Water China: Power and Utilities - China Water Risk

17 February 2009 Nomura

See the important disclosures and analyst certifications on pages 137 to 140. gl

N O M U R A I N T E R N A T I O N A L ( H K ) L I M I T E D

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Nomura Anchor Reports examine the key themes and value drivers that underpin our sector views and stock recommendations for the next 6 to 12 months.

Water | C H I N A

POWER AND UTILITIES

Evan Li +852 2536 7746 [email protected] Ivan Lee, CFA +852 2536 7745 [email protected]

Turning hot again! China’s water resource per capita is only a quarter of the global average, but its water consumption (per unit of GDP) is 5.5x the international level. Over 400 cities are still chronically short of water, and the growth potential is obvious. There is no shortage of catalysts: the government is setting harder targets and larger budgets for the water industry, tariffs are being raised to support reasonable returns, and the RMB4tn stimulus plan accelerates project approvals for water utilities. And yet, valuations have been bogged down by spill-over concerns from the credit crunch and a general aversion to small- and mid-cap stocks. Our analysis finds that core operations and cashflows of the water utilities we are covering in China should remain immune from the global credit crunch, and we believe the corrected valuations present a good entry opportunity. However, as the industry remains fragmented while major consolidation is unlikely and track records are short, we recommend cherry-picking quality players that could evolve into industry leaders. China Everbright International and Guangdong Investments are our BUYs; CWA and BEW are on our watch-list.

Natural water shortages exacerbated by growing pollution

Strong government support on growth

Privatisation is key for urban tap water supply

Higher growth profile seen in wastewater treatment

We recommend cherry picking in a fragmented market

NEW THEME

Stocks for actionIt is a good time to cherry-pick quality players that can march forward as industry leaders in this emerging market. We prefer CEI and GDI, put CWA and BEW on our watch-list, and would avoid Tianjin Capital.

Stock Ticker RatingPrice

(11 Feb)Price

targetCEI 257 HK BUY* 1.56 2.20GDI 270 HK BUY 3.15 4.10CWA 855 HK NEUTRAL* 1.11 1.25BEW 371 HK NEUTRAL* 0.90 1.03Hyflux HYF SP NEUTRAL 1.77 1.90Epure EPUR SP NEUTRAL* 0.32 0.35TCEP 1065 HK REDUCE* 1.45 0.80

* Initiating coverage

Prices in local currency

Analysts Evan Li +852 2536 7746 [email protected] Ivan Lee, CFA +852 2536 7745 [email protected]

mailto:[email protected]




17 February 2009 Nomura 1

Water | C H I N A

POWER AND UTILITIES


Our view Data show operations and cashflows of water utilities in China will remain immune

to the global credit crunch. Now that valuations have corrected, we think it is a good time to cherry-pick quality players that can march forward as industry leaders backed by government support recently reiterated by Beijing.

Anchor themes

China’s per capita water resources are only a quarter of the global average, while its water consumption (per unit of GDP) is 5.5x the global average. Shortages, pollution, geographical disparity and inefficient water use cost 8-10% of the nation’s GDP. More than 400 cities suffer water shortages of 16mn m3/day.

The government is setting harder targets and larger budgets for the water industry to promote privatisation and capacity growth. Water quality has become a key concern for the government, and tariffs are rising to justify investment returns.

Turning hot again! Natural water shortages exacerbated by growing pollution China’s per capita water resources are only a quarter of the global average, but its water consumption (per unit of GDP) is 5.5x higher. More than 400 cities suffer water shortages and pollution, with the shortfall of 16mn m3/day costing 8-10% of China’s GDP, according to government statistics.

Strong government support on growth The government is setting harder targets and larger budgets for the water industry, and raising tariffs to justify reasonable returns. The RMB4tn stimulus plan should help to accelerate project approvals for water utilities.

Privatisation is key for urban tap water supply Growth in tap water supply is seen in privatisation/commercialisation, where M&A execution is a success factor. Fewer regulatory and collection risks and a flexible business mix to realign profitability are positive drivers, proven by the 4pp margin improvement in the industry since the water market was opened up in 2004.

Higher growth profile seen in wastewater treatment China’s wastewater treatment has to reach 121mn m3 by 2010F (a 19% CAGR) to meet the government’s target sewage treatment ratio of 70%. However, only 100mn m3 is included in the government’s original plan, indicating more favourable policies are required to stimulate growth.

We recommend cherry-picking in a fragmented market The emerging water industry builds on visible growth but remains fragmented due to underinvestment and the continued entry of new players. Under our cherry-picking strategy, we like China Everbright and GD Investments, put CWA and BEW on our watch-list, and avoid Tianjin Capital.


Stocks for action It is a good time to cherry-pick quality players that can march forward as industry leaders in this emerging market. We prefer CEI and GDI, put CWA and BEW on our watch-list, and would avoid Tianjin Capital.

Stock Ticker RatingPrice

(11 Feb)Price

targetCEI 257 HK BUY* 1.56 2.20GDI 270 HK BUY 3.15 4.10CWA 855 HK NEUTRAL* 1.11 1.25BEW 371 HK NEUTRAL* 0.90 1.03Hyflux HYF SP NEUTRAL 1.77 1.90Epure EPUR SP NEUTRAL* 0.32 0.35TCEP 1065 HK REDUCE* 1.45 0.80

* Initiating coverage Prices in local currency

Analysts Evan Li +852 2536 7746 [email protected] Ivan Lee, CFA +852 2536 7745 [email protected]

NEWTHEME





Water | China Evan Li / Ivan Lee, CFA


Contents

Our 12-month sector view — Positive 4 China is in a water crisis 4 Clear government support 4 Resilient growth — the nature of water utilities 5 Water tariff on an uptrend 5 Opportunities seen in privatisation for tap water supply 5 Higher growth factors seen in wastewater treatment 6 Potential waiting to be explored in solid waste treatment 6 Cherry-picking in a fragmented landscape 6

China is in a water crisis 14 Natural shortages — worsened by disparity 14 Consistent rise in water demand 15 Pollution exacerbates water scarcity 16

Identifying growth in the water market 17 Strong government support 17 Rich growth opportunities seen in privatisation 19 Demand grows on urbanisation 19

China’s water value chain 21 Water quality in China 21 Non-revenue water 23 Natural gas versus water 23

Urban water supply 24 Revenue model 24 Large potential for an underinvested market 24 Robust growth from privatisation 26 Margin expansion from efficiency improvement 27 Minimal collection risk 27 Suggested 8-12% ROE with direct cost pass-through 27 Change in water usage habit 28 Less risk from China’s slowing industrial outlook 28

Wastewater treatment 30 Revenue model 30 Huge growth potential ahead in wastewater treatment 30 Government’s wastewater treatment budget 31 Demand driven largely by the residential sector 31 In wastewater treatment, we prefer the industrial space 32 Margin expansion from entering into water-recycling 32 Key players involved in the urban wastewater treatment market 33



China’s water tariff under reform 34 Background on water tariff evolution 34 Water tariff is on the rise 34 Faster growth in wastewater treatment tariff 37

RMB4tn stimulus package fuels growth 38 Details of the stimulus plan 38 State Council announced RMB20bn budget for 4Q08 38 Brighten the outlook of the listed water utilities 39

South-to-north water diversion project 40 Timeline 41 Financing 41

Division of power among regulators 42

China’s solid waste industry is emerging 44 China’s solid waste problem 44 Underinvested market for waste treatment 45 Boosting waste incineration 46 Government’s support in waste treatment 46

IFRIC 12 accelerates profit 48 Adoption of IFRIC 12 48

Sensitivity to global recession; trough valuation 50 Trough valuation of individual stocks 52

Latest company views China Everbright 57 Guangdong Investments Ltd 72 Tianjin Capital Environmental 88 China Water Affairs Group Ltd 98 Beijing Enterprises Water 111 Hyflux 123 Epure International Ltd 128



urban water supply by 40bn m3 pa; 3) reduce water consumption per unit of GDP by 20% (not per capita); and 4) increase the sewage ratio to 70% (from 63%). The central government budgeted more than RMB473bn of investment in water assets for 2006-10F (RMB330bn for wastewater treatment, RMB143bn for water supply), which was subsequently raised by RMB33bn in January 2008 by the Ministry of Construction to improve water quality. Also, the State Council requires local governments to include plans for water-treatment facilities in their capital construction budgets.

Note, that the State Council’s RMB4tn stimulus package announced in November 2008 may not provide imminent benefits to the water utilities under our coverage since the agenda is geared more towards improving rural water infrastructure. However, we believe that this gives a green light to all local governments to accelerate project approvals in water and environmental protection.

Resilient growth — the nature of water utilities Water has no significant raw material costs (especially in the southern regions), unlike power production, oil refining and gas distribution, which are subject to the risk of fluctuating fuel costs. Raw water resource fees, charged by the government, are generally 2-5% of the final water tariff, and these are passed on to end users.

Industrial users account for only 45% of the water supply volume in urban China (44% for wastewater treatment), and this is trending down on improved water efficiency among manufacturers and increased water consumption in the residential sector owing to modernisation and urbanisation. The water industry has less exposure to the recent economic turmoil and industrial slowdown than the power sector (industrial sector accounts for 76% of consumption) and gas distribution (50-80%), according to the National Bureau of Statistics and our industry checks.

Water tariff on an uptrend The government has started to view water as a commercial product, and this has seen water prices climb at a CAGR of 11% over 2000-07. Given that China’s water tariff is only 20% of the international average and, per China Water Net, accounts for 1.0% of the average household’s disposable income in China (lower than 2-12% in the case of electricity bills and 3% recommended by the Ministry of Housing as an effective benchmark to reflect water conservation), we see greater upside in terms of tariff hikes than for other utilities. For instance, Guangzhou city has just adopted a progressive tariff mechanism for wastewater treatment, which will increase prices by 29-171% on 1 July, 2009. Also, the MWR indicated in January 2009 that China’s water tariff will have to increase to support the government’s 2010F targets to reduce water consumption (per unit of GDP) by 20% (reduce 60% by 2020F), fight pollution and raise water quality.

Existing policies guarantee an 8-12% ROE for water utilities projects, legitimate justification to safeguard margins over cost escalations. And while regulatory risk remains a concern — water utilities have to obtain approvals from the government and at public hearings — water tariff hikes are made possible by authorities at the local level (city or municipal government), which involves less bureaucracy and fewer social concerns than at the central government level.

Opportunities seen in privatisation for tap water supply Further to the political reforms in the water industry since early-2000, recent central government policies encourage local authorities to privatise/commercialise water utilities. Tap water supply plants in China are still fairly distressed and operating at poor returns (4.1% net margin and 0.8% ROA in 2007) due to their previous status as public welfare enterprises. But with local governments under pressure to improve water quality since the bar is being set higher at the national level, reasonable investment returns are being offered to foreign and domestic investors to take over distressed operations and turn around operations and profitability. After the opening up

… albeit largely in rural areas and outside of our coverage

Water in China is less weighted toward industrial use, and this skew is likely to become more pronounced

Now that water is recognised as a valuable resource, tariffs are on the rise and have more scope to rise

Margins are protected; regulatory risks are not that great

Tap water plants are earning higher returns



of the water market, gross and net profit margins of tap water supply plants in China edged up 4pp to 28% and 3pp to 4%, respectively, in 2004-07.

Unlike wastewater treatment, water supply infrastructure is more developed and has grown at a steady rate (3% CAGR), in line with urbanisation and population growth. For the listed water utilities under our coverage, growth opportunities in the tap water supply sector are identified in privatisation/commercialisation, where management track records and M&A execution are key success factors.

The tap water supply segment has certain advantages over wastewater treatment, since the latter’s standalone operations receive fixed and highly subsidised tariffs from the government as its single debtor. But water supply tariffs are generally passed on to and directly collected from end users; therefore, fewer regulatory and collection risks are involved with the local government. Also, tap water supply plants are involved in pipeline expansion and meter installation, which provide more flexibility and components to realign profitability.

Higher growth factors seen in wastewater treatment Wastewater treatment is still in the development stage and existing capacity is still far below the government’s target set in the 11th Five-Year Plan. We see significant growth potential in the near term, given: 1) severe under-investment and under-penetration; 2) environmental pollution under current conditions; and 3) the sewage pipeline networks not being fully set up in many cities.

We estimate that China’s wastewater treatment has to reach a daily capacity of 121mn m3 by 2010F (19% CAGR) to meet the government’s target sewage treatment ratio of 70% (63% in 2007). But with the 11th Five-Year Plan calling for a daily capacity of only 100mn m3, this may be difficult to reach.

We see greater growth opportunities in wastewater treatment, due to prevailing underdevelopment in China and the positive backdrop set by recent government policies, when compared with conventional tap water supply. However, we are still cautious on whether or not long-term earnings and margins of these build-operate-transfer (BOT) / transfer-operate-transfer (TOT) projects can be sustained, given higher regulatory risks in having concentrated reliance on local governments and intensifying competition in the market.

Potential waiting to be explored in solid waste treatment China’s waste treatment industry is still in its infancy, although proper legislation has been set to open up opportunities in this new market. Serious under-investment (only 62% of residential urban waste was treated properly in 2007) and rising pollution in all Chinese cities create abundant growth opportunities since the government is rolling out stricter policies. However, the competitive landscape remains fragmented and we are waiting for key players to emerge.

To encourage waste treatment coverage, the government promotes investment in waste-to-energy, providing profitable waste treatment fees and on-grid tariffs at a RMB0.25/kWh premium over the provincial benchmark for coal-fired power plants. On our estimates, IRRs for waste-to-energy projects are at 15-17%, beating those for tap water supply (10-12%), hydro power (12%), wastewater treatment (8-10%) and wind energy (6-7%).

Cherry-picking in a fragmented landscape

A fragmented industry China’s water industry has reasonable growth potential in various sub-sectors along the value chain. Although we believe that competition will mount as domestic and international players enter the market, our industry outlook remains positive given China’s under-investment in water and environmental control infrastructure and

Tap water supply is a more developed and flexible market

More growth, but among other things, the regulatory bar is higher

Solid waste treatment has a ways to go, but the government is acting …

… for example, by allowing higherIRRs for these projects

The industry is really waiting for stronger players



favourable government policies that provide visibility for growth over the next few years. However, the industry landscape is fragmented, and we do not expect major consolidation within the next two years. Industry participants are still positioning themselves within this emerging market and generally deliver inconsistent performance.

Stock preferences Our selection criteria in cherry-picking quality players encompass: 1) a solid track-record in executing new projects for expansion; 2) superior investment returns; 3) a healthy balance sheet; 4) quality management, and; 5) undemanding valuation.

Among the water-related companies under our coverage, our preference lies with China Everbright International (CEI, BUY) due to its regional dominance that brings visible growth (14% EPS CAGR) and higher margins; its project IRRs of 10-12% in wastewater treatment and 17% in waste-to-energy have both been 2-3pp higher than those of peers over the past two years. CEI has proven success in cross-selling these two segments in the provinces in which it operates. Its recent (11 January, 2009) win of a 2,000-tonne waste-to-energy plant in Jinan has provided it a foothold to expand on Shandong province’s low penetration of solid waste treatment. At 13x FY09F P/E and 1.6x P/BV, valuations are undemanding when compared with peer averages of 14x and 1.3x, respectively. We believe CEI should trade at a wider premium over peers given its higher ROE (13% FY09F ROE, versus 5-8% for other emerging water companies in China), sustainable earnings growth (30% y-y in FY09F, versus peers’ 15-30% y-y excluding Beijing Enterprises Water), and our floor valuation on existing capacity (excludes future growth) suggests a fair NAV per share of HK$1.60. Our price target is HK$2.20.

We also like Guangdong Investments (GDI, BUY) for its low risk and resilient growth profile. The new agreement signed in December 2008 for water supply to Hong Kong at a fixed revenue came in 19-34% (2009-11F) higher than the previous agreement. Potential injection of infrastructure and utilities assets from its mainland parent should be the next catalyst to watch. GDI’s FY09F P/E of 9x appears attractive against other integrated utilities in Hong Kong, which are trading at 12-26x.

Although we are cautious on China Water Affairs (CWA, NEUTRAL) because of its eroding margins (escalating SG&A expenses) and lack of growth visibility, the company looks positioned to benefit in a multi-year growth cycle. As a pure play in tap water supply, earnings upside remains strong. Thus we put the stock on our watch list until we see signs that cost-control and project pipelines have been re-established.

Beijing Enterprises Water (BEW, NEUTRAL) has reinvented itself into a water utility over the past six months since the takeover by Beijing Enterprises Holdings (BEH, BUY), and we think it is equipped with a clear focus and well-defined management team needed to double capacity to 3.0-3.5mn m3 by end-2009F. However, valuation looks rich due to potential share dilution of up to 67% from its convertible bonds, and we recommend investors wait for better entry points here.

We are Neutral on engineering, procurement and construction (EPC) providers for wastewater treatment, including Hyflux (NEUTRAL) and Epure (NEUTRAL), due to their compromised business model, increasing competition and higher funding costs that cloud earnings visibility.

We recommend investors avoid Tianjin Capital Environmental Protection (REDUCE) given a pending major tariff cut (from RMB1.93/m3 to RMB0.8-1.2/m3) that could form an overhang; the potential government compensation package also looks unattractive.

China Everbright is our top pick in water

We also like Guangdong Investment on growth, valuation and possible asset injection

China Water Affairs is a NEUTRAL, but things could go well here

Beijing Enterprises Water is a rising star, but pricey in light of significant potential dilution

Tianjin Capital Environmental Protection is looking at a tariff cut and poor prospects

Neutral on EPC providers Hyflux and Epure



Valuation comparison

Exhibit 2. Water and integrated utilities: valuation comparison (1)

Nomura PT PriceMarket

capFree float Rept'g Fiscal Net profit (LC mn) Net earnings growth (%)

Company Ticker Rating (lc) (lc) (US$mn) (%) curr Y/E 07 08F 09F 07 08F 09FHong Kong and Singapore listed water utilities China Everbright Intl 257 HK Buy 2.20 1.56 633 43.9 HKD Dec 07 294 290 387 150 (1) 33 Guangdong Investment 270 HK Buy 4.10 3.15 2,504 38.8 HKD Dec 07 1,476 1,743 2,185 3 18 25China Water Affairs 855 HK Neutral 1.25 1.11 173 65.7 HKD Mar 08 44 102 134 n.a. 131 32 Beijing Enterprises Water 371 HK Neutral 1.03 0.90 302 35.7 HKD Dec 07 (3) 23 98 n.a. n.a. 326 Hyflux Limited HYF SP Neutral 1.90 1.77 618 66.2 SGD Dec 07 36 55 65 160 55 19 Epure International EPUR SP Neutral 0.35 0.32 274 37.0 CNY Dec 07 164 207 254 49 26 23 Tianjin Capital * 1065 HK Reduce 0.80 1.45 1,153 43.6 CNY Dec 07 184 216 134 16 17 (38)NWS Holdings 659 HK Buy 11.55 9.80 2,599 37.9 HKD Jun 08 2,005 3,818 2,339 21 90 (39)China Water Industry Group 1129 HK Not rated n.a. 0.13 31 75.6 HKD Dec 07 (24) n.a. n.a. 64 n.a. n.a. Xinjiang Tianye Water Savings 840 HK Not rated n.a. 0.82 55 98.6 CNY Dec 07 70 110 - 8 57 (100)Sinomem Technology SINO SP Not rated n.a. 0.12 37 41.7 SGD Dec 07 31 13 14 31 (57) 6 Bio-treat Technology BIOT SP Not rated n.a. 0.05 27 95.1 CNY Jun 08 (414) n.a. n.a. n.a. n.a. n.a. Average 700 56 37 29 A-share listed water-related utilities Beijing Capital Company 600008 CH Not rated na 6.24 2,009 37.7 CNY Dec 07 510 213 310 13 (58) 46 Shanghai Chengtou Holdings 600649 CH Not rated na 10.46 3,518 44.0 CNY Dec 07 522 630 880 (13) 21 40 Qianjiang Water Resources 600283 CH Not rated na 8.32 347 46.3 CNY Dec 07 34 n.a. n.a. 89 n.a. n.a. Wuhan Sanzhen Industry 600168 CH Not rated na 5.19 335 37.1 CNY Dec 07 59 n.a. n.a. 15 n.a. n.a. Eguard Resources Dev 000826 CH Not rated na 11.98 725 62.7 CNY Dec 07 87 115 169 81 33 47 Jiangxi Hongcheng Waterworks 600461 CH Not rated na 7.22 148 45.2 CNY Dec 07 29 n.a. n.a. 2 n.a. n.a. Nanhai Development Co 600323 CH Not rated na 9.12 362 64.6 CNY Dec 07 93 116 134 8 25 16 Zhongyuan Environment 000544 CH Not rated na 7.85 310 41.4 CNY Dec 07 53 n.a. n.a. 1,630 n.a. n.a. Shanghai Yongsun Invest 900935 CH Not rated na 0.48 117 96.5 CNY Dec 07 13 n.a. n.a. (64) n.a. n.a. Average 874 196 5 37 International water utilities Veolia Environment VIE FP Not rated na 18.65 6,831 92.9 EUR Dec 07 928 781 826 16 (16) 6 RWE AG RWE GR Not rated na 60.93 26,249 77.8 EUR Dec 07 2,659 3,170 3,755 17 19 18 Severn Trent Plc SVT LN Not rated na 1,131.00 1,856 100.0 GBP Mar 08 210 136 241 (16) (35) 77 Northumbrian Water Group Plc NWG LN Not rated na 232.25 838 73.4 GBP Mar 08 158 69 133 42 (56) 93 Pennon Group Plc PNN LN Not rated na 440.00 1,069 99.8 GBP Mar 08 134 123 132 44 (8) 7 United Utilities Group Plc UU/ LN Not rated na 563.00 2,669 100.0 GBP Mar 08 909 334 386 16 (63) 16 Cia Saneamento Minas Gerais CSMG3 BZ Not rated na 22.02 1,118 30.2 BRL Dec 07 329 432 486 (8) 31 13 Cia Saneamento Basico De Sp SBSP3 BZ Not rated na 25.60 2,570 49.7 BRL Dec 07 1,049 1,038 1,232 20 (1) 19 Kurita Water Industries Ltd 6370 JP Not rated na 2,150.00 3,165 84.4 JPY Mar 08 18,297 17,806 19,467 29 (3) 9 Nitto Denko Corp 6988 JP Not rated na 1,728.00 3,328 94.6 JPY Mar 08 46,634 5,873 1,658 13 (87) (72)Danaher Corp DHR US Not rated na 56.38 17,950 87.2 USD Dec 08 1,318 1,270 1,254 6 (4) (1)Gamuda Bhd GAM MK Reduce 1.50 1.92 1,068 75.1 MYR Jul 08 325 278 351 50 (15) 26 PBA Holding Bhd PBAH MK Not rated na 0.88 81 24.6 MYR Dec 07 43 26 26 30 (40) 4 Puncak Niaga Holdings Bhd PNH MK Not rated na 2.70 308 49.9 MYR Dec 07 98 34 127 (84) (66) 280 YTL Power International Bhd YTLP MK Not rated na 1.86 3,020 30.6 MYR Jun 08 1,039 946 931 (15) (9) (2)Easter Water Resources Dev EASTW TB Not rated na 2.84 135 19.2 THB Sep 08 571 476 682 6 (17) 43 Manila Water Company MWC PM Not rated na 11.75 500 67.6 PHP Dec 07 2,419 2,490 2,734 1 3 10 Ion Exchange (India) Ltd ION IN Not rated na 78.95 21 51.5 INR Mar 08 93 n.a. n.a. 91 n.a. n.a. Thai Tap Water Supply Pcl TTW TB Not rated na 4.72 536 22.5 THB Dec 07 920 1,365 1,831 33 48 34 Average 3,858 15 (18) 32 Hong Kong integrated utilities Hongkong Electric 6 HK Buy 50.40 44.20 12,170 61.1 HKD Dec 07 7,445 7,592 6,211 9 2 (18)CLP Holdings 2 HK Neutral 56.50 51.75 16,063 80.2 HKD Dec 07 10,608 9,539 8,262 7 (10) (13)Hong Kong & China Gas 3 HK Reduce 10.30 12.14 10,439 59.0 HKD Dec 07 7,011 3,261 3,803 20 (53) 17 CKI 1038 HK Buy 31.10 29.75 8,651 15.4 HKD Dec 07 4,772 4,444 5,738 30 (7) 29 Average 11,831 16 (17) 4

Note: Prices as of 11 February, 2009; * market cap figure for Tianjin includes A and H shares; minor variance in the numbers above relative to those in the related company reports reflects that all data for the water stocks under our coverage are based on recurring earnings.

Source: Bloomberg consensus for not rated stocks, Nomura International (Hong Kong) Limited estimates



Exhibit 3. Water and integrated utilities: valuation comparison (2) EPS (lc) EPS growth (%) P/E (x) P/BV (x) Company 07 08F 09F 07 08F 09F 07 08F 09F 07 08F 09FHong Kong and Singapore listed water utilities China Everbright Intl 257 HK 0.09 0.09 0.12 133 (3) 32 16.4 16.9 12.8 2.0 1.8 1.6 Guangdong Investment 270 HK 0.24 0.28 0.36 2 18 25 13.0 11.1 8.9 1.4 1.2 1.2 China Water Affairs 855 HK 0.04 0.08 0.10 n.a. 126 29 31.0 13.7 10.6 0.8 0.7 0.6 Beijing Enterprises Water 371 HK (0.03) 0.02 0.04 n.a. n.a. 64 n.a. 39.6 24.1 2.4 1.6 1.6 Hyflux Limited HYF SP 0.06 0.11 0.13 112 67 19 28.0 16.8 14.1 3.8 3.2 2.7 Epure International EPUR SP 0.13 0.17 0.20 49 26 23 11.0 8.7 7.1 1.6 1.3 1.1 Tianjin Capital 1065 HK 0.13 0.15 0.09 8 17 (38) 9.9 8.5 13.6 0.6 0.6 0.6 NWS Holdings 659 HK 1.01 1.89 1.16 14 87 (39) 9.7 5.2 8.5 1.1 0.9 0.9 China Water Industry Group 1129 HK (0.01) n.a. n.a. 64 n.a. n.a. n.a. n.a. n.a. 0.4 n.a. n.a. Xinjiang Tianye Water Savings 840 HK 0.14 0.20 - 8 43 (100) 5.2 3.6 n.a. 0.6 0.9 n.a. Sinomem Technology SINO SP 0.07 0.02 0.03 31 (70) 50 1.8 6.0 4.0 0.3 0.3 0.3 Bio-treat Technology BIOT SP (0.00) n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 0.1 n.a. n.a. Average 47 34 7 14.0 13.0 11.5 1.3 1.3 1.2 A-share listed water-related utilities Beijing Capital Company 600008 CH 0.23 0.10 0.14 13 (56) 38 26.9 61.2 44.3 2.8 2.9 2.8 Shanghai Chengtou Holdings 600649 CH 0.28 0.51 0.38 (13) 84 (25) 37.7 20.5 27.3 2.8 n.a. n.a. Qianjiang Water Resources 600283 CH 0.12 n.a. n.a. 89 n.a. n.a. 70.8 n.a. n.a. 2.3 n.a. n.a. Wuhan Sanzhen Industry 600168 CH 0.13 n.a. n.a. 15 n.a. n.a. 39.1 n.a. n.a. 1.6 n.a. n.a. Eguard Resources Dev 000826 CH 0.31 0.29 0.41 81 (7) 44 39.0 42.0 29.2 7.8 7.4 6.1 Jiangxi Hongcheng Waterworks 600461 CH 0.21 n.a. n.a. 2 n.a. n.a. 34.4 n.a. n.a. 2.1 n.a. n.a. Nanhai Development Co 600323 CH 0.34 0.42 0.50 8 23 18 26.6 21.7 18.4 2.8 2.6 2.4 Zhongyuan Environment 000544 CH 0.20 n.a. n.a. 1,630 n.a. n.a. 39.8 n.a. n.a. 5.5 n.a. n.a. Shanghai Yongsun Invest 900935 CH 0.05 n.a. n.a. (64) n.a. n.a. 61.0 n.a. n.a. 1.7 n.a. n.a. Average 196 11 19 41.7 36.4 29.8 3.3 4.3 3.8 International water utilities Veolia Environment VIE FP 2.16 1.68 1.75 16 (22) 4 8.6 11.1 10.7 1.2 1.1 1.1 RWE AG RWE GR 4.73 6.14 7.18 17 30 17 12.9 9.9 8.5 2.9 2.4 2.1 Severn Trent Plc SVT LN 0.90 0.91 1.02 (16) 1 13 12.6 12.5 11.1 2.8 2.4 2.2 Northumbrian Water Group Plc NWG LN 0.31 0.23 0.26 42 (24) 11 7.6 10.0 9.0 3.8 2.9 2.5 Pennon Group Plc PNN LN 0.38 0.35 0.38 44 (9) 8 11.5 12.6 11.6 2.7 2.4 2.4 United Utilities Group Plc UU/ LN 1.03 0.53 0.57 16 (49) 7 5.5 10.6 9.9 2.9 2.5 2.2 Cia Saneamento Minas Gerais CSMG3 BZ 2.87 3.79 4.22 (8) 32 12 7.7 5.8 5.2 0.7 0.7 0.6 Cia Saneamento Basico De Sp SBSP3 BZ 4.60 4.90 5.41 20 6 10 5.6 5.2 4.7 0.6 0.6 0.5 Kurita Water Industries Ltd 6370 JP 142.21 138.81 146.59 29 (2) 6 15.1 15.5 14.7 1.6 1.5 1.4 Nitto Denko Corp 6988 JP 280.07 35.24 9.54 13 (87) (73) 6.2 49.0 181.1 0.7 0.8 0.8 Danaher Corp DHR US 4.13 3.77 3.94 6 (9) 5 13.7 15.0 14.3 1.8 1.6 1.4 Gamuda Bhd GAM MK 0.16 0.15 0.18 50 (11) 21 11.8 13.2 11.0 1.3 1.2 1.2 PBA Holding Bhd PBAH MK 0.13 0.08 0.08 30 (40) 4 6.8 11.4 11.0 0.5 0.5 n.a. Puncak Niaga Holdings Bhd PNH MK 0.24 0.09 0.31 (84) (64) 265 11.4 31.8 8.7 0.8 1.0 0.9 YTL Power International Bhd YTLP MK 0.20 0.14 0.16 (15) (29) 12 9.3 13.1 11.7 1.6 1.5 1.4 Easter Water Resources Dev EASTW TB 0.35 0.29 0.41 6 (19) 44 8.1 10.0 6.9 0.8 0.8 0.7 Manila Water Company MWC PM 1.06 1.15 1.36 1 8 19 11.1 10.2 8.6 1.9 1.7 1.5 Ion Exchange (India) Ltd ION IN 7.79 n.a. n.a. 91 n.a. n.a. 10.1 n.a. n.a. 0.8 n.a. n.a. Thai Tap Water Supply Pcl TTW TB 0.28 0.35 0.46 33 26 30 16.9 13.4 10.3 3.3 2.2 2.0 Average 15 (15) 23 10.1 14.5 19.4 1.7 1.5 1.5 Hong Kong integrated utilities Hongkong Electric 6 HK 3.49 3.56 2.91 9 2 (18) 12.7 12.4 15.2 2.0 1.8 1.8 CLP Holdings 2 HK 4.40 3.96 3.43 7 (10) (13) 11.7 13.1 15.1 2.0 1.8 1.8 Hong Kong & China Gas 3 HK 1.05 0.49 0.57 19 (53) 17 11.5 24.8 21.3 2.8 2.7 2.6 CKI 1038 HK 2.12 1.97 2.55 30 (7) 29 14.1 15.1 11.7 1.7 1.6 1.6 Average 16 (17) 4 12.5 16.3 15.8 2.1 2.0 1.9

Note: Prices as of 11 February, 2009; minor variance in the numbers above relative to those in the related company reports reflects that all data for the water stocks under our coverage are based on recurring earnings.




Exhibit 4. Water and integrated utilities: valuation comparison (3) Yield (%) Net debt/equity (%) ROE (%) ROA (%) Company 07 08F 09F 07 08F 09F 07 08F 09F 07 08F 09FHong Kong and Singapore listed water utilities China Everbright Intl 257 HK 1.0 0.9 1.2 37 33 36 12.0 10.7 12.6 6.5 5.3 5.9 Guangdong Investment 270 HK 3.5 4.9 4.4 65 52 44 10.5 11.2 13.0 4.8 5.4 6.4 China Water Affairs 855 HK n.a. n.a. n.a. 59 43 17 2.5 4.9 5.4 1.0 2.2 2.6 Beijing Enterprises Water 371 HK n.a. n.a. n.a. Net cash 25 72 (8.2) 1.7 6.0 (8.0) 0.6 2.0 Hyflux Limited HYF SP 0.8 1.3 1.6 32 112 156 21.0 21.0 20.8 10.6 13.1 10.1 Epure International EPUR SP n.a. n.a. n.a. 4 Net cash Net cash 18.0 16.5 17.1 10.7 10.7 11.3 Tianjin Capital 1065 HK 3.1 3.7 2.3 75 76 72 6.4 7.1 4.3 3.1 3.6 2.1 NWS Holdings 659 HK 5.7 9.8 5.9 49 22 23 13.0 21.6 11.6 8.1 12.5 8.3 China Water Industry Group 1129 HK n.a. n.a. n.a. 48 n.a. n.a. (8.4) n.a. n.a. (3.9) n.a. n.a. Xinjiang Tianye Water Savings 840 HK 5.0 8.6 n.a. 28 n.a. n.a. 10.9 15.1 - 7.9 11.6 -Sinomem Technology SINO SP n.a. n.a. n.a. Net cash n.a. n.a. 17.2 6.6 6.6 9.8 n.a. n.a. Bio-treat Technology BIOT SP n.a. n.a. n.a. 92 n.a. n.a. (24.1) n.a. n.a. (11.9) n.a. n.a. Average 3.2 4.9 3.1 49 52 60 5.9 11.7 9.7 3.2 7.2 5.4 A-share listed water-related utilities Beijing Capital Company 600008 CH 2.6 1.5 1.0 6 n.a. n.a. 10.8 5.7 7.3 4.7 n.a. n.a. Shanghai Chengtou Holdings 600649 CH 1.0 1.9 0.8 Net cash n.a. n.a. 7.7 n.a. n.a. 6.8 n.a. n.a. Qianjiang Water Resources 600283 CH n.a. n.a. n.a. 16 n.a. n.a. 3.4 n.a. n.a. 1.6 n.a. n.a. Wuhan Sanzhen Industry 600168 CH 1.2 n.a. n.a. 19 n.a. n.a. 4.1 n.a. n.a. 2.4 n.a. n.a. Eguard Resources Dev 000826 CH n.a. 0.2 0.6 93 n.a. n.a. 22.4 17.9 22.6 6.1 5.8 7.8 Jiangxi Hongcheng Waterworks 600461 CH 1.5 n.a. n.a. 13 n.a. n.a. 6.2 n.a. n.a. 4.5 n.a. n.a. Nanhai Development Co 600323 CH 1.5 1.9 1.5 34 n.a. n.a. 10.8 12.4 13.6 6.7 7.8 7.3 Zhongyuan Environment 000544 CH n.a. n.a. n.a. 9 n.a. n.a. 14.8 n.a. n.a. 9.6 n.a. n.a. Shanghai Yongsun Invest 900935 CH n.a. n.a. n.a. 83 n.a. n.a. 3.2 n.a. n.a. 1.2 n.a. n.a. Average 1.5 1.4 1.0 34 n.a. n.a. 9.3 12.0 14.5 4.8 6.8 7.5 International water utilities Veolia Environment VIE FP 5.6 7.0 7.2 192 204 209 15.5 9.8 10.0 2.1 4.1 4.2 RWE AG RWE GR n.a. 7.6 6.5 5 22 31 19.3 23.0 26.8 3.0 6.4 6.7 Severn Trent Plc SVT LN 0.1 0.1 0.1 355 329 326 17.9 15.3 19.7 3.1 4.1 5.4 Northumbrian Water Group Plc NWG LN 0.1 0.1 0.1 686 525 464 36.7 13.0 32.6 4.2 3.7 5.8 Pennon Group Plc PNN LN 0.0 0.0 0.0 304 293 283 21.1 17.2 19.6 4.1 7.0 7.2 United Utilities Group Plc UU/ LN 0.1 0.1 0.1 216 309 286 30.6 15.7 22.9 8.0 7.1 7.5 Cia Saneamento Minas Gerais CSMG3 BZ n.a. 4.9 7.1 12 23 24 9.7 11.6 11.7 6.2 7.7 7.6 Cia Saneamento Basico De Sp SBSP3 BZ n.a. 4.8 5.1 50 60 60 11.1 10.8 10.8 5.7 n.a. n.a. Kurita Water Industries Ltd 6370 JP 1.5 1.6 1.7 Net cash Net cash Net cash 11.2 10.0 9.7 7.8 10.0 9.3 Nitto Denko Corp 6988 JP 4.6 4.7 4.2 Net cash Net cash Net cash 12.5 1.5 (0.9) 7.8 1.8 (0.3)Danaher Corp DHR US 0.2 0.2 0.2 23 Net cash Net cash 13.9 12.1 11.5 7.5 7.3 7.5 Gamuda Bhd GAM MK 9.4 5.3 5.5 31 37 48 10.8 9.8 11.0 6.0 5.0 5.5 PBA Holding Bhd PBAH MK 5.9 5.8 5.8 Net cash n.a. n.a. 8.0 4.6 4.5 5.1 3.0 2.9 Puncak Niaga Holdings Bhd PNH MK 3.7 2.5 3.8 191 204 204 6.2 2.3 7.7 1.5 0.5 1.5 YTL Power International Bhd YTLP MK 6.0 6.7 6.9 120 94 85 16.7 13.8 14.1 4.0 3.6 4.1 Easter Water Resources Dev EASTW TB n.a. 5.3 8.5 44 n.a. n.a. 10.7 8.3 10.9 6.0 5.9 6.2 Manila Water Company MWC PM 2.6 2.7 3.0 27 50 61 18.2 18.1 18.5 8.7 9.2 8.7 Ion Exchange (India) Ltd ION IN 2.5 n.a. n.a. 73 n.a. n.a. 8.5 n.a. n.a. 2.4 n.a. n.a. Thai Tap Water Supply Pcl TTW TB n.a. 3.9 5.2 224 93 78 21.4 20.2 20.3 6.3 7.4 10.0 Average 3.0 3.5 3.9 159 173 166 15.8 12.1 14.5 5.2 5.5 5.9 Hong Kong integrated utilities Hongkong Electric 6 HK 4.5 4.4 5.0 3 Net cash 3 16.2 15.2 11.9 12.9 12.9 10.1 CLP Holdings 2 HK 4.8 4.5 4.6 40 43 45 17.7 14.5 12.0 8.1 7.0 5.8 Hong Kong & China Gas 3 HK 2.6 2.7 2.8 10 9 13 38.5 11.4 12.6 25.5 8.5 9.4 CKI 1038 HK 3.7 4.0 5.6 Net cash Net cash Net cash 12.7 11.0 13.6 11.8 10.7 14.3 Average 3.9 3.9 4.5 18 26 20 21.3 13.0 12.5 14.5 9.8 9.9

Note: Prices as of 11 February, 2009minor variance in the numbers above relative to those in the related company reports reflects that all data for the water stocks under our coverage are based on recurring earnings.




Exhibit 5. Asia power and utilities: coverage universe (1) Reporting Last

reported Share Free TP Price Mkt cap

Company Type Ticker currency FY end o/s float Rating Local ($) Local ($) (US$mn) 07 08F 09F 07 08F 09F 07 08F 09FHongkong Electric Integrated 6 HK HKD 12/2007 2,134 61.1 Buy 50.40 44.20 12,169 3.49 3.56 2.91 2.01 1.96 2.21 7,445 7,592 6,211

CLP Holdings Integrated 2 HK HKD 12/2007 2,406 80.2 Neutral 56.50 51.75 16,063 4.40 3.96 3.43 2.48 2.34 2.40 10,608 9,539 8,262

Hong Kong & China Gas Gas 3 HK HKD 12/2007 6,666 59.0 Reduce 10.30 12.14 10,439 1.05 0.49 0.57 0.32 0.32 0.34 7,011 3,261 3,803

CKI Integrated 1038 HK HKD 12/2007 2,254 15.2 Buy 31.10 29.75 8,651 2.12 1.97 2.55 1.10 1.18 1.65 4,772 4,444 5,738

HK utilities average 2.77 2.49 2.36 1.48 1.45 1.65 7,459 6,209 6,004

Datang Intl IPP 991 HK CNY 12/2007 11,757 33.0 Buy 5.40 3.71 12,828 0.29 0.02 0.30 0.12 0.01 0.12 3,406 196 3,545

Huaneng Power Intl IPP 902 HK CNY 12/2007 12,328 44.2 Buy 5.70 5.37 14,383 0.51 (0.24) 0.39 0.30 0.00 0.22 6,161 (2,935) 4,858

Huadian Power Intl IPP 1071 HK CNY 12/2007 6,021 36.1 Neutral 2.00 1.73 4,012 0.20 (0.29) 0.17 0.06 0.00 0.05 1,197 (1,761) 1,001

China Power Intl IPP 2380 HK CNY 12/2007 3,606 31.8 Neutral 1.70 1.49 786 0.16 (0.12) 0.35 0.05 0.00 0.10 592 (430) 1,252

China Resources Power IPP 836 HK HKD 12/2007 4,140 33.6 Buy 19.10 14.98 8,145 0.81 0.47 1.05 0.19 0.11 0.24 3,190 1,951 4,361

China power average 0.40 (0.03) 0.45 0.14 0.02 0.15 2,909 (596) 3,003

Suntech Solar STP US USD 12/2007 154 65.8 Buy 7.00 9.57 1,473 1.02 0.89 1.01 - - - 172 164 187

Canadian Solar Solar CSIQ US USD 12/2007 28 85.0 Neutral 3.74 5.08 181 (0.01) 1.86 1.47 - - - (0) 55 43

Trina Solar Solar TSL US USD 12/2007 25 85.0 Reduce 4.71 8.23 241 1.49 2.81 1.85 - - - 35 71 47

LDK Solar LDK US USD 12/2007 113 29.3 Neutral 14.00 10.81 1,223 1.37 2.79 1.96 - - - 139 320 225

Solargiga Solar 757 HK CNY 12/2007 1,691 42.1 Reduce 1.10 1.55 384 0.22 0.17 0.12 0.06 - - 310 271 195

China solar average 0.81 1.43 1.25 0.01 - - 126 148 140

China Everbright Intl Water 257 HK HKD 12/2007 3,144 43.9 Buy 2.20 1.56 633 0.09 0.09 0.12 0.02 0.01 0.02 294 290 387

Guangdong Investment Water 270 HK HKD 12/2007 6,104 38.8 Buy 4.10 3.15 2,504 0.24 0.28 0.36 0.11 0.15 0.14 1,697 1,743 2,185

China Water Affairs Water 855 HK HKD 3/2008 1,207 65.7 Neutral 1.25 1.11 173 0.04 0.08 0.10 - - - 44 102 134

Beijing Enterprises Water Water 371 HK HKD 12/2007 2,605 35.7 Neutral 1.03 0.90 302 (0.03) 0.02 0.04 - - - (3) 23 98

Hyflux Limited Water HYF SP SGD 12/2007 525 66.2 Neutral 1.90 1.77 618 0.06 0.11 0.13 0.01 0.02 0.03 36 55 65

Epure International Water EPUR SP CNY 12/2007 1,290 37.0 Neutral 0.35 0.32 274 0.13 0.17 0.20 - - - 164 207 254

Tianjin Capital Water 1065 HK CNY 12/2007 340 43.6 Reduce 0.80 1.45 1,153 0.13 0.15 0.09 0.04 0.05 0.03 184 216 134

China water average 0.10 0.13 0.15 0.03 0.03 0.03 345 377 465

Xinao Gas Gas 2688 HK CNY 12/2007 1,010 63.6 Buy 10.00 7.20 1,064 0.51 0.57 0.65 0.13 0.16 0.22 508 573 658

Towngas China Gas 1083 HK HKD 12/2007 1,956 24.3 Neutral 1.70 1.47 371 0.08 0.13 0.21 0.00 0.00 0.00 144 263 408

China Resources Gas Gas 1193 HK HKD 12/2007 1,414 25.0 Buy 3.00 2.71 495 0.12 0.54 0.20 0.01 0.05 0.06 344.86 259.31 284.52

China Gas Gas 384 HK HKD 03/2008 3,334 58.3 Neutral 1.20 1.18 507 0.05 0.06 0.10 0.01 0.03 0.03 168.72 199.87 341.11

China gas average 0.19 0.33 0.29 0.04 0.06 0.08 291 324 423

China High Speed Wind 658 HK CNY 12/2007 1,245 73.2 Buy 15.00 11.10 2,022 0.29 0.44 0.65 0.07 0.13 0.19 307 549 813

Shanghai Electric Equipment 2727 HK CNY 12/2007 11,892 87.0 Reduce 2.60 2.54 12,834 0.24 0.25 0.22 - 0.06 0.05 2,815 2,975 2,575

Dongfang Electric Equipment 1072 HK CNY 12/2007 817 93.1 Reduce 14.70 18.96 4,415 2.72 1.05 1.58 0.11 0.31 0.47 2,224 857 1,292

Harbin Power Equipment 1133 HK CNY 12/2007 1,377 93.1 Buy 8.00 5.95 1,199 1.12 0.86 0.88 0.09 0.22 0.22 1,528 1,187 1,216

China equipment average 1.36 0.72 0.89 0.07 0.20 0.25 2,189 1,673 1,695

Korea Electric Power Integrated 015760 KS KRW 12/2008 642 43.9 Reduce 19,000 27,550 12,684 2,363 (2,821) (1,739) 750 - - 1,516,289 (1,809,709) (1,115,541)

E-Ton Solar Tech Solar 3452 TT TWD 12/2007 101 60.0 Reduce 58.80 89.20 268 13.24 13.95 9.42 3.00 3.02 2.04 893 1,495 1,014

Motech Industries Solar 6244 TT TWD 12/2007 251 80.0 Neutral 53.40 84.50 620 12.55 6.89 7.77 7.00 4.07 4.59 2,442 1,720 1,952

