Stock Review: China Water Affairs Group

Kevin Smith, of API Capital and portfolio manager of the TAMIM Asia Small Companies strategy, highlights one of the more interesting stocks in the Asia Small Companies portfolio. While water is not glamorous, it is the one commodity we cannot live with out, read further to find out why the Asia Small Companies team believes this is a stock we need to hold in our portfolio.

China Water Affairs Group Limited (CWA), through its subsidiaries, supplies city water and sewage treatment. CWA supplies raw water and tap water, treats sewage, constructs water supply pipe networks, and installs water meters. CWA has 7,662 employees with staff turnover reported as 1.62% in the 2018 ESG Report. In March 2018 CWA had a total daily supply capacity of 12.15 million cubic metres operating 101 water plants and 22 sewage treatment plants. 

Accounting, Strategy and Governance Comments

Accounting

1. PricewaterhouseCooper (PwC) audit the accounts, use of a big name accounting firm is a positive.
2. Unqualified accounts over all time periods, no issues raised by PwC.
3. Full compliance with the Hong Kong accounting standards.

Strategy

1. Water supply in China is fragmented, the central government is encouraging local governments to deleverage their balance sheets with private-public partnerships, this provides are major source of demand growth for CWA. Only 35% of the population has access to tap water. Strong underlying demand is expected to be maintained while more of the population is provided direct access to tap water. CWA has a focus on Tier 3/4 cities across the interior of China where demand growth for tap water is expected to be particularly strong.
2. FY18 results beat expectations with net profits of HK$1,140 million, an increase of 33.6% over the previous year and 10% ahead of market forecasts. Revenue growth was 32.8% during that same period, with city water supply showing 25.1% growth and sewage treatment increasing by 47.2%. Compound annual growth over five years is 29.6%. These numbers are indicative of an expansion strategy that is working. We were pleased to see a continuing trend of disposal of non-core assets especially in the arena of property development which is an unnecessary distraction for the management of the business.
3. In the past year CWA has entered agreements for the Xinyu urban-rural integrated water supply project, acquired the Huicheng district water supply business and established the Ji’an county water supply company. Organic growth from existing businesses should exceed 15% per annum.
4. The Environmental Services Division (ESD) which includes waste water  related and hazardous waste treatment businesses is being structured for a potential separate market listing. The ESD has strong relationships with petrochemical companies including Shell and China Oilfield Services. We have mixed feelings about an IPO for this division of the business, since it has excellent growth characteristics, our final view will depend on the selling price for that business.
5. CWA is reducing exposure to property development, we would like to see them exit this business entirely except where there is a business merit in relation to the ESD business. 
6. The balance sheet is geared in a manner that is consistent with the structure of the business.

Map showing location of water distribution for China Water Affairs Group

Source: China Water Affairs Group Annual Report 2018

Governance

1. Full compliance with the Hong Kong governance standards. A full ESG Report was published in October 2018 showing all of the required disclosures with respect to environmental, social and operating practices. All emissions are within the compliance standards for the location of operations. CWA has water supply unit power consumption that is 20% better than the industry average. CWA has a water leakage ratio of 14.4% versus the industry average of 22.2%. 
2. Eight independent non-executive directors on the Board. 
3. The company has adopted the Model Code for securities transactions by Directors. 

Conclusion
CWA has a good business model and is well placed to deliver strong returns to their investors in the medium to long term. We will continue to monitor the behaviour of management with respect to non-core businesses, in particular property development and the potential divestment of the ESD business. We are satisfied that CWA meets our standards for accounting, strategy and governance. ​

Source: API Capital

Value, Momentum and Quality Comments
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1. Our VMQ score has been volatile while remaining in the top two quintiles during the past year. The momentum score has been top decile in our universe for the past six months.
2. There are four analysts actively covering this stock, three have buy ratings and the median target price is 30% above current levels. Consensus earnings growth remains in mid-teens percentage growth in 2019 and 2020.
3. Return on capital employed in excess of 11% helps to underpin strength in the score for quality.

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