Turning on the Taps

Utilities / Asia ex Japan 15 February 2012

China Water Sector Initiation: turning on the taps

• Water industry is entering the next phase in which tariff hikes, consolidation and new technologies will improve earnings quality • Despite slowing project growth, investors should see relief with earnings visibility improving and cash flow reaching inflection • Balancing catalysts and risks, in the new phase, our order of stock

preference is: CEI, GDI, Hyflux and BEW How do we justify our view?

1) accounts receivable risks associated than peers) given increasing with local governments’ financial recurring cash flow generated from situations, 2) companies’ financing operating projects. While project ability to win new projects, and 3) additions would be favourable, we

some water companies’ increasing prefer build-operate-transfer (BOT) Jackie Jiang emphasis on build-transfer (BT) and transfer-operate-transfer (TOT) (852) 2848 4994 [email protected] projects, which could raise earnings projects to BT ones. Medium term, volatility due to accounting treatment. government-backed companies (CEI, Dave Dai, CFA GDI and BEW) could increase their (852) 2848 4068 [email protected] Our analysis suggests that China market shares via consolidation. Everbright International (CEI) has the Gary Zhou most attractive risk-reward profile, Valuation (852) 2773 8535 [email protected] followed by Guangdong Investment CEI and Hyflux are trading currently (GDI), Hyflux, and Beijing Enterprises below their past-5-year average PERs, Water (BEW). We also like CEI’s while GDI is trading in line and BEW Investment case leading position in waste-to-energy at a premium. BEW’s valuation looks The China Water Sector has raised (WTE), which offers more attractive unjustified to us, with its earnings concerns among many investors in the returns than water projects. risks not yet priced in. past due to: 1) lumpy earnings recognition, 2) negative operating We initiate coverage with a Positive Risks cash flow, and 3) less attractive sector rating. CEI is our top pick (Buy Investment risks are a slowdown in returns than other utilities sectors [1]) given its balanced profile of solid new project construction, water (such as city gas). However, we expect earnings-growth potential and limited companies’ financing difficulties, the sector to return to investors’ radar risk exposure, along with an attractive and risks arising from increasing screens with improving earnings valuation and scope for ROE involvement in BT projects. visibility in the next industry phase. improvement (to 16% for 2013E vs. 12% for 2010). We also like GDI Key stock calls Following a decade of extensive (Outperform [2]) given its very safe New Prev. project privatisation and rising earnings profile (we forecast 88% of China Everbright International (257 HK) penetration, we believe the China GDI’s 2012 earnings to be highly Rating Buy water sector is about to enter its next predictable) and potential to acquire Target price HK$4.20 Up/downside S 28.4% stage, where new project construction new water projects. We initiate on Guangdong Investment (270 HK) in waste-water treatment may slow. Hyflux and BEW with Hold (3) and Underperform (4) ratings, Rating Outperform However, we expect earnings quality Target price HK$5.35 to improve substantially, driven by: 1) respectively. We are concerned about Up/downside S 14.8% Hyflux’s limited order growth in the continuing water tariff hikes (a CAGR Hyflux (HYF SP) of around 5% over the past four years), near term and BEW’s overly Rating Hold 2) increasing mergers and aggressive project growth at the Target price S$1.40 acquisitions, and 3) wider adoption of expense of earnings quality. Up/downside T (5.4)% new technologies (such as seawater Beijing Enterprises Water Group (371 HK) desalination and water reuse), Catalysts Rating Underperform We forecast most companies to see Target price HK$1.90 providing additional project-growth Up/downside T (11.2)% potential. Some industry risks are operating cash flow improve going forward (BEW turning positive later Source: Daiwa forecasts unlikely to disappear rapidly, however: Note: Please refer to page 3 for details.

Important disclosures, including any required research certifications, are provided on the last two pages of this report. China Water Sector 15 February 2012

How do we justify our view?

Growth outlook Valuation Earnings revisions

Growth outlook China Water Sector: net profit trend (2008-13E)

We forecast the China Water Sector to record a CAGR of (HK$m) (%) 18% in aggregate core net profit for 2011-13, lower than 7,000 60 that in its previous cycle (26% over 2008-10), reflecting 6,000 52.0 50 our view that the sector is entering a new development 5,000 cycle. 40 4,000 32.5 30 3,000 25.4 20.5 20 2,000 14.2 11.2 1,000 10 0 0 2008 2009 2010 2011E 2012E 2013E Aggregate net profit (LHS) Aggregate net profit YoY growth (RHS)

Source: Companies, Daiwa forecasts

Valuation China Water Sector: 12-month-forward PER bands

The China water players are trading currently at an (x) average 12-month-forward PER of 12.5x (based on our 30 EPS forecasts), below their past-5-year average 27.3x Avg+2SD multiple. We believe this reflects the fact that the sector 25 21.5x Avg+1SD has passed its extensive growth phase and entered into a 20 more mature stage with intensive earnings growth 15.7x Avg potential. 15 10 10.0x Avg-1SD

5 4.1 Avg-2SD

0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

Source: Bloomberg, Daiwa forecasts

Earnings revisions China Water Sector: consensus 2012 EPS forecast revisions

The Bloomberg-consensus EPS forecasts for the (Rebased to 100) different companies in the sector have displayed a 115 divergent trend since the start of 2011. The consensus 110 2012 EPS forecasts have been cut by 11% for Hyflux but 105 raised by 3-10% for BEW, CEI and GDI. 100 95 90 85 80 Jul-11 Jul-11 Apr-11 Oct-11 Oct-11 Jan-11 Jan-11 Jun-11 Jan-12 Feb-11 Mar-11 Mar-11 Aug-11 Sep-11 Nov-11 Dec-11 Dec-11 May-11 May-11 BEW CEI GDI Hyflux

Source: Bloomberg

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Key stock calls

EPS (local curr.) Share Rating Target price (local curr.) FY1 FY2 % Company Name Stock code Price New Prev. New Prev. % chg New Prev. % chg New Prev. chg China Everbright International 257 HK 3.27 Buy 4.20 n.a. 0.208 n.a. 0.276 n.a. Guangdong Investment 270 HK 4.66 Outperform 5.35 n.a. 0.414 n.a. 0.462 n.a. Hyflux HYF SP 1.48 Hold 1.40 n.a. 0.056 n.a. 0.113 n.a. Beijing Enterprises Water Group 371 HK 2.14 Underperform 1.90 n.a. 0.114 n.a. 0.144 n.a. Source: Daiwa forecasts

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Table of contents

Initiation: turning on the taps ...... 5 Overview of the China water industry ...... 5 The key question: why invest? ...... 7 Which names to invest in? ...... 10 Water stocks were weak in 2011 ...... 10 Summary of stock recommendations ...... 13 What has held investors back? ...... 14 China water industry is entering a second growth phase ...... 17 Water is underpriced in China ...... 18 Increasing merger and acquisition ...... 22 The future water revolution ...... 25 Returns and cash flow matter ...... 27 Appendix 1: The water industry in MENA and Singapore ...... 29 Appendix 2: world-water resources map ...... 32

Company Section China Everbright International ...... 33 Guangdong Investment ...... 44 Hyflux ...... 58 Beijing Enterprises Water Group ...... 66

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2) Tap-water supply and treatment: responsible for the treatment and distribution of tap water to end users; collect bills directly from end users 3) Waste-water treatment: responsible for sewage treatment, usually under the build-operate-transfer Initiation: turning on (BOT) model; collect bills from local governments 4) Water reuse: responsible for recycling waste water the taps for further use; customers are focused on industrial users currently

Balancing industry growth potential China: water operation industry’s value chain against the investment risks Raw water Tap water supply Wastewater treatment Water resources distribution & treatment and water reuse

Overview of the China water industry Guangdong Investment (270 HK) Beijing Enterprises Water (371 HK) Shanghai Chengtou (600649 CH) China Water Affairs (855 HK)

Sound Global (967 HK/SGL SP) Industry value chain Beijing Capital (600008 CH) The value chain of China’s water industry, from Tianjin Capital (1065 HK) Chongqing Water (601158 CH) upstream to downstream, can be divided into three Zhongshan Public Utilities (000685 CH) major segments: 1) equipment manufacturing, 2) Jiangsu Jiangnan Water (601199 CH) engineering, procurement and construction (EPC), and Qianjiang Water Resources Development (600283 CH) Nanhai Development (600323 CH)

3) operation. In this report we focus on the water China Everbright Int’l (257 HK) operators. Hyflux (HYF SP) Jiangxi Hongcheng (600461 CH) China water operators can be divided into the following Source: Daiwa categories:

1) Raw water distribution: responsible for transporting water from natural resources to tap water treatment facilities

China water industry: value chain

Equipment manufacturing EPC Operation

Pipe Business model: Business model: China Liansu (2128 HK) Build water and sewage plants for Operate water supply/wastewater Xinxing Ductile Iron Pipes (000778 CH) municipals and industrial customers; treatment projects for local governments Pump Payment paid in installments through under a BOT/TOT model Xiangtan Electric (600416 CH) construction process Hyosung (004800 KS) Companies: Companies: Valve Guangdong Investment (270 HK) Sound Global (967 HK/SGL SP) Sufa Technology (000777 CH) Beijing Enterprises Water (371 HK) Hyflux (HYF SP) China Valves Technology (CVVT US) China Everbright Intl (257 HK) United Envirotech (UENV SP) Membrane Hyflux (HYF SP) Jiangsu Jiangnan Water (601199 CH) Beijing Originwater (300070 CH) China Water Affairs (855 HK) Toray (3402 JP) NWS Holdings (659 HK) Margins: Nitto Denko (6988 JP) Sound Global Ltd (967 HK/SGL SP) 20-30% gross margin Sinomem Technology (SINO SP) Beijing Capital (600008 CH) Memstar Technology (MSL SP) Shanghai Chengtou Holdings (600649 CH) Pros/Opportunity: Investment in water infrastructure Margins: 10-30% gross margin Returns: 8-12% ROE construction Pros/Opportunity: investment in water Pros/Opportunity: sustainable and stable Cons/Threat: infrastructure construction earnings from project operation (10-30 yrs) low earnings visibility given short-term projects (12-18 months) Cons/Threat: Low entry barrier; Cons/Threat: long pay-back period of 7- Oversupply in low-end products 10 years

Source: Daiwa

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Regulation and how the money flows China: tap water tariff regulation and pricing principle The retail water tariff follows a cost-plus model and is Integrated tap water tariff set and approved by local governments with a local hearing mechanism. According to the National Water resources fee Tap water supply tariff Wastewater treatment tariff • Regulated by “Regulation on • Regulated by “National • Regulated by “Prevention and Guidelines on Water Tariff published in 1998, the retail the Administration of the Guidelines on Water Tariff (城 Control of Water Pollution (水污 License for Water Drawing and 市供水价格管理办法)” 染防治法)” published in 1996 water tariff should cover water suppliers’ raw-material the Levy of Water Resource implemented since 1998 • Wastewater treatment tariff is Fees (取水许可和水资源费征收 • Tap water tariff is set and set by local governments costs, operating expenses, depreciation and financing 管理条例)” published in 2006 approved by local governments • Wastewater treatment tariff costs, and allows the water suppliers to a reasonable • Should reflect the opportunity • Water tariff raise needs to be should cover operating and cost and scarcity of water go through local hearings maintenance cost, depreciation ROE of 8-10% annually. Compared with other utilities, resources in the region • Water tariff should cover and financing cost operating and maintenance • The State Council issued the regulation stringency for water operators is cost, depreciation and financing guideline for wastewater tariff cost of no less than Rmb0.8 per ton somewhere in between that for independent power • Water tariff should allow a in 2007 reasonable return (ROE of 8- producers (IPPs) and city gas distributors; the former 10%) for water supply operators faces market fuel prices and regulated tariffs, while the • Promote progressive water tariff mechanism latter can generally pass through most increases in regulated gas costs to customers. Source: Daiwa

China water industry: how the water and money flow Pricing regulation comparison: water, gas and power (China) Tap water supplier - Retail price: regulated by local government Municipal - Raw material cost: regulated by local government - Pricing principal: cost plus Water - Cost pass-through? Yes Distribution - ROE: 8-10% $ $ Raw water distributor Consumer Local - Retail price: partially regulated by local government; $ partially decided by market supply and demand government City Gas - Raw material cost: regulated by NDRC Distribution - Pricing principal: cost plus $ - Cost pass-through? Yes Wastewater treatment - ROE: 12-15% Water resources operator - Retail price: regulated by NDRC (for both on-grid and retail tariff) - Raw material cost: market price IPP - Pricing principal: cost plus Source: Daiwa - Cost pass-through? No - ROE: 4-8% BT, BOT and TOT projects Source: National Development and Reform Commission (NDRC), Daiwa Water supply and treatment has long been provided by

the public sector (local governments) as key public The integrated tap-water tariff has three components: utilities. China’s water privatisation journey started in the water resources fee, the tap-water supply tariff and the early 1990s, when foreign capital began to seek the waste-water treatment tariff. All of these tariffs are opportunities in the huge market. The privatisation collected together by tap water supply operators progress was accelerated when the PRC Government directly from end users. Raw-water distributors and officially opened up water services to the market in waste-water treatment operators are paid by local 2002 and introduced the BOT and TOT business governments. End users are divided into the following models into the water market. groups: residential, industrial, administrative, commercial and special industries. For BT projects, water companies mainly provide

construction services and build water facilities for local governments. The construction revenue is paid in lump sums following completion of the construction and no sustainable operation revenue is generated.

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Comparison of BOT, TOT and BT projects Expansion overseas. It is a common trend for BOT TOT BT industry leaders across China’s utilities industries to go Greenfield/existing project Greenfield Existing Greenfield overseas when their domestic markets become Contract period 20-30 years 20-30 years 1-3 years Construction income Yes No Yes saturated or difficult to expand in. Hyflux has been a Operation income Yes Yes No pioneer in this respect, taking up milestone projects in Capex Construction cost to Payment to acquire Construction cost to Middle East and North Africa (MENA) over the past build the plant the plant build the plant few years. China’s domestic players are likely to follow Payback period 7-10 years 7-10 years 3 years Pros 20-30 year stable 20-30 year stable cash Quicker payback the trend, evidenced by BEW obtaining the project to cash stream; contract stream; contract period build waste-water treatment plants in Kuala Lumpur in allows for cost pass- allows for cost pass- through; minimum through; minimum Malaysia in 2011. We believe that expanding in water intake water intake overseas markets is likely to be a long-term trend for guarantee (for waste guarantee (for waste China’s water operators, given their long track records water treatment); water treatment); Cons Longer payback Longer payback No sustainable cash of building up experience and technical knowhow. period period flow; accounts receivable risk; low gross-profit margin of 5-10% The key question: why invest? Source: Daiwa It is widely acknowledged by the investment Potential market size over the long term community that water is set to be a big theme in China Fragmented market. China’s water industry over the next 10 years due to its increasing scarcity remains fragmented, with the top-20 players between driven by population growth, urbanisation and the them accounting for a mere 23% market share of total country’s serious water pollution. How is this very treatment capacity for 2010. Many municipal water favourable industry picture reflected in stock-market projects are still in the hands of the public sector. performance and investment opportunities? (Among the 31 provincial capitals, water projects at 12 of them are operated entirely by local governments Looking at the performance of the S&P Global Water while others have partially privatised – we provide Index relative to the MSCI World Index, we find that further details on page 24.) We expect further the former has outperformed the latter every year for privatisations of publicly-run projects given their low the past 10 years except for 2011. We believe the efficiency and loss-making position and the size of the defensive nature of water stocks and the good overall private water market to double over the next 5-10 years. growth prospects of China’s water industry will continue to enable water stocks in Asia ex-Japan to Is the water industry likely to follow the city gas deliver superior returns over the next five years. industry’s path? The water and city gas industries in China share several similar features. Both are city Performance of S&P Global Water Index vs. MSCI World Index (%) S&P Global Water Index MSCI World Index Outperformance project-based, involve distributing resources to end 2002 (10.8) (23.4) 12.6 users and have in the past been controlled largely by 2003 30.7 29.9 0.8 the public sector. Looking at the city gas industry which 2004 32.6 14.8 17.7 has nurtured quality leaders like ENN Energy (2688 2005 16.8 7.6 9.2 HK, HK$26.2, Buy [1]) and Hong Kong & China Gas 2006 35.3 18.0 17.4 2007 13.3 7.5 5.8 (Not rated) over the past 10 years, we believe investors 2008 (43.2) (44.0) 0.8 could start to wonder the following: will the water 2009 32.5 31.1 1.4 industry follow a similar pattern and will market-share 2010 13.0 9.3 3.8 winners stand out? We believe the answer is likely to be 2011 (9.3) (7.6) (1.7) positive. YTD 7.3 8.2 (0.9) Source: Bloomberg Note: S&P Global Water Index is composed of 10 stocks from Asia, 18 from North America, Over the past 10 years, the top-10 city gas distributors 18 from Europe and 1 from South America have improved their consolidated market share from a single-digit level to over 30%. We believe that the water Why China? industry, which is still fragmented, is likely to see Compared with water utilities in mature markets like similar industry consolidation, and that companies Europe, China’s water stocks do not offer as high with backgrounds as state-owned entities (SOE), ease dividend yields for 2012E (based on our forecasts for of access to financing their businesses, and solid China and the Bloomberg consensus forecasts for project track records are likely to benefit from an European companies.) However, this is compensated expanding industry. by the China water companies’ stronger earnings growth profiles for 2011-13E based on our forecasts,

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driven by new project additions and capacity expansion. the future. By contrast, water operators have relatively In a global context, The China Water Sector is trading more stable raw-material costs (water resources fee) currently at an attractive level both on a PBR-ROE and can usually pass through hikes in other operation basis for 2012E and a PEG basis based on EPS CAGRs costs like electricity. for 2011-13E, as the next charts show. Also, we forecast the free cash flow of the China water Global water companies: PBR vs. ROE (2012E) companies under our coverage to turn positive in 2012E ROE (%) 2012/13 when the recurring cash flow generated from 25.0 operating projects should finally start to cover capex required for new project constructions. In terms of valuation, the China water stocks are trading currently 20.0 UK at attractive levels compared with the city gas distributors and IPPs on a PBR-ROE basis for 2012E. 15.0 China China/Singapore water companies: free cash flows (2008-13E) Italy US Singapore 10.0 Japan Finland (Rmb m) Spain 4,000 France 3,000 5.0 2,000 1,000 0.0 0.00.51.01.52.02.53.0 0

2012E PBR (x) (1,000) Source: Bloomberg, Daiwa forecasts (China and Singapore) (2,000) Note: multiples in the charts in this report are based on closing share prices of 13 February 2012 (3,000) 2008 2009 2010 2011E 2012E 2013E Global water companies: 2012E PER vs. 2011-13E EPS CAGR CEI GDI Hyflux BEW 2011-13E EPS CAGR (%) Source: Companies, Daiwa forecasts

25.0 France China utilities: PBR vs. ROE (2012E) 23.0 2012E ROE (%) 21.0 16.0 19.0 Water Italy 14.0 17.0 China Gas distributor 15.0 12.0

13.0 Japan 10.0 US 11.0 IPP UK 8.0 9.0 Finland 6.0 7.0

5.0 4.0 10.0 11.0 12.0 13.0 14.0 15.0 16.0 17.0 18.0 2.0 2012E PER (x) Source: Bloomberg, Daiwa forecasts (China) 0.0 Note: multiples in the charts in this report are based on closing share prices of 13 February 0.0 0.5 1.0 1.5 2.0 2012 2012E PBR (x) Source: Bloomberg, Daiwa forecasts Why water? Regarding the utilities in China, IPPs are suffering Thoughts on utilities portfolio weightings from volatile fuel costs and the lack of a cost-tariff The utilities as a whole currently account for 2.16% of linkage mechanism that has driven their net-profit the MSCI China Index. The power, gas and water margins into negative territory from time to time over utilities sectors have respective index weightings of the past five years. City gas distributors have been 1.19%, 0.74% and 0.23%, with Guangdong Investment enjoying the ability to pass on most costs to end users (GDI) the only water utility stock in the index. Dave in the past; however, the recent gas price reform trials Dai, Daiwa’s Regional Head of Clean Energy and carried out in Guangdong and Guangxi in December Utilities, recommends a position equal to the 2.16% 2011 may put some pressure on their gross margins in

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index weighting for China utilities with similar 0.35% (higher than the 0.23% index weighting), by portfolio protection (beta) while investing in stocks cutting positions slightly in GDI given its substantial with the potential to capture risk-adjusted returns outperformance in 2011 but adding China Everbright (alpha) from Daiwa’s top picks in each of the three International (CEI) (not an index constituent), to utilities sectors. As we show in the following table, we which we apply a 0.15% weighting. As a result, the recommend that investors underweight the power weighted average beta of our recommended portfolio is utilities (compared with the index weighting) and stay the same as that implied by the index constituents, with the two quality names, China Resources Power while we believe many of our picks will help to offer a and China Longyuan Power. We recommend a slight portfolio of China utilities stocks combining a safe overweight position in the gas sector relative to the profile with the potential to generate positive risk- current index weighting, with ENN Energy our only adjusted returns, such as CEI. pick here. For water, we recommend a weighting of

Daiwa’s recommendation weightings of utilities sectors relative to MSCI China (as of 13 February 2012) MSCI YTD risk- 2011 risk- YTD absolute 2011 absolute Share China Daiwa adjusted stock adjusted stock stock stock Stock Daiwa price Weight recommended performance performance performance performance Bloomberg Sector Company code rating (HK$) (%) weight (%) Reason (%) (%) (%) (%) beta Power China Resources Power* 836 HK Buy 15.2 0.50 Overweight The only vertically integrated IPP in (4.9) 15.9 1.5 6.4 0.47 China; recent lag in sharwe0price performance offers a good entry point Huaneng Power 902 HK Outperform 4.95 0.30 Underweight 11.4 13.1 19.9 0.5 0.62 China Longyuan Power 916 HK Buy 6.23 0.23 Overweight Best managed wind power company in (9.5) 3.4 2.6 (14.6) 0.88 China, weak wind blow should be only a short-term overhang Datang Power 991 HK Hold 2.72 0.16 Underweight (5.1) 10.5 5.8 (5.9) 0.80 Sub-total 1.19 1.00 Gas ENN Energy* 2688 HK Buy 26.2 0.36 Overweight Recent underperformance due to (4.5) 21.6 5.2 7.1 0.71 acquisition overhang, best managed gas distributor in China China Gas 384 HK Hold 3.65 0.22 Underweight (9.9) 23.4 2.2 5.3 0.89 China Resources Gas 1193 HK Hold 11.28 0.16 Underweight (6.9) 13.0 1.6 0.4 0.62 Sub-total 0.74 0.80 Water Guangdong Investment 270 HK Outperform 4.66 0.23 Equalweight Defensive profile but limited upside (9.6) 30.5 (1.1) 17.8 0.62 (GDI) potential following strong performance over 2011 China Everbright 257 HK Buy 3.27 0.00 Overweight We recommend adding CEI for the 0.2 (7.0) 16.4 (31.1) 1.18 International (CEI) * alpha element Sub-total 0.23 0.35 Total 2.16 2.16 Overall equal weighting to current index weighting in China utilities MSCI China Index 13.7 (20.4) Source: MSCI, Daiwa. Data is based on closing share prices of 13 February 2012. Note: *Top sector picks; risk-adjusted performance = absolute performance – MSCI China Index performance*stock beta

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China/Singapore water companies: Daiwa scoreboard CEI GDI Hyflux BEW Which names to invest in? Growth drivers Water tariff hike 2 2 4 4 Privatisation & consolidation 3 4 2 4 Following an extensive growth phase focused on new Seawater desalination 1 1 4 3 project constructions and a rapid increase in Water reuse 4 1 3 5 penetration over the past 10 years, we believe the China Non-water business 5 3 1 1 Growth score 15 11 14 17 water industry is entering a second growth phase that Investment risks we describe as an intensive growth phase, driven Accounts receivable 4 5 2 2 primarily by the following: 1) water tariff hikes, 2) Financing difficulties 3 5 4 3 increasing merger and acquisition activity, and 3) BT project involvement 5 5 5 1 Risk score 12 15 11 6 wider application of new technologies including Valuation 4 4 5 2 seawater desalination and water reuse. ROE improvement potential 5 3 1 2 Total 36 33 31 27 China water industry: growth phases Source: Daiwa Note: Risk scores: 1 is the highest and 5 the lowest; all other scores: 1 is the lowest and 5 is Extensive growth phase Intensive growth phase the highest

Water stocks were weak in 2011

Key words: Key words: • Construction • Upgrade • Penetration • Quality standard The China water stocks have underperformed the HSCEI by 6% between the start of 2011 and early Characteristics: Characteristics: • High government involvement • Rising privatization of projects February 2012, with the exception of GDI, which has • Large capex • Capex focused on pipeline outperformed the HSCEI by 28% and has a larger • Fast additions of projects rehabilitation and upgrade • Fast rising penetration • Slowdown of project additions market cap than the other stocks. We believe the • Low water tariff • Penetration rate already high • Increase in water tariff underperformance of the smaller-cap water stocks is Growth drivers: due mainly to investors’ concerns about the following • Large fixed investment Growth drivers: • New additions of projects • Rising privatization of projects risks: 1) local governments’ mounting debt levels and • Fast rising penetration • Water tariff increase slowdown of infrastructure investment, 2) China’s tight • Future water revolution: water reuse Key achievements: and seawater desalination credit policy, 3) the water companies’ lumpy earnings • Water access rate: 72% by 2001 to 97% by 2010 trend on an annual basis arising from specific • Urban wastewater treatment rate: accounting treatment, and 4) the companies’ increasing 36% by 2001 to 77% by 2010 involvement in BT projects, which we discuss in detail Source: Daiwa elsewhere in this report.

We have identified key industry-growth drivers and China/Singapore water companies: share-price performances investment risks to assess which of the four companies (Rebase to 100) stands out as the champion in the intensive growth 150 phase of the China water industry. On valuation and 130 return profiles, China CEI ranks the highest in our 110 scoreboard given its solid project track record, 90 attractive non-water business (WTE) and ROE 70 improvement from 12% for 2010 to 16% for 2013E. 50 30 -11 BEW is our least favourite stock. Despite BEW’s high -11 g y Jul-11 Jul-11 Apr-11 Oct-11 Oct-11 Jan-11 Jan-11 Jun-11 Jan-12 Feb-11 Mar-11 Mar-11 Au Sep-11 Nov-11 Dec-11 Dec-11 ranking in terms of top-line growth potential, we are May-11 Ma concerned about its substantial exposure to BT projects Hyflux Guangdong Investment and delays in accounts receivable. Also, unlike its peers, Beijing Enterprises Water China Everbright Int'l Sound Global S&P Global Water Index BEW is trading currently at a premium 12-month Source: Bloomberg forward PER compared to its historical average level since it entered the water industry in 2008.

We like GDI for its defensive profile, but for Hyflux we are not impressed by what we consider as its bleak order growth outlook and declining ROE trend likely over the near term.

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Sector looks cheap vis-à-vis past five years China Water Sector: PBR history (2007-11E) The China Water Sector is trading currently at a PER of (x) 3.5 12.5x and a PBR 1.6x for 2012 (based on our and the 3.3x Avg+2SD Bloomberg consensus EPS and BVPS forecasts); these 3.0 multiples are 19% and 20%, respectively, below its 2.6x Avg+1SD past-5-year average levels. However, the sector’s 2.5 2.0x Avg current multiples are still much higher than the trough 2.0 PER of 5.5x and PBR of 0.8x reached in late 2008. 1.5 1.4x Avg-1SD Compared to the financial crisis period of 2008-09, we 1.0 believe the water players’ fundamentals have improved 0.7x Avg-2SD significantly through the following three ways. First, 0.5 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 companies like CEI and BEW had just entered the environmental services business in 2008. Since then, Source: Bloomberg, Daiwa forecasts they have grown much bigger and developed a Looking at share-price performances over the past five diversified project portfolio, which has substantially years, we find that the China and Singapore water reduced the risk of delays in collecting accounts companies have outperformed the S&P Global Water receivable. Second, the water companies’ average ROE Index consistently since 2007, except for in 2010. Of has improved from 9.7% for 2008 to 13.1% for 2011E the individual companies, GDI has tended to based on our forecasts, due to overall profit margin outperform the HSCEI since 2007 and has offered a expansion and an improvement in asset turnover safe haven in market downturns, such as in 2008 and (Hyflux is the exception). 2011. BEW has outperformed the HSCEI each year since 2007, resulting in what we consider as an Also, the companies have strengthened their financial expensive valuation now. CEI’s share-price positions, with average net gearing declining from 48% performance has been unexciting over the past two for 2008 to 30% for 2011E and EBIT interest coverage years, and we believe now is a good entry point. increasing from 6.5x to 9.2x over the same period China/Singapore water companies: returns relative to (based on our 2011 forecasts), which should provide respective market benchmark (2007-YTD 2012) better support for new projects in the future. We see S&P Global limited downside risks from current valuation levels, Sound HSCEI FSSTI Water aside from BEW which trades at a premium to its (%) CEI GDI Hyflux BEW Global Average Index Index Index 2007 134.4 (29.2) 18.2 89.8 21.3 46.9 55.9 18.7 12.2 historical PER since it entered the water industry in 2008 (12.2) 20.9 5.3 63.6 (15.8) 12.4 (51.1) (49.2) (40.4) 2008. 2009 117.6 (16.5) 33.8 125.8 135.5 79.3 62.1 64.5 28.2 2010 2.8 (10.9) (12.1) 13.1 2.8 (0.8) (0.8) 10.1 12.6 China Water Sector: PER history (2007-11E) 2011 (9.4) 39.5 (31.0) 9.8 (22.7) (2.8) (21.7) (17.0) (9.3) 2012 YTD 1.0 (16.5) 10.4 (14.5) 13.5 (1.2) 15.4 12.5 7.3 (x) Source: Bloomberg 30 27.3x Avg+2SD 25 Cheap compared to global peers 21.5x Avg+1SD 20 The water companies that we initiate coverage of in this report are trading currently at 2012E PERs below those 15 15.7x Avg of their regional and global peers on average (based on 10 10.0x Avg-1SD our and the Bloomberg-consensus EPS forecasts), with the exception of BEW, despite their stronger earnings- 5 4.1 Avg-2SD growth outlook overall. In terms of 2012E PBRs, CEI 0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 and BEW are trading above the average multiples of their regional and global peers, which we believe is Source: Bloomberg, Daiwa forecasts justified by their superior ROE levels.

