railway constructor - sector report - 030809

8/8/2019 Railway Constructor - Sector Report - 030809

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Sector Report

03 August 2009

2009 VC Brokerage Limited. All rights reserved. Opinions, projections and other information contained in this report are based upon sourcesbelieved to be accurate, but no responsibility is accepted for any loss occasioned by reliance placed upon the contents herein. Furtherinformation on the companies mentioned in this report is available upon request.

VC Research 1

China Railway Infrastructure Constructor

Calvin K.H.Ho(852) 2913 [email protected]

Investment summary

While it is widely expected that the railway infrastructure Constructor sector will offer promisingearnings outlook over the next few years, we prefer China Railway Construction (CRCC: 1186.HK)to China Railway Group (CRG: 0390.HK) based on the following reasons:

Benefit more if the MOR would increase investment in 2009. CRCC has a lower involvement inproperty development & mining businesses, and focuses more on its core construction business. Also,CRCC has maintained a higher GP margin in railway construction. According to the latest MORannouncement, the amount spent on railway infrastructure up to Jun09 exceeded consensus forecast andgrew 155% yoy to Rmb201bn.

Higher sales growth and GP margin. CRCC appears to have a higher commitment to R&D, andmaintained a larger scale of railway survey & design Institutes. In the long run, we believe that innovationand technological advancement are critical for winning more new contracts with higher GP margin,especially for overseas businesses.

Higher survey, design and consultancy revenue. We believe that survey, design & consultancy revenue

will account for a good portion of core railway revenue for railway construction companies. For instance,most of their customers pursuing survey, design & consultancy services at first end up also going afterrailway construction services. The industry will trend towards a closer coordination between these two linesof businesses, in our view. In FY07 to FY08, CRCCs revenue from survey, design & consultancyexceeded that of CRG.

More overseas business. We expect domestic railway construction new contract value to peak out inFY11, and railway constructors long-term growth lies in their capability of applying their core skills inoverseas projects. Historically, CRCC is stronger in getting overseas business in terms of the amount andpercentage to total of new contracts from overseas. We expect CRCC to continue to outperform CRG infetching overseas contracts given that it appears to have more experience in conducting overseas projectsand a higher commitment to R&D.

Less dependent on performance of other incomes. The predictability and sustainability of growth forother income is low as majority of them for CRG & CRCC are gain on sales of materials and penaltyincome. During FY04 to FY08, other incomes constituted an average 30% & 10% of profit before tax forCRG & CRCC, respectively. That other income accounts for a higher percentage in CRGs EBT couldcloud its earnings visibility.

Less exposed to earnings distortions from financial investments. CRCC invests less aggressively infinancial investments (e.g. listed/unlisted equities, funds or bonds) and thus its bottom line and equity areless exposed to the usually big swings in the fair values in these investments. For instance, CRCCcommanded a dividend yield of around 1% while CRG paid no dividend in FY08.

A laggard in the recent market rally. The recent rally of the local bourse since Mar09 has seen CRG rise71%, HSI 81%, and CRCC 30%. CRCC is also a catch-up play in our view.


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China Railway Infrastructure Constructor 03 August 2009


VC Research 2

Tab le o f con ten t

BACKGROUND .......................................................................................................................................... 3

PREFER CRCC TO CRG............................................................................................................................. 3

FOCUS ON MAIN BUSINESS ........................................................... ............................................................... ............................... 3HIGHER RAILWAY GP MARGIN .............................................................. ................................................................ .................... 3ADDITIONAL MOR INVESTMENTS ......................................................... ................................................................ .................... 4HIGHER RESEARCH CAPACITIES ......................................................... ........................................................... ............................. 5MORE OVERSEAS BUSINESS ......................................................... ............................................................... ............................... 6LESS DEPENDENT ON OTHER INCOME ........................................................... ................................................................ ......... 8LESS EXPOSED TO FINANCIAL INVESTMENTS INCOMES ......................................................... .................................................... 9BETTER POTENTIAL TO IMPROVE ROA ........................................................... ................................................................ ......... 10MARKET OVERESTIMATING PROPERTY BUSINESS ........................................................ ............................................................ 12

RECENT SHARE PRICE PERFORMANCE OF CRG & CRCC RELATIVE TO THE HSI.................. 13

VALUATION............................................................................................................................................. 14

RECOMMENDATION.............................................................................................................................. 18

COMPANY UPDATE CHINA RAILWAY GROUP (0390.HK)............................................................................ 19

BUSINESS DEVELOPMENT & NEWS UPDATE ............................................................... .................................................. 20Sales growth surprises on the upside....................................................................................................20Margin Analysis.............................................................................................................................................21

VALUATION.......................................................... ............................................................... .................................................. 23

RECOMMENDATION : HOLD ............................................................ ................................................................ .................. 24

SENSITIVITY ANALYSIS .......................................................... ............................................................... ............................. 24

COMPANY UPDATE CHINA RAILWAY CONSTRUCTION CO. (1186.HK) ....................................................... 31

BUSINESS DEVELOPMENT & NEWS UPDATE ............................................................... .................................................. 32Stronger than expected top line growth.................................................................................................32Margin Analysis.............................................................................................................................................33

VALUATION.......................................................... ............................................................... .................................................. 35

RECOMMENDATION - BUY .............................................................. ................................................................ .................. 36

SENSITIVITY ANALYSIS .......................................................... ............................................................... ............................. 36

APPENDIX RAILWAY SECTOR OVERVIEW ...................................................................... 43


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VC Research 3

Background

CRG (390.HK) and CRCC (1186.HK) are the two largest listed railway infrastructure constructors in China. WhileCCCC (1800.HK) concentrates in constructing ports & highways, CRG and CRCC focus on constructing railway.Both CRG & CRCC originated from the Ministry of Railways (MOR) and shared similar resources and capacities.

Prefer CRCC to CRGFocus on main business1) CRCC is more focused on its main business. Relative to CRG who involves more in the propertydevelopment & mining businesses, CRCC focuses more on its main business lines. We believe this is good for

CRCC because:

- Infrastructure construction, especially railway construction, is the major source of stable stronggrowth for players in this sector for the coming years.

- The synergetic effect and core competency for CRG or CRCC to diversify into propertydevelopment & mining are yet to be seen.

- Earnings volatility will likely increase through diversifying into cyclical industries like propertydevelopment & mining.

Higher railway GP margin2) CRCC commands a higher GP margin in railway construction. CRCC reported higher GP margin in railwayconstruction than CRG in FY07 and FY08. And we believe this trend will continue at least in the medium term.

Railway GP margin % of CRG & CRCC

6.28%

6.80%

6.42%

7.50%

5.0%

5.5%

6.0%

6.5%

7.0%

7.5%

8.0%

FY2007 FY2008

CRG CRCCSource: VC e stimates

Background information (FY2008)

(in Rmb m unless otherwise specified) CRG CRCC

Market capitalization as at 31 July 09 144,164 131,285

Total new contract value 428,450 423,105

Total backlog 420,750 471,089

Total revenue 225,029 219,410

Revenue mixInfrastructure construction: 90.3%,

of which Railway: 48.2%

Infrastructure construction: 91.6%,

of which Railway: 50.2%

Total assets 251,919 220,101

Market share in domestic railway construction 40% ~ 45% 40% ~ 45%

Marjor shareholder CRECG: 59.4% CRCCG: 63.31%

Major customers MOR / Regional governments MOR / Regional governments

Source: VC estimates, Bloomberg, The companies


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VC Research 4

We expect the two companies railway GP margin to stay flat in FY09, and this is in line with management guidanceand consensus. As such, the margin gap between the two companies will persist. In the short run, the margin gapcan be justified by:

- Design capabilities: CRCC owns two of the top-four railway survey & design institutes in Chinawhile CRG only owns one.

- Strength in different fields within railway construction. CRCC is more specialized in designing andbuilding high-speed railway while CRG in railway electrification.

However, one of the risk factors to our recommendation is that CRGs railway GP margin would catch up with, oreven exceed, that of CRCC in the longer run. Although this scenario is unlikely to take place in the short term,given the two companies similar backgrounds and GP margin trends this particular risk is not negligible. Therefore,to be conservative, we have factored in a railway margin for both firms to converge at 7.1% in the long run.

