Of the three railway operators listed on the Shanghai stock exchange, only Guangshen Railway Co. (NYSE:GSH) trades as an ADR in New York. This company is a good exemplification of China's high quality, top-tier stocks and is an excellent pick as a long term investment in China's future industrial and consumer growth. An investment in Guangshen Railway offers the three cardinal investment virtues: safety, income and growth.
- Safety The company has a 16-year public record of growing earnings and keeping a healthy balance sheet.
- Income The company has paid consecutive annual dividends since 1997.
- Growth The rail industry in China is not now, nor will it soon be in decline — it is a vital component of China's economic growth.
Guangshen Railway fulfills reasonably well the four requirements of Warren Buffett: "We want businesses to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price." The railway business is easy to understand and is one favored by Uncle Warren himself with his purchase of Burlington Northern Santa Fe in 2009. Guangshen Railway has favorable long term prospects due to the popularity of rail travel in the world's fastest growing economy (on some of their lines, the company has trains scheduled every 10 minutes). Management of Guangshen railway is highly experienced and well tenured in the railway business. The stock is trading at five-year lows and at bargain valuations.
Guangshen Railway Company History
1907 The 180.8-kilometer long Canton-Kowloon Railway between Guangzhou and Kowloon began construction in 1907.
1994 Guangshen Railway Company was designated as one of 22 pilot companies in China for shareholding restructuring. Commercial operation of high-speed trains commenced during this year.
1996 After two years of shareholding restructuring, Guangshen Railway Company Limited was established as the first joint-stock railway company in China and its shares were listed in Shanghai, Hong Kong and New York.
2006 - 2008 In 2008, the company finalized the acquisition of the operating assets of Guangzhou-Pingshi Railway (the southernmost section of Beijing-Guangzhou line) which they began in 2006. This acquisition moved the company up the railway industry food chain from a regional to a national trunk operator.
Guangshen Railway Business Review
Guangshen Railway is No. 2 in market cap among the Chinese public railroad companies:
The company had 33,379 employees at year end 2011, an increase of only 1.1% from 2007. From 2006 to 2007 the company increased employees from 9,411 to 33,000 due to the acquisition of Guangzhou-Pingshi Railway.
Guangshen Railway books revenue from the following reporting segments:
- Passenger Transportation
- Freight Transportation
- Railway Network Useage & Services
Passenger Transportation accounted for 54.6% of total company revenue in 2011. As of Dec. 31, 2011, the company operated 231 pairs of passenger trains including 110 pairs of inter-city express trains between Guangzhou and Shenzhen (including 19 pairs of standby trains), 13 pairs of Hong Kong Through Trains (including 11 pairs of Guangzhou-Kowloon Through Trains, one pair of Zhaoqing-Kowloon Through Trains, one pair of Beijing/Shanghai-Kowloon Through Trains) and 108 pairs of long distance passenger trains. The company has successfully carried out their “As-Frequent-As-Buses” operating model by dispatching one pair of their domestically manufactured electric multiple unit trains, known as “China Railway High-Speed” or “CRHs”, every 10 minutes on average during peak hours between Guangzhou and Shenzhen. Passenger train services has three divisions:
- inter-city express trains between Guangzhou and Shenzhen
- Hong Kong Through Trains between Hong Kong and Guangzhou
- domestic long-distance trains
Freight Transportation accounted for 9.4% of total revenue in 2011. Principal market for freight is domestic medium and long-haul freight. The company is well equipped with various freight facilities and transports full and single load cargo and containers. They have established business cooperation with ports, logistics bases and specialized building materials markets in their service region.
The majority of the freight transport is high-volume, medium- to long-distance freight received from and/or transferred to other rail lines. A portion of the freight transported both originates and terminates in the Shenzhen-Guangzhou-Pingshi corridor. The freight business is classified into three categories:
- Inbound freight, which is primarily freight unloaded at freight stations and spur lines connected to ports on our rail line or in Hong Kong;
- outbound freight, which is primarily freight bound for other regions in Mainland China as well as foreign countries loaded at company train stations and spur lines connected to ports on company rail line or in Hong Kong; and
- pass-through freight, which refers to freight that travels on company rail line, but which does not originate from or terminate at company rail line.
Railway Network Usage and other Transportation-Related Services Business accounted for 29.0% of total revenue in 2011. Railway network usage services mainly include the locomotive traction, track usage, electric catenaries (overhead wires used to transmit electrical energy to trains), vehicle coupling and other services; other transportation-related services include railway operation services and lease of locomotive and passenger trains.
