company report china merchants securities (hk) co., ltd...

Tuesday, September 15, 2015

Company Report China Merchants Securities (HK) Co., Ltd. Hong Kong Equity Research

Please see penultimate page for additional important disclosures. China Merchants Securities (CMS) is a foreign broker-dealer unregistered in the USA. CMS research is prepared by research analysts who are not registered in the USA. CMS research is distributed in the USA pursuant to Rule 15a-6 of the Securities Exchange Act of 1934 solely by Rosenblatt Securities, an SEC registered and FINRA-member broker-dealer. 1

China Railway Signal & Communication Corp (3969 HK) Global leader of railway communication & control system solutions ■ CRSC (or the “company”) is the world’s top rail transportation control system solution provider and the only industry chain-wide solution provider in the world that can offer design and integration, equipment manufacturing and system implementation services ■ Apart from its rail transportation business, CRSC will utilize IPO and its own funds to actively participate in PPP projects; we expect 2015-17E revenue to grow 43%, 38% and 29.8% YoY ■ Considering 2016E sector average P/E of 14.52x, we arrived at our TP of HK$7.15, corresponding to 2015-17E P/E of 20.0x, 15.2x and 11.4x, or 2015-17E P/B of 2.14x, 1.92x and 1.69x, respectively The company’s three key competitive advantages to last long 1) CRSC is the natural monopoly in high-speed rail control system market. 2) It possesses national-grade R&D capabilities and extensive experience. 3) Customers prefer working with trusted and fixed suppliers for safety and compatibilities of control system. Huge room for future business growth 1) High-speed rail and urban transit control system market size was RMB25 bn in 2014 and 13.3% CAGR is expected for 2014-20E. 2) Modern tram is springing up, with a control system market size of RMB5.9 bn in 2020E. CRSC is likely to replicate its successful experience in other rail transportation products. 3) Its ample cash, minimum debt ratio and engineering experience should help in developing the PPP market. 4) Major OBOR beneficiary. Forecasts and valuation CRSC‟s 1H net profit grew 40% YoY, and we estimate 2015-17E EPS will be RMB0.31/0.40/0.54, up 5%/32%/33% YoY. The lower growth for 2015 was due to IPO dilution and RMB400 mn one-off gain in 2014. Its current 2016E P/E (12.30x) is lower than sector average (14.52x), and its ROA (5.1%) is also below sector average (8.4%), but this will improve as it undertakes PPP projects. While CSRC is newly listed and thus lacks a track record in the capital market, we expect its 2015-17E profit CAGR to reach 33.6%, better than sector average of 20.3%. We arrived at TP of HK$7.15 in consideration of sector average P/E. Initiate with BUY. Financials

RMB mn 2013 2014 2015E 2016E 2017E

Revenue 13,065 17,329 24,792 34,173 44,368

Growth (%) N.A. 32.6% 43.1% 37.8% 29.8%

Net profit 1,260 2,033 2,379 3,171 4,251

Growth (%) N.A. 61.3% 17.0% 33.3% 34.0%

EPS (RMB) 0.19 0.29 0.31 0.40 0.54

DPS (RMB) 0.02 0.00 0.41 0.06 0.08

P/E (x) 26.15 17.14 16.26 12.30 9.26

P/B (x) 3.48 2.79 1.74 1.56 1.37

ROE (%) 12.6% 17.4% 8.2% 8.7% 9.2%

Source: Company data, CMS (HK) estimates

Yiding JIAO

+86 755 82908475

[email protected]

Initiation

BUY

Price HK$6.13

12-month Target Price (Potential upside)

HK$7.15 (+17%)

Price Performance

Source: Bigdata

% 1m 6m 12m

3969 HK (2.9) N/A N/A HSI (10.1) (9.5) (12.3)

Machinery & Equipment

Hang Seng Index 21562

HSCEI 9729

Key Data

52-week range (HK$) 5.67-6.67

Market cap (HK$ mn) 12069

Avg. daily volume (mn) 16.47

BVPS (HK$) 1.98

Shareholding Structure No. of shares outstanding (mn) 8,235

-20

-15

-10

-5

0

5

Aug/15

(%) 3969 HSI Index


To access our research reports on the Bloomberg terminal, type CMHK 2

Investment thesis The company’s monopolistic advantages to maintain in the long term

The company has practically monopolized China‟s railway control system market for

long term as the railway sector is a closed market and the status quo is expected to last

because: 1) the company‟s research capabilities regarding hardware, laboratories and

technicians have piled up to the national level; 2) it is a primary industry standard maker

who can always stay ahead of others in new product development; 3) as railway control

system is an applied science, technologies are consummated by practical experience,

an area in which the company romps ahead in the world; 4) customers prefer familiar

providers for safety and compatibilities of control system; 5) the company forms a

closed circle in the industry chain with its capabilities in design and integration,

equipment manufacturing and system implementation and is able to streamline

operations to save costs, making it hard for others to compete with.

Advantages in traditional business to remain and expand

The company boasts over 80% market share in the core of high-speed railway control

system and has exclusive access to the core technologies of CTCS3, the sole high-

speed railway standard in China. We expect 15.5% CAGR in 2014-20E in China‟s new-

build high-speed railway control system market and the same growth for such operation

of the company. The company participates in the “4-Es” integration tendering and is

good at communication and signal but does not involve in power supply and

electrification. As these two segments have lower technological requirements and the

company holds one of the three “4-Es” integration tendering licenses, it has the means

and measures to tap into the markets. The market size of these two sectors amounted

to RMB21.3 bn in 2014 and is expected to expand at 15.5% CAGR in 2014-20E.

There is huge room for the company to develop.

Development of modern tram business

The modern tram market is springing up. Tram becomes increasingly popular among

city planners for its low building costs, short setup period, large capacity and use of

clean energy. Fast growth is also permitted by the short approval process compared to

metro. According to rail-transit.com and Frost & Sullivan, modern tram mileage in China

and related control system market size will reach 3,000 km and RMB5.9 bn in 2020E

respectively, representing a CAGR of 64% for 2014-2020E. As the forerunner of railway

and urban transit control system, the company is expected to scoop up not less than

40% market share.

Capital and experience to help PPP business to gain momentum

The company had sufficient cash and only RMB318 mn of debt as at end-2014. It plans

to raise RMB2.5 bn through debt financing in 2015. Compared to other transportation

infrastructure enterprises with over 10% of net debt ratio, the company‟s liquidity is well-

maintained and there is huge room for leverage operation. Control system of rail

transportation accounts for about 6% of its total fixed asset investment (FAI). The

company may tap into all infrastructure segments of rail transportation through the PPP

model. Compared to other infrastructure companies, CRSC has sufficient capital;

compared to other equipment manufacturers with sufficient capital, CRSC is equipped

with system implementation capabilities and experience. We expect its urban transit

PPP business to grow rapidly on the back of its own advantages.

Expansion to overseas markets

“One Belt, One Road” and “Made in China 2025” polices stimulate the oversea

expansion of Chinese enterprises. We always believe that high-speed railway, as the

representative of Made in China, will be the primary beneficiary of the two policies.

CRSC is indispensable for exporting high-speed railway technologies as it possesses

the core technologies. Apart from this, its CTCS3 technologies, developed based on

Europe‟s ETCS, can integrate with overseas technologies seamlessly, allowing the

company to expand into overseas markets quickly through acquisition.



Focus charts Figure 1: Highly competitive 3-in-1 business model Figure 2: Huge potential in new business segments

Source: Company data, CMS (HK) Source: Company data, CMS (HK)

Figure 3: Segment revenue and growth forecasts Figure 4: Segment and overall gross margin forecasts


Figure 5: Expanding railway and urban transit control system new construction markets

Figure 6: CRSC as world‟s top rail transportation control system provider in 2014 in terms of revenue


Upgrade & maintenance

Other new business

Overseas markets

Tram

PPP

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000

2012 2013 2014 2015E 2016E 2017E

其他业务 PPP 城轨业务铁路业务

RMB mn

0%

5%

10%

15%

20%

25%

30%

35%

40%

2012 2013 2014 2015E 2016E 2017E

设计集成设备制造系统交付

PPE 总体

17.9

22.9 26.2

29.4 32.4

35.8

39.8

11.1 14.3

16.8 18.7

20.7 23

25.2

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

2014 2015E 2016E 2017E 2018E 2019E 2020E

Railway Urban transit

RMB bn

16

10 10

8

6

0

2

4

6

8

10

12

14

16

18

CRSC Ansaldo Bombardier Siemens Alstom

RMB bn

CAGR of urban transit new construction market size in 2014-20E: 14.6%

CAGR of railway new construction market size in 2014-20E: 14.2%

Core business Competitiveness

Medium

Medium to high

High System implementation

Equipment manufacturing

Design & integration

Other business Urban transit Railway PPP


PPP

Equip. manufacturing

Overall

Sys. implem.



