Guangdong Investment: A Rock-Solid 4.28% Dividend Yield!

Utility companies are 'boring' stocks that hardly gets investors' hearts pumping, but they can be a reliable and steady source of dividend income for long-term investors. Investors seeking to protect their portfolios during periods of high volatility can also find comfort in the fact that utility companies typically generate strong cash flows and have resilient businesses that can weather weakening economic conditions. Of the approximately 63 utility stocks listed on the Singapore and Hong Kong exchanges, Guangdong Investment (HKEX.270) is one of the stand-out candidates due to its cash flow generation prowess, strong financial position and potential for future growth. Its dividend growth track record is a further reason to hold it as part of a diversified income portfolio.

Resilience In Water Distribution

Headquartered in Hong Kong, Guangdong Investment (GDI) is a subsidiary of the state-owned Guangdong Holdings and is primarily engaged in water distribution. It earns about two-thirds of its revenues from supplying fresh water to Hong Kong, as well as Shenzhen and Dongguan in mainland China. On top of that, GDI also owns other infrastructure assets such as power plants and toll roads in mainland China. As these utility and user-pay assets tend to generate stable and consistent cash flows, GDI is largely insulated from the economic cycle. While it also has exposure to cyclical businesses, such as its property development, department store and hotel operations, they constituted only about 23.8% of total revenues in 2016 (Chart 1). The company's five-year beta of 0.58 is also a reflection of its defensive attributes.

Chart 1: Revenues Anchored By Water Resources Segment

GDI operates the Dongshen Water Supply Project that supplies about 63.7% of Hong Kong's water needs, and from which it stands to receive a pre-determined amount of revenue from the Hong Kong government regardless of the actual volume of water supplied. This has facilitated the stable growth in its water supply revenue from Hong Kong over the years (Chart 2). The contract is re-negotiated every three years, and the payment amount for the next contract period over 2018 – 2020 will soon be discussed, although the likelihood of a price reduction is low, with Hong Kong's demand expected to be resilient given that it relies heavily on Dongshen for its water needs. The competition for Dongshen's water is also increasingly fierce due to rapid economic development in neighbouring cities, such as Shenzhen and Dongguan. Even if Hong Kong's water demand wanes, there is no scarcity of alternative off-takers, and that ensures a steady revenue stream for GDI.

Chart 2: Annual Revenues From The Hong Kong Water Supply Arrangement

Defensive Business Aids Strong Dividend Growth Track Record

As dividends are one of the primary drivers behind long-term stock returns, stocks that pay out progressively increasing dividends magnify the very strong compounding effect of reinvesting dividends. GDI is one such example, with a strong track record of paying out dividends to its shareholders over the past decade, during which its dividend per share grew at an impressive compounded annual growth rate of 15.4% (Chart 3)! Even in the aftermath of the 2007 – 2008 global financial crisis that gripped markets worldwide, GDI has also remarkably grown its dividends year after year. While past performance is not necessarily indicative of future results, GDI's strong dividend growth track record, coupled with its policy of maintaining stable dividend distributions, signals the firm's commitment towards creating long-term shareholder value.

Chart 3: Strong Dividend Growth Track Record

GDI's pace of dividend increase also looks fairly sustainable at the moment, given that the company's profits have been more than sufficient to support its dividend payments. Its pay-out ratio in recent years has fluctuated between 60 – 65%, giving shareholders an adequate return on their investment, while also providing a safety buffer in the event of a sustained downturn in profitability. Its pay-out ratio of about 65% in 2016 implies that it will take at least a -35% plunge in profits before its current dividend per share of HKD 0.42 becomes unsustainable.

It is also worth noting that GDI is a highly cash generative company, whose positive free cash flows to equity have been more than sufficient to support its dividend pay-outs over the years. While GDI has not been able to cover its dividends with free cash flows in 2016 due to a substantial debt repayment of about HKD 2.1 billion, it was only a slight short-fall. Investors can also take comfort in the fact that GDI's cash flow situation is likely to improve over the next few years, with market participants expecting GDI's increased dividends to be supported sufficiently by its cash flows.

Robust Balance Sheet Reflects Prudent Financial Management

GDI continues to maintain a strong liquidity position, with total cash on hand at HKD 14.8 billion as of end-December 2016, a level that is not too far away from its all-time high of HKD 18.2 billion back in 1H 2015. Amongst its peers, GDI has the highest cash ratio of 2.66 (Table 1), which means it is able to pay off all its current liabilities using cash, and still have ample cash remaining. The ratio is way above the peer average of 1.09, and dwarfs that of its peers with comparable market capitalisations, such as Beijing Enterprises Water, China Everbright International and Chongqing Water, which had cash ratios of 0.53, 0.69 and 1.35 respectively.