Other Businesses accounted for 7.0% of total revenue in 2011. Other businesses mainly consist of sales of materials and supplies, maintenance and repair of trains, on-board catering services, labor services and other businesses related to railway transportation.
The company summarizes itself in its literature:
With the continuous and stable increase of the economy of China, the instant innovation and development of railways, the strengthen of economic cooperation within the Pan Pearl River Delta, as well as the daily increasing economic cooperation among inland, Hong Kong and Macau, the Company will have more promising development prospects.
Guangshen Railway Financials
A quick glance at GSH five-year financials reveals a seemingly healthy and growing company with steadily growing earnings, all right profit margin, steadily growing assets with a low amount of debt staying in a range. A quick look at a five-year comparison is just a brief glimpse of the company's health, so we will have to peer closely at the long-term record of Guangshen Railway Co. to determine precisely how good its financials really are.
Guangshen Railway's income statement shows steady growth for over a decade. The company rearranged reporting segments in 2007 to account for their acquisition of the operating assets of Guangzhou-Pinshi railway. Because of this acquisition, for which they issued 2.74 billion shares on the Shanghai exchange to fund the purchase, income more than doubled from '06 to '07 and has been steadily growing since. Principally because the company acquired this new railway, income from Network & Services has become a substantial portion of overall revenue, adding approximately 25% to the company's top line since 2007. Since 2007, the company's net earnings have grown by 27.7%. During the five years prior, net earnings grew by 37.5%. The last five years of net earnings growth have fallen -26.1% from the previous five years. If the next five years trend along similar lines, the company will still grow earnings by 20.5%.
Taking a look at the balance sheets of major U.S. and Canadian railway companies reveals an average total debt-to-total assets of approximately 25%. Guangshen Railway had a very low debt-to-assets ratio of approximately 8% from '99 to '06 and a below average debt of approximately 22% from '07 to 2011. This level of debt to assets reflects a disciplined and debt averse management. Total equity has increased 151.8% from 1999 to 2011 from 10.05 billion to 25.31 billion yuan. The major capital expenditure of acquiring the Guangzhou-Pinshi railway doubled equity on the books. This is what railways are all about!
Debt-to-equity for GSH has been in the 26% to 29% range during the past five years. Before the acquisition of the new railroad, debt-to-equity held under 10%. Now that the company has doubled its assets and income, I would have expected the debt-to-equity to inflate along similar mathematics. The challenge for management will be to get this ratio back down to pre-acquisition levels before continuing further railway expansion. Guangshen Railway had a cash and equivalents greater than total liabilities 4 out of the past 13 years. I would like to see them get back to having more cash and equivalents than liabilities again before they make another large railway acquisition.
Intangible assets represented less than 1 percent of total assets in 2011. Therefore, price-to-book and price-to-intangible book are virtually the same.
In aggregate, I am happy with the balance sheet and look forward to more fiscal prudence from this company as it moves forward.
Free cash flow has been uneven over the years. The company is negative FCF 3 out of the past 5 years and 4 of the past 13 years. This situation is unfortunate and possibly explains the current low share price. In the 2011 annual report, the general manager explains yearly cash flow as follows:
In 2011, net cash inflows from operating activities were RMB3,329 million, representing a decrease of RMB2.40 million as compared to those in the same period of 2010, mainly due to the increase in income tax paid.In rough terms, the financials of Guangshen railway are three-quarters decent. The company has consistently grown both the top and bottom line in the past 13 years and they have kept debt down to a dull roar (their debt-to-equity is at an acceptable ratio). The one cause for concern is company cash flow: It is a weakness they will have to overcome in the years ahead.
In 2011, net cash outflows used in investment activities were RMB3,984 million, representing an increase of RMB2,795 million compared to those in the same period of 2010, mainly due to the increase in time deposit of more than three months during the year.
In 2011, net cash outflows used in financing activities were RMB638 million, representing an increase of RMB38.448 million compared to those in the same period of 2010, mainly due to the increase in the distribution of cash dividend to the shareholders in 2010.
Guangshen Railway Management
Aside from the purely financial aspects, the most noticeable factor regarding management is how often the top spots have changed over the years. Since 2000, the chairman of the board has changed hands five times and the same with the executive director/general manager. I have done some looking but can find no reason written anywhere in their literature why this is the case. I will have to chalk it up to "Chinese management style" — though to be honest I have not dug around to see if this is the case with other Chinese companies.
