Ride the wind of China's railway network construction

We recently had a company update with management.

Company background: The company is a leading supplier of railway fastener systems in China, mainly producing railway fastener system products and flax-cored welding wire.

Competitive railway fastener system supplier: Hebei Yichen is one of seven domestic suppliers of pre-assembled high-speed railway fastener systems that have obtained product certification from the China Railway Inspection and Certification Center, and is also the only mainland private company that has passed certification. The company's cost advantage and extremely wide product coverage have also contributed to the company becoming a leading enterprise. As an industry leader, the company can fully enjoy the opportunities brought by the expansion of China's railway industry and the maintenance and upgrading of railway fastener systems.

A pioneer in pre-assembled railway fasteners: Hebei Yichen pioneered the business of independently providing a complete set of railway fastener systems, adopting an integrated assembly and supply model. We believe that the company's integrated assembly supply model can meet customer needs and shorten construction time, continue to maintain the company's competitiveness and maintain its leading position in the market.

High-speed railways have entered a large-scale warranty period to leverage the 10 billion blue ocean: in addition to the rapid development of China's high-speed railways driving demand for railway fastener systems, China's replacement demand is also supporting market growth. Since high-speed railways operate for a long time, the fastener system needs to be replaced on a large scale after eight to ten years of railway operation due to component fatigue. China's first high-speed railway was put into operation in 2008, so replacement demand should be generated from 2016 onwards. With the rapid growth of high-speed railways after 2008, the replacement demand for China's high-speed rail sector in the next five years is estimated to be around 7,000 kilometers. Based on the need for 7,000 component systems per kilometer, at around RMB 240 per set of components, we expect the total replacement market to reach RMB 11 billion over the next 5 years. According to management, there is already a target date for the replacement track of China's first high-speed railway, the Beijing-Tianjin Line. It can be seen that the overhaul and replacement of high-speed railways may enter a period of explosion. In order to cope with increased demand, the company has built new production capacity, and it is expected that the new plant will not be put into operation until September next year. The company's current production capacity utilization rate is about 90%.

Valuation: The current stock price corresponds to a price-earnings ratio of 10.4 times in FY16, with a 30% discount compared to Hong Kong's listed peers. Hebei Yichen went public in Hong Kong at the end of last year to further expand financing channels and expand the company's production capacity. It is expected that market share will increase, profit growth will be maintained, and stock valuations will be revalued.

Potential Stock Price Catalyst: Obtaining New Supply Contracts. China Railway is speeding up railway investment and China is speeding up track construction.

A competitive supplier of railway fastening systems

The railway fastener system is a connecting device between the track and the railway rail pillow. It can fix the track to the railway rail pillow. The railway fastener system plays a key role in determining the high-speed limit and load capacity of each railway, and can reduce the vertical, lateral and longitudinal sliding of the track caused by the force generated by the movement of the train. The railway fastener system is a key component to ensure the safe and efficient operation of railway transportation in China. Therefore, only suppliers that have obtained product certification from the China Railway Inspection and Certification Center are eligible to supply.

Hebei Yichen is one of seven domestic suppliers of pre-assembled high-speed railway fastener systems that have obtained product certification from the China Railway Inspection and Certification Center. It is also the only mainland private company that has passed certification. The company's cost advantage and extremely wide product coverage have also contributed to the company becoming a leading enterprise. The company is one of the few domestic enterprises capable of producing core components of railway fastener systems. There is no need to go out to purchase, so its production cost is more competitive than other peers. Through research and development, the company's products cover all aspects of high-speed railways, heavy-duty railways, traditional tracks and urban rail transportation.

As an industry leader, the company can fully enjoy the opportunities brought by the expansion of China's railway industry and the maintenance and upgrading of railway fastener systems. In addition, the company is also participating in overseas railway projects by supplying domestic railway builders, such as the Mongolian Railway Project in Kenya. The overseas expansion of China's railway companies has also provided growth impetus for the company.

Due to high market entry barriers and the high technical content of the company's products, the company has maintained a high level of gross margin over the past few years.

Generally speaking, the gross margin of high-speed rail fastener systems is also relatively high (about 46% or more) due to the high technical content, while the gross margin of ordinary railway fastener systems is about 30-40%. Steel is the company's main cost, but the company uses special steel, and price fluctuations are lower than domestic steel prices. Changes in gross margin are mainly affected by changes in product mix.

A pioneer in pre-assembled railway fasteners

Hebei Yichen pioneered the business of independently providing a complete set of railway fastener systems, adopting an integrated assembly and supply model.

