Driven by factors that are not directly related to the core business, Kangda Environmental Protection performed better than expected in 2016. In the second half of 16, the expansion of processing capacity was back on track, with an increase of 690,000 tons per day. In the next few years, the PPP project will become the main driving force of the company's development, with a current project value of 3.1 billion yuan. The company's net debt ratio is expected to rise sharply to 158% by the end of 2017, so the main investment risk is equity dilution. We raised our target price to HK $2.25, corresponding to 9.3 times 2017 forward price-to-earnings ratio.
In view of the low valuation and accelerated growth in 2017, maintain the buy rating.
Support the main points of rating
The performance in 2016 exceeded expectations. Kangda Environmental Protection's 2016 net profit increased by 3% to 335 million yuan compared with the same period last year, which is 13% and 5% higher than our forecast and market consensus, respectively. The main reasons are:
(1) the increase in government subsidy income; (2) the increase in the profits of the associated companies, mainly due to the acquisition of 13.1 million yuan from the 15% equity stake in the Central Plains Asset Management Company and 14.1 million yuan from the 20% equity stake in Nanchang Qingshan Lake sewage treatment Plant; (3) the effective tax rate is relatively low. But corporate income and earnings before interest and tax were 4 per cent and 3 per cent lower than our forecasts, respectively, offsetting these factors.
Capacity expansion is back on track. By the end of 2016, Kangda Environmental Protection's water treatment capacity in the camp reached 2.5 million tons per day, an increase of 15% over the same period last year. By February 2017, the total number of projects in hand reached 3.6 million tons / day, an increase of 28.5% over the end of 2015. The utilization rate remained stable at 85%, and the average water treatment fee increased by 0.8% to 1.32 yuan per ton.
Construction has become the main driving force for growth. At present, the total investment of the three existing PPP projects reaches 3.1 billion yuan, which is expected to be implemented in the next few years, and several more projects are expected to be signed in the near future, so we expect Kangda Environmental Protection's construction income to be the main growth driver of the company. Driven by the Rushan and Hebi PPP projects, the income of the water environment management department is expected to increase 4.8 times to 841 million yuan in 2017.
Main risks faced by rating
The development progress of the contracted project is not as expected.
The debt ratio exceeded 150% by the end of 2017, leading to the risk of equity dilution. According to our forecast, if Kangda Environmental Protection wants to maintain its net debt ratio at the level of the end of 2016 (135%), the company may need to raise about 800 million yuan (equivalent to 20% of the current market capitalization) through equity financing such as issuing perpetual bonds, convertible bonds or rights issues. Management has indicated that these measures may be taken.
Valuation
The buy rating of Kangda Environmental Protection is maintained on the grounds that the company is valued at a 45% discount to the same industry, providing a buffer for the share price, while the momentum of winning the bid for the company's project is back in 2017, and profits are back on the growth track, so the stock price has upward potential. Fine-tune the target price to HK $2.25, corresponding to 9.3 times expected 2017 earnings.