HanKore Environment

CIMB Research, June 6

THE deal between HanKore and China Everbright International (CEI) finally went through, but at a purchase price higher than we expected. We acknowledge the positive outlook ahead but see the current share price level as very demanding. In view of the strong dilution impact from the deal, we downgrade the stock to "reduce", with a target price of S$0.91, based on 2014 residual income value.

The company needs to increase its gearing to leverage return. Potential re-rating catalysts include achieving its target gearing earlier than expected and venturing into businesses with higher returns.

The price was 5.8 billion yuan (S$1.2 billion), a premium over two valuers' valuations of 5.4 billion and 5.6 billion yuan, respectively. This translates into 2.24 times trailing price to book value or 27.3 times 2013 PE. Some 1.94 billion new shares will be issued to CEI. After the deal, CEI will hold 79.2 per cent of HanKore's enlarged issued capital.

The purchase price is not in favour of HanKore. While we acknowledge a number of positive factors from the deal, including the expected much lower interest cost and strong SOE backing, we think the economic surplus from the deal has been more or less fully captured by CEI. Investors should recognise the limitations of a concession business model and its profitability potential. The IRR (internal rate of return) of a typical municipal water treatment concession is 8 to 10 per cent. Hence, a company must gear up to have higher returns.

Even if already optimally geared, HanKore could be worth S$1.15, not far from its current price. We do not think we are conservative as our target price has factored in an EPS expansion by five times in the next five years. A decision simply based on industry price multiples is not immune to a possible industry-wise overvaluation.

Switch to China Merchants Pacific Holdings.

REDUCE