Water firm poised to profit

Runaway water tariffs and wastefulness north of the border make Guangdong Investment - which supplies water to Hong Kong, Shenzhen and Dongguan for a 30-year period - a promising addition to my portfolio.

On Friday, I disposed of 1,700 shares of Manulife in exchange for 233,000 shares of the company.

It is ironic that while China is so close to the ocean, it has a severe water shortage. In 2003, China had the fourth-largest water resource in world, but it had 2,200 cubic metres of water per capita, a quarter of the world average. And it is even more ironic that the coastal province of Guangdong, a close neighbour of Hong Kong, has only 2,100 cubic metres of water per capita, even less than the national average.

Guangdong has nobody else to blame but itself for the problem. Its 86 million habitants consume a wasteful 491 cubic metres per person, much higher than the national average of 412. Guangdong people reportedly waste 80 per cent of the water they use. In terms of recycling of sewage water, Guangdong scores a very backward 30 per cent, compared with 60 per cent for many mainland cities.

The reason for such waste is that the Guangdong people have a deep-rooted and dangerous misconception that Guangdong, being a coastal province with hundreds of rivers linking to the Pearl River, has a plentiful water supply.

By contrast, Shenzhen has a very proud record of being thrifty about water consumption. Being one of the seven Chinese cities with the most severe water shortage, Shenzhen has only 470 cubic metres of water per capita - a fraction of the national average - but it consumes only 181 cubic metres of water per capita. To be fair, industrial use is a major reason why the rest of Guangdong consumes so much more water than Shenzhen.

In August 2004, the Shenzhen residential water tariff was increased 19.2 per cent to 2.337 yuan per cubic metre, while the industrial water tariff was raised to 2.7 yuan per cubic metre. Dongguan, the industrial capital of Guangdong, also raised water tariffs in 2005. And residents of provincial capital Guangzhou began 2006 with a 47 per cent higher water tariff, and more increases are expected.

In 2004, Guangdong Investments (GDI) sold 1.99 billion cubic metres of water, up 14.4 per cent year on year. Sales volume to Hong Kong was 820 million cubic metres, up a small but expected 1.2 per cent year on year. Sales volume for thirsty Shenzhen, however, was 567 million cubic metres, up 21.6 per cent year on year, and sales volume for Dongguan was 603 million cubic metres, up 28.1 per cent.

Water sales revenue was $3.1 billion, up 5.4 per cent year on year, or 61 per cent of total sales. But segment profit was $1.6 billion, down 1.6 per cent year on year, or 82 per cent of total segment profit, due to completion of the phase four renovation project in late 2003, which boosted depreciation and expenses. Phase four will enhance the quality of water supplied to Hong Kong, Shenzhen and Dongguan, and it is widely expected that water tariffs will be raised substantially.

Interim 2005 results saw water sales gain 8 per cent year on year to $1.68 billion or 63 per cent of total sales. Segment profit was $968 million, up 23 per cent year on year on higher tariffs, or 86 per cent of total segment profit. Sales volume for Hong Kong was 437 million cubic metres, up 5.3 per cent year on year; Shenzhen was 316 million cubic metres, up 17 per cent; and Dongguan was 299 million cubic metres, up 5.7 per cent.

GDI's heavy debt of $16 billion and its related interest charge is a concern. But given the growth of recurring profit and interest swaps, GDI should be able to reduce debt and interest charge significantly in a few years.

For the full year of 2005 - including water, Hong Kong and Guangzhou property investments and other businesses - group sales could hit $5.4 billion, up 5.7 per cent year on year. Net reported profit could be $1.4 billion, excluding exceptionals such as interest-swap gain, property revaluation and others. Recurring net profit could be roughly $1.26 billion, up about 14 per cent year on year, or 20 cents per fully diluted share, so that the current share price of $3.50 implies a 2005 recurring price/earnings of probably 17.4 times.

However, if Hong Kong water tariffs are raised, profit growth will be even higher, so that 2006 recurring P/E will be much lower.

Assuming no more tariff increases, which may be too conservative, the real value of GDI is about $4.20 per share. If the tariff rises come, the value will be substantially higher than that.

Possible spin-offs of Teemall Plaza and the soon-to-be completed East Tower and West Tower as a real estate investment rust will bring in a sizable one-off profit.

Major risks could be a surge in Hong Kong interest rates and failure to increase Shenzhen and Dongguan water tariffs.

As of Friday, my $10 million simulated portfolio earned a return excluding dividends of 20.1 per cent, and has outperformed the Hang Seng Index by 6.4 percentage points since its inception 13 months ago.

Henry Chan is the head of research at Quam. He owns shares of Guangdong Investment.