Additional MOR investments3) MOR investments may exceed forecast. We expect CRCC to benefit more than CRG if railway infrastructureinvestment by the MOR would be higher than market expectations in coming years.

The MOR may increase more in railway infrastructure

Railway infrastructure annual spending by MOR

88155 179

337

860

-

100

200

300

400

500

600

700

800

900

1,000

2005 2006 2007 2008 2009E

Rmbbn

Source: VC estimates, MOR

*2009 is projected using announced figures up to Jun-09

The scale of the MORs railway infrastructure investment is no secret to the market and consensus forecast is thatit will invest Rmb600bn in FY09. However, according to the latest MOR announcement, the actual investmentamount up to Jun09 grew 155% yoy to Rmb201bn. If the MORs investment pattern over the previous year repeatsin 2009, the projected total investment could hit Rmb860bn in FY09 according to our estimate. The figure wouldexceed consensus forecast by 43%.

CRCC to benefit more if the MOR increases railway investments

We assume both CRCC and CRG will be able to maintain their market shares at 40-45%. That is to say they wouldsplit the additional investment by the MOR, if any. The following sensitivity tables depict the changes in TPs forCRG & CRCC if their railway related revenue is 20% or 40% higher than our base case. We estimate that the TP ofCRCC would rise 9% more than that of CRG if the growth rates of railway related revenues are 40% higher thanthe base case.


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VC Research 5

Sensitivity analysis - Railway related growth rate assumption

Relative to current

Share price (CRG) -2% -1% 0% 1% 2%

-40% 11% -11% -27% -39% -48%

% change of -20% 28% 3% -14% -28% -38%

Sales 0% 52% 23% 3% -13% -25%

growth rate* 20% 84% 49% 25% 6% -8%40% 126% 83% 53% 31% 13%

WACC

* % change of sales growth rate of railway related revenues (e.g.

Railway & Survey) for each year in projection period

** This table changes sales growth rate of railway & survey revenues at

the same rate (e.g. Railway sales growth rate expands 20% from 40% to

48%, etc.)

Sensitivity analysis - Railway related growth rate assumption

Relative to current

Share price (CRCC) -2% -1% 0% 1% 2%

-40% 10% -5% -15% -23% -29%

% change of -20% 28% 11% -1% -10% -18%

Sales 0% 54% 33% 18% 6% -3%

growth rate* 20% 88% 62% 43% 29% 17%

40% 136% 101% 77% 58% 44%

* % change of sales growth rate of railway related revenues (e.g. Railway &

Survey) for each year in projection period

** This table changes sales growth rate of railway & survey revenues at the

same rate (e.g. Railway sales growth rate expands 20% from 40% to 48%,

etc.)

WACC

Higher research capacities4) We believe that CRCC can attain a higher railway GP margin and overseas revenue than CRG if itcontinues to lead CRG in terms of research capacities. The higher survey & design capabilities andcommitment to R&D of CRCC are supported by the following facts and figures.

CRCC owned four Grade A1 railway construction design and research institutes out of only seven in China. Amongthe seven Grade A1 institutes, CRCC owned two of the four large-scale railway survey and design institutes, whileMOR and CRG each own the other two.

Major Railway Survey and Design Institutes in China

Parent Staff No.

China Railway 1st Survey and Design Institute CRCC 3,800

China Railway 2nd Survey and Design Institute CRG 3,500

China Railway 3rd Survey and Design Institute MOR 3,200

China Railway 4th Survey and Design Institute CRCC 3,000

China Railway 5th Survey and Design Institute CRCC 1,000

China Railway Shanghai Design Institute Group Co., Ltd. CRCC 1,600

Beijing National Railway Research & Design Institute of Signal & Communication MOR 1,000

Design & Research Institute of Ministry of Railway MOR 700

China Railway Electricification Survey Design & Research Institute CRG 350

Source: VC estimates, Design companies' web sites

The R&D expenditure figures show that CRCC has a strong commitment to invest in technology, while CRG investsmore in financial instruments. In FY08, although CRCCs R&D expense as percentage of sales was 0.66% higherthan that of CRG, CRCCs total operating expenses as percentage of sales was just 0.3% higher than that of CRG,indicating that CRCC is more efficient in general administration.


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VC Research 6

R&D expenditure and its % of total revenue for CRG & CRCC

306 316

1,049

1,756

0.2% 0.1%

0.6%

0.8%

-

200

400

600

8001,000

1,200

1,400

1,600

1,800

2,000

FY2007 FY2008

Rmbm

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

%oftotalrevenue

CRG CRCC CRG CRCCSource: VC estimate, The companies

With a larger scale of research institutes and R&D expenditures, CRCCs revenue from survey, design andconsultancy has started to exceed that of CRG since FY07.

Survey, design & consulting revenue and its % of total revenue for CRG & CRCC

3,480

4,124

3,394

4,354

2,346

2,909

3,349

3,709

4,551

2,780

1.9%

1.9%

2.7%

3.1%3.2%

2.6%

2.7%

2.2%

2.2%2.1%

-

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

FY2004 FY2005 FY2006 FY2007 FY2008

Rmbm

1.8%

2.0%

2.2%

2.4%

2.6%

2.8%

3.0%

3.2%

%of

totalrevenue


Survey, design and consultancy business is closely connected with the construction business, especially in therailway construction sector. It is because most of the customers who pursue survey, design and consultancyservices at first will also become major customers of construction operations. The industry trends towards a closercoordination between the two lines of businesses. As such, we believe the revenue trend in survey, design andconsultancy can be a leading indicator of core railway revenues for CRG & CRCC. Higher research capabilities andstronger commitment to R&D will benefit CRCC in terms of more sales and higher margins in the long run.

More overseas business5) The long-term growth of CRCC looks more promising as it is stronger in getting overseas new contracts.

According to the Ministry of Commerce (MOC) and CRCCs annual reports, CRCC ranked 1st

& 2nd

amongoverseas Chinese contractors in terms of new contract value in FY07 & FY08. This may be due to the fact that,China Civil Engineering Construction Corporation (CCECC), which is principally engaged in overseas constructionbusiness, was transferred to CRCC from SASAC as part of restructuring before listing. In its annual reports, CRCCre-emphasised its commitment to carry out the Go Overseas strategy as promoted by the central government.


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VC Research 7

Overseas revenue, new contract value and backlog value of CRCC

1 2 46

17

4

13

43

29

42

39

42

56

83

0

10

20

30

40

50

60

70

80

90

FY2004 FY2005 FY2006 FY2007 FY2008

Rmb

bn

Revenue New contract Backlog

Source: VC estimates, The companies

*: In FY07, we excluded the USD8.3bn Nigeria project as it was suspended.

Given the high backlog value and strong growth in overseas new contracts, CRCCs high growth in overseas

revenue will likely continue over the coming years. Although the percentage of revenue contributed by overseasprojects was still lower than 10% in FY08, CRCC still keeps on reporting the figures of overseas revenue & newcontract value separately since FY04, which could signal managements commitment to expand further overseasbusinesses.

CRCC overseas portion as % of respective total amount

10%

2%

2% 2%8%

4%

3%

7%

20%

10%

4%

21%

17%18%

6%

0%

5%

10%

15%

20%

25%

FY2004 FY2005 FY2006 FY2007 FY2008

Revenue New contract BacklogSource: VC estimates, The companies

*: In FY07, we excluded the USD8.3bn Nigeria project as it was suspended.

While CRGs overseas new contract value for FY08 amounted to Rmb24.5bn, representing 5.7% of its total newcontract value for the year, both figures are lower than that of CRCC (42.17bn/10.0% in the same year. CRG does

not report revenue from overseas business on an annual basis.

There are market views that a lower exposure to overseas business is a positive, as it will then allow the companyenjoy the strong growth in the domestic market. In our opinion, as long as domestic business is not limited bycapacity constraint, we prefer contractors with higher overseas business exposure for the following reasons.

- Overseas projects would serve to support a companys sustainable growth when domesticconstruction demand peaks out. In our current assumptions based on estimates of Chinasinfrastructure investments, new contract values for both CRG & CRCC would hit their peaks inFY11.