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Water companies in China, Asia and globally: valuation comparison Market EPS CAGR Company name Bloomberg code Daiwa rating Share price cap PER (x) PBR (x) ROE (%) Div yield (%) (%) (local curr.) (US$m) 2011E 2012E 2013E 2011E 2012E 2013E 2011E 2012E 2013E 2011E 2012E 2013E 2011-13E Water operators under coverage China Everbright Int'l 257 HK Buy (1) 3.3 1,541 15.7 11.8 10.2 2.0 1.7 1.5 13.4 15.7 16.1 0.9 1.2 2.0 24.5 Guangdong Investment 270 HK Outperform (2) 4.7 3,724 11.2 10.1 9.3 1.4 1.3 1.2 13.0 13.3 13.2 3.4 3.8 4.1 9.9 Hyflux HYF SP Hold (3) 1.5 1,010 26.6 13.1 12.4 1.4 1.3 1.2 6.6 10.1 10.1 1.4 2.9 3.1 46.4 Beijing Enterprises Water 371 HK Hold (3) 2.1 1,896 18.8 14.9 12.6 2.2 2.0 1.8 13.6 14.1 15.1 1.6 2.0 2.4 22.1 Simple average 2,043 18.1 12.5 11.1 1.8 1.6 1.4 11.7 13.3 13.6 1.8 2.5 2.9 25.7 Weighted average 15.7 11.9 10.6 1.7 1.5 1.4 12.4 13.5 13.8 2.3 2.8 3.2 20.0 Regional water operators China Water Affairs 855 HK NR 2.5 473 13.2 11.6 9.7 1.0 1.0 0.9 9.0 9.2 9.7 2.8 2.0 2.0 16.8 Sound Global SGL SP NR 0.6 625 10.2 8.9 8.1 1.8 1.5 1.3 19.8 18.9 17.1 1.5 1.7 3.8 12.1 Beijing Capital 600008 CH NR 5.4 1,872 20.2 17.9 16.0 2.3 2.3 2.3 12.2 12.4 13.2 3.9 5.0 5.2 12.4 Tianjin Capital 1065 HK NR 2.1 1,079 8.9 8.9 9.2 0.7 0.7 0.6 7.8 7.5 7.0 5.6 5.4 5.2 n.a. Kurita Water Industries 6370 JP NR 2038.0 3,515 15.2 14.3 13.6 1.3 1.2 1.1 8.4 8.5 8.4 2.0 2.0 2.1 5.5 Manila Water MWC PM Buy (1) 22.2 1,013 11.6 9.8 8.4 2.1 1.8 1.5 19.1 19.7 19.9 1.7 1.9 2.2 17.7 Simple average 1,429 13.2 11.9 10.8 1.5 1.4 1.3 12.7 12.7 12.5 2.9 3.0 3.4 12.9 Weighted average 14.6 13.3 12.3 1.6 1.4 1.4 11.3 11.3 11.3 2.8 3.1 3.3 8.9 Global water operators Veolia VIE FP NR 9.5 6,319 15.5 11.2 9.6 0.6 0.6 0.6 1.3 6.0 6.1 7.9 8.1 8.4 27.3 Suez Environment SEV FP NR 10.0 6,538 12.4 11.1 10.2 0.9 0.9 0.9 8.7 9.3 10.0 6.6 6.9 7.1 10.2 American Water Works AWK US NR 34.0 5,959 19.1 17.4 16.4 1.4 1.3 1.3 7.8 7.8 8.0 2.7 2.9 3.0 8.1 Aqua America WTR US NR 22.4 3,101 21.8 20.6 19.0 2.5 2.3 2.2 11.6 11.8 12.1 2.8 3.0 3.2 7.1 California Water Service Group CWT US NR 18.5 773 17.8 16.5 15.6 1.7 1.5 1.5 9.4 9.5 9.7 n.a. n.a. n.a. 6.8 United Utilities Group PLC UU/ LN NR 597.5 6,267 17.0 14.8 13.9 2.4 2.3 2.2 14.2 16.4 16.4 5.3 5.7 6.0 10.7 Acciona ANA SM NR 62.7 5,104 25.8 20.4 16.1 0.7 0.7 0.7 5.2 3.2 3.9 4.9 5.0 5.2 26.8 Simple average 4,866 18.5 16.0 14.4 1.4 1.4 1.3 8.3 9.1 9.5 5.0 5.3 5.5 13.8 Weighted average 18.0 15.3 13.6 1.3 1.3 1.2 7.9 9.1 9.4 5.2 5.4 5.6 15.2 Source: Bloomberg for not-rated (NR) stocks, Daiwa forecasts Note: data is based on closing share prices of 13 February 2012

- 12 - China Water Sector 15 February 2012

• Our NAV-based six-month target price is HK$5.35. Summary of stock Our bear-case valuation, which assumes no increase in rental income from 2012E onwards and a flat recommendations water tariff from 2015E onwards, implies a value per share of HK$4.56, indicating limited downside. CEI – Buy (1) rating and six-month target price of HK$4.20 Hyflux – Hold (3) rating and six-month • CEI is our top pick in our coverage universe. We target price of S$1.40 believe it offers a balanced profile of strong earnings- • Hyflux was the worst-performing Asian water stock growth potential and limited risk exposure, along with in 2011, when its share price fell by 48%. We believe an attractive valuation and scope for ROE investors are concerned about: 1) the slow ramp-up improvement (we forecast an ROE of 16% for 2013, of the company’s Tuas II desalination plant, and 2) compared with 12% recorded for 2010). its failure to obtain new projects (especially in China) • CEI’s geographical focus in economically developed since March 2011. provinces in China and limited exposure to BT • We are concerned about Hyflux’s order growth over projects helps to reduce the risk of delays in the next 12 months given the unexciting outlook for collecting accounts receivable. the global water market in the near term. Substantial • We like the company’s WTE business for its high order wins could lead us to turn more positive project returns, with a project equity IRR of 10-15%, towards the company. government policy support and the company’s • Our DCF-based six-month target price is S$1.40. market leadership and solid track record in the WTE The Hyflux stock is trading currently at a 13x PER business. and a 1.3x PBR for 2012E (based on our respective • Our DCF-based six-month target price is HK$4.20. EPS and BVPS forecasts), largely below its past-5- Our target price implies a PER of 15x on our 2012 year average multiples. We believe the current share EPS forecast, below the stock’s past-five-year price has factored in fully what we consider as the average level and we believe this implied PER is company’s bleak near-term outlook, and its current undemanding given our EPS CAGR forecast of 25% valuations suggest limited downside. for 2011-13. BEW – Underperform (4) rating and six- GDI – Outperform (2) rating and six- month target price of HK$1.90 month target price of HK$5.35 • Although BEW ranks the highest in terms of top-line • We forecast 88% of GDI’s EBIT for 2012E to be growth potential in our scoreboard for the four highly predictable, supported by its water supply to companies, we are concerned that its demanding 12- Hong Kong under a fixed revenue agreement which month forward PER (at a premium to its historical runs until 2014, and stable rental income from its average multiple since it entered the water industry investment properties. This makes GDI one of the in 2008 and the most expensive among its peers in most defensive utilities companies in our overall China) may have not have factored in fully the utilities universe. investment risks we see for the company. • We forecast a net cash position for GDI at the end of • We are concerned that BEW may sacrifice achieving 2012, giving it the lowest gearing among its global sound project returns for aggressive capacity peers. Using the company’s threshold net gearing expansion, evidenced by its smaller-scale projects ratio of 100%, we calculate that GDI’s net capital obtained in 2011, which have a higher construction available for acquisitions would amount to HK$23bn cost per tonne and a lower IRR compared with at the end of 2012. larger-scaled projects. • GDI’s management intends to use the company’s • Management’s intention to take on more BT projects strong cash position either to carry out acquisitions is also a concern to us, as this would expose the or raise the dividend payout ratio. Following recent company to a substantial risk of project small acquisitions of commercial properties, postponements and delays in collecting accounts management is actively looking at water-supply receivable. projects in Guangdong Province, which could be • Asset injections into BEW by its major shareholder potentially EPS-accretive. Beijing Enterprises’ (BJE) (392 HK, HK$47.4, Outperform [2]), including Beijing’s No. 9 water

- 13 - China Water Sector 15 February 2012

plant, expected by the market in early 2012, will not As for the collection of accounts receivable, the water necessarily be value-accretive, in our view, as the and waste-water treatment tariff is ultimately paid by connected-party transaction requires an arms-length the end users. Local governments merely act as an valuation. agency that collects the bills from the end users and distributes them to the water suppliers and waste- • Our DCF-based six-month target price is HK$1.90. water treatment operators. There may be some risk of We believe BEW’s current valuations are demanding payment delays, but the impairment risk looks rather and recommend switching to CEI, which we believe small. Of the water companies in our universe, we offers stronger earnings-growth prospects over the believe that Hyflux and BEW have the highest risk on next two years and better potential for ROE accounts receivable, given the former’s exposure to the improvement. Middle East and North Africa (MENA) and the latter’s substantial involvement in BT projects.

What has held investors back? Water companies: accounts receivable risks CEI GDI Hyflux BEW Some investors are of the view that water companies in Risky exposure None None MENA projects BT projects Asia ex-Japan are not investable, partly because of Accounts receivable risk Low Low High High their complicated accounting treatment that can be Source: Daiwa difficult to understand. Also, investors are concerned about a potential slowdown in infrastructure 2. Water companies’ financing ability investment and project roll-outs in China, in an Investors’ concerns about China’s credit tightening environment in which local governments have mounting debt and monetary policy is not considered by investors to be loosening enough. We seek to address these concerns in this section. Q: Are the water companies facing 1. Local governments’ mounting debt financing difficulty? What are their Investors’ concerns of local governments’ mounting debt borrowing costs?

Q: As China’s local governments are facing mounting debt and financing difficulty, does it mean that we’ll see declining investment in water projects? Source: Daiwa Will the water companies have difficulty in collecting account receivables from A: The water business is capital-intensive, as the operators usually need to incur large investments local governments? (around Rmb1,000-1,500 per m3/day for a waste- water treatment plant) upfront and receive cash payments through the entire concession period of

Source: Daiwa around 20-30 years. Therefore, financing capability and the ability to manage the costs is essential for the A: In contrast to the perception by some investors, water companies. local governments’ financial difficulties may actually help to boost their investment in water projects, in our As China has carried out credit tightening and new view, as they are likely to turn to the private sector for loans granted declined steadily for the first nine project financing. Local governments are tending to months of 2011, the private water companies award new planned projects to professional water encountered financing difficulties during that period companies in the form of BOT projects, with the water and had to pay a higher interest rate than SOEs did on companies responsible for the project construction and their borrowings. The companies under our coverage incurring the capital investment. Regarding existing did not have major financing issues, since the three projects, local governments are able to ‘sell’ them to the China companies are SOEs, and Hyflux finances mainly private sector in the form of TOT projects and generate in Singapore and enjoys more favourable borrowing a return on their investment through the upfront costs than other domestic companies. Other companies transfer fee that the water operators have to pay. were not so fortunate. Sound Global (SGL) (Not rated) in China faced financing difficulties in 1H11 and had to pay 5-20% above the base interest rate of 7% per

- 14 - China Water Sector 15 February 2012

annum on its debt. Although policy ‘finetuning’ started A: IFRIC 12 ‘Service concession arrangements’ is the in 4Q11, financing continues to be the key accounting standard that governs the revenue differentiating factor among the water companies. recognition for BOT and TOT projects in China’s water industry. This accounting treatment splits the cash- We believe that GDI has the least financing difficulties, flow streams of a project into three types of revenue: as we forecast a net cash position at the end of 2012 1) Construction revenue. This is recognised during and the company has the lowest borrowing cost of 4%, the construction period of the project at the fair followed by Hyflux, BEW and CEI. CEI pays the highest value of the construction services, based on the average interest rate on its borrowings, as it sources construction progress. Accounts receivable are 85% of its capital from Mainland China, whereas the recognised in the balance sheet as financial assets other two China water companies we cover finance instead of fixed assets and the financial assets are mainly from offshore. Based on our forecasts, BEW reduced by deducting future cash payments from it. should have the highest net gearing at the end of 2011E Construction revenue is the major reason for the due to its aggressive capacity expansion. water companies’ lumpy earnings, since it boosts accounting earnings but there is no cash inflow. China/Singapore water companies: degree of financing difficulty 2) Finance income. This is recognised during the Hyflux BEW CEI GDI operation period and can be seen as interest income SOE/private Private SOE SOE SOE Net gearing as at 2011E 7% 74% 46% Net cash on financial assets recognised, based on incremental Singapore Hong Kong Hong Kong borrowing costs. Debt-financing source mainly mainly PRC mainly mainly Interest rate 4-4.5% 4-5% 5.7-5.75% ~4% 3) Operating income. After stripping out: 1) Degree of financing difficulty Low Medium Medium Low construction revenue, and 2) finance income, the Source: Companies, Daiwa forecasts remaining cash payments are recognised as operating income during the operation period. China/Singapore water companies: net gearing and interest rate on borrowings (2011E) Because of the recognition and one-off nature of (%) (%) 5.7% 74.4 construction revenue, the earnings of water companies 80 6 can be quite lumpy on an annual basis. Construction 4-4.5% 4-5% 60 5 services has a low gross margin of around 10-15%, ~4% 46.1 4 while the gross margin for operating services is 40 typically 30-50%, which explains the volatile margins 3 of this business. Also worth noting is that cash outflows 20 7.1 2 for construction are recognised as part of operating cash flow instead of capex, which is why water 0 1 companies tend to have negative operating cash flows -7.5 (20) 0 during their capacity expansion phase. GDI Hyflux CEI BEW

Net gearing (LHS) Interest rate (RHS) Illustration of accounting treatment of concession projects – Source: Companies, Daiwa forecasts IFRIC 12

Build Operate Transfer 3. Accounting treatment results in lumpy (1-2 years) (20-30 years) earnings Impact to Income Statement: Impact to Income Statement: Impact to • Recognise construction • recognise finance income – the interest Income Investors’ concerns about accounting treatment revenue based on construction income on the financial assets realized Statement: progress during construction period • No impact • recognise operating income – stripping Impact to Balance Sheet: out construction revenue and finance Impact to • Account receivable for income, the remaining estimated future Balance Sheet: construction services is cash flow is recognised as operating • The financial Q: The accounting treatment of recognised as financial assets income over the concession period assets should be (instead of fixed assets), usually reduced to zero concession projects (BOT/TOT) seems termed as “gross amount due Impact to Balance Sheet: through the from customers for contract • The financial assets (account concession very incomprehensible. Why are the work” receivable) recognised is reduced period; no more against payments received account earnings of water companies so Impact to Cash Flow receivable Statement: Impact to Cash Flow Statement: lumpy? • Cash outflow for construction • Cash payments for operation services Impact to Cash services is recognised as is recognised as operating cash flow Flow Statement: operating cash flow instead of • No impact capex

Source: IFRIC 12 ‘Service concession arrangements’, Daiwa

Source: Daiwa

- 15 - China Water Sector 15 February 2012

4. BT projects Investors’ concerns about accounting treatment

Q: What risks do BT projects have? Who is most exposed to BT projects?

Source: Daiwa

A: Water companies sometimes build infrastructure projects for local governments through BT projects. We do not like the BT project for the following three reasons: 1) it is one-off in nature and does not bring sustainable and stable cash flows in the way that BOT and TOT projects do, 2) it is a construction service in nature with a gross margin of only 10-15%, substantially below the gross margin that can be achieved by operation services (30-50%), and 3) it has a higher accounts receivable risk compared to BOT and TOT projects, since local governments are required to pay several large lump sums following project completion.

We forecast BEW to have the largest revenue contribution of 44% from BT projects among its peers for 2012E. BEW’s management has expressed an interest in taking more integrated environmental projects on a BT basis, which we expect to dampen BEW’s gross margin and returns over 2012-13. As a reference point, the China Construction Sector is trading currently at an average PER of 7-8x for 2012E (based on the Bloomberg-consensus EPS forecasts), which compares with an average PER of 12.5x for the water companies under our coverage.

China/Singapore water companies: revenue contribution from BT projects (2012E) (%) 50 44.2 45 40 35 30 25 20 15 10 5 1.0 0.0 0.0 0 BEW CEI Hyflux GDI

Source: Daiwa forecasts - 16 - China Water Sector 15 February 2012

has increased more than five-fold to 125mm3 per day in 2010, with the urban-treatment rate rising to 77% from China water industry is entering a only 34% 10 years ago. second growth phase China: length of urban-water pipelines and % of population with access to water It is a common belief among investors that China’s (km) (%) water industry will offer substantial opportunities and 600,000 100 overall growth potential going forward. We do not disagree, but would point out that the industry has 500,000 80 400,000 passed the first growth phase of what we call extensive 60 growth, which relied mainly on infrastructure 300,000 investment, pipelines and treatment-plant construction, 40 200,000 and a rising penetration rate. 20 100,000 We believe that the industry has now entered a 0 0 different growth phase of what we call intensive growth, 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 characterised by the following: 1) high penetration of Length of water pipeline in city (LHS) fresh water access and a high waste-water treatment % of urban population with access to water (RHS) Source: CEIC rate already achieved, 2) infrastructure investment focused on the rehabilitation and upgrading of water China: municipal waste-water treatment ratio pipelines and treatment plants, 3) a slowdown in new 90% 75% 77% project additions, 4) increasing industry consolidation 80% and rising privatisation of water projects due to local 65% 70% 63% governments’ poor operating profitability, 5) rising 56% 60% 52% water tariffs to promote water conservation, and 6) 46% wider application of new technologies such as seawater 50% 40% 42% 34% 36% desalination and water reuse. 40% 30% 32% 24% 26% 30% 20% China water industry: growth phases 20% Extensive growth phase Intensive growth phase 10% 0%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Urban Development Department Key words: Key words: • Construction • Upgrade th th • Penetration • Quality standard Comparing the 11 and 12 Five-year Plans (FYP) (the 12th one is to be released in 1H12) on water and waste- Characteristics: Characteristics: • High government involvement • Rising privatization of projects water development, we can see a change in focus from • Large capex • Capex focused on pipeline quantity to quality. The key words have switched from • Fast additions of projects rehabilitation and upgrade • Fast rising penetration • Slowdown of project additions construction and penetration to upgrade and quality • Low water tariff • Penetration rate already high • Increase in water tariff standards. Note that half of the investment of Growth drivers: Rmb112m for waste-water treatment is to upgrade • Large fixed investment Growth drivers: • New additions of projects • Rising privatization of projects existing plants and the rest is to build new ones. • Fast rising penetration • Water tariff increase • Future water revolution: water reuse Key achievements: and seawater desalination Treatment capacity growth is set to slow from a five- • Water access rate: 72% by 2001 to 97% by 2010 year CAGR of 17% over 2006-10 to 6% over 2011-15, • Urban wastewater treatment rate: according to the 12th Five Year Plan. Special emphasis 36% by 2001 to 77% by 2010 is given to downstream parts of the value chain and Source: Daiwa also relatively high-tech areas such as sludge treatment

and water reuse, the latter alone will see double the Extensive growth phase has passed amount of investment and the water-reuse rate is China has made great achievements in terms of its targeted to reach around 15% by 2015, from a mere water-infrastructure development and services 8.5% by 2010 according to the Five Year Plan. penetration rate over the past decade, with the length of urban water pipelines more than doubling and the water-access rate increasing from 72% in 2001 to 97% in 2010. The country’s waste-water treatment capacity

- 17 - China Water Sector 15 February 2012

China: 11th and 12th Five Year Plan on urban waste-water- What are the future business-growth treatment development drivers? (Rmb bn) 500 Total: Now that the growth in the number of water- Rmb421bn infrastructure construction projects and new-project 400 Total: Rmb332bn +27% 34 31 additions are slowing, what will be the key business- 10 300 32 112 growth drivers in the intensive growth phase? 81 1) Water-tariff increases will be a crucial way for the 200 PRC Government to promote water conservation, 243 100 209 2) Increasing merger and acquisition; companies will 0 add new projects in the form of the transfer, operate, 11th FYP 12th FYP estimate transfer (TOT) model and M&A activities, Pipeline network Wastewater treatment Sludge treatment Water reuse 3) Water reuse and seawater desalination; important Source: NDRC, Daiwa estimates solutions to water scarcity and a high technology threshold enables supreme returns. China: urban waste-water-treatment capacity and rate (mn m3 per day) CAGR: 6% 180 167 90% Water is underpriced in China 160 125 85% 80% 140 It has been long argued by industry experts as to 120 CAGR: 17% 77% 70% 100 whether water should be treated as an economic 80 commodity and priced according to demand and 57 60% 60 supply equilibrium. China has seen several stages of 40 water-tariff charging mechanisms: free water supply 52% 50% 20 during 1949-64, low water tariff during 1965-84, 0 40% partial cost-recovery during 1985-96, and full-cost 2005 2010 2015E recovery since 1997. Treatment capacity (LHS) Treatment rate (RHS) Source: Ministry of Housing and Urban-Rural Development of China, State Council The current water tariff is regulated by the National Guidelines on Water Tariff published in 1998, with the The slowdown in new treatment capacity additions is guideline indicating that the water tariff is set and evidenced by the quarterly capacity under construction, approved by local governments, based on a local which has continuously declined since the peak in hearing mechanism. The water tariff should cover 4Q09. operational and maintenance costs, depreciation and the financing costs of the water supply operators, and China: quarterly waste water-treatment capacity under allows for a reasonable return or ROE of 8-10% per construction (1Q08-2Q11) year. (mn m3/day) 70 The integrated tap-water tariff is made up of three 60 components: a water resources fee, tap-water supply tariff, and waste-water treatment tariff, which is 50 collected all together by the tap-water supply operators. 40 Raw water distributors and waste-water treatment 30 operators are paid by the local governments accordingly. 20

10

0 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 Source: Ministry of Housing and Urban-Rural Development of China

- 18 - China Water Sector 15 February 2012

China: tap-water tariff regulation and pricing principles Average water bills as a % of net disposable income (2009)

Integrated tap water tariff 12%

10%

Water resources fee Tap water supply tariff Wastewater treatment tariff 8%

• Regulated by “Regulation on • Regulated by “National • Regulated by “Prevention and the Administration of the Guidelines on Water Tariff (?? Control of Water Pollution (?? 6% License for Water Drawing and ????????)” ????)” published in 1996 the Levy of Water Resource implemented since 1998 • Wastewater treatment tariff is 4% Fees (??????????? • Tap water tariff is set and set by local governments ????)” published in 2006 approved by local governments • Wastewater treatment tariff • Should reflect the opportunity • Water tariff raise needs to be should cover operating and 2% cost and scarcity of water go through local hearings maintenance cost, depreciation resources in the region • Water tariff should cover and financing cost 0% y y operating and maintenance • The State Council issued g an ium p

cost, depreciation and financing guideline for wastewater tariff of Italy g ublic ublic Spain China Korea Ja p p

cost no less than Rmb0.8/tonne in Turke France Austria Poland Mexico Iceland Greece Finland Norwa Canada Bel Sweden Portugal Hungary Australia Denmark

• Water tariff should allow a 2007 Germany Singapore

reasonable return (ROE of 8- Switzerland Netherlands Luxembour New ZealandNew 10%) for water supply operators United States Czech Re United Kingdom

• Promote progressive water Slovak Re tariff mechanism Percentage of water bills as net disposable income Average

Source: Daiwa Source: OECD – Managing Water for All, Daiwa Note: Net disposable income for OECD countries is at the lowest deciles of the population Water tariffs have trended up … The water tariff has been on an upward trend over the Government policy supports continuous past decade to better reflect the increasing scarcity of water-tariff growth water resources and water supply and waste-water We believe that increasing water tariffs is a crucial way treatment operators’ increasing operating costs. The to promote water conservation and reduce water average integrated residential water tariff of the 31 consumption per capita for countries with serious provincial capitals (municipalities) increased from water scarcity problems like China. Rmb2.27/tonne in 2007 to Rmb2.71/tonne in 2011, implying a four-year CAGR of 4.5%. The waste-water The Chinese Academy of Sciences published a treatment tariff for the 31 cities increased to sustainable development report in 2006 and set the Rmb0.78/tonne in 2011, implying a CAGR of 5.6%. target of reducing water consumption per capita of Cities with higher disposable income per capita and GDP by 80% by 2020. At the 6th China International those hit with more serious water scarcity tend to raise Water Business Summit (CIWBS) held on 13 October their water tariffs more aggressively than others. 2011 in Beijing, an official from the National Development and Reform Commission’s (NDRC) Price China: average residential water tariffs of provincial capitals Department expressed the government’s determination (Rmb per ton) to promote water-tariff reform in order to better reflect 3.0 4-year CAGR: 4.5% the scarcity of water resources in different regions, improve water-consumption efficiency, and promote 2.5 the sustainable development of water resources. These 2.0 policies and targets all point to further water-tariff 1.5 growth as well as the implementation of a progressive water-tariff mechanism. 1.0

0.5 A water expert from the Chinese Academy of 0.0 Engineering spoke at the 4th CIWBS and pointed out 2007 2008 2009 2010 2011 that the current level of the average water bill’s share of Water tariff Wastewater treatment tariff Integrated water tariff households’ net disposable income of 0.8% is too low to Source: H2O-China, Daiwa enhance water-consumption efficiency. He believes that only when the percentage level goes up to 2% will After a decade of water tariff increases, China’s water people start to take action to save water. This is tariff as a percentage of net disposable income (0.8%) is evidenced by the cases of South Korea and Denmark. still far lower than the global average. We believe that the government is keen to support rising water tariffs to South Korea’s average water bill accounts for 1.1% of promote water conservation, which is a crucial way to net disposable income; Koreans consume more than combat the prevailing water scarcity, not to mention the twice the world average (Korea: per capita residential loss-making status of 38% of the water suppliers and water consumption of 373 litres/day compared with 25% of the waste-water treatment operators in 2010, the world average of 174 litres/day). On the contrary, according to National Bureau of Statistics. by raising water bills to 3% of net disposable income,

- 19 - China Water Sector 15 February 2012

Denmark – another country with a water shortage – which started in 2002 and 2003, aim to solve water has successfully reduced per capita daily water scarcity in northern China including Beijing, Tianjin, consumption to 107 litres. Hebei, and Shandong.

China: thirsty for water The western line, however, was delayed due to Much has been said and written on China’s increasing technical difficulties and is still undergoing a feasibility water shortage and we emphasise how critical this study for now. In total, the project is designed to divert 3 water shortage is. China accounts for 15% of the world’s 44.8bn m per year from the Yangtze River Basin to fresh water demand, but has around only 7% of global northwest and northern China, with an estimated water resources. China’s water resource per capita was investment of around Rmb656bn, according to the 2,125m3 per person per year in 2009, only about one- Ministry of Water Resources. quarter of the global average for that year. China: fresh-water resources per capita and South-to-North Water Diversion Project Global fresh water resources per capita (2009) (Cubic meter per person per year)

100,000 Heilongjiang 90,000 80,000 Central Route 70,000 Jilin

60,000 Liaoning 50,000 Xinjiang Inner Mongolia Beijing 40,000 Gansu Tianjin

30,000 Shanxi Hebei 20,000 Ningxia Qinghai Shandong Eastern Route 10,000 Yellow River Shaanxi Henan 0 Jiangsu Shanghai Tibet (Xizang) Han River Hubei Anhui

Italy Sichuan Yangtze River India Brazil Egypt China Japan Ya-lung River Zhejiang Russia Ireland France Austria Canada

Australia Jiangxi Malaysia Germany Argentina

Singapore Hunan Fujian Guizhou New ZealandNew United States Taiwan United Kingdom Guangdong Yunan Water Resources per capita 2009 (cubic meters) Western Route Guangxi Hong Kong 1 – 500

United Arab Emirates 500 – 1,500 Macau 1,500 – 3,000 3,000 – 5,000 Source: World Resources Institute > 5,000 Hainan Source: China Statistics Year Book 2010, NDRC, Daiwa The problem is especially worrying as China is suffering from a regional water scarcity in the north Summary of South-to-North Water Diversion Project (north of the Yangtze River), which is home to 44% of Route Phase Construction period Static investment (Rmb bn) Current status the country’s population but accounts for only 14% of Central I 2003 - 2014 92.0 In process II 2014 - 2030 83.0 Preparatory the country’s total water resources. According to Eastern I 2002 - 2013 32.0 In process international standards, eight provinces II 2013 - 2016 22.4 Preparatory /municipalities/autonomous regions, including Beijing, III 2016 - 2021 11.6 Preparatory Tianjin, Hebei, Shandong, Henan, Shanxi, Liaoning Western I 2010 - 2020 46.9 Delayed II 2020 - 2030 64.1 Delayed and Ningxia are classified as having extremely scarce III 2030 - 2050 304.0 Delayed 3 fresh-water resources of less than 500m per capita. Source: NDRC, Daiwa

Agriculture, the largest water-consumption group, Nearly 40% of the water suppliers are accounts for around 70% of total water consumption losing money and China’s long-insisted policy of grain self- sufficiency has led to the over-extraction of The National Guidelines on Water Tariff published in underground water in northern China, which produces 1998 set out the principle that the water tariff should half of the country’s wheat. Unlike other resources such cover fully the operation and maintenance costs, as oil that can be sourced from other parts of the world, depreciation and financing costs of the water supply the water problem cannot be solved through operators, and allows for a reasonable return or ROE of international trade. 8-10% per year. The actual situation, however, is that 38% and 25%, respectively, of tap-water supply and The giant South-to-North Water Diversion Project was waste-water treatment enterprises across the country planned and implemented with the aim of solving the were losing money in 2010, according to National regional water scarcity problem in China. The project Bureau of Statistics. includes three lines, ie, eastern, central, and western routes. The eastern and central routes, construction of

- 20 - China Water Sector 15 February 2012

The water operators’ poor profitability in past years has China: residential waste-water treatment tariff of provincial significantly restricted their ability to invest in capital cities (2011) equipment upgrades and pipeline rehabilitation, which (Rmb per cubic meter) counteracts the government’s intention of improving 1.4 water-treatment processes and upgrading tap-water 1.2 quality. The Standards for Drinking Water Quality 1.0 Rmb0.8 per cm published in 2006 by the Ministry of Health increased 0.8 the number of testing standards from 35 to 106. 0.6

0.4 However, half of the 4,000 tap-water suppliers do not monitor their water quality at all. Around 20-30% of 0.2 0.0 g g them monitor only six regular water-quality standards g i g q in in hai j j sha g Xi'an zhou zhou g chun Hefei and only less than a dozen actual test the full list of 106 Jinan g huang g g Xining Harbin Tianjin Bei Haikou Wuhan Hohhot Fuzhou Nan Urum Taiyuan Guiyang Nannin Chongqi Lanzhou Kunming Chengdu Yinchuan Shan Shenyang Han Chan criteria, according to the head of the Water Study Nanchan Zhengzhou Chan Guan Centre of Tsinghua University. Thus, maintaining the Shijiaz current low water tariffs is jeopardising tap-water Residential wastewater treatment tariff Tariff suggested by State Council quality and, more seriously, end user utilities. Source: H2O-China, Daiwa

China: number of loss-making tap-water supply enterprises Over the past two years, we have seen more frequent 2,500 60% water-tariff increases across the country. Tianjin, which has the highest water tariff in the country, 50% 2,000 48% 50% 40% further raised its residential and non-residential water 38% 39% 3 3 3 38% 40% tariff by Rmb0.5/m and Rmb0.35/m to Rmb4.9/m 1,500 3 30% and Rmb7.5/m , respectively, effective from 1 1,000 November 2011. The tariff raise is mainly targeted to 20% relieve the region’s extreme water scarcity problem and 500 10% solve the local waste-water treatment operators’ loss- making conditions. We expect more cities to raise their 0 0% 2005 2006 2007 2008 2009 2010 water tariffs over the next few years. No. of enterprises (LHS) No. of loss-making enterprises (LHS) % of loss-making enterprises (RHS) Who will benefit the most from a potential Source: CEIC water-tariff increase in the short term? We expect the integrated water tariff and waste-water China: number of loss-making waste-water treatment treatment tariff to continue to rise over the next five enterprises years across China. Generally, provinces/regions that 350 40% 34% 36% are wealthy (water bills account for a low percentage of 35% 300 total net disposable income) but also suffer from severe 28% 30% 250 27% 24% 24% 25% water shortages are likely to see more aggressive water- 25% 200 tariff increases. 23% 20% 150 15% Taking into consideration the local governments’ 100 10% attitudes towards raising water tariffs and 50 5% implementing progressive tariffs, we believe there are 0 0% 12 provinces/areas that are most likely to raise their 2003 2004 2005 2006 2007 2008 2009 2010 water tariffs in the near term, namely Beijing, Liaoning, No. of enterprises No. of loss-making enterprises Jilin, Shanxi, Shaanxi, Henan, Jiangsu, Anhui, Hubei, % of loss-making enterprises Hunan, Guangdong and Hainan. Source: CEIC

As with the tap-water tariff, the waste-water treatment tariff should be set to cover the operators’ operation and maintenance costs, depreciation and finance costs, and allow for a reasonable return. The State Council suggested that the waste-water treatment tariff should not be less than Rmb0.8/m3 in 2007. However, the tariff for 14 provincial capitals is still below the guidelines as at the beginning of February 2012.