Contents Company highlights ....................................................................................................................................................... 5

Company profile 5 Competitive advantages 7 Business outlook 12

Earnings forecasts and valuation................................................................................................................................. 20 Key forecasts 20 DCF valuation 24 Mainstream rail transportation control system in China 26 Still large room in China‟s railway market 26 Urban express rail transportation under rapid development too 28 Chinese manufacturers now among world‟s most technologically advanced in railway sector 30

Risk factors .................................................................................................................................................................. 33 Appendix A: Company history and major events ......................................................................................................... 34 Appendix B: Biography of the company‟s management .............................................................................................. 36 Appendix C: Business overview .................................................................................................................................. 37

Overview of design and integration business 37 Overview of equipment manufacturing 39 Overview of system implementation 41 General business flow 42

Financial Summary ...................................................................................................................................................... 44 Investment Ratings ...................................................................................................................................................... 45 Disclaimer .................................................................................................................................................................... 45



Company highlights

Company profile

The company, being a central enterprise directly under the State-owned Assets Supervision and Administration Commission of the State Council (SASAC), is the pioneer and leader in the rail transportation control system industry in China.

Figure 7: Shareholding structure of the company

Source: Company data, CMS (HK)

As of 2014, the company was the largest rail transportation control system solution provider in the world. It has also been the only solution provider in the world that can provide design and integration, equipment manufacturing and system implementation services independently.

More than 60 years of development allows the company to evolve from a follower of advanced technologies overseas to a proprietor of core techniques. The company now possesses CTCS-3 technology (a wireless train control system that uses track circuits to keep track of occupation of high-speed trains which operate at above 300 km/h to satisfy the minimum 3-minute tracking interval requirement), CBTC technology (a wireless automatic train control system primarily used in urban transit that integrates the functionality of automatic protection, autopilot and automatic monitoring) and CIPS technology (a comprehensive system integration technology for marshaling yards that is based on information sharing and aims at management integration, this world leading technology is mostly used for the management of cargo hubs). Leveraging its core technologies, the company has completed 7,000 projects in engineering design services and applied more than 70 proprietary system technologies in railway and provincial and municipal rail transportation. The company is also capable of manufacturing and maintaining signal and communication system products, including computer interlocking system for stations, track circuit, automatic blocking system, train control center, ATP onboard and RBC equipment. It has established 13 production facilities in nine cities in China. As for the system implementation services segment, the company is able to provide comprehensive engineering services such as construction, installation, testing and maintenance, covering areas of railway and urban transit control system project, communication system, electrical and M&E equipment, intelligent building and municipal project.

The company is the unified supplier of the central train dispatch system at the headquarters of China Railway Corporation (CRC) and the provider of centralized traffic control systems for 16 railway administrations out of 18 in China. As at the end of 2014, in terms integration project mileage contracted for, the company had a market share of 65.2% in the high-speed railway control system market and 72.3% in the segment of trains of over 300 km/h. CRSC‟s products are also widely used in non-CRSC integration projects. In terms of contract value in 2011-2014, the company took up 40.1% of the urban transit control system market in China, with over 80% in the core control system market (including radio block center, track circuit, computer interlocking and train control center). The company is also the only rail transportation control system solution provider that participated in all of the major high-speed railway projects and six speed upgrade projects in China.

SASAC

CRSC Group CICC Jiacheng CRHC CCT Group SINOMACH

CRSC



Figure 8: 65.2% market share in high-speed railway control system market (in terms of contracted mileage of completed integration projects as at end-2014)

Figure 9: 40.1% market share in urban transit control system market (in terms of 2011-2014 contract value)

Source: Frost & Sullivan, CMS (HK) Source: Frost & Sullivan, CMS (HK)

The company‟s strong technological capabilities and 3-in-1 business model enable it to provide one-stop solutions to customers and create synergies to heighten economic benefits. The company demonstrates a balanced development of its businesses, namely design and integration, equipment manufacturing and system implementation services, with domestic rail transportation business taking the lead in terms of revenue from end-markets.

Figure 10: 2014 revenue mix by industry chain segment

Figure 11: 2014 revenue mix by end-markets


In terms of total revenue, the company was the world‟s top railway control system supplier in 2014. Its total revenue amounted to RMB17.3 bn (of which RMB16.1 bn being revenue from railway business) in 2014 and a CAGR of 28% was recorded for revenue in 2012-2014. The company was able to maintain a high gross margin while achieving fast revenue growth. In 2012-2014, its overall gross margin was above 24%, and its margins for design and integration and equipment manufacturing were above 31%.

CRSC 65.2%

CRCC (inclu. subsidiaries)

32.5%

CREC (inclu. subsidiaries)

2.3%

CRSC (inclu. subsidiaries)

40.1%

Thales SAIC 14.6%

BTCT 11.8%

CREE (inclu. subsidiaries)

5.4%

FiberHome 4.1%

ZTE 3.9%

Others 20.1%


28%

Equip. manufacturing

34%

System imple. services

31%

Others 7%

Domestic rail transportation

79%

Domestic urban transit

11%

Other businesses

7%

Overseas businesses

3%



Figure 12: Revenue CAGR of 28% in 2012-2014 Figure 13: Highest revenue from rail transportation business in 2014 globally

Source: Company data, CMS (HK) Source: Frost & Sullivan, CMS (HK)

The technological capabilities enjoyed by the company allows it to effectively control capital expenditure (RMB1.43 bn in 2014) and maintain sufficient operating cash flow (RMB1.19 bn in 2014) and minimum finance costs (RMB15 mn in 2014), resulting in an excellent return on capital (8.1% ROA and 18.2% ROE in 2014).

Table 1: Historical return of the company

2012 2013 2014

Return on assets 6.5%

6.4% 8.1%

Return on equity 15.3% 14.0% 18.2%

Debt-to-equity ratio 9.0% 3.5% 2.5%


Competitive advantages

A one-stop solution provider for the entire industry chain

Unlike other companies of similar nature, CRSC is not just a product supplier but an all-round total solution provider. Its business can be divided into three segments, namely design and integration, equipment manufacturing and system implementation services, which form a complete industry chain altogether.

Within this industry chain, design and integration lay down the foundation which decides the directions of the other two components in the chain. On this level, standard means competitiveness. Overall, competition is not that stiff and oligopoly is not so unusual. Enterprises on this level possess the lightest assets but boast the highest gross margin, giving them prominent advantages. In that regard, CRSC itself is irreplaceable in a sense as it participated in the standard making process in China.

The middle layer of the industry chain is equipment manufacturing. In this layer, competition becomes fierce as the number of players increases. Competitiveness is represented by technologies. Enterprises with better technologies can enjoy higher gross margin, but lasting technological advantages require high investment cost. This is challenging for all enterprises if they would like to continue to have technological advantages in the long run. Operating in this layer are companies like CRSC, Zhuzhou CSR Times Electric Company Limited (CSR Times 3898HK) and CRRC Corporation Limited (CRRC 1766HK). Although they produce different products, they all have to continue to invest a lot of capital to ensure technological advantages in order to maintain their leading positions.

At the end of the industry chain is system implementation. Technological requirements on this level lower further and participants are mostly high quality labor-intensive enterprises. Their profitability depends on cost management, so cost is synonymous with competitiveness. Since the companies are dependent on costs for their profitability, gross margins are limited. In addition, as cost control relies heavily on economies of scale, enterprises in this sector face less competition despite lower gross margins. Sector representatives include CRSC, China Railway Group Limited (CREC 390HK) and China Railway Construction Corporation Limited (CRCC 1186HK).

Based on our analysis above, CRSC covers all the three levels of the industry chain. This gives the company an advantage in the integration of the three levels for cost saving purpose. More importantly, the company is able to form a “closed circle” with its products. We believe this “closed circle” is crucial to its business. The company is like

10.6

13.1

17.3

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8

10

12

14

16

18

20

2012 2013 2014

RMB bn

16

10 10 8

6

0

5

10

15

20

CRSC Ansaldo Bombardier Siemens Alstom

RMB bn



Apple in the sector of train control system. The common ground of CRSC and Apple is that they both set the standards and make the products. Apple develops its own operating system for its own mobile products. If it did not have its own operating system, its cell phones would not be as competitive as other companies which sacrifice gross margin for market share. On the other hand, if it did not produce its own cell phones, it would be difficult for its operating system to form an ecosystem to compete with other operating systems that are more compatible. Apple manages to realize a positive feedback loop for its products and standards in its “closed circle”.

