of which are located within Guangdong Province; Xian to Lintong Expressway in Shaanxi Province ( Xian Expressway ); Cangyu Expressway in Guangxi Zhuang Autonomous Region ( Cangyu Expressway ); Jinbao Expressway in Tianjin Municipality; Han-Xiao Expressway in Hubei Province; Changzhu Expressway in Hunan Province; Weixu Expressway in Henan Province and Suiyuenan Expressway in Hubei Province. 2Q16 Earnings Review Total income from operations up 33.7% yoy; all projects recording positive changes in income with the exception of Weixu Expressway GNSR Expressway, Yuexiu s main source of revenue, saw a rise of 16.6% yoy in operating income, contributing to 40.2% of Yuexiu s 1H2016 income The growth in income from operations, net of tax in the 1H2016 was mainly due to GNSR Expressway, Changzhu Expressway and the newly acquired Suiyuenan Expressway (consolidated to the Group since 21 July2015) in the toll operation side. 1H16 gross profit increased 36.5% yoy, and gross margins improving from 68.7% to 70.1% Cost ratio (cost of services excluding VAT and business tax/income from operations, net of tax) was 29.9% in the 1H2016, being 1.4 percentage point lower than same period in 2015 The Group s share of results of associates and a joint venture has increased by 25.7% in 1H2016 to RMB160.7 million. Net profit from controlled projects of RMB405.2 million represented growth of 29.7 percent or RMB92.9 million higher than same period in 2015; of which net profit from toll operation increased 27.5 percent to RMB411.8million. Porter s Five Forces To better understand Yuexiu s position in the transport infrastructure and toll management industry, we did an analysis of Porter s five forces, which provides us with a better idea on Yuexiu s abilities against market forces. Power of Buyers LOW: Given the price inelastic demand for expressways, it is difficult for a road user to challenge the pricing decision of the toll operators. This means that road users are price takers, with no control over the fares Yuexiu charges. There are little alternative routes that offer similar efficiency as roads, since driving is the main mode of transport. High switching costs to other modes of transport such as air (monetary cost) or rail (inconvenience/ gap time/lack of infrastructure) (insert statistics) deters road users from switching to other modes of transport. 1

3 Figure3. Porter s 5 Forces Existing rivalry Threat of new entrants Power of buyers Source: NUS Investment Society Estimates Figure 4: Vehicle Usage in China Power of suppliers Threat of substitutes Power of Suppliers HIGH: The bargaining power of Yuexiu s suppliers is high due to its ability to select who to award the operating rights to. (insert explanation on how operating rights are distributed) Expressways and bridges infrastructure is also controlled by the government. If the government decides not to build new infrastructures, there will be no new supply from which Yuexiu and its competitors are able to bid for. Threat of Substitutes INSIGNIFICANT: Road users are unable to switch to other expressways if the expressway provided by Yuexiu is the most efficient way to reach their destination. Toll price is almost perfectly price inelastic. Threat of New Entrants LOW: High barriers to entry - required capital expenditure to obtain the operational scale of Yuexiu is transport is rather substantial. Furthermore, unique state owned position of Yuexiu gives it special preference in awardance of expressway operating rights by the Chinese government. As the monopoly holder of expressway operating rights in the strategic locations within the Guangdong region, Yuexiu is able to maximise its entrenchment to tap onto the region s high growth potential. Existing Rivalry MODERATE: incumbents such as Shenzhen Expressway Co Ltd tend not to operate in the same region as Yuexiu and hence, there is no direct conflict of interest. SWOT Analysis: Strengths Reduced labor costs China s massive human population allows Yuexiu to gain access to cheap labour. The flow of rural labour towards cities powered the rise in income-seeking population, driving down wages Skilled workforce Source: The Oil Drum, 2015 Figure 5. Major Expressways in China (Blue lines are in operation, red lines are under construction) Source: CEO Quarterly Address Q4 FY15 Weaknesses Investments in research and development o Yuexiu being an infrastructure company, has little to zero need for investments in R&D. However, this might prove to be a shortfall as the lack of need for innovation signifies that the company s growth will eventually peter out. Future profitability o China is in a phase of rapid development. However, just like any other developed country, development will gradually slow down. As growth decreases in the long run, so will the need for infrastructural constructions, limiting Yuexiu s ability to obtain new revenue drivers. Opportunities Income level is at a constant increase o China is progressing towards being a knowledge-based economy. With higher education levels and more innovation, China will no longer be the land of cheap labour. Once touted as the largest cheap labour factory in the world, this title will soon change hands. China s approval of the P3 concession means that Yuexiu can tap on the financial means and expertise of the private sector. Although the financial capacity is often what initially motivates consideration of P3 concessions, the incentives created by concessions can also lead to greater overall value for the public sector through risk-sharing. With P3, the government is effectively hedging themselves against the cost and consequences of probable negative events. 2