- 21 - China Water Sector 15 February 2012

China: residential tap-water and waste-water treatment tariff of China: residential water tariff of provincial capitals and the provincial capitals (2011) geographical project allocation of water companies (2010) Residential waste Possibility Residential tap water treatment tariff % of water of raising water tariff (2011) (2011) bill of net water Heilongjiang Rmb/ disposable tariff in City Province tonne 4-yr CAGR Rmb/tonne 4-yr CAGR income near term

Tianjin Tianjin 4.40 7% 0.90 3% 0.9% Medium Jilin Beijing Beijing 4.00 2% 1.04 4% 0.9% High Inner Mongolia Chongqing Chongqing 3.70 7% 1.00 9% 1.1% Low Liaoning Xinjiang Jinan Shandong 3.50 1% 0.90 6% 0.8% Medium Beijing Hebei Tianjin Kunming Yunnan 3.45 2% 1.00 7% 1.1% Medium Shanxi

Shijiazhuang Hebei 3.30 6% 0.80 7% 0.9% Medium Shandong Ningxia Shaanxi Harbin Heilongjiang 3.20 9% 0.80 12% 1.0% Low Qinghai Gansu Hohhot Inner Mongolia 3.00 6% 0.65 10% 0.5% Low Henan Jiangsu Anhui Shanghai Shanghai 2.93 11% 1.30 10% 0.6% Low Tibet (Xizang) Shanghai Hubei Zhejiang Xi'an Shaanxi 2.90 0% 0.65 0% 1.1% High Sichuan Jiangxi Changchun Jilin 2.90 0% 0.40 0% 0.8% High Hunan Guizhou Fujian Taiyuan Shanxi 2.90 5% 0.50 19% 0.7% High Water resources per capita 2009 Chengdu Sichuan 2.85 7% 0.90 3% 1.3% Low (cubic meter) Yunan 1-500 BEW Guangxi Taiwan Nanjing Jiangsu 2.80 6% 1.30 4% 1.0% High 500 – 1,500 Hyflux Guangdong Guiyang Guizhou 2.70 9% 0.70 0% 0.9% Low 1,500 – 3,000 CEI Hong Kong Fuzhou Fujian 2.55 6% 0.85 0% 0.8% Low 3,000 – 5,000 GDI >5,000 Yinchuan Ningxia 2.50 13% 0.70 15% 1.1% Low Provinces most likely to Hainan raise tariff in near-term Haikou Hainan 2.40 3% 0.80 7% 1.5% High Source: China Statistical Yearbook 2010, Companies, Daiwa Shenyang Liaoning 2.40 3% 0.60 5% 0.6% High Hefei Anhui 2.31 6% 0.76 10% 0.9% High Nanning Guangxi 2.28 10% 0.80 12% 1.2% Medium Lanzhou Gansu 2.25 6% 0.50 14% 1.0% Medium Increasing merger and Zhengzhou Henan 2.25 0% 0.65 0% 0.6% High Guangzhou Guangdong 2.22 3% 0.90 9% 0.8% High acquisition Urumqi Xinjiang 2.06 0% 0.70 0% 0.8% Low Nanchang Jiangxi 1.98 9% 0.80 12% 0.9% Medium Wuhan Hubei 1.90 0% 0.80 0% 0.9% High Water services, including water supply, sanitation, Changsha Hunan 1.86 0% 0.65 0% 0.9% High waste-water treatment and water-pipeline construction, Hangzhou Zhejiang 1.85 0% 0.50 0% 0.5% Medium Xining Qinghai 1.82 0% 0.52 0% 0.9% Low were long provided by the public sector as key public Average 2.71 5% 0.78 6% 0.9% utilities services, and their privatisation has been Source: H2O-China, Daiwa controversial. England and France were among the first countries to promote water privatisation as the public Based on the water companies’ water and waste-water sector proved unable to expand investment in treatment capacity exposure to the 12 provinces/areas infrastructure and improve operational efficiency and in China likely to increase tariffs, we expect Hyflux to service quality. be the biggest beneficiary thanks to its 26% capacity exposure in Jiangsu Province, followed by BEW, GDI Globally, around 2% of the urban population is served and CEI. by privately-owned utilities, essentially in England and Wales, Chile and parts of the US. Another estimated Provinces and players to benefit from potential water-tariff 6% is served by utilities that are privately managed but increase in near term publicly owned in about 40 countries, such as parts of % of total water and waste-water treatment capacity Hyflux BEW GDI CEI France, China, Saudi Arabia, Spain, the Philippines and Beijing 0 1 0 0 Indonesia. Shaanxi 0 0 0 0 Jilin 0 0 0 0 Global water privatisation models Shanxi 0 0 0 0 Privatisation model Country Jiangsu 26 1 0 12 Local government sells the ownership of water service utilities to private sector UK Hainan 0 4 0 0 Local government leases the operational rights of water services to private sector France Liaoning 8 11 0 0 Private sector manages water services for local government and charges Anhui 4 0 0 0 management fee n.a. Henan 2 0 0 0 Source: Company data, Daiwa Guangdong 0 21 22 0 Hubei 0 0 0 0 Hunan 3 6 0 0 China’s water-privatisation journey started in the early Total 43 42 22 12 1990s, when foreign capital began to seek Source: Companies, Daiwa forecasts opportunities in the huge market. One of the pioneers, Suez Environment (Not rated), established a joint venture, Sino French Water (Not listed), and entered China’s water market in 1992. The privatisation progress was accelerated when the PRC Government

- 22 - China Water Sector 15 February 2012

officially opened water services to the market with the privatisation to continue, providing business-growth publication of Opinions on Accelerating the opportunities for the water companies under our Marketization of Municipal Utilities in 2002. The coverage. Ministry of Construction further published Administrative Measures for the Concession of China: number of waste-water treatment plants and % that are Municipal Public Utilities and introduced BOT and privately run TOT business models to the water market. (unit) 3,500 70% 2,996 The big hand that has been and will continue to push 3,000 65% water privatisation and consolidation comes from the 2,500 60% 1,821 55% nature of the industry: 1) natural monopoly relying on 2,000 1,321 50% 1,500 economies of scale, 2) capital intensive, and 3) 49% 45% 45% governments’ lack of capital and incentives to invest in 1,000 40% 41% infrastructure and improve service quality. 500 35% 0 30% Public-water services: deemed to fail 2008 2009 2010 Water services, as a capital-intensive business, need No. of wastewater treatment plants (LHS) % of private operation (RHS) large amounts of investment in infrastructure including Source: H2O-China, Daiwa water-pipeline construction, rehabilitation and equipment installing. Local governments, because of China: waste-water treatment plants operated by public and their non-profit-making nature, do not have the private sectors capability and incentives to invest and improve their 100% 7% 8% 8% operational efficiency, not to mention their mounting 90% 3% 3% 3% 5% 5% 5% debt and a lack of financing channels in the capital 80% 26% market. 70% 29% 33% 60% China: local government debt 50% (Rmb bn) 40% 30% 59% 55% 12,000 10,717 51% 20% 10,000 9,017 10% 0% 8,000 2008 2009 2010 5,569 Local government BOT TOT BT Management consignment 6,000 4,510 Source: H2O-China, Daiwa 4,000

2,000

0 2007 2008 2009 2010 Source: CEIC

Private sector water projects increasing More water projects, especially waste-water treatment projects, have been brought to the market for public tender over the past five years because of the public utilities companies’ failure to provide efficient and quality services. The total number of waste-water treatment plants more than doubled from 1,321 in 2008 to 2,996 in 2010, with the private sector taking a bigger share, from 41% to 49%, respectively.

Plants operated under the BOT model nearly tripled from 342 to 984 over the same period, with the percentage rising from 26% to 33%. Nonetheless, most of the provincial capitals’ water projects are still in the hands of the local governments. We expect this

- 23 - China Water Sector 15 February 2012

China: key city water projects and their existing operators China: top-20 water and waste-water treatment companies Waste-water treatment (2010) Province City Water supply operators operators Treatment Market Anhui Hefei Local gov. Local gov. capacity Share Local gov., Capital Water, Rank Company Stock ticker (m tonnes/day) (%) Beijing Beijing Local gov. Veolia, Sound Group 1 Veolia VIE FP 14.6 3.6 Local gov., Sino French Water, 2 Beijing Capital 600008 CH 12.3 3.1 Chongqi Chongqi China Water Affairs Local gov., Sino French Water 3 Shenzhen Water Group Not listed 9.8 2.4 Fujian Fuzhou Local gov. Local gov., BEW 4 Beijing Enterprises Water 371 HK 7.5 1.9 Gansu Lanzhou Local gov., Veolia Local gov. 5 Sino French Water (JV of Suez Environment) Not listed 6.5 1.6 Guangdong Guangzhou Local gov. Local gov., Goldtrust Water 6 General Water of China Not listed 4.3 1.1 Guangxi Nanning Local gov. Local gov. 7 Tianjin Capital Environmental 1065 HK 3.8 1.0 Guizhou Guiyang Local gov., BEW Local gov., BEW, Tianjin Capital 8 Sound Group Not listed 3.6 0.9 Hainan Haikou Local gov. Local gov. 9 China Water Affairs Group 855 HK 3.3 0.8 Hebei Shijiazhuang Local gov. Local gov. 10 Shanghai Chengtou Not listed 3.3 0.8 Heilongjiang Harbin Local gov. Local gov. 11 Chongqing Water 601158 CH 3.0 0.8 Henan Zhengzhou Local gov., Sino French Water Local gov. 12 Tsinghua Tongfang 600100 CH 3.0 0.7 Hubei Wuhan Local gov. Local gov. 13 Chengdu Xingrong 000598 CH 2.7 0.7 Hunan Changsha Local gov. Local gov., Sound Global, BEW 14 Goldtrust Water Group Not listed 2.7 0.7 Inner Local gov., Veolia, Beijing 15 Asia Environment AENV SP 2.5 0.6 Mongolia Hohhot Local gov., Veolia Capital, BEW 16 Zhongshan Public Utilities 000685 CH 2.4 0.6 Jiangsu Nanjing Local gov. Local gov. 17 China Water Investment Not listed 2.4 0.6 Local gov., Sound Global, Asia 18 Berlinwasser China Not listed 2.2 0.5 Jiangxi Nanchang Local gov. Environment 19 China Water Industry Group 1129 HK 2.1 0.5 Jilin Changchun Local gov. Local gov. 20 China Everbright Int'l 257 HK 2.0 0.5 Liaoning Shenyang Local gov. Local gov. Top 20 94.0 23 Ningxia Yinchuan Local gov. Local gov. Source: H2O-China, companies, Daiwa Qinghai Xining Local gov. Local gov., Asia Environment Shaanxi Xi'an Local gov. Local gov., Sound Global Local gov., China Water Industry Who will be the consolidators? Shandong Jinan Local gov. Group, CEI Local gov., Veolia, China We believe companies that have an SOE background, Shanghai Shanghai Water Investment Local gov., Shanghai Chengtou strong cash position, access to cheap financing Shanxi Taiyuan Local gov. Local gov., Beijing Capital channels, strong synergies with existing businesses, Sichuan Chengdu Local gov., Veolia Local gov., Chengdu Xingrong and operating experience are likely to be the Local gov., Veolia, Sino Frech Local gov., Veolia, Tianjin Tianjin Tianjin Water Capital beneficiaries of future industry consolidation. Tibet Lhasa Local gov. Local gov. Xinjiang Urumqi Local gov. Local gov. Examining the companies under our coverage, Hyflux Yunnan Kunming Local gov., Veolia Local gov. and BEW stand out, as both have a solid track record in Zhejiang Hangzhou Local gov., Qianjiang Water Local gov., Tianjin Capital the water and waste-water treatment business and can Source: Companies, various news reports, Daiwa enjoy cheap capital from Singapore and Hong Kong. From fragmentation to consolidation Although GDI does not have experience in water treatment, we believe its SOE background and strong China’s water industry remains very fragmented. The balance sheet will enable it to benefit from the M&A top-10 players accounted for only 17% of the total tide. market share in terms of water and waste-water treatment capacity in 2010. We believe consolidation is Water companies: possibility of M&A activities in future on the way since the water industry has all the Hyflux BEW CEI GDI characteristics of a natural monopoly. This should SOE/private Private SOE SOE SOE encourage economies of scale, while small enterprises Net gearing end-2011E 7% 74% 46% Net cash without capital strength and access to cheap financing Debt-financing source Singapore mainly Hong Kong mainly PRC mainly Hong Kong mainly Interest rate 3-4% 3-5% 5.7-5.75% 3-4% channels will be phased out over the next few years. Financial position Strong Medium Medium Strong Synergy with existing business and operating experience High High High Medium Benefit from M&A? Medium High Medium High Source: Companies, Daiwa forecasts

- 24 - China Water Sector 15 February 2012

China: seawater desalination capacity The future water revolution ('000 m3 per day) 2,000 1,500-2,000 We expect seawater desalination and water reuse to be 5-year CAGR: China’s future water revolution, as these are the few 1,500 19-26% methods used to actually increase the water supply, which is of strategic importance to a water-scarce country like China. 1,000 640 China: three ways to increase regional water supply: South-to- 500 North Water Diversion project, seawater desalination and water reuse 0 2010 2015E

Heilongjiang Source: China Desalination Association

Jilin The major seawater desalination technologies include Liaoning

Xinjiang reverse osmosis (RO), multi-stage flash distillation Inner Mongolia Beijing Gansu Tianjin (MSF), and multi-effect distillation (MED), with RO Shanxi Hebei Ningxia the most prevailing around the world, thanks to its Qinghai Shandong Yellow River

Shaanxi Henan comparatively less need for power consumption, which Jiangsu Shanghai Tibet (Xizang) Han River Hubei Anhui is the major production cost. Seawater desalination is Sichuan Yangtze River Ya-lung River Zhejiang energy-intensive and around one-third of the Jiangxi Hunan Fujian Guizhou production cost comes from power consumption. RO Seawater desalination Taiwan Guangdong Yunan Water reuse accounts for over 60% of global total installed capacity Guangxi Hong Kong Water Resources per capita 2009 (cubic mete rs) 3 Macau 1 – 500 of over 60m m per day. 500 – 1,500 1,500 – 3,000 Hainan 3,000 – 5,000 > 5,000 China: seawater desalination capacity Source: China Statistical Yearbook 2010, NDRC, Daiwa Hybrid Other 0.7% 4.2% Seawater desalination: wider application MED driven by declining costs 8.3% China has an aggressive plan for seawater desalination capacity to be tripled over the next five years, reaching 1.5-2m m3 per day by 2015 and 2.5-3m m3 per day by MSF 25.7% 2020. The total investment will amount to Rmb20bn RO over the 12th Five Year Plan period, up by around 150% 61.1% from that over the past five years, according to estimates from the China Desalination Association.

We expect future desalination projects to be focused in Source: China Desalination Association six coastal provinces/municipalities, namely Liaoning, Hebei, Tianjin, Shandong, Zhejiang and Fujian. Beijing The key bottleneck that restricts seawater desalination has also strategically included seawater desalination in to be widely used is its high production cost. Over the its fresh-water supply reserves and may accelerate its years, however, technology advancement has driven development if needed. the cost down to around Rmb4-5/tonne from Rmb10/tonne in the 1990s. This is far more economic than the South-to-North Water Diversion project, which has an average cost of over Rmb10/tonne (to Beijing). The fresh water generated from desalination plants is now mostly consumed by industrial users and is not connected to the municipal water supply network to residents in China.

The industrial water tariff in some of the coastal cities is suffering from a water shortage. For example, that in Beijing and Tianjin (Beijing: Rmb6.21/tonne; Tianjin: Rmb7.5/tonne) is already above desalination - 25 - China Water Sector 15 February 2012

production cost, which makes the desalination plants this lucrative market. Its first project, the Caofeidian more than break even. We expect desalination costs to desalination plant, commenced operation in October be brought down further to around Rmb3/tonne by 2011, and could provide as much as 50,000 tonnes/day 2015 as energy is better utilised (eg, utilise off-peak of fresh water to the industrial zone in Heibei. power and introduce more efficient energy-recycling facility) and it may not be long before residents can use Top-20 membrane desalination plant suppliers by contracted desalinated water without tariffs being raised. capacity (2000-09) (million m3 per day) China: seawater desalination production cost vs. residential 3.5 and industrial water price 3.0 2.5 (Rmb/ton) 2.0 12 10.0 1.5 10 7.0 1.0 8 0.5 5.0 6 5.3 0.0 4.6

4 IDE 3.8 ACS

3.6 Inima Sadyt Veolia Hyflux Wetco Wabag Aqualia 2.6 3.1 Doosan 2 2.5 3.0 Cadagua GE Water Degremont

1.5 Kurita Water Mitsubishi HI Befesa Agua Befesa

0 Acciona Agua Biwater AEWT Biwater 2000 2005 2010 2015E H2O Innovation Desalination production cost Nomura Micro Science Residential water price Industrial water price Source: Company

Source: H2O-China, China Desalination Association, various press reports Note: Residential and industrial water price presented includes coastal provincial capitals Water companies: position in future seawater desalination in water shortage: Beijing, Tianjin, Shijiazhuang, Jinan, Shenyang, Hangzhou and Fuzhou development Hyflux BEW CEI GDI Unsurprisingly, countries that are the most water- Technology and track record High Medium Low Low Political relationship Medium High Medium Medium scarce have the largest seawater desalination capacity. Project geographical location High High High Low The top-10 countries in terms of installed capacity are Benefit from desalination development High High Low Low Saudi Arabia, United Arab Emirates, Spain, US, China, Source: Daiwa Algeria, Australia, Qatar, India and Israel. Water reuse: an economic way to increase Total contracted seawater desalination capacity by country the water supply (2009) ('000 m3/day) As with glass bottles and newspapers, water can be also 4,500 recycled and reused. Treated waste water can be reused 4,000 for agricultural and landscape irrigation, industrial 3,500 processes, toilet flushing, replenishing ground water 3,000 basin, and even drinking purposes. Unlike seawater 2,500 desalination, which is only feasible along the coastline, 2,000 water reuse is a crucial way to increase local water 1,500 1,000 supply. Assuming that 80% of the total water supply 500 turns to waste water, 70% of which is then recycled and 0 reused, the reuse of waste water can increase the

US useable water volume by over 50%. It also makes UAE India Israel Qatar Spain China Saudi Arabia Algeria economic sense. Australia

Source: International Desalination Association The key process of water reuse is to add a disinfection Hyflux, as the No. 6 engineering, procurement, step following waste water treatment, which leads to an construction (EPC) contractor and the No. 2 build, incremental cost of around Rmb0.5/tonne in addition operate, own (BOO)/BOT operator in the RO seawater to the waste water treatment cost of Rmb0.7/tonne. desalination field worldwide, has an undoubted Reused water is mostly sold directly by water operators advantage in technology knowhow and project track to industrial users, such as power plants, which find it record, and thus has a better chance of winning in any more economical to purchase reused water at around upcoming desalination projects in China, in our view. Rmb2.5/tonne than tap water at around Rmb3.7/tonne (average of capital cities). Of course, the price of reused BEW, partnered with Norwegian desalination designer water varies depending on the quality and usage. and contractor Aqualyng (Not listed), has also entered - 26 - China Water Sector 15 February 2012

China: price and cost of reused water Water companies: China waste-water treatment operation (Rmb/ton) revenue as % of total revenue (2012E) 4.0 (%) Additional cost for 3.5 water reuse 25 3.0 Wastewater 19.3 treatment cost 20 2.5 2.0 15 13.6 3.7 1.5 0.5 10 1.0 2.0 6.7

0.5 1.0 5 0.0 0.0 Water reuse cost Industrial reuse water tariff Industrial tap water tariff 0

BEW CEI Hyflux GDI Source: H2O-China, various press reports, Daiwa Source: Daiwa forecasts China has realised the strategic importance of water reuse and plans to more than double the investment over the 12th Five Year Plan period compared with the Returns and cash flow matter previous five years, with the water reuse rate targeted to reach more than 10% by 2015 from a mere 5.6% by We believe that a large part of the value is created 2010. through improving ROE and free cash flow for utilities companies. Looking at ROE, CEI stands out, with its China: total investment in water reuse ROE likely to improve from 12% for 2010 to 16% for (Rmb bn) 2013E. Hyflux has the most disappointing downward 25 23 trend, with its ROE likely to decline from 20% to 10% over the same period, due mainly to narrowing margins 20 +121% and lower asset turnover. GDI generates a stable ROE given its defensive business nature, and BEW should 15 see a slight decline in its ROE over the period to 2013E. 10 10 Water companies: ROE (2008-13E) (%) 5 25

0 20 11th FYP 12th FYP estimate

Source: NDRC, Daiwa forecasts 15

10 We believe local governments are likely to grant water reuse projects to existing waste-water treatment 5 operators instead of through new tenders due to 0 process efficiency and optimisation. As we believe that 2008 2009 2010 2011E 2012E 2013E water reuse should be a nationwide effort with some CEI GDI Hyflux BEW regions taking action earlier than others, geographical allocation of projects would not make much difference. Source: Companies, Daiwa forecasts Therefore, water companies that have the largest exposure to waste water treatment would benefit the most. We estimate that BEW will have the highest percentage of revenue from waste water treatment operations, followed by CEI, Hyflux and GDI.

- 27 - China Water Sector 15 February 2012

Water companies: DuPont analysis of water companies’ ROE has been positive since 2009. BEW’s lumpy operating 2008 2009 2010 2011E 2012E 2013E cash flow is due mainly to its heavy reliance on BT ROE (%) projects, which require substantial working capital, and CEI 12.9 10.1 12.4 13.4 15.7 16.2 GDI 12.8 12.6 13.4 13.0 13.3 13.2 is one of our major concerns on this stock. Hyflux 22.0 22.6 20.4 6.6 10.1 10.1 BEW 3.5 8.8 15.7 13.3 13.6 14.4 Water companies: operating cash flow (2008-13E) Net margin (%) (HK$m) CEI 18.2 21.1 21.0 18.7 21.3 29.0 6,000 Operating cash flow turns GDI 28.3 31.7 33.6 37.6 38.5 39.3 positive in 2012 Hyflux 10.7 14.3 15.5 10.6 12.9 15.3 4,000 BEW 9.2 11.1 8.1 14.6 13.6 14.8 2,000 Asset turnover (%) CEI 34.4 23.6 30.0 33.9 34.1 27.0 0 GDI 19.2 19.1 20.3 20.8 21.5 22.2 Hyflux 78.6 54.7 46.8 28.5 40.6 33.0 (2,000) BEW 13.9 28.3 51.5 25.8 33.7 33.6 (4,000) Asset to equity (x) CEI 2.1 2.0 2.0 2.1 2.2 2.1 (6,000) GDI 2.1 1.9 1.7 1.7 1.6 1.5 2008 2009 2010 2011E 2012E 2013E Hyflux 2.6 2.9 2.8 2.2 1.9 2.0 CEI GDI Hyflux BEW BEW 2.7 2.8 3.8 3.5 3.0 2.9 Source: Companies, Daiwa forecasts Source: Companies, Daiwa forecasts

Water companies: adjusted operating cash flow excluding Turning to cash flow, GDI provides stable free cash construction services cash outflow for BOT projects (2008-13E) flow thanks to its defensive businesses. The company’s Hong Kong water distribution business is based on (HK$m) Positive operating cash flow stripping out the effect of 5,000 construction services fixed revenue agreements, while its property 4,000 investment generates stable rental income. We expect 3,000 all three other companies to become free-cash-flow 2,000 positive in 2012 or 2013, when their capital-intensive 1,000 capacity expansion should slow. 0 (1,000) Water companies: free cash flows (2008-13E) (2,000) (3,000) (Rmb m) (4,000) 4,000 2008 2009 2010 2011E 2012E 2013E 3,000 CEI GDI Hyflux BEW

2,000 Source: Companies, Daiwa forecasts 1,000 0 (1,000) (2,000) (3,000) 2008 2009 2010 2011E 2012E 2013E CEI GDI Hyflux BEW Source: Companies, Daiwa forecasts

At first glance, the water players’ operating cash flow looks worrying, as most of the numbers for most of the companies (except GDI) are in negative territory until 2012E (based on our forecasts). However, this is due mainly to the effect of construction services (for both BOT and BT projects) being included in operating activities instead of investing activities.

Stripping out the construction services’ cash flow for BOT projects, which has the nature of capex (one-off cash outflow which generates steady future returns), the adjusted operating cash flow for CEI and Hyflux

- 28 - China Water Sector 15 February 2012

water comes from desalination plants. According to Global Water Intelligence, the current capacity of Appendix 1: The water industry in desalination in MENA region is about five times that of MENA and Singapore water reuse.

Capacity forecasts for desalination and water reuse in the MENA MENA region (2008-16E) Overview: It is no exaggeration to say that water is (mn m3/day) ‘Blue Gold’ for the MENA region. Using a threshold of 80 available per capita water resources below 1,000m3 per year (the United Nations’ definition of ‘water scarcity’), 60 15 of the 19 countries in the MENA region are facing a ‘water scarcity’. In 2011, US$525m of the World Bank’s 40 lending to the MENA region (about 25% of total) was allocated for water and sanitation projects. 20

Map of MENA’s per capita water resources 0 2008 2012E 2016E Water reuse Desalination

Source: GWI Water Market Middle East 2010 Syria Tunisia Iran Lebanon Iraq Morocco Regulation: In recent years, the MENA region has Israel Algeria Jordan already witnessed large investment in the water and Kuwait Libya Egypt waste-water infrastructure sector, and such a trend is Bahrain Saudi Qatar expected to continue in the next five years, with the Arabia UAE Oman market size forecast to expand at a CAGR of 16%, according to Frost & Sullivan.

Yemen Market size for MENA’s water and waste-water treatment Water resource (m3 per capita per year) 0 – 500 industry (2010-15E) 500 – 1500 1500 – 3000 (US$bn) 20 18.9 Source: World Resources Institute

15 CAGR: 16% Water sources: MENA’s internal freshwater resource is 642m3 per capita, which is only one-tenth of the 9.0 world’s average. This number declined by 18% from 10 1997 to 2007 due to rapid population growth, which is quite worrying, as the world average only declined by 5 10% over the same period. 0 Renewable internal freshwater resources per capita (cubic 2010 2015E metres) Source: Frost & Sullivan 3 Internal freshwater resources per capita (m ) 1997 2002 2007 Latin America & Caribbean 27,059 25,156 23,637 North America 18,728 17,759 16,942 Most of MENA’s investments in the water industry Sub-Saharan Africa 6,293 5,540 4,897 come from governments. The World Bank estimates East Asia & Pacific 5,165 4,931 4,752 that public spending on the water sector accounts for 1- Europe 3,126 3,069 2,979 5% of the GDP in the MENA region. South Asia 1,416 1,296 1,202 MENA 784 711 642 World average 7,277 6,918 6,521 Source: World Bank

Because of MENA’s shortage of internal freshwater resources, seawater desalination has become a good solution to water scarcity in the MENA region, especially for those countries located along the coast. For example, about 70% of United Arab Emirates’

- 29 - China Water Sector 15 February 2012

Estimated government spending for MENA’s water and waste the country into a global hub of water technology and water treatment industry (2006-15E) research, with another S$140m being added in 2011. It KSA is estimated that Singapore’s water R&D budget would Egypt amount to about S$275m for the next five years. UAE Iran Water sources: Some 40% of Singapore’s raw water Turkey Kuwait supply is imported from Johor, Malaysia. Four bilateral Libya agreements have been signed since 1927, with two still Algeria effective until 2061. The tariff appears very low, Iraq however, Singapore has to bear all the construction Israel Morocco cost of water projects and also supplies some treated Qatat water to Malaysia at a loss-making price. Nevertheless, Syria the water supply has caused a longstanding conflict Oman between the two nations, which has urged Singapore to Bahrain Lebanon explore internal water sources so as to secure its own Tunisia water supply beyond 2061. Jordan Palest… Bilateral water supply agreements (US$bn) Yemen Volume 0 5 10 15 20 25 (m Tariff Expiry Type of tonnes (S$ per Water Wastewater Contract year water per day) tonne) Note Source: OECD 1927 1961 Raw n.a. Free Although raw water was free, Agreement water Singapore paid for land rents and resold treated water to Malaysia at Private sector participation has also been encouraged a discounted price (S$ 0.023 per in recent years, especially for the seawater desalination tonne) 1961 2011 Raw 0.39 0.0027 Singapore also paid for land rent and waste water treatment industries, in the forms of Agreement water and resold treated water to management contracts and greenfield projects, such as Malaysia at a discounted price BOT, BOO, etc. However, the total amount is still low (S$ 0.045 per tonne) 1962 2061 Raw 1.14 0.0027 The pricing terms are the same as compared with the public sector. Agreement water 1961 Agreement. Tariff should be reviewed every 25 years, and the Water sector investment with private sector participation in next tariff review will be in 2012. MENA region 1990 2061 Treated n.a. slightly Supplementary to the 1962 Agreement water higher than Agreement. (US$m) Johor's 1,600 water tariff* Source: Ministry of Foreign Affairs, National Library Board Singapore, Daiwa 1,400 Note: *The exact price is calculated based on a fixed formula. 1,200 1,000 Another important source of water is reclaimed water 800 (called NEWater in Singapore), accounting for about 600 30% of the water supply. Through technology improvements, Singapore’s cost of reclaimed water has 400 been reduced to S$0.3/tonne, which is competitive 200 compared with the pre-tax water tariff of S$1.17/tonne 0 (the Singapore Government charges a 30% water 2007 2008 2009 2010 conservation tax on water tariffs). Seawater Source: World Bank desalination also represents 10% of water sources, but its production cost (about S$0.45/tonne) is still higher Singapore than reclaimed water. Overview: Water scarcity is one of the biggest risks for Singapore’s economic development. According to With the aggressive capacity growth of water reuse and research conducted by the World Resources Institute in seawater desalination, Singapore aims to be self- 2007, Singapore’s per capita water resources ranked sufficient in water by 2061. 168th of the 177 major countries around the world. As a result of its natural constraints in water, Singapore has developed one of the world’s most thriving water industries, with over 50 local and international water companies in business. In 2006, the National Research Foundation of Singapore set aside S$330m to develop - 30 - China Water Sector 15 February 2012

Sources of water supply (2011) Rainfall catchment 20.0%

Import 40.0% Desalination 10.0%

Reclaimed water 30.0% Source: Public Utilities Board

Planned sources of water supply (2061E) Rainfall Import catchment 0.0% 20.0%

Desalination Reclaimed water 30.0% 50.0%

Source: Public Utilities Board

Regulation: Singapore’s water industry is regulated by the Ministry of the Environment and Water Resources. The Public Utilities Board (PUB), a statutory body under the environment ministry, is responsible for Singapore’s water supply. It also awards water supply and sewerage contracts to private companies in the form of BOT projects, privatisations, etc.