- According to the new contracts detail update announcements by both CRG & CRCC, overseasprojects command a higher average contract value per deal. This helps reducing selling &administrative expense as percentage to revenue.

- This offers the chance for diversification (geographically) and at the same time remains in the corecompetitive industry.


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VC Research 8

According to Ministry of Commerce (MOC), the aggregate new contract value for overseas Chinese contractorsreached USD53.46bn (Rmb365bn) up to May09, up 43.7% yoy. As such, we expect overseas new contract valueof CRG and CRCC to grow at a similar speed FY09.

The main overseas markets for CRG & CRCC are Africa and the Middle East, from which it will be the major sourceof top line growth after the domestic market reaches its peak because of:

- CRG & CRCCs relatively high level of technology and experience- Largely underdeveloped infrastructure systems in those countries- Chinas friendly relationship with those continentals

All in all, while maintaining the same market share as CRG in domestic market, CRCC is in a better position tobenefit from the growth of overseas infrastructure construction business.

Less dependent on Other Income6) CRCCs bottom line depends less on the performance of other incomes, of which the predictabilityand growth sustainability are low.

Other income as % of profit before tax (Exclude FX effect) for CRG & CRCC

42%

51%

17%23%

18%

6% 5% 5%10%

25%

0%

10%

20%

30%

40%

50%

60%

FY2004 FY2005 FY2006 FY2007 FY2008

CRG CRCCSource: VC estimate, The companies

Other incomes may constitute a significant percentage of their bottom lines and can be a source of positive ornegative surprise for EPS estimates. From FY04 to FY08, other incomes constituted an average 30% & 10% ofprofit before tax (Excluding FX effect) for CRG & CRCC, respectively. The high percentage of other incomes forCRG could affect seriously its bottom line performance.

We think that the predictability and growth sustainability of other incomes are low because majority of them forboth CRG & CRCC were Gain on sales of materials and Penalty income, which constituted 60% & 75% of totalother incomes of CRG & CRCC in FY08. The remaining percentage of other income was mostly governmentsubsidies and grants.

Other income for CRG & CRCC

286 317

581

841

1,168

97 89 129180

245

0

200

400

600

800

1,000

1,200

1,400

FY2004 FY2005 FY2006 FY2007 FY2008

Rmbm



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VC Research 9

Less exposed to financial investments incomes7) CRCC is less exposed to gain or loss of financial investments. CRG holds a relatively big portfolio offinancial investments (e.g. Listed / Unlisted equities, funds or bonds) and thus its bottom line and shareholdersequity are more exposed to changes of fair value of these investments.

Financial investments and its % of total assets for CRG & CRCC

836

1,1871,054

3,074

4,070

970 9271,040

1,714

920

0.7%

1.4%

1.6%

1.1%

1.0%

1.2%

0.9%

0.7%

0.8%

0.7%

-

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

FY2004 FY2005 FY2006 FY2007 FY2008

Rmbm

0.5%

0.7%

0.9%

1.1%

1.3%

1.5%

1.7%

1.9%

%

oftotalasset


During FY07 and 08, CRG increased its financial investment portfolio at a faster speed than its total assets. As aresult, it recorded a large gain of Rmb1064m in FY07 but incurred a loss of Rmb1234m in FY08.

Gain / (Loss ) of financial inves tments as % of profit before tax (Exclude FX effect) for CRG & CRCC

-19%

0%-3%

29%

-1%

3%1%

4%

9%

-1%

-30%

-20%

-10%

0%

10%

20%

30%

40%

FY2004 FY2005 FY2006 FY2007 FY2008


We like CRCC better than CRG in the sense that it invests less aggressively in financial investments anddistributes excess cash to shareholders. We see no advantage for CRG or CRCC to further increase their financialinvestments exposure as their track records showed that the rate of return of their investments were not high andthese investments tend to increase their earnings volatility.


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VC Research 10

Better potential to improve ROA8) Ratio analysis: CRCC has a better potential to improve ROA through NP margin expansion while keepingits higher asset turnover ratio over CRGs.

The following table shows that CRCC has a better asset turnover ratio while CRG has a better GP & net margin.Excluding the FX loss, the ROA of CRG & CRCC stood at similar level in FY07 & FY08. We expect the ROA ofCRCC to exceed that of CRG through NP margin expansion while keeping its asset turnover ratios higher than that

of CRG in coming years.

Financial ratios comparison of CRG & CRCC

CRG CRCC CRG CRCC

Profitiablity ratios:

ROA (Average) 1.6% 1.6% 0.7% 2.0%

ROA (Average) - Exclude FX loss 1.7% 1.7% 2.5% 2.4%

ROE (Average) 8.1% 51.5% 2.8% 13.8%

ROE (Average) - Exclude FX loss & MI 9.8% 62.3% 10.4% 17.2%

Profit margin ratios:

Gross profit margin % 7.2% 6.6% 7.3% 7.2%

Net margin % 1.6% 1.3% 0.7% 1.7%

Net margin % - Exclude FX loss 1.7% 1.4% 2.6% 2.1%

Total operating expense as % of Sales 5.5% 4.4% 4.6% 4.9%

Working capital (WC) management ratios:

WC assets as % of Sales (Average) 57.0% 54.2% 57.7% 53.6%

WC liabilities as % of Sales (Average) 60.4% 65.9% 56.0% 62.2%

Net WC assets / (liabilities) as % of Sales (Average) -3.4% -11.7% 1.7% -8.6%

Fixed asset turnover ratios:

Net PPE as % of Sales (Average) 9.5% 8.8% 9.1% 8.6%

Net Capital investment as % of Sales (Average) 15.0% 11.0% 17.5% 11.2%

Debt ratios:

Long term debt to Total assets 18.0% 16.6% 21.4% 10.1%

Long term debt (Net of cash) to Total assets Net cash Net cash 2.8% Net cash

Other ratios:

Backlog to revenue ratio 1.2 1.9 1.9 2.1Net Fx gains / (losses) as % of Profit after tax (exclude Fx effect) -8.0% -3.8% -71.3% -18.7%

Source: VC estimates

FY2007 FY2008

Profitability ratios:

The ROE and ROA (Included FX loss) are not indicative because they are distorted by the abnormally low level ofCRCCs equity before listing in FY07 and the large sum of FX loss of CRG in FY08.


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VC Research 11

Profit margin ratios:

That CRG carries a higher overall GP margin because it generates a higher percentage of revenue from high GPmargin non-construction businesses.

Non-construction revenue as % of total revenue (Bar) and its GP margin % (Line)

11.3%

6.4%

11.5%

9.8%

18.7%20.0%

13.5%

16.2%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

FY2007 FY2008

As%oftotalrevenue

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

GPmargin%


Given the higher construction GP margin of CRCC and the strong growth of construction revenues for both firms inthe coming years, CRCCs total GP margin may catch up with that of CRG, in our view.

As discussed in the previous section regarding R&D, the lower net margin % (Excluding FX loss) of CRCC was dueto its much higher R&D expenditures. While CRCC commented that they expect a flat R&D expenditure for FY09,the overall operating expense as percentage of sales for CRCC should drop to the similar level as that of in FY09.As such, we expect CRCCs net margin will match that of CRG in FY10.

Working capital (WC) management ratios:

We see that CRCC can run the business with lower WC asset and at the same time holding up more WC liability.As such, there is larger room of improvement for CRG than CRCC. We expect CRG to catch up with CRCC in thelong run through better WC management. However, the gap of net WC as percentage of sales actually widenedfrom 8.3% to 10.3% during FY07 to FY08. We use total WC asset/liability as percentage of sales instead of justreceivable/payable for comparison to avoid distortion arising from different accounting classification made by thetwo companies.

Fixed asset turnover ratios:

CRCC is able to generate sales with lower level of PPE & Capital investment (PPE + intangible assets & prepaidland lease, etc.). The higher percentage of fixed asset required for CRG was mainly attributed to its larger size ofnet intangible assets of Rmb13669m (CRCC: Rmb687m). Majority of the intangible assets of CRG & CRCC relatedto service concession arrangements of BOT highways.

Both CRG & CRCC revealed their intention to develop more BOT projects as a means to secure more long-termstable cash flows. While CRG usually has to develop BOT from start-up and thus incurring negative cash flowsfrom these projects during the initial years, majority of BOT projects for CRCC are injected from its parent afteroperating with positive cash flows.

