We increase our valuation for China Water Affairs (CWA) to HK$6.5 per share after upgrading our earnings forecasts. We believe CWA, as the only listed equity play on Chinese tap water supply, offers investors exposure to a unique and attractive set of industry fundamentals. Strong shareholder returns driven by high-teens earnings growth are likely to continue as CWA grows capacity. Capital expenditure requirements will remain elevated as capacity growth continues. However, given CWA’s strong balance sheet and high operating cash returns, we believe it will be able to execute its growth plan without weakening its balance sheet.
Due to a combination of low private sector penetration, higher earnings quality, full asset ownership and a lower risk profile, the tap water sector provides investors with a premium offering in comparison to the wastewater sector. CWA is the only means of gaining equity exposure to this subsector in China which, we forecast, will drive its revenues by a CAGR of 21.5% in the next five years.
For FY16, CWA reported consensus-beating underlying top-line growth of 20% with City Water Supply the main driver. We now update our forecasts to reflect this as well as discussions with management. Our forecast of a 19.8% EBITDA CAGR (previously 19.2%) for FY17-21 is mainly driven by capacity, volume and tariff growth in the City Water Supply (CWS) business (81% of FY16 EBIT).
With a net debt to EBITDA of 2.6x at end March 2016, and also taking into account the HK$9.3bn in net operating cash flow we forecast CWA will generate over the next five years, the company is in a strong position to meet its growth capex requirements. Based on our capacity growth assumptions, we estimate CWA will invest HK$10.6bn between FY17 and FY21, which will be met predominantly by internal cash flows and by increasing debt levels moderately. Net debt (Edison definition) to EBITDA will peak at 2.6x in FY17e.
Since our initiation in April, CWA’s share price has risen by 46%. We have updated our numbers and roll forward our sum-of-the-parts valuation. We increase our fair value (FV) to HK$6.5 per share from HK$4.56.