In the last reporting year, only two of the top five management positions have been with the company for a significant amount of time. Xiangdong Tang and Xiangdong Guo (not sure if they are related) have been with the company twenty-one years each. The rest are relative newbies — to the company but not the railroad industry.
Li Wenxin, the current chairman of the board, has been in and around the parent company of Guangzhou Railway Group serving in various administrative capacities since 2001. Such capacities included assistant general manager of Guangzhou Railway (Group) Company, the general manager of Huaihua Railway Company, the vice chairman of the board of Guangzhou Railway (Group) Company, the general manager of Qingzhang Railway Company, the deputy chief of transportation control center of the MOR, the chief of transportation capacity resource center of the MOR, the deputy dean of Railway Research Institute and the chief of diversified development center of the MOR.
Shen Yi, the current general manager has over 30 years of experience in railway transportation management and has served in many positions. Such positions include general manager of Hong Kong Qiwen Trade, Guangmeishan Railway and Huaihua Railway. Before joining Guangshen Railway, he was the general manager of Shichang Railway.
Bottom line: GSH is run by the steady hands of experienced railway company managers and operators.
Management also does not receive exorbitant salaries. In 2011 the highest paid position was general manager Shen Yi who earned RMB634,000 (USD99,611 equivalent). Regarding company shares, in 2011 neither the company nor its subsidiaries issued or granted any convertible securities, options, warrants or other similar rights, and redeemable securities.
While their minimal length of tenure is a question mark for this management crew, their dedication to paying regular annual dividends is a commendable practice to their collective credit. However, because of new shares issued in 2006, per share dividend went down after 2005. As well, the payout ratio has gone down from a ridiculous 109% in 2000 to 31.4% last year. I would like to see management keep the payout ratio at 30% and deliberately save any dividend increases for future railway expansion.
From 1999 to 2005 operating margin increased 209.2% while from 2006 to 2011 it flat-lined. Is the company having trouble increasing operating margin due to the overhang from their railway acquisition? Be that as it may, the company did increase net income in the last five years by 27.7%. Seen against the backdrop of steady net income gains, the company's stalled operating margin level should not be of too much consequence, for now. If the company can keep increasing revenue and net income, a flat operating margin will still produce growth of the company and hopefully, especially more cash on the balance sheet.
Guangshen Railway Valuation
The stock price of GSH has declined -65.9% from September 2007 to the present ($43.63 to $14.85). P/E and P/B at 2007 end were 25.08 and 1.77, respectively. They are now 8.74 (ttm) and 0.52 (mrq), a -65.2% and -70.6% drop in values. The stock is now trading at '08/'09 lows. Since market price= book value plus premium for future growth, GSH at 0.52 price-to-book is way undervalued.
A conservative investor looks for P/E under 10 before buying shares. GSH P/E is currently at 8.94.
A conservative investor will always look at the share price to see if it is low. Relative to 2008/2009 lows, GSH is just about on par, a marvel considering China's GDP has been running approximately 10% per annum. Since future returns are largely dependent on purchase price, now is a good time to lock in future capital gains. As I stated before under Income Statement commentary, assuming net earnings growth slows along similar lines as the past 10 years, the company will still grow bottom line by 20% in the next five years. Using the GuruFocus DCF calculator, fair value is $25.42 assuming a five-year growth rate of 20%. This provides a margin of safety of 42%.
Guangshen Railway Risks
Of the 21 risks listed by the company in its 2011 filings, there are 4 that have the "wow!" factor:
(1.) Any recurrence of a global financial crisis or economic downturn similar to that which occurred in 2008 and early 2009 could materially and adversely affect our business, financial condition, results of operations and prospects.