With the significant difference of the amount of intangible assets, we expect the gap of fixed asset turnover ratios topersist.


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VC Research 12

Debt ratios:

Both CRG & CRCC maintain a low level of long-term debt and hold big piles of cash. Given their low rate of returnfrom operating assets (3.0% & 2.8% for CRG & CRCC in FY08), it is a wise decision to keep a low level of debtbecause ROEs are unlikely to be boosted up through increasing leverage by interest charging debts.

Other ratios:

CRCC has a higher backlog-to-revenue ratio, indicating that its revenue growth in the coming years is more securethan CRG. Also, its lower percentage of FX loss may indicate its better cash management ability.

In sum, we believe NP margin for CRCC will continue to improve in the coming years. On the other hand, we do notexpect the asset turnover of CRG to catch up with CRCC in the near future. Therefore, we believe CRCC can get abetter return for its assets in coming years than its PRC peer.

Market overestimating property business9) We think the market is overestimating the importance of property development business of CRG &CRCC in the short run.

We agree that, relative to CRCC, CRG is better positioned to gain from a rally in the property market. It is becauseCRG has a greater percentage of revenue and assets related to the property development business and it enjoys ahigher GP margin from property development.

Property / real estate business comparison of CRG & CRCC

(in Rmb m unless otherwise specified) CRG CRCC CRG CRCC

Revenue 3,282 681 3,805 1,072

% of total revenue 1.9% 0.4% 1.7% 0.5%Gross Profit margin % 31.8% 25.4% 30.0% 18.4%

Property under development or for sale 11,911 3,862 19,948 9,100

Book value per share (in Rmb) 0.56 0.48 0.94 0.74

% of total asset 5.5% 2.5% 7.9% 4.1%

Source: VC estimates, The Company

FY2007 FY2008

Both CRG and CRCC have expressed their intentions to develop a stronger property development arm. In FY08,CRG/CRCC had GFA land bank of around 18mn m

2 /10mn m

2, making them among the top-15 listed China

property companies in terms of land bank.

However, we still think that property development business should not be a critical factor for CRG & CRCC in theshort run because:

- Given the strong growth of their core infrastructure construction business, the contribution of theproperty business will still be relatively low in the coming years.

- Although CRGs land bank is around 39% of the largest listed land bank holder, Country Garden,the market capitalisation of CRG is around 2.7x bigger than Country Garden. Therefore, the overallvaluation of CRG would not depend much on the property development business at least in themedium term in our view.

- Competing with a large number of property developers (like Country Garden 2007.HK, AglieProperty 3383.HK & Shimao Property 813.HK, etc.), CRG or CRCC are unlikely to reap fruitful

returns given the additional risks of competition in a non-core business line.


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VC Research 13

Recent share price performance of CRG & CRCC relative to the HSI

Relative performance of HSI, CRG & CRCC since 9-Mar-09

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

10-

Mar

17-

Mar

24-

Mar

31-

Mar

7-

Apr

14-

Apr

21-

Apr

28-

Apr

5-

May

12-

May

19-

May

26-

May

2-

Jun

9-

Jun

16-

Jun

23-

Jun

30-

Jun

7-

Jul

14-

Jul

21-

Jul

28-

Jul

%changesince9-Mar-09

HSI CRG CRCCSource: Bloomberg

Following the noticeable bounce back of the global stock market since Mar09, the HSI has risen 81% while CRG71%. The performance of CRG is more or less in line with that of the HSI. Its slight underperformance may beperhaps attributed to its defensive nature relative to the overall market

However, CRCC under performed by around 40% with respect to CRG. Given the recent strong performance of theMetals & China Property sectors, we believe the market is overestimating the earning contributions of the mining &property development businesses of CRG.


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VC Research 14

Valuation

Our TPs for CRG/CRCC are set at HKD7.15/HKD14.56, representing a potential upside of 2% and 18%respectively.

Given the long investment and construction period of the infrastructure construction sector, we adopted the

Discounted free cash flow (DCF) method to derive our TPs for CRG & CRCC.

For the discount rate, we applied the same 10% for both CRG & CRCC despite the higher historical beta of CRG(CRG: 0.98 V.S. CRCC: 0.79). It is because, in our opinion, investors should have the same perception regardingthe level of risk by investing in CRG or CRCC, given their high level of similarity. Therefore, the market shoulddemand the same level of required rate of return from the two companies. Also, given the short listing period (Lessthan 2 years), their individual betas may not be that much indicative.

The table below shows our discount rate calculation:

Weighted average cost of capital ("WACC")

Cost of equity

Risk-free rate 4.18%

Unlevered beta 0.75

Levered beta 0.85

Equity risk premium 8.00%

Cost of equity 10.99%

Rounded 11.00%

Cost of debt

Cost of debt 5.40%

Tax 25.00%

After tax cost of debt 4.05%

Proportion of debt 15.75%

Proportion of equity 84.25%

WACC 9.90%

Rounded 10.00%

Source: Bloomberg, VC estimates

Risk free rate and cost of debt are the yield of the long term China government bond and the prime lending rate ofChina extracted from Bloomberg as at 31 July 09.

The proportion of debt used in the WACC calculation is the average of expected proportion of debt for CRG (21.4%)& CRCC (10.1%). The impact on WACC is small and the resultant WACC is still 10% for 0% to 34% of theproportion of debt.


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VC Research 15

The unlevered beta of 0.75 is derived from the adjusted average of 15-listed infrastructure constructor includingCRG & CRCC. Please refer to following tables for the betas and company descriptions of all of the comparablecompanies.

VC Research

Infrastructure constructionAs at 31 July 2009

Summary of betas(In Rmb million unless otherwise stated)

Bloomberg Levered Total Market Debt/ Unlevered

Comparable company Ticker Country beta Tax rate debt cap equity beta

China Railway Group Ltd - H 390 HK Equity China 0.98 25% 53,909 144,164 37% 0.77

China Railway Constructio-H 1186 HK Equity China 0.79 25% 22,131 131,285 17% 0.70

China Communications Const-H 1800 HK Equity China 1.25 25% 57,874 131,470 44% 0.94

Vinci Sa DG FP Equity France 1.06 33% 203,672 177,764 115% 0.60

Acs Actividades Cons Y Serv ACS SM Equity Spain 0.77 30% 132,490 115,034 115% 0.42

Fomento De Construc Y Contra FCC SM Equity Spain 0.90 30% 87,836 34,601 254% 0.32

Skanska Ab-B Shs SKAB SS Equity Sweden 1.06 28% 2,944 39,563 7% 1.01Hyundai Engineering & Const 000720 KS Equity Korea 1.29 28% 7,255 39,089 19% 1.14

Daewoo Engineering & Constr 047040 KS Equity Korea 1.18 28% 15,961 23,545 68% 0.79

Impregilo Spa IPG IM Equity Italy 1.09 31% 9,366 10,524 89% 0.68

United Group Ltd UGL AU Equity Australia 1.08 30% 2,865 11,228 26% 0.92

Sumitomo Mitsui Construction 1821 JP Equity Japan 1.02 41% 499 1,907 26% 0.88

Meiko Construction Co Ltd 1869 JP Equity Japan 0.61 41% 1,311 1,088 120% 0.35

Tuksu Construction Co Ltd 026150 KS Equity Korea 0.86 28% 87 650 13% 0.78

Eehwa Construction Co Ltd 001840 KS Equity Korea 0.87 28% 0 423 0% 0.87

Minimum 0.61 0% 0.32

Maximum 1.29 254% 1.14

Average 0.99 63% 0.75Median 1.02 37% 0.78

Adjusted average 0.99 54% 0.75



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VC Research 16

VC Research

Infrastructure construction

As at 31 July 2009

Comparable companies descriptions

Comparable company Ticker Country Description

China Railway Group

Ltd - H

390 HK Equity China China Railway Group Ltd. offers transportation systems construction services. The Company

builds railroads, roads, tunnels, and bridges.

China RailwayConstructio-H

1186 HK Equity China China Railway Construction Corporation Ltd is a full service construction company. TheCompany's services include construction operations, survey design and consulting. China

Railway also has manufacturing operations, real estate operations, and logistics. The

Company specializes in railway construction.

