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China South Locomotive & Rolling Stock Corporation Limited (1766.HK) - Upcycle has just Started!

Friday, December 19, 2008

5882

China South Locomotive & Rolling Stock Corporation Limited(1766)

Recommendation on 19 December 2008
Recommendation	Hold
Price on Recommendation Date	$4.220
Target Price	$3.900

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Summary

According to Porter`s Five Forces analysis, the industry of China South Locomotives & Rolling Stock (1766.HK, CSR) is inclined to have low threat to new entrants, high bargaining power of customers, low-to-medium bargaining power of suppliers, low threat of substitutes, and high competition with domestic players.

In the light of increasing railway infrastructure investment and rolling stocks upcycle should follow the construction cycle that usually takes about 3-5 years We think CSR will enjoy the highest growth lately in 2009 and 2010.

Due to market demand, product mix tends to shift to some rolling stocks and equipment that requires high technical standard. This can boost the profit margin for CSR. Also, we expect the liquidity has improved a lot after collecting the global initial offering proceeds of approx. RMB 10.2bn that some of this will be used to repay debts.

Our 12-month target price is HK$ 3.90 based on the DCF model, implying 2009 P/E to be 25x and 2010 P/E to be 20x. This target 2009 P/E is close to the upper bound of the P/E range traded by the international peer group.

Porter`s Five Forces Analysis

i) LOW threat to new entrants: Railway rolling stocks suppliers require high technical standard that has increased the barriers to entry of new participants. Rolling stocks manufacturers are under stringent supervision and have to obtained approval licenses by government bodies including the Ministry of Railway (MOR) and NDRC, before they can start production and sales. Currently, another primary rolling stocks competitor in China is China North Locomotives and Rolling Stocks Group (CNR). Though there are a number of big international market players like General Electric, Siemens, Alstom and Bombardier, these are not yet able to access China directly but via joint venture or transfer of technical skills. So considering the fast growing railway market in China in coming years, we do not see any potential threat by overseas competitors.

ii) HIGH bargaining power of customers: MOR is the main customer for CSR, whereas they have got less participation in overseas market that only accounted for about 8-10% of the total revenue. As MOR is the big customer, its bargaining power is relatively high and it may provide guidance for pricing of a new type of train or equipment for CR network, when it is commercially launched, by reference to the prices of similar products, the cost structure of locomotives and profit margin. Domestic contracts can be obtained via opening auction or direct bargaining for special technical products. When technology is getting more advanced and more nationalized, we expect this can increase the bargaining power of CSR progressively.

iii) LOW-TO-MEDIUM bargaining power of suppliers: The main raw materials are steel, aluminum and copper. Firstly, due to global economy meltdown and economic activities contraction, metal demand remains very weak that leads to accumulated inventories. Copper and aluminum prices have dropped by 45% and 38% YoY respectively. Steel price also plunged by 46% QoQ. Secondly, CSR has adopted a centralized procurement system and established relationships with key suppliers to enhance the bargaining power and to enjoy discounts on volume procurements.

iv) LOW threat of substitutes: Railway is an economic, efficient and environmental friendly mean of transportation, compared with highway and aviation. CSR has covered a wide range of technical and advanced rolling stocks products including locomotives, passenger carriages, freight wagons, multiple units as well as rapid transit vehicles, thus we do not foresee any substantial threat of substitutes.

v) HIGH competition with domestic players: CSR together with CNR have accounted over 95% market share in China, whereas CSR has focused on the southern region and CNR has focused on northern region. Domestic competition is rather intense as they shared relatively equal presence in China. In particular, CSR has apparently higher market share of multiple units than CNR though.

Upcycle has just Started!

As per the recent announced economic stimulus plan, railway infrastructure investment will be mounted to 600bn yuan in coming year that is at least 1.7 times than 2008 investment and nearly double of 2007 investment. Regarding investment for purchasing rolling stocks, it will jump to 100bn yuan and even 200bn yuan in 2009 and 2010 respectively, from 55.3bn yuan in 2007. It seems the upcycle has started since 2007 and will last until 2010. For investment for purchasing rolling stocks, the amount surged 67% YoY while the investment for maintenance is fairly stable. However, we reckon growth will not declined drastically right after the peak, as CSR`s upcycle is like to sustain and remain rather stable for equipment upgrade and maintenance after procurement of a large number of rolling stocks in prior years.

Sound Financial Position

Apart from material costs, product mix will also greatly affect the profit margin of CSR. For instance, due to increase in average unit price and upgrade of locomotives that accounting higher profit margin, the overall gross profit increased by 51% YoY according to the interim result.

The market is going for high technical equipments with improving degree of nationalization. Contract reference price is determined by the technical standard required, and if it is a unique featured product, CSR can even bargain with the customer directly which increases its bargaining power. In particular, electric locomotives, multiple units as well as rapid transit vehicles are likely increasing the presence in China, owing to higher speed, efficiency, coverage of electrified railways and urbanization. As these products require higher technical standard, we expect this can boost the profit margin for CSR.

Also, we expect the liquidity has improved a lot after collecting the global initial offering proceeds of approx. RMB 10.2bn. RMB 2.6 bn of the proceeds will be used as current capital and some of this will be used to repay debts. As of the third quarter, using the Chinese Accounting Standards, gross gearing ratio dropped from 117.3% in Jan 08 to 31.4% in Sept 08, and the net gearing ratio also decreased from –11.7% to –30.8% between the above period.

Risk

i) Small customer size: Currently, a majority of orders come from the Ministry of Railway.

ii) Price of raw materials and energy may be higher than expectation.

iii) Regulatory risk: Apart from railway fixed asset investment by the Ministry of Railway, the company has to comply with various policies and regulations in terms of environmental protection and safety etc.

Valuation

The international peers are now trading around 18-19x on average. As per our DCF model, 12-month target price is HK$ 3.90, implying 2009 P/E to be 25x and 2010 P/E to be 20x. This target 2009 P/E is close to the upper bound of the P/E range traded by the peer group. We think this target P/E is reasonable, and CSR deserves premium valuation due to revenue visibility as well as expected high earning growth in next 2 years.

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