- 31 - China Water Sector 15 February 2012

Appendix 2: world-water resources map

World fresh-water resources map

Water Resources per capita (cubic meters) 1 – 500 500 – 1,500 1,500 – 3,000 3,000 – 5,000 > 5,000

Source: Daiwa

- 32 -

Utilities / China 15 February 2012

China Everbright International Target price: HK$4.20 Up/downside: +28.4% 257 HK Share price (13 Feb): HK$3.27

Initiation: dual growth drivers

• While water is a clear long-term business focus, WTE provides CEI with good earnings and cash-flow visibility over the next few years • We like CEI for its market leadership in WTE, low exposure to water BT projects, and rapidly improving cash flow

• Coverage initiated with a Buy (1) rating and DCF-based six-month target price of HK$4.20

How do we justify our view?

environmental protection. This Risks reduces CEI’s risk of delay in The risks to our call include delays accounts receivable, in our view. The in waste and water-treatment tariff company’s low exposure to BT hikes, slower-than-expected

projects (1% of 2011-13E revenue) is capacity expansion, and worse-than- Jackie Jiang also appealing relative to its peers, expected cash flow. (852) 2848 4994 [email protected] as we worry about postponements and delays in receivables for BT Share price performance Dave Dai, CFA projects. (HK$) (%) (852) 2848 4068 4.2 120 [email protected] We initiate coverage with a Buy (1) 3.5 100 2.8 80 rating and DCF-based six-month 2.1 60 Investment case target price of HK$4.20. We expect 1.4 40 We forecast China’s waste-to-energy CEI’s operating cash flow to remain Feb-11 May-11 Aug-11 Nov-11 Feb-12 positive from 2011 onwards. China Everbright International (LHS) (WTE) capacity to rise by a CAGR of Relative to HSI (RHS) 16% over 2011-15 to support Catalysts population growth and 12-month range 1.50-3.97 environmental protection. CEI, Near-term catalysts include the Market cap (US$bn) 1.54 currently the largest WTE operator in additional roll-out of new WTE and Average daily turnover (US$m) 3.71 China, is well-positioned to benefit water projects (3 announced over Shares outstanding (m) 3,652 from the lucrative market growth the past 3 months), especially given Major shareholder Guildford Limited (47.8%) (WTE projects earn an IRR 10-15% the reshuffles in a large number of higher than water projects) given its local governments in 2011. Financial summary (HK$) Year to 31 Dec 11E 12E 13E government-owned background. Also, Valuation Revenue (m) 4,057 4,431 4,491 assuming 60% debt financing, CEI’s Operating profit (m) 1,265 1,659 1,916 first grate-furnace plant (core WTE The stock has underperformed the HSCEI Index by 13% since the Net profit (m) 758 1,009 1,177 equipment), which is due to start Core EPS 0.208 0.276 0.322 beginning of 2011 due we believe to operation in 1H12, would reduce total EPS change (%) 22.7 33.0 16.6 construction costs by 6% and raise its its high beta, small market cap, and Daiwa vs Cons. EPS (%) (1.4) 8.7 14.6 project equity IRR by about 1pp. investors’ risk aversion. Based on PER (x) 15.7 11.8 10.2 our forecasts, the current 12-month Dividend yield (%) 0.9 1.2 2.0 CEI’s business is focused in forward PER and PBR are below the DPS 0.031 0.041 0.064 economically developed provinces, stock’s past-5-year averages, despite PBR (x) 2.0 1.7 1.5 including Jiangsu, Shandong and a 2011-13E EPS CAGR of around EV/EBITDA (x) 11.6 9.1 8.0 Guangdong, which are among the 25% and rising ROE (16% for 2013E, ROE (%) 13.4 15.7 16.1 top-5 provinces in terms of the highest since 2007), which Source: Bloomberg, Daiwa forecasts government expenditure on supports an implied 2012E target PER and PBR of 15x and 2x.

Important disclosures, including any required research certifications, are provided on the last two pages of this report. China Water Sector 15 February 2012

How do we justify our view?

Growth outlook Valuation Earnings revisions

Growth outlook CEI: net profit growth history and forecasts

We forecast CEI’s net profit attributable to shareholders (tonne per day) (% ) to rise at a CAGR of around 25% from 2011-13, driven 12,000 11,062 70 66 mainly by WTE and wastewater treatment capacity 9,562 60 10,000 8,662 expansion. 50 8,000 40 6,000 4,692 33 4,292 30 3,292 4,000 23 20 17 2,000 10 10 0 0 0 2008 2009 2010 2011E 2012E 2013E Designed capacity – waste processing Net profit growth (YoY)

Source: Company, Daiwa forecasts

Valuation CEI: 12-month-forward PER bands

The stock is trading currently below its past-5-year (x) average 12-month-forward PER of 16.5x, which we see 40 as appealing. 35 30.7x Avg+2SD 30

25 23.6x Avg+1SD 20 16.5x Avg 15 10 9.4x Avg-1SD

5 2.3x Avg-2SD 0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: Bloomberg, Daiwa forecasts

Earnings revisions CEI: consensus EPS-forecast revisions

The Bloomberg-consensus EPS forecast for 2012 was (Rebased to 100) revised up by 9% in 2011, while that for 2013 has been 120 cut by 13%. However, we expect the consensus forecasts to be raised for 2012-13 given the recently announced, 110 and upcoming, water and WTE projects. 100 90

80

70 Jul-11 Apr-11 Oct-11 Jan-11 Jun-11 Jan-12 Feb-11 Mar-11 Feb-12 Aug-11 Sep-11 Nov-11 Dec-11 May-11 2012E 2013E

Source: Bloomberg

- 34 - China Water Sector 15 February 2012

Financial summary

Key assumptions Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Designed capacity – waste processing 1,050.0 1,692.0 3,292.0 4,292.0 4,692.0 8,662.0 9,562.0 11,062.0 (ton/day) Designed capacity – wastewater 1,160.0 1,260.0 1,320.0 1,460.0 1,550.0 1,611.6 1,861.6 1,861.6 treatment ('000 ton/day) Waste processing tariff (Rmb/ton) 85.8 85.8 83.1 84.3 84.7 84.3 86.0 88.9 Waste-to-energy on-grid tariff 0.6 0.6 0.6 0.6 0.6 0.6 0.6 0.6 (Rmb/KWh) Wastewater treatment tariff (Rmb/ton) 1.0 0.9 0.9 1.1 1.1 1.1 1.2 1.2

Profit and loss (HK$m) Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Environmental energy 496 688 845 604 1,816 2,293 2,462 3,281 Environmental water 298 550 890 1,036 857 764 1,230 746 Others 90 109 128 126 256 1,000 739 465 Total revenue 884 1,348 1,863 1,766 2,929 4,057 4,431 4,491 Other income 8 18 21 53 53 59 96 111 COGS (641) (888) (1,209) (991) (1,784) (2,591) (2,585) (2,399) SG&A (58) (71) (90) (126) (146) (197) (204) (196) Other op. expenses (26) (29) (37) (39) (41) (62) (79) (91) Operating profit 168 378 548 664 1,012 1,265 1,659 1,916 Net-interest inc./(exp.) (53) (55) (140) (161) (169) (221) (271) (297) Assoc/forex/extraord./others 375 43 52 5 2 0 0 0 Pre-tax profit 490 367 461 508 845 1,044 1,388 1,619 Tax (10) (7) (95) (99) (192) (240) (319) (372) Min. int./pref. div./others (20) (22) (26) (37) (37) (45) (60) (70) Net profit (reported) 460 338 339 372 616 758 1,009 1,177 Net profit (adjusted) 460 338 339 372 616 758 1,009 1,177 EPS (reported) (HK$) 0.159 0.109 0.108 0.114 0.169 0.208 0.276 0.322 EPS (adjusted) (HK$) 0.159 0.109 0.108 0.114 0.169 0.208 0.276 0.322 EPS (adjusted fully-diluted) (HK$) 0.156 0.106 0.106 0.112 0.167 0.205 0.273 0.318 DPS (HK$) 0.017 0.016 0.016 0.023 0.025 0.031 0.041 0.064 EBIT 168 378 548 664 1,012 1,265 1,659 1,916 EBITDA 194 407 585 702 1,053 1,327 1,738 2,007

Cash flow (HK$m) Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Profit before tax 490 367 461 508 845 1,044 1,388 1,619 Depreciation and amortisation 26 29 37 39 41 62 79 91 Tax paid (10) (7) (95) (99) (192) (240) (319) (372) Change in working capital (93) (131) (119) (217) 246 23 (89) 199 Other operational CF items (1,679) (1,033) (1,362) (802) (2,154) (856) (913) (1,346) Cash flow from operations (1,266) (774) (1,079) (572) (1,214) 32 146 190 Capex 0 (89) 0 (18) (372) (500) (300) (300) Net (acquisitions)/disposals 413 0 0 (1) 1 0 0 0 Other investing CF items 565 0 94 0 0 36 0 0 Cash flow from investing 978 (89) 94 (19) (372) (464) (300) (300) Change in debt 279 544 962 591 834 1,001 500 500 Net share issues/(repurchases) 52 6 1 1,435 1 2 0 0 Dividends paid (49) (50) (50) (75) (91) (112) (149) (235) Other financing CF items 354 161 79 22 239 0 0 0 Cash flow from financing 636 661 992 1,972 983 891 351 265 Forex effect/others 0 0 0 0 0 0 0 0 Change in cash 348 (202) 7 1,382 (602) 459 197 155 Free cash flow (1,266) (864) (1,079) (590) (1,586) (468) (154) (110)

Source: Company, Daiwa forecasts

- 35 - China Water Sector 15 February 2012

Financial summary continued …

Balance sheet (HK$m) As at 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Cash & short-term investment 757 555 562 1,944 1,341 1,800 1,997 2,152 Inventory 3 6 12 13 21 31 31 29 Accounts receivable 217 431 681 906 1,024 1,379 1,465 1,178 Other current assets 110 77 137 80 96 125 125 125 Total current assets 1,088 1,068 1,391 2,944 2,484 3,335 3,618 3,484 Fixed assets 263 305 165 168 414 584 744 895 Goodwill & intangibles 596 615 624 600 685 952 1,013 1,071 Other non-current assets 1,439 2,538 4,121 4,956 7,288 8,200 9,113 10,459 Total assets 3,386 4,526 6,301 8,667 10,870 13,071 14,488 15,910 Short-term debt 88 143 546 696 732 732 732 732 Accounts payable 249 334 471 481 853 1,240 1,237 1,148 Other current liabilities 2 6 9 10 29 47 47 47 Total current liabilities 339 484 1,026 1,188 1,615 2,020 2,017 1,927 Long-term debt 803 1,293 1,784 2,253 3,037 4,037 4,537 5,037 Other non-current liabilities 131 146 360 297 470 572 572 572 Total liabilities 1,273 1,922 3,170 3,738 5,122 6,629 7,126 7,537 Share capital 308 313 314 364 365 368 368 368 Reserves/R.E./others 1,689 2,138 2,505 4,209 4,973 5,619 6,479 7,420 Shareholders' equity 1,996 2,451 2,820 4,573 5,338 5,987 6,846 7,788 Minority interests 117 152 311 357 411 456 516 586 Total equity & liabilities 3,386 4,526 6,301 8,667 10,870 13,071 14,488 15,910 EV 11,017 12,004 13,082 14,099 15,622 16,208 16,572 16,987 Net debt/(cash) 134 881 1,767 1,005 2,428 2,969 3,272 3,618 BVPS (HK$) 0.649 0.782 0.897 1.257 1.461 1.639 1.874 2.132

Key ratios (%) Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Sales (YoY) n.a. 52.5 38.2 (5.2) 65.9 38.5 9.2 1.3 EBITDA (YoY) n.a. 109.8 43.5 20.1 50.0 26.0 30.9 15.5 Operating profit (YoY) n.a. 125.2 44.8 21.1 52.5 25.0 31.1 15.5 Net profit (YoY) n.a. (26.6) 0.3 9.7 65.8 23.0 33.0 16.6 EPS (YoY) n.a. (31.6) (0.8) 5.5 48.6 22.7 33.0 16.6 Gross-profit margin 27.5 34.1 35.1 43.9 39.1 36.1 41.7 46.6 EBITDA margin 22.0 30.2 31.4 39.8 36.0 32.7 39.2 44.7 Operating-profit margin 19.0 28.1 29.4 37.6 34.5 31.2 37.4 42.7 ROAE 23.1 15.2 12.9 10.1 12.4 13.4 15.7 16.1 ROAA 13.6 8.5 6.3 5.0 6.3 6.3 7.3 7.7 ROCE 5.6 10.7 11.5 9.9 11.6 12.2 13.9 14.3 ROIC 7.3 13.0 10.4 9.9 11.1 11.1 12.7 13.0 Net debt to equity 6.7 35.9 62.7 22.0 45.5 49.6 47.8 46.5 Effective tax rate 2.0 1.9 20.7 19.5 22.7 23.0 23.0 23.0 Accounts receivable (days) 89.7 87.7 108.9 164.0 120.3 108.1 117.1 107.4 Payables (days) 102.9 79.0 78.9 98.4 83.2 94.2 102.0 96.9 Net interest cover (x) 3.2 6.9 3.9 4.1 6.0 5.7 6.1 6.4 Net dividend payout 10.7 14.8 14.8 20.2 14.8 14.8 14.8 20.0 Source: Company, Daiwa forecasts

Company profile China Everbright International (CEI) focuses on its core businesses in green environmental protection and alternative energy. These mainly include waste-to-energy (WTE), solid waste landfill, wastewater treatment, reusable water, biomass power generation, solar photovoltaic energy, wind power, methane-to-energy, environmental protection engineering, and environmental protection equipment manufacturing, etc.

- 36 - China Water Sector 15 February 2012

CEI: 12-month forward PER history (x) 40 35 30 30.9x Avg+2SD

25 23.8x Avg+1SD Initiation: dual growth 20 16.6x Avg 15 drivers 10 9.5x Avg-1SD 5 2.3x Avg-2SD Coverage initiated with a Buy rating. 0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 CEI Global average

Valuation suggests limited Source: Bloomberg, Daiwa forecasts downside CEI: 12-month forward PBR history

(x) CEI has underperformed the HSCEI Index by 13% 3.5 since the beginning of 2011, due we believe to the 3.2x Avg+2SD company’s high beta, its small market cap, and 3.0 investors’ risk aversion. 2.5 2.6x Avg+1SD 2.0 Share performance of CEI vs. HSCEI Index 1.9x Avg 1.5 (Rebase to 100) 1.3x Avg-1SD 1.0 120 0.7x Avg-2SD 0.5 100 0.0 80 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

Source: Bloomberg, Daiwa forecasts 60 40 DCF-based target price of HK$4.20

20 We believe a DCF methodology is appropriate to Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 estimate the intrinsic value of the company, given the CEI HSCEI Index high visibility of CEI’s future cash flows. It also Source: Bloomberg minimises the accounting treatment effect of BOT and TOT projects, which often create earnings volatility in Following the plunge in 2011, CEI’s valuations are the expansion phase of a company. below their past-5-year average levels. On a 12-month forward-PER basis, the stock is trading at 25% below We assume a 3% annual growth in WTE treatment fees past-5-year average and 8% below the global average, and wastewater treatment (WWT) fees, and a terminal despite a much higher earnings growth outlook than its growth rate of 2%. We have also included new projects global peers. with an annual investment of Rmb1bn put into construction in 2012, 2013 and 2014. Our base-case We believe that compared to where the company stood DCF target price works out to HK$4.20. back in 2008 when it had just entered the environmental business and had only a handful of projects in operation, CEI’s fundamentals have significantly improved, with a more diversified business strategy which has largely reduced any risk in delay of accounts receivable. Also, a much stronger balance sheet than back in 2008 provides good support for future project additions. We see limited downside risk from current valuation levels.

- 37 - China Water Sector 15 February 2012

CEI: DCF valuation (in HK$m) 2010 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E Year 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 Risk free interest 3.5% Risk premium 6.0% Beta 1.0 Cost of equity 9.5% Cost of debt 6.5% Equity ratio 70% Debt ratio 30% WACC 8.1% Terminal growth rate 2.0% EBIT(1-t) 767 959 1,258 1,452 1,874 2,143 2,355 2,414 2,468 2,522 2,507 Add: depreciation & amortization 41 62 79 91 99 104 107 107 107 108 108 Add: change in WC 246 23 -89 199 -163 -25 -78 -1 -1 -1 11 Less: capex -2,578 -2,164 -2,000 -1,500 -675 -500 -100 -100 -100 -100 -100 FCF -1,524 -1,121 -752 242 1,135 1,722 2,284 2,420 2,474 2,529 2,525 Discounted FCF -1,121 -696 207 898 1,261 1,546 1,515 1,433 1,355 1,251 Terminal value 54% 10,350 Firm value 19,121 Less: net debt (end 2012E) 3,272 Less: minority 516 Equity value 15,333 No. of shares (m) 3,652 Target price (HK$) 4.20 Source: Daiwa forecasts

Earnings sensitivity We performed an earnings sensitivity analysis on CEI’s key drivers and identified the three most influential Integrated environmental variables. For the environmental energy business, we solutions provider calculate that every 5pp increase in the capacity utilisation rate would raise our 2011 and 2012 EPS CEI has expanded into an integrated environmental forecasts by 1.1% and 1.0%, respectively. For the water company with environmental energy (WTE and solid business, the wastewater treatment tariff is the key waste landfill), environmental water (WWT and water driver, with every 5% increase leading to 1.5% and 1.1% reuse) and alternative energy (biomass, methane-to- increases in our respective 2011 and 2012 earnings energy, solar, wind, etc.) as its core businesses. Among forecasts. Interest rates also play an important role, the business segments, we like water and waste with every 25bps rise leading to a 1.0% decline in our projects for their growing markets, stable ROEs of 10- EPS forecasts for 2011 and 2012. 15%, and CEI’s solid track record, while we are concerned about the alternative energy projects, given CEI: earnings sensitivity to key drivers the prevailing grid connectivity problem and CEI’s lack Change Impact on 2011E EPS Impact on 2012E EPS (%) (%) (%) of expertise and experience in it. Environmental energy Waste processing fee + 5 0.4 0.4 Waste, water and alternative energy account for 47%, On-grid power tariff + 5 0.7 0.6 34% and 10% of our 2011 gross-profit forecast, Utilisation rate + 5pps 1.1 1.0 respectively. CEI plans to leverage on its existing Environmental water Wastewater treatment experience and expand aggressively in the waste and tariff + 5 1.5 1.1 water businesses, while selecting projects cautiously in Utilisation rate + 5pps 0.8 0.8 alternative-energy fields focusing on methane-to- Alternative energy energy and biomass projects, according to our recent On-grid power tariff + 5 0.1 0.4 Utilisation rate + 5pps 0.1 1.0 discussions with management. Interest rate + 25bps (1.0) (1.0) Source: Daiwa estimates

- 38 - China Water Sector 15 February 2012

CEI: gross profit breakdown WTE project in the province, the Huidong WTE plant

100% 10% 9% 8% 8% obtained in 2010. The company has also entered 16% 12% 1% 2% 9% another lucrative market in Zhejiang Province by 0% 10% 11% 80% successfully signing a co-operative framework 26% agreement with the Ningbo municipality in December 41% 34% 32% 60% 48% 53% 2011 to invest HK$3-5bn on environmental protection projects over the next few years. 40%

55% Some may argue that a geographical concentration 20% 46% 50% 36% 34% 47% strategy may increase the risk of a delay in receivables 0% and constrain capacity expansion from new project 2008 2009 2010 2011E 2012E 2013E additions. We hold an opposite view, as these provinces Environmental energy Environmental water Alternative energy Others are more financially capable to commit to Source: Company, Daiwa forecasts environmental protection investment, and the market is far from being saturated. Solid track record is the key to winning new projects Guangdong, for example, generates around 27mt of solid waste per year, of which around 70% is processed CEI has a very successful business model of operating a by non-hazardous treatment. The Guangdong series of environmental projects for a single city. For Government intends to raise the ratio to 80% by 2012 example, CEI started to run WWT plant 1 & 2 in Jinan, and further to 85% by 2015. Every city/county in the Shandong in 2006. It later upgraded the two plants to province targets to have at least one non-hazardous higher standards and larger capacity in 2009. Since waste treatment plant by 2015 (56 cities/counties did 2006, CEI has won two more WWT plants in suburban not have such facilities by 2010), and Guangzhou and Jinan, one reusable water plant, and one WTE plant in Shenzhen target to become national sample cities for 2011. waste treatment and recycling. Guangdong, Jiangsu

and Shandong were among the top-5 provinces in More recently, in January 2012, CEI successfully beat terms of government expenditure on environment more than 10 competitors to win the public tender for protection in 2010. the Nanjing WTE project, which is the largest WTE plant in China with a daily waste processing capacity of China: provincial government expenditure on environmental 2,000 tonnes. Management believes it is the solid track protection (2010) record and project quality CEI delivers that makes local (Rmb m) governments award more projects to the company. We Tibet Hainan expect to see CEI repeating such success in other cities. Tianjin Ningxia Qinghai CEI: projects in operation and pipeline (Jan 2012) Fujian Project type Location Project number Capacity Shanghai Jiangxi Environmental energy Xinjiang WTE (t/day) Jiangsu, 13 12,550 Guizhou Shandong, Beijing Guangxi Guangdong Anhui Waste landfill ('000 m3/year) Jiangsu 4 1,148 Gansu Environmental water Chongqing Jilin WWT ('000 t/day) Jiangsu, 13 1,800 Liaoning Shandong Zhejiang Shanxi Reusable water ('000 t/day) Jiangsu, 3 159 Shaanxi Shandong Yunnan Alternative energy Heilongjiang Hunan Methane-to-energy (GWh/year) Jiangsu 6 45 Hubei Biomass power (GWh/year) Jiangsu, 6 1,092 Henan Shandong, Anhui Inner Mongolia Shandong PV power (GWh/year) Jiangsu, 8 36 Sichuan Guangdong, Hebei Anhui, Germany Jiangsu Guangdong Source: Company 0 5,000 10,000 15,000 20,000 25,000 Source: CEIC Focus on where the money is CEI has a geographical focus in economically developed provinces, including Jiangsu and Shandong, and has entered Guangdong Province, with its first

- 39 - China Water Sector 15 February 2012

Margins trending up CEI and BEW: revenue contribution from BT projects (2011-13E) As CEI is in an expansion phase with new projects (%) added every year, construction revenue is the major 50 44.2 revenue contributor during the period. Since the 40 31.9 construction-services business has a very low gross 28.9 margin of 10-15% compared with 30-70% for the 30 projects in operation, the overall gross margin tends to 20 be low in the expansion phase. We forecast the gross margin to trend up from 36% in 2011 to 47% in 2013, 10 with the construction contribution coming down from 1.1 1.0 1.0 0 67% to 44% over the same period. 2011E 2012E 2013E

CEI BEW CEI: revenue contribution from construction services and gross margin trend Source: Daiwa forecasts

(% ) 80 72 67 70 63 WTE is the sweet spot 59 58 58 60 45 50 50 47 Waste treatment, especially WTE, is still in the early 44 40 39 42 developmental stage in China, and receives policy 34 35 36 support from, and is an investment focus for, the 30 28 20 government. An environmental expert from the 10 Chinese Society for Environmental Sciences has 0 interestingly pointed out that pollution control usually 2006 2007 2008 2009 2010 2011E 2012E 2013E starts with water and air, and later focuses on solid Construction services as % of revenue Gross margin waste, as the Western countries have experienced. And

Source: Company, Daiwa forecasts China is no exception, in our view.

CEI: gross margin of different segments (2011E) The 12th Five Year Plan for urban solid waste treatment 70% development is currently under review by the State 50-70% 50-70% Council and will be published in 1H12. A total 60% investment of around Rmb280bn on municipal solid 50% waste (MSW) treatment is expected over 2011-15, 30-50% 40% according to the Chinese Society for Environmental Sciences, which is larger than that of urban WWT plant 30% construction and upgrade. China targets to improve the 20% 10-15% solid waste non-hazardous treatment ratio to 100% for

10% urban areas by 2020 from the current 78%, according to the National Environment Strategy Study published 0% in April 2011. WTE operation WWT operation Alternative energy Construction services

Source: Company, Daiwa forecasts WTE receives the biggest policy support among the non-hazardous MSW treatment methods given its Recurring earnings limited land requirement, effective waste reduction and energy recycling. China targets to increase WTE CEI has a much smaller revenue contribution from capacity to 30% of total MSW treatment capacity by one-off BT projects compared with its peers. Over the 2030 from 7% currently. years, it has only obtained two BT projects: 1) Xinyi BT Waste Water Treatment Project Phase I, which was We forecast China to more than double its urban WTE completed in October 2010, and 2) Xinyi Surface Water capacity over the next 5 years from 24,000t/day to Project, which is due to be completed in 2013. BT 62,000t/day, implying a 5-year CAGR of 16%, much revenue accounts for only 1% of our 2011-13 total higher than the wastewater treatment capacity growth revenue forecast, while the proportion for Beijing rate (2011-15E CAGR: 6%). The capacity expansion is Enterprises Water Group (BEW) (371 HK, HK$2.14, largely driven by policy support of rising non- Underperform [4]) is 29-44% over the same period. hazardous MSW treatment, especially WTE treatment Our forecast includes only projects currently in the ratio, along with population growth and urbanisation. pipeline for both companies. - 40 - China Water Sector 15 February 2012

China: non-hazardous MSW treatment and WTE capacity China: methods of MSW treatment (2010) (2008-15E) Incineration Others 2008 2009 2010 2011E 2012E 2013E 2014E 2015E (WTE) 3.0% Population (m) 7.0% Total population 1,328 1,335 1,341 1,341 1,341 1,341 1,341 1,341 YoY (%) 0.5 0.49 0.48 0.50 0.50 0.50 0.50 0.50 Urban population 624 645 670 690 710 730 750 771 YoY (%) 3.5 3.4 3.8 3.0 2.9 2.8 2.8 2.7 Urbanisation rate (%) 47 48 50 51 53 54 56 57 City population 335 340 345 350 356 361 366 372 Town population 289 305 325 340 355 369 384 399 MSW generation per person per day (kg) City 1.26 1.27 1.25 1.27 1.28 1.29 1.31 1.32 Town 0.70 0.71 0.73 0.74 0.76 0.77 0.79 0.80 Urban 1.00 1.01 1.00 1.01 1.02 1.03 1.04 1.05 Landfill 90.0% Total annual urban MSW generation (m tonnes) City 154 157 158 162 166 170 175 179 Source: Ministry of Environment Town 74 80 86 92 98 104 111 117 Urban 228 237 244 254 264 274 285 296 Comparison between WTE and landfill Non-hazardous MSW treatment ratio (%) WTE (incineration) Landfill City 67 71 78 80 82 85 87 89 Land requirement (m2/t) 500-900 60-100 Town 16 21 26 31 36 41 46 51 Location difficulty Difficult Comparably easier Urban 50 54 60 62 65 68 71 74 Waste reduction nil 80-90% Non-hazardous MSW treatment capacity ('000 tonnes/day) Waste processing time 20-50 years 2 hours City 282 308 337 356 375 394 415 436 Generate biomass for power Waste recycling; Town 32 46 61 78 97 117 139 164 Energy recycling generation Generate heat and power; Urban 315 353 399 434 471 512 554 600 Investment ('000 Rmb/t excl. land WTE as a % of total non-hazardous MSW treatment capacity cost) 100-200 400-500 City 5.5 6.3 7.0 8.2 9.3 10.5 11.6 12.8 Source: Daiwa Town 0.0 0.0 0.0 0.0 1.0 2.0 3.0 4.0 Urban CO2 emission of municipal solid waste treatment WTE capacity ('000 tonnes/day) (Tonnes of CO2 City 16 19 24 29 35 41 48 56 emitted for each Town 0 0 0 0 1 2 4 7 500 1,000 tonnes of Urban 16 19 24 29 36 44 52 62 waste) YoY (%) 24 24 23 23 24 22 20 19 400 Five-year CAGR (%) 18 18 17 16 300 Source: National Bureau of Statistics, Ministry of Housing and Urban-Rural Development, Daiwa forecasts 200

WTE: a green way of disposing of waste 100 The term ‘non-hazardous MSW treatment’ means the 0 disposal of MSW by recycling, composting, WTE and (100) Landfill (no gas Landfill (with partial Landfill (with full gas Incineration sanitary landfilling. China generated around 159mt of control) gas control) control) MSW in 2010, around 90% of which was disposed of via landfills. Landfills are no longer feasible for land- Source: EPA, CERA scarce cities, and inappropriate landfill of hazardous waste can cause irrecoverable pollution of the soil and Business model makes economic sense underground water. The Earth Engineering Centre of In fact, China is not an ideal country to produce WTE, Columbia University has estimated that 1m2 is used up as the content of better-burning trash is not as high as for every 10 tonnes of MSW land filled forever. in developed economies, like Japan or Singapore. We consider paper and paste as the ideal types of MSW. WTE, on the other hand, is a more ideal disposal Food wastes are much less efficient than paper and method and can recover energy in the form of paste, but better than glass and metal. However, this electricity or heat, or produce a combustible fuel could improve in the long term, as studies have shown commodity, such as methane, methanol, ethanol or a strong positive correlation between GDP per capita synthetic fuel, from the incineration of waste sources. and percentage of paper and plastic composite of MSW. WTE (incineration) especially reduces CO2 emissions into the air, compared with other means of waste treatment, such as landfill.