The company manufactures and assembles railway fastener systems. After receiving the integrated assembly system, the customer installs it at the construction site. The advantage of this business model is that the integrated assembly system is easy to install on site; therefore, the costs associated with the on-site assembly of different railway fastening system parts can be minimized, and the risk of project delays due to different delivery times for railway fastening system components is also reduced. Providing products through a full supply system can effectively solve product compatibility issues from different suppliers. The Ministry of Railways (now China Railway Corporation) later applied the assembly and supply model to high-speed rail procurement, causing the company's market share to continue to expand. We believe that the company's integrated assembly supply model can meet customer needs and shorten construction time, continue to maintain the company's competitiveness and maintain its leading position in the market.

High-speed railways enter a large-scale warranty period to leverage the 10 billion blue ocean

In addition to the rapid development of high-speed railways in China driving demand for railway fastener systems, China's replacement demand is also supporting market growth. Since high-speed railways operate for a long time, the fastener system needs to be replaced on a large scale after eight to ten years of railway operation due to component fatigue. China's first high-speed railway was put into operation in 2008, so replacement demand should be generated from 2016 onwards. With the rapid growth of high-speed railways after 2008, the replacement demand for China's high-speed rail sector in the next five years is estimated to be around 7,000 kilometers. Based on the need for 7,000 component systems per kilometer, at around RMB 240 per set of components, we expect the total replacement market to reach RMB 11 billion over the next 5 years. According to management, there is already a target date for the replacement track of China's first high-speed railway, the Beijing-Tianjin Line. It can be seen that the overhaul and replacement of high-speed railways may enter a period of explosion. In order to cope with increased demand, the company has added new production capacity. It is expected that the new plant will not be put into operation until September next year. The company's current production capacity utilization rate is about 90%.

Addressing huge working capital requirements

The China Railway Corporation (“China Railway Corporation”) is responsible for the construction of the domestic railway network. China Railway Corporation tenders for each project, and tenders are only carried out in the middle and late stages of project construction. More than 95% of domestic railway fastener systems are directly purchased by China Railway Corporation. The company has been in business for more than a year. The reasons include the complicated calculation process of China Railway, and the completion inspection and settlement of several projects in batches. The construction period of some large-scale railway projects took several years, and as a result, the collection of cash from the accounts was slow. As a result, the company needed more working capital. The faster a company develops, the more financing capacity it needs to have. Hebei Yichen went public in Hong Kong at the end of last year to further expand financing channels. Furthermore, the company received more than RMB 550 million in bank credit, which should be able to meet huge working capital requirements.

Performance review for the first half of the year

The company's total revenue increased to RMB 525.6 million year-on-year. Among them, sales of railway fastener system products, the company's main source of revenue (90% of total revenue), fell 3% year on year to RMB 470.8 million, mainly due to delays in the progress of some railway construction under construction in the first half of the year, which led to a decline in sales of railway fastener system products; while sales of welding materials, another source of revenue for the company, rose 60% year on year to RMB 53.0 million, mainly due to the recovery of the domestic shipbuilding industry and new customer orders in the first half of the year.

Gross margin fell slightly by 5 percentage points to 41% in the first half of the year, mainly due to a decrease in the share of sales of railway fastener system products with high gross margins. The gross margin of railway fastening system products decreased from 47.8% in the first half of 2016 to 44.9% in the first half of 2017. The gross margin of welding products has been negatively affected by the rise in the price of the raw material steel strip. The gross margin of welding products fell from 21.4% in the first half of 2016 to 6.4% in the first half of 2017.

The initial value of the contract signed by the company to supply railway fastener systems was RMB 616 million, an increase of 48.4% over the previous year; of this, the initial value of the contract signed for the high-speed railway fastener system was RMB 424 million, an increase of 65.6% over the previous year.

As of the end of June 2017, the amount of the company's outstanding contracts was RMB 1,232 million, equivalent to 1.2 times 2016 revenue.

The profit attributable to corporate equity holders in the first half of the year was RMB 126.9 million, a year-on-year decrease of 19%. Mainly due to the company's listing in December 2016, the number of share capital increased dramatically. The basic earnings per share in the first half of the year were RMB 0.14, a decrease of 39% over the previous year.

Valuation: The current stock price corresponds to a price-earnings ratio of 10.4 times in FY16, with a 30% discount compared to Hong Kong-listed peers. Hebei Yichen went public in Hong Kong at the end of last year to further expand financing channels and expand the company's production capacity. It is expected that market share will increase, profit growth will be maintained, and stock valuations will be revalued.

risk factors

The company's revenue is concentrated on railway fastener systems, and there is a single business risk. Sales will be affected by changes in the Chinese government's policy on the railway transportation industry.

The company has obtained the relevant technology from the Railway Construction Research Institute of the China Academy of Railway Sciences to produce high-speed railway fastening systems. Failure to use this technology or a sharp increase in patent costs will affect the company's operating performance.

Production capacity expansion was delayed.