CRSC shares the same traits as it takes a leading role in formulating most train control system standards in China and, at the same time, manufactures the key conforming products. In this way, it achieves an effect that is greater than the sum of its parts which beefs up its competitiveness. This is where the company has the biggest competitive advantage compared to other similar enterprises.

Figure 14: Structure of industry chain Figure 15: A “closed circle” in industry chain

Source: CMS (HK) Source: CMS (HK)

Unique entry barrier making the company one step ahead

The company is at an advantage in terms of technology, standard formulation, experience and customer loyalty thanks to the unique entry barrier.

The railway market has long en a closed sector in China for national security reasons. Key technologies including rail infrastructure, train manufacturing and train control system are in the hands of state-owned enterprises. However, unlike rail infrastructure (CRCC and CREC) and train manufacturing (CSR and CNR, which merged after long-term competition), CRSC has long been supported by the government as the only carrier that embodies the highest level of train control technology in China. Although the railway market is opening up, the company is one step ahead of others as new entrants are required to have at least five years of experience. This makes the latecomers impossible to catch up with CRSC. Major products of the company enjoy market shares of over 80%. Meanwhile, out of the 18 railway administrations in China, 16 have adopted CRSC‟s centralized train dispatching command system. As at the end of 2014, the company was also the only centralized train dispatching command system provider of CRC.

Products

Standards

Closed circle

Mu

tually

rein

forc

ing

Mu

tually

facilita

ting

Core business Competitiveness

Medium

Medium to high

High System implementation

Equipment manufacturing




Figure 18: CRSC‟s market coverage as at end-2014

Source: CMS (HK)

As customers who are adding new train control systems would require high compatibility between its old and new systems and high safety coefficient, the extensive coverage and good reputation of the company could result in higher customer loyalty and translate into an implicit advantage of the company.

Technological advancement maintained on strong R&D capabilities

The company invests a great deal of effort in R&D despite its unparalleled competitive advantages in China‟s railway market, which is the key to its long-lasting advancement in technologies.

In 2014, the company employed 3,399 R&D personnel, accounting for 23% of its headcount. This was higher than the average level of its domestic and international peers. Although CSR Times had a higher proportion of R&D personnel, the absolute number was almost 500 fewer than that of the company. Among the company‟s R&D team, 50 people enjoy government special stipend, 31 were awarded the Zhan Tianyou Railway Science and Technology Award, and 35 were awarded the Mao Yisheng Railway Engineer Award.

The amount of RMB750 mn invested by the company in R&D in 2014 accounted for 4.3% of its total revenue, higher than the average of its domestic and international peers. The CAGR of R&D investment made by the company in 2012-2014 came in at 30%. It is worth mentioning that we believe the company‟s actual proportion of R&D investment should be higher than what appears in the table below. This is because domestic peers derive their revenue mainly from equipment manufacturing, but only 34% of the company‟s revenue comes from this segment. In fact, the company is able to reduce the pressure from R&D expenses on net margin while maintaining its R&D investment on the back of its 3-in-1 business model.

High-speed lines (in operation and under construction) integrated by CRSC

High-speed lines (in operation and under construction) covered by CRSC’s equipment supply

Cities with urban transit lines covered by CRSC’s products

Railway administrations covered by CRSC’s products



Figure 19: Among the top R&D investors in 2014

Source: CMS (HK)

In addition to the continuous investment in personnel and R&D, the company is also equipped with excellent laboratory facilities. As at the end of 2014, the company owned 61 science laboratories, including two CRTCC laboratories (China Railway Signal & Communication Shanghai Telecommunication Testing Center and Signal Product Examination Station of the Product Quality Examination Center under the MOR), three CNAS certified laboratories (Beijing National Railway Research & Design Institute of Signal & Communication Co., Ltd. (CRSCD) Testing Center, Signal Products Examination Station of the Product Quality Examination Center under the Ministry of Railway (MOR) and CASCO iCMTC Product Testing Laboratory) and five CMA certified laboratories. Furthermore, the company had two ministry-level engineering technology research centers, four academician workstations and 11 provincial enterprise technology centers.

Figure 20: Laboratories of the company

Source: CMS (HK)

Maintaining highest safety standards

In the rail transportation control sector, safe operation is paramount and system safety is one of the company‟s competitive advantages.

The company has a system to guarantee product safety covering the entire industry chain and product lifecycle. It plans and specifies relevant provisions and workflows at each step of its product manufacture processes, from R&D, manufacture (including pre-delivery inspection), construction and system installation (including installation acceptance inspection), system integration (including follow-up services) to post-delivery contingency coordination for system equipment, in order to ensure the performance, functionality and safety of its products. The company classifies various products into level 0 to level 4 based on SIL standard when researching, developing and designing products, and requires the final design of its products to satisfy their respective level of safety standards with all of its core safety products meeting the most stringent SIL4 standard. For products that satisfy the SIL4 standard, the chances that their safety control malfunctions shall be limited to one time in 1,000 years to 10,000 years (10

-9 ≤ Tolerable Hazard Rate < 10

-8).

0%

1%

2%

3%

4%

5%

6%

7%



The company had increased its safety production expenses from RMB47.5 mn in 2012 to RMB75.3 mn in 2013 and RMB120.0 mn in 2014, totaling RMB242.8 mn. As of December 31, 2014, the company had 537 registered engineers in its quality and safety control team, including 327 quality engineers and 210 safety engineers. They are responsible for monitoring the quality and safety of all key processes during product R&D, manufacture, construction and system integration, and are responsible for the appraisal and licensing of raw material suppliers. In the company‟s quality and safety control team, 419 members have professional experience for more than eight years. As of December 31, 2014, the company had collected a large quantity of product test cases in its database, including 946 test cases on CTCS-3, 446 test cases on CTCS-2, 159 test cases on CTCS 2+ATO, 2,520 test cases on urban transit CBTC/MATC and 10,389 test cases on interlocking, train control center, railway ATP Onboard, etc. The company incorporates the test cases into the laboratory database for scenario simulation testing in order to minimize safety risks.

After the incident in 2011, the company proactively cooperated with relevant government authorities, took emergency measures and upgraded all relevant equipment and systems. After examining the malfunction of such on-site equipment, the company followed the instructions of the investigation panel and applied emergency measures to the LKD2-T1 train control center system equipment used for the Ningbo-to-Wenzhou High-Speed Railway. In 2013, CRC arranged to have the LKD2-T1 train control center system equipment used on the aforesaid lines replaced with the LKD2-T2 train control center system equipment, so as to fundamentally eliminate the potential safety hazard of the LKD2-T1 train control center system equipment. The safety platform used by LKD2-T2 train control center system, which satisfies SIL4 safety integrity level under the European EN50126, EN50128 and EN50129 standards, has been operating safely for 15 consecutive years since 2000. Since the completion of the upgrade and up to the latest practicable date, the LKD2-T2 train control system equipment of the line had been operating safely and stably.

At the beginning of 2012, the mileage of high-speed railways in operation in the PRC was only 7,735 km and increased to 16,000 km by the end of 2014. Though the mileage of high-speed railways in operation had increased significantly, the company has not experienced any major safety accidents that involve casualties and severe injuries and the compliance rate of its products remained 100% in the sampling inspection conducted by the NRA each year. Also, the company has not been subject to any material product returns or recalls, or any material product liability or other legal claims arising from product quality issues.

Since 2012, the company has kept a good product safety record and a large market share, which reflects, in part, that the company‟s products are still customers‟ preferred choice. Previous safety issues have motivated the company to improve constantly and such investments in product safety have become one of its competitive advantages.

Porter five forces analysis

Based on Porter‟s Five Forces, we conclude that CRSC has strong bargaining power against both upstream and downstream participants; substitutes for its products can hardly be found; it is difficult for new players to gain a foothold in this market; and no company in the existing market can compete with it on a full-scale basis. Therefore, the company has significant competitive advantages.



SWOT analysis Figure 22: SWOT

Source: CMS (HK)

Business outlook

In our opinion, the company‟s future business development will be divided into five key segments: 1) the maintenance and expansion of traditionally advantageous projects; 2) the expansion of the urban tram business; 3) the expansion of the system upgrade and maintenance business; 4) the expansion into overseas markets; and 5) the expansion into other new businesses.