- 41 - China Water Sector 15 February 2012

Breakdown of MSW by type Levelised cost of electricity, 2010 100% Wave Tidal Stream 80% Solar CSP - CLFR Solar CSP - Tower Solar CSP - Parabolic 60% Solar PV - Thin Film Solar PV - cSi 40% Wind - micro Wind - Offshore 20% Coal CCS Biomass Anaerobic Digestion 0% Nuclear Wind - Onshore Biomass Combustion China Japan Brunei CCGT - Shale Gas S.Korea Vietnam Thailand Malaysia Mongolia Myanmar Indonesia Singapore Combodia CCGT - Coal Bed Methane Philippines Geothermal Food wastes Paper Plastic Metal Glass Others Small Hydro Source: UN Municipal Waste Management Report Waste to Energy US Wholesale China Coal (US$/MWh) Despite the less ideal quality of the waste, China does 0 50 100 150 200 250 300 350 400 compensate by offering attractive on-grid power tariffs Source: Daiwa, BNEF, IEA, EIA, UN (local coal-fired power tariff + Rmb0.25/KWh) as well as lucrative tipping fees paid to WTE operators for Project availability depends on fiscal their community services. A tipping fee is the charge budget of local government levied upon a given quantity of waste received at a waste processing facility. Take the Haining MSW Despite the good economics, WTE projects tend to be project for example: processing capacity of 500t/day constrained by the availability of the local fiscal and tipping fees of Rmb70/t implies that annual budgets as a high volume of waste collection is usually income from tipping fee alone would account for about accompanied by a large budget for tipping fees. In the a 5% return on the total project investment. past, we have only seen a selected few cities/provinces promoting WTE projects, given the relatively better Haining MSW incineration project - BOT financial position of local governments. Concession 25 years Investment Rmb240m Examples of cities/provinces that have promoted WTE power Capacity 500t/day Beijing Jiangsu Sichuan Max capacity <120% Guangdong Shandong Fujian Land 75mu Shanghai Zhejiang Hainan Land cost Rmb80k/mu Heilongjiang Hubei Henan Annual maintenance <45 days Source: Various presses Tipping fee Rmb70/t On-grid tariff Local coal-fired on-grid tariff + Rmb0.25/KWh CEI is currently the largest WTE operator in China, Source: Zhejiang Haining Municipal Government with daily processing capacity of 7,550 tonnes (8

operating projects). The company has another 4 WTE has been one of the cheapest ways to produce projects in the construction pipeline. Besides WTE, CEI electricity globally. In our report, ‘The New Energy also operates an industrial solid waste landfill project, Primer’, published in September 2011, we calculated with a daily processing capacity of 142,000m3, and has that the levelised cost of electricity (tariffs needed to 3 projects in the pipeline. achieve a 10% project return based on various scenarios of capital costs) for WTE is globally competitive compared to traditional power sources like coal, hydro, and geothermal, etc.

- 42 - China Water Sector 15 February 2012

CEI: WTE and waste landfill projects in operation and pipeline (Jan 2012) Investment risks Power WTE generation Investment Project name Province Contract (ton/day) (GWh/year) (Rmb m) In our view, the downside risks to our investment WTE - in operation thesis include: Suzhou WTE Phase 1 Jiangsu BOT 1,050 100 489 Yixing WTE Phase 1 Jiangsu BOT 500 44 238 • a delay in the increase of waste treatment fees and Changzhou WTE Jiangsu BOT 800 77 413 WWT tariffs to pass through rising operating costs, Jiangyin WTE Phase 1 Jiangsu BOT 800 77 389 Jiangyin WTE Phase 2 Jiangsu BOT 400 38 205 • slower-than-expected capacity expansion, and Suzhou WTE Phase 2 Jiangsu BOT 1,000 100 450 Jinan WTE Shandong BOT 2,000 190 901 • an increase in the interest rates on borrowing. Zhenjiang WTE Jiangsu BOT 1,000 100 414 Suqian WTE Jiangsu BOT 600 60 324 WTE - in pipeline Huidong WTE Guangdong BOT 600 104 334 Yixing WTE Phase 2 Jiangsu BOT 300 31 151 Suzhou WTE Phase 3 Jiangsu BOT 1,500 158 750 Nanjing WTE Jiangsu BOT 2,000 200 1,030 Total 12,550 1,279 6,088 Waste Landfill - in operation Suzhou Industrial Solid Waste Landfill Phase 1 Jiangu BOT 142 78 Suzhou Industrial Solid Waste Landfill Phase 2 Jiangu BOT 370 40 Waste Landfill - in pipeline Zhenjiang Industrial Solid Waste Landfill Jiangu BOT 296 100 Suqian Hazardous Waste Landfill Jiangu BOT 340 99 Total 1,148 317 Source: Company

Integrating into midstream equipment manufacturing CEI has successfully developed and manufactured its own grate furnaces, main waste incineration equipment, and an automatic control system. It installed the self-manufactured grate furnaces in the Jiangyin WTE Phase II project in November 2010, and later in the Zhenjiang WTE project and Suqian WTE project in 1H11. CEI is now building an equipment manufacturing site in Changzhou, Jiangsu, and the plant is expected to commence operations in 1H12.

Compared with the equipment CEI used to purchase from Keppel Seghers (Not listed), CEI’s self-developed furnaces can reduce the purchase cost by 40% and are more suitable and efficient for China’s own waste content. Grate furnaces account for around 30% of total equipment costs, which is half of the total construction cost for a WTE plant. We expect that installing self-manufactured grate furnaces could bring down CEI’s total construction costs by 6% and raise project ROE by around 1pp, assuming 60% debt financing.

- 43 -

Utilities / China 15 February 2012

Guangdong Investment Target price: HK$5.35 Up/downside: +14.8% 270 HK | GGDVY US Share price (13 Feb): HK$4.66

Initiation: defensive and acquisitive

• GDI has the highest earnings visibility among its peers, with 88% of 2012E earnings highly predictable • Following recent acquisitions, we expect GDI to further utilise its rich cash position to acquire municipal water supply projects • Coverage initiated with an Outperform (2) rating and NAV-based six-month target price of HK$5.35 How do we justify our view?

lowest gearing among its peers Risks globally) even following its recent The main downside risks relate to acquisitions (properties and a water the investment-property business project in Guangzhou). GDI intends to (delayed new-project construction

utilise its strong cash position to and a worse-than-expected economy Jackie Jiang improve ROE by acquiring more in the Pearl River Delta area). (852) 2848 4994 [email protected] municipal water supply projects or by raising its dividend payout ratio. Share price performance Dave Dai, CFA Potential acquisition targets are (HK$) (%) (852) 2848 4068 5.4 170 [email protected] mainly focused on TOT projects, as 4.9 150 about 30% of water projects in 4.4 130 Gary Zhou Guangdong are loss-making. Using (852) 2773 8535 3.9 110 [email protected] the company’s net-gearing threshold 3.4 90 of 100%, we estimate that GDI’s net Feb-11 May-11 Aug-11 Nov-11 Feb-12 capital available for acquisitions Guangdong Investment (LHS) Relative to HSI (RHS) Investment case would amount to HK$23bn by the We estimate that 88% of GDI’s 2012 end of 2012. 12-month range 3.67-5.14 earnings are highly predictable, Market cap (US$bn) 3.75 given that it provides water to Hong We initiate coverage with an Average daily turnover (US$m) 5.34 Kong under a fixed-revenue scheme Outperform (2) rating and NAV- Shares outstanding (m) 6,233 until 2014 and sees stable rental based six-month target price of Major shareholder GDH Ltd (60.5%) income from investment properties, HK$5.35. making it the most defensive China Financial summary (HK$) Year to 31 Dec 11E 12E 13E utilities company we cover in terms Catalysts Near-term catalysts include value- Revenue (m) 6,874 7,479 7,938 of earnings visibility. To test the Operating profit (m) 3,841 4,182 4,441 downside from the current level, we and EPS-accretive acquisitions of municipal water supply projects. Net profit (m) 2,583 2,877 3,117 performed a bear-case valuation Core EPS 0.414 0.462 0.500 analysis, in which we assumed flat EPS change (%) 20.7 11.4 8.4 Valuation rental income and Hong Kong water Daiwa vs Cons. EPS (%) (4.4) 0.2 0.4 tariffs from 2012 and 2015 onwards, The stock is trading at discounts to PER (x) 11.2 10.1 9.3 together with conservative cap rates its peers’ average PER and PBR, Dividend yield (%) 3.4 3.8 4.1 and multiples to value different while offering the highest dividend DPS 0.160 0.178 0.193 assets. Our bear-case target price of yield (3.8% for 2012E) and PBR (x) 1.4 1.3 1.2 HK$4.56 suggests only 2% downside. attractive sustainable ROE of EV/EBITDA (x) 7.5 6.6 5.9 around 13%, on our forecasts. It is ROE (%) 13.0 13.3 13.2 We forecast GDI to achieve a net cash also the only water company in Source: Bloomberg, Daiwa forecasts position by the end of 2012 (the China generating a stable operating cash inflow currently.

Important disclosures, including any required research certifications, are provided on the last two pages of this report. China Water Sector 15 February 2012

How do we justify our view?

Growth outlook Valuation Earnings revisions

Growth outlook GDI: core earnings history and forecasts

We forecast GDI’s core earnings, which could see upside (HK$m) (%) from potential acquisitions, to rise at a 2011-13 CAGR of 3,500 3,117 70 2,877 10%. 3,000 60 60 2,583 2,500 2,134 50 1,875 2,000 1,675 40 1,500 30 1,000 21 20 14 12 11 500 8 10 0 0 2008 2009 2010 2011E 2012E 2013E Net profit (LHS) Net profit growth (YoY) (RHS)

Source: Company, Daiwa forecasts

Valuation GDI: 12-month-forward PER bands

The stock is trading currently close to its past-5-year (x) average 12-month-forward PER of 10.2x on our 2012 18 EPS forecast. 16 15.0x Avg+2SD 14 12.6x Avg+1SD 12

10 10.2x Avg

8 7.8x Avg-1SD 6 5.4x Avg-2SD 4 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12

Source: Bloomberg, Daiwa forecasts

Earnings revisions GDI: Bloomberg-consensus EPS forecast

The Bloomberg-consensus EPS forecasts for 2012-13 (Rebased to 100) were revised up by 10-16% in 2011. 120

115

110

105

100

95 -11 r-11 p p Jul-11 Jul-11 Oct-11 Oct-11 A Jan-12 Jan-11 Jan-11 Jun-11 Mar-11 Mar-11 Feb-11 Nov-11 Dec-11 Dec-11 Aug-11 Se May-11 May-11 2012E 2013E

Source: Bloomberg

- 45 - China Water Sector 15 February 2012

Financial summary

Key assumptions Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Water sales volume (mn m3) – Hong 617.3 715.4 653.2 724.6 680.8 702.7 702.7 702.7 Kong Water tariff (HK$/m3) – Hong Kong 3.1 3.1 3.1 3.7 3.9 4.2 4.4 4.7

Profit and loss (HK$m) Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Water distribution 3,226 3,365 3,444 3,868 4,067 4,293 4,516 4,750 Property investment and development 429 457 723 804 860 954 1,139 1,222 Others 2,402 2,867 1,747 1,244 1,425 1,628 1,824 1,966 Total revenue 6,056 6,689 5,913 5,916 6,352 6,874 7,479 7,938 Other income 75 51 764 (74) (81) (38) (38) (38) COGS (3,183) (3,615) (2,700) (2,140) (2,159) (2,268) (2,468) (2,620) SG&A (78) (158) (484) (535) (636) (551) (608) (650) Other op. expenses (433) (413) (190) (170) (165) (177) (183) (189) Operating profit 2,438 2,554 3,303 2,998 3,309 3,841 4,182 4,441 Net-interest inc./(exp.) (581) (418) (292) (192) (127) (143) (122) (31) Assoc/forex/extraord./others 191 268 (574) 154 578 209 291 304 Pre-tax profit 2,048 2,404 2,437 2,959 3,760 3,906 4,350 4,714 Tax (269) (406) (442) (500) (942) (898) (1,000) (1,084) Min. int./pref. div./others (272) (301) (118) (415) (398) (425) (473) (512) Net profit (reported) 1,507 1,697 1,877 2,044 2,420 2,583 2,877 3,117 Net profit (adjusted) 1,432 1,048 1,675 1,875 2,134 2,583 2,877 3,117 EPS (reported) (HK$) 0.250 0.278 0.305 0.330 0.389 0.414 0.462 0.500 EPS (adjusted) (HK$) 0.238 0.172 0.273 0.303 0.343 0.414 0.462 0.500 EPS (adjusted fully-diluted) (HK$) 0.231 0.168 0.269 0.301 0.342 0.413 0.459 0.498 DPS (HK$) 0.101 0.110 0.100 0.110 0.150 0.160 0.178 0.193 EBIT 2,438 2,554 3,303 2,998 3,309 3,841 4,182 4,441 EBITDA 2,870 2,967 3,493 3,167 3,475 4,017 4,365 4,630

Cash flow (HK$m) Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Profit before tax 2,048 2,404 2,437 2,959 3,760 3,906 4,350 4,714 Depreciation and amortisation 433 413 190 170 165 177 183 189 Tax paid (269) (406) (442) (500) (942) (898) (1,000) (1,084) Change in working capital (35) 482 (87) 318 233 (5) 104 79 Other operational CF items 342 447 755 526 1,317 378 288 205 Cash flow from operations 2,518 3,339 2,853 3,473 4,533 3,557 3,924 4,103 Capex (239) (2,308) (863) (787) (782) (2,548) (1,048) (1,048) Net (acquisitions)/disposals 2 193 (62) 175 (853) (209) (291) (304) Other investing CF items (188) 1,458 1,312 (310) (631) (297) (424) (290) Cash flow from investing (425) (657) 387 (922) (2,266) (3,053) (1,763) (1,642) Change in debt (1,576) (1,864) (1,323) (2,457) (1,994) 0 (1,000) (2,222) Net share issues/(repurchases) 37 6 29 26 9 0 0 0 Dividends paid (606) (671) (616) (683) (934) (997) (1,110) (1,203) Other financing CF items 190 279 83 338 621 487 586 605 Cash flow from financing (1,955) (2,250) (1,828) (2,777) (2,298) (509) (1,524) (2,819) Forex effect/others 0 0 0 0 0 0 0 0 Change in cash 138 433 1,412 (226) (30) (6) 638 (358) Free cash flow 2,279 1,032 1,990 2,686 3,752 1,009 2,876 3,055

Source: Company, Daiwa forecasts

- 46 - China Water Sector 15 February 2012

Financial summary continued …

Balance sheet (HK$m) As at 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Cash & short-term investment 2,252 2,685 4,097 3,871 3,841 3,828 4,460 4,101 Inventory 59 58 50 49 60 63 68 72 Accounts receivable 330 380 723 563 596 645 702 745 Other current assets 135 157 229 193 126 126 126 126 Total current assets 2,775 3,279 5,099 4,677 4,622 4,661 5,356 5,044 Fixed assets 7,545 2,301 3,003 3,034 3,165 3,288 3,405 3,516 Goodwill & intangibles 11,871 18,557 17,717 16,933 16,129 15,334 14,578 13,861 Other non-current assets 7,983 6,356 5,426 6,144 8,005 10,758 12,221 13,563 Total assets 30,174 30,493 31,245 30,787 31,920 34,041 35,560 35,984 Short-term debt 206 292 310 1,585 720 720 720 720 Accounts payable 1,024 1,416 1,512 1,736 1,838 1,886 2,052 2,178 Other current liabilities 707 762 1,046 1,084 1,268 1,268 1,268 1,268 Total current liabilities 1,937 2,471 2,869 4,405 3,827 3,875 4,040 4,167 Long-term debt 11,375 9,425 8,083 4,351 3,222 3,222 2,222 0 Other non-current liabilities 2,450 2,566 2,811 2,580 2,963 2,963 2,963 2,963 Total liabilities 15,762 14,461 13,763 11,336 10,012 10,059 9,225 7,129 Share capital 3,045 3,052 3,081 3,107 3,115 3,115 3,115 3,115 Reserves/R.E./others 9,577 10,973 12,315 13,923 16,001 17,650 19,530 21,537 Shareholders' equity 12,623 14,025 15,396 17,030 19,117 20,766 22,646 24,653 Minority interests 1,789 2,006 2,086 2,421 2,792 3,216 3,689 4,202 Total equity & liabilities 30,174 30,493 31,245 30,787 31,920 34,041 35,560 35,984 EV 39,443 37,620 35,182 33,714 31,354 31,593 30,143 28,488 Net debt/(cash) 9,329 7,033 4,297 2,065 102 114 (1,518) (3,381) BVPS (HK$) 2.072 2.298 2.499 2.741 3.068 3.332 3.633 3.955

Key ratios (%) Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Sales (YoY) n.a. 10.4 (11.6) 0.0 7.4 8.2 8.8 6.1 EBITDA (YoY) n.a. 3.4 17.7 (9.3) 9.7 15.6 8.7 6.1 Operating profit (YoY) n.a. 4.8 29.3 (9.2) 10.4 16.0 8.9 6.2 Net profit (YoY) n.a. (26.8) 59.8 12.0 13.8 21.0 11.4 8.4 EPS (YoY) n.a. (27.7) 58.6 11.2 13.3 20.7 11.4 8.4 Gross-profit margin 47.4 46.0 54.3 63.8 66.0 67.0 67.0 67.0 EBITDA margin 47.4 44.4 59.1 53.5 54.7 58.4 58.4 58.3 Operating-profit margin 40.2 38.2 55.9 50.7 52.1 55.9 55.9 55.9 ROAE 11.3 7.9 11.4 11.6 11.8 13.0 13.3 13.2 ROAA 4.7 3.5 5.4 6.0 6.8 7.8 8.3 8.7 ROCE 9.4 9.9 12.8 11.7 12.9 14.3 14.6 15.1 ROIC 8.9 9.1 12.1 11.5 11.4 12.8 13.2 13.6 Net debt to equity 73.9 50.1 27.9 12.1 0.5 0.6 net cash net cash Effective tax rate 13.1 16.9 18.2 16.9 25.1 23.0 23.0 23.0 Accounts receivable (days) 19.9 19.4 34.0 39.7 33.3 33.0 32.9 33.3 Payables (days) 61.7 66.6 90.4 100.2 102.7 98.9 96.1 97.2 Net interest cover (x) 4.2 6.1 11.3 15.6 26.0 26.8 34.2 141.4 Net dividend payout 40.2 39.6 32.8 33.4 38.6 38.6 38.6 38.6 Source: Company, Daiwa forecasts

Company profile Listed in 1973, Guangdong Investment Group is principally engaged in the supply of water to Hong Kong, Shenzhen and Dongguan, property investment and development, department-store operations, hotel operations and management, electric- power generation and toll-road and bridge operations.

- 47 - China Water Sector 15 February 2012

Renminbi against the Hong Kong Dollar and increases in GDI’s operating cost for supplying Hong Kong with water. For investment properties, we assume a cap rate of 8% for office buildings and 10% for shopping malls based on the spot rental and transaction price of properties in similar locations. Initiation: defensive GDI: base-case NAV valuation assumption and calculation and acquisitive Equity value Business Valuation method (HK$m) % Water distribution DCF, 9.5% COE, no terminal value 24,602 56% Coverage initiated with an Outperform Property investment 14,146 32% - Teem Plaza NAV based on 8-10% cap rate 11,093 rating. DCF, 9.5% COE, 2% terminal - Sheraton Guangzhou Hotel growth 714 - Tianjin Teem Shopping Mall NAV based on 10% cap rate 2,339 Bull-bear case of valuation Department stores 8.0x 2012E PER 2,365 5% Electric power generation 0.5x 2012E PBR 358 1% Hotel operation 1.0x 2012E PBR 1,666 4% GDI has been a safe haven for investors during bear Toll roads and bridges DCF, 9.5% COE, no terminal value 1,054 2% markets, given its defensive portfolio of utilities and Total EV 44,191 100% infrastructure assets. In recent periods of market Add: net cash 1,518 Less: minority interest (6,453) downturns, it has outperformed the HSCEI Index by Total NAV 39,256 72% (2004), 21% (2008) and 40% (2011). We expect Outstanding shares 6,233 the outperformance to continue given GDI’s high Target fair value (HK$ per earnings predictability and strong balance sheet, share) 6.30 NAV discount 15% supporting potential M&A activity. Target price (HK$ per share) 5.35 Source: GDI: share –price performance relative to the HSCEI Index (%) Relative return to HSCEI GDI HSCEI absolute GDI: gross estimated NAV breakdown (end-2012) 2001 (22.7) 8.2 2002 12.7 13.2 Hotel operation Toll roads and 2003 (91.4) 152.2 3.8% bridges 2004 72.2 (5.6) Electric power 2.4% 2005 (0.9) 12.4 generation 2006 (73.0) 94.0 0.8% 2007 (29.2) 55.9 Department 2008 20.9 (51.1) stores 5.4% 2009 (16.5) 62.1 2010 (10.9) (0.8) Property Water 2011 40.0 (21.7) investment distribution 55.7% Source: Bloomberg 32.0%

Base-case NAV Given GDI’s conglomerate business model, we believe a Source: Daiwa forecasts SOTP valuation is the appropriate method to capture its intrinsic value. We have applied different valuation Our target price of HK$5.35 implies a PER of 11.6x and methodologies for GDI’s different business segments a PBR of 1.5x on our 2012 EPS and BVPS forecasts, and our end-2012 NAV forecast is HK$39,256m. The respectively, which we see as reasonable compared water distribution business accounts for the largest with the stock’s valuation history. As a defensive share of our NAV estimate at 56%, followed by property utilities company, GDI has provided a stable dividend investment and development at 32%. We believe a yield of around 4% over the past 5 years. We expect the conglomerate-business discount of 15% applied is dividend yield to improve when management raises the appropriate to take into account the operation risk and dividend payout ratio in the future. lack of synergies among different business segments.

We use a DCF analysis to value the water asset (COE: 9.5%; no terminal value when the concession expires in 2030) and have factored in 4-6% YoY revenue growth over the next 5 years, and a 1% annual increase thereafter to partially reflect the appreciation of the - 48 - China Water Sector 15 February 2012

GDI: 12-month forward PER history investment properties and apply higher-than-base-case, (x) and therefore more conservative, cap rates of 10% and 18 12% for office buildings and shopping malls, 16 respectively. We assume lower multiples for 15.0x Avg+2SD department stores (5.0x on our 2012 EPS forecast) and 14 the hotel operations (0.8x on our 2012 BVPS forecast) 12.6x Avg+1SD 12 to reflect the lower earnings growth than in our base 10 10.2x Avg case.

8 7.8x Avg-1SD Our bear-case target price under the above 6 5.4x Avg-2SD assumptions is HK$4.56, which is 15% lower than our 4 base-case target price, but only 2% below GDI’s current Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 trading price. Source: Bloomberg, Daiwa forecasts GDI: bear-case NAV valuation assumption and calculation GDI: 12-month forward PBR history Equity value Business Valuation method (HK$m) % (x) Water distribution DCF, 9.5% COE, no terminal value 21,823 58% Property investment 11,383 30% 1.9 1.8x Avg+2SD - Teem Plaza NAV based on 10-12% cap rate 8,720 23% 1.7 DCF, 9.5% COE, 2% terminal 1.6x Avg+1SD - Sheraton Guangzhou Hotel growth 714 2% 1.5 - Tianjin Teem Shopping Mall NAV based on 12% cap rate 1,949 5% Department stores 5.0x 2012E P/E 1,478 4% 1.3 1.3x Avg Electric power generation 0.5x 2012E P/B 358 1% 1.1 Hotel operation 0.8x 2012E P/B 1,333 4% 1.0x Avg-1SD Toll roads and bridges DCF, 9.5% COE, no terminal value 1,054 3% 0.9 Total EV 37,429 100% 0.7 0.7x Avg-2SD Add: net cash 1,518 Less: minority interests (5,498) 0.5 Total NAV 33,448 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Outstanding shares 6,233 Source: Bloomberg, Daiwa forecasts Target fair value (HK$ per share) 5.37 GDI: 12-month forward dividend yield history NAV discount 15% Target price (HK$) 4.56 (%) Source: Daiwa forecasts 8

7 Bull-case NAV suggests exciting upside 6 6.0 Avg+2SD In our bull-case scenario, for the Hong Kong water 5 4.9 Avg+1SD supply project, we assume GDI passes on any changes in the Rmb:HK$ exchange rate and its operating costs 4 3.9 Avg through the water tariff, for which we use China’s CPI 3 2.8 Avg-1SD as a proxy, resulting in 6% annual growth over the next 2 five years and a 3% increase thereafter. 1.8 Avg-2SD 1 For investment properties, we assume a 2-3% rental Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Source: Bloomberg, Daiwa forecasts increase (in Renminbi) over the next few years and apply more aggressive cap rates of 7% and 8% for the Bear-case NAV suggests limited downside office buildings and shopping malls. We also assume a higher multiple of 10x on our 2012 EPS forecast for the To test the potential downside from the latest share department-store operation, factoring in higher price, we performed a bear-case NAV analysis. For the earnings growth than in our base case. water projects, we assume no tariff increase from 2015 onwards until the end of the concession period. We Our bull-case target price of HK$6.00 suggests 12% believe a reduction in water tariffs for Hong Kong is upside to our base-case scenario and 29% to the latest unlikely given Hong Kong’s lack of alternatives for trading price. fresh water supply; and even in cases of water tariff reductions, the Guangdong Government tends to grant extra subsidies to GDI, like during the period of 2006- 08. We also assume no rental growth for the

- 49 - China Water Sector 15 February 2012

GDI: bull-case NAV valuation assumption and calculation GDI: growth/earnings visibility matrix for different business Equity value segments Business Valuation method (HK$m) % High growth potential Water distribution DCF, 9.5% COE, no terminal value 27,050 54% Property investment 16,631 33% - Teem Plaza NAV based on 7-8% cap rate 13,578 27% DCF, 9.5% COE, 2% terminal Hotel operation Department stores - Sheraton Guangzhou Hotel growth 714 1% - Tianjin Teem Shopping Mall NAV based on 10% cap rate 2,339 5% Opportunistic Preferred Department stores 10.0x 2012E P/E 2,957 6% Property investment & development Electric power generation 0.5x 2012E P/B 358 1% Hotel operation 1.0x 2012E P/B 1,666 3% Water distribution Toll roads and bridges DCF, 9.5% COE, no terminal value 1,054 2% Total EV 49,715 100% Add: net cash 1,518 Less: minority interest (7,232) Low earning visibility High earning visibility Total NAV 44,000 Toll road and bridge Outstanding shares 6,233 Target fair value (HK$ per Unattractive Defensive share) 7.06

NAV discount 15% Electric power generation Target price (HK$ per share) 6.00 Source: Daiwa forecasts

GDI: a safe haven with great upside and Low growth potential little downside Source: Daiwa After examining our valuations under different scenarios, we believe GDI is a defensive safe haven that Overall, GDI offers high earnings visibility for investors offers great upside in a bull case, and more importantly, through its water distribution asset and property limits the downside under a conservative assumption investment and development (excluding revaluation of an overall economic slowdown. Our bull-case and gains/losses), which in total accounts for 88% of our bear-case target prices suggest 29% upside and 2% EBIT forecast for 2012, the highest among our covered downside to the latest trading price, respectively. China utilities companies.

GDI: target price under base, bear and bull scenario GDI: revenue contribution from different business segments Base case Bear case Bull case (%) Target price (HK$ per share) 5.35 4.56 6.00 Upside to current price (%) 14.8 (2.1) 28.8 120 0 001 1 11 Source: Daiwa forecasts 100 5 6 5 6 7 7 7 7 14 16 7 6 6 6 80 8 9 10 11 11 7 24 14 14 14 15 15 60 12 A defensive conglomerate with 7 40 65 64 63 61 high earnings visibility 50 58 60 20

0 Among GDI’s different business segments, we like 2007 2008 2009 2010 2011E 2012E 2013E those that offer high earnings visibility with growth potential, like water distribution and property Water distribution Property investment and development Department stores Electric power generation investment and development (property investment Hotel operations and management Toll roads and bridges provides stable cash flow through rental income after Source: Company, Daiwa forecasts stripping out the volatile revaluation gain/loss on investment properties).

Electric power generation and toll roads & bridges are our least favourite businesses since they are vulnerable to variables like coal prices, traffic volume and toll fees, which have been quite volatile historically. The department-store and hotel operations are in the middle ground about which we are sceptical given the businesses’ stronger correlation to the macroeconomic cycle.