China Communications

Const-H

1800 HK Equity China China Communications Construction Company Ltd. is a transportation infrastructure group.

The Company is involved in infrastructure construction, infrastructure design, dredging, and

port machinery manufacturing. China Communications has operations worldwide.

Vinci Sa DG FP Equity France Vinci SA builds roads, offers electrical, mechanical, and civil engineering and construction

services, and operates toll roads. The Company builds and maintains roads and produces road

construction materials, builds electricity and communications networks, installs fire protection

and power and ventilation systems, and operates toll highways, bridges, parking garages, and

a stadium.

Acs Actividades Cons

Y Serv

ACS SM Equity Spain ACS, Actividades de Construccion y Servicios, S.A. designs, builds, and maintains roads,

railroads, hydraulic works, ports, and residential and commercial buildings. The Company

also installs and maintains electricity distribution systems, natural gas distribution systems,telephone networks, and road signaling systems, collects and treats waste, and operates buses.

Fomento De Construc

Y Contra

FCC SM Equity Spain Fomento de Construcciones y Contratas S.A. (FCC) offers construction services and

manufactures building materials. The Company offers civil engineering services, constructs

housing and commercial buildings, roads, and other infrastructure projects, develops real

estate, collects, treats, and disposes of solid waste, markets street cleaning machines, and

produces cement.

Skanska Ab-B Shs SKAB SS Equity Sweden Skanska AB offers construction related and project development services. The Company

focuses on construction of housing, commercial buildings, roads, and railways, as well as

develops and carries out international civil engineering projects. Skanska is also a provider of

facilities management services. The Company is active in Northern Europe, North and South

America, and Asia.

Hyundai Engineering &

Const

000720 KS

Equity

Korea Hyundai Engineering & Construction Co., Ltd., a general construction company, provides

civil engineering, architectural, industrial, and electrical engineering services. The Company

constructs roadways, dams, bridges, ports, industrial plants, apartment complexes, and

cultural facilities.

Daewoo Engineering &

Constr

047040 KS

Equity

Korea Daewoo Engineering & Construction Co., Ltd. is a general engineering constructor. The

Company's projects include architectural works, such as commercial buildings, public

facilities, schools, hospitals, and civil works, such as highways, ports, tunnels, railways, and

dams. Daewoo Engineering & Construction also constructs power plants, and residential

buildings.

Impregilo Spa IPG IM Equity Italy Impregilo S.p.A. offers construction services. The Company constructs dams, hydroelectric

plants, roads and motorways, railways and subways, ports and other maritime projects,

irrigation systems, waste treatment plants, desalination plants, thermal and nuclear power

stations, and hospitals. Impreglio holds interests in companies that operate toll highways.

United Group Ltd UGL AU Equity Australia United Group Limited is a diversified engineering, construction and maintenance company.

The Company's operations include railway manufacturing, maintenance and engineering along

with providing design, construction, operating and maintenance services in the mining,

commercial property, water services, defense and petrochemicals industries.Sumitomo Mitsui

Construction

1821 JP Equity Japan Sumitomo Mitsui Construction Co., Ltd. is a general contractor nationwide and overseas. The

Company constructs infrastructure such as railways, roads and energy facilities. Sumitomo

Mitsui Construction also builds residential, commercial, and institutional buildings such as

high-rise housings. Additionally, the Company operates real estate brokerage and leasing

businesses.

Meiko Construction Co

Ltd

1869 JP Equity Japan MEIKO CONSTRUCTION CO., LTD. is a general contractor based in Chubu region. The

Company constructs infrastructure such as railways, bridges, highways, and water and sewage

facilities.

Tuksu Construction Co

Ltd

026150 KS

Equity

Korea Tuksu Construction Co., Ltd. provides construction and civil engineering services,

specializing in grouting and boring. The Company's projects include subway, railway, and

bridge construction.

Eehwa Construction Co

Ltd

001840 KS

Equity

Korea Eehwa Construction Co., Ltd. provides civil engineering, architectural, and construction

services. The Company constructs government issued projects, such as railways, roadways,

power plants, and subways. Eehwa Construction also sells and leases real estate.

Source: Bloomberg


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VC Research 17

The following table shows the consensus expected P/E for all of the comparable companies including CRG &CRCC. We are more optimistic regarding the earnings growth and thus our expected FY10 P/E for CRG & CRCCare 14.2 and 14.0, which are lower than consensus.

From the peer comparison table, we can see that both CRG and CRCC are trading at a higher expected P/E thantheir global peers. Given their promising growth trend in the coming years, the higher multiples are justified in ourview.

VC ResearchInfrastructure construction

As at 31 July 2009

Peers comparison

(In Rmb million unless otherwise stated)

Bloomberg Market P/E

Comparable company ticker Country cap FY09 FY10 FY11 FY12

China Railway Group Ltd - H 390 HK Equity China 144,164 24.00 18.46 15.32 12.99

China Railway Constructio-H 1186 HK Equity China 131,285 21.21 16.10 13.43 10.82

China Communications Const-H 1800 HK Equity China 131,470 16.46 13.62 11.48 9.02

Vinci Sa DG FP Equity France 177,764 12.82 13.62 12.68 11.67

Acs Actividades Cons Y Serv ACS SM Equity Spain 115,034 9.41 13.85 13.23 12.06

Fomento De Construc Y Contra FCC SM Equity Spain 34,601 11.89 11.59 10.68 8.45

Skanska Ab-B Shs SKAB SS Equity Sweden 39,563 14.70 16.69 15.70 12.89

Hyundai Engineering & Const 000720 KS Equity Korea 39,089 14.21 13.55 11.67 9.31

Daewoo Engineering & Constr 047040 KS Equity Korea 23,545 16.78 13.45 10.94 8.84

Impregilo Spa IPG IM Equity Italy 10,524 13.22 11.12 9.86 9.08

United Group Ltd UGL AU Equity Australia 11,228 13.35 13.66 12.96 11.74

Sumitomo Mitsui Construction 1821 JP Equity Japan 1,907 neg n/a n/a n/aMeiko Construction Co Ltd 1869 JP Equity Japan 1,088 38.77 n/a n/a n/a

Tuksu Construction Co Ltd 026150 KS Equity Korea 650 n/a n/a n/a n/a

Eehwa Construction Co Ltd 001840 KS Equity Korea 423 n/a n/a n/a n/a

Minimum neg 11.12 9.86 8.45

Maximum 38.77 18.46 15.70 12.99

Average 15.51 14.16 12.54 10.62

Median 14.21 13.62 12.68 10.82

Adjusted average 15.28 14.01 12.49 10.60


Adjusted average excludes minimum and maximum as outliers


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VC Research 18

Recommendation

The China railway infrastructure constructor sector is attractive in the sense that it offers a promising top linegrowth, backed by the Chinese governments huge investment in infrastructure construction. Relative to generalinfrastructure constructors, CRG & CRCC are expected to deliver promising growth given the under-investment inrailway infrastructure relative to highways & ports on the mainland.

CRG & CRCCs recent underperformance relative to HSI may attribute to their defensive nature. However, giventheir strong and highly visible growing trend, we expect investment interest will return when market volatilityincreases.

Between the two players, we prefer CRCC to CRG at their current prices because of CRCCs:

- Greater focus and higher GP margin % in railway construction- Higher survey & design capabilities and commitment to R&D- Higher and growing percentage of overseas revenue & new contract value- Lower dependency on other income & financial investment performances- Potential ROA improvement through total GP & net margin expansion while keeping its higher

asset turnover ratios over CRGs

- Share price underperformance relative to CRG in recent months- Higher upside potential from the current price to our TP

We recommend company that concentrates on its core business and is more willing to make long-term investmentto strengthen its core competency.

We believe the market is overestimating the earning contributions of the mining & property developmentbusinesses of CRG and underestimating the impact of design capabilities and overseas revenue source on thelong-term growth of the industry.

Therefore, we believe CRCCs lagged valuation provides a good chance for investors to capitalize on Chinas highgrowth in the railway infrastructure sector. We upgrade CRCC to BUY with a TP of HKD 14.56 and downgradeCRG to HOLD with a TP of HKD 7.15.