Figure 21: Porter five forces analysis

Source: CMS (HK)

New potential competitors Almost no new potential competitors given the closed market and high skill and experience requirements

Substitutes Overseas substitutes unable to enter the Chinese market due to national strategies

Competition between companies

CRSC’s leading position unshaken as other companies can only compete in certain parts of the industry chain

Bargaining power of suppliers

Very limited bargaining power for suppliers due to homogeneous

products

Bargaining power of buyers

Medium-to-strong bargaining power for CRSC thanks to its most advanced and safest products and a semi-open monopolistic

market

Weaknesses

Strengths Opportunities

Threats

Standard-making advantages, the pioneer in a number of aspects in China’s rail communication and signal system

Large customer base and high conversion costs for customers

High safety requirements that send new players away

Huge upgrade and maintenance market potential in respect of the rail transportation communication and signal system

Exemplar of export of Chinese standards under “One Belt, One Road”

Huge development room for tram in the future

Only operating in the rail transportation sector Synchronized investment cycle in the rail transportation

sector Business highly sensitive to safety issues

System implementation business being eaten away Failure to maintain technological advancement National rail transportation blueprint falling much short of

expectations



Maintenance and expansion of traditionally advantageous projects

The driver of the company‟s future business development is its existing advantageous business. The company has developed advanced technologies in relation to railway signal systems and equipment, primarily including a) DS6 series computer-based interlocking technology, b) CTCS-3/CTCS-2 system equipment technologies applied in train control centers, RBC equipment, temporary speed restriction servers and railway ATP Onboard, c) technologies applied in basic signal system equipment such as rail switch equipment, balise and relays, d) CTC/TDCS technologies applied in train dispatching command, and e) CIPS technologies applied in marshalling yards, mines and harbors. With regard to urban transit signal systems, the company has developed ATO and CBTC systems and has innovated Urbalis 888 model CBTC, which have been widely applied to a number of metro lines in Beijing, Shanghai, Changchun, Shenzhen and Wuhan. With regard to communication information systems, the company has developed products such as the railway integrated video monitoring system, the image quality diagnostic system, the video analysis system, the railway integrated intelligent monitoring system, the railway passenger service information system, the railway disaster prevention and safety monitoring system, the railway maintenance management system, the iron tower monitoring system and the metro centralized alarm system. It has successfully implemented these technologies in a number of railway and urban transit lines.

On top of its technological advantages, the company plays a dominant role in the standard-making process of the railway control system thanks to its capacity as “national team” and its long-time R&D capacities. This will not be toppled by new players in the foreseeable future.

The company accounts for over 80% and 40% market shares respectively in the high-speed railway control system market and urban high-speed railway market. Since customers from these two markets require high standards on safety and system compatibility, it takes new players a lot of time to gain their trusts and a great deal of efforts to achieve compatibility in all fronts. That is why customer retention rates in such markets are pretty high. Therefore, the company may maintain and improve its historical market share in the long run.

In our opinion, due to the actual domestic demand for rail transportation facilities and the great influence of infrastructure projects on GDP, the PRC government will continue to increase its investment in rail transportation construction. In the 2015 PPP project base issued by the National Development and Reform Commission (NDRC), there will be 36 railway projects with a total project amount of RMB280 bn, representing 14% of the total; of which 17 are urban express line projects with a total project amount of RMB444.3 bn, representing 22% of the total. According to Frost & Sullivan, in 2020E, mileage of China‟s high-speed railways and urban express lines in operation will reach 40,000 km and 6,600 km respectively, representing CAGRs of 18% and 16% in 2014-2020E. In 2020E, the market size of new-build high-speed railway and urban express line control systems will reach RMB52 bn, representing a CAGR of 13.3% in 2014-2020E.

Figure 23: China‟s rail transportation mileage and forecasts

Figure 24: China‟s new rail transportation control system market size and forecasts


2.5 3.8 4.5 5.2 5.7

6.2 6.6

16.0

20.0

24.4

28.5

32.4

36.1

40.1

0

5

10

15

20

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30

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45

2014 2015E 2016E 2017E 2018E 2019E 2020E

城市快速轨道交通高速铁路

'000 km

Urban transit

14.2

18.8

21.7

24.5

27.1

30.1

33.7

10.8

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16.1 17.7

19.3

0

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40

2014 2015E 2016E 2017E 2018E 2019E 2020E

高铁城市快速轨道交通

RMB bn

CAGR of HSR mileage in operation in 2014-20E: 16.5%

CAGR of urban transit mileage in

operation in 2014-20E: 17.6%

CAGR of new-build HSR control system market size in 2014-20E: 15.5%

CAGR of urban transit control system market

size in 2014-20E: 10.2%

HSR HSR Urban transit



Besides the increase in its market size due to the rise in rail transportation mileage, the company‟s expansion into the electric and electronics integration sector will also increase its market share significantly. The integration refers to communication, signal, power supply and electrification, among which the first two belong to the weak current segment while the latter ones are in the strong current segment. Currently, the general contracting model of integration tendering has become the mainstream business model of China‟s railway control system market. Only three companies, namely CRSC, CRCC and CREC, have obtained the integration qualification, and CRSC is the only one that can provide products and services throughout the industry chain. Although CRCC and CREC have advantages in the strong current market, we believe that due to lower general technical barriers in the strong current market, it is relatively easy for the company to tap into that market. Meanwhile, the company has also acquired some strong current-related companies to complement its weakness in that area.

According to Frost & Sullivan, in 2020E, the integration market size will reach RMB83.4 bn, representing a CAGR of 15.5% in 2014-2020E. Since the company has almost not engaged in the strong current market, which accounts for over 60% of the integration market, there is huge room for market share expansion in the area.

Figure 25: Change in the integration tender model Figure 26: Integration market size and forecasts


Expansion of modern urban tram business

Besides railway and urban express line markets, the modern urban tram market is also emerging rapidly. Due to its low costs, short construction time, high carrying capacity and the use of clean energy, the tram system is becoming popular among city planners. According to the statistics of rail-transit.com, there are nearly 100 cities in China that have intentions or plans to build modern tram tracks, among which over 40 cities have taken action. Haizhu District, Zengcheng District, Liwan District, Luogang District and Guangzhou International Financial City in Guangzhou province have planned to build a total of over 250 km of modern tram tracks. Over 800 km of tram tracks are planned in the long run. Track plans have been commenced in Pudong New District and Songjiang District; tram studies have been conducted in respect of internal tracks in Hongqiao Business District and Disney, as well as tracks in Xuhui riverside greenbelt, Lingang New Town, Sichuan Road in Hongkou District, Renmin Road in Huangpu District and the Bund. The Notice on Strengthening the Plan, Construction and Administration of Urban Transit of the NDRC was approved in 2015, encouraging the development of urban transit such as light rail and tram. Also, since tram plans only need the approval of local government instead of the NDRC, the process is rather simple. We expect an explosive development in the tram market in the future. According to Frost & Sullivan, in 2020E, mileage of China‟s modern urban tram will reach 3,000 km while the control system market size will amount to RMB5.9 bn, representing a CAGR of 64% in 2014-2020E. As the leader of railway and urban express line control systems, the company is expected to gain strong momentum in the modern tram market.

21.3 28.2 32.6

36.8 40.7 45.2 50.6

14.2

18.8 21.7

24.5 27.1

30.1

33.7

0

10

20

30

40

50

60

70

80

90

2014 2015E 2016E 2017E 2018E 2019E 2020E

Weak current Strong current

RMB mn

Electrification & power

supply integration

Communication & signal integration

Integration

CRCC

CREC

CRSC

Integrator Traditional tendering model

Trend of tendering model



Figure 27: Modern tram mileage and growth forecasts Figure 28: Modern tram control system market size and forecasts


Rail transportation PPP business to be boosted by capital and experience

Investment in rail transportation control system accounts for approximately 6% of total FAI in the rail transportation industry. If the company manages to participate in all segments of rail transportation infrastructure through PPP, the market it can embrace will expand more than 15 times. Although the entering of the railway market is unlikely at the moment, urban transit FAI already reached RMB274 bn in 2014. Meanwhile, the PPP business will indirectly increase the competiveness of the company‟s major activities, which will further consolidate its market share in the rail transportation control system market. Also, the government is encouraging private capital to enter the infrastructure construction market through PPP. With its experience in the rail transportation industry and capital, the company is simply responding to the trend by entering this market. Figure 29: China‟s urban transit FAI market size and forecasts

Source: Frost & Sullivan, CMS (HK)

The company‟s historical operations do not rely much on its debts. As of 2014, the company had the lowest net debt ratio and the highest cash-to-total asset ratio among its competitors, giving it the highest potential in leverage and the best liquidity in the sector. As at the end of 2014, the company owed RMB318 mn only. It intends to raise RMB2.5 bn through debt financing in 2015. By the end of 2015, the company‟s cash on hand will increase notably, making its net debt ratio decrease further. As for companies in the transportation infrastructure industry, their net debt ratios amount to over 10%, restraining their ability and intention to increase leverage. As for other companies in the equipment manufacturing industry, despite their relatively sufficient funds, they do not possess the company‟s construction capabilities and experience.