- 50 - China Water Sector 15 February 2012

GDI: EBIT contribution from highly predictable assets (water GDI: water supply revenue breakdown (2007-10) distribution and property investment excl. revaluation gain/loss) 100% 4% 4% 3% 3% (%) 90% 22% 24% 20% 19% 120 110 80% 101 97 70% 100 89 89 88 88 60% 80 50% 40% 74% 72% 77% 77% 60 30% 20% 40 10% 20 0% 2007 2008 2009 2010 Hong Kong Shenzhen Dongguan 0 2007 2008 2009 2010 2011E 2012E 2013E Source: Company Source: Company, Daiwa forecasts Note: Other businesses including power generation and toll road made losses in 2007 and 2008 Hong Kong: earnings stability continues The Hong Kong Government has been purchasing Water: a cash cow with limited water from GDI under a fixed revenue model since 2006, with the negotiation of new agreements taking downside place every three years. A new agreement governing the water supply to Hong Kong over 2012-14 was signed The Dongshen Water Supply Project, with an annual between the Guangdong and Hong Kong Governments designed capacity of 2.4bn m3, was injected into GDI in on 5 December 2011, at fixed purchase lump sums of 2000 and has since become its core business. GDI has HK$3,538.7m, HK$3,743.3m, and HK$3,959,3m for exclusive rights to supply raw water from Dongjiang the three years of 2012, 2013, and 2014, respectively, River to Hong Kong, and non-exclusive rights to implying an annual increase of 5.8% in fixed revenue Shenzhen and Dongguan. The operating rights last for for the next three years. The increase in water tariff is a period of 30 years commencing from August 2000. determined based on increases in GDI’s operational costs and changes in the Rmb:HK$ exchange rate. We Water supply to Hong Kong accounts for around 35% assume an annual increase of 1% in water revenue from of the total volume supplied, but 75% of the total the Hong Kong Government for the rest of the water revenue generated thanks to the much higher water supply concession period until 2030. tariffs implied in the water supply agreements between the Guangdong and Hong Kong Governments GDI: Water supply arrangements with HK government (HK$4.6/m3 for Hong Kong vs. HK$0.74/m3 for 2004-05 2006-08 2009-11 2012-14 Arrangement Fixed volume: 820 Fixed revenue Fixed revenue Fixed revenue Shenzhen and Dongguan for 2010). terms m m3 model; model; model; Fixed tariff: Flexible supply Flexible supply Flexible supply GDI: water supply volume breakdown (2007-10) HK$3.084/m3 volume based on volume based on volume based on actual needs actual needs actual needs 100% Annual HK$2,530m HK$2,495m 2009: HK$2,959m 2012: HK$3,539m 21% 20% 18% 18% revenue (an extra subsidy 2010: HK$3,146m 2013: HK$3,743m 80% of HK$730m for 2011: HK$3,344m 2014: HK$3,959m 2005-08 from Guangdong 60% Government) 45% 47% 46% 46% Source: Company 40% Hong Kong’s two main water sources are rainfall from 20% 34% 32% 36% 35% natural catchment and the Dongjiang water supply from GDI. The raw water from the two sources is first 0% 2007 2008 2009 2010 gathered and stored in impounding reservoirs before going through treatment works and then being Hong Kong Shenzhen Dongguan distributed to end users via service reservoirs located in Source: Company various places across Hong Kong. The Dongjiang water

supply accounts for around 75% of Hong Kong’s total water supply. The total fresh water supply has been quite stable over the past years, while the supply from

- 51 - China Water Sector 15 February 2012

local yield has varied significantly depending on the however, has increased by 16% over the same period. rainfall. Shenzhen raised its tap water tariff by 10-33% for different customer groups earlier in 2011, which Hong Kong: water supply system provided room for raw water suppliers like GDI to raise

Primary Service Reservoir raw water tariffs. Dongguan has lagged behind in its tap water tariff increase (mere 3-4% growth over the past three years), and we believe a tariff rise is on the Water Gathering Impounding Reservoir Treatment Works way. We expect GDI’s average water tariff for Shenzhen Grounds and Dongguan to increase by 3% annually over the next three years. Service Reservoir Other businesses Raw Water from Guangdong Pumping Station

Consumers Among GDI’s non-water businesses, we prefer its property investment, department-store operation to its Source: Hong Kong Water Supplies Department, Daiwa hotel operation, power generation and toll road and bridge businesses. GDI: water supply volume breakdown (1998-2010) (mn m3) Property investment – premium location 1,200 guarantees stable rents 1,000 GDI is not an aggressive property developer. It tends to 800 develop and hold investment properties in city centres 729 771 653 600 760 706 744 761 617 that can generate stable rental income. Currently, its 715 725 681 738 808 portfolio of investment properties includes Teem Plaza 400 in Guangzhou (including Teemall, Teem Tower [office 200 320 332 building] and Sheraton Guangzhou Hotel), Guangdong 238 261 301 252 253 298 220 228 106 111 187 0 Investment Tower in Hong Kong, and Tianjin Teem Shopping Mall, which is under development. All of 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 these properties are located in central business districts Local yield Dongjiang Water Supply of respective metropolises and have been enjoying Source: Company close to 100% occupancy rates since being developed.

Hong Kong: the correlation of YoY growth between rainfall, local yield water supply and Dongjiang water supply (1998-2010) We visited Teem Plaza situated at the heart of Tianhe (%) District, Guangzhou, and were surprised by the crowds 180 on a drizzling Friday afternoon. Opened in 1996, 160 Teemall, which targets middle-end consumers, is well 140 120 connected by metro and provides a full range of 100 entertainment from shopping, dining to movies and 80 60 playing grounds. 40 20 0 Located next to Teemall, the east tower, Teem Tower is (20) a 45-story grade-A office building which was launched (40) (60) in 2007. We checked the lessee list in Teen Tower and 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 recognised many well-known multi-national Rainfall Local yield Dongjiang Water Supply corporations as well as several nations’ consulates. The

Source: Hong Kong Water Supplies Department west tower, Sheraton Guangzhou Hotel, is a 5-star hotel launched in July 2011. China: benefit from water tariff increase potential GDI supplies raw water to Shenzhen and Dongguan besides Hong Kong. The volume supplied has declined by 9% over the past 3 years, due mostly to the priority to supply water to Hong Kong and droughts in southern China in recent years. The average water tariff,

- 52 - China Water Sector 15 February 2012

Exterior of Teemall and Teem Tower Teemall: queue in front of Starbucks Coffee

Source: Daiwa

Sheraton Guangzhou

Source: Daiwa

Teemall: Northern entrance

Source: Daiwa

GDI plans to repeat the success of Teem Plaza and build a landmark shopping mall/office complex in the heart of the business district and on top of a subway station in Tianjin. The construction started in 4Q11 and is expected to be completed in 2013, with a total estimated investment of Rmb2,130m. We have included the earnings contribution from Tianjin Teem Shopping Mall from 2014 onward. Source: Daiwa In our base-case scenario, we assume annual growth of 2-3% in monthly rentals (in Renminbi) for Teemall and Teem Tower over the next few years and apply a cap rate of 8% for office buildings and 10% for the shopping mall to calculate the NAV. In our bear-case scenario, we assume no rental growth (in Renminbi) and apply much higher and conservative cap rates of 10% and 12%, respectively.

- 53 - China Water Sector 15 February 2012

GDI: investment properties valuation assumptions and We forecast the segment to see 10-20% annual revenue calculation growth over the next two years. Cap rate Base case Bear case Bull case Office building - Teem Tower, Guangzhou 8% 10% 7% Power generation – volatile earnings along - Guangdong Investment Tower, Hong Kong 8% 10% 7% with the coal price Shopping mall - Teemall, Guangzhou 10% 12% 8% GDI owns various stakes in four coal-fired power 2012E annual rental income (HK$m) plants in Guangdong. Although it has benefited from Office building the power shortage in the province, it has also suffered - Teem Tower, Guangzhou 182 168 182 from coal price hikes and regulated power tariffs in the - Guangdong Investment Tower, Hong Kong 33 33 33 Shopping mall past. The power-generation business made losses in - Teemall, Guangzhou 840 805 840 2004, 2007 and 2008. We expect a limited NAV at end of 2012E (HK$m) contribution from the segment going forward. Office building - Teem Tower, Guangzhou 2,278 1,683 2,604 - Guangdong Investment Tower, Hong Kong 411 329 470 Toll roads – limited growth ahead Shopping mall GDI owns various stakes in one highway and three - Teemall, Guangzhou 8,404 6,708 10,504 bridges in Guangdong. The toll road and bridges have Total 11,093 8,720 13,578 seen volatile vehicle traffic and overall up-trending toll Source: Daiwa forecasts fees in the past. We expect the segment to see 5% Department stores – leverage on the annual revenue growth over the next two years. Teemall brand GDI currently operates four department stores, Acquisition on the way – unlock Teemall Store (inside Teemall), Mingsheng Store, Wan Bo Store, and Ao Ti Store, all located in Guangzhou. the value of strong cash position The department-store business recorded revenue growth of 26% YoY for 1H11 thanks to aggressive Rich cash position for M&A promotional activities. We expect the segment to see GDI has developed a strong balance sheet and should 10-20% annual revenue growth over the next two years. be in a net cash position by the end of 2012, based on our forecasts, after years of cash inflow from the water Teemall Department Store distribution and property investment businesses. The problem that most of us are wondering now is what to do with all this cash?

GDI: net gearing (2008-13E) (%) 27.9 30 25 20 15 12.1 10 5 0.5 0.6 0 (5) (10) -6.7 (15) -13.7 (20) 2008 2009 2010 2011E 2012E 2013E Source: Daiwa Source: Company, Daiwa forecasts

Hotel management If GDI’s management were not able to utilise the GDI owns seven hotels in Hong Kong, Shenzhen, abundant cash in hand, the long-term ROE (2016-20E) Zhuhai, Zhengzhou and Changzhou, four of which are would decline from near-term levels, and therefore star-rated and the rest are budget inns. GDI also hurt investors. manages another 34 hotels across China. The hotel business recorded revenue growth of 19% YoY for 1H11 due to high occupancy rates and average room rates.

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GDI: ROE (2011-20E) Recent acquisitions (%) It is no surprise to us that the company has announced 14 2011-15E mean: 13.2% a series of acquisitions since November 2011. Target 13 2016-20E mean: 11.5% companies include several pieces of property, and most 12 recently a municipal water supply project in Guangzhou. 11 10 GDI: summary of recent acquisitions Date Type Target company Ownership Consideration 9 28-Nov-11 Property Three pieces of property 40% Rmb135m; another in Guangzhou City Rmb2,325m as 8 shareholders' loans 10-Jan-12 Property A piece of land in Panyu 68% Rmb1,994m, of which 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E District, Guangzhou City Rmb1,636m is paid Source: Company, Daiwa forecasts within the next 5 years 8-Feb-12 Water Huangge Water Plant, 60% Rmb148m; further which supplies water to capital injection and Compared with its regional and global water operator Nansha District, shareholders' loans peers, GDI has the lowest gearing (Sound Global Guangzhou City up to Rmb756m returned to a net-cash position after its re-introduction Source: Company on the Hong Kong Stock Exchange), enabling it to raise For the first acquisition, GDI acquired a 40% equity capital easily when it comes to M&A. Using the interest in three property companies through its company’s target net gearing ratio of 100%, we property arm subsidiary, Guangdong Teem (GD Teem) estimate that GDI’s net capital available for acquisition (Not listed). The key assets are a shopping mall and would amount to HK$23bn by the end of 2012. commercial properties located in Guangzhou, and had

Global water operators: net gearing as of 2010 a book value of Rmb2,119m in total as at 31 October Company Country Net gearing as of 2010 (%) 2011. GD Teem paid a total consideration of Rmb135m, Guangdong Investment China 0.5 implying a trailing PBR of 0.2x, and will be required to Hyflux Singapore 75.0 provide up to Rmb2,325m as shareholders’ loans to Beijing Enterprises Water China 168.8 help the target companies repay outstanding debt. China Everbright Int'l China 45.5 China Water Affairs China 55.4 Sound Global China -29.6 The three properties were valued by an independent Beijing Capital China 45.9 valuer at Rmb7,820m in total as at 31 October 2011, Tianjin Capital China 97.2 which means that if GD Teem were to sell the 40% Nanhai Development China 40.7 equity interest in the properties immediately following Qianjiang Water Resources China 46.1 Veolia France 197.1 the acquisition, it would recover a total of Rmb3,128m. Suez Environment France 158.2 We see the acquisition as positive but insignificant, American Water Works U.S.A 134.5 lifting GDI’s total equity value by only around 2%. Aqua America U.S.A 128.5 Acciona Spain 114.9 Details of the target companies BWT AG Germany 6.0 Property Average 80.3 Company Property Property Book value value Liabilities Source: Bloomberg name Property name type status (Rmb m) (Rmb m) (Rmb m) Guangzhou Shopping GDI: upside on capital if leveraged up Tianyuan Comic City mall In operation 800 1,521 790 HK$m Guangzhou Ming Cheng FY12 net debt -1,518 Guangzhou Commercial Commercial Under FY12 equity to shareholders 22,646 Jindongyuan Plaza property development 341 2,709 2,406 FY12 net gearing -6.7 Land in Target net gearing 100.0 Guangdong Zhujiang New Commercial To be Net capital available for acquisition 22,646 Sancheng City property developed 978 3,590 2,613 Source: Daiwa forecasts Total 2,119 7,820 5,809 40% of total 848 3,128 2,324 GDI’s management has long expressed its intention to Source: Company put its cash to good use in either of two ways: 1) new Note: Book value, property value and liabilities presented were as at 31 October 2011 investment through M&A, likely in water or commercial property projects, and 2) by raising the dividend payout ratio.

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GDI: net addition to equity value through the property earnings forecast by about 1%, according to our acquisition estimates. The acquisition of a group of water supply (Rmb m) projects would be more meaningful. Net realizable value if selling the properties now 3,128 Less: liabilities 2,324 Less: consideration payable 135 Equity value and earnings accretion by municipal water 3 Net addition to equity value 669 supply project (capacity: 500,000m /day) GDI's total NAV (base-case) (HK$m) 39,256 Designed daily capacity ('000 t/day) 500 % out of GDI's total NAV 2.1% Investment per unit (Rmb per t/day) 1000 Source: Company, Daiwa forecasts Total investment (Rmb m) 500 Debt proportion 60% Equity proportion 40% The second acquisition was announced in January Project ROE 8-12% 2012 when GDI acquired 68% of a project company Project earning (Rmb m) 20 that owns a piece of land in Panyu District of GDI's market cap (HK$m) 29,046 Guangzhou city, for a cash consideration of GDI's 2012 forecast earnings (HK$m) 2,877 Rmb1,944m payable within 5 years. GDI intends to Equity value accretion 0.8% 2012 earning accretion 0.8% develop a large-scale integrated commercial project on Source: Daiwa estimates the land, including a shopping centre, offices and parking space. Investment risks Development plan for Panyu land Project type Gross floor area ('000 m2) Shopping mall >100 In our view, the key downside investment risks include: Office building >110 1) a lower-than-expected water tariff increase during Shops >40 Parking lot >250 the period of 2015-30, Source: Company 2) delays in the construction schedule of the Tianjin Teem Shopping Mall and newly acquired properties, We have included the capex for land development in and our assumptions, which puts no pressure on GDI’s financial position (net cash position achieved by the 3) a worse-than-expected economic slowdown in China, end of 2012 in our forecast). We believe the especially in Guangdong Province, that would acquisitions are value-accretive for GDI given its track negatively affect earnings growth for the record in commercial property development, but we department-store operation, hotel operation, and have not included any earnings contributions from the rental income, etc. newly purchased properties given the low visibility of construction schedules and investment return outlook.

Water projects: more to come? On 8 February 2012, GDI acquired a 60% equity interest in Huangge Water Plant, which supplies water to Nansha District, Guangzhou city, for a consideration of Rmb148m. GDI will further provide up to Rmb756m in the form of a capital injection or shareholders’ loans to Huangge Water Plant for its future land lease payment and construction over the next two years. We have not included an earnings contribution from this water project given the low visibility of construction schedules and investment return outlook.

We believe the recent acquisition of a municipal water- supply project is in line with GDI’s development strategy to deliver a stable investment return, and we expect more such acquisitions to come. The company has an investment project ROE threshold of over 8% and is focused on existing projects in Guangdong Province. We believe the equity value and earnings accretion from the acquisition of a single project are limited, raising the current market cap and our 2012

- 56 - China Water Sector 15 February 2012

enabling the company to become the monopolistic water supplier to Hong Kong. Appendix: company background The company carried out a series of business Listed in 1973, GDI is one of the earliest PRC restructuring and sold its non-core businesses companies that came to Hong Kong for capital needs. It including Guangdong Brewery and Guangdong Tanner was later selected as a Hang Seng Index constituent in 2003, with proceeds used to pay back its outstanding stock in November 1994. Over the years, it has loans. developed businesses in power utilities, infrastructure, property investment & development, hotels, industrials, Today, GDI has become a conglomerate focused on retails and finance. However, the company experienced utilities and infrastructure, with water distribution, serious financial insolvency in 1998 and was on the power generation, toll roads and bridges, property brink of bankruptcy. Considering its important role in investment and development, department-store Hong Kong’s economy, the Guangdong Government operation, and hotel operation as its main businesses. bailed out the company via a capital injection and injected Dongshen Water Supply Project into it,

GDI: corporate structure

GDH Limited Guangdong Trust Ltd.

60.5% 9.25% 30.25% Guangdong Investment (270 HK) Public Shareholders

Core Others

Property Investment Electric Power Toll Roads Department Stores Hotel Operations Water Distribution and Development Generation and Bridges Operation and management

88% 85% 100%

Dongshen Water Teem Plaza Zhongshan (60%) Yingkeng Highway (70%) Teemall Sto re 7 owned hotels Supply Project 76% -Teemall Yudean (25%) Panyu Bridge (20%) Ming Sheng Store 31 managed hotels -Teem Tower Yue Jiang (11%) Humen Bridge (12%) Wan Bo Store -Sheraton Meixian (12%) Shantou Bridge (15%) Guangzhou Hotel

100% Guangdong Inv. Tower properties

100% Guangdong Group Building properties

100% Tianjin Teem Shopping Mall

Source: Company, Daiwa

GDI: a brief history Listed on Hong Experienced financial Disposed all non-core New Water Supply Kong Stock insolvency and businesses including Arrangement for 2012- Exchange planned business Guangdong Brewery 2015 expected to be restructuring; on edge and Guangdong announced in Oct of bankruptcy Tanner 2011

1973 1998 2000 2003 2008 2009 2011

Acquired Dongshen Announced Water Acquired 25% equity Water Supply Project Supply Arrangements for interests of and became the 2009-2011 between Guangdong Yudean monopolistic water HKSAR and Guangdong Jinghai Power supplier to Hong Kong Government Generation Co., Ltd.

Source: Company, Daiwa

- 57 -

Utilities / Singapore 15 February 2012

Hyflux Target price: S$1.40 Up/downside: -5.4% HYF SP | HYFXY US Share price (13 Feb): S$1.48

Initiation: the sleeping Merlion

• Hyflux’s share price slumped in 2011 following the political turmoil in MENA and its lacklustre quarterly results • Given a slowdown in new orders, the Tuas II Desalination Plant is the only key earnings contributor over the next few quarters

• Coverage initiated with a Hold (3) rating and DCF-based six- month target price of S$1.40

How do we justify our view?

treatment penetration rates Risks achieved by 2010. Furthermore, Upside or downside risks would overseas companies seem to have include faster or slower-than- lost their once superior competitive expected order growth and revenue

advantage in bidding for projects in recognition of the Tuas II Jackie Jiang China, as the market is maturing Desalination Plant, as well as a rise (852) 2848 4994 [email protected] and the domestic players are gaining or fall in interest rates. market share. Dave Dai, CFA Share price performance (852) 2848 4068 We forecast Hyflux’s 2012 earnings to (S$) (%) [email protected] recover significantly, by 107% YoY, 2.5 120 Ilvin Cornelis mostly due to the ramp-up of the Tuas 2.1 100 (65) 6499 6583 II Desalination Plant. However, we 1.7 80 [email protected] 1.3 60 are concerned about the company’s 0.9 40 order growth over the next 12 months. Feb-11 May-11 Aug-11 Nov-11 Feb-12 Investment case We initiate coverage with a Hold (3) Hyflux (LHS) Relative to FSSTI (RHS) rating and DCF-based six-month Hyflux’s share price plunged in 2011 following the political turmoil in target price of S$1.40. 12-month range 1.03-2.27

MENA in early 2011 and a series of Market cap (US$bn) 1.01 Catalysts lacklustre quarterly results. Average daily turnover (US$m) 2.98 Management refers to 2011 as a The stock lacks clear near-term Shares outstanding (m) 860 transition period and attributes the catalysts. Should there be Major shareholder Ooi Lin Lum (31.1%) company’s revenue decline and poor substantial order wins, we would 9M11 results to: 1) the slow start-up become more positive. Financial summary (S$) of the Tuas II Desalination Plant, 2) Year to 31 Dec 11E 12E 13E Valuation the Magtaa SWRO plant entering Revenue (m) 442 753 672 The stock is currently trading close to Operating profit (m) 116 175 171 the final stages of construction, and its past-5-year valuation lows, at a 12- Net profit (m) 47 97 103 3) slow progress in winning new month forward PER of 13x and a PBR Core EPS 0.056 0.113 0.120 projects in China. of 1.3x, both on our forecasts. We EPS change (%) (47.1) 102.6 6.0 Daiwa vs Cons. EPS (%) 0.0 1.8 3.4 We believe the global water market believe the current share price has fully factored in Hyflux’s bleak near- PER (x) 26.6 13.1 12.4 is entering an uncertain phase, with Dividend yield (%) 1.4 2.9 3.1 term outlook and a rerating could be MENA experiencing further political DPS 0.021 0.044 0.046 difficult without a positive surprise in turmoil, with erratic government PBR (x) 1.4 1.3 1.2 policies and regulations. Also, we new order wins. Any execution delay EV/EBITDA (x) 8.8 6.2 6.4 expect China to see a slowdown in with respect to the Tuas II ROE (%) 6.6 10.1 10.1 new project additions given the high Desalination Plant could lead to lower Source: Bloomberg, Daiwa forecasts water access and wastewater earnings over the next few years.

Important disclosures, including any required research certifications, are provided on the last two pages of this report. China Water Sector 15 February 2012

How do we justify our view?

Growth outlook Valuation Earnings revisions

Growth outlook Hyflux: net-profit growth history and forecasts

We forecast Hyflux to record a 2011-13 CAGR of 48% for (S$m) (% ) its net profit attributable to shareholders, due mainly to 130 120 103 the low base that we expect for 2011, and the major 110 97 107 79 89 100 90 ramp-up of the Tuas II Desalination Plant in 2012. 75 70 80 50 59 27 47 60 30 18 10 6 40 (10) 20 (30) (50) -47 0 2008 2009 2010 2011E 2012E 2013E Net profit Net profit growth (YoY)

Source: Company, Daiwa forecasts

Valuation Hyflux: 12-month-forward PER bands

The stock is trading currently below its past-5-year (x) average 12-month-forward PER of 20.8x, which we see 50 as reasonable given its bleak near-term outlook. 45 40 35 34.7x Avg+2SD 30 27.7x Avg+1SD 25 20 20.8x Avg

15 13.9x Avg-1SD 10 5 6.9x Avg-2SD 0 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12

Source: Bloomberg, Daiwa forecasts

Earnings revisions Hyflux: consensus EPS-forecast revisions (2012-13E)

The 2012-13 Bloomberg-consensus EPS forecasts have (Rebased to 100) been cut by 11-47% since the beginning of 2011 following 120 the political unrest in MENA and the slowdown in project wins in China. 100

80

60

40 Jul-11 Apr-11 Oct-11 Jan-11 Jun-11 Jan-12 Feb-11 Mar-11 Feb-12 Aug-11 Sep-11 Nov-11 Dec-11 May-11 2012E 2013E

Source: Bloomberg

- 59 - China Water Sector 15 February 2012

Financial summary

Key assumptions Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Designed capacity – seawater 186.0 186.0 186.0 286.0 486.0 486.0 986.0 1,304.5 desalination (‘000m3/day) Designed capacity – water and 30.0 150.0 755.0 1,220.0 1,300.0 1,300.0 1,540.0 1,700.0 wastewater treatment (‘000m3/day) Seawater desalination tariff (S$/ton) 0.6 0.6 0.6 0.5 0.4 0.5 0.5 0.5 Water and wastewater treatment tariff 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2 (S$/ton)

Profit and loss (S$m) Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Construction 135 182 545 488 513 364 653 543 Operating and maintenance 4 7 8 22 33 40 51 70 Others 3 4 1 15 24 38 49 59 Total revenue 142 193 554 525 570 442 753 672 Other income 5 3 5 7 7 7 7 7 COGS (78) (106) (384) (308) (300) (235) (414) (370) SG&A (22) (33) (53) (65) (78) (73) (147) (114) Other op. expenses (6) (8) (9) (11) (15) (24) (24) (24) Operating profit 42 48 113 148 183 116 175 171 Net-interest inc./(exp.) (9) (9) (10) (9) (17) (20) (21) (23) Assoc/forex/extraord./others (12) (1) (33) (55) (66) (43) (43) (28) Pre-tax profit 20 39 70 83 100 53 111 119 Tax (5) (2) (8) (9) (12) (6) (14) (16) Min. int./pref. div./others 0 (4) (3) 1 0 0 0 0 Net profit (reported) 15 33 59 75 89 47 97 103 Net profit (adjusted) 15 33 59 75 89 47 97 103 EPS (reported) (S$) 0.020 0.042 0.075 0.095 0.105 0.056 0.113 0.120 EPS (adjusted) (S$) 0.020 0.042 0.075 0.095 0.105 0.056 0.113 0.120 EPS (adjusted fully-diluted) (S$) 0.030 0.062 0.110 0.093 0.102 0.054 0.110 0.116 DPS (S$) 0.009 0.013 0.023 0.033 0.042 0.021 0.044 0.046 EBIT 42 48 113 148 183 116 175 171 EBITDA 47 56 122 158 198 141 199 195

Cash flow (S$m) Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Profit before tax 20 39 70 83 100 53 111 119 Depreciation and amortisation 6 8 9 11 15 24 24 24 Tax paid (5) (2) (8) (9) (12) (6) (14) (16) Change in working capital 20 (66) 129 (96) (91) 26 31 0 Other operational CF items (58) 149 (227) 47 (30) (73) (80) (70) Cash flow from operations (17) 128 (26) 36 (17) 25 72 57 Capex (40) (38) (29) (30) (138) (60) (30) (30) Net (acquisitions)/disposals 5 (93) 5 (8) 28 (33) 0 0 Other investing CF items 0 0 0 0 0 0 0 0 Cash flow from investing (36) (131) (24) (38) (110) (93) (30) (30) Change in debt 42 50 59 142 199 0 50 100 Net share issues/(repurchases) 2 14 9 11 83 396 0 0 Dividends paid (7) (7) (11) (18) (34) (18) (37) (40) Other financing CF items 0 0 0 0 0 0 0 0 Cash flow from financing 37 57 58 135 248 378 13 60 Forex effect/others 0 0 0 0 0 0 0 0 Change in cash (16) 53 8 133 120 310 54 87 Free cash flow (57) 90 (56) 7 (155) (35) 42 27

Source: Company, Daiwa forecasts

- 60 - China Water Sector 15 February 2012

Financial summary continued …

Balance sheet (S$m) As at 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Cash & short-term investment 60 121 91 167 225 535 588 674 Inventory 11 21 34 33 26 20 36 32 Accounts receivable 123 198 249 350 443 375 453 427 Other current assets 0 0 11 0 0 0 0 0 Total current assets 194 340 384 549 694 930 1,077 1,133 Fixed assets 33 63 57 135 156 174 191 206 Goodwill & intangibles 39 41 67 90 192 209 199 189 Other non-current assets 177 121 339 299 319 424 504 574 Total assets 443 564 847 1,073 1,360 1,738 1,971 2,103 Short-term debt 34 5 50 45 96 96 96 96 Accounts payable 59 101 268 266 210 163 287 256 Other current liabilities 13 14 6 7 10 10 10 10 Total current liabilities 106 120 325 318 316 269 393 362 Long-term debt 115 193 208 355 504 504 554 654 Other non-current liabilities 4 3 6 6 26 26 26 26 Total liabilities 225 317 539 679 845 798 972 1,041 Share capital 91 96 99 105 207 604 604 604 Reserves/R.E./others 108 144 198 260 295 324 383 446 Shareholders' equity 200 240 298 365 503 928 987 1,050 Minority interests 18 7 10 28 12 12 11 11 Total equity & liabilities 443 564 847 1,073 1,360 1,738 1,971 2,103

EV 1,241 1,135 1,237 1,321 1,569 1,228 1,224 1,238 Net debt/(cash) 90 78 168 234 375 65 62 75 BVPS (S$) 0.256 0.305 0.378 0.460 0.585 1.079 1.148 1.222

Key ratios (%) Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Sales (YoY) n.a. 35.4 187.5 (5.3) 8.6 (22.5) 70.4 (10.7) EBITDA (YoY) n.a. 18.1 118.3 29.4 25.4 (29.0) 41.2 (1.9) Operating profit (YoY) n.a. 16.1 133.7 30.4 24.3 (36.5) 50.6 (2.5) Net profit (YoY) n.a. 112.9 79.2 27.1 18.0 (47.0) 106.7 6.0 EPS (YoY) n.a. 110.5 78.1 26.8 10.6 (47.1) 102.6 6.0 Gross-profit margin 45.4 45.0 30.7 41.3 47.3 46.8 45.0 45.0 EBITDA margin 33.3 29.0 22.1 30.1 34.8 31.9 26.4 29.0 Operating-profit margin 29.3 25.1 20.4 28.1 32.2 26.3 23.3 25.4 ROAE 7.8 15.0 22.0 22.6 20.4 6.6 10.1 10.1 ROAA 3.5 6.5 8.4 7.8 7.3 3.0 5.2 5.0 ROCE 11.3 11.9 22.4 21.7 19.2 8.8 11.0 9.9 ROIC 10.3 14.5 25.0 24.0 21.4 10.9 14.9 13.5 Net debt to equity 44.9 32.4 56.3 64.0 74.5 7.0 6.2 7.1 Effective tax rate 23.9 5.3 11.6 10.5 11.5 11.5 12.5 13.5 Accounts receivable (days) 315.8 303.9 147.1 208.2 253.9 337.9 200.9 239.0 Payables (days) 150.7 150.8 121.4 185.7 152.4 154.0 109.1 147.5 Net interest cover (x) 4.6 5.5 11.1 15.9 10.9 5.8 8.4 7.3 Net dividend payout 45.0 29.9 30.5 35.0 39.6 37.9 38.7 38.7 Source: Company, Daiwa forecasts

Company profile Hyflux provides a comprehensive suite of integrated services in water and renewable resources, from R&D, membrane manufacturing, process engineering, engineering, procurement and construction to operations and maintenance.

- 61 - China Water Sector 15 February 2012

Hyflux: Bloomberg consensus EPS forecasts (2011-12E)

(S$) Forecast revised downward due to Forecast revised upward following 0.14 political unrest in MENA winning of Tuaspring Desalination Plant 0.13 0.12 0.11 Initiation: the sleeping 0.10 0.09 Merlion 0.08 Disappointing 2Q11 results 0.07 Disappointing 0.06 3Q11 results Coverage initiated with a Hold rating. 0.05 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12

2011E EPS 2012E EPS

Limited downside, but no upside Source: Bloomberg, Daiwa forecasts either Cheap for reasons Hyflux was one of the worst-performing water stocks in Hyflux is now trading at a 2012E PER of 13.1x and a 2011, having dropped by 48% and underperformed the PBR of 1.3x, which are 37% and 55% lower than the FTSE Straits Times Index by 31% over the year. The respective past-5-year trading averages. We believe the stock was first hit hard at the beginning of 2011 when share price has fully factored in the near-term bleak political turmoil in the MENA region broke out, outlook for Hyflux, and valuations suggest limited followed by a series of lacklustre quarterly results and downside. However, an upward rerating could be slow progress in obtaining new projects in China and difficult given the limited sustainable EPS growth that other parts of Asia. we see beyond 2012.