Taiwan solar average 12.89 10.42 8.60 5.00 3.55 3.32 1,667 1,608 1,483

Electricity Generating IPP EGCO TB THB 12/2007 526 40.0 Not rated NA 71.00 1,065 15.96 2.27 12.89 4.75 0.00 5.28 8,402 1,193 6,787

Ratchaburi Generating IPP RATCH TB THB 12/2008 1,450 33.2 Not rated NA 39.50 1,632 4.48 1.25 4.18 2.10 1.10 2.27 6,493 1,808 6,057

Thai power average 10.22 1.76 8.53 3.43 0.55 3.78 7,447 1,501 6,422

Malaysia

Tenaga Nasional Integrated TNB MK MYR 08/2008 4,335 37.7 Not rated NA 5.80 6,969 0.60 0.04 0.52 0.15 0.00 0.20 2,594 172 2,254

Suzlon WTG SUEL IN INR 03/2008 1,497 31.0 Buy NA 45.70 1,406 29.96 8.10 12.03 5.01 0.97 1.20 8,640 11,813 18,004

NTPC IPP NATP IN INR 03/2008 8,245 10.5 Neutral 212.00 180.45 30,555 8.83 9.50 10.49 3.43 3.76 4.14 72,773 78,346 86,487

Tata Power Integrated TPWR IN INR 03/2008 221 67.1 Buy 956.00 808.40 3,675 44.91 54.19 61.70 10.25 11.09 12.34 9,810 12,576 14,500

Power Grid Grid PWGR IN INR 03/2008 4,209 13.6 Reduce 78.00 86.50 7,476 3.41 3.55 4.16 1.07 1.10 1.17 13,937 14,923 17,502

India power average 19.05 22.41 25.45 4.91 5.32 5.88 32,173 35,281 39,496

EPS (local $) Net profit (local $ m)DPS (local $)


Source: Bloomberg consensus for not rate stocks, Nomura International (Hong Kong) Limited estimates



Exhibit 6. Asia power and utilities: coverage universe (2)

Company 07 08F 09F 07 08F 09F 07 08F 09F 07 08F 09F 07 08F 09F 07 08F 09FHongkong Electric 8.9 2.0 (18.2) 8.7 (2.6) 13.0 8.9 2.0 (18.2) 2.7 net cash 3.1 NA NA NA 12.7 12.4 15.2

CLP Holdings 7.2 (10.1) (13.4) 2.9 (5.8) 2.8 7.2 (10.1) (13.4) 40.0 43.0 45.4 NA NA NA 11.7 13.1 15.1

Hong Kong & China Gas 19.6 (53.5) 16.6 9.7 1.5 6.6 19.6 (53.5) 16.6 10.2 8.7 13.0 NA NA NA 11.5 24.8 21.3

CKI 30.0 (6.9) 29.1 10.0 7.5 39.9 30.0 (6.9) 29.1 net cash net cash net cash NA NA NA 14.1 15.1 11.7

HK utilities average 16.4 (17.1) 3.5 7.8 0.2 15.6 16.4 (17.1) 3.5 17.7 25.8 20.5 NA NA NA 12.5 16.3 15.8

Datang Intl 9.6 (94.3) 1,708.8 (6.7) (94.3) 1,710.6 22.6 (94.3) 1,710.6 239.9 305.3 316.5 8.00 6.84 6.16 12.6 144.3 10.9

Huaneng Power Intl 1.5 (147.1) NA 7.1 (100.0) NA 1.5 (147.6) NA 113.3 175.8 163.6 3.29 3.86 3.56 9.8 NA 10.9

Huadian Power Intl (1.2) (247.1) NA - (100.0) NA (0.3) (247.1) NA 226.7 351.8 196.5 2.61 2.75 2.24 8.9 NA 9.3

China Power Intl (25.6) (172.5) NA (32.5) (100.0) NA (15.7) (172.5) NA 76.8 116.8 118.6 1.76 1.94 1.62 8.8 NA 3.6

China Resources Power 33.7 (42.0) 123.5 (6.4) (42.6) 123.5 36.2 (38.8) 123.5 76.1 100.7 121.8 6.35 5.80 5.34 19.4 31.7 14.2

China power average 3.6 (140.6) 916.2 (7.7) (87.4) 917.1 8.8 (140.1) 917.1 146.6 210.1 183.4 4.40 4.24 3.78 11.9 88.0 9.8

Suntech 49.7 (12.8) 14.2 NA NA NA 62.3 (4.6) 14.2 25.5 125.8 92.0 NA NA NA 9.7 11.2 9.8

Canadian Solar NA NA (21.1) NA NA NA NA NA (21.1) 75.7 46.3 45.7 NA NA NA NA 2.8 3.6

Trina Solar 19.8 88.4 (34.2) NA NA NA 200.0 100.2 (34.2) 2.4 68.9 49.9 NA NA NA 5.5 2.9 4.4

LDK 291.7 103.2 (29.6) NA NA NA 437.5 130.0 (29.6) 29.7 53.5 116.7 NA NA NA 8.2 4.0 5.7

Solargiga 182.4 (22.8) (30.8) (22.6) (100.0) NA 166.5 (12.5) (28.2) net cash net cash net cash NA NA NA 7.0 8.3 11.2

China solar average 135.9 12.8 258.2 (22.6) (100.0) NA 216.5 24.1 280.1 38.2 68.4 76.1 NA NA NA 7.6 21.0 6.7

China Everbright Intl 132.7 (2.8) 32.0 0.1 (14.8) 32.0 149.6 (1.3) 33.3 37.1 33.3 35.9 NA NA NA 16.4 16.9 12.8

Guangdong Investment 1.6 17.6 24.7 (0.0) 40.3 (9.2) 2.8 18.0 25.4 65.1 52.3 43.6 NA NA NA 13.0 11.1 8.9

China Water Affairs n.a. 125.5 29.3 NA NA NA n.a. 130.8 31.6 58.8 43.0 17.3 NA NA NA 31.0 13.7 10.6

Beijing Enterprises Water n.a. n.a. 64.3 - - - n.a. n.a. 325.9 net cash 24.6 71.5 NA NA NA n.a. 39.6 24.1

Hyflux Limited 112.2 66.6 19.0 4.3 64.8 19.0 160.0 54.6 19.0 32.3 112.4 155.7 NA NA NA 28.0 16.8 14.1

Epure International 48.7 25.9 22.6 - - - 48.7 25.9 22.6 4.0 net cash net cash NA NA NA 11.0 8.7 7.1

Tianjin Capital 8.0 17.3 (37.8) 9.9 17.3 (37.8) 15.8 17.3 (37.8) 74.8 75.7 72.2 NA NA NA 9.9 8.5 13.6

China water average 60.7 41.7 22.0 2.4 17.9 0.7 75.4 40.9 60.0 45.3 56.9 66.0 NA NA NA 18.2 16.5 13.0

Xinao Gas 26.5 10.7 14.9 65.4 26.5 35.4 33.7 12.9 14.9 90.0 94.2 88.7 NA NA NA 14.2 11.9 9.5

Towngas China NA 61.1 54.9 NA NA NA NA 82.2 54.9 20.8 25.2 25.2 NA NA NA 17.6 10.9 7.1

China Resources Gas NA 338.0 (63.0) (50.3) 361.4 31.7 5.4 (24.8) 9.7 net cash net cash net cash NA NA NA 22.2 5.0 13.5

China Gas 18.3 13.3 69.2 56.1 198.0 (3.8) 28.7 18.5 70.7 137.4 148.2 155.4 NA NA NA 22.1 19.5 11.5

China gas average 22.4 105.8 19.0 23.7 195.3 21.1 22.6 22.2 37.5 82.7 89.2 89.7 NA NA NA 19.0 11.8 10.4

China High Speed 258.1 53.3 48.2 156.2 78.6 48.2 258.1 79.0 48.2 net cash 41.4 48.5 NA NA NA 37.6 23.2 15.7

Shanghai Electric 37.3 5.7 (13.5) (100.0) NA (13.5) 37.3 5.7 (13.5) net cash net cash net cash NA NA NA 9.5 8.9 10.3

Dongfang Electric (2.0) (61.4) 50.7 (60.0) 185.8 50.7 (2.0) (61.4) 50.7 net cash net cash net cash NA NA NA 6.1 15.9 10.6

Harbin Power 40.0 (23.0) 2.5 49.4 136.6 2.5 49.1 (22.3) 2.5 net cash net cash net cash NA NA NA 4.7 6.1 5.9

China equipment average 25.1 (26.3) 13.2 (36.9) 161.2 13.2 28.1 (26.0) 13.2 net cash net cash net cash NA NA NA 6.8 10.3 8.9

Korea Electric Power (26.4) (219.4) NA (34.8) (100.0) NA (26.0) (219.4) NA 31.3 42.7 52.6 NA NA NA 11.9 NA NA

E-Ton Solar Tech (27.2) 5.4 (32.5) (66.7) 0.7 (32.5) 21.9 67.5 (32.2) 154.8 163.9 140.2 NA NA NA 6.7 6.4 9.5

Motech Industries (21.6) (45.1) 12.7 (17.6) (41.8) 12.7 8.2 (29.6) 13.5 net cash net cash net cash NA NA NA 6.7 12.3 10.9

Taiwan solar average (24.4) (19.9) (9.9) (42.2) (20.6) (9.9) 15.0 19.0 (9.3) 154.8 163.9 140.2 NA NA NA 6.7 9.3 10.2

Electricity Generating 39.3 -85.8 467.9 17.6 -100.0 NA 39.3 -85.8 468.9 8.0 NA net cash NA NA NA 4.4 31.3 5.5

Ratchaburi Generating 11.4 -72.1 234.2 4.8 -47.6 106.6 11.4 -72.2 235.0 37.5 NA 10.7 NA NA NA 8.8 31.6 9.5

Thai power average 25.4 -78.9 351.0 11.2 -73.8 NA 25.4 -79.0 351.9 22.7 NA 10.7 NA NA NA 6.6 31.4 7.5

Malaysia

Tenaga Nasional -36.9 -93.3 1200.0 -44.1 -100.0 NA -36.9 -93.4 1210.5 70.4 NA 53.5 NA NA NA 9.7 145.0 11.2

Suzlon 7.8 -73.0 48.5 0.0 -80.6 23.4 19.2 36.7 52.4 103.2 37.1 86.8 NA NA NA 1.5 5.6 3.8

NTPC 10.2 7.7 10.4 10.5 9.9 10.0 10.2 7.7 10.4 23.2 34.1 61.4 NA NA NA 20.4 19.0 17.2

Tata Power 21.7 20.7 13.9 10.8 8.2 11.3 29.6 28.2 15.3 68.5 101.9 114.9 NA NA NA 18.0 14.9 13.1

Power Grid 5.3 4.0 17.3 13.5 2.9 6.8 16.7 7.1 17.3 169.8 165.4 182.1 NA NA NA 25.4 24.4 20.8

India power average 12.4 10.8 13.8 11.6 7.0 9.3 18.8 14.3 14.3 87.2 100.5 119.5 NA NA NA 21.3 19.4 17.0

DPS growth (%) P/E (x)Net debt/equity (%) EV/MW (local $)EPS growth (%) Net earnings growth (%)





Exhibit 7. Asia power and utilities: coverage universe (3)

Company 07 08F 09F 07 08F 09F 07 08F 09F 07 08F 09F 07 08F 09F 07 08F 09F 07 08F 09FHongkong Electric 4.5 4.4 5.0 57.6 55.0 76.0 22.5 24.1 24.8 2.0 1.8 1.8 9.7 9.4 11.9 16.2 15.2 11.9 10.8 10.8 8.7

CLP Holdings 4.8 4.5 4.6 56.3 59.0 70.0 26.5 28.2 29.2 2.0 1.8 1.8 8.0 8.0 8.6 17.7 14.5 12.0 7.9 6.9 5.7

Hong Kong & China Gas 2.6 2.7 2.8 30.2 66.0 60.3 4.3 4.5 4.7 2.8 2.7 2.6 9.6 15.9 15.9 38.5 11.4 12.6 23.3 7.5 8.5

CKI 3.7 4.0 5.6 52.0 60.0 65.0 17.5 18.3 19.2 1.7 1.6 1.6 14.5 10.7 11.7 12.7 11.0 13.6 9.8 9.0 11.3

HK utilities average 3.9 3.9 4.5 49.0 60.0 67.8 17.7 18.8 19.5 2.1 2.0 1.9 10.4 11.0 12.0 21.3 13.0 12.5 13.0 8.5 8.5

Datang Intl 3.2 0.2 3.7 40.9 41.3 41.3 2.5 2.6 2.8 1.5 1.3 1.1 9.2 15.8 9.9 12.7 0.6 11.1 3.2 0.1 2.1

Huaneng Power Intl 5.8 - 4.9 58.7 - 55.6 3.9 3.8 3.9 1.3 1.2 1.1 7.5 17.3 7.3 13.6 (6.3) 10.2 5.2 (2.1) 3.1

Huadian Power Intl 3.5 - 3.3 31.2 - 31.2 2.4 2.1 3.2 0.7 0.8 0.5 7.3 15.9 5.6 8.6 (13.1) 6.3 2.0 (2.5) 1.3

China Power Intl 3.7 - 8.4 32.9 - 30.0 3.1 3.0 3.2 0.5 0.4 0.4 11.0 23.0 6.0 5.9 (3.9) 11.2 3.0 (1.6) 3.8

China Resources Power 1.2 0.7 1.6 23.0 22.8 22.8 6.0 6.4 7.2 2.5 2.4 2.1 12.8 13.7 9.8 15.9 7.6 15.6 6.3 2.7 5.0

China power average 3.5 0.2 4.4 37.3 12.8 36.2 3.6 3.6 4.1 1.3 1.2 1.0 9.5 17.1 7.7 11.4 (3.0) 10.9 3.9 (0.7) 3.1

Suntech - - - - - - 5.9 6.8 8.0 1.7 1.5 1.2 8.8 10.8 8.5 22.3 17.0 16.5 11.3 6.4 5.7

Canadian Solar - - - - - - 4.6 10.5 12.1 1.1 0.5 0.4 NA 3.8 4.5 (0.2) 30.4 18.3 (0.1) 12.1 6.4

Trina Solar - - - - - - 15.7 17.7 19.5 0.5 0.5 0.4 6.0 4.2 4.7 13.6 17.0 10.0 8.4 8.5 4.5

LDK - - - - - - 7.5 9.5 11.1 1.5 1.2 1.0 8.8 5.3 7.5 37.1 37.1 19.7 17.4 13.2 6.3

Solargiga 4.0 - - 28.4 - - 0.4 0.8 0.9 3.3 1.7 1.4 8.5 5.4 5.1 71.1 15.5 13.8 43.3 11.1 10.3

China solar average 0.7 - - 4.7 - - 6.6 8.8 9.9 1.5 1.0 0.9 8.7 5.9 5.4 26.7 19.3 15.3 14.6 8.6 7.3

China Everbright Intl 1.0 0.9 1.2 16.9 14.8 14.8 0.8 0.9 1.0 2.0 1.8 1.6 14.3 11.2 8.7 12.0 10.7 12.6 6.5 5.3 5.9

Guangdong Investment 3.5 4.9 4.4 45.4 54.2 39.5 2.3 2.5 2.7 1.4 1.2 1.2 7.7 7.4 6.0 10.5 11.2 13.0 4.8 5.4 6.4

China Water Affairs n.a. n.a. n.a. - - - 1.4 1.6 1.9 0.8 0.7 0.6 10.5 10.7 4.2 2.5 4.9 5.4 1.0 2.2 2.6

Beijing Enterprises Water n.a. n.a. n.a. - - - 0.4 0.5 0.6 2.4 1.6 1.6 NA 23.2 13.3 (8.2) 1.7 6.0 (8.0) 0.6 2.0

Hyflux Limited 0.8 1.3 1.6 22.2 22.0 22.0 0.5 0.6 0.7 3.8 3.2 2.7 20.2 13.5 12.4 21.0 21.0 20.8 10.6 13.1 10.1

Epure International n.a. n.a. n.a. - - - 0.9 1.1 1.3 1.6 1.3 1.1 NA NA NA 18.0 16.5 17.1 10.7 10.7 11.3

Tianjin Capital 3.1 3.7 2.3 31.1 31.1 31.1 2.0 2.1 2.2 0.6 0.6 0.6 4.3 4.4 5.4 6.4 7.1 4.3 3.1 3.6 2.1

China water average 2.1 2.7 2.4 16.5 17.4 15.3 1.2 1.3 1.5 1.8 1.5 1.3 11.4 11.7 8.4 8.9 10.5 11.3 4.1 5.8 5.8

Xinao Gas 1.8 2.4 3.6 24.5 28.0 33.0 3.7 4.1 4.5 1.9 1.5 1.3 8.4 7.9 7.1 14.9 14.5 15.1 4.5 4.5 4.8

Towngas China - - - - - - 2.9 3.1 3.3 0.5 0.5 0.4 10.5 9.3 6.7 2.5 4.4 6.4 2.1 2.8 4.1

China Resources Gas 0.4 1.7 2.2 8.0 8.4 30.0 1.2 1.3 1.5 2.3 2.0 1.8 3.0 4.9 5.8 - 10.0 14.4 11.3 5.4 7.7

China Gas 0.9 2.8 2.7 20.7 54.5 31.0 0.9 1.0 1.1 1.3 1.2 1.1 14.7 10.5 7.5 6.6 6.3 9.5 3.6 3.8 3.8

China gas average 0.8 1.7 2.1 13.3 22.7 23.5 2.2 2.4 2.6 1.5 1.3 1.2 9.2 8.1 6.8 6.0 8.8 11.3 5.4 4.1 5.1

China High Speed 0.7 1.3 2.1 24.9 29.0 29.0 2.5 2.9 3.4 4.2 3.3 2.6 48.8 20.8 14.6 16.9 16.5 20.9 8.8 8.5 8.5

Shanghai Electric - 2.8 2.4 - 25.0 25.0 1.7 1.8 2.0 1.4 1.2 1.1 3.2 3.6 3.5 15.6 15.4 11.7 5.6 5.3 4.4

Dongfang Electric 0.7 1.9 2.8 4.0 30.0 30.0 3.1 0.3 1.9 5.4 55.4 8.9 3.8 5.7 4.0 70.9 105.8 61.5 6.7 1.9 2.8

Harbin Power 1.7 4.1 4.2 8.1 25.0 25.0 5.3 6.0 6.9 1.0 0.9 0.8 1.4 1.5 1.2 21.2 15.5 13.7 4.3 3.3 2.9

China equipment average 0.8 2.9 3.2 4.1 26.7 26.7 3.4 2.7 3.6 2.6 19.2 3.6 2.8 3.6 2.9 35.9 45.6 29.0 5.5 3.5 3.4

Korea Electric Power 2.7 - - 31.7 - - 68,633 68,026 66,966 0.4 0.4 0.4 4.1 10.8 8.9 3.5 (4.1) (2.6) 1.9 (2.1) (1.3)

E-Ton Solar Tech 3.4 3.4 2.3 22.7 21.7 21.6 59.4 62.8 70.6 1.5 1.4 1.3 16.1 8.5 9.3 27.4 30.0 15.0 10.6 10.0 5.2

Motech Industries 8.3 4.8 5.4 55.8 59.1 59.1 65.1 54.9 59.5 1.3 1.5 1.4 3.8 4.5 3.4 25.7 12.7 13.6 18.3 9.6 10.3

Taiwan solar average 5.8 4.1 3.9 39.2 40.4 40.4 62.2 58.9 65.1 1.4 1.5 1.3 9.9 6.5 6.4 26.6 21.4 14.3 14.5 9.8 7.7

Electricity Generating 6.7 - 7.4 29.8 - 41.0 84.9 91.9 94.0 0.8 0.8 0.8 6.5 NA 5.6 21.9 23.0 13.8 13.4 NA 11.5

Ratchaburi Generating 5.3 2.8 5.8 46.9 88.0 54.4 27.3 29.0 32.4 1.4 1.4 1.2 9.2 NA 6.8 16.2 18.3 13.4 8.2 NA 8.9

Thai power average 6.0 1.4 6.6 38.3 44.0 47.7 56.1 60.5 63.2 1.1 1.1 1.0 7.8 NA 6.2 19.0 20.6 13.6 10.8 NA 10.2

Malaysia

Tenaga Nasional 2.6 - 3.4 24.9 - 38.3 5.7 - 6.5 1.0 NA 0.9 5.9 NA 5.5 10.4 NA 8.4 3.8 NA 3.4

Suzlon 11.0 2.1 2.6 16.7 12.0 10.0 122.1 54.1 65.0 0.4 0.8 0.7 4.9 5.2 3.6 27.7 17.7 20.2 9.8 5.2 6.4

NTPC 1.9 2.1 2.3 38.8 39.6 39.5 62.6 67.8 73.6 2.9 2.7 2.5 10.6 10.8 10.3 14.1 14.0 14.3 8.3 7.8 7.1

Tata Power 1.3 1.4 1.5 22.8 20.5 20.0 239.0 318.4 393.5 3.4 2.5 2.1 10.3 7.9 7.4 18.5 17.9 16.7 4.9 4.8 4.9

Power Grid 1.2 1.3 1.4 31.3 31.0 28.2 30.4 33.8 36.6 2.8 2.6 2.4 12.9 11.7 10.5 10.9 10.5 11.3 3.3 3.3 3.4

India power average 1.5 1.6 1.7 31.0 30.4 29.2 110.7 140.0 167.9 3.0 2.6 2.3 11.3 10.1 9.4 14.5 14.1 14.1 5.5 5.3 5.1

RoA (%)BV/share (local $) P/B (x)Dividend payout (%)Yield (%) EV/EBIDTA (x) RoE (%)





Industry description

China is in a water crisis Natural water shortages, exacerbated by growing demand and water pollution, have transformed China’s water problem into a crisis. New policy frameworks since 2004 are in place to reform the water industry, but strong industrialisation and urbanisation across the country have exerted greater pressure. Government officials have also realised the need for improvement to secure this resource that has no substitute.

We believe more serious political measures will be rolled-out to drive stricter standards, realign bureaucracies/administrations, promote water infrastructure development and efficiency and reduce pollution.

Natural shortages — worsened by disparity China has total annual average water resources of 2.8tn m3, making the country the fourth-largest water source in the world with three of the world’s 10 longest rivers (Yangtze, Huang He and Heilongjiang).

However, due to China’s large population, water resources per capita only came in at 2,156 m3, compared with the global average of 8,462 m3, making China one of the 13 most water-deficient countries in the world, according to the World Bank. While China’s population is estimated by the MWR to reach 1.6bn by the middle of the 21st century, per capita water resources will likely slide further to 1,700 m3.

Exhibit 8. Water resources per capita around the world

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

100,000

Can

ada

New

Zea

land

Bra

zil

Aus

tralia

Mal

aysi

a

Finl

and

Sw

eden

Indo

nesi

a

US

Phi

llippi

nes

Sw

itzer

land

Japa

n

Thai

land

Fran

ce

Kor

ea

Spa

in

UK

Chi

na

Ger

man

y

Indi

a

Bel

gium

China's water resources per capita: 2,156m3

(m3)

Global average

Source: World Bank – World Development Indicators 2008, Nomura International (Hong Kong) Limited

The MWR indicated that 100mn people in over 400 cities (out of 660 in total) in China have limited access to drinking water, while 320mn people in the countryside have unsafe water sources. The MWR estimates the annual water shortage at 40bn m3, affecting economic production to the tune of about RMB500bn.

Further, water resources are unevenly distributed between the north and south, which worsens the shortage problems in some metropolitan areas. Due to the drier climate in Northern China, per capita water volume is 20% that of southern China and only 10% of the world’s average. Northern China, meanwhile, accounts for 46% of the country’s total population, 60% of cultivated lands, and 44% of GDP, but the region’s water resources make up only 19% of the nation’s total, according to government statistics. Also, the water resources in the north are mostly exploited, with relatively high utilisation ratios for surface (66%) and ground (90%) water.

A full spectrum of action to address this crisis

Though China does lie south and north of great rivers …

… its population puts an understandable strain on resources

Limited access to drinking water across China



Since China is still an industrial country, inefficient use of water during production and consumption, as well as leakage and theft of water supply (collectively referred as “non-revenue water”), put China’s water consumption per unit of GDP at 5.5x the international average.

Consistent rise in water demand China’s national water demand (includes both urban and rural areas) rose consistently at a 0.8% CAGR during 2000-07, compared with 0.4% growth in water supply volume. MWR statistics suggest that industrialisation and urbanisation have contributed to an increase in annual demand by 100mn m3 and 1.9bn m3, respectively, aggravating China’s water shortage.

Exhibit 9. China: water supply mix (2007)

Others0.4%Underground

water18%

Surface water82%

Source: China Statistical Yearbook, Nomura International (Hong Kong) Limited

Exhibit 10. China: water demand mix (2007)

Residential12%

Industrial23%

Agriculture63%

Environmental2%


We forecast that China’s growing economy will see total water demand rise consistently at a 1-3% CAGR from 580bn m3 in 2007 to 640bn m3 by 2010F and 1,208bn m3 by 2050F.

Exhibit 11. China: water demand trend and forecasts

378 365 402613

760114 134 148

225

279119

148

550 580640

975

1208

58 7178

0

200

400

600

800

1,000

1,200

1,400

2000 2007 2010F 2030F 2050F

Environmental Agriculture

Industrial Residential

(bn m3)


Demand is also rising faster than supply



Pollution exacerbates water scarcity Natural landscapes and rainfall variations are not the only factors affecting water resources in major cities. Due to rapid growth in the industrial sector, China’s environmental problems are becoming more acute than ever. According to government statistics in 2007, about 50% of the country’s wastewater was released into rivers and the sea without any treatment. Shanghai, for example, is surrounded by rivers but still has one of the lowest water resource per capita in the country, partly due to its large population growth and water pollution in upstream areas.

Over 14mn tonnes of Chemical Oxidation Demand (COD) from industrial and residential water consumption are being discharged into China’s rivers and the sea annually, in addition to 1.5mn tonnes of ammonia and nitrogen. According to SEPA, 62% of the water flow from the seven major river basins is classified as non-potable.

Economic losses caused by environmental pollution accounted for 3% of GDP in 2004, 56% of which involved water pollution. SEPA also states that out of 161 emergency incidents concerning the environment in 2006, 59% involved water.

A SEPA official stated, citing local press, said that the agency recorded 70 water pollution incidents between November 2007 to February 2008, but recent academic research published by the Chinese Research Academy of Environmental Sciences suggests that the actual number of water sources in key cities that failed to meet standards could be six times the official figure.

How much can water pollution cost? The World Health Organization (WHO) and SEPA suggest that water scarcity due to pollution costs China RMB95-199bn pa, and such pollution-caused scarcity is believed to be the cause of drought, which causes China another RMB25bn pa on loss of grains and other crops. Seawater pollution along the coastline also causes loss of fish and other aquatic life. The Ministry of Agriculture estimates that RMB4.3bn in losses at fisheries alone was due to short-term water pollution incidents, while the long-term impact can be much greater. Overall, the World Bank and SEPA estimate that water shortages, inefficient water usage, and pollution can cost 8-10% of the nation’s GDP.

Other than economic losses, polluted water can also affect health in the long-term, while WHO statistics show that incidents of liver cancer in China’s rural areas are well above the world’s average; this could be associated with water pollution as well.

What constitutes water pollution? Water pollution can occur in organic (eg, dead or decaying bodies) or inorganic (eg, heavy metals, untreated acids, salts, agricultural and industrial runoffs) forms, which require oxygen to decompose.

Insoluble particles that block sunlight to the water systems thus preventing oxygen production, as well as excessive nutrients (eg, nitrates and phosphates from fertilisers or industrial waste) that cause algae/plankton to bloom and consume most of the oxygen in the water, is another form of pollution that degrades water quality.

High temperature water consumed by factories and power plants in their cooling systems is known as thermal pollution, and reduces the oxygen being carried in the water.

Acid rain from air pollution also indirectly affects aquatic life and biodiversity.

Untreated waste released into rivers makes matters worse …

… this includes serious industrial pollutants

As anywhere, official statistics likely understate the problem

China might be forfeiting as much as a tenth of GDP in issues related to water pollution …

… not to mention the human cost



China water market

Identifying growth in the water market The water industry in China was previously a commonwealth service run by the government, with limited fees levied for water treatment and the consumption of resources. This system led to significant amounts of water being squandered and polluted, as well as to a lack of capital in the construction, renovation, operation, and maintenance of water and wastewater infrastructure.

In 2000, China made its first reform in the 10th Five-Year Plan (2001-05) to view water as a commercial product, rather than a public welfare product. Following China’s accession into the World Trade Organization, the water market was liberalised with strong legislative reforms (eg, the new Water Resources Law in 2002, and the Quickening the Commercialisation of City Utilities Policy in 2003) to attract capital from private and foreign enterprises. China has budgeted RMB473bn in the 11th Five-Year Plan (2006-10F) for the water industry, which was subsequently raised by RMB33bn in January 2008 by the Ministry of Construction to promote better water quality. Following China’s RMB4tn stimulus package announced in November 2008, the State Council immediately approved RMB20bn to be spent on rural water conservation.

Exhibit 12. China: fixed assets investment in water

0

20,000

40,000

60,000

80,000

100,000

120,000

2004 2005 2006 2007 20080

5

10

15

20

25

30

35

40Fixed assets investment in water (LHS)y-y growth (RHS)

(RMBmn) (%)

Source: CEIC, Nomura International (Hong Kong) Limited

Recent legislative developments reflect China’s new political willingness to take action on water supply penetration, conservation and pollution, and we believe more government initiatives will emerge over the next decade.

Strong government support Following the opening up of the water market in the early 2000s, the government set hard targets in the 11th Five-Year Plan (2006-10F) to promote and implement policies in the development of the water industry.

A key change has been to think of water as a product

Another key change has been a willingness to act on the government’s part



Exhibit 13. Targets set in China’s 11th Five-Year Plan (2006-10F) Event Details Remarks

1. Increase penetration of water supply to serve 100mn people in rural areas by 2010F. At the present, 250mn people in rural areas do not have a safe drinking water supply.

2. Increase wastewater treatment ratio to 70%. 3. Increase urban water supply capacity by 40bn m3 annually. 4. Project to spend RMB470bn for water improvement (RMB330bn

for sewage improvement) during 2006-10, with the majority of this to come from foreign investment.

China’s 11th Five-Year Plan (2006-10F)

5. Reduce water consumption per unit of GDP figure by 20%.

According to State Council directives, plans for water-treatment facilities should be included in local government budgets as capital construction.

Source: NDRC, Nomura International (Hong Kong) Limited

According to State Council directives, plans for water-treatment facilities should be included in local capital construction budgets, where the government has projected over RMB473bn of investment into water assets during 2006-10F (RMB330bn for wastewater treatment; RMB143bn for water supply). This policy has jump-started investment into water utilities, including the expansion, upgrade and replacement of water plants and pipelines.

Exhibit 14. Pipeline reconstruction policy Government authority Details Remarks

1. Reduce leakage by 5%, which would reduce non-revenue water by 1bn m3.

2. Improve water service stability and hygienic conditions of water pipelines.

3. Restore even water pressure over pipelines to reduce bottleneck problems.

Pipeline Reconstruction Policy issued by the Ministry of Construction and NDRC

4. Increase water supply penetration by 5%, benefiting a population of 229mn (non-agricultural population is 159mn)

This policy encourages municipal governments and water companies to raise investments for the replacement and addition of new pipelines, and provides an allowance to raise water tariffs in order to recover additional investment costs.

Source: NDRC, Ministry of Construction, Nomura International (Hong Kong) Limited

In addition to an existing underinvested water market, recent water pollution incidents across China have pushed the government to speed up development in the water market, particularly in wastewater treatment. The government aims to accelerate investment by setting harder sewage treatment ratios and quality standards nationwide. Also, water safety and environmental protection has become a top priority among provincial and municipal government bodies, and has also become a performance criterion to be evaluated by the central government. With consistent inspection by the NDRC and SEPA, local governments are motivated to support and implement these policies.

Exhibit 15. Recent policies to counter water pollution Government authority Details

1. In July 2007, the ministry stated that about 42% of the cities in China are without sewage treatment capabilities. The policy is set to achieve certain national targets by 2010, such as achieving a waste-water treatment rate of above 70% (major cities: above 70%; smaller towns and suburb areas: 30–60%), adding sewage capacity of 45mn m3, and increasing the use of recycled water by 3.5bn m3.

Ministry of Construction

2. In January, 2008, the Ministry of Water Resources approved a plan to spend RMB33bn to raise water quality for 2008, which was 40% more than the original budget.

1. In January, 2008, SEPA stated it aims to reduce COD (chemical oxygen

demand), a measure of water pollution, by 5% from the 2005 level this year.

SEPA

2. Authorities will step up the country's waste water treatment capacity by 12mn tonnes in 2008, with the aim of making sure all waste water in 36 major cities is treated by end-2009.

Source: NDRC, Nomura International (Hong Kong) Limited

Water treatment to figure more strongly in local planning

More careful monitoring being put in place



Tai Lake incident — a good case-in-point The algae outbreak in Tai Lake in May 2007 due to heavy industrial water pollution threatened the water supply of more than 2mn people in Jiangsu Province. Following this incident, SEPA ordered the worst polluting factories along four major water basins to suspend production and government officials set plans that require 20,000 chemical plants in the Tai Lake valley to meet tougher standards for sulphur dioxide emissions and chemical oxygen demand. The Jiangsu area has an urgent need for new sewage facilities, since untreated water can no longer be discharged into the Tai Lake. The provincial government is willing to spend 15% of Jiangsu’s GDP on improving wastewater treatment and environmental protection. Many provinces and municipalities (eg, Shandong, Anhui and Liaoning) have adopted similar policies, and we believe more will follow as environmental protection has become a priority for the central government.

China Everbright International has a strong presence in Jiangsu province and is likely to benefit from such strong support from the regional government.

Rich growth opportunities seen in privatisation In recent policy documents, including the “Opinion on Commercialisation of City Utilities” (2003) issued by the Ministry of Construction and “Water Tariff Management Scheme” (2004) jointly enacted by NDRC and MWR, the government set a positive goal of privatising the water sector by offering reasonable investment returns.

Due to its earlier status as a public welfare enterprise, most existing water infrastructure entities in China are distressed and are operated by local governments at poor returns (low single-digit net profit margin and ROAs). The political reform from a few years ago encourages the local government to privatise/commercialise water utilities as a channel to raise operational efficiency, penetration and treatment quality.

Exhibit 16. Financial performance of all urban water utilities in China Urban tap water supply Urban wastewater treatment Measurement 2004 2005 2006 2007 2004 2005 2006 2007Gross profit margin (%) 24.0 22.9 26.9 27.7 27.5 25.7 17.9 14.1Net profit margin (%) 1.3 (0.3) 3.6 4.1 4.7 0.5 3.7 (2.7)Return on assets (%) 0.2 (0.1) 0.7 0.8 2.4 0.8 1.1 0.5Liabilities-assets ratio (%) 45.3 47.8 50.5 51.5 62.4 47.4 46.0 45.2Revenue growth (%) 20.0 10.6 23.6 11.3 52.8 58.1 27.2 38.1Receivables turnover (days) 5.1 5.3 6.4 5.6 11.4 7.1 8.4 5.3

Note: Year 2007 represents financial information for 11M07 only

Source: State Bureau (Shijing Future) reports; Nomura International (Hong Kong) Limited

Given that most water assets are held by the government, private and/or listed organisations have a strong upside potential to expand capacity in the form of joint ventures or TOT arrangements.

Demand grows on urbanisation In view of historical urbanisation growth of 3-5% (which improves urban water supply penetration) and annual population growth in China of 2%, we estimate that China’s urban water demand will mark at a steady 3% CAGR over 2009-12F.

Algae bloom in Tai Lake underscored the problem

Water infrastructure may be better off in private hands

We see urban water demand ticking along 1pp ahead of population growth



Exhibit 17. China: population

0

200

400

600

800

1,000

1,200

1,40019

80

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

Total population Urban Rural(mn)


Exhibit 18. China: urbanisation level

0

5

10

15

20

25

30

35

40

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

Urbanisation level(ie, urban population/total population)

(%)

Source: Tsinghua University, Nomura International (Hong Kong) Limited



Value chain analysis

China’s water value chain The typical water supply value chain in China can be broken down into three major stages: raw water distribution, tap water supply and wastewater treatment.

Upstream raw water distribution mainly involves the transportation of raw water from natural water sources to downstream water treatment plants, and in some cases, water exploitation and preservation projects (eg, reservoir construction).

Tap water operators treat raw water and supply it to end users through their pipeline network. As stipulated by the regulations, the water supplier is also responsible for installing water meters to measure water usage and correctly bill and collect integrated tariff from its customers.

Finally, the sewage produced by end users is collected through a sewage network and is treated before it is released into the sea/river.

Exhibit 19. China: water sector value chain

Raw water distribution

Tap watersupply

Wastewatertreatment

Freshwater

resources

Discharge torivers/sea

Mainly involved in the transportation of raw water from natural sources to water treatment plant

Also invest in raw water projects, e.g. water dams, reservoirs, long-distance transfer pipelines

Purification of raw water for drinking or industrial use

Installation of water meters

Construction of local water pipelines to end-users

End-user billing and tariff collection

Treatment of waste water before discharging into river/sea

Usually operate under BOT/TOT arrangements

Deal directly with the local government for tariff collection

Concessionary contracts are usually heavily subsidised

Guangdong Investment China Water Affairs

Tianjin Capital

China Everbright

Shanghai Municipal Raw Water

Hyflux Limited

NWS Holdings

Epure International

Source: Nomura International (Hong Kong) Limited

Water quality in China

Fresh water quality classification Currently, one-fourth of China’s population (ie, approximately 300mn people) are still drinking underground water, of which 33% is considered moderately polluted and 64% is considered heavily polluted. Even water from the surface (such as rivers and lakes) is of poor quality. Therefore, over 50% of China’s water resources are considered grade 4 or above (ie, non-drinkable), according to government statistics. The national surface water quality standards of China have five categories for fresh water resources: ie, grade 1 to 3 as suitable for drinking, grade 4 for industrial and recreational use, and grade 5 for agricultural use.

More than 50% of China’s water is not up to potable quality



Exhibit 20. China: water quality

Grade 223%

Beyond grade 55%

Grade 526%

Grade 423%

Grade 319%

Grade 14%

Source: State Environmental Protection Administration of China

Exhibit 21. Quality classification of water resources Content Measurement Class I Class II Class IIIChrome (degree) 15 20 30 Turbidity (degree) 3 10 20 Total dissolved solids (mg/L, CaCO3) 450 550 700 Iron (mg/L) 0.3 0.5 1.0 Manganese (mg/L) 0.1 0.3 0.5 COD (mg/L) 3.0 6.0 6.0 Chlorate (mg/L) 250 300 450 Sulfate (mg/L) 250 300 400 Fluoride (mg/L) 1.0 1.2 1.5 Arsenic (mg/L) 0.1 0.1 0.1 Nitrate (mg/L) 20 20 20 Total bacteria (/mL) 100 200 500 Total coliform (/L) 3 11 27

Source: SEPA, Nomura International (Hong Kong) Limited

Wastewater treatment output quality classification Treated water output from wastewater treatment plants is generally classified as grade 1A, 1B, and 2, etc, within which there are multiple sub-categories depending on the concentration of COD and other micro-organisms.

Exhibit 22. Quality breakdown of treated wastewater (mg/L) IA IB II IIICOD 50 60 100 120BOD 10 20 30 60SS 10 20 30 50Fat 1 3 5 20Petroleum 1 3 5 15Anionic Surfactant 0.5 1 2 5Nitrogen 15 20 - -Ammonian - temperature above 12'c (at or below 12'c) 5(8) 8(15) 25(30) -Phosphorus - on and before 31 Dec 2005 1 1.5 3 5Phosphorus - from 1 Jan 2006 0.5 1 3 5Chroma 30 30 40 50PH 6~9 na na naColi group (unit/L) 103 104 104 -

Source: SEPA; Nomura International (Hong Kong) Limited

There are several grades of water



Non-revenue water Apart from water scarcity and growing demand, non-revenue water (arising from leakages, lack of meters and theft) continues to be a national concern. Asian countries, such as Thailand and the Philippines, have high levels of non-revenue water (40-60%). China’s non-revenue water is also high at around 30%, compared with 18% in the US, 10% in Japan and 5% in Singapore, according to China Water Net). Non-revenue water curbs profit margins. The government expects to raise efficiency through aggressive capital expenditure and privatisation.

Natural gas versus water Both the natural gas and water industries receive support from the government. National policies have been set for cleaner energy use, as well as for conserving water consumption. Although there is excessive demand for water, it has no direct substitute and its volume demand is relatively inelastic to price changes. Regulator reforms in the water industry over the past few years have raised investment opportunities to a good entry point, in our view.

Exhibit 23. Comparison between water and gas utilities

Urban natural gas supply Urban tap water supply and wastewater treatment

Government policies Government encourages use of clean energy to reduce green house gas emissions.

Encourage conservation of water consumption (targeted to reduce water consumption per unit of GDP figure by 20%) and increase water supply capacity by 40bn m3 annually.

Environmental and social benefits

Reduces green house gases significantly, such as SO2, NOx, and CO2.

Improve water quality and minimise endangered use of underground water.

Market potential for investors The gas distribution sector started privatising over a decade ago.

China revised the Water Resource Law in 2002 to fully open up the market for private sectors.

Set up cost and market penetration

China’s natural gas industry is still in its infancy. Many cities are without gas pipelines. Therefore, initial setup costs will be high, but will benefit from high future growth owing to low penetration rate at initial stage.

Tap water supply: most urban cities in China have existing supply pipelines, market penetration more established but yet to be improved. Wastewater treatment: market rather underdeveloped and the government targets reaching a sewage treatment ratio of 70% by 2010 (from 63% in 2007).

Revenue mix One-off connection fees (which are for initial pipeline expansion and represents over 50% of total revenue) and recurring gas supply tariff.

Tap water supply: revenue is driven by recurring water tariff as pipelines are pre-existing, one-off connection fees represents small portion of total revenue. Wastewater treatment: treatment tariff receivable from the government.

Available resources China is one of the world's largest gas reserve countries, with proven reserves of 2,500bn m3. However, available production supply is still scarce and the nation expects to rely on imports in the near future.

Water resource volume per capita is only 2,152 m3, a quarter of the world’s average. China suffers a water shortage of 40bn m3 annually.

Input cost The NDRC has introduced a gradual market-driven pricing policy for natural gas. Under certain restrictions, increases in well-head gas prices can be passed through to industrial end-users through tariff hikes. No such mechanism for residential end-users; residential tariffs are closely regulated.

Tap water supply: water resources fees charged by the government at minimal amount are automatically passed through to end-users. Wastewater treatment: wastewater intake is guaranteed and provided by the government at no cost.

Substitutes Electricity. No found substitute.


In China, about 30% of water that should be paid for, is not

A good entry point to water investment



Value chain — urban water supply

Urban water supply Revenue model The urban water supply business is driven by three types of revenue — water treatment charges, connection fees (meter installation) and construction fees. The revenue model is detailed as follows:

Tap water treatment and supply: Urban water companies collect tariffs directly from end users — residential and commercial and industrial (C&I) customers — for treating and distributing fresh water. However, given that urban water suppliers own the last mile of the pipeline and face end users directly, they are given the right to collect not only the tap water supply fee, but are also responsible for collecting water-resources, city-construction and wastewater treatment fees on behalf of the municipal government and wastewater operators. Also, unlike city gas companies which face challenges in passing on the rise of “well-head” gas charges, water suppliers are able to pass through their raw material cost (ie, water resources fee) automatically and entirely. Growth in water treatment revenue is driven by tariff hikes, improvements in plant utilisation, reduction in leakages (non-revenue water), and urbanisation and population expansion.

Connection (meter installation) fees: City water companies charge one-off meter installation fees for new connections or for users without a meter. Growth is driven by increasing household penetration for safe water usage (large population in China not connected to water pipes), regular urbanisation and population growth. Although this is a business monopolised by regional entities, with profit margins at 50%-plus, income from connection fees is generally one-off upon initial setup and cannot be sustained over the long term.

Construction income: Establishing pipelines for connecting end users and the supply network, as well as other one-off water exploitation projects such as construction of reservoirs and dams, can offer additional revenue from which urban water utilities may benefit.

Large potential for an underinvested market By end-2007, China had more than 1,735 water supply companies in urban areas, with pipelines of 447,229km (up a 7.7% CAGR during 2005-07) and serving a population of 348mn (4.6%), according to the National Bureau of Statistics.

Exhibit 24. Urban population with access to water

(Population in thousands)

150,000

200,000

250,000

300,000

350,000

400,000

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007


Exhibit 25. Length of urban water pipeline

(km)

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

500,000

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007


How to make money in urban water supply —



Apart from steady urbanisation and population growth, one of the main growth factors in urban water supply is its existing under-penetration. In China, 54% of households are not connected to water pipelines, 74% are not equipped with bathing facilities and 77% lack proper or any type of lavatories, according to the China County Population Census.

Basic water utilities are necessities in China’s development plan, and we expect demand for urban water supply to grow at 2% CAGR during 2008-10F, which is line with the long-term growth rate suggested by the Ministry of Construction. According to the Eleventh Five-Year Plan, RMB143bn will be spent in urban water supply during 2006-10 (RMB29bn pa), which includes raw water projects, improvement in water efficiency, and pipeline restructuring and replacements. We believe such infrastructure will provide a more positive backdrop for water utilities to penetrate households.

Exhibit 26. Budget for urban water supply in the Eleventh Five-Year Plan (2006-10)

Water sources and quality

35%

Urbanisation growth35%

Rebuild aged water supply

network16%

Automated water supply for urban

population14%

Urban water supply budget during the 11th 5-Year Plan: RMB143bn

Source: Ministry of Construction, Nomura International (Hong Kong) Limited

Exhibit 27. Availability of tap water

Piped water45.7%Non-piped

water54.3%

Source: China County Population Census

Exhibit 28. Proportion of types of drinking water

Piped water49.7%

Hand pump25.8%

Other (surface)15.4%Rain

collection2.6%

Well6.5%

Source: Third National Health Service Survey

Exhibit 29. Availability of bathing facilities

Other facility for bath

9.7%

Water heater at

home15.4%

No facility for bath74.0%

Centralised support of hot water

0.9%


Exhibit 30. Availability of lavatories

Lavatories at home18.0%

No lavatory28.0%

Sharing lavatories

with neighbors

0.7%Other type of lavatory at home53.3%


Growth aside, China infrastructure is sketchy …

… hence the RMB143bn budgeted to be spent here



Robust growth from privatisation In accordance with “Quickening the Commercialisation of City Utilities Policy” published by the Ministry of Construction in 2003, local governments are encouraged to privatise existing water assets. Unlike wastewater treatment, water supply infrastructure is more developed and capex is mainly required for maintenance and water quality upgrades. Having been part of the public welfare system for decades, Chinese water supply assets are mostly distressed with unattractive profitability and through the privatisation process local governments are searching for investments and management to turn around operations.

