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Morningstar | Guangshen Sees Higher Traffic Diversion on Guangzhou-Kowloon Line; VAT Cut Positive

No-moat Guangshen Railway’s fourth-quarter operating performance signaled a 33% traffic diversion on its Guangzhou-Kowloon line, which is 10% higher than our expectation. However, the shortfall should be offset by earnings upside from a 1% value-added tax rate cut announced by Premier Li Keqiang in his annual report. Guangshen’s core operations were decent. Passenger volume on the Guangzhou-Shenzhen intercity express and long-distance lines rose 8% and 0.5%, respectively, in the fourth quarter. Freight volume remained largely flat with a year ago, compared with a sharp 8% decline in September. While the U.S.-China trade impasse is likely to pressure Guangshen’s freight operation in 2019, we think the downside is limited, as freight revenue accounts for only 10% of the total. We tweaked our earnings forecasts to reflect higher traffic diversion as well as the impact of the 1% VAT cut, but our recurring net profit forecasts of CNY 1.1 billion and CNY 1.5 billion in 2018 and 2019 are largely unchanged. We maintain our fair value estimate of HKD 6.30 per share. We think the shares are undervalued at present, trading at only 0.7 times price/book, below its 10-year average of 0.8, despite improving profitability and cash flows amid deepening railway reform.

The Guangzhou-Shenzhen-Hong Kong high-speed train, or XRL, officially commenced operation Sept. 25, and Guangshen saw its passenger volume on the Guangzhou-Kowloon train fall 33% year over year in the fourth quarter following double-digit growth in the prior three quarters. We think the XRL’s shorter travel time and integration with China’s high-speed network make it an attractive option, and we expect a potential 35% cannibalization of traffic away from Guangshen’s Guangzhou-Kowloon line in 2019. However, given that the revenue from Guangzhou-Kowloon line is just 3% of the group revenue, the impact is limited. We estimate a 35% traffic diversion will lower Guangshen’s 2019 net profit by CNY 180 million.

Li officially announced that China will lower the value-added tax rate that covers the transportation sector by 1%, as part of measures to support the slowing economy. We expect the VAT rate cut to bring an additional CNY 90 million to Guangshen’s revenue on an annual basis in 2019, and CNY 40 million-50 million to net profit, after taking account into the cost-side VAT rate cuts. This will help to partly offset the earnings downside from the traffic diversion on the Guangzhou-Kowloon line. In addition, with the completion of the overhaul cycle, Guangshen will save about CNY 200 million in repair and maintenance expense. We expect Guangshen’s operating margin to improve to 9.1% in 2019 from an estimated 8.1% in 2018, with recurring net profit rising 26% to CNY 1.5 billion.

We remain upbeat on China’s railway reform, following a few actions towards railway land monetization and railway asset securitization. In 2018, Guangshen started to monetize its railway land, which will bring about CNY 600 million of one-off income to its 2019 net profit. In March 2019, the Beijing-Shanghai high-speed rail announced it was preparing for an initial public offering. We think this marks an important move towards railway assets securitization. We think Guangshen, with 25 years of operating experience in high-speed rails, is well positioned to benefit from enormous acquisition opportunities from its parent, which owns China’s longest high-speed mileage, in order to expand its high-speed assets.