Meanwhile, the 2011-12 Bloomberg-consensus EPS Hyflux: 12-month forward PER history forecasts have been revised down by 50% and 11%, (x) respectively. As such, some investors have started to 45 wonder: What’s going wrong? Is this disappointing 40 year just a transition period, or is this what we can 35 34.7x Avg+2SD expect to see in the future? 30 27.7x Avg+1SD 25 Hyflux share-price performance vs. FTSE Straits Times Index 20 20.8x Avg (Rebase to 100) Political turmoil broke Disappointing 2Q11 15 110 out in MENA results 13.9x Avg-1SD 10 100 Disappointing 6.9x Avg-2SD 3Q11 results 5 90 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 80 Hyflux Global average 70 Hyflux won the tender for Tuas II Source: Bloomberg, Daiwa forecasts 60 seawater desalination plant 50 Hyflux: 12-month forward PBR history 40 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 (x) 6.0 Hyflux FTSE Straits Times Index 5.2x Avg+2SD 5.0 Source: Bloomberg 4.0 4.0x Avg+1SD 3.0 2.9x Avg

2.0 1.7x Avg-1SD 1.0

0.0 0.5x Avg-2SD Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Hyflux Global average

Source: Bloomberg, Daiwa forecasts

- 62 - China Water Sector 15 February 2012

DCF-based target price of S$1.40 TOT projects, which often create earnings volatility during the expansion phase of a company. Our six- We believe DCF methodology is appropriate to month target price of S$1.40 is based on our DCF estimate the intrinsic value of the company given the valuation, and we assume a WACC of 8.3%, a 2% high visibility of Hyflux’s future cash flow. It also terminal-growth rate, and capacity additions until 2015. minimises the accounting-treatment effect of BOT and

Hyflux: DCF valuation (S$m) 2010 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E Year 1 2 3 4 5 6 7 8 9 Risk free interest 3.5% Risk premium 6.0% Beta 1.0 Cost of equity 9.5% Cost of debt 6.5% Equity ratio 70% Debt ratio 30% WACC 8.3% Terminal growth rate 2.0% EBIT(1-t) 104 64 114 123 216 233 157 116 134 154 180 Add: depreciation & amortization 15 24 24 24 25 25 26 26 27 27 27 Add: change in WC -91 26 31 0 -24 -31 14 9 -11 -12 -1 Less: capex -272 -200 -200 -200 -50 -50 -30 -30 -30 -30 -30 FCF -245 -85 -31 -53 167 177 166 121 120 139 177 Discounted FCF -85 -29 -45 132 129 112 75 68 73 86 Terminal value 53% 680 Firm value 1,281 Less: net debt 64 Less: minority 11 Equity value 1,206 No. of shares (m) 860 Target price (S$) 1.40 Source: Daiwa forecasts

- 63 - China Water Sector 15 February 2012

Hyflux: revenue contribution from different locations (2007-10) (% ) Is this a transition period? 120

100 3.0 2.5 Looking at Hyflux’s history, we are impressed by the 14.3 13.2 80 34.6 26.5 milestone projects it has won and delivered, namely: 56.8 China’s largest seawater reverse osmosis (SWRO) 60 desalination plant in Tianjin Dagang obtained in 2004; 40 81.4 63.0 60.3 the world’s largest SWRO plant in Magtaa, Algeria in 20 40.2 2008; and Singapore’s largest SWRO plant in Tuas in 0 4.3 2011. 2007 2008 2009 2010 MENA PRC Singapore However, since it announced it had won the tender for the Tuas II Desalination Plant in March 2011, it seems Source: Company Hyflux’s efforts to shift its business focus from MENA However, the outlook for MENA’s prosperous water to Asia, especially China, have not seen much progress. market suddenly changed when political unrest broke Management refers to 2011 as a transition period and out in early 2011. The water industry, as a utilities attributes the unexciting 9M11 results to: 1) the slow sector, relies heavily on government policy and start-up of the Tuas II SWRO plant, 2) the Magtaa regulations. After the fall of the Tunisian and Egyptian SWRO plant entering the final stage of construction, regimes in 2011, the ministers in charge of water in the and 3) the slow progress in winning new projects in two countries were dismissed from office. China. We are also uncertain whether the public-private Hyflux: key seawater desalination projects partnerships in the water industry promoted before the Project name Country Capacity ('000 m3/day) Note unrest will be in place in the future. Libya’s civil war is Magtaa Desalination Algeria 500 Largest membrane-based over but it could be a long time before the country’s Plant desalination plant in the world normal economic life, let alone investment in Tuaspring Singapore 318.5 Largest desalination plant in Desalination Plant Singapore infrastructure, resumes. Although the long-term Tianjin Dagang China 100 (expandable to 150) Largest membrane-based outlook for the water industry in MENA is still bright, Desalination Plant seawater desalination plant in China we do not expect to see a significant revival in Source: Company investment in the next two years. Excluding its projects in Libya, Hyflux’s current exposure to the region is via MENA will likely be stagnating for two the Magtaa Desalination Plant, which we expect to be years completed by May 2012. MENA used to be one of the hottest regions to invest money in the water sector, especially seawater and China: smaller projects expected brackish water desalination, given its extreme fresh- We have already discussed the shift in China’s water water scarcity. MENA’s internal fresh-water resources industry from an extensive growth phase focused on per capita is equivalent to only one-tenth of the world large investment in infrastructure and plant average and we expect this to halve by 2050 as the construction to an intensive growth phase in which we region’s population rises and industrial growth expect to see a slowdown in new project additions. continues at a rapid rate. The 2010 revenue contribution from MENA was around 60% for Hyflux. From Hyflux’s and the other players’ recent project developments in the region, as well as our industry research, we can see a trend of companies winning smaller-sized projects with designed capacity of less than 50,000m3/day over the next few years. Any larger-sized projects are likely to be in the form of TOT and therefore less profitable than BOT projects as water companies are required to pay an upfront transfer fee, usually at a premium.

Overseas companies, such as Hyflux, also seem to have lost their once-superior competitive advantage when bidding for projects as the China market has matured

- 64 - China Water Sector 15 February 2012

and been commoditised, and the domestic China Hyflux: order backlog (2005-1H11) players have been gaining market share. (S$m) 2,500 Hyflux plans to shift its future business focus to Asia, 2,000 especially China, and targets to achieve a revenue mix 955 940 of 40%, 30% and 30% from China, Southeast Asia and 1,500 other regions by 2014, respectively. We believe Hyflux 335 1,100 1,000 is unlikely to win mega-projects in China in the near 254 1,273 500 168 1,145 1,161 future, and are downbeat about its earnings growth in 30 863 748 the country beyond 2012. 435 435 0 Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Mar 11 Jun 11 Hyflux: targeted revenue contribution from different geographical locations (2014E) EPC O&M Source: Company

Others 30.0% PRC 40.0%

Southeast Asia 30.0%

Source: Company

Slowdown in orders expected Hyflux’s order book was boosted to a record-high following its win of the Tuas II Desalination Plant in March 2011. Its order backlog for O&M (operating and maintenance) and EPC stood at S$940m and S$1.2bn as at 30 June 2011, respectively, which in total is equivalent to 2.8x our 2012 revenue forecast. We forecast 2012 earnings to recover significantly by 107% YoY as the Tuas II plant ramps up.

However, in light of the difficulty in winning large- sized projects in MENA and China, we are concerned about the company’s potential order growth over the next 12 months, which is the major share-price driver, and expect the Tuas II plant to be a major earnings contributor for the next few quarters. Hyflux is currently looking for new opportunities in China, India, Southeast Asia and Australia, and we would turn more positive on the stock if substantial order wins are achieved.

- 65 -

Utilities / China 15 February 2012

Beijing Enterprises Water Group Target price: HK$1.90 Up/downside: -11.2% 371 HK Share price (13 Feb): HK$2.14

Initiation: overly aggressive project growth = greater risk

• Now the No.3 water player in China, BEW has expanded its treatment capacity fivefold since 2008 • We are concerned about BEW’s overly aggressive capacity expansion plan and its large exposure to BT projects • Coverage initiated with an Underperform (4) rating and DCF- based six-month target price of HK$1.90 How do we justify our view?

Despite its impressive project- Risks addition track record, we are In our view, the upside catalysts concerned that BEW may have include faster-than-expected sacrificed project returns for top- capacity expansion and more-than-

line growth, evidenced by smaller- expected increases in water-supply Jackie Jiang scale projects (IRR: 8-10%) obtained and wastewater-treatment tariffs. (852) 2848 4994 [email protected] in 2011 with higher construction costs per tonne and lower IRR Share price performance Dave Dai, CFA compared with larger-scaled (HK$) (%) (852) 2848 4068 3.2 130 [email protected] projects (IRR: 10-12%) obtained previously. Management’s intention 2.7 110 to take on more BT projects also 2.2 90 Investment case concerns us as it would expose the 1.7 70 company to project postponement 1.2 50 Between 2008, when it entered the Feb-11 May-11 Aug-11 Nov-11 Feb-12 and accounts receivable risk. Beijing Enterprises Water Group (LHS) water business, and June 2011, BEW Relative to HSI (RHS) expanded its treatment capacity fivefold to become the third-largest We initiate coverage with an 12-month range 1.33-2.92 water enterprise in China, providing Underperform (4) rating and DCF- Market cap (US$bn) 1.91 a full range of services from water based six-month target price of Average daily turnover (US$m) 1.83 supply, wastewater treatment, HK$1.90. Shares outstanding (m) 6,909 reclaimed water to seawater Major shareholder Beijing Enterprises Group (44.1%) desalination. Desalination may Catalysts bring upside to future earnings Although we expect BEW to Financial summary (HK$) Year to 31 Dec 11E 12E 13E growth, as BEW is well positioned continue to add project, investors should be aware of each project’s Revenue (m) 4,819 7,008 7,521 with its first project, the Caofeidian Operating profit (m) 1,292 1,750 2,027 desalination plant, completed in return and earnings quality. Net profit (m) 721 993 1,174 October 2011. Core EPS 0.114 0.144 0.170 Valuation EPS change (%) (12.2) 26.1 18.2 BEW is to acquire 10 water and Among its peers, BEW is the most Daiwa vs Cons. EPS (%) (1.7) (2.0) 0.0 waste treatment projects from its expensive stock on a 12-month PER (x) 18.8 14.9 12.6 parent BJE by a consideration of forward PER/PBR basis. Unlike its Dividend yield (%) 1.6 2.0 2.4 shares in 1H12. We do not believe peers, it is trading at a premium to DPS 0.034 0.043 0.051 the asset injection will be value its average since it entered the water PBR (x) 2.2 2.0 1.8 accretive as the transaction between business in 2008. We believe the EV/EBITDA (x) 17.0 12.2 11.0 two connected parties, both listed, share price has factored in very high ROE (%) 13.6 14.1 15.1 requires arms-length valuation. confidence of earning growth while Source: Bloomberg, Daiwa forecasts the risks are not fully reflected.

Important disclosures, including any required research certifications, are provided on the last two pages of this report. China Water Sector 15 February 2012

How do we justify our view?

Growth outlook Valuation Earnings revisions

Growth outlook BEW: net profit growth history and forecast

We forecast BEW’s net profit attributable to (%) shareholders to rise at a 2011-13 CAGR of 28%, mainly (HK$m) 1,400 600 driven by capacity expansion of water supply and 1,174 1,200 522 wastewater treatment. 993 500 1,000 400 721 800 300 600 513 200 400 193 166 100 200 31 41 38 0 0 18 0 2008 2009 2010 2011E 2012E 2013E Net profit Net profit growth (YoY)

Source: Company, Daiwa forecasts

Valuation BEW: 12-month-forward PER bands

The stock is trading currently at a 14.9x PER on our (x ) 2012 EPS forecast, which is above its average 12-month 25 forward PER of 14.5x since entering the water business 22.8x Avg+2SD in 2008. 20 18.6x Avg+1SD

15 14.5x Avg

10.3x Avg-1SD 10

6.2x Avg-2SD 5

0 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Source: Bloomberg, Daiwa forecasts

Earnings revisions BEW: Bloomberg-consensus EPS forecast (2012-13E) The Bloomberg-consensus EPS forecasts for 2012-13 (Rebased to 100) were revised up by 4-33% in 2011. 150 140 130 120 110 100 90 80 -11 -11 p y Jul-11 Jul-11 Apr-11 Oct-11 Oct-11 Jan-11 Jan-11 Jun-11 Jan-12 Feb-11 Mar-11 Mar-11 Aug-11 Se Nov-11 Dec-11 Dec-11 May-11 Ma

2012E 2013E

Source: Bloomberg

- 67 - China Water Sector 15 February 2012

Financial summary

Key assumptions Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Wastewater treatment capacity in 0.0 0.0 1,100.0 1,615.0 2,532.0 3,800.0 4,800.0 5,800.0 operation (‘000 ton/day) Water supply capacity in operation 0.0 0.0 50.0 150.0 150.0 150.0 1,300.0 1,300.0 (‘000 ton/day) Average wastewater treatment tariff 0.0 0.0 1.1 1.0 0.9 1.0 1.0 1.0 (Rmb/ton) Average water supply tariff (Rmb/ton) 0.0 0.0 2.0 1.7 1.6 1.6 1.7 1.7

Profit and loss (HK$m) Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Construction services 0 0 131 1,066 5,432 3,218 4,561 4,652 Sewage treatment services 0 0 138 440 592 1,070 1,352 1,732 Others 36 20 68 225 325 531 1,095 1,137 Total revenue 36 20 338 1,730 6,348 4,819 7,008 7,521 Other income 1 1 11 20 77 186 159 167 COGS (35) (20) (183) (1,214) (5,226) (3,415) (5,010) (5,229) SG&A (5) (4) (41) (115) (211) (237) (342) (363) Other op. expenses 0 0 (9) (29) (65) (61) (65) (69) Operating profit (3) (3) 116 392 923 1,292 1,750 2,027 Net-interest inc./(exp.) 0 0 (60) (119) (228) (369) (465) (485) Assoc/forex/extraord./others 0 0 (1) 5 1 22 33 35 Pre-tax profit (3) (3) 55 277 695 945 1,317 1,576 Tax 0 0 (12) (49) (131) (151) (224) (284) Min. int./pref. div./others 0 0 (12) (36) (52) (73) (100) (118) Net profit (reported) (3) (3) 31 193 513 721 993 1,174 Net profit (adjusted) (3) (3) 31 193 513 721 993 1,174 EPS (reported) (HK$) (0.039) (0.031) 0.038 0.061 0.130 0.114 0.144 0.170 EPS (adjusted) (HK$) (0.039) (0.031) 0.038 0.061 0.130 0.114 0.144 0.170 EPS (adjusted fully-diluted) (HK$) (0.039) (0.031) 0.037 0.054 0.117 0.114 0.144 0.170 DPS (HK$) 0.000 0.000 0.000 0.000 0.000 0.034 0.043 0.051 EBIT (3) (3) 116 392 923 1,292 1,750 2,027 EBITDA (3) (3) 117 407 931 1,296 1,759 2,039

Cash flow (HK$m) Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Profit before tax (3) (3) 55 277 695 945 1,317 1,576 Depreciation and amortisation 0 0 1 14 8 4 9 13 Tax paid 0 0 (12) (49) (131) (151) (224) (284) Change in working capital 0 0 426 (282) (2,205) (1,462) 967 64 Other operational CF items 0 0 (3,182) (1,703) (2,854) (886) (960) (1,750) Cash flow from operations (3) (3) (2,711) (1,742) (4,487) (1,549) 1,109 (380) Capex 0 0 (15) (233) (45) (100) (100) (100) Net (acquisitions)/disposals 0 0 (25) 25 (119) (22) (33) (35) Other investing CF items 0 0 (8) (6) (355) 0 0 0 Cash flow from investing 0 0 (47) (214) (519) (122) (133) (135) Change in debt 0 0 1,868 1,326 5,334 1,728 0 1,000 Net share issues/(repurchases) 0 0 1,696 672 757 2,283 0 0 Dividends paid 0 0 0 0 0 (216) (298) (352) Other financing CF items 0 0 0 0 0 0 0 0 Cash flow from financing 0 0 3,564 1,997 6,091 3,795 (298) 648 Forex effect/others 0 0 0 0 0 0 0 0 Change in cash (3) (3) 806 42 1,085 2,123 678 132 Free cash flow (3) (3) (2,726) (1,975) (4,532) (1,649) 1,009 (480)

Source: Company, Daiwa forecasts

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Financial summary continued …

Balance sheet (HK$m) As at 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Cash & short-term investment 34 30 835 877 1,962 4,085 4,763 4,896 Inventory 0 0 4 7 13 7 10 10 Accounts receivable 0 2 647 997 6,253 5,408 4,908 4,908 Other current assets 0 0 8 15 593 593 593 593 Total current assets 34 32 1,494 1,896 8,820 10,092 10,273 10,406 Fixed assets 0 0 13 232 46 142 233 320 Goodwill & intangibles 0 0 1,469 1,579 1,585 1,585 1,585 1,585 Other non-current assets 0 0 1,840 3,717 6,773 8,342 9,335 11,120 Total assets 34 32 4,816 7,424 17,225 20,161 21,426 23,432 Short-term debt 0 0 212 1,291 5,296 5,296 5,296 5,296 Accounts payable 1 1 717 928 3,207 1,577 2,047 2,112 Other current liabilities 0 0 23 32 113 113 113 113 Total current liabilities 1 1 952 2,251 8,617 6,986 7,457 7,521 Long-term debt 0 0 1,656 1,903 3,231 4,959 4,959 5,959 Other non-current liabilities 0 0 210 258 309 286 286 286 Total liabilities 1 1 2,818 4,412 12,157 12,232 12,702 13,767 Share capital 8 8 241 348 457 685 685 685 Reserves/R.E./others 25 23 1,518 2,275 3,436 5,996 6,691 7,513 Shareholders' equity 33 31 1,758 2,623 3,893 6,681 7,376 8,198 Minority interests 0 0 240 389 1,175 1,248 1,348 1,466 Total equity & liabilities 34 32 4,816 7,424 17,225 20,161 21,426 23,432 EV 179 183 2,129 10,053 17,258 21,855 21,244 22,195 Net debt/(cash) (34) (30) 1,033 2,317 6,566 6,171 5,492 6,360 BVPS (HK$) 0.331 0.312 4.211 0.753 0.852 0.967 1.068 1.187

Key ratios (%) Year to 31 Dec 2006 2007 2008 2009 2010 2011E 2012E 2013E Sales (YoY) n.a. (44.4) n.m. 412.3 266.9 (24.1) 45.4 7.3 EBITDA (YoY) n.a. n.a. n.a. 246.1 129.0 39.2 35.7 16.0 Operating profit (YoY) n.a. n.a. n.a. 237.4 135.3 40.0 35.5 15.8 Net profit (YoY) n.a. n.a. n.a. 522.0 165.9 40.7 37.8 18.2 EPS (YoY) n.a. n.a. n.a. 59.9 112.6 (12.2) 26.1 18.2 Gross-profit margin 2.4 1.0 45.8 29.8 17.7 29.1 28.5 30.5 EBITDA margin n.a. n.a. 34.8 23.5 14.7 26.9 25.1 27.1 Operating-profit margin n.a. n.a. 34.4 22.7 14.5 26.8 25.0 26.9 ROAE n.a. n.a. 3.5 8.8 15.7 13.6 14.1 15.1 ROAA n.a. n.a. 1.3 3.1 4.2 3.9 4.8 5.2 ROCE n.a. n.a. 6.0 7.8 9.3 8.1 9.4 10.2 ROIC 766.0 n.a. 6.0 7.7 8.8 8.4 10.3 11.0 Net debt to equity net cash net cash 58.8 88.3 168.7 92.4 74.5 77.6 Effective tax rate n.a. n.a. 22.2 17.5 18.8 16.0 17.0 18.0 Accounts receivable (days) 1.6 22.1 350.9 173.4 208.4 441.6 268.6 238.2 Payables (days) 7.6 13.1 388.1 173.6 118.9 181.2 94.4 100.9 Net interest cover (x) n.a. n.a. 1.9 3.3 4.0 3.5 3.8 4.2 Net dividend payout n.a. n.a. 0.0 0.0 0.0 30.0 30.0 30.0 Source: Company, Daiwa forecasts

Company profile As the environmental flagship under Beijing Enterprises Holdings, Beijing Enterprises Water Group provides full range of water services from water supply, sewage treatment, reclaimed water and seawater desalination. The Group had treatment capacity of 2.86 million ton per day as at the end of 2010.

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BEW: 12-month forward PER history

(x ) BEW's 12-month forward PER 25 is 11% above global average 22.8x Avg+2SD 20 18.6x Avg+1SD

Initiation: overly 15 14.4x Avg aggressive project 10 10.2x Avg-1SD

6.0x Avg-2SD growth = greater risk 5 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 BEWG Global average Coverage initiated with an Underperform Source: Bloomberg, Daiwa forecasts rating. BEW: 12-month forward PBR history

(x ) BEW's 12-month forward PBR is 24% Current valuation suggests too 3.0 above global average 2.9x Avg+2SD high growth 2.5 2.4x Avg+1SD 2.0 Unlike Hyflux (HYF SP, S$1.48, Hold [3]) and CEI (257 1.9x Avg HK, HK$3.27, Buy [1]), which are trading below their 1.5 respective 5-year historical average levels, BEW’s 1.4x Avg-1SD 1.0 valuations are now above its historical average level 0.9x Avg-2SD since its entry into the water business in 2009. Its 12- 0.5 month forward PER and PBR are around 11% and 24% Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 above its global peers, respectively. We do not see a BEWG Global average solid reason why BEW should trade at a premium to its Source: Bloomberg, Daiwa forecasts peers given its similar growth and return outlook.

DCF-based target price at HK$1.90 Also, we are concerned that the company’s overly aggressive capacity expansion target might come at the We believe a DCF methodology is appropriate to price of sacrificing project returns. Management’s estimate the intrinsic value of the company given the intention to take on more BT projects also concerns us high visibility of BEW’s future cash flows. It also as these low-margin infrastructure construction minimises the accounting treatment effect of BOT and projects expose the company to significant accounts TOT projects, which often create earnings volatility in receivable risk. the expansion phase of a company. Our six-month target price of HK$1.90 is based on our DCF valuation, Share performance of BEW and HSCEI Index (2011 to 2012 YTD) with assumptions of an 8.1% WACC, a 2% terminal- (Rebase to 100) growth rate and capacity additions until 2014. 140

120

100

80

60

40

20 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 BEW HSCEI Index

Source: Bloomberg

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BEW: DCF valuation (in HK$m) 2010 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E Year 1 2 3 4 5 6 7 8 9 Risk free interest 3.5% Risk premium 6.0% Beta 1.0 Cost of equity 9.5% Cost of debt 6.5% Equity ratio 70% Debt ratio 30% WACC 8.1% Growth rate 2% EBIT(1-t) 755 1,116 1,505 1,719 1,861 2,139 2,320 2,387 2,456 2,532 2,611 Add: depreciation 8 4 9 13 17 20 23 24 25 26 27 Add: change in WC -2,205 -1,462 967 64 959 -96 -58 -28 -29 -30 -31 Less: capex -1,338 -2,500 -2,500 -1,500 -500 -500 -150 -150 -150 -150 -150 FCF -2,780 -2,841 -19 297 2,336 1,563 2,135 2,233 2,302 2,378 2,457 Discounted FCF -2,841 -18 254 1,848 1,144 1,445 1,398 1,333 1,274 1,218 Terminal value 50% 10,070 Firm value 19,968 Less: net debt (end 2012E) 5,492 Less: minority 1,348 Equity value 13,127 No. of shares (m) 6,909 Target price (HK$) 1.90 Source: Daiwa forecasts

BEW: capacity expansion (2009-11) ('000 ton/day) Integrated water solutions 8,000 7,333 7,000 provider 5,910 6,000 5,000 4,580 The water flagship of BJE, BEW had expanded its 4,000 3,357 3,513 treatment capacity fivefold by June 2011, since entering 2,864 3,000 the water business in 2008, to 7.3m tonnes/day (in 1,765 1,955 operation and construction pipeline), becoming the 2,000 third-largest water enterprise in China. The company 1,000 0 provides a full range of water services from water Dec 2009 Jun 2010 Dec 2010 Jun 2011 supply, wastewater treatment (WWT), reclaimed water Capacity in operation Total capacity in operation and construction pipeline to seawater desalination. Construction services, sewage treatment, water supply, and technical services account Source: Company for 65%, 19%, 8%, and 5% of our 2011 revenue forecast, BEW: revenue breakdown respectively. 100% Construction revenue, which is generated in the 80% building process of BOT and BT projects, will continue 60% to be the major revenue contributor over the next three years as the company ramps up capacity. However, this 40% construction revenue accounts for a much smaller 20% portion of only 25% of our 2012 gross profit forecast given its low gross margin of 10% compared with 29% 0% 2008 2009 2010 2011E 2012E 2013E that we forecast for the whole company in 2011. Sewage treatment Water supply Construction Technical services Sales of sewage treatment facilities

Source: Company, Daiwa forecasts

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BEW: gross profit breakdown 100% Asset injection: not necessarily 90% value accretive 80% 70% 60% BEW entered into an exclusive agreement with BJE to 50% acquire the latter’s water and waste treatment projects 40% on 21 December 2010. The proposed asset list includes 30% 10 projects, 5 water supply and WWT projects and 5 20% waste treatment projects. All of these projects are 10% greenfield projects except for the No. 9 Water Plant in 0% 2009 2010 2011E 2012E 2013E Beijing, which is currently in operation.

Sewage treatment Water supply Construction Technical services According to the agreement, BEW is to issue Source: Company, Daiwa forecasts consideration shares to BJE at a share price of HK$1.91 per share (at a discount of 15% to the closing share BEW: gross margin of different segments (2012E) price as at 21 December 2010). The assets are being 100% 94% valued by an independent appraiser currently and are expected to be injected into BEW in 1H12. 80% 63% BEW: proposed asset injections from BJE 60% Project Location Operation type Capacity ('000 ton/day) Status Water assets 42% No. 9 Water Plants Beijing Water supply 500 In operation 40% No. 10 Water Plants Beijing Water supply 500 Greenfield Baishamen plants Hainan Sewage treatment 200 Greenfield 20% 10% Changliu plants Hainan Sewage treatment 250 Greenfield Weifang plants Shandong Sewage treatment 30 Greenfield 0% Waste treatment assets Sewage treatment Water supply Construction Technical services Hengyang plants Hunan Waste treatment n.a. Greenfield Wenchang plants Hainan Waste treatment n.a. Greenfield Source: Daiwa forecasts Wuhan plants Hubei Waste treatment n.a. Greenfield Pingdu plants Shandong Waste treatment n.a. Greenfield Seawater desalination: potential growth Qingdao plants Shandong Waste treatment n.a. Greenfield Source: Company driver Seawater desalination is of strategic importance to Whether the asset injection will be value-accretive increase fresh water supply to coastal water-scarce depends completely on the purchase price. As this is a provinces/municipalities such as Beijing, Tianjin, connected-party transaction between two listed Hebei, Liaoning, and Shandong. In April 2010, BEW companies which requires arms-length valuations, it is successfully partnered up with the Norwegian likely that neither party can gain on a valuation desalination designer and contractor Aqualyng (Not standpoint. The Beijing No. 9 Water Plant, which listed) and subscribed to 50% of the shares of Aqualyng should comprise the major part of the consideration to China (Not listed). be paid as the only operating asset currently, is under a regulated return mechanism and generates a profit of The company’s first attempt in the desalination field, Rmb190m per year. the Caofeidian desalination plant, which was jointly built by Aqualyng China and Tangshan Caofeidian Infrastructure (Not listed), was completed in October Risk overrules growth 2010 and has the capacity to provide 50,000m3/day of fresh water to the industrial zone in Hebei Province. The key growth driver of these water companies in the The commissioning is expected in early 2012, when a expansion phase is the capability to ramp up capacity. second phase to expand the plant to 400,000m3/day We are sceptical about BEW’s capability to convert its will be considered. There are further plans to expand to overly aggressive capacity expansion plan into quality an eventual 900,000m3/day, aiming to provide fresh returns. Management’s intention to take on more BT water to Beijing to diversify the water supply sources. projects also concerns us as these low-margin infrastructure construction projects expose the company to significant accounts receivable risk.

