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Morningstar | Guangshen’s 2018 Result Implies a Net Loss in 4Q; Cutting FVE to HKD 5.80, Shares Remain Undervalued

We lower our fair value estimate for Guangshen to HKD 5.80 per share from HKD 6.30, following the company’s full-year 2018 result that was below our expectations. Net profit fell 23% year over year to CNY 784 million, pointing to a net loss of 180 million in the fourth quarter. We think the significant miss was primarily driven by the negative impact from the change of settlement method on freight transport, while rising overhaul and repair costs also dampened margins. Core operating performance was largely on track, with full-year passenger volume rising 5% and freight turnover remaining largely flat from a year ago. According to management, the change in freight settlement will boost both revenue and cost in freight operation. Nevertheless, as Guangshen’s dispatch volume accounts for only 30% of the total freight volume, the new change will see cost outpacing revenue and narrowing margins. We tweak our earnings forecasts to reflect the change in freight settlement, and we lower our 2019 net profit forecast by 15% to CNY 1.1 billion; this also factors in a slower pace of passenger tariff reform, given the government’s priority to support the economy through cost reductions. However, we think railway asset securitization and railway land utilization will speed up, as the railway system’s debt continued to climb fast.

We think the shares are undervalued at present, trading at only 0.6 times price/book, which is well-below its 10-year average of 0.8 times, despite improving profitability and cash flows amid deepening railway sector reform. We think Guangshen’s focus on passenger railways will continue to put the company’s existing operations on a stable growth outlook with robust cash flows, while China’s railway reform will boost Guangshen’s profitability and drive the company’s long-term investment value.

We expect Guangshen’s recurring net profit to rise 49% in 2019 to CNY 1.1 billion, with operating margin improving to 7.6% from 5.9% a year ago as its significant overhaul is largely complete. In addition, Guangshen will be receiving a CNY 600 million one-off land sales payment in 2019, which will further boost net profit to CNY 1.7 billion. Given the swing in one-off items, the company’s reported net profit is expected to jump 122% in 2019. And we estimate Guangshen’s net profit to grow at 10% CAGR between 2020 and 2023.

Rising costs have hampered Guangshen’s earnings during the past two years, with operating margin falling to 5.9% in 2018, from 9.5% in 2016. There are signs that Guangshen’s profitability should have bottomed: 1) 100% of its overhaul schedule is complete, and we expect repair and maintenance expense to fall more than CNY 100 million from 2019 (till next repair cycle in 8-10 years); and 2) the central government plans to lower enterprises’ contribution in employee social security, which we estimate to save about 3%-4% of labor costs; and 3) the planned 1% VAT rate cut in transportation sector will bring an additional CNY 90 million to Guangshen’s revenue on annual basis in 2019, and CNY 40-50 million to net profit, after taking account into the cost-side VAT rate cuts.

Guangshen’s fourth-quarter operating performance signals a 33% traffic diversion to Guangzhou-Shenzhen-Hong Kong High-speed Rail, or XRL, which officially commenced operation on Sept. 25, 2018. We think the XRL’s shorter travel time and its integration with China’s high-speed network make it an attractive option, and we have factored in a potential 35% cannibalization of traffic away from Guangshen’s Guangzhou-Kowloon line in 2019. However, given 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.

We remain upbeat on China’s railway reform, but expect slower pace for passenger tariff hikes, given the government’s priority to support economy through a series of cost-cutting plans announced during the two sessions of National People’s Congress and Chinese People’s Political Consultative Conference. We maintain our view that passenger tariff rate will be raised at least 25% to cover its cost inflation over the past 24 years. We factor in the rate hikes in our 2020-21 earnings forecasts. A few actions towards railway land monetization and railway asset securitization indicate the sector’s reform is taking positive progress. In 2018, Guangshen started to monetize its railway land, which will bring about CNY 600 million one-off income to its 2019 net profit. In March 2019, the Beijing-Shanghai High-speed Rail announced its was preparing for an initial public offering, which 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 who owns China’s longest high-speed mileages, in order to expand its high-speed assets.