Exhibit 31. Gross profit margins of different industries in China

0

5

10

15

20

25

30

2000 2001 2002 2003 2004 2005 2006 2007

Power Water Gas

The gas supply industry was opened up in 1998

The water industry was opened up in

2002

The power industry was opened up in 1990s

(Gross profit margins %)


Exhibit 32. Industry revenue of water and gas

0

20

40

60

80

100

120

2000 2001 2002 2003 2004 2005 2006 2007

Gas Water(RMBbn)


Exhibit 33. Industry revenue of power producers

0

500

1,000

1,500

2,000

2,500

3,000

2000 2001 2002 2003 2004 2005 2006 2007

Power(RMBbn)


Privatisation can be carried out in the form of concessionary agreements, such as TOT leases or perpetually through joint ventures. The majority of existing water infrastructure is held by the government, indicating large potential growth is available for foreign and private enterprises to extend through M&A.

China water supply infrastructure is run down

Assets are overwhelmingly state held



Exhibit 34. China: urban water supply

30,000

35,000

40,000

45,000

50,000

55,000

60,00019

96

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

F

2009

F

2010

F

2011

F

2012

F

(mn m3)

Source: Ministry of Construction

Margin expansion from efficiency improvement Owing to the earlier state-owned status for water supply operations, some end users are connected to the water pipeline network without being charged for water use. This, in addition to pipeline leakages and intentional water theft, form non-revenue water (NRW), ie, water supplied without being paid for.

Following the “One Household, One Meter” policy that was pushed forward by the Ministry of Construction in 2002, water supply operators are given the right to install water meters in each urban household and collect tariffs for water supplied. Such improvement in NRW would translate into a direct expansion of profit margin. We expect China’s NRW to improve gradually to 18% in 2010, from 22% in 2007.

Minimal collection risk Water supply operators not only have the right to collect the tap water supply fee (for treatment and distribution to end users), but are also responsible for collecting water-resources, city-construction and wastewater treatment fees on behalf of the municipal government and wastewater operators. Due to its direct exposure to the fee-collection process, water supply operators generally have a very low debtor turnover period.

Besides, water suppliers also have the right to shut down water supply when users default on payment by more than 60 days, which minimises collection risks.

Suggested 8-12% ROE with direct cost pass-through In 1998, the City Water Supply Pricing Scheme guided that urban water suppliers should be allowed a return on equity (net assets) of 8-12%. Upon escalating operating costs from power, labour, upgrade and maintenance, water suppliers can ask for a tariff hike to maintain the allowable return. Even without an application for a tariff hike, the water tariff is generally reviewed by the local government every two years to adjust for inflationary cost effects. Although the water tariff is ultimately controlled by the local pricing bureau of the municipal government and a tariff hike has to be approved through public hearings, this policy allows water utilities a legitimate channel to justify reasonable returns, in our view.

Unlike wastewater treatment operations, which are still highly subsidised by the government, water supply tariffs are mostly passed through to end users. Therefore, there are fewer regulatory and collection risks involved in negotiating for a water supply tariff hike.

Quite a bit of water is supplied but not paid for …

… but installation of meters will cut down on this

Water suppliers can turn off the tap if not paid

Of course tariff hikes have to be approved but there is a mechanism for this …

… and not as onerous as in some kindred industries



Most importantly, water has no significant raw material cost (especially in the southern regions), unlike power, oil and gas, which are subject to the risk of fluctuating fuel costs. Raw water resource fees charged by the government are generally 2-5% of the final water tariff and are generally passed through to end users.

Change in water usage habit Currently, Chinese residents consume only 15-20 litres of fresh water per day, since: 1) a large amount of the population in rural areas does not have stable water supply, and; 2) China has only recently built up the infrastructure for heavier water use. However, modernisation and urbanisation would gradually promote higher per capita water consumption, prompting greater demand for water in the long run.

In developed countries, on an average, residents consume 150-300 litres of water daily, while in developing countries this figure is 20-100 litres daily, according to UNESCO. A conventional toilet flush consumes 10-15 litres per use, while a shower consumes 15-35 litres per minute and a full bath would use 150 litres.

Exhibit 35. Water consumption by activity Activities Litres usedToilet flushes 10 - 15Shower (per minute) 15 - 35Bath (full tub) 150Laundry machine (full load) 160 - 220Dishwasher 25 - 55Dishwashing by hand (tap running) 110Shaving (tap running) 20 - 30Brushing teeth (tap running) 10 - 30

Source: GWM Water

Less risk from China’s slowing industrial outlook Industrial users account for only 45% of the total water supply in urban areas (23% at the national level, per the National Bureau of Statistics), and this number too is on a downtrend as water efficiency rises among manufacturers and water consumption by households increases with modernisation and urbanisation.

The recent economic turmoil has slowed production in various industries, as is evident from the drop in industrial output growth to 5.7% in December 2008 from 8.2% in October 2008 and 11-16% in 9M08. Our economics team expects industrial output growth to continue its downtrend in the months to come, possibly reporting negative year-on-year growth in early 2009. However, the impact on water supply volume is still not significant when compared with the power sector (where the industrial sector accounts for 76% of total consumption) and gas distribution (where the industrial sector accounts for 50-80%), according to the National Bureau of Statistics and our industry checks. We believe water plant utilisation in China is less exposed to macro-economic conditions — due mainly to inelastic demand from the residential sector and the growth outlook for water utilities is more resilient and defensive.

Modern habits are much more water-intensive

At the same time, modern infrastructure makes more efficient use of water

Demand here is largely inelastic



Exhibit 36. China: water supply mix

39% 41% 42% 45% 47% 40%51% 52% 52% 54% 47%

55%

61% 59% 58% 55% 53% 60%49% 48% 48% 46% 53%

45%

0%10%20%30%40%50%60%70%80%90%

100%

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Residential Industrial




Value chain — wastewater treatment

Wastewater treatment Revenue model Standalone wastewater treatment operations receive tariffs directly from the government, which are generally highly subsidised. Generally, the government is responsible for setting up sewage pipelines and the provision of wastewater intake, while wastewater treatment plants carry out the treatment process independently.

Due to the standalone nature of the business, privatisation is usually in the form of BOT/TOT arrangements for a concession period of 25-30 years. As an incentive to encourage investments, local governments may guarantee a minimum volume being supplied to the wastewater treatment plant. Many cities don’t have existing wastewater treatment facilities and thus demand is generally in excess of supply, making it easier to ramp up plant utilisation to optimal levels (90%-plus).

Huge growth potential ahead in wastewater treatment Unlike urban water supply, which has existing infrastructure, wastewater treatment is still in the development stage and far behind the government’s target in the 11th Five-Year Plan. We see significant growth potential in the near term on the following:

Severe under-investment and under-penetration.

Environmental pollution under current conditions.

Sewage pipeline network has not been fully set up in many cities.

Aggressive expansion implied from the government’s 2010 target According to the National Bureau of Statistics, China’s daily capacity of wastewater treatment grew to 71.5mn m3 in 2007 (from 27.5 m3 in 2000), representing a 14.6% CAGR. Wastewater emissions in China increased to 55.7bn m3 in 2007 (from 41.5bn m3 in 2000), representing a CAGR of 4.4%. Despite significant development, we see higher potential growth in the next few years given that 42% of the cities in China (or 297 cities) are still without sewage treatment capabilities. Specific policies have been announced by the Ministry of Construction for 2010 to support such aggressive development, which targets a wastewater treatment ratio of 70% for major cities (30-60% for smaller towns and suburbs) by 2010, up from 63% in 2007.

Exhibit 37. China: urban wastewater emission

19 20 21 21 22 24 24 25 26 27 28

22 23 23 25 26 28 30 31 32 34 35

56 58 61 63

4853 54

46444342

0

10

20

30

40

50

60

70

80

2000 2001 2002 2003 2004 2005 2006 2007 2008F2009F2010F

Industry Non-industrial(bn m3)


Exhibit 38. China: wastewater treatment capacity

(mn m3/day)

33

4957

6471

85

102

121

0

20

40

60

80

100

120

140

2003 2004 2005 2006 2007 2008F 2009F 2010F


BOT with long concession periods, if privatised

Wastewater much less developed than water supply

Nearly 300 cities in China do not have sewage treatment plants



If we assume that China’s wastewater emissions continue to grow at their historical CAGR of 4.4% until 2010, annual sewage is likely to reach 63.3bn m3 by 2010. Taking into account the government’s target of raising the sewage treatment ratio to 70% by 2010, China would need to have a daily treatment capacity of 121mn m3 by then, implying a potential CAGR of 19% in 2008-10F. However, only a daily capacity of 100mn m3 was planned in the 11th Five-Year Plan, indicating that the government’s target may not be met unless it implements further policies to push for higher growth.

We see higher growth opportunities in wastewater treatment due to prevailing underdevelopment in China and the positive backdrop set by recent government policies (especially following China’s RMB4tn stimulus package announced in November 2008), when compared with conventional tap water supply.

Exhibit 39. China: sewage treatment ratio in urban areas

34% 36%40% 42% 44%

48%

58%63%

0

10

20

30

40

50

60

70

2000 2001 2002 2003 2004 2005 2006 2007

(%)

Source: National Bureau of Statistics, Xinhua News

Government’s wastewater treatment budget In accordance with the 11th Five-Year Plan to increase wastewater treatment penetration and improve water quality, the Ministry of Construction has budgeted an investment of RMB330bn (RMB66bn pa) in wastewater treatment, compared with RMB143bn (RMB29bn pa) for urban water supply.

Exhibit 40. Wastewater treatment budget in 11th Five-Year Plan (2006-10F)

Collection ducts and pipelines

65%

Wastewater treatment plans

35%

Wastewater treatment budget for the 11th 5-Year Plan: RMB330bn

Source: Ministry of Construction, Nomura International (Hong Kong) Limited

Demand driven largely by the residential sector According to a study by the US Department of Commerce, China has only one treatment facility for every 1.5mn urban and suburban dwellers, compared with one for every 10,000 persons in the US.

More aggressive policies may be needed

Government investment in wastewater is about twice that in urban water supply



Sewage output has been increasing rapidly in volume and the residential sector is becoming a major contributor to this growth rate. In 1999, the residential wastewater emission volume exceeded that of the industrial sector, and continued to increase at a higher rate thereafter. Due to the high rate of urbanisation in China, sewage facilities are needed more urgently in urban areas, to keep up with economic development.

Exhibit 41. Wastewater output comparison

54.6% 50.7% 49.2% 46.7% 46.9% 47.2% 46.2% 45.9% 46.3% 44.7% 44.3%

45.4% 49.3% 50.8% 53.3% 53.1% 52.8% 53.8% 54.1% 53.7% 55.3% 55.7%

0%10%20%30%40%50%60%70%80%90%

100%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Industrial Residential


In wastewater treatment, we prefer the industrial space We prefer industrial wastewater treatment to residential, because:

On our estimates, the tariff for industrial wastewater treatment is 2-6x higher than that of residential, with estimated project IRRs at 10% (compared to 8-9% for residential).

The wastewater treatment tariff is mostly passed through to industrial users who can afford the cost. In contrast, the residential wastewater tariff is highly subsidised by the government.

Following the government’s goal to counter pollution and promote water efficiency, tariff hikes are more likely among industrial users.

We believe industrial wastewater treatment plants face less regulatory and collection risks with the local government, and the existing underinvested market should provide stable growth opportunities for operators to expand capacity.

Margin expansion from entering into water-recycling At most of the wastewater treatment plants in China, processed water output is directly discharged into rivers or the sea. Many municipal governments in the north-eastern provinces have recently pushed for initiatives to promote the use of recycled water. The aim is to avoid using potable water for industrial use, such as for cooling off power plants, cement production, and flushing toilets, where recycled water can be used. The encouragement for recycling water and the escalating water tariffs in most northern provinces (due to water shortages), lead us to believe that recycled water would be a high-margin business, since treatment cost would already have been taken care of during sewage treatment, and additional supply/distribution costs would be minimal.

Following the government’s target to increase the use of recycled water by 3.5bn m3, as announced by the Ministry of Construction in early 2007, we see growing opportunities in this business segment.

Growth from the cities is the fastest, outstripping industrial use

Industrial use pays better

Amid a water shortage no reason to use potable water for industrial applications



Key players involved in the urban wastewater treatment market Key players that are involved in China’s wastewater treatment market in the urban area are as follows:

Exhibit 42. China: top players in wastewater treatment market

Rank Company TickerDaily capacity

(mn m3) % of total urban

capacity in China1 Beijing Capital 600008 CH 7.60 10.6 2 Shanghai Chengtou Holding Co 600649 CH 3.50 4.9 3 Tianjin Capital Environmental Protection * 1065 HK 2.69 3.8 4 Shenzhen Water Group unlisted 1.86 2.6 5 Sound Group unlisted 1.77 2.5 6 General Water of China (listed parent: Shanghai Industrial Investment) (a) 1.66 2.3 7 Beijing Enterprises Water * 371 HK 1.63 2.3 8 China Everbright International * 257 HK 1.28 1.8 9 Tsinghua Tongfang unlisted 1.20 1.7 10 Veolia Water of China (listed parent: Veolia Environment) VIE FP 1.17 1.6 11 Sino French Water (JV of NWS Holdings and Suez) (b) 0.55 0.8 12 Golden State Holdings unlisted 0.25 0.3 13 Hyflux Limited * HYF SP 0.14 0.2

Notes: (a) General Water of China - listed parent is Shanghai Industrial Investment (363 HK, BUY); (b) Sino French Water - joint-venture of NWS Holdings (659 HK, BUY) and Suez (SEV FP, BUY)

* For companies under coverage, capacity based on our estimates for end-2008; others quoted from H2O-China as of end-2007

Source: H2O-China, Nomura International (Hong Kong) Limited



Revenue and regulation

China’s water tariff under reform Background on water tariff evolution Over the past two decades, the Chinese government has made noticeable reforms in the pricing mechanism of water tariffs. Before 1985, water in China was provided to citizens free of cost. Following severe water shortages, government officials realised this situation would hinder China’s economic growth and began to create awareness about the need for water conservation.

Exhibit 43. Evolution of the Water Resources Law New Water Resource Law (2002) Old Water Resource Law (1988)

Article 7: The state will establish a water abstraction permit system, and anyone who consumes the water resource shall pay accordingly for this usage.

Article 32: the state will establish a water abstraction permitting system.

Article 12: The State Council's Ministry of Water Resources shall be in charge of the unified administration of water resources throughout the entire country.

Article 9: The state shall carry out a system of unified administration on water resources in association with administration at various levels and by various departments.

Article 30: The Ministry of Water Resources should consider maintaining the flux in rivers, the water level in lakes and water reservoirs, and the water table of groundwater at a reasonable level and should consider maintaining the self-purification capability for water bodies when drafting the development and utilisation plan of water resources.

No corresponding rules

Article 49: Water consumption will be charged based on the actual amount of water consumption, and the progressive water tariff system will be executed if users exceed their water quotas.

No corresponding rules

Source: US Department of Commerce, International Trade Administration

Water pricing reforms were planned in 21 provinces, autonomous regions and municipalities, with 12 provinces and cities implementing firm methods of water price management by 2005. According to the policy outline provided by the NDRC and the MWR in 2005, “…the number of people who should pay for water consumption will increase, and the amount they pay will see a moderate hike.”

Water tariff is on the rise

Water tariff has been on an uptrend Ever since the government recommended in the Tenth Five-Year Plan (2001-05) that water should be viewed as a commercial product and prices should be set according to its scarcity, water prices have been on the rise. In 2007, the integrated water price of 100 large and medium-sized cities was RMB2.8/m3, a CAGR of 11% for 2000-07, according to H2O China and Ministry of Water Resources.

Giving water away did not promote economic use …

… now more people will pay more



Exhibit 44. Average water tariff among China’s 100 largest cities

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2000 2001 2002 2003 2004 2005 2006 2007

Wastewater Water tariff Integrated

Source: H2O-China, Ministry of Water Resources, Nomura International (Hong Kong) Limited

Government is reducing water consumption per unit of GDP by 20% As set out in the 11th Five-Year Plan, China aims to reduce water consumption per unit of GDP by 20% during 2006-10F. Water consumption per RMB10,000 of GDP was 229 m3 in 2008, down from 306 m3 in 2005. Meanwhile, the MWR aims to cut this ratio by another 45% by 2020F from current level (or down 60% from 2005 level), given the severe water shortages and China’s long-term goal to improve water conservation and efficiency, according to the latest press conference in February 2009.

We believe that aggressive tariff hikes are a possible solution to achieve these targets, given the natural price inelasticity of water. Also, the MWR indicated in January 2009 that China’s water tariffs will have to rise to support the government’s targets of cutting water consumption per unit of GDP by 20%, fighting pollution and raising water quality.

China’s urban water tariff is only 20% of the world’s average China’s current water tariff in urban areas is only 20% of the world’s average, although demand for water is more inelastic than that for other utilities. In line with the government’s agenda to benchmark water tariffs to international standards, as well as to reflect the value of water scarcity, we see an upward trend in China’s water prices.

Exhibit 45. Water tariffs in different countries/cities

0

5

10

15

20

25

30

35

40

45

New York Turkey Germany Paris Denmark Germany UnitedKingdom

Belgium Japan Italy Canada China SouthKorea

(RMB/m3)

Source: H2O, NUS Consulting, International Trade Administration, Nomura International (Hong Kong) Limited

Charging more will also promote environmental ends



Larger upside potential in tariff hike than other utilities China’s water tariff only accounts for 1.0% of average disposable income among Chinese households, lower than the 2-12% in the case of electricity bills and 3% recommended by the Ministry of Housing as an effective benchmark to reflect water conservation.

Unlike the electricity tariff which is centrally controlled by NDRC, water tariff hikes are regulated and approved by local governments. Since 2000, water tariffs (water supply and wastewater treatment) have seen a larger gain than electricity and piped natural gas, since: 1) water prices have historically been below those for other utilities due to water’s earlier public-welfare status, and; 2) water accounts for a relatively small portion of production costs as compared with other types of energy sources.

Exhibit 46. Changes in residential utilities prices

50

100

150

200

250

300

Jan 01 Oct 01 Jul 02 Apr 03 Jan 04 Oct 04 Jul 05 Apr 06 Jan 07 Oct 07 Jul 08

Residential wastewater treatment tariff

Residential tariff for piped gas

Residential water tariff (excluding wastewater treatment)

Residential tariff for piped natural gas

Retail electricity tariff for residents (220v)

Note: Rebased to 100


Exhibit 47. Water bill as a percentage of disposable household income among Chinese cities

0

1

2

3

Hai

kou

Kun

min

g

Cho

ngqi

ng

Hef

ei

Xia

men

Fuzh

ou

Cha

ngsh

a

Jina

n

Nan

ning

Har

bin

Xin

ing

Gua

ngzh

ou

Wuh

an

Taiy

uan

Che

ngdu

Nan

jing

Gui

yang

Cha

ngch

un

Uru

mch

i

Han

gzho

u

Xia

n

Tian

jin

Hot

ter

Nin

gbo

Nan

chan

g

Zhen

gzho

u

Lanz

hou

She

nzhe

n

Shi

jiazh

uang

Qin

gdao

Dal

ian

Yin

chua

n

Bei

jing

She

nyan

g

Sha

ngha

i

(%)

Source: Bureau Statistics of China, Nomura International (Hong Kong) Limited

In proportion to income, China households are paying little for water



Faster growth in wastewater treatment tariff We believe the wastewater tariff will be raised sooner and by a larger magnitude, mainly due to the prevailing underinvestment and the government’s aggressive push to boost water quality across all cities in China. Historically, China has had very few wastewater treatment plants, operated in poor conditions and low tariffs to end users. To meet the central government’s target of a 70% sewage treatment ratio by 2010, local governments will allow a higher tariff for wastewater treatment projects, as an instrument to attract investments, in our view.

Also, the State Council has set a guidance in June 2007 that the wastewater treatment tariff should benchmark at RMB0.8/m3, which implies a 25% rise from current averages. The government also aims to upgrade treatment output from wastewater plants to Grade 1B (from Grade 2 or below). As a result, we see further upside from the RMB0.8/m3 benchmark.

For instance, Guangzhou city (Guangdong province) adopted a progressive water tariff mechanism on 30 December, 2008, which will increase wastewater treatment fees by 29-171% effective 1 July, 2009, according to a local press report on 16 January, 2009. New tariffs would bring Guangzhou in line with other cities in the Pearl River Delta area.

Exhibit 48. Proposed tariff hike in Guangzhou, Guangdong province After

Before

(RMB/m3) Water consumption

(m3/month) Wastewater treatment fee

(RMB/tonne)Change

(%)< 22 0.90 29

23 - 30 1.20 71Residential 0.7

> 30 1.50 114Civil service 1.20 71

Industrial 1.40 100Servicing 1.40 100

Non-residential 0.7

Specialised industry 1.90 171

Note: Public hearing held on 30 December, 2008

Source: People's Daily, Nomura International (Hong Kong) Limited

Risks associated with wastewater treatment tariff However, we see the following risks associated with wastewater treatment operations:

Since tariffs for new wastewater treatment projects may not be fully passed-through to end users (due to previously low or non-existent wastewater treatment tariffs), payments to project operators are highly subsidised by local governments. Depending on the financial strength of the local treasury, we are concerned about regulatory risks on future tariff hikes in the event of cost escalations. Therefore, we prefer industrial wastewater operations, since they are less subsidised by the government than residential operations.

Wastewater treatment operators are only dealing with a single customer — ie, the local government — which may pose certain collection risks for wastewater tariffs.

Wastewater treatment tariffs could go quite a bit higher

Industrial use is less subsidised, which in this case we prefer since subsidies are not guarantees …

… no single-customer risk, either



RMB4tn stimulus plan

RMB4tn stimulus package fuels growth Details of the stimulus plan China’s RMB4tn stimulus plan announced on 9 November, 2008, intends to ease economic pressure arising from the global financial crisis and slowing growth. The stimulus package includes investment plans in low-income housing, rural infrastructure, water, power distribution, technological innovation in environmental protection and recovering losses suffered from previous natural disasters. The aim is to enlarge infrastructural spending, stimulate domestic demand, and improve living standards for low-income populations.

Exhibit 49. Details of China’s RMB4tn stimulus package in November 2008 Items 1 Increase spending on public housing programmes 2 Increase spending on rural infrastructure projects, including water, renewable energy, road, and electricity networks 3 Increase spending on public transportation projects, including railway, highway and airports 4 Increase spending on health care and education 5 Increase spending on environmental protection, including waste water treatment, energy conservation and forest restoration 6 Support the high-tech industry via encouraging innovation, and boost the development of the service industry 7 Accelerate the reconstruction of the disaster-affected areas 8 Increase rural and urban household income via increasing procurement prices for grain products and various types of direct subsidies 9 Reform the value-added tax (VAT) regime, to reduce the tax burden of enterprises by RMB120bn 10 Remove bank lending quotas and increase the size of total loans

Source: Xinhua, Nomura International (Hong Kong) Limited

Regarding water investments, the stimulus package will concentrate mainly on safe drinking water in rural areas, the south-to-north water diversion project, reservoir development and governance, water conservation, urban waste treatment and pollution management.

Exhibit 50. Brief breakdown of the stimulus package by monetary value Items (RMBbn) (%)Railways, roads, airports and power grids 1,800 45.0 Post-earthquake reconstruction 1,000 25.0 Rural development and infrastructure projects 370 9.3 Housing 280 7.0 Ecology and environmental protection 350 8.8 Innovation 160 4.0 Healthcare and education 40 1.0 Total 4,000 100.0

Source: Xinhua, Nomura International (Hong Kong) Limited

State Council announced RMB20bn budget for 4Q08 Following the RMB4tn stimulus package, the State Council also announced (19 November, 2008) that it would spend RMB20bn on rural water conservancy projects as one of the steps to stimulate domestic demand, to be part of the stimulus spending in 4Q08, which has been put at a total of RMB100bn.

The budget will mainly go to projects to reinforce risky water reservoirs, save water in major irrigation areas and improve drinking water safety in rural areas, according to MWR. This additional budget should have boosted total spending in water-related assets to RMB66bn for the full year in 2008, from the RMB46bn of investments made since early 2008.

Of course a far-ranging stimulus package will include spending on water

Additional measures for water conservancy



Exhibit 51. Breakdown of the RMB20bn water spending budget for 4Q08 Items (RMBbn) (%)Water conservancy and river diversion 7 35 Safety of drinking Water 5 25 Rural irrigation 3 15 Reinforce risky water reservoirs 3 15 South-to-North water diversion project 2 10 Total 20 100

Source: Chinawater; Nomura International (Hong Kong) Limited

Although we believe some of the projects were already in the pipeline for development prior to the RMB4tn stimulus plan, we believe the investment in rural water conservancy projects indicates that the government is taking stronger steps to promote water and environmental protection projects. Also, at a press conference on 9 January 2009, the MWR anticipated an increase in water investments in 2009, with larger support from the government.

Brighten the outlook of the listed water utilities Although most spending from the original RMB4tn stimulus plan is tailored to rural areas, where the listed water utilities under our coverage do not focus, we understand a key mandate behind this stimulus plan is to boost spending and sustain China’s economic growth at a government target of 8% for 2009 (our economics team also forecasts 8%), up from 6.8% in 4Q08.

We believe the stimulus plan announced in November 2008 was just to kick-start government spending and direct government budgets to intended areas. Eventual spending by the government could be much larger than the RMB4tn package announced by the central government, as local governments are enthusiastic about investing in infrastructure and utilities projects, according to our economics team. In fact, following the announcement by the central government, local governments have so far announced spending plans exceeding RMB18tn over the next three to four years. While we believe that the RMB18tn spending plan cannot be fully financed, a minimum of RMB7-8tn is likely, as low-leveraged Chinese banks are eager to find new lending opportunities, and water and waste utilities (with their rich and steady cashflows) would serve as attractive candidates.

Listed water utilities and environmental protection operators should largely benefit from the positive outlook painted by the RMB4tn stimulus package, as provincial and municipal governments accelerate project approvals in ramping up operations in wastewater treatment, water supply and waste incineration. According to China Everbright International, Hyflux and China Water Affairs, discussions with government officials have become more active following the stimulus package, and we believe more positive catalysts may follow in terms of capacity expansion and the like.

Indications are water investments will only grow larger

Local government also eager to chip in with projects; and the banks see utilities as good lending candidates

Listed players will surely get a piece of the pie



Water diversion

South-to-north water diversion project Since most of China’s water resources are unevenly distributed, for many years China has been formulating the “south-to-north” water project to move water from areas in the south which have oversupply (ie, frequent flooding) to drought-prone northern cities such as Zhengzhou (Henan's capital), Shijiazhuang, Beijing and Tianjin. This project was extended from a strategy first introduced in 1958, targeted at diverting water supply for farming and other industries. After 40 years of investigation and analysis, three routes were chosen by the government:

The eastern route will involve diversion of water from the lower reaches of the Yangtze River, China’s longest river, to Shangdong Province, Tianjian municipality and the east part of Hebei Province.

The central route will divert water from the Hanjiang River, a tributary of the Yangtze River, to Beijing and Tianjin, as well as cities along the Beijing-Guangzhou Railway in the Hebei and Henan provinces.

The western route will divert water from the Dadu River, the Yalong River and the Tongtian River, to the upper reaches of the Yellow River and is targeted at increasing water supply in the Ninxia Hui Autonomous Region, the Inner Mongolia Autonomous Region and Shaanxi Province.

The project is also considered crucial for reducing water shortage, improving the ecosystem and promoting the central government’s western region development strategy.

Exhibit 52. South-to-north water diversion project

Source: Bureau of South to North Water Transfer of Planning Design and Management; Nomura International (Hong Kong) Limited

The Chinese government has been looking at moving water from the flooded south to the parched north for a generation



Clear water passages are targeted to produce zero discharge of polluted water in the main canals for water diversion. Construction of these passages will cost about RMB16bn. The government expects that 4.1bn m3 of water will be saved annually in the diversion areas of the middle route and east route, with pollution controls mainly focused on the east. During the land requisition for the construction of these projects, 21,000 residents were relocated with 62,000 others either provided with land for farming in nearby places or offered jobs in displaced enterprises, according to the State Council’s office in charge of the south-to-north project. In addition, 102 sewage plants are planned to be built along the route.

Upon completion of all three routes, about a dozen provinces, municipalities and autonomous regions in north China would benefit, including Beijing, Tianjin, Hebei, Henan, Shandong, Qinghai, Gansu, Ningxia, Inner Mongolia, Shaanxi and Shanxi, affecting about 300mn people. These areas produce one-third of the country’s grain output and GDP with only about 20% of the country’s water resource per capita.

This water diversion project would create government spending in infrastructure and higher water penetration in the covered locations would promote city development. This sets a positive backdrop to attract further government and private investments in the development of water supply and wastewater treatment plants.

Timeline Construction for the first phase of the two routes was officially launched six years ago. Since then, up to 39 projects were under construction involving an accumulated investment of RMB48bn with 66% already completed.

The entire project is expected to be completed by 2050, reaching a flow capacity of 44.8bn m3 (in which the east route would account for: 14.8mn m3; the middle route: 13mn m3; and the west route: 17mn m3) annually to cover a total population of 300mn.

According to the south-to-north Water Diversion Office, the eastern route, which mostly follows the ancient Grand Canal, is largely done. The mountainous western route, which is the most controversial and technically challenging, is not slated for completion until 2050.

However, the central section was supposed to start operation in 2010, but in December 2008, officials indicated that commencement is now set for 2014. Studies showed that diverting water from the Hanjiang River would reduce water flow and damage the river’s ecological system, which in essence, would worsen pollution.

Upon completion of the eastern and central stretches of this diversion project, the government expects the water shortages in the northern provinces and the surrounding areas to ease and economic growth to blossom.

Financing This ambitious water diversion project will cost an estimated RMB500bn, while the west route alone (the largest of the three) will cost more than RMB300bn. About RMB200bn will be invested in the construction of the east and middle water-diversion routes stretching over 2,400 km. The central government will share 60% of the total investment, with the rest to be paid by local authorities and private investors who will benefit from the project. As much as 30% of the state’s investment will be in the form of loans from domestic banks.

A new pricing system will be established upon completion of the project, which may integrate the cost of water diversion from the main canals into local water tariffs for the benefit of areas in the north.

The north is the granary of the nation

This project is also generational in scope — going out to 2050

The cost is heroic, too, estimates could easily run to a trillion renminbi



Regulatory bodies

Division of power among regulators China is realigning the authorities on water-related policies among three main governmental bodies, with more distinct functions and responsibilities. They are the MWR, Ministry of Construction (MoC) and SEPA.

In general, the MWR is responsible for the reservation and exploitation of water resources, agriculture irritation and residential usage in rural areas. The MoC regulates water resources engineering and urban water usage, while the SEPA mainly looks into pollution and wastewater treatment.

Exhibit 53. Government regulatory regime on water

Functions Ministry of Water

Resources Ministry of

Construction

State Environmental Protection

Administration Supply value chain Raw water distribution Tap water supply Wastewater treatment Reservation and conservation

- Water resource reservation

- Water engineering

- Flood control

Agricultural

- Irrigation

- Rural residential usage

Industrial

- Water usage

- Wastewater discharge

Residential (urban)

- Water usage

- Wastewater discharge

Source: NDRC; Nomura International (Hong Kong) Limited

The NDRC and MWR have jointly issued a new target for the Eleventh Five-Year Plan to reduce water consumption per unit of GDP by 20%. SEPA demands that local/municipal governments reduce COD discharges by 10%; failure to meet this target would jeopardise performance evaluations and promotions. The MoC has issued a progressive tariff scheme to compensate the initial cost in water assets incurred during the construction phase, which was implemented by local governments.

To replace legacy regulations, the Ministry of Health has renewed the Hygiene Standards of Drinking Water in 2006 with broader requirements for residential drinking water. Tap water suppliers are now bound to stricter tolerance level of water quality indicators.

Exhibit 54. Main changes in hygiene standards by Ministry of Health (Number of indicators) Old rule New ruleMicro-organism 6 10Disinfectant 4 7Inorganic compound 21 32Organic compound 53 101Physical 20 25Radiation emittent 2 2 Total 106 177

Source: H2O China Water; Nomura International (Hong Kong) Limited

Three regulators



Exhibit 55. China: regulatory reform for the water industry Date Particulars

Prior to 1985 Water in China was provided as national welfare, where the use of water was meant to be costless.

1985 The National Council issued a policy to establish connection between tariffs and costs of water supply. Consequently, most provinces and municipals individually developed local pricing schemes on water tariffs, and water was no longer a free good. However, water tariffs remained at bottom levels and governmental entities experienced severe debt collection problems from end users.

1993-1994 The Ministry of Water Resources and the Pricing Bureau drafted the Water Tariff Management Scheme and submitted to the National Council in 1994 for approval. The approval process was enduring as parties involved contributed comments and prompted for further amendments, and so the tariff scheme was left pending for final approval.

1998 On 23 September, 1998, the Ministry of Construction enacted the City Water Supply Pricing Scheme (Issuance [1998]1810) to introduce two-tier and progressive pricing methods, which scientifically defined water tariff calculations applicable to city water supply operations for the first time. Details are summarised as follows:

Two-tier pricing – The water tariff is comprised of two components, ie, capacity and measurement charges. Capacity charge is defined to compensate initial fixed asset costs incurred when water supply was first setup, such as pipeline infrastructure, water treatment facilities and other initial setup costs. Measurement charge is defined to recover operating and subsequent maintenance costs. This pricing method is targeted for non-residential users.

Progressive pricing – The water tariff is defined by (1) water usage, (2) quality improvement, and (3) market conditions, weighted by coefficients of 1 to 1.5 to 2, respectively. This pricing method is targeted for residential water users.

Guaranteed return - City water suppliers are entitled to operate at a return on equity (after tax) of 8-10%, with a maximum of 12% under leveraged businesses.

Debtor risk - Water suppliers can shut down water supply in the event of end-users who are unable to repay tariffs for two months and beyond.

2000 At the 10th National 5-Year Plan, recommendations were made to view water as a commercial product, and prices should be set according to its scarcity.

2002 Revision on Water Resources Law. Water consumption will be charged based on the actual amount of water consumption, and the progressive water tariff system will be executed if users exceed their water quotas.

April 2002 “Further Improvement of City Water Supply Pricing Scheme” jointly enacted by NDRC, Ministry of Finance, Ministry of Construction, Ministry of Water Resource, and Ministry of Environmental Protection.

To introduce ladder water tariff for tap water supply, levy wastewater treatment tariff nationwide, and encourage privatisation/commercialization of water utilities in large and medium cities.

2003~ 2005 The “One Household, One Water Meter” policy issued by NDRC, Ministry of Construction, and related governmental bodies.

2004 On 1 January, 2004, the Water Tariff Management Scheme was finally approved and enacted jointly by the NDRC and Ministry of Water Resources to reform pricing on the water resources fee (the cost of water resources that is collected from end-users and passed through to the government). This policy ensures water exploitation projects and construction work relating to water resources obtain reasonable returns. Details are summarised as follows:

For agricultural use – The water resources fee is defined to recover cost of production with no mark-up for profits.

For non-agricultural use – The water resources fee is defined to provide a return on equity (after tax) of 2-3% above the interest rates used in long-term loans suggested by domestic commercial banks.

Sewage tariff – The sewage tariff is collected along with the water supply tariff, but calculated and approved separately.

2006 NDRC announced the pricing basis of water supply companies. The urban water supply tariff comprises of water manufacturing cost, transportation cost, and SGA expenses.

2007 State Council published working plans in “energy savings and pollution reduction”.

Urban sewage treatment - increasing urban wastewater treatment capacity by 45mn tonnes during 11th 5-year- plan, and bringing the urban sewage treatment ratio above 70%.

Seawater desalination - increasing seawater desalination daily capacity by 70k m3 in 2007, and up by 900k m3 during 11th Five-Year plan.

Urban sewage treatment fee - set a national benchmark for the wastewater treatment tariff at RMB 0.8/m3




China’s waste environment

China’s solid waste industry is emerging China’s solid waste problem Chinese municipalities currently generate about 160mn tonnes of residential (municipal) waste per year and, by 2030, this could increase to 480mn tonnes, nearly double that projected for the US over the same period. Every year, Chinese cities generate one-third of the total waste produced in the world, and this is growing at a rate of 10% annually, compared with 8% worldwide.

Exhibit 56. China: industrial solid waste

0200400600800

1,0001,2001,4001,6001,8002,000

2000 2001 2002 2003 2004 2005 2006 2007

Industrial solid waste generated

Industrial solid waste utilised

(mn tonnes)

Source: National Bureau of Statistics

Exhibit 57. China: residential solid waste

0

20

40

60

80

100

120

140

160

180

2000 2001 2002 2003 2004 2005 2006 2007

Residential solid waste disposed

Harmless residential solid waste treated

(mn tonnes)

Source: National Bureau of Statistics

According to a study by the China Council for International Cooperation on Environment and Development (CCICED) in 2006, about 860mn people will be living in cities by 2020, exerting further pressure on the already overburdened urban waste disposal system. Trends and estimates of China’s waste industry are as follows:

According to the World Waste Survey, China came in just after Europe and the US in terms of waste output in 2004. The average Chinese urban resident generates 440kg of waste a year (compared with the US’s 766kg per year), but China will overtake the US within a decade if it maintains waste output growth at its historical 19% CAGR.

Among China’s 660 cities, 52 of the big and medium cities (with a population of over 500,000) account for 60% of the country’s total garbage. Less than a dozen of these cities have adopted comprehensive municipal waste reduction and recycling programmes, according to government statistics.

Garbage pile-up in 2020 could reach 400mn tonnes for China, the volume generated by the entire world in 1997, according to China Council for International Cooperation on Environment and Development (CCICED).

Landfills of solid waste have already rendered 50,000 hectares of land around cities, and in another 12 years, the landfills in China’s urban areas will reach capacity, according to CCICED.

Chinese cities generate about one-third of the world’s garbage…

…but per capita garbage production is about half that of the US



Exhibit 58. Municipal waste collection volume

0

50

100

150

200

250

UnitedStates

China Germany Japan Italy UnitedKingdom

France

(mn tonnes)

Source: United Nations MBS database

Exhibit 59. Treatment of municipal waste

0%10%20%30%40%50%60%70%80%90%

100%

UnitedStates

China Germany Japan Italy UnitedKingdom

France

Landfilled IncineratedRecycled/composted Others/untreated

Source: United Nations MBS database

In 2005, the World Bank reported that for China to adequately address its growing solid waste the country must:

Increase the national waste management budget eightfold over the next 15 years.

Develop approximately 1,400 more landfills over the next 25 years.

Underinvested market for waste treatment In 2007, only 62% of China’s residential waste in urban areas was properly treated. Investments made in waste treatment were only 2.2% of total expenditure for municipal public utilities, and only 40% (260 cities) of China’s cities had adopted some level of waste treatment fee-charging mechanism. Except for the few cities that have built-in waste treatment fees into water tariffs, most other cities have a fee collection ratio of only 30%. As a result, municipal governments are encouraged to privatise and commercialise the market to bring efficiency in waste collection and treatment.

Exhibit 60. China: investments made in treatment pollution

0

10

20

30

40

50

60

2000 2001 2002 2003 2004 2005 2006 20070.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

Investment in solid waste (RHS)Investment in gas waste (RHS)Investment in wastewater (RHS)Solid waste share to GDP (LHS)

(RMBbn) (bps)

Source: National Bureau of Statistics; Nomura International (Hong Kong) Limited

As elsewhere, privatization is the way to go



Boosting waste incineration Since landfill is a less capital-intensive approach toward waste treatment, it has been widely used among less developed cities in China. Although landfills are easy to construct with immediate effect, solid waste can cause considerable threats to the environment and human health as it decomposes. Land filling may produce contaminated land that is unsuitable for some future uses. When poorly managed, leachate (ie, contaminated liquid arising from solid waste) will contaminate underground water. Landfill gases, such as methane and carbon dioxide, pose serious health concerns. According to the World Bank, as most of China’s older landfills do not have proper linings (ie, a dense synthetic material that acts as a barrier between the wastes and ground), these landfills will leach toxins into nearby soil, ground and surface water resources. Residents of China are already suffering from the impact of landfills, reporting health concerns such as respiratory diseases, cancers and high blood pressure. The US Environmental Protection Agency indicated dioxins from landfills are considered a serious threat to public health, and it has been widely reported that landfills could have an adverse effect on health and increase the likelihood of cancer.

While industrial waste is commonly treated by landfills and recycling due to their hazardous nature, municipal waste would be ideally treated by incineration. Although waste incineration also emits chemicals detrimental to human health (for instance, dioxins, furans and mercury), landfills produce larger volume of methane and other hazardous gases over time due to waste decomposition, as compared with ashes arising from incineration.

Government’s support in waste treatment In 1995, the Solid Waste Law and Regulations was passed as China’s first comprehensive law to prevent and control environmental pollution from solid waste, which authorised the Chinese government to impose solid waste discharge fees on enterprises responsible for discharging waste in a manner that failed to comply with relevant environmental laws governing the land filling of hazardous wastes. In 2004, the import of hazardous wastes was banned, while the imports of solid wastes could only be used as raw materials or for recycling. Under the Eleventh Five-Year Plan (2006–2010), the central government re-emphasised the need to reduce industrial waste, which includes the goal of reusing 60% of industrial solid waste and to reduce waste output by 10%.

Examples of tax concessions for waste-related and environmental projects include:

Corporate income tax: three-year exemption plus three-year 50% reduction (under 2008 new tax law).

Value-added tax in on-grid power tariff will be refunded immediately upon collection for waste-to-energy and methane-to-energy projects.

On-grid power tariff at a premium of RMB0.25/kWh above the provincial benchmark tariff for waste-to-energy and methane-to-energy projects.

VAT refund on purchase of local equipment during construction.

No VAT and import tax chargeable on imported equipment, for environmental protection projects that have investments by foreign entities.

Landfill is an easy solution, but one with adverse long-term consequences

Incineration seems more toxic, but decay over time release more toxins and greenhouse gases

Getting much more serious about recycling



Exhibit 61. China: regulatory reform for the waste industry Date Rules & regulations Authorities Particulars

Jun 2002 Directive for Establishing Charging System for Municipal Residential Waste Treatment

NDRC, Ministry of Finance, Ministry of Construction, SEPA

Establishes the requirement for treating municipal residential waste. Defines requirements and scope for calculating, charging and regulating waste collection and treatment services. Promotes commercialisation of waste treatment, to foster a sustainable environment. Defines national standards to meet.

May 2004 Management Policy of Operating Concession Rights for Hazardous Waste

State Council Defines requirements and procedures for obtaining concession rights for hazardous waste treatment, transport, landfill and incineration.

May 2004 Management Policy of Operating Concession Rights for Municipal Utilities


Defines the requirements, responsibilities, procedures for obtaining concession rights in operating municipal utilities, which includes, water supply, gas supply, heat supply, public transport, sewage treatment, waste treatment, etc. This rule opens up China’s utilities market for foreign investment opportunities, in order to accelerate commercialisation of public utilities among major municipalities.

Mar 2005 Management Policy for Municipal Construction Waste


Defines requirements for disposing, treating and transporting municipal construction waste (e.g. facilities treating construction waste are prohibited to treat residential and industrial waste). Defines penalty charges for violations.

Apr 2005 Management Policy for Preventing Pollution from Solid Waste Disposal

National Congress Defines the prevention of solid waste generation, promotes recycling and proper treatment. Defines guidelines in collecting, treating and transporting solid waste, which includes municipal residential waste, industrial and hazardous waste.

Oct 2005 Management Policy for Preventing Pollution from Disposing Hazardous Chemical Waste

SEPA Defines treatment and disposing policies for disposing hazardous chemical waste. Encourages hazardous chemical waste be centrally and professionally treated.

Jan 2006 Subsidized Tariff for Power Generated from Renewable Energy Rule

NDRC Power generated from renewable/alternative energy (eg, wind, solar, biomass and waste) will be given a subsidised tariff of RMB0.25/kWh over respective provincial benchmark tariffs, for 15 years, but allowance of which would be reduced by 2% pa for operations entered after 2010.

Jul 2006 Disclosure Requirement for Solid Waste Pollutants for Big and Medium Size Municipalities

SEPA Requires all state environmental protection authorities in big and medium size municipalities to regularly disclose information such as solid waste generation, treatment situation, type, etc.

Jun 2007 List of Products encouraged to be developed (revised)

NDRC The NDRC has revised the list of products/equipments for environmental protection which the government encourages to develop. This includes, sewage treatment facilities, waste incineration equipments, flue gas filtrations, solid waste disposal facilities, etc. This revised list covers 107 products, and development which would receive government subsidizes/concessions.

Jul 2007 Management Policy for Municipal Residential Waste


Defines requirements for disposing, treating and transporting municipal waste. Defines minimum capital requirement for entering into residential waste treatment operations (register capital of RMB5-50mn for landfill, > RMB100mn for incineration). Defines the extent of use in automatic equipments. Defines penalty charges for violations.

Aug 2007 New Dispatch Priorities for Renewable Energy

NDRC, SEPA, SERC, Energy Council

The NDRC has ordered grid companies to give dispatch priorities to renewable energy providers, and then to efficient power generators according to fuel consumption and pollutant emission levels. Trial process has already started in September in five southern provinces — Jiangsu, Guangdong, Guizhou, Sichuanand Henan.

Source: Various entities, Nomura International (Hong Kong) Limited



New accounting standard

IFRIC 12 accelerates profit Adoption of IFRIC 12 IFRIC 12 “Service concession arrangements” is a new accounting standard, which has become effective for financial periods beginning on or after 1 January, 2008. This new standard affects the measurement, extent and timing of revenue recognition for BOT/TOT projects, which may affect many water and environmental protection companies engaged in concessionary agreements with the government.

