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Morningstar | Interim Result Disappoints; CSCI's FVE Slashed to HKD 10 Amid Rising Competition. See Updated Analyst Note from 21 Aug 2018

China State Construction International, or CSCI, reported a 2018 interim result below our estimates. The margin for its Mainland China operation (approximately 70% of company bottom line) dropped to 20% versus 23% for the same period last year. We believe much of the decline in profitability has to do with the rising level of competition as the country's infrastructure spending slows. Consequently, we are cutting our fair value estimate for no-moat CSCI to HKD 10 from HKD 14 to reflect further deterioration in the company's China margins.

Despite a falling margin, management guided a brighter outlook for its Mainland China business for the second half of the year. We echo management's view that the Chinese authorities will stimulate the economy by pumping money into infrastructure investment to counter tightening measures on the real estate market and rising pressure from U.S. tariffs. However, we think stimulus on infrastructure spending will be short-lived, and further slowdown on the country's infrastructure spending is inevitable over the long term. Given the firm does have a sizable backlog, we forecast the company's Mainland China operation to achieve average revenue growth of 11% over the next five years. We adjusted down the group's gross margin assumption for Mainland China by an average of 100 basis points for the next five years, resulting in the bulk of the reduction in fair value.

The company's Hong Kong and Macau operation (approximately 26% of bottom line) contracted by 10% year over year but was slightly offset by improvements in margin. We slightly lifted top line assumption for the group's Hong Kong and Macau operations as management guided HKD 30 billion for this year. However, we are sticking with our view that CSCI's traditional strongholds in Hong Kong and Macau will face more competitions from other state-owned peers.

Recall that the company has an internal guideline of keeping its net gearing ratio at 40% max. However, that ratio jumped to 60% by the end of the first half of 2018. While management once again reassures investors that it will not raise capital via equity issuance in 2018 or 2019, it did not rule out the possibility of potential asset injection from parent company China State Construction Engineering. The higher level of gearing will likely see any asset injection funded by a combination of debt and equity. Given the lack of clarity, we have not factored in the above scenario into our forecast. We will issue another update once the firm provides more details on the assets.