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Morningstar | Guangshen’s First Half In Line; It Takes a Further Step Amid Railway Land Monetization

Guangshen’s first-half result, with net profit rising 29% to CNY 654 million, contained little in the way of surprises and implies an 8% fall in second-quarter earnings from a year ago, as the majority of overhaul costs were booked in during the quarter. Core operations were decent, and passenger volume on the Guangzhou-Shenzhen intercity express and Guangzhou-Kowloon train rose 9.7% and 11.2%, respectively, driving revenue up by 13.4% from a year ago. With 74% of the planned overhaul completed, we expect Guangshen’s profitability to improve in the second half, with operating margin rebounding to 8.6% from 6.6% in the second quarter. We maintain our full-year net profit forecast of CNY 1.7 billion (including the one-off land sale gain), but we lower our fair value estimate slightly to HKD 6.50 per share from HKD 6.80, after taking into account the weaker Chinese yuan against the Hong Kong dollar. We think the shares are undervalued at present, trading at only 0.7 times price/book, compared with its 10-year average of 0.8 times and 1.3-1.4 times for its close peers in Hong Kong and Japan. We think Guangshen’s focus on passenger railways will continue to provide the company with a stable growth outlook and robust cash flows, while China’s railway reform will boost the company’s profitability and drive its long-term investment value.

The shares have pulled back by 34% since the beginning of the year, underperforming the 7% decline of the Hong Kong Hang Seng Index. We think the underperformance is attributable to concerns over traffic diversion from the commencement of the Guangzhou-Shenzhen-Hong Kong Express Rail Link, or XRL, in September 2018 and the slow pace of railway reform. While the XRL promises a speedier travel time of 50 minutes versus two hours on the conventional rail, the locations of the stations, coupled with the 18%-20% higher fare cost, may limit the convenience and benefits to passengers. The XRL’s Guangzhou station is 30-40 minutes by car or subway outside of downtown Guangzhou. We assume a 15% loss of traffic in the coming two years, followed by flat volumes in the next three years. In addition, the revenue contribution from through train services comprised only 6% of group revenue, so the impact should be limited. We estimate a further 20% traffic diversion will lower our 2019 net profit forecast by 3% only.

It’s worth noting that Guangshen has taken a further step toward monetizing its large land reserves. It will enter an entrustment agreement with GRRE (Guangzhou Railway Real Estate Construction and Engineering Co. Ltd), a wholly owned property developer of Guangzhou Railway Group, in relation to the redevelopment of an old railway goods yard in downtown Guangzhou. This is the second move, following its sale of 37,000 square meters of land to the local government. While it is still too early to project the development’s cash flow, we think it marks an important move toward commercializing its 11.8 million square meters of land. Our valuation model has factored in a CNY 12 billion revaluation gain for Guangshen, equivalent to HKD 1.70 per share.

We remain upbeat on China’s railway reform. We think more concrete action will be taken over the next 12-24 months, including progress in passenger tariff reform, as well as railway asset securitization and further deregulation. We expect all these to boost Guangshen’s profitability and returns over the next five years, and we forecast the company’s annual income to grow at a decent 21% during 2018-22, with return on invested capital improving to 9.5% in 2022 from 3.9% in 2017. While the improved return is still below the company’s cost of capital of 10%, we think further operating efficiency gains and additional income streams from land utilization will improve Guangshen’s long-term profitability, with returns above its cost of capital. These changes should enable the company to develop a moat.