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Morningstar | Strong 1H Result China Railway Construction Helped By Changing Project Mix, FVE Remains at HKD 11.50. See Updated Analyst Note from 04 Sep 2018

No-moat China Railway Construction Corporation's, or CRCC's, the strong first-half result came in ahead of our expectations, with revenue and recurring profit up 7% and 18%, respectively. Management attributes the faster bottom-line growth to a more favorable project mix and better cost management. With new contracts expanded by 10% during the first half, the company's uncompleted orders amounted to more than three times sales, boding well for future growth. We retain our fair value estimate of HKD 11.50 on CRCC, as recent Chinese yuan depreciation offsets our revised more optimistic earnings outlook.

Public-private-partnership, or PPP, projects had a major positive impact on the company's top and bottom lines during the first half. On average, PPP contracts’ gross margins are 500 basis points higher than regular construction projects due to their higher risk nature. In the near term, we expect the Chinese government to take an accommodative stance on infrastructure spending to support the economy, leading to faster project approval and execution for PPP. Management of CRCC also guided a better outlook for the second half of 2018, as local governments are expected to be given more liberty to take up infrastructure-related debts. We now expect the company to achieve a gross margin of 9.7% for the full-year 2018, compared with 9.2% in 2017.

However, as PPP projects represent an ever more important source of the company's revenue, we expect CRCC'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 CRCC to seek equity financing and asset disposals over the next few years. In fact, 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.