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VC Research 19

Company Update

03 August 2009

China Railway Group (0390.HK) HOLD (Downgraded)Company Update China Railway Group (0390.HK)


Price (HK$)6.98

Target price (HK$) 7.15Mkt Cap (HK$bn)

163.54

52-week high7.24

52-week low3.00

FY09 PE (x)19.9

FY10 PE (x)14.2

Historic P/B (x)2.2

Forward P/B (x)2.0

FY09 ROE (%)10.9

FY10 ROE (%)13.8

FY09 Yield (%)1.3

FY10 Yield (%)1.8

Investment Summary

We have revised down CRG from BUY to HOLD following its 30% share price

increase since the beginning of May09. Based on the recent strong new contracts inflows and higher than expected

MOR investment up to Jun09, we have revised upward our revenue forecasts

for FY09 & FY10 by 9.6% & 24.3% and EPS from HK$0.25/HK$0.37 to HK$0.31

/HK$0.43 for FY09/FY10.

Given the decrease in average raw material costs in 1H09 and management

cost control policy, we believe CRG can at least keep its GP margin flat in

FY09.

NP margin (Exclude FX effect) improve by 0.1% as we expect selling &

administrative expenses as % of revenue to decrease from 4.6% in FY08 to

4.5% in FY09.

However, we revise downward our growth rate assumptions of FCFs for FY14

to FY20 from CAGR 10% to CAGR -0.9%, as we believe the recent strong

growth cannot sustain.

Our DCF based TP is set at HKD7.15, representing 2% upside from the

current trading price. We think CRG is fully valued at current price level.We

prefer CRCC (1186.HK) to CRG.

Earnings Summary - China Railway Group (0390.HK)

Y/E 31 Dec FY2007A FY2008A FY2009E FY2010E

Revenue (Rmb m) 177,391 225,029 316,795 442,970

YoY change 15.5% 26.9% 40.8% 39.8%

Profit / (Loss) attributable to shareholders (Rmb m) 2,488 1,350 6,570 9,211

Basic EPS (Rmb) 0.186 0.063 0.308 0.432

YoY change 16.1% -65.8% 386.7% 40.2%

PER (x) 33.2 97.1 19.9 14.2

PBR (x) 2.2 2.2 2.0 1.8

Dividend Yield (%) 0.0% 0.0% 1.3% 1.8%

Gross profit margin 7.2% 7.3% 7.3% 7.3%

Return on Equity (ROE) (Average) 8.1% 2.8% 10.9% 13.8%

Total Liabilities to Total Assets 72.4% 75.8% 79.8% 82.7%

Debt to Total Assets 18.0% 21.4% 21.4% 21.4%

Debt (net of cash) to Total Assets Net cash 2.8% 3.2% 2.7%

Sources: VC estimates, The company


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VC Research 20

Bus iness deve lopment & New s updateSales growth surprises on the upside

Strong new contracts inflows. Total new contract value secured and announced fromJan09 to Apr09 already reached Rmb200bn, more than 50% managements annual

target of Rmb390bn for FY09. Based on the new contracts inflows pattern over the past

few years for CRG and CRCC, the value of new contracts inflows in 2H would usually be

much higher than that in 1H. Therefore, we expect the strong growth of new contract

value in FY08 to carry over in FY09. Taking into account the newly announced contract

value in our projection, we have revised up our contract value forecast from Rmb413.8bn

to Rmb583.9bn for FY09.

New contract value (in Rmb m) - China Railway Group (0390.HK)

FY2009E

Recent company announcement for Jan09 - Apr09 Around 200,000

Management target for the year 390,000

Last year total 428,450

Change

Our current estimate 583,869 41.1%

Our previous estimate (4-May-09) 413,882


MOR investments may beat expectations. According to the latest announcement by

the Ministry of Railways (MOR), the amount of railway investments up to Jun09 grew155% yoy to Rmb201bn. The MOR has followed an investment pattern over the past few

years that the amount spent in 2H of the year is higher than that in 1H. If this investment

pattern will repeat in 2009 and given the 1H09 investment number is already quite high,

it is possible that the total investment by the MOR would come in at Rmb860bn, 43%

higher than market consensus of Rmb600bn.

Railway infrastructure monthly spending by MOR

-

10

20

30

40

50

6070

80

90

100

Jan-07

Mar-07

May-07

Jul-07

Sep-07

Nov-07

Jan-08

Mar-08

May-08

Jul-08

Sep-08

Nov-08

Jan-09

Mar-09

May-09

Rmbbn

Source: VC estimates, MoR

*There is a regular jump in Dec due to p roject sett lements made before the end of the year.


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VC Research 21

Revenue recognition rate to increase. In the absence of serious natural disasters in

2009, construction projects are expected to complete at a faster rate and thus we revise

upward our revenue recognition rate, i.e., the revenue as % of current new contract and

backlog, from 27.2% to 30.8% for FY09. However, given the expected strong new

contract value growth rate in FY09, the revenue recognition rate in FY09 will likely come

in lower than that in FY08.

Historical & Assumed Revenue as % of (Current year New contract + Last year Backlog)

FY2007A Y2008A FY2009E FY2010E

Revenue as % of (Current year New contract + Last year Backlog) 45.2% 35.1% 30.8% 32.5%

Our previous estimate (4-May-09) n/a n/a 27.2% 28.3%

New contract value Historical or Assumed growth rate 18.0% 69.9% 47.5% 10.6%

Sources: VC estimates

Factoring in a higher-than-expected new contract value inflows and a higher revenuerecognition rate, we have revised upward our revenue growth forecasts for FY09/FY10

from 28.5%/23.2% to 40.8%/39.8%. Our revenue forecast for FY09 is now 6% higher

than market consensus from Bloomberg.

Margin Analysis

GP margin to remain flat

There are market views that CRGs overall GP margin will improve drastically in 2009

due to decreases in raw material prices and the companys cost controls. We hold a

different view and project that CRGs overall GP margin will be flat for FY09 and FY10. Itis because:

- Revenue from construction projects, of which margins are relatively lower than other

lines of businesses, constitutes a higher % of total revenue in FY09.

- Raw material costs will start bounce back towards the end of 2009, when stronger

demands for construction materials emerges.

- The MOR, as the largest customer who contributes a good share of CRGs revenue,will unlikely increase contract prices.

- We do not expect CRG to gain much from economies of scale through project

management because its existing construction operation scale is already sizeableby national standards.

- The decline in raw material prices since 4Q08 does not warrant an improvement in

CRGs overall GP margin in 2009. The diagram overleaf shows a positive

correlation between CRGs construction GP margin and the prices of Rebar and

425-grade cement since 2007.


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VC Research 22

Construction GP margin % (Left bar) and Construction material prices (Right bar)

5.5%

5.7%

5.9%

6.1%

6.3%

6.5%

FY05 FY06 FY07 FY08

GPmargin

%

2,400

2,900

3,400

3,900

4,400

4,900

AveragepricesperTon(o

rper10Tons)

Rebar per Ton Cement (42.5 grade) per 10 TonsCRG infrast ructure GP margin CRCC infrast ructure GP margin

Source: VC estimate, Bloom berg, CEIC

Conservative overall GP margin assumptions. Management guided that they are

looking to bolster GP margin through better internal cost controls. Also, given the

continued decrease in average raw material costs in 1H09, we believe CRG will be

capable of maintaining its overall GP margin.

Railway GP margin to be intact for FY09 & FY10. Railway GP margin for CRG was

around 6.8% in FY08. We believe this margin will remain intact in the medium term, and

this view complies with management conservative tone regarding the outlook of this

particular segment.

NP margin (ex-FX loss) rises slightly

Foreign exchange (FX) loss distortions. That the company NP margin dropped to

0.7% in FY08 was distorted by the huge amount of FX loss of Rmb4139m. Excluding this

amount and net of tax, NP margin would have been 2.1% for FY08. We project no

further FX loss to incur in FY09 because the company has obtained governments

approval to repatriate Rmb10bn of its Rmb15bn H-share IPO proceeds to the mainland.

Also, management confirmed that certain FX losses would be written back due to a

stronger AUD.

