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Morningstar | China Railway Construction’s 3Q 2018 Results in Line; Fair Value Estimate Maintained at HKD 11.50

No-moat China Railway Construction Corp reported third-quarter earnings that are on track to deliver our full-year estimate. The group’s top and bottom lines booked decent 6% and 20% year-over-year growth, respectively, in the third quarter. However, value of total new contracts signed posted a drop of 4% during the third quarter, broadly in line with what we have seen from its infrastructure peers. The company's uncompleted orders amounted to more than three times sales, boding well for future growth. We reaffirm our fair value estimate of HKD 11.50 per share on the firm and consider the current market price fairly valued.

Much of the company’s year-on-year drop in new orders was on the construction segment. With a goal of reducing balance sheet leverage, the company can no longer take up as much debt to finance PPP projects called forward by debt-saddled local governments. We are also starting to see signs that construction companies are holding back on investing too much into PPP projects with long payback cycles. Even though China has granted its local governments CNY 1.35 trillion in specialty debts (up 69% from 2017’s annual cap) to spend on infrastructure, it appears that a large portion of those funds is utilized to pay back past debts as opposed to launching new projects. Since PPP projects often carry much higher profitability for constructors, expected reduction in its top-line contribution will most certainly drag down CRG’s construction margins over the next few years.

However, we continue to see PPP projects serving as a necessary source of the company's revenue and expect the company’s capital expenditure to remain elevated, pressuring free cash flow. Coupled with the company’s plan to lower its balance sheet leverage further, we expect China Railway Construction Corp to seek equity financing and asset disposals over the next few years. The company has already obtained approval from its board to spin-off and list its subsidiary China Railway Construction Heavy Industry. It is hard to tell whether the asset sales will be value-creative, given the limited information that is disclosed at the moment, but we will issue a follow-up note on the transaction once details become available.