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Summary of "Receding Tide Reveals Value"

Core Content

This document provides an analysis of the water sector in both Hong Kong and Singapore, highlighting the opportunities for investment in the industry due to recent share price corrections. It emphasizes the long-term secular growth potential of water stocks driven by the marketisation of the water sector, increased private sector funding, and stricter government regulations on water quality. The report also outlines key valuation metrics and recommends specific stocks based on their growth prospects and financial performance.

Main Views

• Valuation Opportunities: After a significant selloff, the valuations of water stocks have become more attractive. Despite a rebound of up to 60%, the current prices are now at less than +1SD above the historical average for the past 4-5 years.
• Marketisation Trends: The water sector is becoming increasingly market-driven, with more private sector involvement and the government's push for outsourcing water services.
• Tariff Increases: The upward trend in water tariffs is expected to continue, leading to increased demand for water services and more business opportunities.
• Value-Added Services: The development of outsourcing services such as sludge treatment, O&M services, and water quality monitoring is anticipated to grow.
• Membrane Technology: As water quality standards tighten, membrane technology is expected to be a key driver of growth for companies with expertise in this area.

Key Information

• Market Performance: Water stocks in both Hong Kong and Singapore outperformed the HSI and STI indices in the first four months of 2015. However, the recent crash in the A-share market caused a significant correction in share prices.

• Valuation Adjustments: Adjusted earnings are used to better reflect the true financial performance of water companies, as reported earnings can be inflated due to the accounting treatment for service concessions.

• Stock Recommendations:

  • Buy: United Envirotech (UENV SP), CT Environmental Group (1363 HK), Kangda (6136 HK), Beijing Enterprises Water (371 HK), China Everbright International (257 HK), and China Everbright Water (CEWL SP).
  • Hold: SIIC Environment (SIIC SP).
  • Sell: Tianjin Capital (1065 HK).

• Valuation Table (HK Stocks):

• Valuation Table (SGD Stocks):

Top Picks

• United Envirotech (UENV SP): A pioneer in membrane technology, expected to benefit from stricter water quality standards. The company has strong financial backing and a leadership position in the membrane sector. Target price is SGD 2.00 based on 15x FY3/17 EPC earnings, 40x for treatment services, and 18x for membrane sales. The adjusted PE is 27x, below the historical average of 30x.
• CT Environmental Group (1363 HK): Benefits from the BOO business model, offering higher ROE and shorter payback periods. It has a first-mover advantage in the sludge treatment market in Guangdong. Target price is HK$12.00 based on 20x FY16 PE.
• Kangda (6136 HK): Despite smaller scale, it will benefit from the outsourcing of industrial wastewater treatment. Target price is HK$4.00 based on 40x FY17 adjusted PE, offering a 60% discount to historical averages.

Key Trends

• Private Sector Involvement: The government is encouraging private sector investment in the water industry, leading to increased funding and more business opportunities.
• Water Quality Standards: Stricter regulations are driving the adoption of advanced technologies like membrane treatment.
• Outsourcing Services: The demand for outsourcing services such as sludge treatment and O&M is expected to grow significantly.
• Capacity Expansion: Companies are expanding their capacity to meet the growing demand, with some expected to achieve double-digit growth rates in adjusted earnings.

Risks and Considerations

• Volatility: The A-share market volatility may continue to impact water stock prices in the short term.
• Execution Risks: Companies with weaker execution or deal flow, such as Tianjin Capital, are at risk of underperformance.
• Earnings Discrepancy: Adjusted earnings are significantly lower than reported earnings, indicating a need for careful valuation analysis.

Conclusion

The water sector is expected to benefit from long-term secular growth driven by marketisation, increased private sector involvement, and stricter water quality standards. While short-term volatility may affect share prices, the current valuations offer good opportunities for investors to load up on quality stocks. The report recommends focusing on companies with strong technical capabilities and early-mover advantages in key areas of the industry.