0%

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120%

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160%

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200%

0

500

1,000

1,500

2,000

2,500

3,000

3,500

2012 2013 2014 2015E 2016E 2017E 2018E 2019E 2020E

Tram Mileage YoY (RHS)

km

0.3 0.9

2.1

3.6

4.6 5.3

5.9

0

1

2

3

4

5

6

7

2014 2015E 2016E 2017E 2018E 2019E 2020E

RMB bn

274 301 320

340 374

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477

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500.0

600.0

2014 2015E 2016E 2017E 2018E 2019E 2020E

中国城市轨道交通投资规模

RMB bn

Investment in China's urban transit



Figure 30: Lowest net debt ratio among competitors Figure 31: Highest cash-to-total asset ratio


Expansion of system upgrade and maintenance business

Besides growth brought about by the new-build market, the enormous rail transportation network in China implies a huge market in relation to system upgrade and maintenance. Since the designed life span of China‟s high-speed railway control systems is 8-10 years and such railways commenced operation in 2008, their control systems will need upgrading going forward.

Figure 32: High-speed railway construction calendar Figure 33: Potential of China‟s rail control system

upgrade and maintenance market and forecasts

Source: MOR, CMS (HK) Source: Frost & Sullivan, CMS (HK)

In China, the maintenance market has not fully unfolded. We believe this is mainly because companies would like to attract more customers with free services at its rapid development stage, during which revenue from new-build business comprises a major component of their income stream. We reckon that as the market stabilizes and product warranty expires, maintenance fees will come into play. Frost & Sullivan forecasts that in 2020E, the upgrade and maintenance market sizes of China‟s rail transportation will reach RMB57.7 bn. The company, however, has derived little revenue from such markets. On the other hand, Bombardier, an international peer, derived 18% of its total revenue from the maintenance operation in 2014. In the long run, the company‟s revenue structure will approximate to that of mature enterprises abroad, implying a significant increase in its revenue.

Expansion into overseas markets

With the launch of the “One Belt, One Road” program, expansion into overseas markets is now officially a must-do for an established PRC company. Among those “Made in China” exports, high-speed railway has already become a representative for its world-leading technologies. The exporting high-speed railway is not only “Made in China”, but also “Made with Chinese standards”. CRSC, as a major player in the standard-making process, will develop an intimate relationship with the “One Belt, One Road” policy.

-30%

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30%

Net debt ratio

0%

5%

10%

15%

20%

25%

Cash-to-total asset ratio

0 10,000 20,000 30,000 40,000

2008

2009

2010

2011

2012

2013

2014

2015E

2016E

2017E

2018E

2019E

2020E

15 18

21

25

30

34

39

4.2 5.8

7.5 9.8

12.6 15.7

18.7

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5

10

15

20

25

30

35

40

45

2014 2015E 2016E 2017E 2018E 2019E 2020E

China's national railway China's urban transit

RMB bn

km



Table 2: Recent overseas projects

Project name Designed speed (km/h) Country or region

Bidding time

Commencement

Completion

Contract amount (RMB bn)

Mileage (km)

Two-ocean railway Pending Brazil, Peru Pending Pending Pending 372 3000

U.K. HS2 400 U.K. Pending 2017 2025 301 540

Sino-Russia high-speed railway 350

Russia (Moscow - Kazan) 2015 2016 2018 372 770

Singapore-Malaysia high-speed railway 350 Singapore, Malaysia 2015 2015 2020 67 350

California high-speed railway 350 U.S. Pending Pending Pending 422 1280

Mexico high-speed railway 300 Mexico 2015 Pending Pending 27 210

Delhi-Chennai high-speed railway 300 India Pending Pending Pending 196 1754

Hungary-Serbia railway 200 Hungary, Serbia 2014 2015 2017 14 370

Sino-Thailand high-speed railway 160 Thailand 2014 2015 2021 145 800

Coastal railway 120 Nigeria 2014 2014 Pending 81 1400

Mombasa Harb-Nairobi railway 120 Kenya 2014 2014 2017 24 480

East Africa railway 80

Kenya, Uganda, Rwanda, Burundi, South Sudan Pending Pending Pending 86 2350

Sino-Nepal railway 200 China, Nepal Pending Pending Pending Pending 251


Putting the “One Belt, One Road” strategic policy aside, the company is able to undertake general project management alone. In the rail transportation and infrastructure construction sectors, it provides one-stop solutions including project consultation, engineering design, logistics, installation and maintenance services in form of project contracting. In overseas business expansion, the company still holds technological advantages. Since the company‟s CTCS3 technologies match up with Europe‟s mainstream ETCS2 technologies, its products are also highly competitive in overseas markets. Meanwhile, the company has a lot of cash on hand, which allows it to tap into overseas markets by acquiring foreign companies.

Currently, the company only derives 3% of its revenue from overseas business, which is lower than that of other local railway-related companies and far from close to that of its overseas peers. With the implementation of the “One Belt, One Road” policy and the progress in overseas M&A, its revenue from overseas business is expected to increase notably.



Figure 34: Peers‟ revenue from overseas business in 2014


Expansion into other new businesses

In addition to above railway-related business opportunities, the company also strives to explore new business segments to complement its existing rail transportation business leveraging its own technological and R&D advantages. Such new segments mainly include:

Wireless broadband: The company has formed an exclusive cooperation with the PRC companies that independently developed enhanced Ultra-High-Speed Wireless LAN technology. It has started to deploy this technology on high-speed train internet solutions, providing internet value-added services to meet the needs of high-speed railway passengers requiring broadband internet access in the same way as in stationary status. In addition, the company plans to leverage its existing broadband transmission technology to improve the R&D of wireless broadband transmission processing under high-speed environments. It will conduct research and development and formulate related standards for existing wireless communication systems and high-speed train broadband wireless communication systems, develop key technologies for high-speed train broadband communication, informatization and automation and create the track-train information interoperability for rail transportation, all of which will enable it to become a provider of both high-speed train broadband wireless communication system solutions and equipment, and system operation value-added services.

Informatization: The company has successfully developed information systems such as railway customer service system and railway electricity information system, and plans to leverage its experiences in information system to develop railway passenger information processing, geographical information services and location-based intelligent decision-making based on cloud computing technologies. Along with system R&D, it also plans to develop electronic devices specially designed for informatization and provide informatization and industrialization combined system integration solutions, software products and key special equipment for enterprise, industry and municipal informatization.

Integrated dispatching and communication: The company plans to conduct technological and industrial research on communication products used in multimedia dispatching based on its existing integrated dispatching and communication system platform and explore the application and development of multimedia dispatching technologies in rail transportation control systems. It will research and develop multimedia dispatching and communication products based on IP technology that can have a wide variety of applications, such as airports, nuclear power plants and harbors and application systems for specific industries.

Security protection and monitoring: The company plans to improve the functions and key performance index of video surveillance system based on its existing video surveillance system platforms, and develop the existing three-tier surveillance platforms adopted in the PRC railway networks toward intelligent and high-definition railway video surveillance platforms with a unified technological architecture. It will conduct in-depth research on key technologies relating to urban transit and other non-railway video information integration platform systems, intelligent high-definition video products and intelligent video analysis products. The company plans to integrate video surveillance systems with other business systems and incorporate Internet of Things (IoT) technologies, such as the technology that links security surveillance systems to security services, in order to provide customized solutions for areas with higher safety requirements such as railways, airports and Smart Cities.

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20%

40%

60%

80%

100%



Smart cities/IoT: The company plans to leverage its technologies accumulated through existing communication technologies, the BeiDou Satellite navigation technologies and R&D of security protection and monitoring systems and disaster prevention systems, to provide more comprehensive application solutions for smart cities and to conduct in-depth research on technologies such as key business models for smart cities, basic platforms for cloud computing, high-speed and large capacity data storage and public information platforms. It plans to drive the improvement and promotion of overall solutions for smart city construction with a breakthrough in key project demonstration and application, enhance the R&D of basic platforms and business application systems for smart cities and gradually become an operator of smart cities.