A smaller S&A expense to revenue ratio to improve NP margin. On an ex-FX loss

basis, we believe CRGs NP margin will improve from 2.1% in FY08 to around 2.2% in

FY09. This can be attributable to a smaller S&A expense to revenue ratio. We believethere is room for CRG to decrease its S&A expenses as % of revenue from 4.6% in

FY08 to 4.5% in FY09 and 4.4% FY10. However, the chance of a further decrease is

limited given that the relevant % in CRCC (1186.HK) & CCCC (1800.HK) have stabilized

at around 4.4% over the past few years.


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VC Research 23

Assumptions - China Railway Group (0390.HK)

FY2007A Y2008A FY2009E FY2010E

Historical or Assumed GP margin % of:

Railways 6.3% 6.8% 6.8% 6.8%

Highways 3.8% 4.1% 4.1% 4.1%

Municipal works 6.6% 6.6% 6.6% 6.6%Survey, design & consulting services 29.5% 27.0% 27.0% 28.0%

Engineering equipment & component manufacturing 16.2% 16.0% 17.0% 17.0%

Property development 31.8% 30.0% 30.0% 30.0%

Other businesses 13.7% 13.0% 13.5% 13.5%

Total GP% 7.2% 7.3% 7.3% 7.3%


Revenue mix - China Railway Group (0390.HK)

FY2007A FY2008A FY2009E FY2010E

Railways 44.6% 48.2% 49.1% 55.7%

Highways 23.6% 17.3% 18.4% 13.4%

Municipal works 26.8% 24.9% 25.2% 25.3%

Survey, design & consulting services 1.9% 1.9% 1.4% 1.2%

Engineering equipment & component manufacturing 2.9% 3.1% 2.6% 2.3%

Property development 1.9% 1.7% 1.5% 1.3%

Other businesses 4.6% 4.8% 3.5% 2.7%

Elimination of inter-segment revenue -6.3% -1.8% -1.8% -1.8%

Total Revenue 100.0% 100.0% 100.0% 100.0%


Valua t ionGiven the long investment and construction period of the infrastructure constructionsector, we adopt DCF methodology to come up with our TP for CRG.

Growth sustainability. The implied growth rate assumption in our DCF model for FY14

to FY20 is of -0.9% CAGR, as we believe the recent strong growth cannot sustain in a

very long run. In our current valuation, we expect new contract value and revenue to

peak out in FY11 & FY13, respectively.

A discount rate of 10%. Our WACC is derived from the following assumptions: Risk

free rate: 4.18%, Unlevered beta: 0.75, Equity risk premium (ERP): 8%, Cost of debt:

5.4%, Tax rate: 25% and expected capital structure for CRG. Meanwhile, the low

unlevered beta of 0.75 is justified by the average of global railway constructors.


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VC Research 24

DCF - China Railway Group (0390.HK)

Value Average

(in Rmb millions) As at before Terminal

31/7/2009 Terminal Year

FY2009 FY2010 Year FY2012

Free Cash Flow available to firm (FCF) (851) 2,129 13,126 14,709Total Firm Value 152,939

Net (Debt) / financial asset (13,447)

Minority interest (5,154)

Total Equity value 134,338

Total no. of shares 21,300

Fair value per share 6.31

HKD/RMB exchange rate 1.13 Terminal growth % 3.0%

Fair value per share (in HKD) 7.15 WACC % 10.0%


Recommendat ion: HOLDFollowing the noticeable bounce back of the global stock market since Mar09, the HSI

has risen 81% while CRG 71%. The performance of CRG is more or less in line with that

of the HSI. Its slight underperformance may be perhaps attributed to its defensive nature

relative to the overall market.

Our DCF based TP is set at HKD7.15, representing a 2% upside from the current share

price. In our view, CRG is fully valued and unattractive at current share price relative toCRCC (1186.HK), which commands an 18% potential upside based on our estimates.

However, CRG is a defensive play and may become again an investment focus when

market volatility increases. We downgrade CRG to HOLD on valuation base.

Sens i t i v i ty ana lys isWe identified 6 major assumptions, namely Sales growth rate, GP margin, Capital

investment growth rate, S&A expenses as % of revenue, terminal growth rate & WACC

for DCF, and prepared sensitivity tables to show the TP if those assumptions derivate

from our base case. Please refer to appendix for details.


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VC Research 25

Income Statement - China Railway Group (0390.HK)

Y/E 31 Dec

Historical and Projected Consolidated Income Statement

(in RMB millions, RMB for per share figures) FY2007A FY2008A FY2009E FY2010E

Revenue 177,391 225,029 316,795 442,970

Cost of sales (164,659) (208,534) (293,579) (410,689)

Gross profit 12,732 16,495 23,215 32,281

Other income 841 1,168 1,226 1,288

Other gains / (losses) 516 (4,232) 0 0

Selling and marketing expenses (932) (933) (1,235) (1,728)

Administrative expenses (8,913) (9,499) (12,989) (17,719)

Interest income 982 1,581 1,154 1,856

Interest expenses (1,850) (2,372) (2,171) (3,224)

Share of profits / (losses) of jointly controlled entities (3) 44 39 43

Share of profits / (losses) of associates 11 48 37 41

Profit before taxation 3,384 2,300 9,277 12,838

Income tax expense (549) (631) (2,319) (3,210)

Profit for the year 2,835 1,669 6,958 9,629

Minority interests (347) (319) (388) (418)

Profit attributable to equity holders of the Company 2,488 1,350 6,570 9,211

Earning per share (Basic) 0.186 0.063 0.308 0.432



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VC Research 26

Balance Sheet - China Railway Group (0390.HK)

Y/E 31 Dec

Historical and Projected Consolidated Balance Sheet

(in RMB millions) FY2007A FY2008A FY2009E FY2010E

ASSETS

Non-current assets

Total Property, plant and equipment (PPE) 30,276 36,457 43,748 51,186

Accumulated Depreciation - PPE (11,969) (13,772) (16,295) (19,496)

Net Property, plant and equipment (PPE) 18,307 22,685 27,454 31,690

Deposit for acquisition of property, plant and equipment 683 1,328 1,594 1,865

Deposit for land use rights & investment and other

prepayments & receivables 107 301 301 301

Lease prepayments 6,091 6,314 7,577 8,865

Investment properties 857 1,502 1,802 2,109Intangible assets 7,223 13,806 16,567 19,384

Mining assets 1,104 1,333 1,600 1,872

Total depreciable assets other than PPE 15,275 22,955 27,546 32,229

Accumulated Depreciation / Amortisation (132) (267) (567) (938)

Net depreciable assets other than PPE 15,143 22,688 26,979 31,291

Interests in jointly controlled entities 651 741 815 897

Interests in associates 2,591 3,539 3,893 4,282

Goodwill 779 836 920 1,012

Available-for-sale & Held-to-maturity financial assets 2,908 3,929 3,929 3,929

Other loans and receivables 989 914 914 914

Deferred income tax assets 1,925 2,554 2,554 2,55444,083 59,515 69,352 78,733

Current assets

Lease prepayments - current 106 108 130 152

Properties held for sale & under development for sale 11,911 19,948 23,781 19,976

Inventories 10,448 18,482 26,333 37,825

Trade and other receivables 63,375 78,260 109,293 154,838

Amounts due from customers for contract work 27,021 25,197 35,704 51,152

Other loans and receivables - current 272 892 892 892

Held-for-trading & held-to-maturity financial assets 166 141 141 141

Restricted cash 2,171 2,530 2,783 3,061

Cash and cash equivalents 56,772 46,846 59,674 79,367

172,242 192,404 258,731 347,403

Total assets 216,325 251,919 328,083 426,137



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VC Research 27

Balance Sheet - China Railway Group (0390.HK)

Y/E 31 Dec

Historical and Projected Consolidated Balance Sheet

(in RMB millions) FY2007A FY2008A FY2009E FY2010E

EQUITY

Equity attributable to the equity holders of the Company 55,791 55,995 60,923 67,831