Before the adoption of this new accounting standard, fixed assets purchased/ constructed under BOT and TOT arrangements were classified as finance lease receivables and property, plant and equipment (fixed assets), while revenue was recognised once these assets commenced operations and generated operating cashflows.

Under IFRIC 12, accounting profits are recognised even during the construction of fixed assets, on a percentage-to-completion basis, as the new standard assumes that the entity also provides a valued-service during the construction process as part of the BOT/TOT arrangement as a whole. This changes how accounting revenue is recognised on the income statement, since a fraction of the future revenue stream is shifted to the construction stage, and reclassifies revenue into three categories:

Revenue from construction services. The fair value of construction, which is a mark-up to actual costs incurred for fixed assets constructed, is recognised as revenue proportionate to the progress of completion of the construction. The amount receivable for construction services (corresponding to revenue) is recognised on the balance sheet as financial assets, instead of fixed assets. These financial assets are named “gross amount due from customers for construction work” for BOTs, and “other receivables and deposits” for TOTs, which are reduced when payments are received from operation.

Finance income. The underlying value of financial assets (ie, infrastructure assets) recognised during the construction period is represented by deferred income flow for the future. Finance income is charged as a result, based on an incremental borrowing rate of interest.

Revenue from operation services. Stripping out the above two revenue items from total future income stream (over the 25-30 year concession period of the project), the remainder is recognised over the concession period as soon as operation commences.

All costs of construction and recurring operation are recognised as incurred costs (same basis). Since non-current assets are no longer recognised as property, plant and equipment (since related investments in infrastructures are now classified as financial assets and reduced by cash receipts), depreciation charges are significantly reduced.



Exhibit 62. Changes in BOT/TOT projects due to IFRIC 12

1-2 years 22-29 years (depending on concession agreements)

OperationBuild (construction)

Transfer to government

No construction revenue recognized.

Infrastructure assets are recognized as fixed assets/finance lease receivables.

Recognize revenue during construction process, shifting a portionof future revenue from operation.

Infrastructure assets are recognized as financial assets (i.e. receivables), and reduced against cashreceipts.

Revenue recognition starts when operations commence, and are measured by services rendered.

The underlying value of financial assets (i.e. infrastructure assets) recognized during construction period, is represented by deferred income flow for the future. Finance income is charged as a result, based on an incremental borrowing rate of interest.

Stripping out (i) construction revenue and (ii) finance income, remaining estimated future cash flow is recognized over the concession period.

BEFORE

AFTER

Revenue


In essence, this new accounting standard smoothes out earnings for BOT/TOT concession contracts as a whole, given that it shifts revenue from the operation to construction stage. The fair value portion of construction income is generally determined by independent evaluation, which is generally at 15-25% of total estimated income flow receivable from the contract at present value.

Although IFRIC 12 will be retroactive for relevant companies, this change is unlikely to significantly affect the DCF valuation of the companies under our coverage, since it will only change the presentation of accounting results and has no impact on actual cashflow.



Sensitivity

Sensitivity to global recession; trough valuation Earnings and price target sensitivity As the financial turmoil in the US spreads to the real economy globally, the downside risks to the world economy in 2009 have increased further.

We continue to expect sub-zero growth rates at least until 2Q09F in advanced economies including the US, the EU and Japan. In the US, we believe the credit crunch will be prolonged, even though systemic risk in the financial system is likely to be averted via various measures, including injections of public funds into banking institutions and coordinated reductions in policy interest rates. In the Eurozone, the knock-on effect of the situation in the US is likely to keep the real economy stagnant, with real growth in 2009F projected at negative 0.8%. Japan will suffer as a result of lower demand for its exports, yen appreciation, as well as lower stock prices. We now expect -2.1% real GDP growth for Japan in 2009F. The cumulative impact on Asia ex-Japan is a tough 2009F all round.

Our Base Case, to which we assign 60% probability, assumes that US real GDP is set to shrink by 1% in 2009F. We think US economic growth will remain negative sequentially until 2Q09F, and we have slashed our Asian growth forecasts across the board. China remains relatively resilient.

Exhibit 63. Asia: 2009F real GDP growth forecasts (%) Base Case Downside Scenario Upside ScenarioAsian NIEs Korea (6.0) (8.0) (4.0) Taiwan (2.5) (4.7) 0.3 Hong Kong (1.5) (3.8) 1.3 Singapore (4.9) (6.3) (2.0)ASEAN 5 Indonesia 3.6 3.0 5.6 Malaysia 1.5 (0.2) 3.5 Philippines 2.8 1.0 4.3 Thailand 0.2 (1.0) 2.0 Vietnam 5.0 4.2 7.3 China 8.0 7.5 9.0 India 5.3 3.0 7.0 Australia 1.2 (0.5) 2.5

Source: Nomura estimates

We assign 30% probability to our latest Downside Scenario, a 2.5% contraction in US real GDP in 2009F. This implies a rather bleak outlook for Asia’s largely export-driven economies, as shown in the table above.

Our Upside Scenario, with 10% probability, looks for the US to eke out 0.8% real GDP growth in 2009F. This would see positive growth in all of Asia except Singapore.

Increasing risk of economic contraction in the West

Our base case assumes -1% growth for the US in 2009F with 60% probability

A steeper US decline (30% chance) would hurt exporters badly

US growth (10% chance) would keep most of Asia in positive territory



Exhibit 64. US real GDP growth assumptions under different scenarios

(10)

(8)

(6)

(4)

(2)

0

2

4

6

07 08 09 10

Optimistic scenario Base case

Pessimistic scenario

(%, annualised q-q)


An economic slowdown would have a remote and distant impact to the water utilities in China, in our view, as demand is mainly domestically driven. In our sensitivity analysis below, we form a connection that slowing growth in the export sector (to the U.S.) would result in declining water consumption among industrial and residential users, as well as long-term growth investment prospects. In our Downside Scenario, we assume a 30% decrease in water treatment volume, capacity growth and/or projects for turnkey solutions. In our Upside Scenario, our assumptions would be a 30% increase over the same parameters.

The following tables summarise our price target and FY09-10F earnings forecasts under each economic scenario. Note: these upside/downside estimates are approximate and are based on the scenarios outlined above, assuming all else remains equal.

Exhibit 65. China Everbright earnings and price target sensitivity

(HK$mn) Base Case:

60% probability Downside Scenario:

30% probabilityUpside Scenario:

10% probabilityFY09F earnings 387 329 445FY10F earnings 414 360 476Price target (HK$) 2.20 1.87 2.53


Exhibit 66. Guangdong Investment earnings and price target sensitivity

(HK$mn) Base Case:



10% probabilityFY09F earnings 2,185 1,857 2,513FY10F earnings 2,426 2,110 2,790Price target (HK$) 4.10 3.49 4.72


Exhibit 67. China Water Affairs earnings and price target sensitivity

(HK$mn) Base Case:







Exhibit 68. Beijing Enterprises Water earnings and price target sensitivity

(HK$mn) Base Case:





Exhibit 69. Hyflux earnings and price target sensitivity

(S$mn) Base Case:



10% probabilityFY09F earnings 65 57 75FY10F earnings 79 69 91Price target (S$) 1.90 1.65 2.19


Exhibit 70. Epure earnings and price target sensitivity

(RMBmn) Base Case:



10% probabilityFY09F earnings 254 216 292FY10F earnings 291 253 335Price target (S$) 0.35 0.30 0.40


Exhibit 71. Tianjin Capital earnings and price target sensitivity

(RMBmn) Base Case:





Trough valuation of individual stocks

China Everbright International How far above the historical trough valuation? 8%

The shares trade at 13x FY09F P/E, at similar level from the previous trough of 12x in FY06 when environmental projects were first introduced to revamp the business profile.

Support or breakdown?

With a healthy balance sheet, utilisation and capacity growth should boost operating cashflow, backing further expansion.

Last downcycle

Since 2005, CEI has transformed from a timber manufacturer into an environmental protection utility, with daily wastewater treatment capacity of 1.3mcm, and waste-to-energy capacity of 4,100 tonnes.



Launched first wastewater treatment facility in Shandong

Launched first waste-to-energy project in Jiangsu

New water supply contract for 2009-11 with the Hong Kong government brightens the outlook for GDI

Exhibit 72. CEI: P/E band chart (one-year forward)

10x

20x

30x

40x

50x

0

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6

7

Jan-04 Aug-04 Mar-05 Oct-05 May-06 Dec-06 Jul-07 Feb-08 Sep-08

Price (HK$)


Guangdong Investment How far above the historical trough valuation? 80%

The shares are trading at 9x FY09F P/E, versus an average P/E of 12x since 2000 and 5x during its trough in 2002.


Earnings should be resilient amid market volatility, given the company’s attractive dividend yield of 4%, low-risk growth profile in China, fixed water agreement with the Hong Kong government (50%-plus of earnings) and diversified portfolio.

Last downcycle

In the previous downcycle, the stock bottomed at 5x P/E in 2002, after its parent rescued the listed-company from losses via restructuring.

Exhibit 73. GDI: P/E band chart (one-year forward)

5x

10x

15x

20x

25x

0123456789

10

Jan-00 Feb-01 Mar-02 Apr-03 May-04 Jun-05 Jul-06 Aug-07 Sep-08

Price (HK$)


Tianjin Capital Environmental Protection How far above the historical trough valuation? 100%

The stock is trading at 14x FY09F P/E, versus an trough P/E of 7x in FY01, when the company first ramped up its wastewater treatment capacity.


Share prices should find support at 7.5x FY09F P/E, based on our price target of HK$0.80, some 45% downside from the current price.



Despite aggressive capacity expansion and robust earnings growth, reported earnings have missed the market’s high expectations

Expansion outside of Tianjin has been fulfilled since January 2007

Last downcycle

To diversify earnings and reduce collection risk from a single debtor, TCEP has expanded its wastewater treatment capacity outside of urban Tianjin since 2006, and this now accounts for 35% of total capacity.

Exhibit 74. TCEP: P/E band chart (one-year forward)

10x15x20x25x30x

0

1

2

3

4

5

6

7

Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09

Price (HK$)


China Water Affairs How far above the historical trough valuation? N/A

The stock trades at 11x FY10F P/E, versus an average of 56x since 2007, when the company turned profitable.


The company has missed earnings expectations in previous reporting periods and management has offered little growth guidance. But with its water capacity at 3.8mn m3, CWA is trading 26% below replacement cost.

Last downcycle

The water supply business was introduced in 2004 through a reverse takeover. Current management has a solid track record of turning around distressed/loss-making water plants.

Exhibit 75. CWA: P/E band chart (one-year forward)

10x

20x

30x

40x

50x

0

1

2

3

4

5

6

Jan-04 Aug-04 Mar-05 Oct-05 May-06 Dec-06 Jul-07 Feb-08 Sep-08

Price (HK$)




Beijing Enterprises Water has just reinvented itself into a water utility operator over the last six months

Beijing Enterprises Water How far above the historical trough valuation? N/A

Beijing Enterprises has just reinvented itself into a pure water utility (with a focus in wastewater treatment) over the past six months, since the takeover by its parent (Beijing Enterprises Holdings).


Valuation looks rich at 24-17x P/E (fully-diluted: 31-22x) for FY09-10F and 1.6x P/BV for FY09F, compared to the peer averages of 11-10x and 1.2x, respectively.

Last downcycle

The company has just started its operations in water utilities, and its track record is yet to be shown.

Exhibit 76. BEW: P/E band chart (one-year forward)

3x2x1x

4x5x6x

0

1

2

3

4

5

6

Jan-01 Oct-01 Jul-02 Apr-03 Jan-04 Oct-04 Jul-05 Apr-06 Jan-07 Oct-07 Jul-08

Price (HK$)


Hyflux Limited How far above the historical trough valuation? N/A

The stock now trades at 14x FY09F P/E and recently hit a low of 9x FY09F, versus average P/E of 33x since 2004.


While the stock has limited upside we believe current prices should hold. Our price target of HK$1.90 implies a 15x FY09F P/E, compare to peers’ average of 12x.

Last downcycle

Given higher risk premiums, we expect Hyflux’s medium-term ability to divest assets to HWT to be hurt, lifting capital requirements, and supporting our below-market PT



Recently hit an all-time low of 9x FY09F P/E

Recently hit a all-time low of 4x FY09F P/E in November 2008

Exhibit 77. Hyflux: P/E band chart (one-year forward)

10x

20x

30x

40x

50x

0

1

2

3

4

5

6

7

8

Jun-04 Jan-05 Aug-05 Mar-06 Oct-06 May-07 Dec-07 Jul-08

Price (S$)


Epure International How far above the historical trough valuation? N/A

The stock trades at 7.7x FY09F P/E, versus a recent low of 4x in November 2008 and average of 17x since 2005.


We believe the stock should find its support at our price target of S$0.35 (implies a P/E of 8x FY09F EPS), since it represents 2 S.D. below the historical P/E.

Last downcycle

Epure is yet to develop a track record since its public-listing in late 2006.

Exhibit 78. Epure: P/E band chart (one-year forward)

5x

10x

15x

20x

25x

0.1

0.3

0.5

0.7

0.9

1.1

1.3

Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Jun-08 Oct-08

Price (S$)



China Everbright International Ltd 257 HK

POWER & UTILITIES | CHINA


Making cash from trash Regional focus brings higher margins CEI’s single-geography strategy of focusing on wastewater treatment (WWT) in Shandong and waste-to-energy (WTE) in Jiangsu brings project IRRs to the high end of 10-12% (versus peers’ 8-10%) and 17-20% (versus peers’ 15–18%), respectively. As CEI’s regional dominance accumulates, additional projects from local governments should come into view.

Strong visible growth Given CEI’s success in running BOT/TOT projects, management has set a minimal capex budget of RMB1bn annually, implying an EPS CAGR of 14% (30% without effect of IFRIC 12, the newly adopted accounting policy) during 2009-11F. Its recent win of the 2,000-ton WTE project in Jinan helped it gain a foothold based on Shandong’s low penetration of solid waste treatment.

Well-positioned in a favourable market CEI is a major beneficiary of China’s growing market. China’s government will spend RMB330bn on WWT during 2006-10F, and increase spending for waste management by 8x in the next 15 years.

Emerging catalysts to provide further potential upside On the heels of Beijing’s RMB4trn stimulus package, meaningful new projects for CEI are under way, in our view. Margin expansion from water recycling, higher power tariffs for WTE plants, lower dividend withholding tax and better control in finance cost should all improve earnings.

Valuations below replacement cost and peer average At 13x FY09F P/E, CEI’s valuation appears undemanding compared with peers. Our alternative sum-of-the parts valuation (on replacement cost multiples) suggests a floor valuation of HK$1.60.

Key financials & valuations31 Dec (HK$mn) FY07 FY08F FY09F FY10FRevenue 1,348 1,243 1,970 2,266Reported net profit 337.9 290.5 387.1 413.8Normalised net profit 294.2 290.5 387.1 413.8Normalised EPS (HK$) 0.095 0.092 0.122 0.130Norm. EPS growth (%) 132.7 (2.8) 32.0 6.4 Norm. P/E (x) 16.8 17.2 12.9 12.0EV/EBITDA (x) 14.3 11.2 8.7 8.1Price/book (x) 2.0 1.8 1.6 1.5Dividend yield (%) 1.0 0.9 1.2 1.2ROE (%) 15.2 11.2 13.4 12.7 Net debt/equity (%) 37.1 33.3 35.9 40.1Earnings revisionsPrevious norm. net profit na na naChange from previous (%) na na na Previous norm. EPS (HK$) na na naSource: Company, Nomura estimates

Share price relative to MSCI China

1m 3m 6m 13.9 88.0 (15.7) 14.0 87.9 (15.0) 15.1 80.9 17.3

Easy

Source: Company, Nomura estimates

52-week range (HK$)3-mth avg daily turnover (US$mn)Stock borrowabilityMajor shareholders (%)China Everbright Holdings 56.1

Absolute (HK$)Absolute (US$)Relative to Index

Estimated free float (%)Market cap (US$mn) 631

43.94.05/0.46

3.65

0.000

1.000

2.000

3.000

4.000

5.000

Feb0

8

Apr0

8

Jun0

8

Aug0

8

Oct

08

Dec

08

20406080100120140

PriceRel MSCI China

(HK$)

Closing price on 11 Feb HK$1.56

Price target HK$2.20

Upside/downside 41.0%Difference from consensus 29.4%FY09F net profit (HK$mn) 387.1

Difference from consensus -4.1%Source: Nomura

Nomura vs consensusWe believe CEI will reignite project executions in FY09F to drive growth. In the longer term, new projects should trigger the market to upgrade consensus estimates.

Initiating

BUY


Our view CEI focuses on environmental protection, which includes wastewater treatment

(48% of total revenue in 2009F), waste-to-energy (38%), and solid waste disposal (6%). We like its regional dominance, which supports future growth and rich cashflow. We initiate with a BUY rating and a 12-month price target of HK$2.20.

Anchor themes

China’s water resource per capita is only a quarter of the global average, but its water consumption (per unit of GDP) is 5.5x the international average. Shortages, pollution, geographical disparity and inefficient water use cost 8-10% of the nation’s GDP. Over 400 cities are suffering water shortages of 16mn m3/day.

The government is setting harder targets and larger budgets for the water industry to promote privatisation and capacity growth. Water quality has become a key topic for the central government, and tariffs are on the rise to justify investment returns.



China Everbright International Ltd Evan Li


Earnings drivers

Regional dominance is the difference

Growth momentum continues Given CEI’s successful track record in acquiring and operating BOT/TOT projects, the company’s businesses are well-established at the provincial levels of Shandong and Jiangsu. According to management, provincial governments are satisfied with the environmental improvement that CEI’s projects have delivered, and the government has urged the company to take on additional projects. Its “Everbright Environment (光大环保)” brand name has penetrated across cities, and CEI is now recognised as a leader in environmental protection in this region. We think this gives the company an edge over its competitors, such as Beijing Capital (600008 CH, not rated), Veolia (VIE FP, not rated), and Sino-French (unlisted), to ramp up capacity in these provinces.

CEI’s project orderbook shrank in 2008, as evidenced by a reduced capital commitment of HK$652mn as of June 2008 (from HK$924mn in December 2007). Except for the WWT tender in Jinan Unit 3 (100k m3, accounting for 7% of CEI’s total water capacity) that was announced on 3 August, 2008, CEI did not announce any meaningful new projects during the year. Hence, we forecast weak results for FY08F, after recurring IFRIC 12 profit was up by 150% in FY07. However, the company’s announcement on 11 January, 2009, about winning a BOT waste-to-energy (WTE) project in Jinan city indicates that expansion momentum is intact. This project alone enlarges CEI’s capacity in WTE to 6,100 tons in 2010F (up 49% from 2009F), and sets the platform for further WTE expansion in Shandong province, in our view.

Based on secured/announced projects already in the pipeline, wastewater treatment (WWT) daily capacity would grow from 1.0mn m3 in FY08F to 1.5mn m3 by FY10F; and WTE daily capacity from 1,500 tons to 6,100 tons, enabling revenue to rise at a CAGR of 20% during FY08-10F. Management guided a minimum capex target for expanding capacity at RMB1.0bn annually, which is likely to increase, given the existing project pipeline already has capex of RMB900mn in FY09F, on our estimates.

Regional focus builds the company’s brand name

Regional dominance delivers higher profit margin… CEI focuses on its sewage treatment business in Shandong province and waste-to-energy in Jiangsu province because of industry demand and governmental policies that are encouraging waste reuse in these areas. This single-geography strategy has maximised benefits, in our view, as the company is able to enjoy economies of scale, translating to lower average maintenance costs due to concentrated locations and a more effective management execution. Moreover, upon the recent issuance of national targets to fight pollution, the onus is on local authorities to seek improvement in environment protection, and product quality is likely to become a priority over monetary price value during open bidding. As a result, CEI has demonstrated competitiveness in winning open bids for projects to be acquired in the neighbourhood.

CEI’s sewage treatment and waste-to-energy projects have IRRs at the high end of 10-12% (vs peers’ 8-10%) and 17-20% (vs peers’ 15-18%), respectively. As management gains technical expertise and improves its operational efficiency, we expect new projects in Jiangyin and Changzhou to generate higher investment returns.

…and expedites growth from new project acquisitions CEI is now the dominant environmental player in Shandong and Jiangsu. It has won the support of provincial governments, due to its strong project management and operational system — a key advantage over its peers — in our view. We think the Suzhou government plans to foster the use of WTE to a daily capacity of 4,000 tons. When CEI completes the Suzhou Phase II project in 2Q09, Suzhou’s capacity will

Established presence in Shandong and Jiangsu

Continued expansion

Single-geography strategy



reach 2,000 tons (ie, 50% of the city’s requirement), and we believe CEI is likely to be awarded the constructing phase III of the WTE project to accommodate all urban household waste of the city and beyond. Furthermore, following CEI’s successful upgrade of four WWT plants in Jiangyin to deliver national Grade-1A water quality, we believe CEI is likely to expand further in the wastewater industry in Jiangsu, especially CEI’s water technology (which specialises in removing nitrogen and phosphorus), which should help to address Jiangsu’s widely publicised pollution situation along the Tai Lake area.

Expanding on lucrative return in waste-to-energy

Why waste-to-energy is more attractive In accordance with China’s rules on “On-grid Tariffs of Electricity Generated from Renewable Energy”, renewable energy power producers can enjoy a subsidy of RMB0.25/kWh above the respective provincial benchmark on-grid tariffs, allowance of which would be reduced by 2% annually for operations entering after 2010F.

Hence, CEI’s WTE plants are receiving an approved tariff of RMB0.58-0.65/kWh, 25-42% higher than the provincial benchmark in Jiangsu during 2007. In conjunction with favourable waste processing fee (average at RMB90/ton) granted by the local government, CEI’s WTE projects generally deliver a project IRR of 17% (15% for peers), higher than wastewater treatment (8-10%), water supply (10-12%), most other alternative energy projects (8-12%), and conventional power generation (8%).

Exhibit 79. Comparison of estimated project IRRs for energy projects in China

Waste-to-

energy Tap water

supply Wastewater

treatmentGas-fired power

generationCoal-fired power

generation Wind energy Hydro powerEstimated project IRR 15-17% 10-12% 8-10% 7% 8% 6-7% 12%

Source: Company data; Nomura International (Hong Kong) Limited

Winning the 2,000-ton WTE project in Jinan may be just the start Leveraging its existing recognition in running WWT operations in Shandong, CEI recently (11 January, 2009) won a WTE project in the capital city of the province (ie, Jinan) under a BOT arrangement, at an estimated investment sum of RMB901mn. At a treatment capacity of 2,000 ton/day, we expect this WTE plant to enter operation by end-2010F, alleviating pressure from an existing landfill site in Jinan that could reach full capacity in 2-3 years. Since Shandong province has few waste incinerators and the solid waste treatment ratio remains low, we believe this project sets a foothold for WTE projects in the future.

Entering into sewage treatment in Jiangsu In November 2007, CEI acquired four wastewater treatment plants (190k m3 in capacity) in Jiangyin city (Jiangsu province), where water tariffs are 44% higher than the average of existing projects. We view CEI’s entry into Jiangsu for wastewater treatment as a logical step that should provide a stronger growth profile at more lucrative returns.

Although Jiangsu is CEI’s territory for waste-to-energy, the recent water pollution outbreak offers opportunities for sewage treatment projects. The algae outbreak in Tai Lake during May 2007, due to heavy industrial water pollution, has threatened the water supply for more than 2.3mn people in the Jiangsu Province. The State Environmental Protection Agency has ordered the worst-polluting factories along four major water basins to suspend production, and government officials have immediately set plans that require 20,000 chemical plants in the Tai Lake valley to meet tougher standards for sulphur dioxide emissions and chemical oxygen demand. The Jiangsu area has seen a surge in demand to set up sewage facilities, as untreated water can no longer be discharged into Tai Lake.

Jinan project could open doors



CEI’s treatment technology deployed in Shandong is already delivering treated water of grade 1A (highest standard in China), underlining its effectiveness in removing nitrogen and phosphorus (the main nutrients for growing algae) to address the Tai Lake pollution. In addition to the company’s presence in Jiangsu, management could exercise effective execution in deploying expansion in wastewater projects in the area, in our opinion.

On our reading, the Jiangsu government is willing to spend 15% of Jiangsu’s growth on improving wastewater treatment, and the wastewater tariff for new projects looks set to increase to RMB1.3/m3-RMB1.6/m3 (compared with an average of RMB1/m3 in other provinces and RMB0.9/m3 of CEI). On 28 October, 2007, provincial officials announced plans to spend RMB109bn to clean up Tai Lake, where such a campaign would focus initially on eradicating the toxic algal bloom.

Cash earnings are strong, as seen in non-IFRIC 12 presentation CEI’s operations in environmental protection projects have shown solid growth. During 1H08, waste processing volumes and upload electricity were up by 90% y-y and 56% y-y to 399k tons and 86.9mn kWh, respectively. Wastewater treatment volumes were up by 31% y-y to 171mn m3. EBITDA margins for its WTE projects came in at 39.5% (up 7.8pp y-y), as we believe the newly completed projects were acquired on favourable terms.

Management indicated that water plants in Shandong generally are operating at a utilisation rate of above 80%. For CEI’s toll road business (6% of total revenue), traffic flow has increased by 15% y-y for the Minjiang Bridge, which serves the Shenhai Expressway for coastal trunk transportation.

If we strip out the effect from IFRIC 12 (the newly adopted accounting policy), we estimate CEI’s “Non-IFRIC 12” EPS will register a 29% CAGR over FY09-11F (vs 14% from IFRIC 12), based on existing project pipelines without any assumed capacity growth.

To recall, IFRIC 12 is a new accounting standard which smoothes earnings for BOT/TOT concessionary contracts as a whole, as it accelerates earnings by shifting operational revenue to the construction phase of the project.

Exhibit 80. Key financial matrix comparison before and after adoption of IFRIC 12 (HK$mn unless otherwise stated) FY06 FY07 FY08F FY09F FY10F FY11FReported results: adopted IFRIC 12 Revenue 884 1,348 1,243 1,970 2,266 2,537 Net income — reporting 460 338 290 387 414 435 Net income — recurring 118 294 290 387 414 435 EBIT — recurring 168 378 479 647 734 855 EBITDA — recurring 198 407 518 687 775 898 EPS, basic (HK$) 0.041 0.095 0.092 0.122 0.130 0.136 EPS, diluted (HK$) 0.040 0.093 0.091 0.121 0.130 0.136 3-year CAGR for EPS, basic (%) na 44 11 14 0 4 Adjusted results: without the effect of IFRIC 12 Revenue 236 481 768 1,097 1,287 1,621 Net income 35 195 227 348 405 509 EBIT 66 233 416 608 726 928 EBITDA 92 262 454 648 767 971 EPS, basic (HK$) 0.012 0.063 0.072 0.110 0.127 0.159 EPS, diluted (HK$) 0.012 0.062 0.071 0.109 0.127 0.159 3-year CAGR for EPS, basic (%) na 109 26 30 22 22

Source: Company data; Nomura International (Hong Kong) Limited estimates

Strong growth in water processing volumes and upload electricity



Healthy balance sheet CEI’s net debt-to-equity ratio for FY08F remains healthy, at 33%, compared with 30-120% for peers, and 100-250% for Chinese and Korean utilities. Assuming a recurring cash inflow from operations of RMB700-800mn annually, we believe management’s target of RMB1bn annual capex should be affordable, given that a 40:60 debt-to-capital ratio is adopted for funding.

Exhibit 81. Gearing among Chinese water plays

(50) 0 50 100 150

Eguard Resources Development Bio-treat Technology

Tianjin Capital EnvironmentalChina Water Affairs Group Ltd

China Water Industry GroupGuangdong Investment

China Everbright InternationalNanhai Development Co.

Hyflux LimitedShanghai Youngsun

NWS HoldingsWuhan Sanzhen Industry

Qianjiang Water ResourcesQianjiang Water Resources DevJiangxi Hongcheng Waterworks

Zhongyuan EnvironmentBeijing Capital Co

Hong Kong and China GasSinomem Technology Limited

Shanghai Municipal Raw WaterNet debt/(cash) as % to equity

(%)

Source: Bloomberg; Nomura International (Hong Kong) Limited

Exhibit 82. Gearing among international water plays

(100) 0 100 200 300 400 500

Northumbrian Water Group PLCSevern Trent PLC

Pennon Group PLCPuncak Niaga Holdings Bhd

Ranhill BerhadVeolia Environmental

Kelda Group PLCYTL Power International

United UtilitiesIon Exchange (India)

Suez SACia Saneamento Basico de Sao

Eastern WaterDanaher Corp

China Everbright InternationalGamuda Berhad

Manila Water Co. IncCia Saneamento Minas Gerais

RWE AGPBA Holdings Berhad

Nitto Denko CorpKurita Water Industries

Net debt/(cash) as % to equity

(%)


Exhibit 83. Gearing among Chinese utilities & infra

(50) 0 50 100 150 200 250

Datang PowerHuadian Power

GD Power DevelopmentHuaneng Power

CLP HoldingsChina Power International

China Resources PowerShenzhen Expressway

Guangdong Electric PowerChina Everbright

Dalian Port (PDA) CoSichuan Expressway

NWS HoldingsCosco Pacific

Anhui ExpresswayHongkong Electric

Hopewell Highway InfraGZI Transport

Galileo Holdings LtdNet debt/(cash) as % to equity

(%)


Exhibit 84. CEI’s EBITDA/interest coverage

0

1

2

3

4

5

6

7

8

2005 2006 2007 2008F 2009F 2010F 2011F 2012F

(x)


Support from the state government CEI’s ultimate parent, the China Everbright Group (unlisted), with total assets of RMB800bn as of the end of 2007, is a core state-owned enterprise under the direct supervision of the State Council of China. The parent company started operations in Hong Kong in 1983 and had undergone a number of asset restructurings, mergers and acquisitions over the past 20 years. About 98% of the parent conglomerate is made up of businesses in banking, securities, insurance and investment management in Hong Kong and Mainland China.

Being a state-owned subsidiary, CEI has an advantage over competitors in locating and acquiring profitable projects from municipal governments. In 2004, CEI had an opportunity to organise the 2004 Beijing International Environment Forum with the Beijing Municipal Environmental Protection Bureau and the Beijing Organizing Committee, where the goal was to foster environmental protection ahead of the “Green Olympics”, in Beijing. Not only has the forum built brand recognition for the company, it has extended the company’s relationship with the provincial government that led to

Capex target looks attainable

Status as state-owned subsidiary gives CEI an edge



successful acquisitions of sewage projects in Shandong and the construction of the Suzhou Everbright Environmental Protection Industrial Zone. CEI management believes that the company has an advantage in Suzhou and that the government could grant it priority for new environmental protection projects in the future.

Despite having received solid financial support from the parent in the past to fuel its working capital and future investments, CEI intends to fund its expansion from fund-raising at the company level. CEI has a long-term loan from the parent, amounting to HK$213mn as of June 2008, down from a balance of HK$536mn in 2005.



Risks

Risks on margin compression Higher-than-average waste processing fee To encourage investment in environmental protection operations, municipal governments subsidise the industry by paying waste processing fees for each ton of treated waste. Currently, CEI is awarded an average waste processing fee of RMB90/ton in Jiangsu, which we assume will remain flat, and would account for more than 30% of total revenue made from waste-to-energy (remainder from electricity tariffs).

However, such an expensive processing fee is mainly due to the serious pollution in Suzhou and other cities of the Jiangsu province as a result of heavy industry. Given that the average processing fee for the industry is only about RMB40/ton, we have identified the downside risk of a reduction in subsidised fee for waste treatment by the government. According to our industry checks, waste processing fees for waste-to-energy plants in Dongguan of Guangdong province are as low as RMB25-30/ton.

Given that environmental protection is the top priority of many municipalities, we see a remote chance of waste processing fees being lowered in the near term, as the government intends to create an attractive return to encourage investments and expansions. Indeed, we note that the city of Tianjin is granting waste processing fees of up to RMB150/ton, as environmental protection has become a key development strategy.

Is CEI’s higher cost of capital justifiable? When CEI entered China’s water market in 2004, it partnered with Veolia Environmental of France for its sewage project in Qingdao to learn about managing and operating waste-water treatment. Thereafter, Veolia Environmental was appointed to lead a consortium in extending and upgrading the Qingdao facilities from a daily capacity of 150,000 m3 to 220,000 m3. CEI also formed a strategic alliance with Keppel Seghers (unlisted) in Belgium for turnkey solutions for its waste-to-energy projects, which uses a technology that does not require any flammable fuel during the incineration process.

Although CEI is in the process of developing its proprietary technology, it still sources foreign equipment and solutions for most of its waste-to-energy projects, except for the project in Yixing. As a result, CEI appears to have a higher cost of capital compared with peers, as its plants perform more cleanly (do not require additional fuel) during incineration. China Sciences Conservational Power Limited (351 HK, not rated) developed its waste-to-energy plants from proprietary technology and completed greenfield construction domestically, therefore the average cost for each MW of power capacity was only RMB304,000 per ton, compared with RMB485,000 per ton for CEI. Although the current political regime favours environmental protection and municipal governments are more willing to grant subsidies at a premium, we see downside risk if governmental budgets run tight in the future and become more cost-conscious in subsidising WTE projects.

Municipal governments subsidise the industry by paying waste processing fees

But we see downside risk in fees

Initially partnered with French firm…

…and still sources foreign equipment for waste-to-energy projects



Exhibit 85. Cost of capital comparison in waste-to-energy projects

Details China EverbrightChina Sciences

Conservational Power HKC

(Holdings) China Power New

Energy DevelopmentComparison among sampling projects Province Jiangsu Guangdong Shandong Guangdong City various Dongguan Linyi Dongguan Investment (RMBmn) 1,990 1,368 278 122 Waste processing capacity (tons) 4,100 4,500 822 1,096 Power generation capacity (MW) 69 150 23 36 Average cost per ton of processing capacity (RMB'000) 485 304 338 111 Average cost per MW of power capacity (RMBmn) 29 9 12 3


Nonetheless, CEI is taking measures to drive down investment costs by developing its domestic technology to take over eventually the construction and setup of plants and machinery. The waste-to-energy project in Yixing was the company’s first attempt to use locally manufactured equipment enhanced from imported technologies. In early 2006, CEI set up an R&D centre to develop its technological strength, and formed strategic partnerships with the North Carolina China Centre, Tsinghua University and Tongji University. This new centre plans to carry out 16 research projects, including production of incinerators, sludge treatment, and leachate treatment. Another R&D centre is planned in Beijing to collect first-hand information and government policies about the environmental protection sector.



Catalysts

Upside potential to consider

More project announcements in the offing? We believe CEI has maintained its competitive advantage in acquiring new projects, given it is still among one of the top national operators in terms of operational efficiency and quality. In fact, we think CEI is now in a better position to capture growing opportunities, subsequent to the central government’s RMB4trn stimulus package announced in November 2008 to promote water conservation and treatment quality.

Due to management’s strict hurdle requirement for investment returns (project IRRs of 12% for WWT and 17% for WTE) in new projects, we believe any further project announcements in 2009 would be value-accretive and a positive surprise to the market

Additional upside seen in water recycling CEI picked Shandong to invest in sewage treatment because this northeastern province has long suffered from water shortages (as most water resources are in the south). Currently, treated wastewater from CEI’s facilities is discharged directly to rivers or the sea. Many municipal governments in the northeastern provinces have pressed ahead with initiatives to promote use of recycled water. The underlying intention is to prohibit taking potable water supply for industrial use, such as for cooling off power plants, cement production, and toilet flushing, and substitute it with recycled water being discharged by WWT plants. Coupled with escalating water tariffs in most northern provinces (due to water shortages), management believes recycled water would be a high-margin business, since treatment costs have already been forgone during sewage treatment, and additional supply/distribution costs would be minimal.

The Anhui province unveiled an economic development plan in April 2007, which targets to increase the use of recycled water to 15% of the total by 2010F and 25% by 2020F, respectively. Management expects similar policies would be set officially for Shandong in the near future.

Hike in power tariff for waste-to-energy Following an 11% combined hike in on-grid power tariff during 3Q08 by the National Development and Reform Commission (NDRC) to compensate coal-fired power plants from escalated coal costs, management sees potential for upward adjustment in tariff for CEI’s WTE plants (given that electricity tariff for WTE is set on a provincial benchmark tariff plus RMB0.25/kWh), though operating costs remain unaffected as garbage (instead of coal) was used during incineration. Any tariff hike for existing or new WTE projects would enhance investment returns even further. For every 1% increase in electricity tariff, CEI’s earnings would improve by 2-4% over FY09-11F, on our sensitivity analysis.

Lower dividend-withholding tax on corporate restructuring Management is in the process of undertaking certain corporate restructuring and tax planning to lower its applicable dividend-withholding tax payment to the Chinese government — from an existing 10% (as most projects are held by BVI subsidiaries) to 5% for Hong Kong companies. If this is implemented successfully, we expect CEI’s average withholding tax rate to reach 7.5% by FY11F.

Conservative tax rate adopted Although tax concessions for existing projects can be carried forward and new projects can enjoy a new concession of “three-year exemption and three-year 50% reduction” upon the adoption of China’s new and unified tax law that came into effect in January 2008, CEI used the highest applicable tax rate of 25% in calculating deferred tax

Government stimulus could strengthen CEI’s hand

Recycling projects could carry high margins

Tariff hikes could be expected to lift returns



expenses in relation to temporary difference arising from IFRIC 12 accounting treatment and dividend withholding tax. Management believes such treatment is conservative, and a downward revision in the effective tax rate (and net tax expenses) is possible in the near term when the company gains more practical understanding of the new tax law.

Lower finance cost by swapping foreign loans Due to aggressive rate hikes and credit-tightening implemented by the People’s Bank of China since 2007, we had expected CEI’s finance cost to rise due to its large exposure to domestic bank loans for project financing. Management now intends to expand the portion of foreign loans in order to benefit from lower interest costs and future renminbi appreciation, and explains its environmental protection business should be immune to fundraising difficulties due to China’s credit tightening policy.



Valuations

Assumptions and valuations DCF valuation Our valuation is based on discounted cashflow (DCF) methodology, employing a WACC of 11% and 0% terminal growth.

Exhibit 86. DCF model for CEI FCF (HK$'mn) 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018Revenue (cash basis) 1,096.9 1,287.5 1,620.7 1,915.4 2,003.8 2,010.8 2,017.2 2,023.8 2,030.7 2,037.7…Growth rate 17% 26% 18% 5% 0% 0% 0% 0% 0%EBIT 608.4 725.5 928.1 1,116.8 1,189.1 1,212.3 1,235.6 1,259.6 1,284.2 1,309.5Share of associates - - - - - - - - - - Depreciation/amortization 39.5 41.2 43.2 45.8 48.8 52.0 55.2 58.6 62.0 65.4EBITDA 647.9 766.7 971.4 1,162.6 1,237.9 1,264.3 1,290.9 1,318.2 1,346.2 1,375.0…EBITDA margin 59% 60% 60% 61% 62% 63% 64% 65% 66% 67%less:tax (120.6) (158.7) (231.5) (301.2) (320.6) (327.2) (333.8) (340.7) (347.7) (354.9) minority interest (26.9) (31.5) (39.7) (46.9) (49.0) (49.2) (49.4) (49.5) (49.7) (49.9) change in working capital 177.8 205.0 312.5 346.3 100.2 246.2 207.0 208.5 210.0 211.7 CAPEX (893.1) (1,136.2) (1,108.9) (26.6) (28.2) (28.8) (29.4) (30.0) (30.6) (31.2) Leveraged FCF (214.8) (354.7) (96.3) 1,134.2 940.3 1,105.3 1,085.3 1,106.4 1,128.2 1,150.6

WACCSum of PV

(HK$) PV of TV (HK$) EV (HK$)net cash/(net

debt) (FY07)Equity Value

(HK$)outstanding shares ('mn)

Value per share (HKD) WACC Calculation

6.00% 11,028 5,606 16,634 (903) 15,731 3,135 5.026.50% 10,454 4,666 15,120 (903) 14,217 3,135 4.54 Equity Beta 1.707.00% 9,918 3,908 13,827 (903) 12,923 3,135 4.12 Risk Free Rate 2.00%7.50% 9,418 3,292 12,710 (903) 11,807 3,135 3.77 Equity Risk Premium 7.50%8.00% 8,949 2,787 11,736 (903) 10,833 3,135 3.46 Country Risk Premium 0%8.50% 8,511 2,370 10,880 (903) 9,977 3,135 3.18 Cost of Equity 14.8%9.00% 8,100 2,023 10,123 (903) 9,219 3,135 2.94 Cost of Debt 7.0%9.50% 7,715 1,733 9,447 (903) 8,544 3,135 2.73 Debt/Capital 40%10.00% 7,353 1,489 8,842 (903) 7,938 3,135 2.53 Tax 25.0%10.50% 7,013 1,283 8,296 (903) 7,393 3,135 2.36 WACC 11.0%11.00% 6,693 1,109 7,802 (903) 6,899 3,135 2.2011.50% 6,392 961 7,353 (903) 6,450 3,135 2.0612.00% 6,109 835 6,944 (903) 6,040 3,135 1.93 Terminal growth rate 0%12.50% 5,842 727 6,568 (903) 5,665 3,135 1.8113.00% 5,589 634 6,223 (903) 5,320 3,135 1.7013.50% 5,351 554 5,905 (903) 5,002 3,135 1.6014.00% 5,126 485 5,611 (903) 4,708 3,135 1.5014.50% 4,913 425 5,339 (903) 4,435 3,135 1.4115.00% 4,712 373 5,085 (903) 4,182 3,135 1.3315.50% 4,521 328 4,850 (903) 3,946 3,135 1.2616.00% 4,340 289 4,630 (903) 3,726 3,135 1.19 Source: Nomura International (Hong Kong) Limited estimates

Larger premium warranted Since early March 2008, CEI’s stock price has corrected by 60% (compared with a 40% fall in the Hang Seng Index), which we deem unjustified, as CEI’s core business operation remains on track, with project IRRs holding stable. In addition, we have a positive view on the water and environmental protection sectors, especially since the NDRC has just reiterated its stance to promote energy savings, wastewater treatment, and environmental protection through expanded government budgets. If management continues to announce more projects in 2009F, both IFRIC 12 and cash-related earnings growth would be enhanced further, in our view.

At 13x FY09F P/E and 1.6x FY09F P/BV, we believe valuations are undemanding compared with a peer average of 14x and 1.3x, respectively. We think CEI should trade at a larger premium over peers, given its higher ROE (13% FY09F ROE, vs 5-8% for other emerging water companies in China) and sustainable earnings growth (30% y-y in FY09F vs peers’ 15-30%; excluding Beijing Enterprises Water [371 HK, NEUTRAL]).

Floor valuation determined by sum-of-the-parts To look at CEI’s floor valuation, we use a sum-of-the-parts methodology to value CEI’s major and existing assets and secured project pipelines to be completed by mid-FY09F. This excludes value from: 1) the recently announced 2,000-ton WTE project in

60% selldown looks out of step with fundamentals



and 3) methane-to-energy plant. We arrive at an NAV per share of HK$1.60, by valuing CEI’s WWT plants using a multiple of RMB1,500/m3 and WTE plants at RMB486,000/ton, based on prevailing replacement cost multiples. At the current level, the stock is trading below replacement cost. We see potential downside as limited, since we expect CEI’s asset portfolio and underlying value will continue to expand in the near term.

Exhibit 87. Sum-of-the-parts valuation (floor valuation) Wastewater Existing capacity ('000 m3) 1,380Secured projects to be completed by FY09F ('000 m3) 100Total capacity 1,480 Replacement cost of wastewater treatment plants (RMB/m3) 1,500Replacement cost of wastewater treatment plants (HK$mn) 2,442 Waste-to-energy Existing capacity (ton) 2,300Secured projects to be completed by mid-FY09F (ton) 1,800Total capacity 4,100 Replacement cost of waste-to-energy plants (RMB/ton) 486,000Replacement cost of waste-to-energy plants (HK$mn) 2,192 Solid waste disposal Total investment cost for 600k tons in capacity (RMBmn) 234Existing capacity accounts for only 33% (or 200k tons) of total capacity (HK$mn) 85 Infrastructure investment Book value of infrastructure business (eg, toll road operations) in FY07 (HK$mn) 671 Property investment Book value of investment properties in HK and PRC in 2007 (HK$mn) 358 Listed-securities Available-for-sale securities listed in Hong Kong (market value based on 31 Dec 2007) 53 Net debt as of FY08F (HK$mn) (903) Total fair value of WWT and WTE assets (excluding waste disposal facility, and others) 4,898Total number of shares (shares in mn) 3,164 NAV per share (HK$) 1.60




Assumptions

Key financial and operating assumptions In our forecasts, we have made the following assumptions:

Flat WWT tariff, waste processing fees; and power tariff generated from waste incineration.

A 3% y-y improvement in utilisation of WWT.

A 10% y-y improvement in utilisation for waste-to-energy incineration during FY09-12F.

In terms of capacity expansion, we assume capex of RMB1bn pa until FY11F (including projects already announced) for acquiring an equal share of investments in wastewater treatment and waste-to-energy projects, with an average IRR of 10% and 17%, respectively. This would add three medium-size projects over FY10-11F beyond those already announced. To be conservative, we have not assumed any capex for project acquisitions and expansion for FY12F and thereafter.

