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China Infrastructure
Cement: tighter supply and strong demand leads to industry
consolidation and structural ASP growth
Positive on cement and environmental sectors on reduced
overcapacity and favourable policy; neutral on construction and
toll roads
Top picks: Sinoma, CR Cement and CE
Strong demand: Demand from infrastructure
construction has been filtering through to the
cement industry since 2H09; we expect this to
last for 2-3 years as most of the key projects
take some time to complete. Together with
boosting affordable housing construction, this
should offset slower demand from the private
property market. Based on estimated fixed
asset investment growth of 22%, we estimate
cement production will grow by 10.4% to
2.0bn tonnes in 2011.
Tighter new supply: Following the
tightening of cement investment requirements
in September 2009, we expect slowing new
capacity releases. Year-to-October, China’s
cement investment grew just 8.7% y-o-y,
down from 60% over the past two years. As
the construction period for cement plants is
usually 18-20 months, new capacity should
slow from 2H11. Currently, we forecast new
supply to come down to 195mt in 2012 from
247mt in 2009.
Faster old capacity elimination: The
government has been strict about eliminating
vertical kiln capacity. As of September, the
total phase-out of old capacity reached 90mt,
more than the number of 74mt in 2009.
Following the 107mt to be eliminated in
2010, we expect another 80mt to be phased
out next year. The risk is to the upside.
Structural ASP growth: In view of the
improving supply/demand dynamic, we
expect structural ASP growth starting in 2H11
with the slowing of new capacity. In 1H11,
ASPs may fall on seasonality, particularly in
Eastern China where we saw a 13.6% h-o-h
increase in 2H10 largely due to one-off power
restriction measures.
Earnings outlook: Northwest and Southern
regions should see the most stable ASPs in
the short term, given the strong demand from
infrastructure and pricing power of local
producers. Hence, we expect higher margins
or gross profit per tonne in 2011. Coal prices
are likely to stay at high levels with mild
increases. Capacity and volume growth,
which is largely driven by M&As, will be the
key to earnings growth.
Infrastructure construction
Strong railway investment: The Ministry of
Railways (MoR) is on track to meet its budget
of RMB700bn (up 16.7% y-o-y, a record high)
of railway investment in 2010. Railways are
still the focus of transport development in the
12
th
Five-Year Plan. Based on the
government’s budget, we expect railway
investment to remain high at RMB700bn pa
over the next two years. New order flow for
the two railway constructors – CRC (1186
HK, N, HKD9.22, TP HKD12) and CRG
(390.HK,N, HKD5.44, TP HKD7.0) – should
remain strong in 2011-12. However, orders for
CCC (1800 HK, N, HKD6.76, TP HKD8.0)
are still slow as the majority of its sales are
from port construction and global port
machinery.
Low pricing power: The structure or system
of railway investment should not see major
changes over the next five years. That means
the MoR is still the largest railway investor,
accounting for nearly 95% of projects, while
CRC and CRG should take about 90% of the
construction market share. The price-setting
mechanism for the construction of high-speed
railways has not yet been set. This is up to the
MoR while constructors have little say in the
matter.
Slow margin recovery. Gross margins saw a
slower-than-expected recovery in 2010. The
unstable margin was due to rising raw material
costs and delay in compensation on highspeed railway projects. We do not expect a
significant margin improvement in 2011 as it
is a structural issue, unless the constructors
gain more pricing power.
High policy risk: CRC’s substantial loss on
its overseas project (light rail in Saudi Arabia)
reflects the political risk it faced. It registered
a RMB4.15bn loss in 3Q10, accounting for
44% of our original full-year earnings. Being
one of the three largest constructors in China,
they have a social responsibility both
domestically and overseas (to carry out
government-related projects), thus there are
significant policy and execution risks.
Toll roads
Steady traffic growth: We see slow organic
traffic volume growth, while traffic diversion
due to new roads or high-speed rail is a longterm threat. For Jiangsu Expressway (177
HK, OW, HKD8.45, TP HK10) and Zhejiang
Expressway (576.HK, N, HKD7.32, TP
HK8.0), we expect 6-7% organic volume
growth in 2011. The latter is facing traffic
diversion away from one of its operating toll
roads, Shangsan, where traffic volume fell by
12.3% y-o-y in 3Q10 after a new road
commenced operation in July. It will take a
year to stabilise the y-o-y impact.
