OSK found silver lining in China Automation's railway business

Rebound may be expected by 2013.

Here's from Billy Leung, Vice President,  Research Dept OSK Securities Hong Kong Limited: 

 We organized a non-deal road show for China Automation Group (CAG) yesterday. Investors’ questions were mainly focused on: i) its 26 November profit warning and ii) the current situation and outlook for its railway and petrochemical units.

CAG said that: i) the profit warning relates to a non-cash provision (we estimate at RMB60m), on accounts receivables (A/R) that have been outstanding over two years, ii) China’s railway expenditure remains weak but their order backlog remains solid at about RMB2bn. Management expects the formal handover of power in March 2013 to kick start a rebound in China’s railway projects from 2Q13 and iii) the outlook of petrochemical control-valves business remains positive.

We pare our FY12F reported EPS estimates by 43% on: i) the A/R provision and ii) less aggressive estimates on the railway business. Our FY13F/FY14F EPS estimates, are also reduced, but by a lesser 4%/5% as we anticipate a recovery in the railway business. Our TP rises to HKD2.45 (from HKD2.13) as we roll over our valuation to 7x FY13F PE (from 7x FY12F). We believe that China’s railway sector has bottomed out and any positive news flow regarding new projects (including subway), will likely act as a share price driver. Maintain BUY.

Potential A/R provision of RMB60m. Management revealed that it has been their practice since CAG’s listing in 2007 to make full provision for its A/R’s aged over two years. During the group’s recent pre-audit, an estimated RMB60m of the A/R was found to be outstanding for over two years and, hence, will be fully provided for in FY12. We note that roughly 80% of the A/R owed by railway customers (Ministry of Railways and China Railway Construction) and the remaining by petrochemical-related customers along with coal and iron & steel firms.

Weak 2H12. Wuzhong to drive growth. During the roadshow, management noted that spending on China’s national railway sector remains stagnant and several projects that were originally scheduled for bidding during 3Q12, are still currently suspended. We believe CAG’s petrochemical control valves business, Wuzhong Investment (WZI), which was fully acquired in May this year, will be the core revenue driver going forward. WZI only accounted for 7% of CAG’s revenues in 1H12, but we expect this percentage to rise to 14% for the full year of FY12F) as management targets 20% y-o-y growth. In our view, this is achievable since WZI has a dominant market share in China’s control valves sector especially for coal-related firms.

Maintain BUY with higher HKD2.45 TP. Our new TP target is set at the same 7x multiple but based on revised FY13F EPS vs. FY12F EPS previously. Our target PE is greater than one standard deviation below CAG’s past five-year forward average. We reckon CAG’s share price has already factored in the poor performance of its railway division this year and any positive news flow on new railway sector expenditure is likely to lead to a re-rating.