The global financial markets experienced periods of extreme volatility and disruption in 2008 and early 2009. The global financial crisis, [...] adversely affected the expectations for the continuous growth of the global economy, the capital markets and the consumer industry. These factors, combined with others, resulted in a severe global economic downturn and also a slowdown in the PRC economy. This change in the macro-economic conditions had an adverse impact on our business and operations by causing a decrease in the number of passengers and the volume of freight that we transported. Although the global and PRC economies began to show signs of recovery since the second half of 2009, the sustainability of these recoveries is uncertain due to escalating concerns regarding Europe’s sovereign debt crisis, the stability of the Eurozone and concerns regarding the decreased growth rate of China’s economy . In particular, we experienced decreased inbound freight volume and revenue in 2011, partially due to diminished export of PRC commodities affected by the slowdown of the global economic growth and international trades. Any recurrence of a global financial crisis [...] may adversely affect the growth of the PRC economy, which could adversely affect our business, financial condition, results of operations and prospects.My commentary: A global economic slowdown will hamper the company's ability to grow. The company could lose customers, revenues and much-needed free cash flow. The valuations could even fall back to early 2000's levels, i.e. 0.14 price-to-book value. While I would rejoice if GSH fell in valuation to a price-to-book of 0.14, I would probably be the only one (insert laughter here).
(2.) Any significant decrease in the overall levels of business, industrial, manufacturing and tourism activities within the Pearl River Delta region and elsewhere in China may have a material adverse effect on our revenue and results of operations.
The volume of freight and the number of passengers we transport are affected by the overall levels of business, industrial, manufacturing and tourism activities within the Pearl River Delta region [...]. Any significant decrease in the overall levels of passenger travel or freight transportation, whether due to an economic slowdown or other reasons, such as freezing weather, floods, earthquake and other natural disasters or a recurrence of the SARS epidemic or outbreaks of avian flu or H1N1 influenza or other similar health epidemics, may have a material adverse effect on our business, results of operations and financial condition. For example, we experienced decreased inbound freight volume and revenue in 2011, partially due to the State’s tightened policies on property and infrastructure investment projects, which led to a decrease in market demand for steel, cement and other raw materials. Furthermore, following China’s accession to the WTO, the policy advantages that Shenzhen currently enjoys due to its status as a special economic zone may be phased out, and its economic growth rate may not be sustained in the long run. Other coastal regions and ports in China may develop at a faster pace and become more competitive than Shenzhen. As a result, part of the freight currently imported or exported through ports in Hong Kong, Shenzhen or Guangzhou may be shipped through other ports in China, which may adversely affect our freight transportation business.My commentary: The company is dependent on an overall strong economy or they may suffer operating results. It is true that the Chinese government, seeing the already overheated economy of southern-coastal region now wishes to develop other areas of the country. This shift in focus could very well take away business from Guangshen Railway and is a very real risk in my opinion.
(3.) Changes in the income tax rate applicable to us as a result of a change of law could have a material adverse effect on our results of operations.
Before January 1, 2008, as a company located in the Shenzhen Special Economic Zone, we had enjoyed a preferential income tax rate of 15%, rather than the 33% income tax rate then generally applicable to domestic companies in the PRC. On March 16, 2007, the National People’s Congress of the PRC promulgated the PRC Enterprise Income Tax Law, or the EIT Law, which took effect on January 1, 2008. According to the EIT Law, the preferential income tax rate of 15% that was previously applicable to companies incorporated in Shenzhen (like us) and other special economic zones was gradually phased out over the five years beginning from January 1, 2008, and effective from January 1, 2012, the tax rate applicable to us is 25%, i.e., the unified income tax rate applicable to all domestic companies in the PRC with some minor exceptions. The increase in our effective tax rate as a result of the above and any subsequent changes to the tax laws and regulations in the PRC may adversely affect our operating results.My commentary: Since the tax rate is increasing this fiscal year, net income will be reduced and therefore free cash flow. Is this factor already priced into the company's stock? While I do not know the answer to that question, I do know the stock is undervalued already, so the downside is protected already.
(4.) We have very limited insurance coverage.
We do not maintain any insurance coverage against third party liabilities, except compulsory automobile liability insurance. In addition, we do not maintain any insurance coverage for most of our property, for business interruption or for environmental damage arising from accidents that occur in the course of our operations. As a result, we have to pay for financial and other losses, damages and liabilities, including those caused by natural disasters and other events beyond our control, out of our own funds, which could have a material adverse effect on our results of operations and financial condition.My commentary: I do not know how business is done in China, but not having comprehensive insurance seems amazingly self-confident. I mean, they have auto insurance, the same as if I crashed my vehicle! If there is an accident, the company must absorb the full cost of cleanup and reparations. This is no laughing matter, as tempted as I am to laugh. The big risk is that free cash flow will suffer and debt levels will increase. It is my hope the company will eliminate this risk factor soon.
Disclosure: Long GSH.
Questions, comments and corrections welcome. Thank you.