Infrastructure Construction Insights July 16, 2012 Infrastructure FAI We expect stimulus to kick in during 2H12 We visited a number of major infrastructure construction companies in Beijing and Tianjin, including China Railway Group [0390.HK] (CRG) China Railway Construction [1186.HK] (CRC); China Communication [1800.HK] (CCC) and China State Construction International [3311.HK] (CSCI). Source: Wind 12-month forward PER for construction companies Source: Bloomberg Note: companies included in the chart above include CSCI, CRG, CRC and CCC Edwin Lee, CFA (852) 3698-6319 Our discussions with management revealed that the business environment for the infrastructure construction sector in the first half of this year (1H12) remained difficult, although fundamentals should improve in 2H12. In the current environment we prefer companies with higher earnings visibility. We are thus more positive on social housing, railway and metro railway construction due to their promising outlook and secure funding support. In order of our preference: CSCI, CRC/CRG, CCC. In light of the strategic position highlighted by the policy makers, we do not expect much pressure on financing for social housing and railway projects in 2H12, and see strong support by the government. Following the recent monetary easing (cuts to the reserve ratio requirement and in benchmark interest rates), we believe payments from customers have been accelerated and thus see improvements in operating cash flow for construction companies. We expect new project approvals to accelerate in 2H12 while construction activity should accelerate in late Q3 to early Q4 this year. Figure 1: Comparable valuation table edwinlee@chinastock.com.hk John Mulcahy (852) 3698-6889 johnmul@chinastock.com.hk Source: Bloomberg (Valuation refers to 2012; price as of 13 July, 2012)
Inflection point reached The construction companies we met did not see a particular demand pick-up in May/June resulting from the central government stimulus, but they are optimistic for 2H12 and expect new contract approvals to accelerate during the period. The companies believe the stimulus will be selective and targeted at key infrastructure projects under construction (railways should be the key beneficiary), social housing and metro railways. We do not expect financing pressures on social housing and railway projects to continue in 2012. Also, the railway construction companies expect an upward revision of railway infrastructure spending in 2012, up to RMB450bn (from the original target of RMB406bn), which could produce positive earnings surprises for railway companies. In our view, the stimulus may take time to kick in especially after the handover of political leadership in 2H12. Increased construction activity may accelerate in late Q3 to early Q4 this year. Figure 2: Infrastructure FAI Source: Wind
KEY FINDINGS: Operation expecting a better 2H12 despite challenges. The pace in the construction sector was healthy in 1H12 and contractors expect it to accelerate in 2H12. Following the recent monetary easing (cuts to the reserve ratio requirement and in benchmark interest rates), companies feel payments from customers have been accelerated and thus see improvements in operating cash flow. Although the companies still report pressure on project funding, the situation is much better than in 2H11, when many construction projects were suspended due to an industry-wide funding shortage. New contract wins changing landscape. It is apparent from our discussions with management that China has seen a shift in the focus of spending on transport infrastructure. For CRG new contracts in 1H12 may surge 20% year-on-year (YoY) despite minimal new contract wins from its key business national railways. Instead, metro railways and the property sector took the bulk of new contracts. For CRC, although the company did not provide specific guidance on 1H12 new contract wins, management noted that the momentum in Q1 (new contracts up 30% YoY) should be sustained in 2Q12. We expect a similar growth profile for CRG during the same period. Surprisingly, new contracts for CCC may have dropped by 15-20% YoY in 1H12, due mainly to a significant decline in project wins in the highway segment. Generally, we believe the central government s investment focus will switch from railways/highways in the past few years into metro railways. Profit margin slowly recovering. Companies expect their gross-profit margins to improve slightly in 2012 due to 1) more effective management of resources after the scale-down of infrastructure spending, and 2) reduced materials cost, which should benefit margins. Figure 3: Price for Portland cement: grade 42.5 in china Figure 4: Price for steel bar: HRB335 12mm in China Source: Wind Source: Wind
