China Construction:Railway FAI target higher than expected

Railway FAI target higher than expected. A recent article in the People’s Daily suggests 2014 China railway investment is going to be more substantial than originally thought by the market: FAI will rise from RMB700b to RMB720b, railway new starts from 44 projects to 48, and new rail lines will be increased from 6,600km to over 7,000km, 90% of which will be located in the west.

Railway financing reform making progress.(1) China’s Railway Development Fund will receive RMB200b-300b each year from 2014 to 2015. (2) Land development adjacent or close to the railways will be encouraged to help railway construction companies diversify returns. (3) Pricing mechanism reform. On 15 February, the basis for railway cargo pricing was changed from government- dictated pricing to government-guided pricing. In future, railway cargo prices will be pegged to and adjusted with toll-road fees.Historically, China’s railway prices had been fixed at levels too low to attract private investment. A floating pricing system would attract private investment while reducing losses for the China Railway Corporation, successor to the Ministry of Railways.

Railway construction an effective means of stimulating the economy, as (1) China’s railways are under-invested, (2) increases in railway investment digest some of the excess capacity of downstream sectors such as steel and cement, and (3) railways are labor intensive and so boost employment, especially within rural areas.

Sector still compelling. Railway construction sector valuations are attractive at the moment and, in our view, offer a buying opportunity that affords investors exposure to China’s short-term economic stimulus and long-term urbanization-driven infrastructure construction demand. CRG (390 HK, Neutral) and CRCC (1186 HK, Outperform) have 35% and 39% revenue exposure to railway construction and would benefit from any bump in railway FAI. CRCC remains our sector top pick.

Three main risks. (1) Macro risk: Government policy, especially as it relates to FAI, could cause severe volatility in company earnings for the next several years.(2) Default risk: Delays in customer payments could hurt constructors’ working capital and cash flow.(3) Financing risk: Failure to obtain sufficient funding could also affect company expansion plans and development prospects.