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Capacity expansion target too aggressive BEW: average project capacity obtained in 2010 and 2011 Management expects to add annual total capacity of ('000ton per day) 90 2mt per day over the next 2 years, but has not been 77 specific as to how much attributable capacity will be in 80 operation by 2013. We believe the gross capacity target 70 is achievable given the expected asset injection of 60 around 1.5mt per day from BJE by the end of 2011. 50 40 30 However, we are very sceptical as to whether BEW can 30 turn this capacity expansion into an earnings 20 contribution on a timely basis. Seven projects won in 10 2008 and 2009 were still not in operation as at June 0 2011, and should have been completed on a project 2010 2011 Source: Company construction schedule of 12-18 months. Although the Note: We do not include the two large projects of Guiyang and Xiangfan in calculating the reason for the delay is not clear, we are concerned average capacity about further project delays given BEW’s limited resources and increasing scale. We expect BEW to add annual operating water capacity of around 1.5m, 2.2m, and 1.0m tonnes per day over BEW: projects won in 2008 and 2009 not yet in operation by 2011-13E, excluding potential asset injections from its June 2011 parent. Every 100,000 tonnes/day miss would lead to Designed Concession capacity ('000 2.5%, 1.9%, and 1.7% declines in our EPS forecasts for Project name Province Type Contract period ton per day) 2011-13, according to our sensitivity analysis. Penzhou Guangdong Sewage treatment BOT 25 30 Changping Beijing Reclaimed water BOT 29 30 BEW: water capacity in operation Qi Qi Har Heilongjiang Sewage treatment BOT 30 100 Mianyang Nong Ke Qu Sichuan Sewage treatment BOT 30 10 ('000 ton/day) Kunming Yunnan Sewage treatment BOT 20 70 8,000 50 Guangan Sichuan Sewage treatment BOT 20 19 7,000 400 50 1,300 Jiaozhou (Phase II) Shandong Sewage treatment BOT 20 50 6,000 400 1,300 Source: Company 5,000 0 4,000 400150 Looking at BEW’s projects obtained in 2011, most are 3,000 1820 5,800 of a small scale with processing capacity of 10,000- 150 4,800 2,000 0 3,800 0 150 50,000t per day compared with earlier projects of 1,000 500 2,532 1,100 1,615 50,000-100,000t per day. We believe small-scale 0 projects have lower IRRs due to their higher 2008 2009 2010 2011E 2012E 2013E construction costs per tonne, since part of the Sewage treatment Water supply Reclaimed water Desalination investment, such as construction and equipment Source: Company, Daiwa forecasts purchase, is not perfectly proportional to project capacity. BEW: EPS sensitivity to an annual capacity addition miss of 100,000 tonnes/day The only two large projects BEW obtained recently are (% ) water supply in Guiyang and Xiangfan, each with 0.0 capacity of over 900,000t per day. However, both projects are joint ventures with local governments, (0.5) from which BEW can only enjoy half of the earnings (1.0) generated. (1.5) (2.0) -1.7 -1.9 (2.5) -2.5 (3.0) 2011E 2012E 2013E

Source: Daiwa forecasts

- 73 - China Water Sector 15 February 2012

Heavy reliance on BT projects BEW: revenue contribution from BT projects and gross margins We are concerned about BEW’s increasing involvement 80% 72% in BT projects to build infrastructure for local governments, some only remotely related to the water 60% industry. We believe the BT projects that BEW has 44% commenced, such as the construction of roads and 40% 29% 32% bridges in Kunming city, are largely construction 28% 29% 28% 30% services in nature, which do not require any expertise 20% 18% 5% in water treatment and deliver very thin gross margins 9% 11% 11% 11% of around 10%, compared with 40-60% for the water 0% 1% supply and WWT projects in operation. 2009 2010 2011E 2012E 2013E Revenue contribution from BT projects BT gross margin We forecast the company’s overall gross margin to Company gross margin improve from 18% in 2010 to 29% in 2011 due to the Source: Company, Daiwa forecasts completion of 2 massive BT projects in 2010. However, management has expressed an interest in taking more Another risk BT projects face is the delay in accounts integrated environmental projects in the BT model, receivable from local governments. The BOT model is which we believe would hurt BEW’s margins and much safer in this ground, as local governments pay returns. The China Construction Sector is trading at an the project operators in terms of water supply or WWT average 2012E PER of 7-8x currently based on the tariffs over the concession period of 20-30 years, while Bloomberg forecasts. BT projects require several large lump-sum payments following project completion. BEW: list of BT projects Contract price Our industry research indicates that 50% of BT project Project name Province Nature Construction period (Rmb m) contractors have difficulty in chasing their accounts Completed receivable. Although sufficient due diligence can reduce Kunming Huan Hu Nan Yunnan Construction of roads Sep 2009 - Sep 2010 1,770 Lu and bridges the risk, we are not comfortable with such uncertainty Kunming Dian Chi Yunnan Construction of canal, Sep 2009 - Sep 2010 1,600 in the current monetary environment, where local sewage treatment governments have mounting debt and no easy access to plant Kunming Dian Chi - Lao Yunnan Renovation of river Dec 2008 - Aug 2010 64 financing. BEW had a surging trade receivable of Yun Niang He Rmb4,340m as at the end of June 2011, mainly Kunming Dian Chi - Xi Yunnan Renovation of river Dec 2008 - Aug 2010 106 composed of payments for BT projects. Bei He Kunming Dian Chi - Yu Yunnan Renovation of river Dec 2008 - Aug 2010 70 Dai He BEW: current trade receivables Dilian Changxingdao Liaoning Construction of Jul 2010 - Apr 2011 1,076 (HK$m) Phase II sewage treatment, 5,000 water supply 4,340 In pipeline 4,500 4,002 Hua Xi Guizhou Water environmental Jun 2011 - 2013 700 4,000 renovation 3,500 Dalian Tong Yong Liaoning Fundamental facility 2011 - 2015 3,060 3,000 Aviation Property construction Garden 2,500 Yingkou Liaoning Land 1st-class 2011 - 2013 460 2,000 development 1,500 Source: Company 1,000 500 103 0 1H10 2H10 1H11 Source: Company

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Daiwa’s Asia Pacific Research Directory Hong Kong Regional Research Head Nagahisa MIYABE (852) 2848 4971 [email protected] Regional Research Co-head Christopher LOBELLO (852) 2848 4916 [email protected] Head of Product Management John HETHERINGTON (852) 2773 8787 [email protected] Head of Thematic Research; Product Management Tathagata Guha ROY (852) 2773 8731 [email protected] Head of China Research, Chief Economist (Regional) Mingchun SUN (852) 2773 8751 [email protected] Macro Economics (Regional) Kevin LAI (852) 2848 4926 [email protected] Regional Chief Strategist; Strategy (Regional) Colin BRADBURY (852) 2848 4983 [email protected] Head of Hong Kong Research; Regional Property Coordinator; Jonas KAN (852) 2848 4439 [email protected] Co-head of Hong Kong and China Property; Property Developers (Hong Kong) Automobiles and Components (China) Jeff CHUNG (852) 2773 8783 [email protected] Head of Greater China FIG; Banking (Hong Kong, China) Grace WU (852) 2532 4383 [email protected] Banking (Hong Kong, China) Queenie POON (852) 2532 4381 [email protected] Insurance Jennifer LAW (852) 2773 8745 [email protected] Capital Goods –Electronics Equipments and Machinery (Hong Kong, China) Joseph HO (852) 2848 4443 [email protected] Consumer, Pharmaceuticals and Healthcare (China) Hongxia ZHU (852) 2848 4460 [email protected] Conglomerate (Hong Kong, China) Peter CHU (852) 2848 4430 [email protected] Consumer/Retail (Hong Kong, China) Matthew MARSDEN (852) 2848 4963 [email protected] Head of HK and China Gaming and Leisure; Hotels, Restaurants and Leisure – Casinos Gavin HO (852) 2532 4384 [email protected] and Gaming (Hong Kong); Capital Goods – Conglomerate (Hong Kong) Internet (Hong Kong, China) Alicia HU (852) 2532 4180 [email protected] Regional Head of IT/Electronics; Semiconductor/IC Design (Regional) Eric CHEN (852) 2773 8702 [email protected] IT/Electronics - Semiconductor/IC Design (Taiwan) Ashley CHUNG (852) 2848 4431 [email protected] Regional Head of Materials; Materials/Energy (Regional) Alexander LATZER (852) 2848 4463 [email protected] Materials (China) Felix LAM (852) 2532 4341 [email protected] Head of Hong Kong and China Property; Property Developers (Hong Kong, China) Danny BAO (852) 2773 8715 [email protected] Property (Hong Kong, China) Yannis KUO (852) 2773 8735 [email protected] Regional Head of Small/Medium Cap; Small/Medium Cap (Regional) Mark CHANG (852) 2773 8729 [email protected] Small/Medium Cap (Regional) John CHOI (852) 2773 8730 [email protected] Head of Solar Pranab Kumar SARMAH (852) 2848 4441 [email protected] Telecommunications (Greater China) Alan KAM (852) 2848 4978 [email protected] Transportation – Aviation, Land and Transportation Infrastructure (Regional) Kelvin LAU (852) 2848 4467 [email protected] Transportation –Transportation Infrastructure; Capital Goods – Construction and Edwin LEE (852) 2532 4349 [email protected] Engineering (China) Regional Head of Clean Energy and Utilities; Utilities; Power Equipment; Dave DAI (852) 2848 4068 [email protected] Renewables (Hong Kong, China) Head of Custom Products Group; Custom Products Group Justin LAU (852) 2773 8741 [email protected] Custom Products Group Philip LO (852) 2773 8714 [email protected] Custom Products Group Jibo MA (852) 2848 4489 [email protected] Custom Products Group Kenji SERIZAWA (852) 2532 4159 [email protected]

South Korea Head of Research; Strategy; Banking/Finance Chang H LEE (82) 2 787 9177 [email protected] Regional Head of Automobiles and Components; Automobiles; Shipbuilding; Steel Sung Yop CHUNG (82) 2 787 9157 [email protected] Banking/Finance Anderson CHA (82) 2 787 9185 [email protected] Capital Goods (Construction and Machinery) Mike OH (82) 2 787 9179 [email protected] Consumer/Retail Sang Hee PARK (82) 2 787 9165 [email protected] IT/Electronics (Tech Hardware and Memory Chips) Jae H LEE (82) 2 787 9173 [email protected] Materials (Chemicals); Oil and Gas Jihye CHOI (82) 2 787 9121 [email protected] Telecommunications; Software (Internet/Online Games) Thomas Y KWON (82) 2 787 9181 [email protected] Custom Products Group Shannen PARK (82) 2 787 9184 [email protected]

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Taiwan Head of Taiwan Research; Strategy Alex YANG (886) 2 8758 6245 [email protected] Banking/Diversified Financials Jerry YANG (886) 2 8758 6252 [email protected] Consumer/Retail Yoshihiko KAWASHIMA (886) 2 8758 6247 [email protected] IT/Technology Hardware (Communications Equipment); Software; Small/Medium Caps Christine WANG (886) 2 8758 6249 [email protected] IT/Technology Hardware (Handsets and Components) Alex CHANG (886) 2 8758 6248 [email protected] IT/Technology Hardware (PC Hardware - Panels) Chris LIN (886) 2 8758 6251 [email protected] IT/Technology Hardware (PC Components) Jenny SHIH (886) 2 8758 6250 [email protected] Materials; Conglomerates Albert HSU (886) 2 8758 6246 [email protected]

India Head of India Research; Pharmaceuticals and Healthcare Kartik A. MEHTA (91) 22 6622 1012 [email protected] Deputy Head of Research; Strategy; Banking/Finance Punit SRIVASTAVA (91) 22 6622 1013 [email protected] All Industries Fumio YOKOMICHI (91) 22 6622 1003 [email protected] Automobiles and Components Ambrish MISHRA (91) 22 6622 1060 [email protected] Capital Goods/Utilities Saurabh MEHTA (91) 22 6622 1009 [email protected] FMCG; Consumer Percy PANTHAKI (91) 22 6622 1063 [email protected]

Singapore Head of Singapore Research Tony DARWELL (65) 6321 3050 [email protected] Quantitative Research Josh CHERIAN (65) 6499 6549 [email protected] Quantitative Research Suzanne HO (65) 6499 6545 [email protected] Banking (ASEAN) Srikanth VADLAMANI (65) 6499 6570 [email protected] Consumer; Food and Beverage; Small/Medium Cap (ASEAN) Pyari MENON (65) 6499 6566 [email protected] Regional Head of Oil and Gas; Oil and Gas (ASEAN and China); Capital Goods (Singapore) Adrian LOH (65) 6499 6548 [email protected] Property and REITs David LUM (65) 6329 2102 [email protected] Head of ASEAN & India Telecommunications; Telecommunications (ASEAN & India) Ramakrishna MARUVADA (65) 6499 6543 [email protected] Thematic Research Amy CHEW (65) 6321 3085 [email protected]

Philippines Head of the Philippines Research; Strategy; Capital Goods; Materials Rommel RODRIGO (63) 2 813 7344 ext 302 [email protected] Economy; Consumer; Power and Utilities; Transportation – Aviation Alvin AROGO (63) 2 813 7344 ext 301 [email protected] Property; Banking; Transportation – Port Danielo PICACHE (63) 2 813 7344 ext 293 [email protected]

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Daiwa’s Office Office / Branch / Affiliate Address Tel Fax DAIWA SECURITIES GROUP INC HEAD OFFICE Gran Tokyo North Tower, 1-9-1, Marunouchi, Chiyoda-ku, Tokyo, 100-6753 (81) 3 5555 3111 (81) 3 5555 0661 Daiwa Securities Trust Company One Evertrust Plaza, Jersey City, NJ 07302, U.S.A. (1) 201 333 7300 (1) 201 333 7726 Daiwa Securities Trust and Banking (Europe) PLC (Head Office) 5 King William Street, London EC4N 7JB, United Kingdom (44) 207 320 8000 (44) 207 410 0129 Daiwa Securities Trust and Banking (Europe) PLC (Dublin Branch) Level 3, Block 5, Harcourt Centre, Harcourt Road, Dublin 2, Ireland (353) 1 603 9900 (353) 1 478 3469

DAIWA CAPITAL MARKETS LIMITED HEAD OFFICE Gran Tokyo North Tower, 1-9-1, Marunouchi, Chiyoda-ku, (03) 5555 3111 (03) 5555 0661 Tokyo, 100-6753 Daiwa Capital Markets America Inc Financial Square, 32 Old Slip, New York, NY10005, U.S.A. (1) 212 612 7000 (1) 212 612 7100 Daiwa Capital Markets America Inc. San Francisco Branch 555 California Street, Suite 3360, San Francisco, CA 94104, U.S.A. (1) 415 955 8100 (1) 415 956 1935 Daiwa Capital Markets Europe Limited 5 King William Street, London EC4N 7AX, United Kingdom (44) 20 7597 8000 (44) 20 7597 8600 Daiwa Capital Markets Europe Limited, Frankfurt Branch Trianon Building, Mainzer Landstrasse 16, 60325 Frankfurt am Main, (49) 69 717 080 (49) 69 723 340 Federal Republic of Germany Daiwa Capital Markets Europe Limited, Paris Branch 127, Avenue des Champs-Elysées, 75008 Paris, France (33) 1 56 262 200 (33) 1 47 550 808 Daiwa Capital Markets Europe Limited, Geneva Branch 50 rue du Rhône, P.O.Box 3198, 1211 Geneva 3, Switzerland (41) 22 818 7400 (41) 22 818 7441 Daiwa Capital Markets Europe Limited, Milan Branch Via Senato 14/16, 20121 Milan, Italy (39) 02 763 271 (39) 02 763 27250 Daiwa Capital Markets Europe Limited, 25/9, build. 1, Per. Sivtsev Vrazhek, Moscow 119002, Russian Federation (7) 495 617 1960 (7) 495 244 1977 Moscow Representative Office Daiwa Capital Markets Europe Limited, Bahrain Branch 7th Floor, The Tower, Bahrain Commercial Complex, P.O. Box 30069, (973) 17 534 452 (973) 17 535 113 Manama, Bahrain Daiwa Capital Markets Europe Limited, Dubai Branch The Gate village Building 1, 1st floor, Unit-6, DIFC, P.O.Box-506657, (971) 47 090 401 (971) 43 230 332 Dubai, UAE. Daiwa Capital Markets Hong Kong Limited Level 28, One Pacific Place, 88 Queensway, Hong Kong (852) 2525 0121 (852) 2845 1621 Daiwa Capital Markets Singapore Limited 6 Shenton Way #26-08, DBS Building Tower Two, Singapore 068809, (65) 6220 3666 (65) 6223 6198 Republic of Singapore Daiwa Capital Markets Australia Limited Level 34, Rialto North Tower, 525 Collins Street, Melbourne, (61) 3 9916 1300 (61) 3 9916 1330 Victoria 3000, Australia DBP-Daiwa Capital Markets Philippines, Inc 18th Floor, Citibank Tower, 8741 Paseo de Roxas, Salcedo Village, (632) 813 7344 (632) 848 0105 Makati City, Republic of the Philippines Daiwa-Cathay Capital Markets Co Ltd 14/F, 200, Keelung Road, Sec 1, Taipei, Taiwan, R.O.C. (886) 2 2723 9698 (886) 2 2345 3638 Daiwa Securities Capital Markets Korea Co., Ltd. One IFC, 10 Gukjegeumyung-Ro, Yeouido-dong, Yeongdeungpo-gu, (82) 2 787 9100 (82) 2 787 9191 Seoul, 150-876, Korea Daiwa Securities Capital Markets Co Ltd, Room 3503/3504, SK Tower, (86) 10 6500 6688 (86) 10 6500 3594 Beijing Representative Office No.6 Jia Jianguomen Wai Avenue, Chaoyang District, Beijing 100022, People’s Republic of China Daiwa SSC Securities Co Ltd 45/F, Hang Seng Tower, 1000 Lujiazui Ring Road, (86) 21 3858 2000 (86) 21 3858 2111 Pudong, Shanghai 200120, People’s Republic of China Daiwa Securities Capital Markets Co. Ltd, Level 8 Zuellig House, 1 Sliom Road, (66) 2 231 8381 (66) 2 231 8121 Bangkok Representative Office Bangkok 10500, Thailand Daiwa Capital Markets India Private Ltd 10th Floor, 3 North Avenue, Maker Maxity, Bandra Kurla Complex, (91) 22 6622 1000 (91) 22 6622 1019 Bandra East, Mumbai – 400051, India Daiwa Securities Capital Markets Co. Ltd, Suite 405, Pacific Palace Building, 83B, Ly Thuong Kiet Street, (84) 4 3946 0460 (84) 4 3946 0461 Hanoi Representative Office Hoan Kiem Dist. Hanoi, Vietnam

DAIWA INSTITUTE OF RESEARCH LTD HEAD OFFICE 15-6, Fuyuki, Koto-ku, Tokyo, 135-8460, Japan (81) 3 5620 5100 (81) 3 5620 5603 MARUNOUCHI OFFICE Gran Tokyo North Tower, 1-9-1, Marunouchi, Chiyoda-ku, Tokyo, 100-6756 (81) 3 5555 7011 (81) 3 5202 2021

New York Research Center 11th Floor, Financial Square, 32 Old Slip, NY, NY 10005-3504, U.S.A. (1) 212 612 6100 (1) 212 612 8417 London Research Centre 3/F, 5 King William Street, London, EC4N 7AX, United Kingdom (44) 207 597 8000 (44) 207 597 8550

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Disclaimer This publication is produced by Daiwa Securities Group Inc. and/or its non-U.S. affiliates, and distributed by Daiwa Securities Group Inc. and/or its non-U.S. affiliates, except to the extent expressly provided herein. This publication and the contents hereof are intended for information purposes only, and may be subject to change without further notice. Any use, disclosure, distribution, dissemination, copying, printing or reliance on this publication for any other purpose without our prior consent or approval is strictly prohibited. Neither Daiwa Securities Group Inc. nor any of its respective parent, holding, subsidiaries or affiliates, nor any of its respective directors, officers, servants and employees, represent nor warrant the accuracy or completeness of the information contained herein or as to the existence of other facts which might be significant, and will not accept any responsibility or liability whatsoever for any use of or reliance upon this publication or any of the contents hereof. Neither this publication, nor any content hereof, constitute, or are to be construed as, an offer or solicitation of an offer to buy or sell any of the securities or investments mentioned herein in any country or jurisdiction nor, unless expressly provided, any recommendation or investment opinion or advice. Any view, recommendation, opinion or advice expressed in this publication may not necessarily reflect those of Daiwa Securities Capital Markets Co. Ltd., and/or its affiliates nor any of its respective directors, officers, servants and employees except where the publication states otherwise. This research report is not to be relied upon by any person in making any investment decision or otherwise advising with respect to, or dealing in, the securities mentioned, as it does not take into account the specific investment objectives, financial situation and particular needs of any person.

Daiwa Securities Group Inc., its subsidiaries or affiliates, or its or their respective directors, officers and employees from time to time have trades as principals, or have positions in, or have other interests in the securities of the company under research including derivatives in respect of such securities or may have also performed investment banking and other services for the issuer of such securities. The following are additional disclosures.

Japan Daiwa Securities Capital Markets Co. Ltd Daiwa Securities Capital Markets Co. Ltd is a subsidiary of Daiwa Securities Group Inc. Investment Banking Relationship Within the preceding 12 months, The subsidiaries and/or affiliates of Daiwa Securities Group Inc. * has lead-managed public offerings and/or secondary offerings (excluding straight bonds) of the securities of the following companies: Patel Engineering (PEC IN); International Taifeng Holdings Limited (873 HK); Sihuan Pharmaceutical Holdings Group Limited (460 HK); Strides Arcolab Limited (STR IN); China Metal Resources Holding Limited (8071 HK); China 33 Media Group Limited (8087 HK); Sabana Shari’ah Compliant Industrial Real Estate Investment Trust (SSREIT SP); SBI Holdings Inc. (6488 HK); Shunfeng Photovoltaic International Limited (1165 HK); Rexlot Holdings Limited (555 HK). *Subsidiaries of Daiwa Securities Group Inc. for the purposes of this section shall mean any one or more of: • Daiwa Capital Markets Hong Kong Limited • Daiwa Capital Markets Singapore Limited • Daiwa Capital Markets Australia Limited • Daiwa Capital Markets India Private Limited • Daiwa-Cathay Capital Markets Co., Ltd. • Daiwa Securities Capital Markets Korea Co., Ltd.

Hong Kong This research is distributed in Hong Kong by Daiwa Capital Markets Hong Kong Limited (“DHK”) which is regulated by the Hong Kong Securities and Futures Commission. Recipients of this research in Hong Kong may contact DHK in respect of any matter arising from or in connection with this research. Ownership of Securities For “Ownership of Securities” information, please visit BlueMatrix disclosure Link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. Investment Banking Relationship For “Investment Banking Relationship”, please visit BlueMatrix disclosure Link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. Relevant Relationship (DHK) DHK may from time to time have an individual employed by or associated with it serves as an officer of any of the companies under its research coverage. DHK market making DHK may from time to time make a market in securities covered by this research.

Singapore This research is distributed in Singapore by Daiwa Capital Markets Singapore Limited and it may only be distributed in Singapore to accredited investors, expert investors and institutional investors as defined in the Financial Advisers Regulations and the Securities and Futures Act (Chapter 289), as amended from time to time. By virtue of distribution to these category of investors, Daiwa Capital Markets Singapore Limited and its representatives are not required to comply with Section 36 of the Financial Advisers Act (Chapter 110) (Section 36 relates to disclosure of Daiwa Capital Markets Singapore Limited’s interest and/or its representative’s interest in securities). Recipients of this research in Singapore may contact Daiwa Capital Markets Singapore Limited in respect of any matter arising from or in connection with the research.

Australia This research is distributed in Australia by Daiwa Capital Markets Stockbroking Limited and it may only be distributed in Australia to wholesale investors within the meaning of the Corporations Act. Recipients of this research in Australia may contact Daiwa Capital Markets Stockbroking Limited in respect of any matter arising from or in connection with the research. Ownership of Securities For “Ownership of Securities” information, please visit BlueMatrix disclosure Link at https://daiwa3.bluematrix.com/sellside/Disclosures.action.

India This research is distributed by Daiwa Capital Markets India Private Limited (DAIWA) which is an intermediary registered with Securities & Exchange Board of India. This report is not to be considered as an offer or solicitation for any dealings in securities. While the information in this report has been compiled by DAIWA in good faith from sources believed to be reliable, no representation or warranty, express of implied, is made or given as to its accuracy, completeness or correctness. DAIWA its officers, employees, representatives and agents accept no liability whatsoever for any loss or damage whether direct, indirect, consequential or otherwise howsoever arising (whether in negligence or otherwise) out of or in connection with or from any use of or reliance on the contents of and/or omissions from this document. Consequently DAIWA expressly disclaims any and all liability for, or based on or relating to any such information contained in or errors in or omissions in this report. Accordingly, you are recommended to seek your own legal, tax or other advice and should rely solely on your own judgment, review and analysis, in evaluating the information in this document. The data contained in this document is subject to change without any prior notice DAIWA reserves its right to modify this report as maybe required from time to time. DAIWA is committed to providing independent recommendations to its Clients and would be happy to provide any information in response to any query from its Clients. This report is strictly confidential and is being furnished to you solely for your information. The information contained in this document should not be reproduced (in whole or in part) or redistributed in any form to any other person. We and our group companies, affiliates, officers, directors and employees may from time to time, have long or short positions, in and buy sell the securities thereof, of company(ies) mentioned herein or be engaged in any other transactions involving such securities and earn brokerage or other compensation or act as advisor or have the potential conflict of interest with respect to any recommendation and related information or opinion. DAIWA prohibits its analyst and their family members from maintaining a financial interest in the securities or derivatives of any companies that the analyst cover. This report is not intended or directed for distribution to, or use by any person, citizen or entity which is resident or located in any state or country or jurisdiction where such publication, distribution or use would be contrary to any statutory legislation, or regulation which would require DAIWA and its affiliates/ group companies to any registration or licensing requirements. The views expressed in the report accurately reflect the analyst’s personal views about the securities and issuers that are subject of the Report, and that no part of the analyst’s compensation was, is or will be directly or indirectly, related to the recommendations or views expressed in the Report. This report does not recommend to US recipients the use of Daiwa Capital Markets India Private Limited or any of its non – US affiliates to effect trades in any securities and is not supplied with any understanding that US recipients will direct commission business to Daiwa Capital Markets India Private Limited.

Taiwan This research is distributed in Taiwan by Daiwa-Cathay Capital Markets Co., Ltd and it may only be distributed in Taiwan to institutional investors or specific investors who have signed recommendation contracts with Daiwa-Cathay Capital Markets Co., Ltd in accordance with the Operational Regulations Governing Securities Firms Recommending Trades in Securities to Customers. Recipients of this research in Taiwan may contact Daiwa-Cathay Capital Markets Co., Ltd in respect of any matter arising from or in connection with the research.

Philippines This research is distributed in the Philippines by DBP-Daiwa Capital Markets Philippines, Inc. which is regulated by the Philippines Securities and Exchange Commission and the Philippines Stock Exchange, Inc. Recipients of this research in the Philippines may contact DBP-Daiwa Capital Markets Philippines, Inc. in respect of any matter arising from or in connection with the research. DBP-Daiwa Capital Markets Philippines, Inc. recommends that investors independently assess, with a professional advisor, the specific financial risks as well as the legal, regulatory, tax, accounting, and other consequences of a proposed transaction. DBP-Daiwa Capital Markets Philippines, Inc. may have positions or may be materially interested in the securities in any of the markets mentioned in the publication or may have performed other services for the issuers of such securities. For relevant securities and trading rules please visit SEC and PSE Link at http://www.sec.gov.ph/irr/AmendedIRRfinalversion.pdf and http://www.pse.com.ph/ respectively.

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United Kingdom This research report is produced by Daiwa Securities Capital Markets Co., Ltd and/or its affiliates and is distributed by Daiwa Capital Markets Europe Limited in the European Union, Iceland, Liechtenstein, Norway and Switzerland. Daiwa Capital Markets Europe Limited is authorised and regulated by The Financial Services Authority (“FSA”) and is a member of the London Stock Exchange, Chi-X, Eurex and NYSE Liffe. Daiwa Capital Markets Europe Limited and its affiliates may, from time to time, to the extent permitted by law, participate or invest in other financing transactions with the issuers of the securities referred to herein (the “Securities”), perform services for or solicit business from such issuers, and/or have a position or effect transactions in the Securities or options thereof and/or may have acted as an underwriter during the past twelve months for the issuer of such securities. In addition, employees of Daiwa Capital Markets Europe Limited and its affiliates may have positions and effect transactions in such securities or options and may serve as Directors of such issuers. Daiwa Capital Markets Europe Limited may, to the extent permitted by applicable UK law and other applicable law or regulation, effect transactions in the Securities before this material is published to recipients.

This publication is intended for investors who are not Retail Clients in the United Kingdom within the meaning of the Rules of the FSA and should not therefore be distributed to such Retail Clients in the United Kingdom. Should you enter into investment business with Daiwa Capital Markets Europe’s affiliates outside the United Kingdom, we are obliged to advise that the protection afforded by the United Kingdom regulatory system may not apply; in particular, the benefits of the Financial Services Compensation Scheme may not be available.

Daiwa Capital Markets Europe Limited has in place organisational arrangements for the prevention and avoidance of conflicts of interest. Our conflict management policy is available at http://www.uk.daiwacm.com/about-us/corporate-governance-and-regulatory. Regulatory disclosures of investment banking relationships are available at https://daiwa3.bluematrix.com/sellside/Disclosures.action.

United States This report is distributed in the U.S. by Daiwa Capital Markets America Inc. (DCMA). It may not be accurate or complete and should not be relied upon as such. It reflects the preparer’s views at the time of its preparation, but may not reflect events occurring after its preparation; nor does it reflect DCMA’s views at any time. Neither DCMA nor the preparer has any obligation to update this report or to continue to prepare research on this subject. This report is not an offer to sell or the solicitation of any offer to buy securities. Unless this report says otherwise, any recommendation it makes is risky and appropriate only for sophisticated speculative investors able to incur significant losses. Readers should consult their financial advisors to determine whether any such recommendation is consistent with their own investment objectives, financial situation and needs. This report does not recommend to U.S. recipients the use of any of DCMA’s non-U.S. affiliates to effect trades in any security and is not supplied with any understanding that U.S. recipients of this report will direct commission business to such non-U.S. entities. Unless applicable law permits otherwise, non-U.S. customers wishing to effect a transaction in any securities referenced in this material should contact a Daiwa entity in their local jurisdiction. Most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as a process for doing so. As a result, the securities discussed in this report may not be eligible for sales in some jurisdictions. Customers wishing to obtain further information about this report should contact DCMA: Daiwa Capital Markets America Inc., Financial Square, 32 Old Slip, New York, New York 10005 (telephone 212-612-7000).

Ownership of Securities For “Ownership of Securities” information please visit BlueMatrix disclosure Link at https://daiwa3.bluematrix.com/sellside/Disclosures.action.

Investment Banking Relationships For “Investment Banking Relationships” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action.

DCMA Market Making For “DCMA Market Making” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action.

Research Analyst Conflicts For updates on “Research Analyst Conflicts” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. The principal research analysts who prepared this report have no financial interest in securities of the issuers covered in the report, are not (nor are any members of their household) an officer, director or advisory board member of the issuer(s) covered in the report, and are not aware of any material relevant conflict of interest involving the analyst or DCMA, and did not receive any compensation from the issuer during the past 12 months except as noted: no exceptions.

Research Analyst Certification For updates on “Research Analyst Certification” and “Rating System” please visit BlueMatrix disclosure link at https://daiwa3.bluematrix.com/sellside/Disclosures.action. The views about any and all of the subject securities and issuers expressed in this Research Report accurately reflect the personal views of the research analyst(s) primarily responsible for this report (or the views of the firm producing the report if no individual analysts[s] is named on the report); and no part of the compensation of such analyst(s) (or no part of the compensation of the firm if no individual analyst[s)] is named on the report) was, is, or will be directly or indirectly related to the specific recommendations or views contained in this Research Report.

The following explains the rating system in the report as compared to relevant local indices, based on the beliefs of the author of the report. "1": the security could outperform the local index by more than 15% over the next six months. "2": the security is expected to outperform the local index by 5-15% over the next six months. "3": the security is expected to perform within 5% of the local index (better or worse) over the next six months. "4": the security is expected to underperform the local index by 5-15% over the next six months. "5": the security could underperform the local index by more than 15% over the next six months.

Additional information may be available upon request.

Japan - additional notification items pursuant to Article 37 of the Financial Instruments and Exchange Law (This Notification is only applicable where report is distributed by Daiwa Securities Capital Markets Co. Ltd.)

If you decide to enter into a business arrangement with us based on the information described in materials presented along with this document, we ask you to pay close attention to the following items. • In addition to the purchase price of a financial instrument, we will collect a trading commission* for each transaction as agreed beforehand with you. Since commissions may be included in the purchase price or may not be charged for certain transactions, we recommend that you confirm the commission for each transaction. • In some cases, we may also charge a maximum of ¥ 2 million (including tax) per year as a standing proxy fee for our deposit of your securities, if you are a non-resident of Japan. • For derivative and margin transactions etc., we may require collateral or margin requirements in accordance with an agreement made beforehand with you. Ordinarily in such cases, the amount of the transaction will be in excess of the required collateral or margin requirements. • There is a risk that you will incur losses on your transactions due to changes in the market price of financial instruments based on fluctuations in interest rates, exchange rates, stock prices, real estate prices, commodity prices, and others. In addition, depending on the content of the transaction, the loss could exceed the amount of the collateral or margin requirements. • There may be a difference between bid price etc. and ask price etc. of OTC derivatives handled by us. • Before engaging in any trading, please thoroughly confirm accounting and tax treatments regarding your trading in financial instruments with such experts as certified public accountants. *The amount of the trading commission cannot be stated here in advance because it will be determined between our company and you based on current market conditions and the content of each transaction etc.

When making an actual transaction, please be sure to carefully read the materials presented to you prior to the execution of agreement, and to take responsibility for your own decisions regarding the signing of the agreement with us.

Corporate Name: Daiwa Securities Capital Markets Co. Ltd. Financial instruments firm: chief of Kanto Local Finance Bureau (Kin-sho) No.109 Memberships: Japan Securities Dealers Association, Financial Futures Association of Japan Japan Securities Investment Advisers Association Type II Financial Instruments Firms Association

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