Earnings forecasts and valuation

Key forecasts

Based on the above analysis, we make some forecasts for the company‟s revenue by segment in 2015-17E. Our basic assumptions are as follows: 1) The company already enjoys relatively large market shares in the railway control system and urban transit markets and the technological advancement of the company will maintain in the long term. Thus, we believe growth of these two segments will be in line with that of the industry. 2) As one of the holder of the three licenses for the integration tendering, the company will have a larger market share going forward. We predict that its market share of strong current business will increase from 1% in 2015E to 5% in 2017E. 3) Given the company‟s first-mover advantages in rail transportation and as its competitiveness of core business will strengthen with the PPP model, we project market shares of 5%/23%/40% for the company in 2015-17E. 4) Leveraging its own capital and experience, the company will make inroads in the PPP business in 2016. According to our previous estimation, total investment in rail infrastructure will be 15 times of that in control system. To be cautious, we calculate the company‟s revenue from PPP business as ten times of that from tram control system. 5) We believe the maintenance market will start to ramp up in 2015 and growth will be fast on low bases. 6) The system upgrade business will commence in 2017 after eight years of high-speed railway operation with a small market size in the beginning. 7) Growth of the company‟s overseas business will be more volatile, but we reckon it will likely beat expectation with the support from the Chinese government (the exceeding part is not included in our forecasts). 8) The company‟s shareholding in CRSC CASCO increased from 49% to 50% at the end of 2014, so the revenue of the latter will be consolidated in 2015 but not in 2014. We believe its core business, which is metro control system, will grow in phase with the industry average. In view of the above, we project the company‟s total revenue growth at 43%/38%/30% in 2015-17E. The increase in 2015 includes the effect of CRSC CASCO, without which the company‟s revenue growth in 2015E would be 29%. For 2016-17E, high revenue growth is attributable to the ramp-up of its PPP business.

Table 3: Revenue forecasts by segment

Revenue Growth

RMB mn 2015E 2016E 2017E 2015E 2016E 2017E Railway 17,432 19,705 21,979 28% 13% 12%

Urban transit 2,393 2,714 2,935 24% 13% 8%

Strong current business 282 913 1,693 N.A. 224% 85% Tram 45 473 1,440 N.A. 950% 205% PPP N.A. 4,725 8,727 N.A. N.A. 85% Overseas business 865 1,298 2,206 50% 50% 70%

Maintenance 110 234 364 N.A. 113% 56%

System upgrade N.A. N.A. 550 N.A. N.A. N.A. Other business 1,299 1,429 1,572 10% 10% 10%

CRSC CASCO 2,366 2,683 2,902 N.A. 13% 8%

Total revenue (excluding CRSC CASCO) 22,426 31,490 41,466 29% 40% 32%

Total revenue 24,792 34,173 44,368 43% 38% 30%


We also estimate the expenses and gross margins of the company‟s business segments. Our major assumptions are: 1) We readjust the business structure to reflect the gross margins of each segment more accurately. We reclassify railway control system, urban transit control system, overseas business, system upgrade and CRSC CASCO in the forecast table into design and integration, equipment manufacturing and system implementation services on a pro rata basis. Design and integration and equipment manufacturing are the segments where the company enjoys long-term technological advantages. We believe gross margins of these two segments will maintain for a long period of time. On the contrary, the system implementation services segment will see narrower gross margin on its lower technological barrier. 2) The strong current business is a new business to the company with relatively lower technological content. We



believe gross margin will be low at first and turn higher as more experience is accumulated. 3) The barrier in tram control system business is not as high as those in high-speed railway and metro. Despite its first-mover advantages in high-speed railway and metro, the company will still face stiff competition. We estimate that gross margin of this business will represent a discount from those of high-speed railway and metro and stay at around 19.4%. 4) Based on industry experience, gross margin of the PPP business shall include EPC income (12%) and finance income (8%), making the gross margin at around 20%. 5) Maintenance is usually an important revenue source for a mature company. We believe gross margin of this business will be at least the same as that of design and integration.

Table 4: Revenue and gross margin based on business structure

2012 2013 2014 2015E 2016E 2017E

Design & integration 31.2% 34.6% 33.3% 33.3% 33.3% 33.3%

Equipment manufacturing 35.3% 35.0% 32.6% 32.6% 32.6% 32.6%

System implementation services 11.4% 11.0% 9.5% 9.4% 9.3% 9.2%

Tram control system N.A. N.A. N.A. 19.4% 19.4% 19.4%

PPP N.A. N.A. N.A. 20.0% 20.0% 20.0%

Others N.A. 9.5% 11.3% 11.3% 11.3% 11.3%

Strong current business N.A. N.A. N.A. 5.0% 7.5% 10.0%

Maintenance N.A. N.A. N.A. 33.3% 33.3% 33.3%

Overall gross margin 27.5% 26.3% 24.2% 24.2% 23.3% 22.9%


We make forecasts on the company‟s income statement based on our analysis of revenue and gross margins. 1) We believe its sales and marketing expenses as well as general and administrative expenses will increase with revenue but their proportions to total revenue will shrink due to economies of scale. 2) Other income and gains will drop due to the lack of the two non-recurring gains amounting to RMB529 mn (gains on disposal of non-current assets held for sale and gains on re-measurement of fair value of original equity interests on subsidiary-acquisition date) recognized in 2014. 3) The increase in other operating expenses is mainly attributable to the rise in financing costs. 4) Higher finance costs are due to the interest expenses of loans amounting to RMB25 bn to be raised in 2015. 5) Lower share of profit of jointly controlled entities and higher minority interests are the result of changes in accounting after the increase in capital in CRSC CASCO. 6) As there is no material change to the income tax policy of the company, we continue to use its income tax rate of 17.5% in 2014. 7) Attributable net profit growth will slow in 2015 mainly on the decrease in the non-recurring gains under other income and gains mentioned above.

Table 5: Income statement forecasts and analysis RMB mn 2014 2015E 2016E 2017E 2014 2015E 2016E 2017E

Revenue 17,329 24,792 34,173 44,368 N.A. N.A. N.A. N.A. Growth 32.6% 43.1% 37.8% 29.8% N.A. N.A. N.A. N.A. Cost of sales -13,134 -18,795 -26,207 -34,218 N.A. N.A. N.A. N.A. Growth 36.5% 43.1% 39.4% 30.6% N.A. N.A. N.A. N.A. Gross margin 4,195 5,997 7,966 10,151 24.2% 24.2% 23.3% 22.9%

Other income & gains 757 418 651 489 4.4% 1.7% 1.9% 1.1%

Sales & marketing exp. -459 -594 -770 -890 -2.6% -2.4% -2.3% -2.0%

G&A exp. -2,158 -2,748 -3,765 -4,377 -12.5% -11.1% -11.0% -9.9%

Other operating exp. -29 -39 -39 -39 -0.2% -0.2% -0.1% -0.1%

Finance costs -15 -66 -118 -116 -0.1% -0.3% -0.3% -0.3%

Share of profit of JCE 183 82 107 139 1.1% 0.3% 0.3% 0.3%

Operating profit 2,473 3,051 4,033 5,357 14.3% 12.3% 11.8% 12.1%

Income tax -433 -534 -706 -938 -2.5% -2.2% -2.1% -2.1%

Post-tax profit 2,040 2,516 3,327 4,419 11.8% 10.2% 9.7% 10.0%



RMB mn 2014 2015E 2016E 2017E 2014 2015E 2016E 2017E Minority interests 6 137 155 168 0.0% 0.6% 0.5% 0.4%

Attributable net profit 2,033 2,379 3,171 4,251 N.A. N.A. N.A. N.A.

Growth N.A. 17.0% 33.3% 34.0% N.A. N.A. N.A. N.A.


The following table shows our forecasts on and analysis of the key items under the company‟s balance sheet. 1)

According to its disclosure, the company will invest RMB4 bn and RMB2.5 bn in the construction of office and

laboratory facilities in 2015 and 2016 respectively. 2) Trade receivables will increase with revenue, but the trade

receivable turnover rate will still be manageable as the company does not have material bad debt issues at the

moment. 3) As the PPP business develops, franchise rights will increase accordingly. 4) According to its disclosure,

the company will raise loans of RMB25 bn in 2015, bearing an interest at the historical level. 5) Based on the above,

the company has a low gearing ratio and sound state of affairs with good solvency.

