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China Merchants buys new toll road; plans more acquisitions, placements

Jiang Yanfei, CEO of toll-road operator China Merchants Holdings (Pacific) (CMHP), is on a fundraising drive to finance the recently completed acquisition of the Yongtaiwen expressway in eastern China. It is the first time in seven years that the Mainboard listed company has made any acquisition, and Jiang says more such deals could be announced in the next year.

CMHP became a toll road operator in 2004, when its parent, the state-owned China Merchants Group (CMG), injected five toll roads into the company. Since then, analysts have touted the possibility of CMHP gradually acquiring more toll roads from its parent. Yet, it wasn’t until July that it obtained approval from the authorities for the purchase of a 51% stake in the Yongtaiwen expressway for RMB 2.2 billion ($442 million)

For investors, the deal appears to have been well worth the wait. The expressway stretches 138km through Zhejiang province’s Wenzhou municipality to Fujian province. It is by far the largest asset that CMHP has in its portfolio and will provide a massive boost to its revenue and earnings from 2H2011.

Now, Jiang is seizing the opportunity to drum up interest in CMHP’s shares. He visited Singapore recently and spent two days selling the merits of the company to some 20 fund managers and investors. “We are also considering a share placement, which is why we are doing this road show. We want to create the conditions and gauge market support,” he says. “If we can do a placement, we reduce our gearing by half.”

Not that CMHP needs any cash. The company had accumulated some RMB 1.2 billion in cash reserves that it used, along with a bank loan of HK$1.4 billion ($231.3 million), to pay for the purchase of its Yongtaiwen stake, Jiang explains. That pushed its gearing up from zero to 40%. But it is still below the gearing of 60% to 70% that other toll-road operators carry, according to analysts. Indeed, Jiang says it would be safe for CMHP to raise its gearing to 60%.

Moreover, CMHP’s earnings and cash-generation potential has increased significantly with the addition of the new asset. Last year, Yongtaiwen reported earnings of RMB430 million. It should begin contributing to CMHP’s bottom line for the full 2HFY2011. According to Jiang, the highway could boost the company’s annual cash flow to some RMB500 million, which he believes will enable it to service its debts, gradually repay its bank borrowings and continue paying decent dividends.

And, that’s without raising any new equity. “We plan to distribute all our profits after paying bank borrowings,” Jiang says. “If we distribute RMB200 million, like we have been doing, we still have RMB 300 mil to service interest and pay the principal.”

Paul Yong, an analyst at DBS Vickers, calls the acquisition of the Yongtaiwen expressway a “transformational deal”, because of the significant boost it will give to CMHP’s top and bottom lines. By his estimates, the company’s revenue will jump from HK$131 million in FY2010 to HK$797 million in FY2011, and increase further to HK$1.59 billion in FY2012. Meanwhile, its earnings are set to nearly double to HK$502 million in FY2012 from HK$261 million in FY2010, according to Yong’s forecasts.

The Yongtaiwen expressway will also extend CMHP’s average portfolio life by one year to about six years, Yong says in a recent report. And, the reasonable valuation at which the company acquired the highway signals strong support from CMG, he adds. “CMHP can continue to leverage its parent’s network and connections to buy more quality toll-road assets either from CMG itself or other third parties.”

Much like other toll-road operators, the key attraction of CMHP’s stock is its potentially high dividend payouts. “This is because the cash flow of toll-road operators is higher than their net profit,” Says Yong.

According to the analyst, CMHP has distributed no less than 50% of its earnings since it acquired its first set of toll-road assets. By comparison, Hong Kong-listed Hopewell Highway Infrastructure distributes all of its earnings as dividends. Meanwhile, Jiangsu Expressway and Zhejiang Expressway distribute 70% of their earnings; Yuexiu Expressway distributes 60%; while Anhui Expressway and Shenzhen Expressway distribute 40% to 50%.

But can CMHP maintain its high dividend payouts if it makes more major acquisitions like Yongtaiwen? Shouldn’t the company hold on to its cash ahead of these deals.

Equity-raising plans

Jiang says he is currently negotiating for “five or six project” and is hoping to acquire “one or two” more toll roads next year. But he intends to fund these deals through placements of new shares. Currently, 82.5% of CMHP is owned by a unit of China Merchant Group. So, even if CMHP were to do three share placements equivalent to 20% of its market capitalization, its parent could still have a controlling 51% stake, Jiang points out. Moreover, a larger free float of shares and better trading liquidity could help the company garner a better market valuation, he adds.

But Jiang first needs to get investors sufficiently interested to drive shares in CMHP high enough for its controlling shareholder to back a placement of new shares. He figures the threshold for this would be when shares in CMHP rise above their net asset value of 76 cents apiece. “But I think that is a chicken-and-egg situation,” Jiang says of his dealings with officials of CMHP’s parent. “I tell them the share price is low because of lack of liquidity.”