Minority interests 3,950 4,929 5,317 5,735

Total equity 59,741 60,924 66,239 73,565

LIABILITIES

Non-current liabilities

Other payables 232 366 519 715

Borrowings 10,239 16,829 21,917 28,467

Obligations under finance lease (beyond 1 year) 69 266 319 373

Financial guarantee contracts 77 35 35 35

Retirement and other supplemental benefit obligations 8,650 7,368 7,368 7,368

Provisions 0 47 47 47

Deferred income government grant 209 138 138 138

Deferred income tax liabilities 588 398 398 398

20,064 25,447 30,741 37,542

Current liabilities

Trade and other payables 95,869 111,270 157,632 217,611

Amounts due to customers for contract work 11,144 15,509 22,331 31,171

Current income tax liabilities 541 870 2,133 2,952

Borrowings - current 28,527 36,594 47,658 61,901

Obligations under finance lease (within 1 year) 44 220 264 309Financial guarantee contracts - current 10 2 2 2Retirement and other supplemental benefit obligations -

current 385 1,003 1,003 1,003

Held-for-trading financial liabilities 0 80 80 80

136,520 165,548 231,103 315,029

Total liabilities 156,584 190,995 261,844 352,571

Total equity and liabilities 216,325 251,919 328,083 426,137

Net current assets 35,722 26,856 27,628 32,374

Total assets less current liabilities 79,805 86,371 96,980 111,107



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VC Research 28

Financial Ratios - China Railway Group (0390.HK)

FY2007A FY2008A FY2009E FY2010E

Valuation

PER (x) 33.2 97.1 19.9 14.2

PBR (x) 2.2 2.2 2.0 1.8

Dividend Yield (%) 0.0% 0.0% 1.3% 1.8%Dividend payout ratio 0.0% 0.0% 25.0% 25.0%

Profitability and Efficiency

Gross profit margin 7.2% 7.3% 7.3% 7.3%

EBITDA margin 4.1% 2.8% 4.6% 4.3%

EBIT margin 2.4% 1.4% 3.2% 3.2%

Net margin 1.6% 0.7% 2.2% 2.2%

Return on Equity (ROE) (Average) 8.1% 2.8% 10.9% 13.8%

Return on Assets (ROA) (Average) 1.6% 0.7% 2.4% 2.6%

Liquidity ratiosCurrent ratio (x) 1.26 1.16 1.12 1.10

Cash ratio (x) 0.43 0.30 0.27 0.26

Asset turnover ratios

Average Receivables / Sales 45.9% 43.1% 39.2% 39.6%

Average Inventory / Relevant CGS 10.8% 15.3% 15.5% 13.4%

Average net WC assets / (liabilities) as % of Sales -3.4% 1.7% 2.9% 2.1%

Total operating expense / Sales 5.5% 4.6% 4.5% 4.4%

Average net PPE / Sales 9.5% 9.1% 7.9% 6.7%

Average net capital investment / Sales 15.0% 17.5% 15.8% 13.3%

Financial leverage ratiosTotal Liabilities to Total Assets 72.4% 75.8% 79.8% 82.7%

Debt to Total Assets 18.0% 21.4% 21.4% 21.4%

Debt (net of cash) to Total Assets Net cash 2.8% 3.2% 2.7%

Interest Coverage 2.30 1.30 4.74 4.41



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VC Research 30

Values from DCFF

Sensitivity analysis - Sales growth rate assumption Sales growth rate assumption

(Per share in HKD) Our Base case Average of

-2% -1% 0% 1% 2% FY2009E FY2010E FY11 to FY18

-20% 7.96 6.42 5.32 4.49 3.85 40.8% 39.8% 2.8%

% change of -10% 9.20 7.44 6.18 5.23 4.50

Total Sales 0% 10.62 8.60 7.15 6.08 5.24

growth rate* 10% 12.23 9.91 8.26 7.03 6.0720% 14.06 11.41 9.52 8.10 7.01

Sensitivity analysis - Gross profit margin assumption Gross profit margin assumption


-2% -1% 0% 1% 2% FY2009E FY2010E FY11 to FY18

-10% 7.83 6.22 5.08 4.23 3.57 7.3% 7.3% 7.5%

% change of -5% 9.22 7.41 6.12 5.15 4.40

GP Margin 0% 10.62 8.60 7.15 6.08 5.24

%* 5% 12.02 9.78 8.19 7.00 6.07

10% 13.41 10.97 9.23 7.92 6.90

Sensitivity analysis - CAPEX assumption CI growth rate assumption


-2% -1% 0% 1% 2% FY2009E FY2010E FY11 to FY18

-10% 12.19 10.27 8.89 7.84 7.01 20.0% 17.0% 6.3%

% growth of -5% 11.24 9.34 7.98 6.94 6.13

Capital 0% 10.62 8.60 7.15 6.08 5.24

Investment* 5% 9.87 7.65 6.09 4.93 4.05

10% 8.83 6.34 4.61 3.36 2.43

Sensitivity analysis - Operating expense assumption Operating expense assumption


-2% -1% 0% 1% 2% FY2009E FY2010E FY11 to FY18

-1.0% 14.32 11.77 9.94 8.57 7.51 4.5% 4.4% 4.4%

% of sales -0.5% 12.47 10.18 8.55 7.32 6.37

for operating 0.0% 10.62 8.60 7.15 6.08 5.24

expenses* 0.5% 8.77 7.01 5.76 4.83 4.10

1.0% 6.92 5.43 4.37 3.58 2.97

Sensitivity analysis - Terminal growth rate assumption Terminal growth rate assumption

(Per share in HKD) Our Base case

-2% -1% 0% 1% 2% Terminal g WACC

-2% 8.28 7.02 6.04 5.26 4.63 3.0% 10.0%

Terminal -1% 9.25 7.69 6.53 5.62 4.90

growth 0% 10.62 8.60 7.15 6.08 5.24

rate - FCFF* 1% 12.67 9.86 7.99 6.66 5.66

2% 16.08 11.76 9.16 7.43 6.19

* % change of gross profit margin for each year in projection period

** This table changes the % of sales of total operating expenses (except

CGS) to revenue (e.g. From 4.5% to 5.5% of sales)

WACC

* Change of terminal growth rate from our base case assumption.

** This table changes % growth of all kinds of CIs at the same rate (e.g.

From CIs increase at 20% to 30%)

Note: This table reflects change in amount of CAPEX each year

WACC

* Change of % of sales for total operating expense (e.g. SGA) for each

year in projection period

** This table changes GP margin % of all kinds of revenues at the same

rate (e.g. GP margin expands 10% from 7% to 7.7%, etc.)

WACC

* Change of % growth of total capital investment for each year (exceptthe final year) in projection period

WACC

* % change of sales growth rate for each year in projection period

** This table changes sales growth rate of all kinds of revenues at the

same rate (e.g. Sales growth rate expands 20% from 40% to 48%, etc.)

WACC

Source: VC estimates


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VC Research 31

Company Update

03 August 2009

China Railway Construction Co.(1186.HK)

BUY (Upgraded)Company Update China Railway Construction Co. (1186.HK)


Price (HK$)12.36

Target price (HK$) 14.56

Mkt Cap (HK$bn)148.93

52-week high13.44

52-week low7.10

FY09 PE (x)19.5

FY10 PE (x)14.0

Historic P/B (x)2.8

Forward P/B (x)2.5

FY09 ROE (%)13.6

FY10 ROE (%)16.8

FY09 Yield (%)1.3

FY10 Yield (%)1.8

Investment Summary

We have revised up CRCC from HOLD to BUY given the 18% potential upside

based on our new TP. Based on the recent strong new contracts inflows and higher than expected

MOR investment up to Jun09, we have revised upward our revenue forecasts

for FY09 & FY10 by 20.5% & 34.0%.

Given the decrease in average raw material costs in 1H09 and management

expectation, we believe CRCC can improve its overall GP margin slightly by

0.1% in FY09.

NP margin (Exclude FX effect) improve by 0.2% as we expect selling &

administrative expenses as % of revenue to decrease from 4.7% in FY08 to

4.5% in FY09.

However, we are cautious on the sustainability of the recent strong growth.We expect new contract value & revenue to peak out in FY11 & FY13,

respectively.

DCF based TP is set at HKD14.56, representing 18% upside from the current

trading price.

We prefer CRCC to CRG (390.HK), where CRGs DCF based TP is estimated at

HKD7.15, representing only 2% upside from the current trading pric

railway constructor - sector report - 030809

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