Exhibit 88. Key financial and operating assumptions (HK$'000, unless otherwise stated) FY06 FY07 FY08F FY09F FY10F FY11F FY12FWaste-water treatment business Daily capacity volume by year-end - secured ('000 m3) 620 990 1,280 1,480 1,480 1,480 1,480 Daily capacity volume by year-end - assumed ('000 m3) - - - - - 417 833 Total 620 990 1,280 1,480 1,480 1,897 2,313 Average utilization - both secured and assumed (%) 85% 85% 89% 90% 93% 96% 97% Daily supply volume - secured ('000 m3) 336 723 1,013 1,246 1,401 1,443 1,443 Daily supply volume - assumed ('000 m3) - - - - - 194 598 Total 336 723 1,013 1,246 1,401 1,637 2,041 Weighted-average tariff (RMB/m3) 0.81 0.88 1.13 1.10 1.10 1.10 1.10 Waste-to-energy business Power generation capacity - secured (MW) 18 27 39 69 105 105 105 Power generation capacity - assumed (MW) - - - - - - 25 Total 18 27 39 69 105 105 130 Annual supply electricity - secured (MWh) 29,247 131,155 224,302 375,180 509,851 749,380 785,996 Annual supply electricity - assumed (MWh) - - - - - - 197,100 Total 29,247 131,155 224,302 375,180 509,851 749,380 983,096 Weighted-average utilization (%) 63% 70% 72% 79% 84% 88% 90%Weighted-average tariff (RMB/KWh) 0.58 0.60 0.58 0.58 0.58 0.58 0.58 Daily waste processing capacity by year-end - secured (tons) 1,000 1,500 2,300 4,100 6,100 6,100 6,100 Daily waste processing capacity by year-end - assumed (tons) - - - - - - 1,000 Total 1,000 1,500 2,300 4,100 6,100 6,100 7,100 Daily waste processing volume - secured (tons) 500 1,250 1,900 3,550 4,267 6,100 6,100 Daily waste processing volume - assumed (tons) - - - - - - 500 Total 500 1,250 1,900 3,550 4,267 6,100 6,600 Weighted-average procession fee (RMB/ton) 90 90 90 90 90 90 90




Financial statements

Income statement (HK$mn)Year-end 31 Dec FY06 FY07 FY08F FY09F FY10FRevenue 884 1,348 1,243 1,970 2,266Cost of goods sold (632) (870) (647) (1,177) (1,368)Gross profit 252 478 597 793 898SG&A (84) (100) (118) (146) (164)Employee share expense - - - - - Operating profit 168 378 479 647 734

EBITDA 198 407 518 687 775Depreciation (24) (7) (11) (12) (14)Amortisation (6) (22) (27) (27) (27)EBIT 168 378 479 647 734Net interest expense (70) (73) (118) (138) (158)Associates & JCEs 33 (0) - - - Other income 18 18 18 26 29Earnings before tax 148 323 379 535 604Income tax (10) (7) (70) (121) (159)Net profit after tax 138 316 309 414 445Minority interests (20) (22) (19) (27) (32)Other items - - - - - Preferred dividends - - - - - Normalised NPAT 118 294 290 387 414Extraordinary items 343 44 - - - Reported NPAT 460 338 290 387 414Dividends (49) (50) (43) (57) (61)Transfer to reserves 411 288 247 330 352

Valuation and ratio analysisFD normalised P/E (x) 39.1 16.8 17.2 12.9 12.0 FD normalised P/E at price target (x) 55.2 23.7 24.3 18.2 17.0 Reported P/E (x) 9.8 14.3 16.9 12.8 12.0 Dividend yield (%) 1.0 1.0 0.9 1.2 1.2 Price/cashflow (x) 25.3 23.5 6.9 6.4 5.8 Price/book (x) 2.4 2.0 1.8 1.6 1.5 EV/EBITDA (x) 21.7 14.3 11.2 8.7 8.1 EV/EBIT (x) 25.0 15.3 12.1 9.3 8.5 Gross margin (%) 28.5 35.5 48.0 40.3 39.6 EBITDA margin (%) 22.4 30.2 41.6 34.8 34.2 EBIT margin (%) 19.0 28.1 38.5 32.8 32.4 Net margin (%) 52.1 25.1 23.4 19.6 18.3 Effective tax rate (%) 6.7 2.1 18.5 22.6 26.3 Dividend payout (%) 10.7 14.8 14.8 14.8 14.8 Capex to sales (%) 71.5 60.0 45.0 40.2 40.9 Capex to depreciation (x) 26.8 113.3 50.9 65.0 66.7 ROE (%) 29.0 15.2 11.2 13.4 12.7 ROA (pretax %) 8.5 11.8 11.3 12.8 12.3

Growth (%)Revenue 565.4 52.5 (7.7) 58.5 15.0 EBITDA 227.3 106.0 27.0 32.6 12.9 EBIT 304.2 125.2 26.7 35.0 13.4 Normalised EPS 27.4 132.7 (2.8) 32.0 6.4 Normalised FDEPS 26.5 133.0 (2.6) 33.3 7.4

Per shareReported EPS (HK$) 0.16 0.11 0.09 0.12 0.13Norm EPS (HK$) 0.04 0.09 0.09 0.12 0.13Fully diluted norm EPS (HK$) 0.04 0.09 0.09 0.12 0.13Book value per share (HK$) 0.65 0.78 0.86 0.96 1.08DPS (HK$) 0.02 0.02 0.01 0.02 0.02Source: Nomura estimates

14% earnings CAGR (a 30% CAGR for non-IFRIC 12 cash-based earnings) during FY09-11F on new capacity



Cashflow (HK$mn)Year-end 31 Dec FY06 FY07 FY08F FY09F FY10FEBITDA 198 407 518 687 775Change in working capital (94) (126) 118 120 135Other operating cashflow 75 (76) 74 (33) (58)Cashflow from operations 179 206 709 774 852Capital expenditure (632) (808) (559) (792) (926)Free cashflow (454) (602) 150 (19) (74)Reduction in investments (11) 3 - - - Net acquisitions (119) - - - - Reduction in other LT assets (6) (13) - - - Addition in other LT liabilities 11 7 - (0) 0Adjustments 886 1 (17) (6) (1)Cashflow after investing acts 307 (603) 133 (25) (75)Cash dividends (34) (50) (43) (57) (61)Equity issue 326 22 17 17 18Debt issue (183) 480 263 290 249Convertible debt issue - - - - - Others (48) (85) (101) (132) (157)Cashflow from financial acts 62 367 136 118 49Net cashflow 368 (236) 270 93 (26)Beginning cash 499 867 631 901 994Ending cash 867 631 901 994 968Ending net debt 123 910 903 1,100 1,376Source: Nomura estimates

Balance sheet (HK$mn)As at 31 Dec FY06 FY07 FY08F FY09F FY10FCash & equivalents 867 631 901 994 968Marketable securities - - - - - Accounts receivable 40 54 123 165 167Inventories 3 6 - - - Other current assets 177 377 633 805 860Total current assets 1,088 1,068 1,657 1,964 1,996LT investments 63 60 60 60 60Fixed assets 95 104 103 106 110Goodwill 46 46 46 46 46Other intangible assets 550 569 542 514 487Other LT assets 1,544 2,679 3,102 3,817 4,652Total assets 3,386 4,526 5,509 6,507 7,351Short-term debt 88 143 149 310 336Accounts payable 249 334 768 1,097 1,287Other current liabilities 2 6 10 15 17Total current liabilities 339 484 927 1,421 1,640Long-term debt 901 1,399 1,655 1,785 2,008Convertible debt - - - - - Other LT liabilities 32 40 40 40 40Total liabilities 1,273 1,922 2,622 3,246 3,688Minority interest 117 152 171 198 229Preferred stock - - - - - Common stock 308 313 316 319 319Retained earnings 1,689 2,138 2,400 2,744 3,114Proposed dividends - - - - - Other equity and reserves - - - - - Total shareholders' equity 1,996 2,451 2,716 3,063 3,434Total equity & liabilities 3,386 4,526 5,509 6,507 7,351

Liquidity (x)Current ratio 3.21 2.21 1.79 1.38 1.22 Interest cover 2.4 5.2 4.1 4.7 4.6

LeverageNet debt/EBITDA (x) 0.62 2.23 1.75 1.60 1.77 Net debt/equity (%) 6.2 37.1 33.3 35.9 40.1

Activity (days)Days receivable 11.3 12.7 25.9 26.6 26.7 Days inventory 1.0 2.0 1.7 - - Days payable 139.3 122.4 311.9 289.1 318.1 Cash cycle (127.0) (107.8) (284.3) (262.4) (291.4) Source: Nomura estimates

Balance sheet looks healthy when compared with peers


Guangdong Investments Ltd 270 HK



Water monopoly: low-risk growth New water agreement and subsidies brighten outlook The agreement for water supply to Hong Kong, renewed on 11 December, 2008, lifts fixed revenue by 19-34% for FY09-11F and boosts earnings by 16-26%, on our estimates. The RMB652mn in subsidies (pre-tax) from the Guangdong government also came as a positive surprise, in our view — about 6x higher than the HK$105mn expected by the market (combined revenue shortfall during 2006-08), and potentially enhancing FY08F earnings by 35%.

Defensive portfolio: low risk and steady growth GDI’s well-established businesses in raw water distribution (63% of FY09F earnings), property investment (25%), department stores (10%), hotel operations (5%), and power generation (breakeven) should generate free cashflow of HK$1.7-3.5bn annually during FY09-12F, which should help to fund expansion in China, and afford a higher dividend payout (now 40%) on 46% net gearing.

Potential catalysts to serve as potential upside Guangdong’s 5-10x higher water consumption (per mu) and 20% lower tariff relative to the national average could prompt quicker tariff hikes in the future, on our reading. Asset injections from the parent also appear more probable, with power plants and toll roads potential assets under consideration. If GDI’s power plants can restore profitability due to falling coal prices, FY09F earnings could be lifted by 5%, on our forecasts.

Risk-reward justified We like GDI’s monopoly in Hong Kong and defensive growth in China, given that the global market lacks visibility and entails higher risk. At 9x FY09F P/E and 1.2x P/BV, GDI is trading at a discount to integrated utilities in Hong Kong and emerging water firms in China.

Key financials & valuations31 Dec (HK$mn) FY07 FY08F FY09F FY10FRevenue 6,689 7,294 8,147 8,460Reported net profit 1,697 2,395 2,185 2,426Normalised net profit 1,476 1,743 2,185 2,426Normalised EPS (HK$) 0.24 0.28 0.36 0.39Norm. EPS growth (%) 1.6 17.6 24.7 10.6 Norm. P/E (x) 13.4 11.3 9.1 8.2EV/EBITDA (x) 7.8 7.6 6.1 5.3Price/book (x) 1.4 1.2 1.2 1.1Dividend yield (%) 3.5 4.9 4.4 4.9ROE (%) 12.7 16.2 13.5 13.8 Net debt/equity (%) 65.1 52.3 43.6 32.6Earnings revisionsPrevious norm. net profit 1,603 1,720 1,898Change from previous (%) 8.7 27.0 27.8 Previous norm. EPS (HK$) 0.26 0.28 0.31Source: Company, Nomura estimates


1m 3m 6m 0.6 23.5 7.9 0.7 23.5 8.7 1.9 16.5 41.0

Easy


2,48138.8

4.21/1.663.73


Estimated free float (%)Market cap (US$mn)

Major shareholders (%)Guangdong Holdings Limited 61.2

52-week range (HK$)3-mth avg daily turnover (US$mn)Stock borrowability

1.41.92.42.93.43.94.4

Feb0

8

Apr0

8

Jun0

8

Aug0

8

Oct

08

Dec

08

6080100120140160180

PriceRel MSCI China

(HK$)



Upside/downside 30.2%Difference from consensus 10.8%FY09F net profit (HK$mn) 2,185

Difference from consensus 11.3%Source: Nomura

Nomura vs consensusWe have factored in earnings improvement from the new Hong Kong water supply agreement (December 2008), which should be reflected by consensus gradually.

Maintained

BUY


Our view The new Hong Kong water supply agreement boosts FY09-11F earnings by

16-26% for the monopoly business, which accounts for 60% of earnings. We like GDI for its low risk, steady growth and discounted valuations, and view it as an attractive stock amid China’s increasing risk profile. BUY maintained.

Anchor themes

China’s water resource per capita is only a quarter of the global average, but its water consumption (per unit of GDP) is 5.5x the international average. Shortages, pollution, geographical disparity and inefficient water use cost 8-10% of the nation’s GDP. Over 400 cities are suffering water shortages of 16mn m3/day.

The government is setting harder targets and larger budgets for the water industry to promote privatisation and capacity growth. Water quality has become a key topic for the central government, and tariffs are on the rise to justify investment returns.



Guangdong Investments Ltd Evan Li


Annual shortfall of HK$34.9mn

Earnings drivers

Defensive cash cow New Hong Kong water agreement boosts earnings by 16-26% On 11 December, 2008, the government bodies of Hong Kong Special Administrative Region (SAR) and Guangdong province finalised their water supply arrangement for 2009-11F, bringing in a new agreement that upgrades Guangdong Investment’s (GDI) revenue from the Hong Kong water distribution business by 19% in FY09F, and 6.3% apiece for FY10F and FY11F. In essence, revenue would be up 34% in FY11F compared with FY08F levels.

Exhibit 89. Details of the Hong Kong water supply agreement New arrangement

Annual parameters Old arrangement,

expired in 2004

Transition period in 2005

(follows 2004 arrangement)Arrangement for

2006-28 2009F 2010F 2011FVolume (mn m3) 820 820Tariff (HK$/m3) 3.085 3.085

Flexible supply volume based on actual needs

Flexible supply volume based on actual needs

Revenue (HK$'bn) 2.53 2.53 2.49 2.96 3.15 3.34Change Y-Y (%) - - (1.6) 18.8 6.3 6.3


Background to HK water agreement: Under the water agreement (HKWA) that expired at end-2008, the Hong Kong government was paying a lump-sum of HK$2.49bn annually for flexible supply volume. Following negotiations with the Guangdong provincial government, the newly signed agreement will keep the lump-sum payment mechanism in order to maintain water supply reliability in Hong Kong at 99%.

Larger water bill due to renminbi appreciation and inflation: The key arguments for a larger water bill from Guangdong are renminbi appreciation and inflation. During 2005-08, the renminbi appreciated by 14%, while CPI for Guangdong and Hong Kong went up by 10.4% and 7.4%, respectively.

No impact on end-users' water tariffs: Since Hong Kong’s Financial Secretary stated in June 2008 that he planned to keep water prices stable until 2010F to counter inflation, we do not expect the new agreement to affect end-user water prices in the near term.

Boosts earnings on margin expansion: Given that the volume of water being supplied to Hong Kong has been fairly stable at 700-800mn m3 annually, securing a larger water payment would imply direct margin expansion. We estimate the new agreement will improve earnings by 16-26% during FY09-11F.

Defensive cash cow: GDI’s water supply business to Hong Kong (76% of earnings from the water segment, or 56% of total earnings) is a defensive cash cow, in our view, primarily because of its steady water distribution volume (around 740k m3 annually, about 78% of Hong Kong’s total water consumption) and higher implied water tariffs (4x higher than in Shenzhen and Dongguan), supported by the HKWA.

New terms lift top and bottom lines



Exhibit 90. Hong Kong's water availability

698

760

738

706

729

744

761

808

771

617 71

5

224 23

8

106 26

1 301

252

253

111 29

8

320

187

0

200

400

600

800

1,000

1,20019

97

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Local water yieldDongjiang water consumed by Hong Kong

(Hong Kong's water resources, mn m3)

Source: Hong Kong Water Supplies Department; Nomura International (HK) Ltd

Exhibit 91. Hong Kong's rainfall water volume

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

(Hong Kong's rainfall, mn m3)

Source: Hong Kong Water Supplies Department; Nomura International (HK) Ltd

Volume growth potential from water supply in China Although GDI’s exclusive raw water supply to Hong Kong is locked, with revenue fixed, we see potential upside from the growing market in China, especially in Guangdong province.

Through the Dongshen Water Supply Project, GDI distributes raw water to downstream water supply plants in Shenzhen, Dongguan and Hong Kong. Due to continued urban development in Shenzhen and Dongguan, we expect water volume generated in mainland China to record a minimum CAGR of 5% over 2008-10F (10.5% in 2007 alone), compared with a 3% CAGR for Hong Kong. Although GDI does not enjoy sole distribution rights for supplying water in mainland China, its rich and high-quality water resources available in Dongjiang (25% of Guangdong’s total) prevail through the selection of choice by cities along the distribution pipeline, compared with water running from smaller reservoirs and lakes.

Operating in two of China’s fastest-growing cities, with water resources per capita at one-third and one-quarter of the national and provincial average, respectively, GDI has the potential to further expand its capacity and network in the mainland. Disregarding China’s under-penetration of pipe-water supply, Guangdong’s natural water consumption is expected to rise consistently at a 2% CAGR during 2006-10E, reaching 51bn m3 annually, implying an annual shortage of 8.3bn m3, according to the China Economic Herald. We see future volume growth in mainland China coming from: 1) greater pipeline penetration in response to the government’s aim to promote safer water consumption; and 2) population growth and continued urbanisation.

Exhibit 92. GDI's water volume mix

0

500

1,000

1,500

2,000

2,500

2003 2004 2005 2006 2007 2008F 2009F 2010F

Mainland China Hong Kong

Annual water volume (mn m3)


Exhibit 93. GDI's water revenue mix

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

2003 2004 2005 2006 2007 2008F 2009F 2010F

Mainland China Hong Kong

Revenue (RMB'mn)


Potential upside from growth in China…

…through capacity and network expansion



Defensiveness justified by gearing and dividend yield With a cash position of HK$3.0bn (as of June 2008), GDI has a net-debt-to-equity ratio of 46%. Although its gearing is at the higher end among emerging water companies, which should be poised to grow at a faster rate, GDI’s balance sheet still appears healthy compared with international water peers, domestic utilities and infrastructure companies of similar market cap. In addition, its well-established and stable operating cash inflow, and high EBITDA/interest coverage (7.5x in FY08F) due to corporate and debt restructuring in 2000, during which controlling parent GHD Limited (unlisted) stripped out most of its financial burden, should allow GDI to bring down gearing or take on more capital-intensive project expansion in the future, in our view.


-50% 0% 50% 100% 150%


Tianjin Capital EnvironmentalChina Water Industry Group

Guangdong Investment China Everbright International

Nanhai Development Co.Hyflux Limited

Shanghai YoungsunChina Water Affairs Group Ltd






Source: Bloomberg data; Nomura International (Hong Kong) Limited


-100% 0% 100% 200% 300% 400% 500%






Suez SACia Saneamento Basico de Sao

Eastern WaterGuangdong Investment

Danaher CorpGamuda Berhad

Manila Water Co. IncCia Saneamento Minas Gerais

RWE AGPBA Holdings Berhad

Nitto Denko CorpKurita Water Industries

Net debt/(cash) as % to equity


Exhibit 96. Gearing among Chinese utilities & infra plays

-50% 0% 50% 100% 150% 200% 250%

Datang PowerHuadian Power

GD Power DevelopmentHuaneng Power

CLP HoldingsChina Power International

China Resources PowerShenzhen Expressway

Guangdong Electric PowerGuangdong Investment

Dalian Port (PDA) CoSichuan Expressway

NWS HoldingsCosco Pacific

Anhui ExpresswayHongkong Electric

Hopewell Highway InfraGZI Transport

Galileo Holdings Ltd Net debt/(cash) as % to equity


Exhibit 97. GDI’s EBITDA/interest coverage

0x

2x

4x

6x

8x

10x

12x

2005 2006 2007 2008E 2009E 2010E 2011E 2012E


Strong support from parent During the corporate restructuring in 1999-2000 undertaken by the Guangdong provincial government to help GDI weather financial difficulties, GDH (GDI’s parent) absorbed GDI’s non-profitable businesses, such as its money lending and timber businesses, and injected the raw water distribution business into GDI on favourable terms. Although GDH’s utilities and infrastructure arm held by GDI now accounts for 43% of GDH’s total revenue, GDH has expanded into other businesses, such as manufacturing (28%), wholesale and retail (21%), and property development (3%). The parent group’s profit before tax has improved significantly to HK$2.7bn in FY06 (from a loss of HK$2.5bn in FY00), with a debt-to-capital ratio of 48% (from 68%). We

Healthy balance sheet compared with international peers

Parental ties bring favourable terms and asset injection opportunities



believe GDH’s strong presence in Guangdong is positive for GDI, in terms of financial support and potential asset injection opportunities.

Exhibit 98. Listed companies under GDH

Listed subsidiaries under GDH Ticker RatingMarket cap

(US$mn) Growth potential Guangdong Investments (GDI) 270 HK BUY 2,481 - 12% EPS CAGR during 2008-10F Kingway Brewery Holdings (KBH) 124 HK NR 152 - Expected to make HK$88mn profit by 2009, from

loss of HK$23mn in 2007 Guangdong Tannery Limited (GDT) 1058 HK NR 21 - Steady profit of HK$15-20mn pa Guangnan Holdings (GNH) 1203 HK NR 91 - 4% CAGR during 2008-09F

Note: Stock prices as of 20 Jan 2008


Exhibit 99. Businesses held under GDH Business segment Activities Corporate ownership Utilities Water and power supply GDI, parent Infrastructure Toll roads and bridges GDI, parent Manufacturing Brewery KBH Malting KBH Tinplate and packaging materials GNH Property development and investments

Residential, commercial and industrial real estates

GDI, parent

Wholesale and retail Stores and shopping malls GDI, parent Hotels Hotels and hotel management GDI, parent Tannery Processing and sale of semi-finished and

finished leather in China GDT

Food Livestocks and frozen food distribution GNH Others Packaging materials, merchandize and

trading, travelling and tours, etc. parent

Source: GDH Limited; Nomura International (Hong Kong) Limited

Overdue subsidies from Guangdong government finalised When the HKWA was revised in April 2006, with the contract amount fixed at HK$2.49bn annually, the Guangdong provincial government agreed to an annual shortfall in revenue compared with the 2004 level, (ie, 820mn m3, HK$2.52bn annually). Since GDI does not take part in the HKWA negotiation process and management believes it should not bear any non-commercial outcome from a regulatory judgment made between government bodies, a subsidy would by rights be warranted to compensate GDI from any adverse impact. After years of discussion by the market, the Guangdong government finalised total subsidies to GDI on 23 December, 2008, at a pre-tax sum of RMB652mn — 6x more than the combined shortfall in revenue during FY06-08F. This one-off income boosts FY08F earnings by 35%, on our reading.

Subsidies to GDI are far in excess of combined shortfall in revenue in FY06-08F



Risks

Expanding on lower margins Diversification plan may weigh on profitability In FY07, 60% of GDI’s profit before tax (50% of total revenue) came from the cash-rich business of water distribution, while the remainder was from property investment (19%), power (9%), department stores (6%), hotel operations (5%), toll roads and bridges, and others.

We think raw water distribution (GDI’s core) is a stable business with unexciting growth. This is because new projects/expansion involve large-scale capex and intra-city government approval, unlike downstream water supply and wastewater-treatment operators that can grow aggressively through greenfield construction or privatisation of local government assets. However, we are unsure whether GDI’s expansion plan (to enter into property development, toll roads and bridges, and hotel operations/ management with lower investment returns) is meaningful compared with water distribution or other environmental protection utilities.

Exhibit 100. Breakdown of GDI’s profit before tax

66% 60%52%

60% 63% 64% 65%

23%24% 22% 19%

27%27% 27%

5% 5% 5% 6% 5% 4%4% 5%5%

4% 4%

8%

9%6%4%

5%

10%

1%4%

0%10%20%30%40%50%60%70%80%90%

100%

2004 2005 2006 2007 2008E 2009E 2010E

Water Power Toll roads & bridges PropertyDepartment stores Hotel operations Others

Note: Excluding one-off items (eg, asset impairment, property valuation gains, etc)


We estimate infrastructure, power generation and property development normally will deliver a project IRR of 8-12%, lower than the 15% for GDI’s Dongshen water distribution project, 10-12% for water supply and wastewater treatment, and 15-17% for waste-to-energy utilities.

Rising water demand in Hong Kong could be negative for GDI under capped revenue mechanism While revenue derived from a fixed contract guarantees steady income flow and limits the downside risk from rainfall variations in Hong Kong (reducing water intake from GDI), persistently capped water prices would squeeze profit margins if: 1) rainfall precipitation in Hong Kong dropped significantly in any given year; and/or 2) Hong Kong’s water demand were to rise, increasing the actual water volume being processed. Being a mid-stream water distributor, GDI’s main variable costs would include electricity consumed by pumping stations and maintenance costs for the 69-km-long pipeline due to wear and tear.

However, we think the impact should be insignificant. On our sensitivity analysis, we estimate that every 10% increase in actual volume being processed to Hong Kong would reduce net earnings by 1%.

Diversification may bring lower returns



Potential drivers

Catalysts to upgrade estimates Tariff hike possibility in mainland China Guangdong’s daily water consumption per capita is 322 litres, or 48% more than the national average, while water consumption per mu (one hectare equals 15mu) is 827 m3, or 5-10x than in northern China. Amid high water wastage and shortages, the government is more likely to allow tariff hikes, considering Guangdong residents’ high affordability and 20% lower end-user tariffs compared with other major cities.

Any tariff hikes implemented in mainland China would present potential upside to our forecasts, as our base case assumes flat tariffs (zero growth).

Exhibit 101. Water resources and consumption in Guangdong province

01,0002,0003,0004,0005,0006,0007,0008,0009,000

Shen

zhen

Don

ggua

n

Fosh

an

Sha

ntou

Zhon

gsha

n

Gua

ngzh

ou

Zhan

jiang

Zhuh

ai

Qie

yang

Mao

min

g

Zhao

zhou

Gua

ngdo

ng

Jian

gmen

Yun

fou

Sha

nmei

Yan

gjia

ng

Jiao

qing

Hui

zhou

Mei

zhou

Hey

uan

Qin

gyua

n

Shao

guan

(m3) Water resources per capita Annual water consumption per capita

Low water resources; high consumption

Compare to average of Guangdong province

Source: Guangdong Water Bureau; Nomura International (Hong Kong) Limited

Potential to hike dividend payout Since the company’s corporate restructuring in 1999 and its acquisition of the Dongshen Water Supply business in 2000, GDI has derived positive value from its utility and property arms. Its steady and reliable cash-generating businesses have been of good support to dividend distribution to shareholders, which is a defensive edge that investors would likely value against smaller-sized peers on the back of its 5% dividend yield. With operating cash inflow at HK$4bn annually during FY09-12F — which is 2.5-3.0x its annual capex, 8.5x finance cost, and 4.5x paid dividend— we believe GDI can comfortably control its gearing and/or hike its dividend payout ratio above the current 40%.

Exhibit 102. GDI's gearing vs dividend payout

0%

20%

40%

60%

80%

100%

120%

140%

160%

Dec

02

Jun

03

Dec

03

Jun

04

Dec

04

Jun

05

Dec

05

Jun

06

Dec

06

Jun

07

Dec

07

Jun

08

Net debt to equity

Dividend payout ratio


Exhibit 103. GDI's dividend yield

0.0%0.5%1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%5.0%

Dec

02

Jun

03

Dec

03

Jun

04

Dec

04

Jun

05

Dec

05

Jun

06

Dec

06

Jun

07

Dec

07

Jun

08


Guangdong could absorb higher tariffs, in our view



Asset injections from parent GDI has been a raw water supplier to downstream treatment plants in Guangdong province for a long time, and management has indicated that the company may avoid wastewater treatment operations due to regulatory risk, since such operations are heavily reliant on government subsidies. Although GDI does not appear to be particularly proactive in seeking M&A opportunities from third parties, parent GDH Limited has a basket of potential assets that could be injected into this listed subsidiary, in our view.

The possibility of an asset injection from parent GDH Limited has been discussed by the market since 2006, but we believe that GDI would implement an acquisition deal from GDH only if the asset size and mix were meaningful to the listed company, which perhaps explains the lack of progress to date.

Other than acquiring minority stakes in some power plants (ie, Huilai and Zhongshan), which management indicated on 17 December, 2008, we understand GDH has toll road operations (connecting Guangdong to Guangxi, a major pathway to Vietnam) and other utilities projects, which may be potential assets to be injected into the listed vehicle. GDH also has water supply projects in Jiangsu and Guangdong that could possibly be included as part of this injection exercise.

Power business to turn around on falling coal costs In 2008, GDI’s 1.4GW (including associates) of thermal power plants came under pressure from the rising coal cost environment in China (spot prices for thermal coal at Qinghuangdao port were up 150% from the 2007 average). Although upgrades have been completed on parts of the plants to cogenerate power and heat so as to bring in extra income, skyrocketing spot coal prices would likely force GDI’s power plants into the red (HK$40mn losses in FY08F, on our estimates).

However, a recovery looks to be just around the corner for independent power producers (IPPs), mainly due to a sharp fall in domestic coal prices (down 44% from July 2008’s peak), and our base case assumes GDI’s power plant should recoup losses and break even in FY09F. We see upside potential from a further drop in coal prices in 2009F, given demand for power and industrial output may remain weak in China. Spot coal prices have already retreated to the early-2008 level, and further downward pressure on coal prices (for instance, back to the 2007 average) should restore profitability to GDI’s power plants, which contributed 5% (HK$83mn) of total earnings in FY07.

According to our sensitivity analysis, a 5% increase in coal cost would reduce total earnings by 2-3% during FY08-12F.

Expansion of Dongshen water project due to continued growth from Pearl River Delta GDI’s Dongshen Water Supply Project, which currently distributes raw water to Hong Kong, Shenzhen and Dongguan, will reach its maximum capacity of 2.4bn m3 annually by 2010F if water volume off-take from mainland China (ie, Shenzhen and Dongguan) sustains moderate growth of 5% annually (compared with 8-9% during 2006-07). Moreover, Dongjiang, the river sourcing water to the Dongshen project, is the main water resource for Guangzhou (10mn in population, having increased at an 8% CAGR during 2001-07) and other cities around the Pearl River Delta, and has potential for future development.

Parent has basket of potential injections

Potential upside in sharp fall in domestic coal prices



According to the Guangdong Water Bureau, water utilisation of Dongjiang is expected to reach only 40% by 2010F. Management believes capacity can be easily enlarged for the existing network in Dongjiang by upgrading water pumps and reinforcing pipelines, and GDI is in a dominant position (being the largest and most developed mid-stream water operator in Guangdong) to unlock value from new water users in these areas, in our view. On the other hand, management does not see extensive infrastructure being developed to exploit water resources from Xijiang and Beijiang, as extensive capex to connect new pipelines with the existing network (at least 200-500km away from Dongjiang) may not bring reasonable investment returns. If capacity were expanded by 30% in 2010F, GDI’s DCF value and earnings during FY11-15F would improve by 4% and 1-4%, respectively, according to our estimates.

Exhibit 104. Water supply among different river flows in Guangdong province

02468

101214161820

Xijiang Beijiang Dongjiang Pearl RiverDelta

Hanjiang &Yuedongstream

Yuexi stream

Others

Underground water

Direct water extraction

River diversion

Water storage

(M3 in billion)

Source: Guangdong Water Bureau; Nomura International (Hong Kong) Limited

Capacity expansion could boost DCF value and earnings



Valuations and sensitivity

Assumptions deemed conservative DCF valuation Our valuation is based on discounted cashflow (DCF) methodology, employing a WACC of 10% and zero terminal growth.

In our view, our forecasts are conservative, considering potential upside from asset injections by the parent group, enlargement of the dividend payout, and expansion of the water network in mainland China. We believe growth factors for water distribution, toll roads and bridges, property investments, and department stores are reasonably prudent compared with the aggressive growth seen in 2005-07.

Exhibit 105. DCF model for GDI FCF (HK$'mn) 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019Revenue 8,146.5 8,459.8 8,767.8 9,312.7 9,373.6 9,404.5 9,435.8 9,467.4 9,499.3 9,531.5 9,564.0…Growth rate 4% 4% 6% 1% 0% 0% 0% 0% 0% 0%EBIT 3,367.0 3,744.7 4,178.0 4,218.2 4,245.3 4,256.7 4,268.2 4,279.8 4,291.5 4,303.3 4,315.3Depreciation/amortization 1,063.3 1,063.3 1,057.9 1,104.5 1,104.5 1,104.5 1,104.5 1,104.5 1,104.5 1,104.5 1,104.5EBITDA 4,430.3 4,808.0 5,235.9 5,322.7 5,349.9 5,361.2 5,372.7 5,384.3 5,396.0 5,407.9 5,419.8…EBITDA margin 54% 57% 60% 57% 57% 57% 57% 57% 57% 57% 57%less:tax (472.8) (558.7) (638.4) (671.8) (715.6) (718.3) (721.0) (723.8) (726.6) (729.4) (732.2) minority interest (288.6) (316.9) (356.4) (346.8) (346.3) (346.5) (346.7) (346.8) (347.0) (347.2) (347.3) change in working capital 130.5 47.9 47.1 83.4 9.3 4.7 4.8 (464.4) 3.3 3.3 3.4 CAPEX (2,125.5) (1,561.3) (1,010.4) (869.5) (916.8) (966.8) (1,019.5) (1,075.1) (1,133.7) (1,195.4) (1,260.6) Leveraged FCF 1,673.9 2,419.1 3,277.9 3,518.1 3,380.4 3,334.3 3,290.3 2,774.2 3,192.1 3,139.2 3,083.0

WACCSum of PV

(HK$'mn)PV of TV (HK$'mn)

EV (HK$'mn)

Net cash/(debt)

(FY2009)Equity Value

(HK$'mn)

Shares out

('000)

Value per share (HK$) WACC Calculation

6.00% 24,743.3 28,692.3 53,435.6 (7,469.6) 45,966.0 6,169 7.456.50% 24,201.5 25,267.7 49,469.2 (7,469.6) 41,999.5 6,169 6.81 Equity Beta 1.207.00% 23,678.5 22,389.2 46,067.7 (7,469.6) 38,598.1 6,169 6.26 Risk Free Rate 2.00%7.50% 23,173.6 19,944.8 43,118.4 (7,469.6) 35,648.7 6,169 5.78 Equity Risk Premium 7.50%8.00% 22,686.0 17,850.4 40,536.4 (7,469.6) 33,066.7 6,169 5.36 Country Risk Premium 0%8.50% 22,214.9 16,042.0 38,257.0 (7,469.6) 30,787.3 6,169 4.99 Cost of Equity 11.0%9.00% 21,759.8 14,470.0 36,229.8 (7,469.6) 28,760.1 6,169 4.66 Cost of Debt 8.0%9.50% 21,319.8 13,095.1 34,415.0 (7,469.6) 26,945.4 6,169 4.37 Debt/Capital 20%

10.00% 20,894.5 11,886.3 32,780.8 (7,469.6) 25,311.2 6,169 4.10 Tax 25.0%10.50% 20,483.1 10,818.4 31,301.5 (7,469.6) 23,831.8 6,169 3.86 WACC 10.0%11.00% 20,085.1 9,870.8 29,955.9 (7,469.6) 22,486.2 6,169 3.6511.50% 19,699.9 9,026.7 28,726.6 (7,469.6) 21,257.0 6,169 3.4512.00% 19,327.1 8,272.1 27,599.2 (7,469.6) 20,129.5 6,169 3.26 Terminal growth rate 0%12.50% 18,966.1 7,595.2 26,561.3 (7,469.6) 19,091.7 6,169 3.0913.00% 18,616.5 6,986.3 25,602.8 (7,469.6) 18,133.2 6,169 2.9413.50% 18,277.8 6,437.0 24,714.8 (7,469.6) 17,245.2 6,169 2.8014.00% 17,949.6 5,940.2 23,889.8 (7,469.6) 16,420.2 6,169 2.6614.50% 17,631.5 5,489.7 23,121.3 (7,469.6) 15,651.6 6,169 2.5415.00% 17,323.1 5,080.5 22,403.6 (7,469.6) 14,933.9 6,169 2.4215.50% 17,023.9 4,707.9 21,731.8 (7,469.6) 14,262.2 6,169 2.31

Source: Nomura International (Hong Kong) Limited estimates

Attractive valuation compared with peers GDI is trading at 9x FY09F P/E, a discount to downstream water companies or EPC (engineering, procurement, and construction) providers, which are still emerging to take on market share and trading at 14x FY09F P/E.

Given its water monopoly in Hong Kong, we think GDI looks even more attractive when compared with well-established integrated utilities and infrastructure companies, which we believe are more direct comparables. For instance, Hong Kong & China Gas (3 HK, REDUCE), Cheung Kong Infrastructure (1038 HK, BUY) and CLP Holdings (2 HK, NEUTRAL) are trading at 12-21x FY09F P/E, on our numbers — 30-130% premiums to GDI’s valuation.



Sensitivity analysis

Sensitivity to terminal growth rate and WACC Our DCF model for FY09-19E employs a zero terminal growth rate, the value derived from which is reasonably conservative, in our view, considering GDI’s utility and infrastructure business models look positioned for long-term growth in Guangdong and China. We also have employed a relatively high beta (ie, 1.2x, compared with the stock’s historical norm of 1.0x in recent years) in view of market volatility in Asia, though we think GDI’s water business in Hong Kong should be insulated from downside concern.

Exhibit 106. DCF-value sensitivity Terminal growth rate 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0%

8.0% 5.36 5.57 5.81 6.08 6.40 6.78 7.24 7.79 8.49 8.5% 4.99 5.17 5.37 5.60 5.86 6.17 6.53 6.97 7.50 9.0% 4.66 4.81 4.98 5.17 5.39 5.65 5.94 6.29 6.71 9.5% 4.37 4.50 4.64 4.80 4.99 5.20 5.44 5.72 6.06

10.0% 4.10 4.21 4.34 4.48 4.63 4.81 5.01 5.24 5.52 10.5% 3.86 3.96 4.07 4.19 4.32 4.47 4.64 4.83 5.06 11.0% 3.65 3.73 3.82 3.93 4.04 4.17 4.31 4.47 4.66 11.5% 3.45 3.52 3.60 3.69 3.79 3.90 4.02 4.16 4.32

WA

CC

12.0% 3.26 3.33 3.40 3.48 3.56 3.66 3.76 3.88 4.01 Source: Nomura International (Hong Kong) Limited estimates

Exhibit 107. Percentage change Terminal growth rate 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0%

8.0% 31% 36% 42% 48% 56% 65% 76% 90% 107%8.5% 22% 26% 31% 36% 43% 50% 59% 70% 83%9.0% 14% 17% 21% 26% 31% 38% 45% 53% 63%9.5% 6% 10% 13% 17% 22% 27% 33% 40% 48%

10.0% 0% 3% 6% 9% 13% 17% 22% 28% 34%10.5% -6% -3% -1% 2% 5% 9% 13% 18% 23%11.0% -11% -9% -7% -4% -2% 2% 5% 9% 14%11.5% -16% -14% -12% -10% -8% -5% -2% 1% 5%

WA

CC

12.0% -20% -19% -17% -15% -13% -11% -8% -5% -2% Source: Nomura International (Hong Kong) Limited estimates

Sensitivity to water volume growth to Shenzhen and Dongguan Our base case assumes that water distribution volume to mainland China (ie, Shenzhen and Dongguan) stays flat (zero growth). Compared with robust growth of 10.5% in 2007 amid rising demand for water, it is possible that volume growth could exceed our expectations.

Exhibit 108. Sensitivity over water supply volume growth to Mainland China (ie, Shenzhen and Dongguan) Revenue (HK$mn) Net earnings (HK$mn) TPGrowth p.a. 2008 2009 2010 2011 2012 Growth p.a. 2008 2009 2010 2011 2012 (HK$)-5.0% 7,248.5 8,057.5 8,329.5 8,598.3 9,106.1 -5.0% 2,378.8 2,154.9 2,382.7 2,606.0 2,591.1 3.98-2.5% 7,271.3 8,101.4 8,392.9 8,679.8 9,204.1 -2.5% 2,386.7 2,169.9 2,403.9 2,632.5 2,622.6 4.040.0% 7,294.1 8,146.5 8,459.8 8,767.8 9,312.7 0.0% 2,394.7 2,185.2 2,426.1 2,661.1 2,657.5 4.102.5% 7,317.0 8,192.8 8,530.0 8,862.6 9,432.8 2.5% 2,402.6 2,201.0 2,449.5 2,691.8 2,695.9 4.175.0% 7,339.8 8,240.2 8,603.7 8,964.6 9,565.1 5.0% 2,410.6 2,217.1 2,474.0 2,724.9 2,738.3 4.257.5% 7,362.6 8,288.7 8,681.1 9,074.2 9,710.7 7.5% 2,418.5 2,233.6 2,499.7 2,760.3 2,784.8 4.3310.0% 7,385.5 8,338.4 8,762.1 9,191.7 9,870.4 10.0% 2,426.5 2,250.5 2,526.6 2,798.3 2,835.7 4.42 Change over base case(%) Change over base case(%) TP 2008 2009 2010 2011 2012 2008 2009 2010 2011 2012 (HK$)-5.0% -0.6% -1.1% -1.5% -1.9% -2.2% -5.0% -0.7% -1.4% -1.8% -2.1% -2.5% -3.0%-2.5% -0.3% -0.6% -0.8% -1.0% -1.2% -2.5% -0.3% -0.7% -0.9% -1.1% -1.3% -1.6%0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%2.5% 0.3% 0.6% 0.8% 1.1% 1.3% 2.5% 0.3% 0.7% 1.0% 1.2% 1.4% 1.7%5.0% 0.6% 1.1% 1.7% 2.2% 2.7% 5.0% 0.7% 1.5% 2.0% 2.4% 3.0% 3.6%7.5% 0.9% 1.7% 2.6% 3.5% 4.3% 7.5% 1.0% 2.2% 3.0% 3.7% 4.8% 5.6%10.0% 1.3% 2.4% 3.6% 4.8% 6.0% 10.0% 1.3% 3.0% 4.1% 5.2% 6.7% 7.7%


Sensitivity to water tariffs in Shenzhen and Dongguan Our base case assumes that water tariffs stay flat (zero growth). Given the government is targeting to promote conservation and reduce water consumption by 20% by 2010F, it is possible that tariff hikes may be granted in the future.



Exhibit 109. Sensitivity over water tariff change in Mainland China (ie, Shenzhen and Dongguan) Revenue (HK$mn) Net earnings (HK$mn) TPGrowth p.a. 2008 2009 2010 2011 2012 Growth p.a. 2008 2009 2010 2011 2012 (HK$)0.0% 7,294.1 8,146.5 8,459.8 8,767.8 9,312.7 0.0% 2,394.7 2,185.2 2,426.1 2,661.1 2,657.5 4.10 2.0% 7,294.1 8,164.8 8,496.7 8,823.7 9,388.0 2.0% 2,394.7 2,197.3 2,449.8 2,696.1 2,704.1 4.19 4.0% 7,294.1 8,183.1 8,534.3 8,881.8 9,467.9 4.0% 2,394.7 2,209.3 2,474.0 2,732.5 2,753.4 4.28 6.0% 7,294.1 8,201.3 8,572.7 8,942.3 9,552.5 6.0% 2,394.7 2,221.3 2,498.6 2,770.3 2,805.6 4.38 8.0% 7,294.1 8,219.6 8,611.8 9,005.0 9,642.0 8.0% 2,394.7 2,233.3 2,523.7 2,809.5 2,860.7 4.48 10.0% 7,294.1 8,237.9 8,651.6 9,070.1 9,736.7 10.0% 2,394.7 2,245.3 2,549.2 2,850.1 2,918.9 4.58 12.0% 7,294.1 8,256.1 8,692.1 9,137.7 9,836.6 12.0% 2,394.7 2,257.3 2,575.2 2,892.1 2,980.2 4.69 Change over base case(%) Change over base case(%) TP 2008 2009 2010 2011 2012 2008 2009 2010 2011 2012 (HK$)0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%2.0% 0.0% 0.2% 0.4% 0.6% 0.8% 2.0% 0.0% 0.5% 1.0% 1.3% 1.8% 2.1%4.0% 0.0% 0.4% 0.9% 1.3% 1.7% 4.0% 0.0% 1.1% 2.0% 2.7% 3.6% 4.3%6.0% 0.0% 0.7% 1.3% 2.0% 2.6% 6.0% 0.0% 1.6% 3.0% 4.1% 5.6% 6.7%8.0% 0.0% 0.9% 1.8% 2.7% 3.5% 8.0% 0.0% 2.2% 4.0% 5.6% 7.6% 9.1%10.0% 0.0% 1.1% 2.3% 3.4% 4.6% 10.0% 0.0% 2.7% 5.1% 7.1% 9.8% 11.7%12.0% 0.0% 1.3% 2.7% 4.2% 5.6% 12.0% 0.0% 3.3% 6.1% 8.7% 12.1% 14.4%


Sensitivity to rental prices for property investment and department stores Our base case assumes the average rental price for GDI’s property investments (including Teemall, East and West Tower, Guangdong Investment Tower, and department stores) grows by 5-10% annually during 2008-12F. Property prices in these areas experienced an increase of up to 40% in 2007.

