Rating: OUTPERFORM (maintain)

Against currently low valuations, 1H financial results and orders demonstrate better company fundamentals, with strong numbers from the prefab segment. In the short term, we see BIPV as a strong catalyst and recommend local and blue-chip infrastructure SOEs, and housing construction related companies. In the medium to long term, we recommend the high-growth prefab building supply chain (steel structure, design, components). We would also monitor the BIPV and energy storage, seismic base isolation and other green building supply chains.

1H industry fundamentals improved strongly; ROEs entered a new growth cycle 

Revenue in China’s construction sector rose 32.38% yoy in 1H21, 26.2ppt higher yoy. Net profit lifted 35.51 % yoy, 42.2ppt higher yoy. Industry fundamentals showed an accelerated improvement trend. The sector’s diluted ROE was 4.84% in the period, up 0.69ppt yoy, mainly due to the dual promotion of net margin (up 0.03ppt yoy) and total asset turnover rate (up 0.04x yoy). Growth rates of revenue/net profit were 17.62%/15.89% in 2Q21, both at high levels on 38.46%/25.97% yoy growth. Local SOEs and leading prefabrication companies demonstrated better revenue and profit elasticity. We expect fundamentals for the companies in the sector to continue improving. 

Industry expense control tightened in 1H21, so annual cash flow could improve

1H21 gross profit margin was down 0.51ppt yoy, while net margin rose 0.03ppt. Sales/ management/ R&D/ financial service cost ratios fell 0.02/ 0.23/ 0.11/0.21ppt. With better expense control and asset (including credit) impairment losses as a percentage of revenue narrowing 0.09ppt, profit erosion was reduced. In 1H, the construction sector’s net cash outflow from operating activities increased by RMB45.6bn yoy, while CFO net outflow growth (16.27%) was lower than revenue growth (32.38%), indicating that the substantial increase in revenue had not sacrificed cash flow. Considering that the engineering business model tends to be based on initial net expenditure in 1-3Q, followed by net return in 4Q, we would expect annual cash flow to perform well. The debt ratio in 1H21 fell 0.81ppt yoy, maintaining the trend of lower leverage at centrally managed companies and higher leverage in private sector companies.

Deep differentiation: large-infrastructure SOEs, local SOEs and prefab leaders

Net profits in the construction market segments (except landscape) were positive in 1H21 as cost control and fundamentals improved at the same time. Trends included an accelerated increase in the market shares of local SOEs and infrastructure SOEs, and significant improvements in quality and efficiency, with prefabrication segment fundamentals remaining strong. Specifically:

1) Infrastructure SOEs: 1H21 revenue and profit grew substantially from 1H19 and fundamentals also showed higher growth, leading a rise in market share. 

2) Local SOEs generally showed uptrends as reflected in regional infrastructure projects and high economic reforms and improving efficiency. 1H21 income/net profit growth of Shandong Hi-Speed Road&Bridge Group (000498 CH, BUY) increased 90.1%/68.9% yoy.

3) Prefab segment fundamentals remained strong: leaders Anhui Honglu Steel Construction (Group) (002541 CH, BUY), Shenzhen Capol International & Associates (002949 CH, BUY) and others performed beyond expectations.

Investment summary and risks

Against currently low valuations, indicators such as financial statements and orders have demonstrated improvements in company fundamentals, while the rise of the prefab segment has been verified by data. In the short term, we see BIPV as a strong catalyst and would recommend local and blue-chip infrastructure SOEs, as well as housing construction related companies. In the medium to long term, we recommend the high-growth prefab building supply chain (steel structure, design, components). We would also monitor the BIPV and energy storage, seismic base isolation and other green building supply chains. Risks include: Duration of the pandemic exceeding expectations; growth rates of infrastructure investment not rebounding as expected; and increases in net interest rates of construction companies falling short of expectations.

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