Stable toll rate: JSE has applied for rate
hikes, subject to local government approval.
We do not expect rate hikes to be granted
given inflation concerns.
Growth priced in. JSE and ZJE are trading at
16x 2011e PE, close to their 3-year average of
15-16x, the high end of regional and
international peers with comparable growth.
Top pick
Sinoma (1893 HK, OW(V), HKD7.53,
TP HKD9.9)
Sinoma is the largest cement operator in
Northwest China with 40% local market share. It
is also the largest cement equipment and
engineering services provider in the world.
Strong demand came from infrastructure
construction, with fairly stable ASPs as 50% of
sales (for key projects) are under contracted
prices. For cement equipment, overseas orders
should be the key growth driver. We expect new
orders to grow by 15% and 10% in 2011-12.
Valuation
At HKD7.53, it trades at 13.2x 2011e PE, below
its mid-cycle PE of 17.2x. Our target price of
HKD9.9 is based on a sum-of-the-parts
methodology and implies 33.8% potential return.
Risks
The key risks to our view are new capacity in
Northwest China and the potential for fundraising.
Catalysts include M&A and cement equipment
orders.
Themes for 2011
Winners from Chinese growth
The listed cement producers would be benefited
from the elimination of obsolete capacities and
restriction on approval of new capacities and
gaining market share from M&As. The government
aims to reduce the number of cement producers
from 5,000+ to 3,500 by 2010 and 2,000 in 2020e.
The market share of the top 10 producers is
expected to rise from 23% to 60% by 2015.
CR Cement (1313 HK, OW, HKD6.11,
TP HKD7.4)
CRC is the largest cement operator in Southern
China with 15-20% market share. We are optimistic
on earnings growth owing to high visibility on new
capacity, sales volume upside surprises and stable
ASPs on improving supply/demand conditions and
strong pricing power. Margins and gross profit per
tonne should remain high, delivering the highest
earnings growth in our cement universe.
Valuation
At HKD6.11, the stock trades at 13.4x 2011e PE,
a 29% discount to Conch (914 HK, N, HKD33,
TP HKD38.1), with higher margins and earnings
growth (EPS CAGR: 38.9% vs 15.8% in 2010-
12e). We think this is unjustified. We use PE and
EV/t pricing methodology to arrive at our target
price of HKD7.4, which implies a 21.1% potential
return. (See our recent note, Gaining pricing
power via acquisition, 6 December 2010.)
Risks
Key risks to our view include weaker ASPs,
equity fundraising and operation risk in JVs.
Catalysts include M&A and falling coal costs.
Techtonic shifts
Under the 12
th
Five-Year Plan, China promises to
increase the use of non-fossil fuels as a percentage
of total energy expenditure to 15% by 2020; and
reduce unit GDP energy consumption to 40-45%.
In early 2009, the PRC government drafted a
proposal on energy development which entailed
investing RMB5trn in clean and traditional energy
over 2011-20. We favour CEI given its solid track
record in waste treatment and its diversification
into alternative energy.
CEI (257 HK, OW(V), HKD4.34,
TP HKD5.4)
CEI is a conglomerate focusing on environmental
protection and alternative energy projects,
including waste-to-energy (WTE), solar
photovoltaic energy, industrial solid waste
landfill, waste water treatment (WWT), etc.
Earnings growth is picking up as construction is
on track, while traffic remains stable, utilisation is
rising and operating margins are increasing. The
government’s RMB5trn investment in new energy
sectors over the next 10 years should accelerate its
diversification from WWT/WTE to alternative
energy, supporting long-term growth.
Valuation
At HKD4.34, CEI trades at 21.6x 2011e PE.
We value each project using a DCF methodology
(risk-free rate of 4%, market risk premium of 6.0%
for China and WACC of 8.0%). Our target price of
HKD5.4 implies a potential return of 25.1%.
Risks
The key risks to our view include delays in project
execution and funding requirements for new
projects. Catalysts include encouraging policies
and projects in the pipeline.
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