Exhibit 110. Sensitivity over rental prices for property investment and department stores Revenue (HK$mn) Net earnings (HK$mn) TPGrowth p.a. 2008 2009 2010 2011 2012 Growth p.a. 2008 2009 2010 2011 2012 (HK$)0%-5% 6,885.3 7,374.2 7,639.2 7,903.2 8,399.4 0%-5% 2,284.9 2,059.5 2,270.5 2,479.3 2,447.5 3.715%-10% 7,089.7 7,744.3 8,032.7 8,316.8 8,833.5 5%-10% 2,339.8 2,121.3 2,346.8 2,567.4 2,546.8 3.8910%-15% 7,294.1 8,146.5 8,459.8 8,767.8 9,312.7 10%-15% 2,394.7 2,185.2 2,426.1 2,661.1 2,657.5 4.1015%-20% 7,498.6 8,580.8 8,920.6 9,256.3 9,838.5 15%-20% 2,449.6 2,251.2 2,508.5 2,760.5 2,780.5 4.34 Change over base case(%) Change over base case(%) TP 2008 2009 2010 2011 2012 2008 2009 2010 2011 2012 (HK$)0%-5% -5.6% -9.5% -9.7% -9.9% -9.8% 0%-5% -4.6% -5.8% -6.4% -6.8% -7.9% -9.5%5%-10% -2.8% -4.9% -5.0% -5.1% -5.1% 5%-10% -2.3% -2.9% -3.3% -3.5% -4.2% -5.1%10%-15% 0.0% 0.0% 0.0% 0.0% 0.0% 10%-15% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%15%-20% 2.8% 5.3% 5.4% 5.6% 5.6% 15%-20% 2.3% 3.0% 3.4% 3.7% 4.6% 5.9%




Assumptions

Key financial and operating assumptions In our forecasts, we have made the following assumptions:

Exhibit 111. Key financial and operating assumptions FY06 FY07 FY08F FY09F FY10F FY11F FY12FWater Hong Kong water volume ('mn m3) 617 715 736 736 736 736 736Implied water tariff (HK$/m3) 4.04 3.49 3.39 4.02 4.27 4.54 4.54 Mainland China water volume ('mn m3) 1,243 1,374 1,374 1,374 1,374 1,374 1,374Implied water tariff (HK$/m3) 0.59 0.63 0.66 0.66 0.66 0.66 0.66 Power Total capacity (MW) 1,295 1,430 1,430 1,430 2,630 2,920 2,920Attributable capacity (MW) 274 290 290 290 650 913 913Attributable generation (mn kWh) 1,774 1,885 1,885 1,885 2,831 4,252 4,914Plant utilization (%) 77 72 72 72 60 63 66Implied power tariff (HK$/kWh) 0.401 0.425 0.425 0.467 0.455 0.448 0.452 Toll roads and bridges Total traffic flow (vehicle/day, '000) 153 149 158 168 179 179 179Attributable traffic (vehicle/day, '000) 31 26 28 29 30 30 30Attributable tariff (HK$/vehicle) 3.18 3.55 3.88 3.84 3.88 3.82 3.77 Property investment Teemall Gross floor area ('000 m2) 160 160 160 160 160 160 160Lettable area ('000 m2) 97 97 97 97 97 97 97Occupancy rate (%) 99 99 99 99 99 99 99Implied monthly rent (HK$/m2) 285 299 404 424 429 433 437 The East Tower Gross floor area ('000 m2) - 102 102 102 102 102 102Lettable area ('000 m2) - 90 90 90 90 90 90Occupancy rate (%) - 20 60 80 90 90 90Expected monthly rent (HK$/m2) - 150 173 181 190 200 210 The West Tower Number of rooms - - - 450 450 450 450Occupancy rate (%) - - - 50 70 80 90Expected rate per night (HK$/night) - - - 1,300 1,365 1,433 1,505 Guangdong Investment Tower Lettable area ('000 m2) 11 11 11 11 11 11 11Occupancy rate (%) 89 98 98 98 98 98 98Implied monthly rent (HK$/m2) 166 234 257 283 311 311 311Implied monthly rent (HK$/sq foot) 18 25 28 30 34 34 34 Department store Lettable area ('000 m2) 40 39 39 39 39 39 39Implied annual revenue (HK$'000/m2) 32 41 51 53 54 54 55


Replacement of GDI’s smaller power plants in Guangdong Along with the central government’s policies of reducing energy intensity and pollution emissions, GDI will be replacing some existing power plants with larger, more efficient units. The Shaoguan power plant D (1x200MW) is to be replaced by 2x600MW units in 2010F, and this project would be carried out by a joint venture formed with Guangdong Shaoguan Yue Jiang Power Supply Limited (unlisted), a subsidiary of Guangdong Yudean (000539 CH, not rated); we believe GDI will take a minority stake. The Zhongshan power plant (2x55MW) is to be replaced by 2x300MW units, and we expect this project to be completed by 2011F, with GDI taking a controlling stake.



Company overview

Structure of GDI

Exhibit 112. Company structure

GH Water Supply (Holding)

Water

Guangdong Yue Gang Water Supply

88.17%

99%

Electric power generation

Guangdong Power (International)

Shaoguan Power Plant D

Guangdong Shaoguan Yue

Jiang Power

51%

90%

25%

Zhongshan Power Plant

Guangdong Investment Limited

Meixian Power Plant

59%

49%

25%

Toll roads and bridges

1 Road & 2 Bridges(held under Guangdong

Transport Inv (BVI))

Yingkeng highway

Panyu bridge

51%

70%

20%

Property investment and development

Teemall, East Tower, West Tower

Guangdong Investment Tower

Guangdong Group Building properties

75.85%

100%

100%

Department stores

Teemall department stores business

85.03%

Hotel operations and management

Guangdong (Int'l) Hotel management

Wharney Guangdong Hotel Hong Kong

Guandong Hotel Hong Kong

Guangdong Hotel Zhuhai

Guangdong Hotel Shenzhen

100%

Guangdong Investment Limited (257 HK)

GDH Limited (61.69%) Public float (38.31%)





Income statement (HK$mn)Year-end 31 Dec FY06 FY07 FY08F FY09F FY10FRevenue 6,056 6,689 7,294 8,147 8,460Cost of goods sold (3,183) (3,615) (3,942) (4,403) (4,572)Gross profit 2,873 3,074 3,352 3,743 3,887SG&A (511) (571) (925) (568) (389)Employee share expense - - - - - Operating profit 2,362 2,503 2,426 3,175 3,498

EBITDA 3,448 3,566 3,490 4,239 4,561Depreciation (1,086) (1,063) (1,063) (1,063) (1,063)Amortisation - - - - - EBIT 2,362 2,503 2,426 3,175 3,498Net interest expense (581) (418) (375) (420) (443)Associates & JCEs 121 48 109 141 212Other income 75 51 83 51 35Earnings before tax 1,978 2,183 2,244 2,947 3,302Income tax (269) (406) (311) (473) (559)Net profit after tax 1,709 1,777 1,933 2,474 2,743Minority interests (272) (301) (190) (289) (317)Other items - - - - - Preferred dividends - - - - - Normalised NPAT 1,437 1,476 1,743 2,185 2,426Extraordinary items 70 221 652 - - Reported NPAT 1,507 1,697 2,395 2,185 2,426Dividends (606) (671) (947) (865) (960)Transfer to reserves 901 1,026 1,447 1,321 1,466


Growth (%)Revenue 15.4 10.4 9.0 11.7 3.8 EBITDA 11.2 3.4 (2.2) 21.5 7.6 EBIT 16.2 5.9 (3.1) 30.9 10.2 Normalised EPS 15.6 1.6 17.6 24.7 10.6 Normalised FDEPS 16.8 2.6 17.8 25.1 11.0

Per shareReported EPS (HK$) 0.25 0.28 0.39 0.36 0.39Norm EPS (HK$) 0.24 0.24 0.28 0.36 0.39Fully diluted norm EPS (HK$) 0.23 0.24 0.28 0.35 0.39Book value per share (HK$) 2.07 2.30 2.53 2.73 2.96DPS (HK$) 0.10 0.11 0.15 0.14 0.16Source: Nomura estimates

Revised agreement on water supply to Hong Kong seen enhancing margins in FY09-11F



Cashflow (HK$mn)Year-end 31 Dec FY06 FY07 FY08F FY09F FY10FEBITDA 3,448 3,566 3,490 4,239 4,561Change in working capital 69 415 126 212 91Other operating cashflow (92) (315) 629 (237) (305)Cashflow from operations 3,426 3,666 4,245 4,213 4,347Capital expenditure (314) (161) (1,830) (2,125) (1,561)Free cashflow 3,111 3,505 2,415 2,088 2,786Reduction in investments (76) (17) - - - Net acquisitions (132) (77) - - - Reduction in other LT assets 58 194 (22) (28) (42)Addition in other LT liabilities 50 116 (0) - 0Adjustments 91 (739) 22 28 42Cashflow after investing acts 3,103 2,982 2,415 2,088 2,786Cash dividends (603) (610) (947) (865) (960)Equity issue 60 22 35 33 32Debt issue (2,344) (2,435) (611) (611) (611)Convertible debt issue - - - - - Others (78) 474 0 - (0)Cashflow from financial acts (2,965) (2,550) (1,523) (1,442) (1,539)Net cashflow 138 433 892 646 1,247Beginning cash 2,114 2,252 2,685 3,576 4,222Ending cash 2,252 2,685 3,576 4,222 5,469Ending net debt 11,444 9,125 8,115 7,351 5,986Source: Nomura estimates

Balance sheet (HK$mn)As at 31 Dec FY06 FY07 FY08F FY09F FY10FCash & equivalents 2,252 2,685 3,576 4,222 5,469Marketable securities 104 121 121 121 121Accounts receivable 330 380 365 407 423Inventories 59 58 63 70 73Other current assets 31 36 3 3 3Total current assets 2,775 3,279 4,128 4,823 6,089LT investments - - - - - Fixed assets 14,106 14,567 15,827 17,383 18,374Goodwill 216 256 256 256 256Other intangible assets 11,655 11,162 10,669 10,175 9,682Other LT assets 1,422 1,228 1,250 1,278 1,321Total assets 30,174 30,493 32,129 33,915 35,721Short-term debt 513 708 708 708 708Accounts payable 1,024 1,416 1,544 1,725 1,791Other current liabilities 400 477 432 513 556Total current liabilities 1,937 2,601 2,684 2,945 3,055Long-term debt 13,183 11,102 10,984 10,866 10,747Convertible debt - - - - - Other LT liabilities 642 758 758 758 758Total liabilities 15,762 14,461 14,426 14,569 14,560Minority interest 1,789 2,006 2,197 2,485 2,802Preferred stock - - - - - Common stock 3,045 3,052 3,070 3,084 3,096Retained earnings 8,975 10,363 11,489 12,912 14,303Proposed dividends 603 610 947 865 960Other equity and reserves - - - - - Total shareholders' equity 12,623 14,025 15,507 16,861 18,359Total equity & liabilities 30,174 30,493 32,129 33,915 35,721



Activity (days)Days receivable 23.8 19.4 18.7 17.3 17.9 Days inventory 6.2 5.9 5.6 5.5 5.7 Days payable 124.2 123.2 137.4 135.5 140.3 Cash cycle (94.3) (97.9) (113.1) (112.7) (116.7) Source: Nomura estimates

GDI’s gearing looks healthy when compared with international water companies and integrated utilities in Hong Kong


Tianjin Capital Environmental 1065 HK

POWER & UTILITIES| CHINA


Unclear outlook Margin cut is an overhang Negotiations between TCEP and the local government are continuing, with tariffs likely to be cut from the existing RMB1.93/m3 to RMB0.8-1.2/m3 — similar to that for regions outside Tianjin. Compensation packages regarding buyback of wastewater pipelines and/or guaranteed water volume intakes look unattractive, providing minimal additional value for TCEP, in our view. Tianjin city’s tight budget and need to minimise its costs may pressure it to cut water tariffs even more steeply. We estimate a tariff cut will be carried out in July 2009, taking the tariff to RMB1.0/m3, with margins to contract thereafter.

Expansion outlook has been invisible, so far TCEP’s capacity expansion plans (greenfield: 10%, acquisitions: 20%) appear lacklustre. Its most recent deal (early 2008) was the acquisition of a wastewater plant in Xian — delivering an IRR of less than 5%, which appears value-dilutive. Being a municipal government-backed enterprise, TCEP may lack the edge to break into new markets beyond its home of Tianjin.

Potential upside risks Internal cost control, R&D in wastewater treatment technology and a rising trend in water tariffs could prompt earnings to surprise on the upside. Also, the A share’s 4.4x premium to the H share could provide some support.

Valuation looks excessive Given possible margin compression, TCEP is trading at 14-43x P/E for FY09-10F. We recommend avoiding the stock until its historical problems are fully resolved. In the absence of a successful track record, growth visibility, and local government support, TCEP joins our coverage list with a REDUCE rating.

Key financials & valuations31 Dec (RMBmn) FY07 FY08F FY09F FY10FRevenue 939 994 996 936Reported net profit 183.8 215.6 134.0 43.4Normalised net profit 183.8 215.6 134.0 43.4Normalised EPS (RMB) 0.133 0.151 0.094 0.030Norm. EPS growth (%) 11.8 13.3 (37.8) (67.6)Norm. P/E (x) 11.5 9.3 13.9 42.9EV/EBITDA (x) 7.1 7.1 8.5 10.2Price/book (x) 0.7 0.7 0.6 0.6Dividend yield (%) 2.7 3.3 2.2 0.7ROE (%) 7.0 7.3 4.3 1.4 Net debt/equity (%) 74.9 75.9 72.4 68.7Earnings revisionsPrevious norm. net profit na na naChange from previous (%) na na na Previous norm. EPS (RMB) na na naSource: Company, Nomura estimates


1m 3m 6m 12.4 43.6 (19.4) 12.5 43.5 (18.8) 13.7 36.5 13.5

Easy


52-week range (HK$)3-mth avg daily turnover (US$mn)

Atlantis Investment Management

Stock borrowability

2.1

Major shareholders (%)Tianjin Municipal Management 54.3


Estimated free float (%)Market cap (US$mn) 267.0

43.63.59/0.58

0.66

0.200.701.201.702.202.703.203.704.20

Feb0

8

Apr0

8

Jun0

8

Aug0

8

Oct

08

Dec

08

30

50

70

90

110

130PriceRel MSCI China

(HK$)



Upside/downside -44.8%Difference from consensus -20.0%FY09F net profit (RMBmn) 134.0


Nomura vs consensusWe assume wastewater treatment tariff can be cut in FY09F to RMB0.8-1.2/m3 (from RMB1.93/m3), which is not fully reflected in consensus.

Initiating

REDUCE


Our view Negotiations between TCEP and the local government are continuing, with tariffs

likely to be cut by 40-60% in FY09F. Expansion plans have been lacklustre, so far, and management has yet to provide visibility on growth. We initiate coverage with a REDUCE rating, given our price target implies 45% downside.

Anchor themes

China’s water resource per capita is only a quarter of the global average, but its water consumption (per unit of GDP) is 5.5x the international average. Shortages, pollution, geographical disparity and inefficient water use cost 8-10% of the nation’s GDP. Over 400 cities suffer water shortages at 16mn m3/day.

The government is setting harder targets and larger budgets for the water industry to promote privatisation and capacity growth. Water quality has become a key concern for the government, and tariffs are on the rise to justify investment returns.



Tianjin Capital Environmental Evan Li


Tariff outlook

Margin cut remains an overhang Wastewater treatment tariffs — negotiations ongoing Negotiations between Tianjin Capital Environmental Protection (TCEP) and the Tianjin government are continuing, with the process having lasted more than a year. Management expects a major cut in wastewater treatment (WWT) tariffs in the Tianjin urban area in 2009F — from the current RMB1.93/m3 to RMB0.8-1.2/m3 — similar to that in other provinces.

The government may award a compensation package (eg, buy-back of wastewater pipelines and/or guaranteed water volume intake) to TCEP for the tariff cut. But we are concerned that this may result in minimal additional value for TCEP, and therefore have not factored this into our forecasts. According to management, possible compensation packages under consideration could include:

Water pipeline buy-back. TCEP could be restricted from operating the sewage pipelines, and the Tianjin government could acquire the pipelines back from TCEP. However, valuation and payment terms have not been determined, and we are concerned about whether or not related consideration (cash or an asset-swap) would be favourable. If the government offers some distressed water plants (instead of cash) as consideration, the additional NAV or earnings for TCEP could be minimal, in our view.

Guaranteed volume intake. Management has turned more positive that the government will provide a minimum guarantee on wastewater volume treatment for the affected plants in Tianjin. Unlike many other concessionary contracts operating elsewhere in China for wastewater treatment, TCEP charges a treatment fee based on the actual volumes processed, which are usually 60-65% of designated capacity. As a reward, the government may guarantee a minimum payment to TCEP based on 80% utilisation, to partly offset the shortfall on account of the tariff cut, according to management. However, we expect TCEP’s processing volumes to increase gradually, as treatment demand surges in Tianjin city, and utilisation levels top 80% by 2010F. Therefore, such a volume guarantee may not safeguard earnings, in our opinion.

We assume that tariffs for the four wastewater treatment plants in Tianjin are reduced to RMB1.0/m3 in July 2009, from the current RMB1.93/mw, which should reduce earnings by 44-84% during FY09-10F.

Why TCEP is subject to a tariff cut by the government? Since 2000, when China’s water laws were still underdeveloped and not standardised, TCEP has set its wastewater treatment fees in accordance with the “Sewage Water Processing Agreement” signed with the Tianjin municipal government. According to this agreement, the unit price of wastewater treatment should be sufficient to compensate for operating costs and taxation and to obtain a 15% return pa over the net book value of underlying assets.

However, following regulatory changes in the water industry in recent years, TCEP is required to change its sewage treatment operations into a “franchise agreement” for a period of not more than 30 years, similar to existing build-operate-transfer/transfer-operate-transfer (BOT/TOT) concessionary arrangements for wastewater treatment. With this change, the Tianjin Municipal Construction Administration Authorities (TMCAA) are working with TCEP to renew its sewage treatment fees.

Management expects a major cut in wastewater treatment tariffs in the Tianjin urban area in 2009F

A volume guarantee may not safeguard earnings

TCEP is required to change its sewage treatment operations into a “franchise agreement” for a period of not more than 30 years



TCEP’s water tariffs in Tianjin city were initially at a high level to justify capex in both plant and sewage pipelines during the construction phase. After industry reforms, sewage pipelines are generally constructed and run by the government. The government plans to standardise this for all wastewater treatment operations in China. Hence, the city government now plans to take over the pipeline business (ownership, operation and maintenance) from TCEP, and renew its water tariffs to a level similar to those of other standalone wastewater treatment plants in other parts of China. These clock an 8-12% ROE, compared with 15% for TCEP. Therefore, we think TCEP’s current water tariff of RMB1.93/m3 is at risk, compared with the industry average of RMB0.8-1.0/m3.

Since higher funding is required to invest in other infrastructure projects in the city, the Tianjin government may lower tariffs to TCEP as an opportunity to lift pressure from the government’s financial budget, according to management.

Invisible expansion pipeline TCEP had expected to expand capacity (greenfield: 10%; acquisitions: 20%) during 2007-08. However, progress has been lacklustre, so far, with no meaningful expansion due to rising competition and perhaps some lack of focus. TCEP, as a municipal government-backed company, may lack the competitive advantages to break into new regional markets, in our view. Also, due to the absence of a successful track record in project acquisitions and expansion, we think TCEP’s growth prospects are uncertain.

Acquisition in Xian (March 2008) was value-dilutive We believe TCEP’s most recent acquisition was at unfavourable terms, implying that the company has yet to gain strength outside its home base. On 18 March, 2008, TCEP signed a transfer agreement to acquire WWT plants in Xian, with a combined treatment capacity of 310k m3 per day, for RMB643mn funded, in part, through internal resources and domestic debt. This transaction implies a P/BV of 2.7x (June FY07) and a price of RMB2,074/m3 in terms of treatment capacity, which is higher than the historical acquisition price of RMB1,000-1500/m3. The preset water tariff of RMB0.8/m3, as per the service agreement signed by TCEP, also suggests a lower project IRR of below 5% (our estimate), compared with an average 8-10% for TCEP’s existing projects. Considering a standard WACC of 8% which we apply for this company, we think this acquisition is value-dilutive to our DCF valuation.

However, given Xian is a major city in western China, management thinks value can be unlocked from: 1) higher economic development in Xian (resulting in higher utilisation of wastewater facilities); 2) potential upside for second phase expansion; and 3) water recycling project opportunities.

Expanding outside of Tianjin at lower returns In order to expand and diversify away from Tianjin’s tariff-cutting regime, TCEP has been investing aggressively in other locations, such as Guizhou, Heibei, Anhui and Jiangsu. As operations are ramped up in these areas, where tariffs range from RMB0.6/m3 to RMB1.2/m3 (50% lower than the exceptional Tianjin urban area), we expect TCEP’s average profit margin to narrow.

We have already noticed a decline in profit margins in 1H08, on a change in TCEP’s business mix and revenue collection mechanism. The impact under PRC GAAP for 1H08 results (without the effect of IFRIC 12), which better reflects the operational performance of water plants, is detailed below:

TCEP’s current water tariff of RMB1.93/m3 is at risk, compared with the industry average of RMB0.8-1.0/m3

Due to the absence of a successful track record in project acquisitions and expansion, TCEP’s growth prospects remain uncertain

This transaction implies a P/BV of 2.7x (June FY07) and a price of RMB2,074/m3 in terms of treatment capacity

We expect TCEP’s average profit margin to decline as it expands outside of Tianjin



Margins declined by 2pp for wastewater treatment — as utilisation rates were ramped up in non-Tianjin areas.

Margins declined by 8pp for tap water supply — TCEP has two tap water supply plants, which were recently required to collect raw water resources fees from end-users, on behalf of the local government. According to management, such additional fees are directly passed on to end-users, which could inflate both revenue and costs, and hence, reduce profit margins.

Exhibit 113. TCEP: 1H08 financial performance 1H08 1H07 change Profit margins under HKFRS (with the effect of IFRIC 12) Wastewater/sewage water processing 25.6% 37.4% -11.8 ppTolls 74.2% 93.5% -19.3 ppTap water processing 63.0% 83.4% -20.4 ppWater recycling and others 19.4% -66.0% na Profit margins under PRC GAAP (without the effect of IFRIC 12) Wastewater/sewage water processing 54.8% 57.2% -2.4 ppToll road 80.0% 78.1% 1.8 ppTap water processing 33.9% 42.3% -8.4 ppWater recycling and others 20.8% -253.5% na


Upgrade of wastewater plants in Tianjin — not positive for TCEP In step with heightened environmental concern, TCEP is required to upgrade its four wastewater plants in Tianjin to deliver at least Grade 1B quality, and management plans to carry out these upgrades during 2009-10F. Although a higher water tariff could be granted by the government after these upgrades, we believe the adjustment would not be sufficient to compensate for the required capex of RMB1.5-2.0bn.

Potential higher tariff may not cover extra capex



Devil’s advocate

Risks Internal cost control may prove to be effective We assume TCEP’s production costs for wastewater treatment remain flat vis-à-vis the historical average of RMB0.63/m3 — implying a gross margin of 46% based on the 2008 tariff (likely to be reduced in 2009F). We also assume treatment costs to be similar, regardless of plant location. This assumption may be conservative, as some sewage treatment plants could have different cost structures due to variations in labour costs and technology efficiency; also, management said that internal cost control is under way.

R&D may improve efficiency TCEP has its own research & development (R&D) facility at its Tianjin sewage treatment plant, which can be migrated to more sophisticated treatment technology such as Sequencing Batch Reactor (SBR). If the company adopts such new technologies, it could result in higher-than expected capacity utilisation and improved efficiency, or better-than-expected volume and gross margins.

Upward tariff trend may benefit wastewater treatment We expect China’s integrated water tariffs to trend north, in order to promote water conservation. Since TCEP is only responsible for sewage treatment or water purification, and does not deal with end users directly, rising tariffs in this regard may not have any direct impact on the company. However, we believe that part of the increase in water tariffs may be passed on to wastewater treatment companies, as the government may want to offer more incentives to promote investments in the sewage treatment business. Except for a 60% cut in tariffs for projects in the Tianjin urban area in July 2009, we assume tariffs stay flat for the remaining projects post-2008.

Premium to H-share counterpart provides support TCEP is one of the dual-listed stocks where the A share is at a substantial premium to the H shares. This may support H-share valuations.

Exhibit 114. A shares: premium to H shares # H share A share Name HK$ CNY Premium # H share A share Name HK$ CNY Premium1 42 000585 Northeast Electric Development 0.62 3.17 480% 21 753 601111 Air China 2.29 5.09 152%2 553 600775 Nanjing Panda Electronics 1.03 5.2 473% 22 1053 601005 Chongqing Iron & Steel 2.14 4.7 149%3 670 600115 China Eastern Airlines 1.1 5.29 446% 23 991 601991 Datang International Power 3.71 7.84 140%4 1033 600871 Sinopec Yizheng Chemical 0.89 4.22 438% 24 1919 601919 China Cosco Holdings 5.51 11.6 139%5 1065 600874 Tianjin Capital Environment 1.45 6.85 436% 25 548 600548 Shenzhen Expressway 2.66 5.56 137%6 187 600860 Beiren Printing 0.93 4.26 420% 26 317 600685 Guangzhou Shipyard 9.23 18.99 133%7 350 000666 Jingwei Textile Machinery 0.91 3.93 390% 27 1171 600188 Yanzhou Coal Mining 5.56 11.43 133%8 1108 600876 Luoyang Glass 0.87 3.32 333% 28 386 600028 China Petroleum & Chemical 4.4 8.78 126%9 719 000756 Shandong Xinhua Pharmaceutical 1.34 4.9 315% 29 857 601857 PetroChina 6.4 11.61 106%10 921 000921 Hisense Kelon Electronics 0.87 3.15 311% 30 1072 600875 Dongfang Electric 18.96 33.36 100%11 1055 600029 China Southern Airlines 1.32 4.28 268% 31 525 601333 Guangshen Railway 2.54 4.31 92%12 588 601588 Beijing North Star 1.32 4.18 259% 32 2338 000338 Weichai Power 15.8 26.73 92%13 338 600688 Sinopec Shanghai Petrochemicals 1.96 6.13 255% 33 995 600012 Anhui Expressway 2.75 4.59 89%14 300 600806 Shenji Group Kunming Machinery 4.36 12.42 223% 34 2899 601899 Zijin Mining Group 4.85 7.78 82%15 2866 601866 China Shipping Container 1.33 3.73 218% 35 998 601998 China Citic Bank 2.85 4.57 82%16 874 600332 Guangzhou Pharmaceutical 2.75 7.66 216% 36 3988 601988 Bank of China 2.11 3.31 78%17 1071 600027 Huadian Power 1.73 4.79 214% 37 902 600011 Huaneng Power 5.37 8.02 69%18 358 600362 Jiangxi Copper 6.64 17.95 207% 38 1898 601898 China Coal Energy 6.09 8.93 66%19 2600 601600 Aluminum Corp of China 4.4 9.93 156% 39 1138 600026 China Shipping Development 8.2 11.72 62%20 2883 601808 China Oilfield Services 6.47 14.45 153% 40 168 600600 Tsingtao Brewery 14.8 20.9 60%

Note: Price as of 11 February 2009


Gross margin assumption may prove too conservative

The government may want to offer more incentives to promote investment in the sewage treatment business



Valuation

Premium over-stated DCF We value TCEP based on DCF, using a WACC of 12% with zero terminal growth.

Exhibit 115. TCEP: DCF model FCF (RMB'mn) 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017Sales 996.3 936.2 974.0 1,006.1 1,042.4 1,068.9 1,087.5 1,097.2 1,098.0 1,098.8…Growth rate -6% 4% 3% 4% 3% 2% 1% 0% 0%EBIT 323.2 208.6 219.9 230.5 241.3 247.3 250.0 251.7 252.4 253.2Add: Dep & Amortization 182.7 202.0 219.2 234.1 246.7 257.0 265.3 272.2 278.0 283.0EBITDA 505.9 410.6 439.1 464.6 488.1 504.3 515.3 523.9 530.4 536.1…EBITDA margin 51% 44% 45% 46% 47% 47% 47% 48% 48% 49%less:tax (45.4) (14.7) (18.8) (22.2) (25.1) (26.7) (28.8) (31.9) (34.2) (36.0)minority interest (2.0) (0.7) (0.8) (1.0) (1.1) (1.2) (1.3) (1.4) (1.5) (1.6)change in working capital 15.9 70.1 (16.9) (12.7) (17.1) 64.8 (204.4) (12.6) (2.7) (1.7)CAPEX (250.0) (200.0) (150.0) (100.0) (50.0) (50.0) (50.0) (50.0) (50.0) (50.0)Leveraged FCF 224.4 265.4 252.5 328.7 394.7 491.1 230.8 427.9 441.9 446.9

WACCSum of PV

(Rmb)PV of TV

(Rmb) EV (Rmb)Net cash/(debt)

(FY08)Equity Value

(Rmb)outstanding shares ('mn)


6.00% 2,644 4,408 7,053 (2,303) 4,750 1,427 3.426.50% 2,588 3,901 6,488 (2,303) 4,186 1,427 3.02 Equity Beta 1.777.00% 2,533 3,472 6,006 (2,303) 3,703 1,427 2.67 Risk Free Rate 2.00%7.50% 2,480 3,108 5,588 (2,303) 3,286 1,427 2.37 Equity Risk Premium 7.5%8.00% 2,429 2,794 5,224 (2,303) 2,921 1,427 2.11 Country Risk Premium 0%8.50% 2,380 2,523 4,903 (2,303) 2,600 1,427 1.87 Cost of Equity 15.3%9.00% 2,332 2,286 4,619 (2,303) 2,316 1,427 1.67 Cost of Debt 6.5%9.50% 2,286 2,078 4,365 (2,303) 2,062 1,427 1.49 Debt/Capital 30%10.00% 2,241 1,895 4,137 (2,303) 1,834 1,427 1.32 Tax 33.0%10.50% 2,198 1,733 3,931 (2,303) 1,628 1,427 1.17 WACC 12.0%11.00% 2,156 1,588 3,744 (2,303) 1,442 1,427 1.0411.50% 2,116 1,459 3,575 (2,303) 1,272 1,427 0.9212.00% 2,076 1,343 3,419 (2,303) 1,117 1,427 0.80 Terminal growth rate 0%12.50% 2,038 1,239 3,277 (2,303) 974 1,427 0.7013.00% 2,001 1,144 3,146 (2,303) 843 1,427 0.6113.50% 1,965 1,059 3,024 (2,303) 722 1,427 0.5214.00% 1,931 982 2,912 (2,303) 610 1,427 0.4414.50% 1,897 911 2,808 (2,303) 505 1,427 0.3615.00% 1,864 847 2,711 (2,303) 408 1,427 0.2915.50% 1,833 788 2,621 (2,303) 318 1,427 0.2316.00% 1,802 734 2,536 (2,303) 233 1,427 0.17


Excess valuation; initiating with REDUCE call Considering that TCEP is likely facing margin compression on a substantial cut in tariffs, the stock is at 14-43x P/E for FY09-10F. We think this is an excessive premium next to comparable peers such as CEI (257 HK, BUY) and Hyflux (HYF SP, NEUTRAL). Given that management does not yet have a successful track record, in our view, and growth visibility is unclear, we initiate coverage with a REDUCE rating. Our price target is HK$0.80, implying 45% downside.

Change in financial presentation

Transitioning into IFRIC 12 presentation TCEP adopted IFRIC 12 (a new accounting standard under HKFRS which is applicable to all projects under BOT and TOT arrangements) for the first time during its interim reporting for 1H08. Reported earnings may be accelerated by recognising non-cash construction income during the build-out phase of the project.

When the company reports for full-year FY08 (with retrospective restatement of historical figures presented), we plan to transition to present our primary forecast in accordance with IFRIC 12, as such an accounting presentation would be consistently applied and the financial information would be valued by the market, going forward. However, we believe that the traditional non-IFRIC 12 basis provides a more transparent analysis of the company’s operational performance.

Our price target is HK$0.80, implying 45% downside

We believe that the traditional non-IFRIC 12 basis provides a more transparent analysis of the company’s operational performance



Minimal impact on our DCF valuation HK (IFRIC) 12 is a new accounting standard which smoothes earnings for BOT/TOT concessionary contracts as a whole, as it shifts revenues from the operation to the construction stage. As the fair value portion of construction income would be realised earlier, the switch retrospectively increases TCEP’s revenue and earnings in the near term. We believe this new accounting policy creates minimal value to actual cashflows (which justifies our DCF valuation).

Exhibit 116. Comparison of key financial matrix before and after adoption of IFRIC 12 (HK$mn unless otherwise stated) FY06 FY07 FY08F FY09F FY10F FY11F FY12FIFRIC 12 results Revenue na na 1,227 1,223 875 915 949 Net income na na 230 151 40 53 64 EBITDA - recurring na na 570 479 396 422 446 EPS, Basic (HK$) na na 0.161 0.106 0.028 0.037 0.045 3-year CAGR for EPS, basic (%) na na na -38.6 -24.7 23.4 14.6 Adjusted results (w/o IFRIC 12) Revenue 770 939 994 996 936 974 1,006 Net income 159 184 216 134 43 56 66 EBITDA 269 344 341 328 357 369 381 EPS, basic (HK$) 0.119 0.129 0.151 0.094 0.030 0.039 0.046 3-year CAGR for EPS, basic (%) na -7.7 -38.2 -36.3 -21.2 19.6 12.4


We believe this new accounting policy creates minimal value to actual cashflows (which justifies our DCF valuation)



Company background

TCEP’s profile Background TCEP was formed in 2000, through the restructuring and asset exchange of the formerly listed Bohai Chemical and Tianjin Municipal Investment. Post restructuring, the group focused on the sewage treatment business in Tianjin. It also maintains a toll road operation. In 2004, TCEP expanded its sewage treatment operations outside Tianjin. The company has four sewage treatment plants in Tianjin, along with seven other sewage/water treatment projects in the Guizhou, Yunnan, Zhejiang, Hubei, Anhui, and Jiangsu provinces.

Exhibit 117. TCEP: revenue mix in FY08F

Toll road6%

Tap water processing

8%

Wastewater treatment

81%

Construction materials

0.4%

Water recycling5%


Competitive advantages In our view, TCEP’s key competitive advantages are its: 1) strong political connections in Tianjin; 2) expertise in sewage treatment; and 3) strategically located sewage treatment network across China. TCEP dominates Tianjin’s sewage treatment market, mainly due to its shareholder background. The majority shareholder in TCEP is Tianjin Municipal Investment (TMICL), which is owned by Tianjin Urban Construction Bureau (under the Tianjin municipal government), a bureau that is in charge of municipality (sewage, sewage water treatment, etc), highway construction (roads, highways, bridges, subway trains) and city management. Such a background gives TCEP a competitive edge in securing new sewage treatment projects. In view of the expected significant decline in earnings of the core Tianjin sewage project post the tariff cut, we do not rule out the possibility of Tianjin Urban Construction Bureau injecting more urban utilities in Tianjin (such as toll roads, subway trains, water treatment and sewage plants) into TCEP in order to compensate for the expected earnings decline, or to sustain growth.

Post restructuring, the group focused on the sewage treatment business in Tianjin

Competitive advantages: 1) strong political connections in Tianjin; 2) expertise in sewage treatment; and 3) strategically located sewage treatment network across China



We factor in a substantial tariff cut in mid-FY09F


Income statement (RMBmn)Year-end 31 Dec FY06 FY07 FY08F FY09F FY10FRevenue 770 939 994 996 936Cost of goods sold (330) (425) (477) (579) (641)Gross profit 440 514 516 417 295SG&A (94) (108) (114) (114) (107)Employee share expense - - - - - Operating profit 346 406 402 303 188

EBITDA 485 604 609 486 390Depreciation (139) (198) (207) (183) (202)Amortisation - - - - - EBIT 346 406 402 303 188Net interest expense (130) (146) (134) (145) (155)Associates & JCEs 4 3 3 3 5Other income 16 12 20 20 21Earnings before tax 236 275 292 181 59Income tax (80) (92) (73) (45) (15)Net profit after tax 156 183 219 136 44Minority interests 2 1 (3) (2) (1)Other items - - - - - Preferred dividends - - - - - Normalised NPAT 159 184 216 134 43Extraordinary items - - - - - Reported NPAT 159 184 216 134 43Dividends (53) (57) (67) (42) (13)Transfer to reserves 105 127 149 92 30


Growth (%)Revenue 32.7 21.9 5.9 0.3 (6.0) EBITDA 18.9 24.4 0.9 (20.3) (19.7) EBIT 2.6 17.4 (0.9) (24.7) (37.9) Normalised EPS (10.6) 11.8 13.3 (37.8) (67.6) Normalised FDEPS (12.7) 15.8 17.3 (37.8) (67.6)

Per shareReported EPS (RMB) 0.12 0.13 0.15 0.09 0.03Norm EPS (RMB) 0.12 0.13 0.15 0.09 0.03Fully diluted norm EPS (RMB) 0.11 0.13 0.15 0.09 0.03Book value per share (RMB) 1.79 2.03 2.13 2.20 2.22DPS (RMB) 0.04 0.04 0.05 0.03 0.01Source: Nomura estimates



Cashflow (RMBmn)Year-end 31 Dec FY06 FY07 FY08F FY09F FY10FEBITDA 485 604 609 486 390Change in working capital 73 (452) (362) (1) 54Other operating cashflow (366) 96 273 (16) 14Cashflow from operations 192 248 520 468 458Capital expenditure (1,132) (286) (1,466) (250) (200)Free cashflow (940) (38) (946) 218 258Reduction in investments (1) 1 (1) (1) (1)Net acquisitions (54) - - - - Reduction in other LT assets (395) 76 308 15 12Addition in other LT liabilities (4) (3) (1) (1) (1)Adjustments 372 (65) 702 (5) (2)Cashflow after investing acts (1,022) (30) 62 226 266Cash dividends (54) (57) (67) (42) (13)Equity issue - - - - - Debt issue 988 (355) (144) 285 (225)Convertible debt issue (1) 47 - - - Others 69 (0) (0) 0 (0)Cashflow from financial acts 1,003 (364) (211) 243 (238)Net cashflow (20) (394) (149) 470 28Beginning cash 753 734 340 191 661Ending cash 734 340 191 661 688Ending net debt 2,326 2,168 2,308 2,269 2,172Source: Nomura estimates

Balance sheet (RMBmn)As at 31 Dec FY06 FY07 FY08F FY09F FY10FCash & equivalents 734 340 191 661 688Marketable securities 3 4 5 6 7Accounts receivable 43 443 735 737 693Inventories 8 7 10 10 10Other current assets 25 133 174 173 162Total current assets 813 926 1,115 1,587 1,559LT investments 6 4 4 4 4Fixed assets 4,107 4,076 4,312 4,380 4,378Goodwill - - - - - Other intangible assets - - - - - Other LT assets 956 880 572 557 545Total assets 5,882 5,887 6,004 6,529 6,486Short-term debt 899 710 270 370 413Accounts payable 10 12 13 13 12Other current liabilities 311 363 337 337 335Total current liabilities 1,219 1,085 620 720 760Long-term debt 2,158 1,794 2,224 2,554 2,441Convertible debt 3 4 5 6 7Other LT liabilities (1) (4) (5) (6) (7)Total liabilities 3,379 2,879 2,844 3,274 3,201Minority interest 116 115 118 120 121Preferred stock - - - - - Common stock 1,331 1,427 1,427 1,427 1,427Retained earnings 1,003 1,409 1,548 1,665 1,723Proposed dividends 53 57 67 42 13Other equity and reserves - - - - - Total shareholders' equity 2,387 2,893 3,042 3,134 3,164Total equity & liabilities 5,882 5,887 6,004 6,529 6,486



Activity (days)Days receivable 26.3 94.5 217.0 269.8 278.8 Days inventory 10.9 6.2 6.5 6.4 5.6 Days payable 10.1 9.6 9.8 8.3 7.3 Cash cycle 27.1 91.2 213.6 267.9 277.1 Source: Nomura estimates

Gearing is also higher than peers’


China Water Affairs Group Ltd 855 HK



Waiting for catalysts to emerge Well-positioned in a multi-year growth cycle As a privately owned pure water utility in China, CWA looks well-positioned to take advantage of the sector’s growth opportunities, due to favourable policies and an under-invested water market.

Success in turning around distressed assets CWA has a proven strategy of investing in and turning around distressed state-owned water utilities. Management raised tariffs by 7-95% during 2006-08 and improved “non-revenue water” by 50% on some of its key projects.

Sound track record, waiting for catalysts On the chairman’s close ties with local government, the company has doubled capacity since March 2007 to 3.4mn m3. Although growth slowed in 2008, we believe China’s RMB4tn stimulus package will soon revive M&A activity.

Margin erosion clouds outlook Although we are positive about CWA’s long-term prospects, we are concerned that financial securities and SG&A expenses (2-3x higher than peers’) may dampen profits. Liquidity seems satisfactory, but an overly geared balance sheet may crimp near-term growth.

Valued at a discount to peers and replacement cost CWA is at 11x P/E and 0.6x P/BV for FY10F (ending 31 March, 2010) — a discount to peers. Alternatively, our sum-of-the-parts analysis (based on replacement cost) pegs its existing water assets at an NAV of HK$1.40/share, implying limited downside.

Key financials & valuations31 Mar (HK$mn) FY07 FY08 FY09F FY10FRevenue 140 766 817 945Reported net profit 63.4 427.2 (4.5) 134.4Normalised net profit (7.1) 44.2 102.1 134.4Normalised EPS (HK$) (0.007) 0.036 0.081 0.105Norm. EPS growth (%) na na 125.5 29.3 Norm. P/E (x) na 31.1 14.0 10.6EV/EBITDA (x) na 15.8 7.0 4.1Price/book (x) 1.3 0.8 0.7 0.6Dividend yield (%) 0.0 0.0 0.0 0.0ROE (%) 9.9 30.5 (0.2) 5.9 Net debt/equity (%) 16.9 58.8 43.0 17.3Earnings revisionsPrevious norm. net profit na na naChange from previous (%) na na na Previous norm. EPS (HK$) na na naSource: Company, Nomura estimates


1m 3m 6m 8.8 37.0 (27.0) 8.9 37.0 (26.4) 10.1 30.0 5.9

Easy


52-week range (HK$)3-mth avg daily turnover (US$mn)

Duan Chuan Liang

Stock borrowability

13.3

Major shareholders (%)Atlantis Investment Management 21.0



65.73.40/0.69

0.80

0.400.901.401.902.402.903.403.90

Feb0

8

Apr0

8

Jun0

8

Aug0

8

Oct

08

Dec

08

30405060708090100110

PriceRel MSCI China

(HK$)



Upside/downside 12.6%Difference from consensus -3.8%FY09F net profit (HK$mn) (4.48)


Nomura vs consensusDespite solid core earnings from water supply, we are more bearish than consensus since CWA may suffer sharp FV losses from financial investments in FY09F.

Initiating

NEUTRAL


Our view CWA is poised to take advantage of growth opportunities, underpinned by

government policies and an under-invested water market. It has a solid track record in expanding capacity and turning around distressed projects, plus valuations are attractive. Yet, the earnings outlook is unclear. Initiating with NEUTRAL.

Anchor themes

China’s water resource per capita is only a quarter of the global average, but its water consumption (per unit of GDP) is 5.5x the international average. Shortages, pollution, geographical disparity and inefficient water use cost 8-10% of the nation’s GDP. Over 400 cities suffer water shortages of 16mn m3/day.

The government is setting harder targets and larger budgets for the water industry to promote privatisation and capacity growth. Water quality has become a key concern for the government, and tariffs are on the rise to justify investment returns.



China Water Affairs Group Ltd Evan Li


Earnings drivers

A pure water play Well-positioned in a multi-year growth cycle Given that the water market was only formally opened in 2004 and that most urban water infrastructure projects are still held by local governments, we think CWA is well-positioned to capture growth opportunities.

Exhibit 118. CWA's business coverage

CWA water supply coverage

Newly acquired water supply projects

Capacity expansion of existing water supply plants

Newly constructed sewage treatment projects

Guangdong

Henan

Jiangxi

Hainan

ZhejiangHubei

Gansu

Yunnan Guangxi

Sichuan

Xinjiang

Tibet

Qinghai

Heilongjiang

Jilin

Liaoning

Inner Mongolia

Taiwan

Hong KongMacau

GuizhouHunan

Shaanxi

Anhui

Jiangsu

Shandong

HebeiShanxi

Fujian


Focuses on tap water supply… CWA primarily invests in and operates water service projects in China, including urban tap water supply (64% of revenue in 1H FY09), wastewater treatment (4%) and infrastructure (15%).

Given that one quarter of China’s population drinks untreated underground water, according to government statistics, CWA stands to be a major beneficiary of the government’s favourable policies, in our view:

“One household, one meter” policy. This ensures that a water meter is installed in every household to keep readings on water usage.

Guidelines to close all private underground wells. This policy promotes the expansion of water pipelines to ensure that people obtain direct access to treated water.

City water supply pricing scheme. As per this policy, urban water suppliers are entitled to operate at ROEs of 8-12%.

CWA invests in and turns around distressed state-owned water utilities (mainly water supply plants) in second-tier cities, at low entry prices. During our visit to one of the company’s water plants in Jingzhou (Hubei province), we learned that non-revenue water had been lowered by 5-10pps and water tariffs were raised by 7%, since CWA’s entry in 2007. According to management, the water plant turned from a RMB4mn loss in 2006 to a RMB10mn profit in 2007. We believe that CWA’s other projects could also

In a solid position to harness sector growth

CWA primarily invests in and operates water service projects in China, including urban tap water supply (64% of revenue in 1H FY09), wastewater treatment and infrastructure



deliver similar benefits, given its track record of raising tariffs by 7-95% and improving non-revenue water by 50% for some of its projects.

...but sometimes invests in wastewater treatment plants In 2005, CWA acquired a wastewater business in Hebei. However, this business was disposed of in the same year due to low profitability and the problems collecting treatment fees from local governments, since sewage operators are the last entity in the water supply chain to collect payment. CWA faced difficulties in collecting its dues from the local government, and therefore had disposed of the sewage business by end-2005.

However, CWA resolved this issue by adopting a new strategy of investing in only those sewage companies where it also has control over water supply operations at the same location. This ensured better control over debt collection. Consequently, in December 2006, CWA acquired another sewage operation in Jingzhou, in Hebei province, with a daily processing capacity of 100,000 m3, in conjunction with a joint-venture agreement with the local government for a water supply operation with a daily capacity of 715,000 m3 at the same location.

Sound track record, waiting for catalysts to emerge

Solid growth hitherto We believe management’s experience in running water supply operations provides an edge in obtaining new projects. It has a proven track record, with its water supply capacity (consolidated) having doubled to 3.4mn m3 since March 2007 (expanding 10x since March 2006).

Although CWA’s capacity growth has slowed owing to less attractive M&A prospects because of the government’s temporary cap on utility prices in late-2007, we believe its M&A activities may resume following the government’s RMB4tn stimulus package, announced in November 2008.

Exhibit 119. CWA's water supply capacity

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Mar 2006 Sep 2006 Mar 2007 Sep 2007 Mar 2008 Sep 2008

(mn m3)


For project acquisition as well as organic expansion (water plant extension), CWA is aggressively negotiating with local governments, with many projects pending in the pipeline, according to management. Apart from acquiring projects across regions, management expects to raise capacity by at least 20% pa through water plant extensions, owing to the rapid urbanisation and infrastructure development taking place in second-tier cities.

CWA faced difficulties in collecting its dues, and therefore had disposed of the sewage business by end-2005

We believe management’s experience in running water supply operations provides an edge in obtaining new projects

Many projects pending in the pipeline



Chairman’s ties with government support growth Having worked in the government’s water bureau for more than 10 years, the company’s Chairman, Duan Chuan Liang, has extensive knowledge of water operations and hydro power. The company’s ability to revive its expansion plans and regain investor confidence arguably depends on whether or not it can leverage relationships with various local governments.

Successful at hiking water tariffs The water supply treatment projects acquired by CWA have had low water treatment tariffs (excluding water resources, city construction and wastewater treatment fees on behalf of municipal governments and sewage treatment operators). This is because these projects were state-owned, prior to their acquisition. Given that water suppliers have legitimate rights to raise tariffs, in accordance with the City Water Supply Pricing Scheme, and earn a decent ROE of 8-12%, CWA has, so far, successfully raised tariffs by 7-95% since 2006-07.

