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Morningstar | Guangshen’s Weak 3Q In Line; Lowering FVE to HKD 6.30 on Weaker Freight Volume. See Updated Analyst Note from 26 Oct 2018

Guangshen’s 18% year-over-year fall in net profit to CNY 310 million was within expectations, as the scheduled overhaul costs continued to weigh on margins. On a positive note, Guangshen’s gross margin recovered to 9.9% from 8.3% in the prior quarter, and with the majority of the planned overhaul completed, we expect the company’s profitability to further improve in the fourth quarter.  Core passenger operations were decent, and passenger volume on the Guangzhou-Shenzhen intercity express and Guangzhou-Kowloon train rose 15.6% and 11.5%, respectively, in the third quarter. However, freight volumes fell sharply by 9.3% in September. This probably suggests the negative impact from the US-China trade war, and we think the prolonged impasse will pressure Guangshen’s freight operation in the coming year. Still, given that freight revenue accounts for less than 10% of the total revenue, we think further downside should be limited. We maintain our full-year recurring net profit forecast of CNY 1.1 billion (CNY 1.7 billion with one-off land sale gain included). We lower our fair value estimate slightly to HKD 6.30 per share from HKD 6.50, after factoring in a weaker freight volume in 2019 and the slightly negative impact from the change of settlement method on freight transport.

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 a 30% increase in free cash flow to CNY 1.1 billion from the 10-year average. The shares have pulled back by 46% since beginning of the year, underperforming the 17% decline of the Hong Kong Hang Seng Index. We think this underperformance is attributable to concerns over the slower pace of railway reform, along with traffic diversion from the commencement of the Guangzhou-Shenzhen-Hong Kong Express Rail Link, or XRL, in September 2018.

In our view, passenger tariff reform is not a question of “will or will not”, but rather a question of “when and how.” According to China Railway Corporation’s, or CRC’s, first-half financial statement, the railway debt further climbed up to CNY 515 billion with a net loss of 368 million, compared with net profit of CNY 1.8 billion at the end of 2017. In addition, we think the U.S.-China Trade War is likely to be prolonged, which will further pressure freight rail-transport volumes and further dampen CRC’s profitability. However, China’s planned railway investment is unlikely to change, meaning CRC’s debt will balloon further. We expect the tariff hike on conventional lines to be delayed, given the government’s focus on boosting the economy from the challenges from the prolonged U.S.-China trade war. But we think the approaching debt-repayment peaks, which are likely to come between 2020 and 2025, will force the system to carry out more concrete steps to boost the railway industry’s profitability, and we expect to see more material progress on tariff reform in the second half of 2019. As such, we tweak our earnings forecasts in 2019 and 2020, with part of the earnings upside from tariff reform factored into our 2020 forecast.

The Guangzhou-Shenzhen-Hong Kong high-speed train, or XRL, officially commenced operation on Sept. 25, and Guangshen saw its passenger volume on Guangzhou-Kowloon train fall 4.3% year over year in September following double-digit growth in the past two months. We think the opening of the XRL has resulted in some traffic diversion, but the start of the school season is also another reason. The coming months should provide more accurate data on the potential cannibalization of traffic away from Guangshen’s Guangzhou-Kowloon train line. We think the XRL’s shorter travel time and its integration with China’s high-speed network make it an attractive option, and our model has factored in 20% traffic diversion in 2019. However, given that the through train service contributes only about 3% of revenue, the impact on our earnings forecasts and fair value estimate is limited. We estimate a further 20% traffic diversion would lower our 2019 revenue and net profit forecast by only 0.5% and 2.9%, respectively.