4 Figure 6: Percentage of Tolled Expressways in China Source: ChinaFile, 2015 Figure 7: List of Major Expressway Companies in China Threats Increasing rates of interest Increase in labor costs Government regulations o The government s recent initiative of discounting toll fares in Hubei through the 一降两惠 policy is a boon to Yuexiu. As a whole, the toll fare for all vehicle classes fell by 10%. Although the fall in fares encourages higher traffic volume, the lower toll fare is expected to outweigh the rise in traffic volume, leading to a net fall in revenue from the Hubei province. Industry Outlook Stable Country Economic Outlook The economy of China is in a transforming stage, which will fully switch into a new normal state in future and will gradually realize a more stable growth rate and an incremental model with diversified growth forces. Meanwhile, with further penetration of reforms in various sectors and the rise of emerging industries, the economy of China will gain sustainable vitality and momentum in the medium to long term development process. Rising Affluence of Chinese & Increasing Reliance on Expressways Given the background of continuous growth in private car ownership, increase in consumption by residents, fast development in tourism, significant advancement in e-commerce development that leads to rapid development in the courier and logistics industry, highway transportation still has a great potential for growth. Source: The Oil Drum, 2015 Figure 8: China Online Sales Private-Public Partnership Opens Financing Opportunities Also, taking into account the government has been actively promoting the PPP model to attract private capital for supporting the construction of infrastructure facilities, therefore enhancing reasonable return, improving policies and operating environment are prerequisite for attracting private capital. Demand Drivers Rising affluence Guangdong people are rich, and can increasingly afford to travel more. Rising ownership of cars Due to the rise of the middle class, a larger proportion of the Chinese population can afford to own cars. For some families, this either means getting their first family car or even starting to own their own personal car. Higher car ownerships will consequently lead to higher demand and usage of expressways Development of infrastructure in China China is a rapidly evolving country, and the government is diverting more resources towards connecting rural and urban areas. The exodus of people in rural areas towards cities in search of better job opportunities paves the way for higher need of road infrastructures to provide better accessibility. E-commerce leading to rise in logistical and courier services Stable and sound government policies on toll fares (AR chairman statement) Source: Ministry of Commerce, Citi Research, GLP Report 2015 Supply Drivers Increased government expenditure on expressway infrastructure Building expressways at a breakneck speed, China today boasts of 65,000 kilometers (40,389 miles) of expressway network, the second largest in the world, compared to a mere 147 kilometers (91.34 miles) in The country is poised to expand this network further to 85,000 kilometers 3

5 (52,817 miles) by 2020, according to the Ministry of Transport. For greater integration of rural areas in the economic development process, the government also plans to build and modernize about 270,000 kilometers (167,770 miles) of rural roads. Figure 9: Hong Kong-Shenzhen Stock Connect Overview Source: Charltons, 2016 Figure 10: Hong Kong-Shenzhen Stock Connect Trade Quota RMB Aggregate quota Daily quota Northbound 300 billion 13 billion Southbound 250 billion 10.5 billion Source: Charltons, 2016 Investment Thesis 1) PPP Prompts Propitious Prospects P3 concessions are public private agreements in which the private sector takes on some of the risks and rewards of financing, constructing, operating and maintaining a transportation facility in exchange for the right to future revenues or payments for a specified term. Expanded financial capacity is one of the primary reasons public agencies consider P3 concessions for transportation facilities. Equity contributions, commercial loans, and other debt taken out by the private partner can substitute for public debt when the public is unable or unwilling to borrow for the project, supplementing the public s initiative on new projects. China has been strongly promoting highway constructions with 1.6trillion RMB worth of investment in 2015, leading to rapid increase in the mileage of express highways. Expressway mileage stands at 125,300 km at end 2015, more than 3 times the 2005 level, which wouldn t have been possible without PPP. Yuexiu being a constructor and operator of expressways, will definitely be a beneficiary of PPP. 2) Impending launch of Shenzhen-HK Connect The introduction of the Shenzhen-Hong Kong stock connect allows investors to grab a share of the pie of both Hong Kong and Shenzhen, and bring the financial markets of each closer together. With robust economic growth in both countries, this trading link offers an unprecedented opportunity for investors to gain access to a whole new territory. Foreign investors, who currently have to obtain their own quotas from China s government to buy Shenzhen equities and vice versa, will now be able to bypass that rule, albeit the daily quota still applies. This ushers in a new group of investors keen on investing in HKEX-listed stocks such as Yuexiu, potentially raising the stock s price. Assuming 60% of the quota is used, there will be an inflow of 150 billion RMB flowing to HKEX. At the current market capitalization of HKEX of 22 trillion RMB, stock prices will inflate by 0.7%. 3) The only way is up: rise in operating rights tenure Upward reclassifications of the operating tenure of Yuexiu s infrastructure signals better project security and a steady source of revenue. Extensions in the operating tenure of existing infrastructure proves the government s faith in Yuexiu s ability to manage the infrastructures in a proper and profitable manner. Strong ties between the government and management will allow Yuexiu to establish greater presence in the region. 4) Prudence is a virtue Yuexiu s cautious behavior in spending signifies strong management capabilities. A good corporate governance in a firm of Yuexiu s size is imperative in sustaining the company s healthy growth. Although Yuexiu boasts extremely healthy cash balances (RMB1,123,517 in 2014, RMB866,655 in 2015, RMB1,083,402 in 1H2016),, her strategic investments in key developing regions which promises positive returns shows no signs of recklessness from the Management. 4