Table 1: Robust Balance Sheet Relative To Peers

Even after the acquisition of a 73.82% stake in Guangdong Land (HKEX.124) for a total consideration of HKD 3.8 billion earlier this year, GDI's net debt-to-equity ratio of -24.56 and interest coverage ratio of 42.29 still compare favourably to that of most of its other water utility peers. Given its sound financial position, GDI is unlikely to slash its dividend anytime soon, with its healthy balance sheet also providing plenty dry powder for acquisitions to further supplement future growth. The consensus is expecting the company's dividends to grow by 11.9% in 2017, which translates into a forecasted dividend yield of 4.28% that is above the Hang Seng Index average.

Well-Positioned For Future Growth

Being one of the few companies in the industry to have a net cash position, GDI remains in a good position to fund its investments in other defensive assets without the use of debt financing. It is also expected to be one of the beneficiaries in China's move towards public-private partnership (PPP) projects as an alternative means to develop and fund infrastructure projects. GDI's status as a state-owned enterprise also aids cheap access to domestic funding. Already, the company has secured a total of five PPP projects over the past two years (Table 2), and along with eight other water projects that are still under construction, they are expected to drive GDI's bottom line over the next few years when fully operational. In line with its strategy to boost its water supply capacity, GDI is likely to make further acquisitions to ramp up on the scale of its water operations.

Table 2: PPP Projects Won In 2015 And 2016

GDI has also been looking beyond its core water business for attractive acquisition opportunities. It acquired the Xingliu Expressway project from its parent company in 2015, giving GDI the right to operate it until September 2032. With five toll stations located in the Guangxi province, the expressway is slowly becoming a key project for GDI, with high profitability and a 6.0% revenue contribution in 2016 (Chart 4). The company expects traffic growth on the expressway to remain robust, driven by rising private vehicle ownership in the Guangxi province, a development that is likely to bode well for GDI's future bottom line. Meanwhile, the profitability of its coal-fired power plants, which have been negatively impacted in recent times by a sharp rise in coal prices, is expected to improve, with a stabilisation in coal prices and a planned on-grid tariff hike in 2H 2017.

Chart 4: Xingliu Generates Stable Income And Has High Margins

An Undervalued Utility Stock For The Defensive Investor

Investors can make use of the dividend discount model to determine the intrinsic value of GDI, as it pays regular dividends to its shareholders. Since declaring its first dividend in 2004, the company has been consistently paying increasing dividends each year. Assuming a discount rate of 7.3% (calculated using the capital asset pricing model) and a constant dividend growth rate of about 3.7% (assuming dividends grow in line with long-run inflation expectations), the simplified model yields an estimated target price of HKD 12.88 (Chart 5), which implies an upside potential of about 17.3% based on its last traded price of HKD 10.98 (as of 10 August 2017).

Chart 5: Using The Dividend Discount Model To Estimate Intrinsic Value

In terms of its valuation multiples, GDI currently trades at a forward price-to-earnings (PE) ratio of 14.9X (Table 3). By way of comparison, its closest competitors, Beijing Enterprises Water, China Everbright International and Chongqing Water are trading at PE ratios of 13.7X, 13.4X and 20.3X respectively. While this may be an indication that GDI's current valuations are perhaps on the upper end of the value scale, we believe the company's higher PE ratio is justified due to its superior returns on invested capital and high margins relative to most of its competitors. Its estimated dividend yield of 4.28% is also fairly high, and will certainly appeal to income investors looking for defensive dividend plays in the stock market.

Table 3: Valuations Of Water Utility Companies In China

Not Without Its Pitfalls!

GDI's rock-solid dividend yield of 4.28% certainly strikes investors as an attractive proposition, but it comes with a caveat – the Guangdong government owns a 56.5% stake in GDI. As state-owned enterprises have traditionally played strategic roles in supporting state policies, the Chinese government is likely to have a heavy hand in corporate decision making, and investors could potentially be faced with governance challenges. While GDI boasts an impressive dividend track record, strong cash flow generation and a healthy balance sheet, it is likely to act in the best interests of the government when called upon to do so, and such decisions may not help to maximise shareholder value. Non-controlling shareholders may end up on the losing end when such a scenario precipitates.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.