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Morningstar | Transferring Coverage of CCCC; Lowering FVE to HKD 8.60; Shares Look Fairly Valued. See Updated Analyst Note from 29 Aug 2018

After transferring coverage of China Communication Construction Company, or CCCC, to a new analyst, we are lowering our fair value estimate to HKD 8.60 from HKD 12.50. The bulk of the downward adjustment comes from the expectation of slowing infrastructure project demand that will put pressure on the company’s margins for the next couple of years. Recovery in margins will more likely be seen over the longer term (post-2023) as capital investment toll roads start to bear fruit. Our valuation has factored in the government’s proactive measure of bringing forward infrastructure investment to help soften the potential blow to the economy from the U.S.-China trade war. Our fair value estimate implies 6 times forward earnings per share.

The company’s first-half result reaffirms our view that the business' profitability will gradually decline over the next couple of years. Its operating profit margin fell to 7.2% for the first six months of 2018, versus 7.9% for the year-ago period. Capital expenditure on build-own-transfer, or BOT, projects increased by 11%, in line with our expectation. CCCC’s near-term outlook is intact, with new contract numbers continuing to register year-on-year growth on robust public-private partnership and overseas contracting demand. On a more political front, Malaysian Prime Minister Mahathir Mohamad’s decision to cancel the East Coast Railway Link did not surprise us. As the leading contractor for the project, CCCC will most likely receive a hefty cancellation fee in compensation. What we are worried about, however, is that the incident could spark other national authorities to reassess their involvement in China’s Belt and Road initiative. As such, we still believe Belt-Road projects are adding risk to the company’s business.

On the capital investment front, we still see the company taking on more public-private partnership, or PPP, contracts. We forecast CCCC to spend an average of CNY 41 billion on investment-related capital expenditure annually over the next five years, weighing on the company’s free cash flow to the firm, or FCFF, and return on invested capital, or ROIC, as a result. However, as traffic volume gradually ramps up on its portfolio of toll roads, we see the company’s FCFF turning positive starting in 2023. Our forecast implies 41 times enterprise value/FCFF by the end of our explicit 10-year forecast period.

We reaffirm our view that the company does not possess sustainable competitive advantages over peers, despite its position as one of the largest (by contract value) contractors in and outside of China. We believe the firm lacks an economic moat, as most projects require the company to compete fiercely with competitors of all sizes on costs, the speed of completion, and leveraging relationships with clients. While CCCC’s rising investments and ownership in toll roads appears to give the company potential for an economic moat based on efficient scale, we do not believe that segment will enable the firm to maintain ROICs above the weighted average cost of capital, or WACC, over the next 10 years.