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Morningstar | SEG’s 1Q19 Operating Profit Better than Expected on One-off Items; FVE Maintained at HKD 3.18

Shanghai Electric Group’s, or SEG’s, operating income growth of 16.7% year over year in the first quarter of 2019 came in above our expectations, primarily driven by a significant jump of CNY 488 million in other income owing to revenue from repossession of land by the government. We maintain SEG’s fair value estimate at HKD 3.18 per share and consider the stock to be modestly undervalued. Our no-moat and negative moat trend ratings remain. Overall revenue growth decelerated to 11.4% year over year from a cyclically high of 41.3% in the preceding period, while gross margins contracted to 19.8% from 20.7% over the same period. We maintain our relatively optimistic medium-term outlook on the industrial equipment business, which accounts for 42% of total revenue and is SEG’s largest segment, as robust growth in elevator services and automation should more than offset weak property-led demand for elevator products. We continue to expect strong pulled-forward demand for wind turbines as wind tariffs are scheduled to be lowered by 2021. Our positive outlook on the industrial equipment and wind turbine businesses is partially offset by structurally weak demand for coal-fired power equipment, as the government continues to clamp down on coal-fired projects.

Despite the slowdown in China’s property market, we expect SEG’s industrial equipment business to post average revenue growth of 7% in the medium term, albeit at the expense of gross margins. SEG’s partnership with Mitsubishi Electric and aggressive pricing strategy should enable it to extend its leadership position in elevator products. Additionally, long-term demand for elevator maintenance services and automation should underpin strong growth for the segment. Indeed, the industrial equipment backlog growth accelerated to 16.6% year over year in the first quarter of 2019 from 9.6% at the end of 2018. While SEG’s Mitsubishi-branded elevators have gained market share in recent years, we don’t think this is sufficient to impact our no-moat and negative moat trend view on SEG. The elevator business is a commoditized market, as evidenced by the lack of pricing power among major players. Furthermore, competition should remain heated as foreign players such as ThyssenKrupp expands its capacity in the domestic market. Our negative moat trend is also underpinned by the structural headwinds in the high efficiency and clean energy equipment business segment, which has curtailed demand for coal-fired power equipment. Evidently, the segment’s revenue has fallen to 34% of overall sales in 2018 from 48% in 2009. We are less optimistic on the trajectory of the coal-fired equipment business, with order backlog growth worsening to negative 22.3% year over year in the first quarter of 2019 from negative 14.2% at the end of 2018. While pulled-forward demand for wind turbines in the medium term should mitigate some of the long-term slowdown in the coal-fired equipment business, we note wind turbines are subjected to regulatory risks that are outside of SEG’s control. This was evident in 2017, when revenue for the new energy and environmental protection segment fell almost 18% year over year, on the back of suspension in wind power construction by the National Energy Administration. That said, demand visibility for wind turbines in the medium term remains robust, with backlog order growth of 19% year over year in the first quarter of 2019, following 29% growth at the end of 2018.

We have revised our long-term revenue growth forecast for modern services upwards to negative 0.3% CAGR between 2019 and 2023 from negative 1.9% previously. While the segment is mainly engaged in power plant engineering and services and is dependent on coal-fired equipment demand, we have a taken a more optimistic stance due to the “Belt and Road” initiatives, which has seen the company expanded its services into over 50 countries, such as Pakistan, Dubai and South Africa. Given SEG’s status as a state-owned entity, we think that it should benefit as China is funding numerous infrastructure projects overseas.