Yong of DBS Vickers says that withholding dividends in order to preserve cash won’t really help CMHP, because it would be at least three years before CMHP has saved enough for an acquisition. “But with a higher dividend payout, it can raise its valuation so that it can tap equity and do a combination of internal funds, equity financing and bank borrowing for an acquisition,” he says.

Yong is also confident that CMHP’s high dividend yield of 8%, based on a projected distribution of five cents a share for the full year, would tempt more investors to buy more of the stock. Shares in CMHP have risen 29% from the year’s low of 46 cents just before the company announced in July it had received all approvals for the Yongtaiwen deal. Yong says that CMHP’s announcement of an interim dividend of 2.5 cents a share for 1HFY2011 also helped stoke the positive sentiment.

Highway to growth

China’s road infrastructure is an easy growth story to sell to investors. The country built its first modern expressway 23 years ago – a toll road that linked Shanghai to Jiading, a satellite town. By end-2010, China had 65,055km of expressways.

Yet, the long-term profitability of toll-road operators isn’t easy to judge. For one thing, toll rates are determined by individual provincial governments. Besides taking into account the cost of construction, they also consider factors such as the economic situation and the people’s standard of living. The toll rates tend to range between 40 and 45 RMB cents per km.

Recently, shares in toll-road operators have been weighed down by speculation that government will lower toll rates. Jiang says the government was only cracking down on illegally constructed toll-collection plazas and the awarding of concessions that exceeded the maximum 30 years allowed.

Whatever the case, toll-road operators like CMHP are careful not to base their investment decisions on the prospect of high toll rates. “We look more to growth in traffic,” Jiang says. “The growth in the number of auto vehicles has exceeded the rate of economic growth in the past five years.”

Another problem that’s specific to CMHP is that acquiring toll-road assets from its parent isn’t a straightforward matter. While its parent owns some RMB15 billion worth of toll-road assets, most of these are minor stakes in listed companies, which wouldn’t be suitable for injection into CMHP. In the case of its latest acquisition, CMHP’s parent had actually swapped its 11.98% stake in Hong Kong-listed Zhejiang Expressway with Zhejiang Transport Group for the latter’s 51% stake in Yongtaiwen, which it then injected into CMHP.

Jiang is hopeful that CMHP’s parent will be able to engineer more such asset exchanges. Again, government regulations and policies could be a key stumbling block here. A recent government directive sought to curb the acquisition and listing of state-owned toll roads, in particular in Guangdong province, that could be acquired.  Whatever the case, it will clearly take time for CMHP’s parent to work out a deal.

In the meantime, Jiang has to ensure that the assets CMHP already owns don’t deteriorate in value. Specifically, the government plans to phase out toll collection on Class 1 highways, where the speed limit is capped at 80kph. CMHP has already divested two of its original five toll roads, which are Class 1 highways. Now, it is negotiating to divest the Yuyao toll road, which is in Zhejiang province. “The government will give us fair compensation because not only are we an SOE [state-owned enterprise] but we are listed,” Jiang says. The compensation paid to CMHP in the past has been as high as 50% above the value of the assets.

Pan-China coverage

Unlike most other state-owned toll-road operators, however, CMHP’s assets aren’t confined to a specific province. In fact, it has assets in the developed coastal part of the country, where traffic volume is high, as well as in the less-developed provinces of Guizhou and Guangxi, where volume is low but growing fast. “They have a good business model,” says an analyst based in Hong Kong. “Guihuang expressway is a good asset. Yongtaiwen is a good road too.” The Guihuang expressway links the provincial capital, Guiyang, to the airport and also to the popular Huangguoshu waterfall.

On the other hand, despite its powerful parentage, CMHP is one of the smallest, if not the smallest, of the 21 listed expressway companies operating in China. It has a market capitalization of $337 million compared with Hong Kong-listed Jiangsu Expressway’s HK$31.6 billion, Zhejiang Expressway’s HK$18.4 billion and Sichuan Expressway’s HK$14 billion.

CMHP’s dividend yield of 6.9% is, however, as high as Zhejiang Expressway’s and higher than that of Sichuan Expressway. And, CMHP is trading at 5.9 times earnings compared with Jiangsu Expressway’s eight times and Zhejiang Expressway’s 7.8 times. With the significant new asset that CMHP has acquired, however, its shares may begin to close the valuation gap versus its much larger peers.

Yong of DBS Vickers has a “Buy” rating on the stock, with a price target of $1.02.

China Merchant Pacific 2011 sep 13 vickers

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