Table 6: Forecasts on and analysis of key balance sheet items RMB mn 2013 2014 2015E 2016E 2017E Property, plant & equipment 1,675 2,750 6,557 8,768 8,402

Inventories 2,048 2,861 3,703 5,200 6,847

Trade & bills receivables 6,311 7,920 10,094 14,174 18,664

Cash & cash equivalents 3,974 6,346 15,351 10,269 4,908

Franchise rights N.A. N.A. N.A. 4,725 13,452 Interest-bearing bank & other borrowings 234 228 2,728 2,500 2,500

Total assets 21,645 28,577 46,308 56,757 69,177

Inventory turnover 6.38 6.06 6.69 6.57 6.48

Trade receivable turnover 2.07 2.19 2.46 2.41 2.38

Current ratio 1.56 1.46 1.64 1.31 1.11

Quick ratio 1.37 1.26 1.47 1.14 0.93

Gearing ratio 0.54 0.56 0.49 0.54 0.57

Net debt ratio Net cash Net cash Net cash Net cash Net cash


The table below illustrates our forecasts on and analysis of the key items under the company‟s cash flow statement.

1) The company has sufficient cash flow from its traditional businesses. As its PPP business develops, the company

will experience temporary operating cash outflow. However, the increase in gearing ratio will be beneficial to its

return on equity given the low gearing at present. 2) Cash outflow from investing activities in 2015-16E is primarily

attributable to the increase in fixed asset investment mentioned above. 3) Cash flow from financing activities will be

negative in 2015-16E, but the company will still be able to make use of bond financing given its low gearing ratio. 4)

Dividend payout ratio will stay at 15%, and a special dividend of RMB3,227 mn will be paid to shareholders in 2015

based on the shareholding as at the end of 2014.

Table 7: Cash flow statement forecast RMB mn 2013 2014 2015E 2016E 2017E

Cash flow from operation 1,585 1,191 2,712 -1,314 -4,214

Net of PPP business 1,585 1,191 2,712 3,411 4,513

Cash flow from investment -1,354 1,504 -4,395 -2,900 -393

Cash flow from financing 689 52 11,116 -869 -754

Dividend paid to shareholders -151 0 -3,406 -476 -638

Net increase in cash 920 2,747 9,433 -5,082 -5,361




Peer comparison and relative valuation Compared to its peers, the company has the following advantages: 1) The company operates in a market with extremely high technological and entry barriers, thus its competitive edges can be maintained in the long term. 2) The company has many opportunities to development its business as it provides comprehensive services throughout the industry chain, including design, manufacturing and implementation. 3) The company‟s gearing ratio is significantly lower than peers, which gives it more room to participate in PPP projects. Downside of the company includes: 1) Gross margin of system implementation business is lower than that of peers. The entry barrier of the business is also low. 2) Compared to overseas companies, the company relies on fixed asset investment with a lower proportion of service income. 3) Its return on assets is not at the optimum level given its low gearing ratio. Although the company is the single largest in the field of rail signal and communication with no fully comparable peers, we reckon CSR Times and CRSC have relatively high comparability on high-tech, light assets and railways as their main markets. The current valuation of CRSC is lower than CSR Times, and we believe this is mainly due to the lack of market understanding and confidence towards the newly listed company. At present, CRSC has lower ROA than peers, but we think it is because the IPO funds have not been utilized and the company‟s gearing ratio is too low. With the commencement of PPP projects, CRSC‟s utilization of funds will increase significantly. We also expect its profit growth to be better than peers (mainly driven by the revenue contribution of PPP business). Based on sector average 2016E P/E of 14.52x, we arrived at the company’s TP of HK$7.15, corresponding to 2015-17E P/E of 20.0x, 15.2x and 11.4x, or 2015-17E P/B of 2.14x, 1.92x and 1.69x, respectively. We initiate coverage with BUY rating.

Table 8: Peer comparison

Company

Ticker

P/E 2015E

P/E 2016E

P/E 2017E

EPS CAGR 2015-17E

H-list average 17.39 14.52 12.27 20.3%

CRSC 3969 HK 16.26 12.30 9.26 33.6%

CSR Times 3898 HK 18.67 16.40 14.64 12.9%

CRRC 1766 HK 17.24 14.85 12.92 15.5%

A-list average 40.91 35.75 21.45 42.4%

Jinxi Axle 600495 CH 38.33 34.07 N.A. N.A.

TMT 600458 CH 43.49 37.42 21.45 42.4%

International average

16.63 17.28 15.55 2.3%

Alstom ALO FP 24.73 27.84 20.05 11.1%

Nippon Signal 6741 JP 15.28 13.01 11.76 14.0%

Ansaldo STS STS IM 21.75 20.29 20.25 3.6%

Bombardier BBD/B CN 7.83 12.71 14.24 -25.8%

Siemens SIE GR 13.53 12.56 11.43 8.8%

Company

Ticker

P/B 2015E

ROE 2015E

ROA 2015E

Debt-to-asset 2015E

H-list average 2.63 15.6% 8.4% 12.1%

CRSC 3969 HK 1.74 10.5% 5.1% 6%

CSR Times 3898 HK 3.97 22.9% 15.2% 11.4%

CRRC 1766 HK 2.18 13.5% 4.8% 19.0%

A-list average 3.03 0.0% 0.0% 0.3%

Jinxi Axle 600495 CH N.A. 0.0% 0.0% 15.2%

TMT 600458 CH 3.03 4.8% 0.0% 36.1%

International average

2.29 0.2% 0.0% 0.1%

Alstom ALO FP 1.72 3.6% 0.3% 15.6%

Nippon Signal 6741 JP 1.11 7.3% 4.4% 0.0%

Ansaldo STS STS IM 3.21 14.6% 0.0% 0.0%

Bombardier BBD/B CN 3.20 69.9% 1.4% 31.1%

Siemens SIE GR 2.23 20.5% 6.1% 27.3%

Source: Bloomberg, Wind, CMS (HK) *Share prices as at September 11



DCF valuation

We believe CSR Times is the most comparable company among others. Based on the beta, risk-free interest rate, risk premium, asset structure and free cash flow of CSR Times, CRSC is valued at RMB6.12 or HK$7.46 under DCF valuation. This value corresponds to 20.0/15.2/11.4x 2015/16/17E P/E or 2.14/1.92/1.69x 2015/16/17E P/B. We believe the company‟s DCF value is slightly higher than its relative value. But with the commencement of PPP business, it will be difficult to estimate the company‟s cash flow accurately. We believe P/E valuation can better reflect the value of the company.

Table 9: Key assumptions Assumptions

Risk-free interest rate 3.7%

Risk premium 12.1%

Equity risk premium 9.6%

Equity ratio 68.7%

Debt ratio 31.3% Long-term borrowing rate

6.3%

Income tax rate 17.5%

Stock beta 0.79

WACC 11.8% long-term growth assumption 2.0%

Source: Bloomberg, Company data, CMS (HK)

Table 10: Forecasts on free cash flow

Dominant forecast period

Semi-dominant forecast period

2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

Post-tax net op. profit after adjustment 2,516 3,327 4,419 5,744 7,353 9,265 11,396 12,535 14,332 15,765

D&A 392 496 585 585 585 585 585 585 585 585

Increase in working capital -362 -5,434 -9,516 -7,613 -6,090 -4,872 -3,898 -3,118 -2,495 -1,996

Capex -4,107 -2,613 -118 -118 -118 -118 -118 -118 -118 -118

Free cash flow -1,560 -4,223 -4,630 -1,402 1,729 4,859 7,965 9,884 12,304 14,236

Discounting years 0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5 8.5 9.5

Discount factor 0.95 0.85 0.76 0.68 0.61 0.54 0.49 0.43 0.39 0.35

Present value of free cash flow -1,476 -3,575 -3,507 -950 1,048 2,636 3,866 4,292 4,781 4,949


Table 11: Calculation of value Calculation of equity value (RMB mn)

Dominant/semi-dominant forecast value 12,066

Terminal value 51,708

Total enterprise value 63,774

Liabilities -12,533

Minority interests 812

Fair value of equity 50,429

Estimate price(RMB) 6.12




Table 12: Sensitivity analysis WACC

RMB 11.8% 12.3% 12.8% 13.3% 13.8%

1.0% 6.78 6.10 5.48 4.93 4.43

1.5% 7.18 6.45 5.79 5.20 4.67

Perpetual growth rate 2.0% 7.63 6.83 6.12 5.49 4.93

2.5% 8.13 7.26 6.49 5.81 5.21

3.0% 8.69 7.74 6.91 6.17 5.52

Source: CMS (HK)



Industry overview Mainstream rail transportation control system in China

Chinese Train Control System (CTCS) is the standard railway and tram control system in China. To adapt to the rapid development of China‟s high-speed railways and passenger-dedicated railways and to ensure rail transportation safety, the MOR developed CTCS based on Europe‟s ETCS specification. The ground sub-system of CTCS is comprised of balise, track circuit, wireless radio communication network (GSM-R) and train control center (TCC)/radio block center (RBC). Among them, GSM-R is not a piece of CTCS equipment but is an important component. Balise is a transmission device that can transmit data to the on-board sub-system. It may transmit fixed information and connect to trackside units to transmit variable information. Track circuit has the functions of track occupation check and continuous transmission of car information along the track and should adopt the UM series or digital track circuit. Wireless radio communication network (GSM-R) is a bilateral communication system between the on-board sub-system and TCC. TCC is a control system based on safety calculation. It gives movement authority to the on-board sub-system through the train-ground information transmission system based on the information of ground sub-systems or external ground systems such as track occupation information and interlocking status to ensure the safety of trains under the control of the TCC. The on-board sub-system is comprised of CTCS on-board equipment and wireless on-board module. CTCS on-board equipment is a control system based on safety calculation. It controls the movement of trains by exchanging information with the ground sub-system. Wireless on-board module is used for the bilateral information exchange between the on-board sub-system and TCC.