Financing risk so far, so good. Although companies like CRG and CCC have relatively high net debt to equity ratio (70-80 %), they are not keen on raising funds from the equity market in current sluggish conditions. As state-owned enterprises (SOEs), these companies have relatively little difficulty in sourcing bank loans, with interest at benchmark rates, and can consequently secure adequate bank credit. Stimulus should be selective We expect the upcoming stimulus in China will be smaller than the RMB4trn package in 2008 and to be selective to certain sectors. Sustainability of funding is the key for this round of stimulus and it should be led by central government or local governments which have adequate financial resources. Railways, metro railways and social housing projects should be better-positioned than highways and port projects, which are differentiated by type of funding sources Figure 5: Monthly FAI: railways Figure 6: Monthly FAI : highways Source: The Ministry of Railways Source: The Ministry of Transport Figure 7: Monthly FAI: Coastal water ports Figure 8: Monthly FAI: Inner river ports Source: The Ministry of Transport Source: The Ministry of Transport
Metro railways will accelerate. Our checks with construction companies indicated that the construction of metro railways is being maintained at a fast pace and some tier-1 cities are prioritizing metro railways even ahead of social housing. We believe metro railways are usually built in cities with a certain economy of scale. The financial strength of those cities is generally stronger than the national average, providing upside demand potential while the urban population should continue to increase. This is also reflected in the significant increase of new contract growth for metro railway projects by CRG in 1H12. Social housing, the priority project. New starts of social housing reached 63% of the full-year target in 1H12, which is encouraging. Including the 10m units new start in 2011, construction demand should be strong this year. In addition, social housing will continue to be a priority project in China, as stated in the 12 th Five Year Plan, which calls for the provision of 36m social housing units during the five years of the plan. This is reflected in the central government s supportive policies, such as the increased subsidy for social housing construction in 2012, up by 23.1% YoY, from RMB170bn to RMB210bn. Railways bottoming out. Although the absolute amount of spending budget for the railway sector in 2012 will be way below its peak of RMB700bn in 2010, we see limited downside for spending this year. The government has announced funding for railway construction due to its strategic position, reflected in the potential upward revision of the spending budget for the railway sector. Highways and ports are lackluster. As highway projects are mainly financed by local governments, the poor debt situation among Local- Government-Financing-Vehicle (LGFV) in the past years suggests this segment will face financing obstacles. The tight liquidity position is likely to curtail further construction work and new project launches. On the other hand, the key customers for port construction are private enterprises, and the slower-than-expected recovery of the global economy may dampen the interest from such investors in the near-to-medium term.
Looking for new earnings drivers China is undoubtedly under-developed and more construction work is expected to be supported by its continuing urbanization. However, companies share our view that the growth rate during 2012-15 should be low due to the over-spending on infrastructure in the past few years. The topline growth driven by capital expenditure is unlikely to be repeated and companies will need to find new earnings drivers. Amid this challenging environment CRG, CRC and CCC all share the same strategy to sustain long-term growth. Their consensus is that the growth should come from 1) overseas markets and 2) diversification. According to CRC, its management set a long-term target to generate no less than 50% of its revenue from non-construction business (such as property and mining) and 30% of revenue from overseas markets by 2020. We acknowledge that overseas projects should yield higher returns, but we have concerns about the execution capability of Chinese construction companies in overseas projects. With some exceptions the record is not good, notably the big losses incurred on a CRC railway project in Saudi Arabia in 2010 and a CRG highway project in Poland in 2011. The outlook for construction companies remains challenging and a successful transformation of construction companies will be a key for its long term development. CSCI should be the best-positioned, followed by CRG/ CRC We noted that short-term trading opportunities may emerge from the impact of the easier monetary policy in China. However, we are concerned at the longer-term outlook for the sector due to a lack of new earnings drivers. In our view, the infrastructure construction companies should see headwind in 2012, but we expect the earnings for companies to improve in 2H12 on the back of accelerating government spending and improving credit environment. In the prevailing uncertain environment we prefer companies with higher earnings visibility. CSCI is better positioned than CRG, CRC or CCC due to its stronger execution and exposure to lowrisk social housing projects through the build & transfer (BT) model. Among the large-cap construction companies, we believe CCC should see higher earnings risk and it is the last on our list.
Figure 9: CSCI: PER band Figure 10: CCC: PER band Source: Company, Bloomberg Source: Company, Bloomberg Figure 11: CRG: PER band Figure 12: CRC: PER band Source: Company, Bloomberg Source: Company, Bloomberg
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