Exhibit 120. CWA's projects that enjoyed tariff hikes

Province City Acquisition

date Date of

tariff hikeDaily

capacity (M3) Original tariff

(RMB/M3) Latest tariff

(RMB/M3) % of change Guangdong Renhau Dec 2003 Jun 2007 30,000 1.05 1.55 48Henan Luyi Dec 2004 Jan 2008 30,000 1.43 1.85 29Jiangxi Wannian Jan 2006 2006-07 50,000 0.83 1.62 95Jiangxi Xinyu Jan 2006 Jan 2008 130,000 1.10 1.55 41Hubei Jingzhou Feb 2007 Mar 2007 715,000 1.00 1.07 7Jiangxi Gaoan Apr 2007 Oct 2008 45,000 1.21 1.57 30Jiangxi Fenyi Sep 2007 Oct 2008 30,000 1.34 1.63 22


The company’s ability to revive its expansion plans and regain investor confidence arguably depends on whether or not it can leverage relationships with various local governments



Risks

Risk of slower growth, slimmer margins Earnings hit by financial losses Although CWA’s core earnings from water supply have been growing steadily, its investments in financial assets and other marketable securities have placed the company at risk, especially amid the current stormy financial markets. On our estimates, CWA’s investments in Hong Kong and China have fallen by 50-80% over the past 12 months, resulting in the company posting a loss of HK$175mn for 1H FY09. The fair value of its convertible bonds has also declined, leading to losses of HK$41mn during the same period. The potential for further losses in the near term may discourage investor interest.

Exhibit 121. Reporting and recurring results of CWA

(100)

0

100

200

300

400

500

2005 2006 2007 2008 2009F 2010F 2011F

Reporting profit/(loss)

Recurring profit/(loss) from water

(31 March | HK$mn)

Source: Company data, Nomura International (Hong Kong) Limited

However, we think these non-cash losses are likely to be one-off, as management has reiterated its stance to focus on water-related operations. Furthermore, according to management, Ming Hing Holdings (402 HK, not rated) has agreed to repurchase its shares held by CWA, which would be at a premium to historical cost and payable through an asset swap. By December 2008, CWA had already redeemed 50% of the issued convertible bonds, which should help minimise potential fair value losses from these listed debt securities, in our view.

High SG&A expenses The company’s SG&A expenses are much higher than at peers (owing to its aggressive growth / expansion plans), which reduces visibility on profitability. According to management, CWA incurred high corporate expenditure for executing M&As during this high growth phase, a significant proportion of which are one-off expenses. These expenses include legal and administration expenses for M&A transactions, bank loan transaction fees, valuation fees by independent valuers and sign-on bonuses for certain key management.

On our estimates, CWA’s investments in Hong Kong and China have fallen by 50-80% over the past 12 months

We presume these non-cash losses are one-off, as management has reiterated its stance to focus on water-related operations

High corporate expenditure for executing M&As during this high growth phase, a significant proportion of which are one-off expenses



Exhibit 122. SG&A expenses as a percentage of revenue CWA China Everbright HyfluxTicker 855 HK 257 HK HYF SPRating NEUTRAL BUY NEUTRALFinancial period FY1H09 FY1H08 FY1H08Currency (HK$mn) (HK$mn) (S$mn)Revenue 386.0 788.7 197.7 SG&A expenses 128.3 70.4 28.1 SG&A as a % of revenue 33 9 14Recurring EBITDA margin (%) 35 28 25Recurring net profit margin (%) 14 17 14


Given that CWA’s water operating data have been promising and on track, we believe profitability should improve from here. As the company expands its scale through better execution, we expect SG&A expenses to decline gradually (as a percentage of revenues), owing to due to better cost management, at both the corporate and subsidiary levels.

Gearing reasonable, but may pressure growth Although CWA’s net debt-to-equity ratio was 71% at September 2008, higher than at comparable peers, we believe this should not be cause for concern, as international water companies and utilities in China normally have a gearing ratio of up to 100-200%. Once the water plants acquired in mid-2008 are fully ramped-up, we expect CWA to generate operating cash inflows of RMB150-200mn pa over FY09-10 — this is 2-3x its maintenance capex and 3-4x its gross interest payments, which should help sustain its existing operations. In December 2008, management reiterated that domestic commercial banks would continue to support CWA, and that the majority of its short-term borrowings would be rolled over.

Although liquidity is not a concern for CWA’s survival, we are concerned that its overly-geared balance sheet may limit growth in the near term Although liquidity is not a concern for CWA’s survival, we are concerned that its overly-geared balance sheet may limit growth in the near term, especially since the company has to adhere to certain financial covenants from existing commercial lenders.


-50% 0% 50% 100% 150%


Tianjin Capital EnvironmentalChina Water Affairs Group Ltd

China Water Industry GroupGuangdong Investment

China Everbright InternationalNanhai Development Co.

Hyflux LimitedShanghai Youngsun








-100% 0% 100% 200% 300% 400% 500%






China Water Affairs Group Ltd Suez SA

Cia Saneamento Basico de Sao PauloEastern WaterDanaher Corp

Gamuda BerhadManila Water Co. Inc

Cia Saneamento Minas GeraisRWE AG

PBA Holdings BerhadNitto Denko Corp

Kurita Water Industries Net debt/(cash) as % to equity


Although CWA’s net debt-to-equity ratio is higher than at comparable peers, we believe this should not be cause for concern



M&As could become more expensive CWA’s expansion plans of raising its water supply capacity will be mainly accomplished through acquisitions or by joint-ventures with local governments, in our view. Both domestic and international investors have keen interest in the water treatment industry and have been investing in major Chinese cities, such as Beijing, Shanghai, Chengdu and Wuhan.

In general, CWA does not take on projects in the western and north-eastern regions of China, which have scarce water resources and local governments are more bureaucratic towards foreign investments, according to management. As a result, the company limits its investments to the central and south-eastern regions, along the coastal cities, where competition is rising.

CWA’s international rivals are keen to invest in tier-1 cities with populations over 2mn, and they are willing to pay a premium in order to secure a foothold in China’s water industry. Therefore, with limited capital, CWA does not have the war-chest to compete head-to-head with international rivals such as Veolia and Suez SA (SZE FP, not rated). Also, in such tier-1 cities, projects are awarded through tendering and open bidding, which mainly compete on the basis of prices, where CWA is at a disadvantage. Therefore, the company‘s strategy has been to focus on tier-2 cities, thus utilising its relationships and domestic knowledge, thereby securing projects at fairer prices.

Although most of the water assets are still government-owned, we notice competition is slowly developing in tier-1 cities where asset prices have inflated. Although not imminent, we believe this should gradually spread to tier-2 and tier-3 cities (the markets in which CWA operates) as the market matures.

For instance, Veolia Water (VIE FP, not rated) paid 3x P/BV or RMB3,346/m3 to acquire a water firm at Haikou in Hainan province in June 2007. This compares with RMB1,725/m3 and RMB1,327/m3 when Veolia Water acquired water plants in the Gansu and Yunan provinces in January 2007 and November 2005, respectively.

Departure of the Chairman could have a significant impact CWA was acquired by Mr Duan (the current Chairman) through a back-door listing in 2003. The original shareholding of Mr Duan, at the time of the acquisition, was limited by the listing regulations to no more than 30%, as the transaction would have been made as a general offer if otherwise. Moreover, after a series of share placements in 2006 and 2007 to finance the company’s M&A activities, Mr Duan’s interests in the company had been significantly diluted. Therefore, the company granted significant share options (treated as expenses in the income statement) to the Chairman, through which he exercised shareholding interest.

The success of CWA has been linked to its industry connections and the relationships which its Chairman, Mr Duan, brought to the company. Therefore, the departure of the Chairman would have a significantly adverse impact on the company’s prospects, in our view. In order to provide incentives to the Chairman and to avoid losing management control, we cannot ignore the possibility of further options being granted to the Chairman and management, which could result in continuous share dilution risk.

However, Chairman has also been buying back CWA’s shares We note that the Chairman Mr Duan has acquired 18mn shares in the company since January 2008, thus increasing his controlling stake in the company from 15.9% to 18.2%. This suggests that the Chairman, who oversees the company’s operations and executes M&As for CWA, remains confident in the company’s long-term growth opportunities.

The company limits its investments to the central and south-eastern regions, along the coastal cities, where competition is rising

The success of CWA has been linked to its industry connections and the relationships which its Chairman, Mr Duan, brought to the company



Catalysts and potential upside

Value possibly waiting to be unlocked Positive catalysts lined up At CWA, we see potential value waiting to be unlocked. Our major arguments are highlighted below:

Value in hydro power to be explored upon further stake increases: CWA has a 45% interest in Jianghe Long Chuan, which owns a number of small hydro power plants in southern China that have already delivered a consolidated profit of RMB26.7mn in the year ended December 2007 (RMB12mn attributable to CWA). As CWA has accounted for this holding as a financial investment on its balance sheet, such earnings are not reflected in the income statement for its fiscal year ended March 2008. According to management, it plans to extend its control over Jianghe Long Chuan in the near term, and expects then to account for the holding as an associate. Moreover, we note that these hydro power projects have already applied for Clean Development Mechanism (CDM) credits from the Chinese government and the relevant authorities — this could potentially deliver a total reward of about RMB300mn upon approval, according to management.

In line to acquire 80 wastewater treatment plants in Jiangxi: Since May 2008, CWA has been in line to acquire 80 wastewater treatment plants in Jiangxi, which provides a visible pathway to expand into wastewater treatment (a segment with higher profit margins and less regulatory risks, in our view). At a refundable deposit of RMB50mn, CWA has been given the first right of refusal by the Jiangxi government to acquire 80 wastewater plants (at combined capacity of 1.9mn m3) at RMB3bn once construction is completed. According to the company, the first phase (45 plants) is expected to come on stream by September 2009, and the rest by September 2010. We believe this provides clear growth visibility, given that CWA is the only party with the first right of refusal. This has not been included into our forecasts though, because we await the final agreement and terms to be settled with the Jiangxi government.

More value waiting to be unlocked from investment in CWIIC: In November 2007, CWA said it had acquired a 19.38% interest in China Water Industry Investment Corporation (CWIIC) from Shanxi Wanjiazhai (state-government authority) for RMB175mn. CWIIC has aggregate capacity of 2.8mn m3 in tap water supply and wastewater treatment. CWIIC also owns a coal mine in Xinjiang which is worth HK$0.6/share to CWA by valuing its reserves level with comparable multiples. We have not factored the additional water capacity and value from the coalmine into our forecasts due to CWA’s minority stake in such assets, as well as our uncertainty about the timeline for distributing any cash dividends to CWA. However, we believe that CWA’s investment in CWIIC is a strategic move to unlock profitable assets reserved by the state government. Besides, the success in securing this deal demonstrates that the Chairman has close ties with government authorities, in acquiring water-related and other assets.

CWA has a 45% interest in Jianghe Long Chuan, which owns a number of small hydro power plants in southern China

At a refundable deposit of RMB50mn, CWA has been given the first right of refusal by the Jiangxi government to acquire 80 wastewater plants



Exhibit 125. Water assets held by CWIIC

City water supply and wastewater treatment projects Principle business Capacity ('000m3) CWIIC's stake (%)

Inner Mongolia Junger Yellow River Water Industry Co. Industrial water supply 100 36.6Shandong Water Investment Co. Ltd. Raw & city water supply 650 51.0Rongcheng Water Group Co. Ltd. Raw & city water supply 120 58.2Huai'an Water Co. Ltd. Water supply 200 80.0Xinjiang changyuan Water Group Co. Ltd. Water supply 230 60.0Yixing Water Industry Group Co. Ltd. Raw & city water supply 300 68.0Qingdao Diverting Yellow River to Qingdao Water Co. Ltd Water supply 100 51.0Jiangsu Wujin Water Wastewater treatment 60 60.0Sichuan Zigong Water Water supply 200 51.0Zhongshui Xinhua Irrigation and Drainage Technology Co. Ltd. Irrigation solution - 90.0Shanghai Water Investment Construction Co. Ltd Irrigation solution - 43.3 Qianjiang Water Resources Development Co. Ltd. (A-share listed) Water supply, real estate 740 25.5


Exhibit 126. CWIIC's coalmine in Xinjiang CWIIC's coalmine in Xinjiang Total reserve of coal mine (mn tonnes) 4,000 Attributable to CWIIC at 25% 1,000 Assumed heat content (kcal/kg) 4,500 Assumed annual output (mn tonnes) Annual output in first year 25 At full capacity 60 Average output 43 Attributable to CWIIC at 25% (mn tonnes) 11 Valuation By EV/tonne Average EV/tonne reserve (US$) - adjusted by heat content 4.0 Average EV/tonne output (US$) - adjusted by heat content 120 Estimated attributable EV (HK$mn) Based on reserves (assume 50% by international standard) 62,240 Based on annual production 39,678 Estimated attributable equity value (30:70) Based on reserves 18,672 Attributable to CWIIC (25%) 4,668 Attributable to CWA (19.38%) 905 Based on annual production 11,903 Attributable to CWIIC (25%) 2,976 Attributable to CWA (19.38%) 577 CWA's per share value (HK$) Based on reserves 0.73 Based on annual production 0.47 Average 0.60 Note: Average EV/tonne derived from comparable Chinese coal producers listed in Hong Kong

Source: Company data, Nomura International (Hong Kong) Limited



Valuations

Valuations look attractive DCF valuation Our valuation is based on discounted cashflow (DCF), employing a WACC of 14% with no terminal growth rate.

Exhibit 127. DCF model for CWA March | HK$mn 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019Sales 944.9 1,122.2 1,151.9 1,212.5 1,273.3 1,339.5 1,408.9 1,477.0 1,547.7 1,626.8…Growth rate 19% 3% 5% 5% 5% 5% 5% 5% 5%EBIT 247.6 302.9 326.7 355.4 379.7 406.6 429.7 461.7 484.3 510.2Share of associates 49.7 70.2 74.4 78.9 83.4 87.8 92.5 97.4 102.6 108.1 Depreciation/amortization 165.0 190.3 205.3 220.4 235.4 250.1 271.4 293.0 314.6 335.8EBITDA 462.4 563.4 606.5 654.7 698.5 744.5 793.7 852.1 901.5 954.1…EBITDA margin 49% 50% 53% 54% 55% 56% 56% 58% 58% 59%less:tax (47.2) (68.4) (75.5) (104.8) (114.0) (123.3) (131.3) (141.1) (148.0) (155.9)minority interest (97.3) (121.9) (134.0) (139.6) (151.5) (163.6) (174.1) (186.9) (196.1) (206.4)change in working capital 1.8 3.6 20.5 20.0 22.4 24.8 27.7 1.0 1.0 1.1CAPEX (153.1) (91.5) (164.6) (163.2) (160.2) (233.4) (235.5) (235.0) (231.6) (224.7)Leveraged FCF 166.5 285.1 252.9 267.1 295.2 249.0 280.5 290.1 326.8 368.2

WACCSum of PV

(HK$)PV of TV

(HK$) EV (HK$)net cash/(net debt) (FY08)

Equity Value (HK$)

Outstanding shares ('mn)


6.00% 4,937 2,395 7,332 (1,034) 6,297 1,240 5.086.50% 4,674 1,956 6,630 (1,034) 5,596 1,240 4.51 Equity Beta 1.887.00% 4,433 1,608 6,041 (1,034) 5,007 1,240 4.04 Risk Free Rate 2.00%7.50% 4,210 1,330 5,539 (1,034) 4,505 1,240 3.63 Equity Risk Premium 7.50%8.00% 4,004 1,105 5,109 (1,034) 4,075 1,240 3.29 Country Risk Premium 0%8.40% 3,851 956 4,806 (1,034) 3,772 1,240 3.04 Cost of Equity 16.1%9.00% 3,637 773 4,410 (1,034) 3,376 1,240 2.72 Cost of Debt 7.5%9.50% 3,474 650 4,124 (1,034) 3,090 1,240 2.49 Debt/Capital 20%10.00% 3,322 549 3,871 (1,034) 2,836 1,240 2.29 Tax 25.0%10.50% 3,181 464 3,645 (1,034) 2,611 1,240 2.11 WACC 14.0%11.00% 3,050 394 3,444 (1,034) 2,410 1,240 1.9411.50% 2,928 335 3,263 (1,034) 2,229 1,240 1.8011.90% 2,836 295 3,131 (1,034) 2,097 1,240 1.69 Terminal growth rate 0%12.50% 2,707 245 2,951 (1,034) 1,917 1,240 1.5513.00% 2,607 210 2,817 (1,034) 1,782 1,240 1.4413.50% 2,514 180 2,694 (1,034) 1,659 1,240 1.3414.00% 2,426 155 2,581 (1,034) 1,547 1,240 1.2514.50% 2,344 133 2,477 (1,034) 1,443 1,240 1.1615.00% 2,267 115 2,382 (1,034) 1,348 1,240 1.0915.50% 2,194 100 2,294 (1,034) 1,260 1,240 1.0216.00% 2,126 86 2,212 (1,034) 1,178 1,240 0.95


Discount against peers

Valuation has fallen sharply since November 2007 Since November 2007, CWA’s stock price has fallen over 80% (compared with a 50% fall in the Hang Seng Index over the same period), due to: 1) earnings results coming in around 20% lower than expected owing to higher-than-expected SG&A expenses; and 2) slowing capacity growth.

Trading below replacement cost multiples CWA currently trades at 11x March 2010 P/E and 0.6x P/BV, discounts to peer averages of 12x and 1.3x, respectively.

Fall on weak results and slowing capacity growth



Based on our alternative analysis, by valuing CWA’s existing assets under its portfolio (excluding financial assets and projects not yet completed), our sum-of-the-parts valuation suggests an NAV of HK$1.40/share. We value CWA’s water assets using the company’s replacement costs (ie, RMB1,000/m3 for water supply treatment plants and RMB1,500/m3 for wastewater treatment plants), which are generally 20-30% higher than CWA’s historical costs of acquisitions (as CWA’s strategy is to turn around distressed assets acquired from the government at discounts) but 20-60% below the construction costs of China Everbright International and Hyflux, and 1.5-3.0x below the acquisition costs by international water companies.

Exhibit 128. Sum-of-the-parts valuation (alternative valuation)

Province City Date of

operation Stake

(%)

Daily Capacity ('000m3)

Fair value (RMB/m3) Asset type

Exchange factor

Estimated fair value

(HK$mn)Water-related assets Jiangxi Wannian Jan-06 98 90 1,000 Water supply 1.137 100.3 Jiangxi Xinyu Jan-06 66 190 1,000 Water supply 1.137 143.3 Henan Luyi Dec-04 100 30 1,000 Water supply 1.137 34.1 Henan Fugou Jul-06 100 50 1,000 Water supply 1.137 56.9 Henan Xihua Sep-06 55 50 1,000 Water supply 1.137 31.3 Henan Zhoukou Oct-06 70 132 1,000 Water supply 1.137 105.1 Guangdong Yenhau/Renhua Dec-03 73 30 1,000 Water supply 1.137 24.9 Chongqing Yongchuan Nov-06 100 55 1,000 Water supply 1.137 62.5 Hubei Jingzhou Feb-07 51 715 1,000 Water supply 1.137 414.6 Guangdong Xinhui Jun-07 50 300 1,000 Water supply 1.137 170.6 Jiangxi Gaoan Apr-07 60 45 1,000 Water supply 1.137 30.7 Jiangsu Gangwu Jun-07 40 600 1,000 Water supply 1.137 272.9 Guangxi Wuzhou Jun-07 49 355 1,000 Water supply 1.137 197.8 Guangdong Xinhui - Siqian Sep-07 50 90 1,000 Water supply 1.137 51.2 Guangdong Xinhui - Gujing Sep-07 50 50 1,000 Water supply 1.137 28.4 Hubei Jiangling Apr-08 100 20 1,000 Water supply 1.137 22.7 Chongqing Sunjiakou Apr-08 100 30 1,000 Water supply 1.137 34.1 Guangdong Huizhou Jul-08 49 410 1,000 Water supply 1.137 228.4 Jiangxi Xinyu Jul-08 100 150 1,000 Water supply 1.137 170.6 Chongqing Konggang Industrial

Park Jun-09 100 150 1,000 Water supply 1.137 170.6

Jiangxi Gaoan (phase II) Jul-09 60 80 1,000 Water supply 1.137 54.6 Hubei Jingzhou Dec-06 100 100 1,500 Wastewater 1.137 170.6 Hainan Xingshui Jun-07 53 100 1,500 Wastewater 1.137 90.4 Existing capacity 3,822

CWA's net cash/(debt) position at FY2009F (894) 1,773 Outstanding number of shares at FY2009F ('mn) 1,286 Fair NAV per share by SOTP 1.4




While core earnings from tap water supply are ramping up strongly, potential losses from financial securities remain an overhang in FY09F earnings


Income statement (HK$mn)Year-end 31 Mar FY06 FY07 FY08 FY09F FY10FRevenue 53 140 766 817 945Cost of goods sold (31) (82) (499) (428) (470)Gross profit 22 58 267 389 475SG&A (32) (87) (153) (230) (258)Employee share expense (31) - (50) - - Operating profit (41) (29) 65 160 217

EBITDA (34) (6) 138 288 386Depreciation (7) (23) (64) (118) (159)Amortisation (0) (1) (9) (11) (11)EBIT (41) (29) 65 160 217Net interest expense (2) (19) (67) (38) (35)Associates & JCEs - 0 14 35 50Other income 5 192 64 48 48Earnings before tax (39) 144 75 204 279Income tax (5) (49) (135) 4 (47)Net profit after tax (44) 95 (60) 209 232Minority interests (14) (40) (93) 3 (97)Other items 19 (62) 197 (110) - Preferred dividends - - - - - Normalised NPAT (39) (7) 44 102 134Extraordinary items - 70 383 (107) - Reported NPAT (39) 63 427 (4) 134Dividends - - - - - Transfer to reserves (39) 63 427 (4) 134

Valuation and ratio analysisFD normalised P/E (x) na na 31.1 14.0 10.6 FD normalised P/E at price target (x) na na 35.0 15.7 12.0 Reported P/E (x) na 16.9 3.2 na 10.6 Dividend yield (%) - - - - - Price/cashflow (x) 49.3 80.4 8.9 30.3 4.2 Price/book (x) 3.8 1.3 0.8 0.7 0.6 EV/EBITDA (x) na na 15.8 7.0 4.1 EV/EBIT (x) na na 30.5 11.6 6.7 Gross margin (%) 41.1 41.4 34.9 47.7 50.2 EBITDA margin (%) (64.9) (4.2) 18.0 35.2 40.9 EBIT margin (%) (77.8) (20.8) 8.5 19.5 22.9 Net margin (%) (72.9) 45.2 55.8 (0.5) 14.2 Effective tax rate (%) na 33.9 179.2 (2.2) 16.9 Dividend payout (%) na - - na - Capex to sales (%) (11.9) 236.9 108.5 30.4 16.2 Capex to depreciation (x) (0.9) 14.8 13.0 2.1 1.0 ROE (%) (27.9) 9.9 30.5 (0.2) 5.9 ROA (pretax %) (21.3) (2.9) 2.8 4.6 5.8

Growth (%)Revenue 9.1 165.3 445.5 6.7 15.7 EBITDA na na na 108.7 34.1 EBIT na na na 145.8 35.8 Normalised EPS na na na 125.5 29.3 Normalised FDEPS na na na 122.5 31.6

Per shareReported EPS (HK$) (0.07) 0.07 0.35 (0.00) 0.10Norm EPS (HK$) (0.07) (0.01) 0.04 0.08 0.10Fully diluted norm EPS (HK$) (0.04) (0.01) 0.04 0.08 0.10Book value per share (HK$) 0.29 0.88 1.42 1.62 1.93DPS (HK$) - - - - - Source: Nomura estimates



Cashflow (HK$mn)Year-end 31 Mar FY06 FY07 FY08 FY09F FY10FEBITDA (34) (6) 138 288 386Change in working capital 10 63 (169) (22) 2Other operating cashflow 38 (44) 185 (220) (51)Cashflow from operations 13 13 153 46 336Capital expenditure 6 (333) (830) (248) (153)Free cashflow 19 (319) (677) (202) 183Reduction in investments - (270) (518) - - Net acquisitions (5) (369) (305) - - Reduction in other LT assets (1) (127) (330) (35) (50)Addition in other LT liabilities - 43 70 (0) 0Adjustments 3 366 797 53 67Cashflow after investing acts 15 (676) (963) (184) 200Cash dividends - - - - - Equity issue 225 514 369 - - Debt issue (5) 171 252 (50) (50)Convertible debt issue (1) 300 254 0 - Others (20) (24) 26 - - Cashflow from financial acts 200 962 901 (50) (50)Net cashflow 215 285 (62) (234) 150Beginning cash 20 235 520 458 224Ending cash 235 520 458 224 374Ending net debt (113) 177 1,034 894 428Source: Nomura estimates

Balance sheet (HK$mn)As at 31 Mar FY06 FY07 FY08 FY09F FY10FCash & equivalents 235 520 458 224 374Marketable securities - 229 296 296 296Accounts receivable 8 23 356 123 142Inventories 8 26 61 128 141Other current assets 47 116 277 497 561Total current assets 298 915 1,449 1,268 1,514LT investments - 42 492 492 492Fixed assets 227 960 1,773 2,146 2,287Goodwill - 80 104 104 104Other intangible assets - 130 146 141 137Other LT assets 6 133 463 498 548Total assets 530 2,259 4,426 4,649 5,081Short-term debt 62 321 506 374 404Accounts payable 12 31 165 150 165Other current liabilities 57 204 430 476 559Total current liabilities 131 556 1,101 1,000 1,128Long-term debt 60 311 396 478 398Convertible debt - 65 590 265 - Other LT liabilities - 43 113 113 113Total liabilities 191 975 2,200 1,857 1,639Minority interest 98 240 469 714 964Preferred stock - - - - - Common stock 8 12 12 13 13Retained earnings 233 1,032 1,745 2,065 2,465Proposed dividends - - - - - Other equity and reserves - - - - - Total shareholders' equity 241 1,044 1,758 2,078 2,478Total equity & liabilities 530 2,259 4,426 4,649 5,081

Liquidity (x)Current ratio 2.27 1.65 1.32 1.27 1.34 Interest cover (19.4) (1.5) 1.0 4.2 6.2

LeverageNet debt/EBITDA (x) na na 7.49 3.10 1.11 Net debt/equity (%) net cash 16.9 58.8 43.0 17.3

Activity (days)Days receivable 49.1 40.6 90.7 106.9 51.0 Days inventory 60.4 75.3 32.0 80.9 104.5 Days payable 78.4 95.2 71.8 134.2 122.0 Cash cycle 31.2 20.8 50.8 53.6 33.6 Source: Nomura estimates

Liquidity and gearing should not be a concern in terms of overall survival, but may limit near-term growth


Beijing Enterprises Water 371 HK



Wait for better entry points Locking-in benefits from a growing water market BEW has reinvented itself into a water utility through three major acquisitions over the past six months, following its takeover by its current parent (BEH). Its acquisition of ZKC Environmental in July 2008 was made at what look undemanding valuations (14x 2008 P/E), and which provides a platform to win contracts outside Beijing. We believe its growth momentum should continue.

Clear, focused growth target As BEH’s strategic investment arm in China’s water industry, BEW has a clear focus and a well-defined management team to expand. Management is targeting to double capacity to 3.0-3.5mn m3 by end-2009 via acquisitions and/or new project biddings, and break into the top wastewater treatment players in China. A potential asset injection from BEH (combined water capacity: 1.3mn m3) seems a positive catalyst waiting to emerge in FY10F. We estimate BEW’s earnings will grow 330-60% y-y in FY09-10F (EPS: 65-40%).

Share dilution from convertibles a major overhang CBs can potentially dilute earnings by 67%, a major overhang given a conversion price of HK$0.40-0.69. However, the near-term impact should be less negative given that 75% of the CBs issued to vendor ZKC are locked-up for two years (ends FY10-11F), with a dilution effect of 33%.

Despite positive growth profile, rich valuation While we are confident in BEW’s growth prospects and management’s ability to execute, valuations look rich at 24-17x P/E (fully diluted: 31-22x) for FY09-10F and 1.6x P/BV for FY09F, compared with peer averages of 11-10x and 1.2x, respectively.

Key financials & valuations31 Dec (HK$mn) FY07 FY08F FY09F FY10FRevenue 20 549 1,498 1,989Reported net profit (2.9) 23.0 98.0 159.6Normalised net profit (2.9) 23.0 98.0 159.6Normalised EPS (HK$) (0.034) 0.023 0.037 0.052Norm. EPS growth (%) na na 64.3 38.3 Norm. P/E (x) na 124.8 31.1 22.2EV/EBITDA (x) na 23.5 15.3 10.5Price/book (x) 2.4 1.6 1.6 1.5Dividend yield (%) 0.0 0.0 0.0 0.0ROE (%) (8.8) 3.4 6.6 8.7 Net debt/equity (%) net cash 24.6 71.5 116.2Earnings revisionsPrevious norm. net profit na na naChange from previous (%) na na na Previous norm. EPS (HK$) na na naSource: Company, Nomura estimates


1m 3m 6m (5.3) 5.9 (22.4) (5.2) 5.9 (21.8) (6.6) (3.9) 8.8

Easy


304.635.7

3.80/0.680.027


Estimated free float (%)Market cap (US$mn)

Major shareholders (%)Beijing Enterprises Holdings Limited 64.3

52-week range (HK$)3-mth avg daily turnover (US$mn)Stock borrowability

0.300.801.301.802.302.803.303.804.30

Feb0

8

Mar

08

Apr0

8

May

08

Jun0

8

Jul0

8

Aug0

8

Sep0

8

Oct

08

Nov

08

Dec

08

Jan0

9

50100150200250300350

PriceRel MSCI China

(HK$)



Upside/downside 14.4%Difference from consensus naFY09F net profit (HK$mn) 98.0

Difference from consensus naSource: Nomura

Nomura vs consensusWe are the first brokerage to cover this stock. We believe BEW is overlooked and overshadowed, and should garner more attention as expansion plans bear fruit.

Initiating

NEUTRAL


Our view BEW has reinvented itself into a water utility following its takeover by Beijing

Enterprises Holdings. Management expects to double capacity to 3.0-3.5mn m3 by end-FY09. Yet valuation is rich on potential share dilution. Initiate with NEUTRAL call and HK$1.03 target price based on DCF (10.5% WACC; 0% terminal growth).

Anchor themes

China’s water resource per capita is only a quarter of the global average, but its water consumption (per unit of GDP) is 5.5x the international average. Shortages, pollution, geographical disparity and inefficient water usage are costing 8-10% of the nation’s GDP. Over 400 cities are suffering water shortages of 16mn m3/day.

The Chinese government is setting harder targets and larger budgets for the water industry to promote privatisation and capacity growth. Water quality has become a key topic for the central government, and tariffs are on an uptrend to justify returns.



Beijing Enterprises Water Evan Li


Positive drivers

Rising to be a leader Robust growth in the past to ramp up capacity Since the takeover by Beijing Enterprises Holdings (BEH, 392 HK), the current controlling parent, Beijing Enterprises Water Group (BEW) has turned itself into a water utility operator through a number of acquisitions. Its legacy business in trading computers is likely to remain within the company, but its significance may fade.

Entered into the water industry by acquiring ZKC… In July 2008, BEW acquired an 88.4% equity interest in ZKC Environmental Group (ZKC, unlisted), one of the leading operators in China’s water market, which took over 13 wastewater treatment plants (aggregated capacity of 885,000 m3). From this deal, BEW made its first and critical step into the water industry with a platform to expand.

ZKC has shown water treatment volume and net profit CAGRs of 25% and 21% during FY05-07, respectively, and the guaranteed profit of RMB100mn (by the original shareholders of ZKC) implies a 14x FY08 P/E over the price tag of HK$1.37bn, which looks undemanding compared with the prevailing multiples of comparable water utilities.

Already, one of the treatment plants under ZKC, Taizhou, has started phase 2 extension (3Q08) with an additional capacity of 50,000 m3. Upon completion of all expansion projects under the ZKC vehicle, BEW’s capacity can grow by another 15% on our estimates. As a local government-backed enterprise, the exposures of BEW and its parent are generally limited to metropolitan Beijing. We believe the acquisition of ZKC is a logical step to set new frontiers for BEW, providing more opportunity to win contracts outside of Beijing.

Exhibit 129. Water treatment volume of ZKC

105

135

165

020406080

100120140160180

2005 2006 2007

(mn m3)

25% CAGR in 2005-07


Exhibit 130. Net profit of ZKC

56

72

82

0

10

20

30

40

50

60

70

80

90

2005 2006 2007

(RMBmn)

21% CAGR in 2005-07


…a few more acquisitions were made subsequently In October 2008, BEW acquired 60% of Shenzhen Hua Qiang (unlisted) to expand coverage in Guangdong and Shandong provinces, which contributed an aggregated capacity of 315,000 m3 (not attributable). Also in January 2009, BEW’s board approved the acquisition of 80% of Guigang Municipality Water Supply Limited (unlisted), with an aggregated capacity of 200,000 m3.

BEW has turned itself into a water utility operator through a number of acquisitions

Acquired an 88.4% equity interest in ZKC — a critical step into the water industry with a platform to expand

We believe the acquisition of ZKC is a logical step to set new frontiers for BEW, providing more opportunity to win contracts outside of Beijing

Expanding coverage in Guangdong and Shandong



Exhibit 131. Strong capacity growth over the last six months in BEW

0200400600800

1,0001,2001,4001,6001,800

Acquired ZKC in July 2008

Organic growth fromexpansion and new

project biddings

Acquired Shenzhen HuaQiang

in Oct 2008

Acquired GuigangWater

in Jan 2009

In operation Under construction('000 m3)


Visible and focused growth ahead With a total capacity of 1.6mn m3 (1.3mn m3 already in operation) in its portfolio — 91% of which is in wastewater treatment and the remaining in tap water supply — BEW during the past six months has transformed itself from a loss-making trading company of computer parts into a growing, profitable wastewater utility.

Exhibit 132. BEW's capacity under portfolio in FY08-12F

1.6m3

3.1m3

4.5m3

1.6m3

2.6m3

3.6m3

4.6m3

5.6m3

0

1

2

3

4

5

6

FY08 FY09F FY10F FY11F FY12F

Management guidance Our base-case forecast('000 m3)

Expand from new project bidding and acquisitions

Water asset injection from parent (BEH)

Note: Capacity includes those in operation as well as under construction


As BEH’s strategic investment arm in China’s water industry, BEW is focused on driving earnings by expanding capacity. Management states it is eyeing projects in provinces and municipalities including Beijing, Fujian, Heilonjiang and Shandong with a total capacity of 1.9mn m3 in wastewater treatment, and 2.9mn m3 in tap water supply (some of which are covered in a memorandum of understanding). Management is targeting to double capacity to 3.0-3.5mn m3 by the end of FY09, which is likely to be accomplished via acquisitions and/or new project biddings. Further, BEH has tap water supply plants in Beijing (plant #9 and #10) and wastewater treatment plants in Hainan and Shandong provinces, with a combined capacity of 1.3mn m3. These water utilities are slated to be injected into BEW after the two-year restriction expires in FY10 on the subsidence of the back-door listing rule.

We have only factored in annual capacity growth of 1mn m3, versus guidance of 1.3-2.0m3, during FY09-10F. If BEW meets its target for the next two years, we see potential earnings upside of 30-40% over our estimates.

A growing, profitable wastewater utility

Management is eyeing projects in provinces and municipalities including Beijing, Fujian, Heilonjiang and Shandong

If BEW meets its target for the next two years, we see potential earnings upside of 30-40% over our estimates



Exhibit 133. Water assets under Beijing Enterprises Holdings Details Type Location Capacity (m3)No. 9 water plant Tap water supply Beijing 500,000 No. 10 water plant Tap water supply Beijing 500,000 Haikou plants Wastewater treatment Hainan 270,000 Weifang plants Wastewater treatment Shandong 40,000 1,310,000


Focused on being an industry leader in wastewater treatment

Positioned to capture near-term growth in wastewater treatment BEW is one of the few water players in China with a key focus on wastewater treatment (though tap water supply is within its business scope), and we think it is poised to maximise near-term growth opportunities in this emerging market.

China’s wastewater treatment system is still at a development stage and existing capacity is far behind the government’s target as per the 11th Five-Year Plan. On our estimates, China’s wastewater treatment capacity has to expand at a 19% CAGR until 2010 to meet the sewage treatment ratio of 70% (up from 63% in 2007) set by the government. Therefore we see significant growth potential in the near-term due to: 1) severe under-investment and under-penetration; 2) environmental pollution under current conditions; and 3) a sewage pipeline network has not been fully set up in many cities. On the other hand, tap water supply infrastructure is more developed and we see the industry enjoying a steady 3% CAGR along with urbanisation and population growth, where growth opportunities are more identified in privatisation / commercialisation.

Moving up the ranks Looking at wastewater treatment capacity data from H2O-China for 2007, BEW’s current wastewater treatment capacity of 1.6mn m3 (including that under construction) ranks number seven. If its capacity target of 3.0-3.5mn m3 for end-FY09 can be met, management believes BEW should move up the ranks and become a top three wastewater treatment player in China. Once market share is ramped up, the company may enjoy economies of scale.

Exhibit 134. Top players in China's wastewater treatment market Daily capacity % of total urbanRank Company Ticker (mn m3) capacity in China1 Beijing Capital 600008 CH 7.60 10.6 2 Shanghai Chengtou Holding Co. Ltd 600649 CH 3.50 4.9 3 Tianjin Capital Environmental Protection * 1065 HK 2.69 3.8 4 Shenzhen Water Group unlisted 1.86 2.6 5 Sound Group unlisted 1.77 2.5 6 General Water of China (a) 1.66 2.3 7 Beijing Enterprises Water * 371 HK 1.63 2.3 8 China Everbright International * 257 HK 1.28 1.8 9 Tsinghua Tongfang unlisted 1.20 1.7 10 Veolia Water of China (listed parent: Veolia Environment) VIE FP 1.17 1.6 11 Sino French Water (b) 0.55 0.8 12 Golden State Holdings unlisted 0.25 0.3 13 Hyflux Limited * HYF SP 0.14 0.2

Notes: a) General Water of China - listed parent is Shanghai Industrial Investment (363 HK)

b) Sino French Water - joint-venture of NWS Holdings (659 HK) and Suez (SEV FP)

* For companies under coverage, capacity is based on our estimates for end-2008; others quoted from H2O-China as of end-2007

Source: H2O-China; Nomura International (Hong Kong) Limited

Key focus on wastewater treatment

Growth potential following under-investment and under-penetration

BEW should move up the ranks and become a top three wastewater treatment player in China



Upside from joining forces with parent company

Strong support from parent BEH, the parent company, is the Beijing provincial government’s flagship in gas distribution, toll roads and technology. The group’s commitment to build out its presence in China’s growing water market will be done through BEW, according to management. Other than asset injection, we believe the parent will continue to provide financial support to ensure BEW has adequate funds for capex.

Partnership with parent creates synergy After a series of acquisitions, BEW has already employed sound technology in water treatment and exposure in operating BOT wastewater projects in various provinces. In conjunction with the parent’s competitive advantage in gas distribution, the group as a whole (BEW and its parent) can offer a well-rounded solution in the utilities sector, which prompts greater competitiveness in winning contracts.

Exhibit 135. Group structure of Beijing Enterprises Holdings (parent)

Utilities and infrastructures Consumer products Technology and others

Beijing Enterprises Water (371 HK)

2 tap water supply plants in Beijing

Haikou & Weifang sewage plants

Beijing Gas Group

Capital Airport Expressway

Shenzhen Shiguan Road

Yanjing Brewery Beijing Development

China Information Technology Development

BE High-tech

Biosino Bio-Tech

Beijing municipal government

Beijing Enterprises Group

Beijing Enterprises Holdings Limited (392 HK)

Utilities and infrastructures Consumer products Technology and others

Beijing Enterprises Water (371 HK)

2 tap water supply plants in Beijing

Haikou & Weifang sewage plants

Beijing Gas Group

Capital Airport Expressway

Shenzhen Shiguan Road

Yanjing Brewery Beijing Development

China Information Technology Development

BE High-tech

Biosino Bio-Tech








Strong backing from parent company

With its parent, BEW can offer a well-rounded solution in the utilities sector



Devil’s advocate

Dilution adds uncertainty to earnings Convertibles dilute earnings

Convertible bonds can dilute earnings by 67% BEW’s aggressive expansion was mainly financed by share placements and convertible bonds, with a potential dilution impact on the existing share base of up to 67% over the next few years, in our view.

As of end-January 2009, BEW has convertible bonds of HK$789mn outstanding. Upon the final completion of the acquisition in ZKC to enlarge BEW’s stake to 88% (from 63%), which management expects in 1H09, additional convertible bonds of HK$239mn will be issued, per the plan. At a conversion price of HK$0.40-0.69 per share (below the current share price of BEW), we believe potential dilution is a big overhang.

Exhibit 136. Convertible bonds of BEW Original Outstanding Equivalent Dilution effect Conversion principal amount at shares on existing price amount Jan 2009 in BEW share base Bonds Exercising period (HK$) (HK$'mn) (HK$'mn) (mn) (%) BondholdersTranche 1 bond July 2007 - July 2010 0.40 100.0 34.0 85 3.3 Third parties Tranche 2 bond March 2008 - March 2011 0.40 100.0 80.0 200 7.7 Third parties Firm bonds March 2008 - March 2011 0.40 200.0 120.0 300 11.5 BEH (parent) ZKC bonds (1) July 2008 - July 2013 0.69 589.3 555.1 804 30.9 Original ZKC shareholders 989.3 789.1 1,389.4 53.3

Final completion of the ZKC acquisition ZKC bonds (2) July 2009 - July 2014 0.69 238.7 - 346 13.3 Original ZKC shareholders

Note: 75% of ZKC bonds have a lock-up period of 2 years


We assume the outstanding convertible bonds are gradually exercised and converted into shares of BEW, diluting EPS by 4-16% during FY09-13F.

Exhibit 137. Convertibles and shares of BEW

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

2007 2008F 2009F 2010F 2011F 2012F 2013F

Outstanding CBs (HK$'mn)Outstanding shares in BEW (mn shares)


Exhibit 138. Net profit and EPS growth of BEW

0

50

100

150

200

250

300

350

2009F 2010F 2011F 2012F 2013F

Net profit growthEPS growth

(%)


At a conversion price of HK$0.40-0.69 per share (below the current share price of BEW), we believe potential dilution is a big overhang

Diluting EPS by 4-16% during FY09-13F



Near-term impact less negative However, the near-term impact should be less negative, given that 75% of the convertible bonds attributable to the acquisition of ZKC have a lock-up period of two years (expiring July 2010-11F), representing 863mn additional shares in BEW or 33% of the existing share base. Moreover, 70% of the ZKC bondholders (original shareholders of ZKC) have been employed by BEW as board directors or senior management, therefore the share dilution process should be gradual and under the control of management, in our view.

Exhibit 139. Exercisable period of BEW's convertible bonds Equivalent number of PotentialPeriod from which becomes exercisable shares in BEW (mn) dilution effect (%) Year 2007 85 3.3 Year 2008 701 26.9 Year 2009 86 3.3 Year 2010 603 23.2 Year 2011 259 10.0 1,735 67


To achieve BEW’s aggressive expansion target (double capacity by end-FY09), the company may continue to finance capex through new equity placements, implying further dilution. However, given that past acquisitions were mostly value-accretive, any further M&A deals should be positive to shareholders, in our view.

Exhibit 140. Existing shareholder structure

BEH (parent)

65%

Public - free float18%

Public - original ZKC

vendors17%

Source: Company data

Exhibit 141. Assume all bonds are converted by 2011F

BEH (parent)

46%

Public - free float17%

Public - original ZKC

vendors37%


BEW may look to the equity market for new financing At a 25% net debt-to-equity in FY08F, we believe raising debt for future acquisition may be a preferred choice of financing for BEW at this point. Under our current forecasts, which see BEW adding 1mn m3 of new capacity annually (starting 2009F), net debt-to-equity would reach 100-150% during FY10-12F, providing projects are financed at a 50% debt-to-asset ratio.

While debt financing appears more affordable, the company would have to leverage up its balance sheet by multiple times in order to cope with its aggressive growth target, which inevitably adds pressure on financing costs and credit risks. We believe management would have to consider new equity placements to improve liquidity, but this would see further dilution risks.

The near-term impact should be less negative, given that 75% of the convertible bonds attributable to the acquisition of ZKC have a lock-up period of two years

Potential new equity placements but deals should be value-accretive

BEW may look to the equity market for financing as its gearing streches to over 100%



Exhibit 142. BEW's net debt-to-equity and EBITDA/interest coverage

0

20

40

60

80

100

120

140

160

180

2008F 2009F 2010F 2011F 2012F 2013F 2014F0

1

2

3

4

5

6

7EBITDA/interest coverage (RHS)Net debt-to-equity (LHS)

(%) (x)


Lack of performance track record After a spree of major acquisitions over the past six months, BEW has shown strong ability in executing acquisition deals. However, the operational performance and profitability of the combined assets under BEW’s umbrella have yet to be proven.

Exhibit 143. Income statement of ZKC (Dec, RMB'mn) 2005A 2006A 2007ARevenue 209.2 170.2 337.1 Cost of sales (178.1) (121.2) (274.0)Gross profit 31.1 49.0 63.1 EBIT 82.6 108.9 144.5 Pretax profit 64.5 86.2 117.1 Net profit 50.0 68.0 80.2 GP margin (%) 14.9 28.8 18.7 EBIT margin (%) 39.5 64.0 42.9 Net margin (%) 23.9 39.9 23.8 Note: Acquired by BEW in July 2008


Exhibit 144. Income statement of Guigang Water (Dec, RMB'mn) 2005A 2006A 2007A 9M08ARevenue 28.5 32.0 36.9 29.7 Cost of sales (22.4) (21.9) (24.6) (20.3)Gross profit 6.1 10.1 12.4 9.4 EBIT (1.8) 0.6 2.8 1.0 Pretax profit (5.1) (2.4) 0.2 (0.7)Net profit (5.3) (2.4) 0.2 (0.7) GP margin (%) 21.3 31.4 33.5 31.6 EBIT margin (%) (6.2) 1.9 7.6 3.3 Net margin (%) (18.8) (7.5) 0.5 (2.4) Note: Acquired by BEW in January 2009


Acquisitions get expensive as competition intensifies Both domestic and international investors have a keen interest in the water treatment industry and are investing in major Chinese cities, such as Beijing, Shanghai, Chengdu and Wuhan. Although the majority of the water assets are still government-owned, we notice that competition is slowly developing in tier-1 cities where asset prices have inflated. Although not imminent, we believe this should gradually spread to tier-2 cities (the markets in which BEW operates) as the market matures.