CBTC (Communication Based Train Control System) is an automatic train control system based on wireless communication and is mainly used in metro. CBTC has the advantage of bilateral train-ground communication with large data flow and fast transmission for the easy implementation of automatic blocking system. This can greatly reduce the number of cables among sections, amount of one-off investment and daily maintenance and significantly increase traffic capacity among sections. It also allows two-way traffic and one-way continuous traffic and can easily adapt to the control of hauling trains of different speed, capacity and types. With CBTC, both train control and operation management can be realized since the bilateral wireless communication system allows the bi-directional transmission of safety and non-safety information such as that related to locomotive, maintenance and electrical services, including train number, crew number, car number, operating schedule, locomotive status and fuel consumption. CBTC can be used to establish CBTC-FAS as well as CBTC-MAS.

Table 13: Types of rail transportation and their control systems Type of rail transportation Control system

Railway

National railway

High-speed railway

Operating speed of 300 km/h and above CTCS-3

Operating speed of 200 km/h and above CTCS-2

Normal-speed railway

CTCS-0/CTCS-1

Intercity railway

CTCS-2

Urban transit Metro

CBTC

Light rail

CBTC


Still large room in China’s railway market

China‟s railway infrastructure is a result of demand and government adjustment. The government would generally take a more active role during economic downturn. At present, as China‟s economy is at its bottom, railway infrastructure shoulders the responsibility for propping up domestic demand. We reckon that railway infrastructure will maintain relatively high growth in the near future. In 2014, fixed asset investment (FAI) of RMB809 bn was completed in China‟s railway market. According to the forecast of Frost & Sullivan, China will complete FAI of RMB1.054 tn in the railway market by 2020 at a CAGR of 5.4%. There is 112,000 km of railways in operation in China and 16,000 km of which are high-speed railways, accounting for 14.3% of the total. Frost & Sullivan forecasts that there will be 158,400 km of railways in operation in China by 2020 with 40,100 km or 25.3% being high-speed railways. Based on this, mileage of normal-speed railways will increase at 3.5% CAGR while high-speed ones at 16.5% in 2014-2020E. Given the higher safety standard of high-speed railways for its higher speed, investment in train control system will expand accordingly.



Figure 35: 4.5% CAGR expected for railway FAI completed in China in 2012-2020E

Figure 36: Mileage forecast for railways in China


Based on the report from Frost & Sullivan, we may project the approximate market size of railway control system with the estimated mileage. The following data will also be used for urban transit later on.

Table 14: Estimates on costs of rail transportation and control system

Rail transportation

Total cost (RMB100 mn/km)

Cost of control system

(RMB10,000/km) % of total (%)

Upgrade cost of control system

(RMB10,000/km)

Maintenance cost of control system

(RMB10,000/yr/km)

Life of control system

High-speed/intercity 0.9-2 450-900 ~6% 500-1,000 29-35

8-10 yrs

Normal-speed 0.3-0.5 150-300 ~6% 200-350 5.4-6.5 8-10

yrs

Urban transit 3-10 1,800-2100 5% 2,000-2300 108-126 15-20

yrs

Tram 1.3-1.6 600-800 ~6% - - -


The market size of railway control system amounted to RMB33.1 bn in 2014. According to Frost & Sullivan‟s forecast, the number will increase to RMB78.8 bn in 2020 at 15.6% CAGR. The CAGRs of new-build, maintenance and upgrade segments will be 14.2%, 14.4% and 19.8% respectively. The differences in segment growth rates are mainly because high-speed railway construction will slow down on network consummation, but maintenance and upgrade markets will enlarge as operating mileage increases and more sections will require equipment upgrade after 8-10 years of operation. The market mix in Europe in 2014 may shed some light on the future development of the Chinese market. The proportion of new-build business will drop whereas maintenance and upgrade businesses will become the main drivers in the market.

Table 15: Market segments of railway control system

CAGR in 2014-2020 % in 2014 % in 2020

% in 2014 in Europe

New-build 14.2% 54.5% 50.6% 41.8%

Maintenance 14.4% 24.2% 24.1% 20.9%

Upgrade 19.8% 21.2% 25.3% 37.3%

Total 15.6% Source: Frost & Sullivan, CMS (HK)

809 850

894 933

973 1014

1054

0

200

400

600

800

1,000

1,200

2014 2015E 2016E 2017E 2018E 2019E 2020E

Railway investment in China

RMB bn

96 102 104.1 108 111.6 115 118

16 20 24.4

28.5 32.4 36.1

40

0

20

40

60

80

100

120

140

160

180

2014 2015E 2016E 2017E 2018E 2019E 2020E

High-speed railway Normal-speed railway

'000 km



Figure 37: Forecasts for China‟s railway control system market

Figure 38: Market share of CRSC‟s high-speed railway control system integration and equipment contracted for as at end-2014 in terms of value


CRSC dominates the new-build segment of China‟s railway control system market. In terms of design capabilities, no rival can compete at the level of CRSC. On the industry chain level, no rival can provide the same services throughout the industry chain as CRSC does. As at the end of 2014, in terms of contracted integration mileage, CRSC accounted for 58.3% of the high-speed railway (200-250 km/h) control system market and has a 72.3% market share in the high-speed railway (300-350 km/h) control system market in China. As at the end of 2014, in terms of value, CRSC obtained 84.4% of high-speed railway control system integration and equipment contracts among completed projects. This means that the company enjoys a larger market share at the high-tech end of system integration and equipment manufacturing, while other players may only compete with the company at the implementation end where the technological content is low.

Table 16: Integration capabilities of high-speed railway control system

Design Manufacturing Implementation

CRSC High High High

CREC Medium Incapable High

CRCC Medium Incapable High

CARS Incapable High Medium

HollySys Incapable High Incapable


Urban express rail transportation under rapid development too

With the growing urban population in China, congestion and environmental problems manifest and make the advantages of urban express rail transportation (mainly metro) more visible. At present, urban express rail transportation schemes have extended from tier 1 cities to tier 2&3 cities.

In 2014, FAI of RMB274 bn in urban transit was completed in China. Frost & Sullivan forecasts that urban transit FAI of RMB477 bn will be completed in 2020, representing a CAGR of 9.7% in 2014-2020E. In 2014, mileage of urban transit in China was 2,700 km. With metro construction and completion reaching their peaks, Frost & Sullivan forecasts that urban transit mileage will amount to 9,600 km in 2020, representing a CAGR of 23.5% in 2014-2020E.

18 23 26 29

32 36 40 8

11 13

14 16

17 19

7

7 8

11 14

17

20

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

80.0

90.0

2014 2015E 2016E 2017E 2018E 2019E 2020E

Upgrade Maintenance New-build

RMB bn

CRSC 84%

Others 16%



Figure 39: Forecasts for urban transit FAI completed Figure 40: Forecasts for urban transit mileage


According to the report from Frost & Sullivan, the total value of China‟s urban transit market amounted to RMB15.3 bn in 2014, and the number will reach RMB43.9 bn in 2020E, representing a CAGR of 19.2% in 2014-2020E. Based on this, new-build, maintenance and upgrade segments should increase at CAGRs of 14.6%, 23% and 45.3%. The share of the new-build market is higher at the moment as China‟s express rail transportation control system is developing rapidly, but the maintenance and upgrade markets will register higher growth given their low bases.

Figure 41: Forecasts for urban transit control system market

Figure 42: Changes in control system segment

CAGR in 2014-

2020 % in 2014

% in 2020E

New-build 14.6% 72.5% 71.1%

Maintenance

23.0% 22.9% 24.4%

Upgrade 45.3% 4.6% 4.5%

Total 19.2% 100.0% 100.0%


The existing rail transportation system integration market is comprise

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