Through a mixture of volume and price increases and inorganic growth, we expect China Water Affairs (CWA) to grow operating profit by a CAGR of 17.8% over the next five years. CWA owns and operates water supply assets in 46 cities across China. China’s economy suffers from polluted water and water scarcity and only around 50% of households are connected to a water network. The Chinese government has become increasingly supportive of private companies developing the water sector and, for now, is happy to reward private firms with attractive ROEs. Favourable regulatory drivers, coupled with a well-regarded management team, have enabled CWA to deliver excellent earnings growth and we believe this will continue.
Globally, most private water utilities offer the investor low single-digit earnings growth plus a healthy dividend, driven by stable regulated cash flows. However, over the coming years an investor in CWA will be moving up the risk-reward curve as the company has embarked on an aggressive growth strategy; we forecast that CWA will more than double capital employed by 2019, while maintaining ROCE in the 15-17% range and, in the process, make investments of around HK$8,500m (2016-20).
Management has used its collective experience in privatising and managing water supply assets to drive stellar growth in post-tax returns on capital, which moved from 9.2% to 13% between 2013 and 2015. The existing business is well run, makes an economic profit and still offers the potential to increase shareholder returns despite the recent improvements. However, by taking on such an ambitious growth plan CWA is changing its equity proposition to that of a growth company.
CWA is currently trading at 1.1x 2016e book value, despite it delivering on its growth plan and producing returns well in excess of its cost of capital. By 2020, we forecast the book value will double and EBIT and EBITDA will more than double. The company is currently trading at a 2016e EV/EBITDA multiple of 7.2x adjusted for minorities (with a trailing 2015 EV/EBITDA multiple of 9.0x), and below our SOTP-derived valuation of HK$4.56, which is well supported by Chinese and international peer valuations.