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China Water Sector Summary

Core Content

The China water sector is positioned for a golden era over the next three years, driven by rising water prices, strong government policy support, and industry consolidation. The report highlights the potential for growth, especially in wastewater treatment (WWT), and identifies key players such as SIIC Environment, Hankore Environment Tech Group, and United Envirotech.

Main Viewpoints

• The sector is expected to experience rapid growth, with sector EPS projected to rise at a 15% CAGR from FY14E to FY16E.
• Rising water tariffs will be a key growth driver, with an estimated 10% annual increase in water prices over the next three years, surpassing the previous 4% CAGR.
• Government policy support is central to the industry's expansion, particularly under the 12th Five-Year Plan, which aims to increase WWT coverage and improve water quality standards.
• Industry consolidation is anticipated, with larger state-owned enterprises (SOEs) expected to dominate due to their stronger financial position, government ties, and access to cheap funds.
• The water pricing mechanism reform, especially tiered pricing, is set to unlock significant upside potential by making water prices more reflective of true costs.

Key Information

Sector Valuation

• The water sector currently trades at 24x FY15E P/E, which is considered an attractive entry point after a recent 10-15% correction.
• Companies with strong asset quality, project sourcing ability, and financial firepower are expected to outperform.

Stock Picks

Investment Thesis

• Rising water tariffs will provide a recurring revenue stream for WWT companies, especially those with a high proportion of tariff-based income.
• Government investment in WWT infrastructure is expected to reach CNY430b by 2015, with a 30% increase compared to the previous five-year period.
• SOEs are likely to benefit more from the industry consolidation due to their strong balance sheets, government relationships, and lower financing costs.

Water Pricing Components

• The water tariff in China is composed of four main components:
  • Water resource fee (7%)
  • Water treatment fee (35%)
  • Water supply charge (55%)
  • Other fees (3%)

Water Scarcity and Pollution

• China faces severe water scarcity, with 20% of the global population but only 7% of global water resources.
• Groundwater quality is a major concern, with over half classified as poor or very poor.
• WWT coverage is currently at 80% for cities, 60% for counties, and 20% for towns, with targets of 85%, 70%, and 30% by 2015.

Water Pricing Reform

• The government plans to implement tiered pricing to increase water prices.
• In Beijing, the new pricing scheme is expected to raise water prices by 24-125% depending on usage tiers.
• Only 30% of Chinese cities have adopted the tiered pricing system, indicating a significant growth opportunity.

Government Investment Plan

• The 12th Five-Year Plan (2011-2015) includes CNY3.4t in environmental protection spending, with CNY430b allocated to urban wastewater systems.
• New sewage treatment capacity is expected to increase from 164m tons/day to 208m tons/day by 2015, creating a CNY90b market.
• Existing capacity upgrades are estimated to require CNY10b in investment over the next two years.

Market Fragmentation

• The water sector is highly fragmented, with the top 10 players accounting for only 20% of total market share.
• SOEs and larger companies are better positioned to capture market share and benefit from consolidation.

Future Outlook

• The WWT story is expected to continue beyond the 12th Five-Year Plan, driven by population growth, increased water usage, and rural market penetration.
• The sector's ROE is projected to expand by 180bps to 8.9% over the next three years.
• Pollution control will be a major driver, with higher investment in industrial and urban areas, especially in Guangdong, Shandong, and Jiangsu.

Key Risks

• Project sourcing: Companies must maintain strong relationships with local governments to secure new projects.
• Refinancing risk: Capital-intensive nature of the industry may lead to EPS dilution from equity fundraising.
• Credit risk from local governments: Delays in tariff payments could impact cash flow for water companies.

Conclusion

The China water sector is set for sustained growth due to rising water prices, government support, and industry consolidation. Companies with strong asset quality, recurring revenue, and government ties are best positioned to capitalize on this growth. The sector's valuation is currently attractive, and the investment in WWT infrastructure is expected to surpass initial targets. The long-term growth potential remains robust, with the WWT story likely to continue for decades.