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Morningstar | Daqin Sees Robust Coal Rail Demand, Despite New Settlement Measure Weighing on 2Q

We maintain our fair value estimate of CNY 9.80 per share for narrow-moat Daqin, following the company’s in-line first-half result with net profit rising 7.5% year over year to CNY 8.2 billion. The result implies an 8.2% fall in the second quarter from a year ago, despite robust coal demand growth, with volume on Daqin Line edging up 4.8% in the quarter. This reflects some fee-structure changes, following the implementation of new freight settlement measures commencing this year, as well as a lower electricity surcharge. On the sequential basis, recurring profit in the second quarter remains largely flat, and Daqin’s first half makes up 53% of our full-year forecast. We think China’s stricter air-pollution controls will lead to rail transport replacing coal trucks, which will continue to drive robust coal transport volume for Daqin in the coming years. However, with the daily volume reaching 1.3 million tons in the first half, we think Daqin’s average utilization rate should be well above 95%, which suggests further volume upside will be capped by capacity constraints. We maintain both our coal volume assumptions and our earnings forecasts, and we expect Daqin’s net profit to grow at a CAGR of 3.2% between 2018 and 2027.

We think the shares, currently trading at 1.2 times price/book, are slightly below our valuation of 1.4 times price/book and its 10-year average of 1.7 times, reflecting some market concerns on the higher costs driven by the new freight settlement measures. We think the margin pressure during the transition period will prove temporary. As part of China’s railway reform, the change in freight settlement measures is to promote long-term healthy growth in freight rail-transport, but not hurt participants’ profitability.

The new settlement measure calls for a change of the previous section-fare system to a consignment system, meaning the carrier will receive full fares on its outbound volumes but pay network usage and service fees to the owners of pass-through tracks and arrival stations. This encourages carriers to achieve higher operating leverage. We view this as a positive move toward a market-oriented railway system.

We expect Daqin’s dominant position in coal rail transport, with its cost and structural advantages, especially its access to key coal gateway Qinhuangdao Port, will make it a long-term winner. Its strong market position is reflected in the company’s robust coal volume growth, with first-half coal volume rising 7.3% compared with the lackluster 1.6% growth at key competitor Shuohuang Line. In addition, Daqin’s outbound volume accounts for about 65%-70% of its total coal volume, which should mean the company will benefit from the change in freight settlement measures, as higher outbound volumes will bode well for revenue growth; this will also flatten its cost curve, given its operating leverage. In addition, we think the company’s robust cash flow and lower capital needs will continue to support more generous dividend payouts, and our estimated 2018 dividend of CNY 0.54 per share implies a 6.3% dividend yield, higher than 4%-6% for its infrastructure and utility peers.

We remain upbeat on China’s railway reform. We expect passenger tariff reform to be concluded within the next 12-24 months, with a one-off 25%-30% tariff hike on conventional passenger lines, given the urgent need to cover the cost inflation of the past two decades. Despite Daqin’s focus on coal rail transport, we think it will still benefit, given that the company derives about 10% of its revenue from passenger service. We estimate a 25% tariff hike on conventional passenger lines from 2019 will add about CNY 0.9 billion to Daqin’s 2019 net profit, or 6%, and increase its fair value estimate by CNY 0.70 per share, which has already been factored into our valuation model. Upside to our valuation and earnings forecasts would also come from railway asset securitization, and we think Daqin’s strong balance sheet and robust cash flow will support acquisition opportunities. In addition, the possible benefit from the elimination of the CNY 0.033/ton-kilometer construction fund is also a long-term catalyst for Daqin. This would lower Daqin’s unit base tariff to CNY 0.11/ton-kilometer, compared with CNY 0.132 on Shuohuang Line, and further strengthen Daqin’s cost advantages.