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Morningstar | Daqin’s Decent 2018 Performance In Line; Safety Checks at Coal Mines Lead to Weak 1Q

Narrow-moat Daqin Railway reported a decent 2018 result, with net profit up 9% to CNY 14.5 billion, boosted by robust demand for coal transport by rail that coincided with a freight rate hike in late March 2017. Full-year volume on Daqin Line edged up a further 4% year over year to 451 million metric tons in 2018 following a sharp 23% volume recovery in 2017. However, a few coal mine disasters in Shanxi, Shaanxi, and Inner Mongolia have triggered stricter safety checks on coal production, leading to a 4% fall in first-quarter volume. This was largely in line with our expectations, and we expect Daqin’s daily average volume to gradually recover to 1.2 million tons in the second half. We maintain both our coal volume assumptions and our fair value estimate of CNY 9.80 per share. We expect Daqin’s coal volume to fall slightly to 425 million tons in 2019, due to lackluster coal-fired power demand that will be dampened by higher hydropower outputs and China’s supportive policy for clean and renewable policies, as well as the coal mine safety checks and Daqin’s maintenance works in April. We forecast Daqin’s net profit to rise 2.3% to CNY 14.9 billion in 2019, which also incorporates the earnings contribution from Daqin’s recent acquisition of an addition 20% in Tanggang Line.

We think the shares, currently trading at 1.1 times price/book, are undervalued compared with the company’s 10-year average of 1.6 times and our valuation of 1.3 times price/book at our fair value estimate. This reflects some market concerns over long-term coal demand and potential volume diversion from Menghua Line slated for 2020. Although the excess coal-rail transport capacity should increase competition, we expect Daqin’s dominant position here, with its cost and structural advantages, especially its access to key coal gateway Qinhuangdao Port, will make it a long-term winner.

In addition, we think Daqin’s robust cash flow and lower capital needs will continue to support more generous dividend payouts. The company’s proposed 2018 dividend of CNY 0.48 per share implies a 5.8% dividend yield, higher than the typical 3%-4% for its infrastructure and utility peers.

We expect Daqin to maintain a stable annual coal volume of 440 million tons over the midcycle. We think China’s stricter air pollution controls will see rail transport replacing coal trucks and drive robust coal-rail transport volume in coming years, despite rising shares of renewable energy and China’s shift away from energy-intensive growth mode. However, the capacity constraints and the high utilization rate on Daqin Line should mean a relatively low growth outlook for Daqin, and we expect net profit to grow at a CAGR of 2.8% between 2018 and 2028.

Daqin acquired an additional 20% stake in Tanggang Line at CNY 1.7 billion in March 2019. Tanggang Line connects Daqin Line to Caofeidian Port, which is one of the key coal ports in Bohai Rim, with designed capacity of 200 million tons. The deal is priced at about 1.1 times price/book, which we think is fairly valued compared with Daqin’s current valuation of 1.1 times price/book. After the acquisition, Daqin’s holdings in Tanggang Line increased to 62%, which will be consolidated in financial statements and reclassified as a subsidiary from associate investment. We’ve adjusted our model accordingly, but there’s little impact to our fair value estimate. We expect the deal to create synergies with Daqin’s current operation and strengthen its bargaining power over ports, with increasing flexibility for shipments to Caofeidian Port in the case of capacity constraint and volume control at Qinghuangdao Port, and further enhance its dominant position in coal-rail transport.