6 Figure 11: EPS Ratio Earnings Per Share Catalysts Hong Kong-Shenzhen Stock Connect will trigger an immediate rise in the value of Yuexiu Transport Stock as mainland investors are able to purchase, increasing demand for the stock Acquisition of SuiYueNan Expressway will raise the revenue of Yuexiu Transport and increase its overall value, and add another long-term revenue driver Continued plans for expansion and acquisition, Government support for building of expressway infrastructure and strong consumer trends for expressway usage suggest strong and steady revenue streams and growth trends for Yuexiu transport s revenue model Financial Analysis Source: Bloomberg, NUS Investment Society Estimates Figure 12. Yuexiu Transport Return on Equity & Return on Assset Trend Source: Annual Report, NUS Investment Society Estimates Overview: The financial condition chart above reveals Yuexiu Transport s prospects moving 5 years forward, highlighting our assumptions (refer to appendix for more details), with specific assumption that Yuexiu Transport will acquire new expressways and bridges at a relatively constant rate, based on past historical trends. While revenue and profit margin is significantly impacted each time Yuexiu Transport makes an acquisition, it still maintains positive net profit margin and the gain in toll revenue of a new expressway/bridge generally cancels out the costs by the next acquisition. Strategic Acquisition Improves Yuexiu Transport s Financials Recent acquisition of the SuiYueNan Expressway has set the company back in terms of net profit margins for the year 2015, but the potential raise in equity value and income far outweighs the capital expenditure. Being located in the Hubei section of the duplicate trunk line of the Beijing- Hong Kong-Macau expressway and ending at the Jing-Yue Yangtze River Highway Bridge, the Suiyuenan Expressway is situated at a strategic location with a distinguished geographical advantage and thus has bright prospects. With a toll length of km, this is the longest compared to other expressways operating by the Group and is in line with the Group s strategy to explore large scale projects. The concession period of the Suiyuenan Expressway has a remaining term of more than 25 years before its expiry in March 2040 which is relatively long and can, therefore, allow the Suiyuenan Expressway to contribute to the future growth of the Group in the long run. Moreover, the toll traffic volume of the SuiYueNan Expressway posted a positive month-on-month growth since May 2016 and its toll revenue recorded a double-digital month-on-month growth, mainly due to the expressway Overall reduction in toll fees and preferential treatment for both passenger and cargo vehicles policy implemented by Hubei province since 1 June Its toll revenue for the first eight months of 2016 grew 24.3% YoY to RMB billion. Thus, we hold a cautiously optimistic view towards the Company s business outlook in FY

7 Operating Margins Yuexiu is facing an increasing profit margin partly due to its strategy to continuously expand and acquire new expressways and bridges. While it affects profit margins negatively in the short run (as mentioned previously), it is to be noted that during each year an acquisition occurs, the profit margin increases relatively to the previous year, suggesting that Yuexiu Transport s bottom line is slowly but surely becoming less affected by the acquisitions. Valuations Valuation Price Target: RMB 6.47 (+25.3%) 26 Analysts Estimates DCF EV/EBITDA P/E min 0-25th Pctl 25-50th Pctl 50th-75th Pctl th Pctl Figure 13. WACC Buildup Discount Factor Asset Beta 0.35 D/E Tax rate 0.00% Equity beta 0.35 Market risk premium 6.92% Rfr 1.25% Equity return 3.67% Weighted average debt return 4.60% Cost of capital (WACC) 3.67% Source: Bloomberg, NUS Investment Society Estimates DCF Model A discounted cash flow analysis was used to estimate intrinsic value of Yuexiu Transport s share price due to concerns with its cash flow generation capabilities. The primary model is forecasted over 10 years to forecast the acquisition and growth trajectory of Yuexiu s business model. The model is driven by toll revenue, segmented according to the individual expressways operated by Yuexiu, with handling income from toll fee collection, management service income and income from service area and gas station on the revenue side. On the cost front, expressway and bridge maintenance, expressway and bridge operating rights purchase expense as well as employee expense serve as crucial perimeters for projections due to Yuexiu Transport s nature as a expressway and bridge toll operator with constant acquisition of new expressway and bridge operating rights. Three cases were formulated, with the base case consisting of guidance from historical performance, annual report, industry outlook, along with investor day presentations. The DCF is most sensitive to the following factors, derivation of which are explained below. The 10 year DCF model presents a gauge of long term cash flow generation capability of Yuexiu Transport. Weighted Average Cost of Capital (WACC) To calculate Beta, linear regression of Yuexiu Transport s stock price was run against the Hang Seng for time frame of 12 months on a weekly basis and then averaged and adjusted. CAPM was used to estimate Cost of Equity, while a risk free rate and AAA corporate panda bond was used during calculation of Cost of Debt in a weighted average manner. Tax shield was taken into account as Yuexiu Transport pays income taxes for all operations. 6