Profitability of the combined assets under BEW’s umbrella has yet to be proven

Both domestic and international investors have a keen interest in the water treatment industry and are investing in major Chinese cities



Valuations

Valuations look rich DCF valuation Our valuation is based on discounted cashflow (DCF) methodology, employing a WACC of 10.50% with no terminal growth rate.

Exhibit 145. DCF model for BEW FCF (HK$'mn) 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019Reporting tevenue 1,497.7 1,989.0 2,504.9 2,777.5 3,126.4 3,483.6 3,099.2 2,566.7 2,627.9 2,689.1 2,750.3…Growth rate 33% 26% 11% 13% 11% -11% -17% 2% 2% 2%EBIT (non-IFRIC) 111.9 195.1 384.5 574.2 761.1 962.2 1,201.8 1,361.8 1,394.5 1,424.7 1,464.0Depreciation/amortization 29.3 150.8 318.0 455.9 583.1 703.9 818.7 852.8 810.1 769.6 731.2EBITDA 141.2 345.8 702.5 1,030.1 1,344.1 1,666.1 2,020.5 2,214.6 2,204.7 2,194.3 2,195.1…EBITDA margin 9% 17% 28% 37% 43% 48% 65% 86% 84% 82% 80%less:tax (36.3) (59.1) (73.0) (87.3) (106.8) (122.5) (123.8) (123.9) (142.1) (162.0) (178.9) minority interest (10.9) (17.7) (21.9) (26.2) (32.0) (36.8) (37.1) (37.2) (42.6) (48.6) (53.7) change in w orking capital 43.5 15.7 12.8 (0.2) 0.1 (2.4) (23.2) (23.1) (9.3) (9.8) (10.3) CAPEX (1,244.6) (1,822.9) (1,696.5) (1,727.9) (1,791.5) (1,852.0) (1,159.4) (426.4) (405.1) (384.8) (365.6) Leveraged FCF (1,107.2) (1,538.2) (1,076.2) (811.5) (586.1) (347.6) 677.0 1,603.9 1,605.5 1,589.1 1,586.7

WACC

Sum of PV

(HK$'mn)PV of TV (HK$'mn)

EV (HK$'mn)

Net cash/(debt) (FY09)

Equity Value

(HK$'mn)

Shares out

('000)

Value per share (HK$) WACC Calculation

6.00% (543.6) 14,766.7 14,223.1 (1,167.9) 13,055.2 2,841 4.596.50% (668.4) 13,004.2 12,335.8 (1,167.9) 11,167.9 2,841 3.93 Equity Beta 1.447.00% (786.8) 11,522.8 10,736.0 (1,167.9) 9,568.0 2,841 3.37 Risk Free Rate 2.00%7.50% (899.2) 10,264.7 9,365.5 (1,167.9) 8,197.6 2,841 2.89 Equity Risk Premium 7.50%8.00% (1,005.9) 9,186.8 8,181.0 (1,167.9) 7,013.0 2,841 2.47 Country Risk Premium 0%8.50% (1,107.1) 8,256.2 7,149.0 (1,167.9) 5,981.1 2,841 2.10 Cost of Equity 12.8%9.00% (1,203.2) 7,447.1 6,243.9 (1,167.9) 5,075.9 2,841 1.79 Cost of Debt 7.0%9.50% (1,294.4) 6,739.5 5,445.1 (1,167.9) 4,277.2 2,841 1.51 Debt/Capital 30%

10.00% (1,381.0) 6,117.4 4,736.5 (1,167.9) 3,568.5 2,841 1.26 Tax 25.0%10.50% (1,463.1) 5,567.8 4,104.7 (1,167.9) 2,936.8 2,841 1.03 WACC 10.5%11.00% (1,541.0) 5,080.1 3,539.1 (1,167.9) 2,371.2 2,841 0.8311.50% (1,614.9) 4,645.7 3,030.8 (1,167.9) 1,862.9 2,841 0.6612.00% (1,685.0) 4,257.3 2,572.3 (1,167.9) 1,404.4 2,841 0.49 Terminal grow th rate 0%12.50% (1,751.5) 3,908.9 2,157.5 (1,167.9) 989.5 2,841 0.3513.00% (1,814.5) 3,595.6 1,781.0 (1,167.9) 613.1 2,841 0.2213.50% (1,874.3) 3,312.8 1,438.5 (1,167.9) 270.6 2,841 0.1014.00% (1,931.0) 3,057.2 1,126.2 (1,167.9) (41.8) 2,841 (0.01)14.50% (1,984.7) 2,825.3 840.7 (1,167.9) (327.3) 2,841 (0.12)15.00% (2,035.6) 2,614.7 579.1 (1,167.9) (588.8) 2,841 (0.21)15.50% (2,083.8) 2,422.9 339.1 (1,167.9) (828.8) 2,841 (0.29)


Trading at premium against peers BEW is at 24-17x P/E (fully-diluted P/E of 31-22x) for FY09-10F and 1.6x P/BV for FY09F. Valuations appear richer than the comparable peer averages of 14x and 1.3x, respectively, as the market may have already priced in BEW’s potential growth.

However, given that we have only factored in annual capacity growth of 1mn m3, versus management guidance of 1.3-2.0m3 during FY09-10F, potential upside in earnings could be positive for the stock. Also, given that BEW is likely to deliver earnings growth of 330-60% during 2009-10F (EPS: 65-40%), compared with the peer average of 15-35%, its premium valuation can be justified, in our view.

For the China water stocks in our coverage, our target prices are subject to growth assumptions in treatment volumes (including tap water supply, wastewater treatment, and waste-to-energy), tariffs, capacity and capex. Changes in the macro landscape and government regulations over the water industry may result in key changes in our forecasts, and hence our target prices.

The market may have already priced in potential growth



Initiating coverage with a NEUTRAL rating on valuation We are confident about BEW’s strong growth prospects and its ability to become an industry leader (double capacity and become a top-three player in China’s wastewater treatment market) on robust support from its parent and its well-defined management team. But valuations appear richer than those of peers. Also, potential dilution from further issuance of convertible bonds or new placements would be an overhang for the share price, in our view.

Valuations appear richer than those of peers




Income statement (HK$mn)Year-end 31 Dec FY06 FY07 FY08F FY09F FY10FRevenue 36 20 549 1,498 1,989Cost of goods sold (35) (20) (423) (1,222) (1,589)Gross profit 1 0 127 276 400SG&A (5) (4) (27) (75) (99)Employee share expense - - - - - Operating profit (4) (4) 99 201 300

EBITDA (4) (4) 114 230 451Depreciation (0) (0) (15) (29) (151)Amortisation - - - - - EBIT (4) (4) 99 201 300Net interest expense - - (59) (89) (75)Associates & JCEs - - - - - Other income 1 1 1 33 12Earnings before tax (3) (3) 41 145 237Income tax 0 0 (10) (36) (59)Net profit after tax (3) (3) 31 109 177Minority interests - - (8) (11) (18)Other items - - - - - Preferred dividends - - - - - Normalised NPAT (3) (3) 23 98 160Extraordinary items - - - - - Reported NPAT (3) (3) 23 98 160Dividends - - - - - Transfer to reserves (3) (3) 23 98 160

Valuation and ratio analysisFD normalised P/E (x) na na 124.8 31.1 22.2 FD normalised P/E at price target (x) na na 142.8 35.6 25.5 Reported P/E (x) na na 39.6 24.1 17.4 Dividend yield (%) - - - - - Price/cashflow (x) 76.0 na 5.8 9.8 6.7 Price/book (x) 2.2 2.4 1.6 1.6 1.5 EV/EBITDA (x) na na 23.5 15.3 10.5 EV/EBIT (x) na na 27.1 17.6 15.8 Gross margin (%) 2.4 1.0 23.0 18.4 20.1 EBITDA margin (%) (11.2) (19.8) 20.9 15.4 22.7 EBIT margin (%) (11.4) (20.0) 18.0 13.4 15.1 Net margin (%) (9.0) (14.4) 4.2 6.5 8.0 Effective tax rate (%) na na 25.0 25.0 25.0 Dividend payout (%) na na - - - Capex to sales (%) 0.0 0.1 136.1 83.1 91.6 Capex to depreciation (x) 0.0 0.7 48.5 42.5 12.1 ROE (%) (9.7) (8.8) 3.4 6.6 8.7 ROA (pretax %) (202.4) (164.7) 7.1 5.5 5.5

Growth (%)Revenue (44.4) 2,659.4 172.8 32.8 EBITDA na na 101.0 96.1 EBIT na na 102.7 49.6 Normalised EPS na na 64.3 38.3 Normalised FDEPS na na 301.4 39.8

Per shareReported EPS (HK$) (0.04) (0.03) 0.02 0.04 0.05Norm EPS (HK$) (0.04) (0.03) 0.02 0.04 0.05Fully diluted norm EPS (HK$) (0.04) (0.03) 0.01 0.03 0.04Book value per share (HK$) 0.40 0.38 0.55 0.57 0.61DPS (HK$) - - - - - Source: Nomura estimates

Strong visible earnings growth during FY09-10F as capacity expands



Cashflow (HK$mn)Year-end 31 Dec FY06 FY07 FY08F FY09F FY10FEBITDA (4) (4) 114 230 451Change in working capital 5 (1) 459 47 22Other operating cashflow 0 (1) (417) (36) (59)Cashflow from operations 1 (6) 156 241 414Capital expenditure (0) (0) (747) (1,245) (1,823)Free cashflow 1 (6) (591) (1,004) (1,409)Reduction in investments - - (0) - - Net acquisitions - - - - - Reduction in other LT assets - - (1,107) - - Addition in other LT liabilities - - 206 - - Adjustments 1 2 902 33 12Cashflow after investing acts 2 (3) (591) (971) (1,398)Cash dividends - - - - - Equity issue 3 - - - - Debt issue - - 859 (42) 1,439Convertible debt issue - - 989 239 - Others 0 1 37 (89) (75)Cashflow from financial acts 3 1 1,885 108 1,364Net cashflow 5 (3) 1,294 (863) (34)Beginning cash 27 32 29 1,323 460Ending cash 32 29 1,323 460 426Ending net debt (32) (29) 325 1,168 2,383Source: Nomura estimates

Balance sheet (HK$mn)As at 31 Dec FY06 FY07 FY08F FY09F FY10FCash & equivalents 32 29 1,323 460 426Marketable securities - - - - - Accounts receivable 0 2 134 368 491Inventories - - 5 12 16Other current assets 2 1 180 437 572Total current assets 34 32 1,641 1,277 1,505LT investments - - 0 0 0Fixed assets 0 0 293 1,508 3,180Goodwill - - 860 860 860Other intangible assets - - 194 194 194Other LT assets - - 1,107 1,107 1,107Total assets 34 32 4,096 4,947 6,847Short-term debt - - 169 160 443Accounts payable 0 0 51 137 179Other current liabilities 1 0 725 1,184 1,425Total current liabilities 1 1 944 1,481 2,047Long-term debt - - 690 656 1,813Convertible debt - - 789 812 554Other LT liabilities - - 206 206 206Total liabilities 1 1 2,629 3,155 4,620Minority interest - - 148 158 176Preferred stock - - - - - Common stock 8 8 241 284 334Retained earnings 25 23 1,078 1,349 1,717Proposed dividends - - - - - Other equity and reserves - - - - - Total shareholders' equity 33 31 1,319 1,633 2,051Total equity & liabilities 34 32 4,096 4,947 6,847

Liquidity (x)Current ratio 45.70 47.19 1.74 0.86 0.74 Interest cover na na 1.7 2.3 4.0

LeverageNet debt/EBITDA (x) na na 2.84 5.08 5.28 Net debt/equity (%) net cash net cash 24.6 71.5 116.2

Activity (days)Days receivable 0.1 19.4 68.3 61.2 78.8 Days inventory - - 2.9 2.5 3.3 Days payable (0.0) 2.9 33.2 28.0 36.3 Cash cycle 0.2 16.5 38.1 35.7 45.7 Source: Nomura estimates

We forecast BEW will add 1mn m3 in new capacity annually (starting 2009F), and that net debt-to-equity will top 100% in the near term. Management may need to look to the equity market for financing


Hyflux HYF SP

INDUSTRIALS | SINGAPORE

Evan Li +852 2536 7746 [email protected] Daniel Raats +852 2536 7228 [email protected]

Momentum stalling Mortally dependent on equity

Pace of growth uncertain despite a healthy order book

More pressure on gearing

Valuation and risks

Mortally dependent on equity We see Hyflux’s business model as mortally dependent on equity. The ability of Hyflux to exit development projects via third-party divestments is essential to growth and the execution of its “asset light” business model. While EPC revenue is booked on a stage-of-completion basis, based on a management-assumed margin, the quality of those earnings — and indeed Hyflux’s ability to recycle and redeploy invested capital — rests crucially with successful divestment to third parties, with Hyflux Water Trust (HYFT SP, not rated) in our view, the preferred party. While we believe that recent distortions in the interbank market may well be transitory, heightened risk premiums, coupled with satellite trust HWT’s ultimately equity-dependent nature, are likely to impede the seamless divestment of water plant assets to the trust, thereby increasing capital intensity at Hyflux. The rising risk of Hyflux’s inability to recycle and redeploy capital is likely to impact future profitability.

Pace of growth uncertain despite a healthy order book Hyflux’s orderbook, currently at S$1.5bn (includes primarily municipal contracts in China and Hyflux’s two desalination projects in the Middle East and North Africa [MENA] region), has underpinned earnings expectations and should deliver a 70% CAGR in EPC revenue over FY08-10F. Management has indicated a desire to maintain earnings growth of 30%, though such expectations, in our view, are predicated on asset divestments to its satellite fund and/or third parties. Attempts by the government of the People’s Republic of China (PRC) to pump

Key financials & valuations31 Dec (S$mn) FY07 FY08F FY09F FY10FRevenue 193 478 615 699Reported net profit 46.3 54.9 65.3 79.2Normalised net profit 35.5 54.9 65.3 79.2Normalised EPS (S$) 0.068 0.105 0.126 0.152Norm. EPS growth (%) 158.0 54.6 19.0 21.2 Norm. P/E (x) 26.3 16.8 14.1 11.6EV/EBITDA (x) 19.7 13.3 12.3 11.4Price/book (x) 3.8 3.2 2.7 2.2Dividend yield (%) 0.8 1.3 1.6 1.9ROE (%) 21.0 21.0 20.8 21.1 Net debt/equity (%) 32.3 112.4 155.7 190.0Earnings revisionsPrevious norm. net profit 77.1 89.9 100.2Change from previous (%) (28.8) (27.3) (21.0)Previous norm. EPS (S$) 0.148 0.173 0.192Source: Company, Nomura estimates

Share price relative to MSCI Singapore

1m 3m 6m (8.8) (10.2) (32.2) (10.4) (10.6) (36.7) (3.2) (4.5) 7.8

Hard


52-week range (S$)3-mth avg daily turnover (US$mn)Stock borrowabilityMajor shareholders (%)Ooi Lin Lum 33.9

Absolute (S$)Absolute (US$)Relative to Index

Estimated free float (%)Market cap (US$mn) 617

66.23.71/1.27

1.17

1.01.52.02.53.03.54.0

Feb0

8

Apr0

8

Jun0

8

Aug0

8

Oct

08

Dec

08

5060708090100110

PriceRel MSCI Singapore

(S$)

Closing price on 11 Feb S$1.77

Price target S$1.90

Upside/downside 7.1%Difference from consensus -17.6%FY09F net profit (S$mn) 65.3


Nomura vs consensusGiven higher risk premiums, we expect Hyflux’s medium-term ability to divest assets to HWT to be hurt, lifting capital requirements, and supporting our below-market PT

Maintained

NEUTRAL


Our view We see earnings momentum stalling at Hyflux, as higher hurdle rates from its

satellite funds result in divestment concessions and/or lower asset valuations. With divestment risks inevitably higher, orderbook growth is likely to slow, as we expect Hyflux to conserve cash to pare debt. On transfer of coverage, maintain NEUTRAL.

Anchor themes

Regulatory changes in China’s water market have underpinned demand for the provision of water and water treatment plants. Returns, nevertheless, are not uniform, with project IRRs dictated by the quality of off-take agreements.

Traditional utility companies will increasingly have their demand growth eroded by green energy sources, such as domestic wind and solar applications and energy-saving devices and measures. Smart companies will move into the renewable space, while luddites will be de-rated.



Hyflux Evan Li


prime the economy via infrastructure developments may offer new opportunities to secure new orderbook wins, but we believe the pace of Hyflux’s orderbook growth will be constrained by the company's balance sheet and its impaired ability to divest assets to its satellite funds — with such disappointments weighing on share performance.

Exhibit 146. Hyflux: revenue by country

MENA, 38%

China, 58%

Singapore/other, 4%

Note: MENA stands for Middle East and North Africa region

Source: Company data, Nomura International (HK) Ltd

Exhibit 147. Hyflux: revenue by segment

Others, 0%

Municipal, 83%

Industrial, 17%

Note: MENA stands for Middle East and North Africa region

Source: Company data, Nomura International (HK) Ltd

More pressure on gearing The digestion of Hyflux’s mushrooming Mainland China orderbook, currently at about S$600mn, with management expressing a desire to maintain growth of 30% y-y, is predicated on third-party divestments and recycling, and redeploying capital. While we see a net debt/equity ratio of 1.12x at end-FY08E (versus 0.32x at end-FY07), we expect it to rise to 1.56x by FY10F, as the ability to divest to third parties and satellite funds is likely to be compromised by rising hurdle rates and the implicit expectation that acquisitions are “yield accretive” (the current consensus DPU yield at HWT: 12.5%). Higher hurdle rates imply that Hyflux will either have to incubate assets on its balance sheet for longer periods to ensure that they are operating at sufficient levels of utilisation to allow for yield-accretive divestment to HWT or, alternatively, the assets will need to be sold at lower valuations, in our view. We believe that both scenarios will affect profitability — lower plant valuations directly impact profitability through lower divestment gains, while longer gestation periods imply slower capital turnover (or increased capital intensity), which would affect future EPC revenue growth. More importantly, from a valuation perspective, both scenarios imply higher net capex (ie, gross capex less divestment proceeds), lower free cashflow, and thus lower valuations.

Valuation and risks Our S$1.90 price target is based on a DCF methodology, assuming a 7.8% WACC and a 4.5% terminal growth rate (unchanged). For the China water stocks in our coverage, our target prices are subject to growth assumptions in treatment volumes (including tap water supply, wastewater treatment, and waste-to-energy), tariffs, capacity and capex. Changes in the macro landscape and government regulations over the water industry may result in key changes in our forecasts, and hence our target prices.

Higher hurdle rates imply Hyflux will either have to incubate assets on its balance sheet for longer, or that the assets will need to be sold at lower valuations

Our price target of S$1.90 is based on a DCF methodology, assuming a 7.8% WACC and 4.5% terminal growth

Hyflux Evan Li


Exhibit 148. Current China orderbook Project name

Project type

Estimated completion date

Design capacity (MT)

Estimated project value (RMB)

Jiangsu Wuxi WWTP TOT 2Q08 10,000 30.8Jiangsu Yancheng Yilin WTP BOT 3Q08 50,000 82.3Shandong Xiajin WTP BOT 3Q08 100,000 239.3Jiangxi Leping WWTP BOT 4Q08 30,000 43.4Dafeng (North) WTP BOT 4Q08 20,000 37.4Yankou Rudong WWTP BOT 1Q09 20,000 55.2Jiangsu Guangyuan WWTP BOT 4Q08 30,000 72.2Jiangsu Guanyuan WTP (phase 1) BOT 4Q08 50,000 88.8Jiangsu Guanyuan WTP (phase 2) BOT 2Q09 50,000 88.8Beichen Shuangjie WWTP BOT 1Q09 50,000 90.5Beichen Shuangjie WRP BOT 1Q09 30,000 44.5Xuzhou Jiawang WTP BOT 1Q09 30,000 36.2Xuzhou Jiawang WWTP BOT 1Q09 20,000 52.4Hebei Mancheng WWTP 1 TOT 4Q09 30,000 78.54Hebei Mancheng WWTP 2 BOT 4Q09 50,000 52.36Hebei Mancheng WRP BOT 3Q09 30,000 29.3Shandong Xuecheng WWTP TOT 3Q08 40,000 63.8Shandong Xuecheng WRP BOT 1Q09 20,000 23.9Shandong Xuecheng WTP 1 TOT 2Q08 30,000 36.45Shandong Xuecheng WTP 2 BOT 4Q08 30,000 36.45Hunan Taoyuan WTP TOT 4Q08 60,000 120.4Jiangxi Leping WTP BOT 4Q09 30,000 44.5Jiansu Yilin WWTP BOT 2Q09 20,000 41.6Tianjin Dagang Desalination Plant BOO 3Q09 100,000 919Liaoning Huludao Desalination Plant BOT TBA TBA TBAJiangsu Wujin WWTP BOT TBA TBA TBAHenan Lushan WTP BOT TBA TBA TBALiaoning GongChangling WTP TOT 4Q08 40,000 107.0Anhui Mingguang WWTP TOT 4Q08 30,000 53.0Anhui Mingguang WTP BOT 4Q09 35,000 87.0Jiangsu Yangkou Port WTP BOT 2Q10 50,000 224.0Jiangsu Yangkou Port WWTP BOT 2Q10 30,000 137.0

Source: Company data, Nomura Singapore Ltd

Hyflux Evan Li


Strong EPC revenue growth driven by an orderbook of S$1.5bn


Income statement (S$mn)Year-end 31 Dec FY06 FY07 FY08F FY09F FY10FRevenue 142 193 478 615 699Cost of goods sold (78) (106) (283) (366) (406)Gross profit 65 87 195 248 294SG&A (35) (41) (106) (137) (157)Employee share expense (3) (3) (6) (8) (9)Operating profit 27 43 83 103 128

EBITDA 32 50 93 118 149Depreciation (5) (7) (10) (15) (22)AmortisationEBIT 27 43 83 103 128Net interest expense (9) (9) (17) (20) (20)Associates & JCEs (1) 1 1 1 1Other income 1 6 (3) (8) (14)Earnings before tax 18 41 65 77 95Income tax (5) (2) (6) (8) (11)Net profit after tax 14 39 59 69 83Minority interests 0 (4) (4) (4) (4)Other itemsPreferred dividendsNormalised NPAT 14 36 55 65 79Extraordinary items 6 11 - - - Reported NPAT 19 46 55 65 79Dividends (7) (7) (12) (14) (17)Transfer to reserves 12 39 43 51 62

Valuation and ratio analysisFD normalised P/E (x) 67.6 26.3 16.8 14.1 11.6 FD normalised P/E at price target (x) 72.4 28.1 18.0 15.1 12.5 Reported P/E (x) 47.6 19.9 16.8 14.1 11.6 Dividend yield (%) 0.8 0.8 1.3 1.6 1.9 Price/cashflow (x) na 12.5 7.2 10.4 8.0 Price/book (x) 4.6 3.8 3.2 2.7 2.2 EV/EBITDA (x) 33.0 19.7 13.3 12.3 11.4 EV/EBIT (x) 39.3 23.0 14.9 14.1 13.3 Gross margin (%) 45.4 45.0 40.8 40.4 42.0 EBITDA margin (%) 22.4 25.8 19.5 19.3 21.3 EBIT margin (%) 18.9 22.1 17.4 16.8 18.2 Net margin (%) 13.5 24.0 11.5 10.6 11.3 Effective tax rate (%) 26.3 5.0 9.0 10.0 12.0 Dividend payout (%) 36.5 15.8 22.0 22.0 22.0 Capex to sales (%) 21.0 15.9 74.4 48.8 58.9 Capex to depreciation (x) 6.0 4.3 36.3 19.8 19.1 ROE (%) 9.9 21.0 21.0 20.8 21.1 ROA (pretax %) 7.1 10.6 13.1 10.1 9.2

Growth (%)Revenue 8.3 35.4 148.1 28.5 13.8 EBITDA (2.7) 56.0 87.1 27.1 26.0 EBIT (6.7) 58.0 95.7 23.9 23.7 Normalised EPS 158.0 54.6 19.0 21.2 Normalised FDEPS 157.5 56.4 19.0 21.2

Per shareReported EPS (S$) 0.04 0.09 0.11 0.13 0.15Norm EPS (S$) 0.03 0.07 0.11 0.13 0.15Fully diluted norm EPS (S$) 0.03 0.07 0.11 0.13 0.15Book value per share (S$) 0.38 0.46 0.56 0.67 0.79DPS (S$) 0.01 0.01 0.02 0.03 0.03Source: Nomura estimates

Hyflux Evan Li


Higher hurdle rates at HWT imply greater capital intensity at parent Hyflux

Cashflow (S$mn)Year-end 31 Dec FY06 FY07 FY08F FY09F FY10FEBITDA 32 50 93 118 149Change in working capital (55) (37) 48 (11) (10)Other operating cashflow (6) 61 (13) (19) (24)Cashflow from operations (29) 74 128 89 115Capital expenditure (30) (31) (356) (300) (412)Free cashflow (59) 43 (228) (211) (297)Reduction in investments 2 (2) - - - Net acquisitions (20) (112) (13) (11) 23Reduction in other LT assets (91) (13) (12) 23Addition in other LT liabilities (1) (0) - - Adjustments (1) 90 13 12 (23)Cashflow after investing acts (78) (73) (241) (222) (274)Cash dividends (7) (7) (12) (14) (17)Equity issue 3 5 - - - Debt issue 79 141 195 166 281Convertible debt issueOthers (38) (0) 3 24 48Cashflow from financial acts 37 138 186 176 312Net cashflow (41) 65 (55) (46) 38Beginning cash 96 56 121 66 20Ending cash 56 121 66 20 58Ending net debt 93 77 327 539 782Source: Nomura estimates

Balance sheet (S$mn)As at 31 Dec FY06 FY07 FY08F FY09F FY10FCash & equivalents 56 121 66 20 58Marketable securities - - - - - Accounts receivable 31 46 69 92 105Inventories 11 21 23 31 35Other current assets 96 152 183 223 250Total current assets 194 340 341 365 448LT investments 6 8 8 8 8Fixed assets 193 75 406 670 1,031Goodwill 4 4 4 4 4Other intangible assets 37 38 46 56 67Other LT assets 9 100 112 124 102Total assets 443 564 918 1,227 1,660Short-term debt 34 5 - - 191Accounts payable 35 55 138 183 210Other current liabilit ies 37 60 82 95 103Total current liabilities 106 120 219 278 504Long-term debt 115 193 393 560 650Convertible debtOther LT liabilit ies 4 3 3 3 3Total liabilities 225 317 616 841 1,156Minority interest 18 7 11 40 92Preferred stockCommon stock 91 96 96 96 96Retained earnings 114 140 191 246 311Proposed dividendsOther equity and reserves (5) 4 4 4 4Total shareholders' equity 200 240 291 346 412Total equity & liabilities 443 564 918 1,227 1,660



Activity (days)Days receivable 72.7 44.0 47.7 51.3 Days inventory 54.8 28.2 26.6 29.5 Days payable 155.5 124.5 159.9 176.8 Cash cycle - (27.9) (52.3) (85.6) (96.1) Source: Nomura estimates


Epure International Ltd EPUR SP



Higher risk in BOT exposure Strong orderbook points to healthy growth Epure is a major beneficiary of growth in China’s wastewater treatment sector, and we believe it is likely to sustain its growth on the back of favourable policies aimed at helping China meet the government’s target for 70% sewage treatment. As at end-FY08F, Epure’s unrealised EPC orderbook stood at RMB1bn — unchanged from June 2008, suggesting strong market demand.

Long-term R&D investment We believe Epure has a distinct competitive edge in project bidding, due to its extensive R&D platform and award-winning treatment technologies. Its wastewater treatment system saves unit costs and meets government standards, and can produce a phosphorus content of just 0.1-0.3mg/L in treated wastewater, compared with 1.0mg/L found in traditional treatment technologies, according to management.

BOT move could mean margin contraction We remain cautious about Epure’s ability to transform itself from pure EPC vendor into well-rounded operator, since the company has yet to prove its skills in project operations. Increased exposure to build, operate and transfer (BOT) projects in FY09F is likely to intensify pressure on near-term cashflow and margins, in our view.

NEUTRAL rating due to small-cap discount Our target P/E of 8x (FY09F EPS of RMB0.2) is 2 S.D. below the stock’s historical average since listing in 2006. We believe this discount captures the increased risks expected in FY09-10F due to the company’s plan to expand BOT operations, as well as limited visibility attributable to its small market capitalisation (US$264mn). We initiate with a NEUTRAL call.

Key financials & valuations31 Dec (RMBmn) FY07 FY08F FY09F FY10FRevenue 697 941 1,177 1,353Reported net profit 164.4 207.1 253.8 291.4Normalised net profit 164.4 207.1 253.8 291.4Normalised EPS (RMB) 0.13 0.16 0.20 0.23Norm. EPS growth (%) 38.4 25.9 22.6 14.8 Norm. P/E (x) 12.7 9.8 7.7 6.7EV/EBITDA (x) 6.0 4.4 2.9 1.9Price/book (x) 1.8 1.5 1.2 1.0Dividend yield (%) 0.0 0.0 0.0 0.0ROE (%) 18.0 16.5 17.1 16.6 Net debt/equity (%) 4 net cash net cash net cashEarnings revisionsPrevious norm. net profit na na naChange from previous (%) na na naPrevious norm. EPS (RMB) na na naSource: Company, Nomura estimates


1m 3m 6m14.3 25.5 (42.9)12.2 24.8 (46.7)15.3 18.4 (9.4)

Easy


52-week range (S$)3-mth avg daily turnover (US$mn)

International Finance

Stock borrowability

8.6

Major shareholders (%)Yibo Wen 54.4



37.00.66/0.165

1.55

0.100.200.300.400.500.600.70

Feb0

8

Mar

08

Apr

08

May

08

Jun0

8

Jul0

8

Aug

08

Sep

08

Oct

08

Nov

08

Dec

08

Jan0

9

406080100120140160

PriceRel MSCI China

(S$)

Key financials & valuations31 Dec (RMBmn) FY07 FY08F FY09F FY10FRevenue 697 941 1,177 1,353Reported net profit 164.4 207.1 253.8 291.4Normalised net profit 164.4 207.1 253.8 291.4Normalised EPS (RMB) 0.13 0.16 0.20 0.23Norm. EPS growth (%) 38.4 25.9 22.6 14.8 Norm. P/E (x) 12.7 9.8 7.7 6.7EV/EBITDA (x) 6.0 4.4 2.9 1.9Price/book (x) 1.8 1.5 1.2 1.0Dividend yield (%) 0.0 0.0 0.0 0.0ROE (%) 18.0 16.5 17.1 16.6 Net debt/equity (%) 4 net cash net cash net cashEarnings revisionsPrevious norm. net profit na na naChange from previous (%) na na naPrevious norm. EPS (RMB) na na naSource: Company, Nomura estimates


1m 3m 6m14.3 25.5 (42.9)12.2 24.8 (46.7)15.3 18.4 (9.4)

Easy


52-week range (S$)3-mth avg daily turnover (US$mn)

International Finance

Stock borrowability

8.6

Major shareholders (%)Yibo Wen 54.4



37.00.66/0.165

1.55

0.100.200.300.400.500.600.70

Feb0

8

Mar

08

Apr

08

May

08

Jun0

8

Jul0

8

Aug

08

Sep

08

Oct

08

Nov

08

Dec

08

Jan0

9

406080100120140160

PriceRel MSCI China

(S$)

Closing price on 11 Feb S$0.32

Price target S$0.35

Upside/downside 9.4%Difference from consensus 0.0%FY09F net profit (RMBmn) 253.8


Nomura vs consensusWe are conservative with our assumptions, as we have only factored in 25%/15% revenue growth in FY09-10F, though management is guiding for a higher level.

Initiating

NEUTRAL


Our view Epure is a major beneficiary of China’s growing wastewater treatment market, a

segment with a 15% capacity CAGR over 2000-07. It has maintained its unrealised orderbook at RMB1bn since June 2008, indicating strong market demand. Still, we are cautious, since plans to expand BOT projects will increase earnings risk.

Anchor themes

China’s water resource per capita is only a quarter of the global average, but its water consumption (per unit of GDP) is 5.5x the international average. Shortages, pollution, geographical disparity and inefficient water usage are costing 8-10% of the nation’s GDP. Over 400 cities are suffering water shortages of 16mn m3/day.

The Chinese government is setting harder targets and larger budgets for the water industry to promote privatisation and capacity growth. Water quality has become a key topic for the central government, and tariffs are on an uptrend to justify returns.

Epure International Ltd Evan Li


Strong orderbook points to healthy growth Epure is a major beneficiary of growth in China’s wastewater treatment sector, which saw a 15% CAGR in 2000-07. Data from China’s National Bureau of Statistics indicate that China’s sewage treatment ratio was only 63% in 2007, versus the government’s target of 70% by 2010F. In this context, we believe the government is likely to introduce more favourable policies that will support higher growth rates.

As at end-2008, Epure’s unrealised EPC orderbook stood at RMB1bn, unchanged from June 2008. We believe this suggests that market demand remains strong.

Exhibit 149. Epure: revenue and net profit trends

0

200

400

600

800

1,000

1,200

1,400

1,600

2005 2006 2007 2008F 2009F 2010F

(RMBmn)Revenue Net profit


Epure has projects throughout China, including Jiangxi, Inner Mongolia, Hebei and Jilin. This project network, which mainly runs along China’s coastal areas, puts the management in a position to benefit from the growing economies locally.

Exhibit 150. Epure: record of significant projects completed Daily treatmentProject Description capacity (m3)Chengbei water supply plant project in Huzhou Municipal 300,000 Hubei Xianning water supply project Municipal 200,000 Xianghu wastewater treatment project in Nanchang Municipal 200,000 Hubei Jingmen Xiajiawan wastewater treatment project Municipal 100,000 Jilin Iron and Steel Group Corporation water supply and demineralisation project Industrial 91,000 Demineralisation Project of Inner Mongolia Jinyu Group Co., Ltd Industrial n.a. Inner Mongolia Yitai Coal Liquifaction wastewater treatment project Industrial n.a. Hebei Tangshan Guofeng Iron and Steel Co., Ltd Dafeng Corking Industrial Wastewater Treatment Project Industrial n.a. Jilin Iron and Steel Group Corporation Central Water Plant Project Regional 113,000 Hubei Yichang City Water Affairs (including tap water and sewage) management services Regional 740,000


Specialised technology: competitive advantage In our opinion, Epure’s wastewater treatment technologies give it an edge in winning bids from local governments. Its technologies cover biological filtration technology to membrane-based technology for municipal and industrial wastewater treatment.

Backed by continuous R&D investment, the company’s broad spectrum of treatment technologies are cost-effective and yet meet the Chinese government’s standards. Its proprietary solutions (eg, SPR municipal wastewater dephosphorisation) yield a phosphorus content of just 0.1-0.3mg/L in treated wastewater, compared with 1.0mg/L found in traditional treatment technologies. Epure was ranked one of the “Top Ten

Riding on sector growth

Projects throughout China

Technological edge



EPC companies of China’s water industry” in 2006, and ranked number four among the top-ten most influential water supply enterprises in China in the same year.

BOT move could mean margin contraction Epure entered into its first BOT wastewater treatment contracts in China in mid-2008, involving nine plants in Shaanxi province with a daily capacity of 10,000-30,000 m3. We remain cautious about Epure’s ability to transform from pure EPC vendor into well-rounded operator, as we think the company has yet to prove it has the requisite skills, including project management and operations. While water utilities provide rich and steady cashflows over the tenure of the project lifetime, the transition into BOT projects during FY09F could put pressure on near-term cashflow and margins, as the operational income of wastewater treatment projects often results in lower ROEs than on one-off EPC contracts.

However, we understand Epure’s parent (a private entity) has ten years of experience in BOT operations, and the listed subsidiary may be able to leverage this expertise.

NEUTRAL rating due to small-cap discount At 7.7x FY09F P/E, Epure is trading at a steep discount to the average 12x multiple of other emerging water utilities, such as Hyflux (HYF SP, NEUTRAL), China Everbright International (257 HK, BUY) and Tianjin Capital Environmental (1065 HK, REDUCE), among others. We believe P/E is an appropriate valuation methodology, since unlike other downstream water utilities which are also involved in operations with steady cash earnings, Epure is a pure EPC provider; meaning earnings depend on its prevailing orderbook of design contracts.

We set our target price based on 8x 12-month forward EPS to capture near-term growth. Our target P/E is 2 S.D. below the stock’s historical average since its public listing in 2006, to reflect increased risks expected in FY09-10F due to expansion in BOT operations (margin erosion and financial cost pressure) and limited visibility on growth, owing to the company’s small market capitalisation. We initiate coverage of Epure with a 12-month price target of S$0.35 and a NEUTRAL rating.

For the China water stocks in our coverage, our target prices are subject to growth assumptions in treatment volumes (including tap water supply, wastewater treatment, and waste-to-energy), tariffs, capacity and capex. Changes in the macro landscape and government regulations over the water industry may result in key changes in our forecasts, and hence our target prices.

Exhibit 151. Epure: 12-month forward P/E band

0

1

2

3

4

5

6

Oct

06

Nov

06

Jan

07

Feb

07

Apr

07

May

07

Jul 0

7

Aug

07

Oct

07

Nov

07

Jan

08

Feb

08

Apr

08

May

08

Jul 0

8

Aug

08

Oct

08

Nov

08

Dec

08

5x5x

10x

15x

20x

25x

Source: Company data; Bloomberg prices; Nomura International (Hong Kong) Limited

Shift from pure EPC player to well-rounded operator may hit margins

Trading at discount to other emerging water utilities




Income statement (RMBmn)Year-end 31 Dec FY06 FY07 FY08F FY09F FY10FRevenue 506 697 941 1,177 1,353Cost of goods sold (344) (474) (659) (824) (947)Gross profit 161 223 282 353 406SG&A (20) (30) (42) (59) (71)Employee share expenseOperating profit 141 193 240 294 335

EBITDA 143 195 242 296 337Depreciation (1) (1) (2) (2) (2)AmortisationEBIT 141 193 240 294 335Net interest expense (5) (0) 4 6 9Associates & JCEs - 0 - - - Other income 1 1 - - - Earnings before tax 138 194 245 300 344Income tax (22) (29) (37) (45) (52)Net profit after tax 116 166 208 255 292Minority interests (6) (1) (1) (1) (1)Other itemsPreferred dividendsNormalised NPAT 111 164 207 254 291Extraordinary itemsReported NPAT 111 164 207 254 291DividendsTransfer to reserves 111 164 207 254 291

Valuation and ratio analysisFD normalised P/E (x) 17.5 12.7 9.8 7.7 6.7 FD normalised P/E at price target (x) 19.2 13.9 10.7 8.5 7.4 Reported P/E (x) 17.5 12.7 9.8 7.7 6.7 Dividend yield (%) - - - - - Price/cashflow (x) 25.0 17.3 16.4 12.5 9.2 Price/book (x) 2.9 1.8 1.5 1.2 1.0 EV/EBITDA (x) 12.1 6.0 4.4 2.9 1.9 EV/EBIT (x) 12.2 6.1 4.5 2.9 1.9 Gross margin (%) 31.9 32.0 30.0 30.0 30.0 EBITDA margin (%) 28.2 27.9 25.7 25.1 24.9 EBIT margin (%) 28.0 27.7 25.5 25.0 24.7 Net margin (%) 21.9 23.6 22.0 21.6 21.5 Effective tax rate (%) 15.6 14.8 15.0 15.0 15.0 Dividend payout (%) - - - - - Capex to sales (%) 0.1 0.5 0.4 0.3 0.3 Capex to depreciation (x) 0.3 2.6 2.0 2.0 2.0 ROE (%) 25.6 18.0 16.5 17.1 16.6 ROA (pretax %) 30.8 31.6 32.4 30.7 29.5

Growth (%)Revenue 33.0 37.9 35.0 25.0 15.0 EBITDA 47.8 36.5 24.3 22.2 13.9 EBIT 49.0 36.7 24.3 22.3 13.9 Normalised EPS 3.8 38.4 25.9 22.6 14.8 Normalised FDEPS 3.8 38.4 25.9 22.6 14.8

Per shareReported EPS (RMB) 0.09 0.13 0.16 0.20 0.23Norm EPS (RMB) 0.09 0.13 0.16 0.20 0.23Fully diluted norm EPS (RMB) 0.09 0.13 0.16 0.20 0.23Book value per share (RMB) 0.56 0.89 1.05 1.25 1.48DPS (RMB) - - - - - Source: Nomura estimates

Source: Company data, Nomura estimates

Unrealised orderbook of RMB1bn as of end-FY08 paves the way for further growth



Cashflow (RMBmn)Year-end 31 Dec FY05 FY06 FY07 FY08F FY09FEBITDA 97 143 195 242 296Change in working capital 29 (194) 105 (81) (94)Other operating cashflow (1) 129 (180) (37) (45)Cashflow from operations 125 78 121 124 157Capital expenditure (0) (0) (4) (4) (4)Free cashflow 77 117 120 153Reduction in investments (1) (1) (58) (8)Net acquisitions - Reduction in other LT assets 0 (10) (13) - Addition in other LT liabilities - - - - Adjustments 0 (501) 85 11 24Cashflow after investing acts 125 (425) 191 60 169Cash dividends (72) (2) - - - Equity issue - 372 318 - - Debt issue 115 398 258 (10) (10)Convertible debt issueOthers (71) 205 (252) (6) (19)Cashflow from financial acts (28) 973 324 (16) (29)Net cashflow 97 548 515 44 141Beginning cash 20 117 665 1,180 1,224Ending cash 117 665 1,180 1,224 1,365Ending net debt (287) (832) (886) (1,037)Source: Nomura estimates

Balance sheet (RMBmn)As at 31 Dec FY05 FY06 FY07 FY08F FY09FCash & equivalents 117 665 1,180 1,224 1,365Marketable securitiesAccounts receivable - 579 591 753 941Inventories - 0 0 0 0Other current assets 299 1 0 0 0Total current assets 416 1,245 1,772 1,978 2,307LT investments - 1 2 60 68Fixed assets 17 16 18 20 22Goodwill - - - - - Other intangible assets - - - - - Other LT assets 3 3 12 25 25Total assets 436 1,264 1,804 2,083 2,422Short-term debt 125 378 348 338 328Accounts payable - 181 296 377 471Other current liabilities 100 6 9 9 9Total current liabilities 225 565 653 723 807Long-term debt - - - - - Convertible debt - - - - - Other LT liabilities - - - - - Total liabilities 225 565 653 723 807Minority interest 20 26 - 1 2Preferred stock - - - - - Common stock 63 516 833 833 833Retained earnings 128 157 318 525 779Proposed dividends - - - - - Other equity and reserves - - - - - Total shareholders' equity 190 673 1,152 1,359 1,613Total equity & liabilities 436 1,264 1,804 2,083 2,422

Liquidity (x)Current ratio 1.85 2.20 2.71 2.73 2.86 Interest cover 16.4 28.8 403.7 na na

LeverageNet debt/EBITDA (x) net cash net cash net cash net cash net cashNet debt/equity (%) net cash net cash net cash net cash net cash

Activity (days)Days receivable 208.9 306.2 261.3 262.8 Days inventory 0.1 0.2 0.3 0.2 Days payable 96.2 183.7 186.8 187.7 Cash cycle - 112.8 122.7 74.8 75.3

Source: Company data, Nomura estimates

Net cash position should assuage concern over liquidity and capex requirements for BOT operations



Contributor: Xiaobing Wang +852 2252 1567 [email protected]









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Explanation of Nomura’s equity research rating system for Asian companies under coverage ex Japan published from 30 October 2008 and in Japan from 6 January 2009: Stocks:

Stock recommendations are based on absolute valuation upside (downside), which is defined as (Price Target – Current Price) / Current Price, subject to limited management discretion. In most cases, the Price Target will equal the analyst’s 12-month intrinsic valuation of the stock, based on an appropriate valuation methodology such as discounted cash flow, multiple analysis, etc. • A "Buy" recommendation indicates that potential upside is 15% or more. • A "Neutral" recommendation indicates that potential upside is less than 15% or downside is less than 5%. • A "Reduce" recommendation indicates that potential downside is 5% or more. • A rating of "RS" or "Rating Suspended" indicates that the rating and target price have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstances including when Nomura is acting in an advisory capacity in a merger or strategic transaction involving the subject company. • Stocks labelled as "Not rated" or shown as "No rating" are not in Nomura's regular research coverage. Sectors:

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Explanation of Nomura's equity research rating system in Japan published prior to 6 January 2009 (and ratings in Europe, Middle East and Africa, US and Latin America published prior to 27 October 2008): Stocks:

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Explanation of Nomura's equity research rating system for Asian companies under coverage ex Japan published prior to 30 October 2008: Stocks:

Stock recommendations are based on absolute valuation upside (downside), which is defined as (Fair Value - Current Price)/Current Price, subject to limited management discretion. In most cases, the Fair Value will equal the analyst's assessment of the current intrinsic fair value of the stock using an appropriate valuation methodology such as Discounted Cash Flow or Multiple analysis etc. However, if the analyst doesn't think the market will revalue the stock over the specified time horizon due to a lack of events or catalysts, then the fair value may differ from the intrinsic fair value. In most cases, therefore, our recommendation is an assessment of the difference between current market price and our estimate of current intrinsic fair value. Recommendations are set with a 6-12 month horizon unless specified otherwise. Accordingly, within this horizon, price volatility may cause the actual upside or downside based on the prevailing market price to differ from the upside or downside implied by the recommendation. • A "Strong buy" recommendation indicates that upside is more than 20%. • A "Buy" recommendation indicates that upside is between 10% and 20%. • A "Neutral" recommendation indicates that upside or downside is less than 10%. • A "Reduce" recommendation indicates that downside is between 10% and 20%. • A "Sell" recommendation indicates that downside is more than 20%. Sectors:

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