8 Figure 14. Revenue Breakdown per Expressway Revenue Growth Revenue growth for Yuexiu Transport is based primarily on growing ownership of automobiles in China, increasing level of traffic flow on expressways, continued preference of driving as the main mode of domestic transport and most importantly, the strategic acquisitions they make to increase the number of expressways they own. Yuexiu Transport has continuously maintained revenue growth, achieving almost 14% CAGR over the past 5 years. As favorable macroeconomic factors combined with more strategic acquisitions, we believe that CAGR will continue to hover around 14% for Yuexiu over the next 5 years. Terminal Growth We adopt a prudent stance towards terminal growth rate forecast. There is an ongoing debate on sustainability of current 7-8% growth and whether China s mounting debt crisis will cripple its GDP growth rate in the future. We thus forecast a conservative 0.7% revenue growth expecting vehicle volume to remain stable after planning period and enhanced transport network to limit traffic volume passing expressways under Yue Xiu. Relative Valuation Source: Chairman Quarterly Statement, Q3Y15 Source: Bloomberg Source: Annual Report, NUS Invest Estimates Using price multiples such as EV/TTM EBITDA and P/E, Yue Xiu is slightly undervalued relative to industry average. Its EV/ TTM EBITDA are one of the lowest amongst peers. Price to Book ratio is not suitable in this case as majority of Yue Xiu s NCA is operating rights at NBV. Difference in depreciation method amongst peers may distort the comparison. 7

9 Figure 15. Investment Risk Matrix Investment Risks R1: Development of new roads The principal risk that threatens Yuexiu transport infrastructure s operations is the development of new roads due to the ever-changing road network that exists in China. As the Chinese government continues its effort to alleviate traffic congestion, it continues to improve on its road networks, increasing the number of ways to get from one point to another, resulting in a dip in demand for highways and bridges owned by Yuexiu. Source: NUS Investment Society Estimates R2: Weather The demand for highways and bridges owned by Yuexiu will be adversely affected by poor weather. During rainy seasons, the Chinese population will travel less, lowering traffic volume and hence, adversely affecting Yuexiu s bottom line. R3: FX Risk As the outlook of Chinese yuan is weak, the threat of FX risk remains a pertinent factor for Yuexiu. However, this risk has been adequately mitigated by the management who foresaw this trend coming and has refinanced most of its capital away from foreign bonds and notes. Disclaimer This research material has been prepared by NUS Invest. NUS Invest specifically prohibits the redistribution of this material in whole or in part without the written permission of NUS Invest. The research officer(s) primarily responsible for the content of this research material, in whole or in part, certifies that their views are accurately expressed and they will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this research material. Whilst we have taken all reasonable care to ensure that the information contained in this publication is not untrue or misleading at the time of publication, we cannot guarantee its accuracy or completeness, and you should not act on it without first independently verifying its contents. Any opinion or estimate contained in this report is subject to change without notice. We have not given any consideration to and we have not made any investigation of the investment objectives, financial situation or particular needs of the recipient or any class of persons, and accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the recipient or any class of persons acting on such information or opinion or estimate. You may wish to seek advice from a financial adviser regarding the suitability of the securities mentioned herein, taking into consideration your investment objectives, financial situation or particular needs, before making a commitment to invest in the securities. This report is published solely for information purposes, it does not constitute an advertisement and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein. The research material should not be regarded by recipients as a substitute for the exercise of their own judgement. Any opinions expressed in this research material are subject to change without notice NUS Investment Society 8

10 Appendix: Scenario Assumptions: 9

11 Pro Forma Financial Statements 10

12 11

13 Revenue 12

14 13

15 Expenses Fixed Assets: 14

16 Debt: 15

17 Ratios: 16