Guangshen Railway: A COVID-19 Victim With Potential Upside From Pricing Reform

Elevator Pitch

I have a Neutral rating on Chinese railway company Guangshen Railway Company Limited (GSH, OTCPK:GNGYF, 525:HK).

Guangshen Railway is one of the victims of COVID-19, with the company incurring a net loss attributable to shareholders of -RMB1,117 million in the first nine months of FY 2020. It is expected to remain loss-making for full-year FY 2020 due to negative operating leverage and the continued restrictions on cross-regional travel between Guangzhou, Hong Kong and Macau.

Looking beyond the pandemic, Guangshen Railway is a potential beneficiary of the ongoing railway reform in China, but it is difficult to predict the timing and extent of such pricing reforms. It is uncertain when Guangshen Railway will be allowed to charge market-oriented passenger fees for all its railway services, including both high-speed lines and conventional lines (the majority of the lines for the company). Pricing reform is a key re-rating catalyst for Guangshen Railway, as it could help the company improve its profitability in a significant manner.

Guangshen Railway trades at 17.4 consensus forward FY 2021 P/E and 0.34 times P/B, and it offers a consensus forward FY 2021 dividend yield of 3.8%.

Readers have the option of trading in Guangshen Railway shares listed either on the Over-The-Counter Bulletin Board/OTCBB as ADRs with the tickers GSH and GNGYF, or on the Hong Kong Stock Exchange with the ticker 525:HK. For those shares listed as ADRs on the OTCBB, note that liquidity is low and bid/ask spreads are wide.

For those shares listed in Hong Kong, there are limited risks associated with buying or selling the shares in terms of trade execution, given that the Hong Kong Stock Exchange is one of the major stock exchanges that is internationally recognized, and there is sufficient trading liquidity. Average daily trading value for the past three months exceeds $1 million, and market capitalization is above $2.2 billion, which is comparable to the majority of stocks traded on the US stock exchanges.

Institutional investors which own Guangshen Railway shares listed in Hong Kong include Kopernik Global Investors, BlackRock, The Vanguard Group, Dimensional Fund Advisors and State Street Global Advisors, among others. Investors can invest in key Asian stock markets either using U.S. brokers with international coverage such as Interactive Brokers and Fidelity, or international brokers with Asian coverage like Hong Kong's Monex Boom Securities and Singapore's OCBC Securities.

Company Description

Established in 1996, Guangshen Railway is a Chinese railway transportation company, and it is engaged in the business of railway passenger and freight transportation. The company operates The Shenzhen-Guangzhou-Pingshi Railway, which it refers to as "the southern part of Beijing-Guangzhou Railway, forming an aorta connecting northern and southern China" and a "key integral part of the railway transportation network" in China in its FY 2019 annual report. Apart from operating The Shenzhen-Guangzhou-Pingshi Railway, Guangshen Railway also manages the Hong Kong Through Train passenger services together with Hong Kong-listed rail operator and property company MTR Corporation Limited (OTCPK:MTRJF, OTCPK:MTCPY, 66:HK), and provides railway management services to other companies.

Victim Of The Coronavirus Pandemic

Guangshen Railway's core railroad business accounted for 94.6% of the company's FY 2019 revenue and 97.8% of its operating profit in the most recent fiscal year. The company is a victim of COVID-19, as evidenced by its 3Q 2020 and 9M 2020 financial results reported on October 28, 2020.

In the first nine months of FY 2020, the company registered a net loss attributable to shareholders of -RMB1,117 million, as compared to a net profit of RMB875 million in 9M 2019. Its revenue decreased by -26.0% YoY from RMB15.6 billion in 9M 2019 to RMB11.6 billion in 9M 2020.

Earlier, Guangshen Railway explained the reason for the YoY revenue decline in its 1H 2020 interim report, saying that "passengers’ willingness of travelling had significantly reduced, resulting in a drastic reduction in the number of trains in operation" due to COVID-19. Although COVID-19 has been relatively well-contained in Mainland China, Guangshen Railway's revenue recovery has been below expectations, as it is dependent on cross-regional travel between Guangzhou, Hong Kong and Macau, where travel restrictions relating to the pandemic have not been lifted in a significant manner.

Also, the company is loss-making despite a relatively mild -26.0% YoY decline in its top line, because of negative operating leverage. The core railroad business has a cost structure with a high proportion of fixed costs that do not vary with revenue. Furthermore, it is noteworthy that Guangshen Railway's net loss attributable to shareholders widened from -RMB151.7 million in 2Q 2020 to -RMB503.0 million in 3Q 2020. This was largely attributable to an increase in costs associated with the lifting of the exemption associated with the payment of social insurance premiums for employees (government's temporary initiatives to provide relief to companies) and a resumption of maintenance activities which were suspended in 1H 2020.

Sell-side analysts see the company remaining in a net loss position for full-year FY 2020 prior to returning to profitability in FY 2021. This will be dependent on how the COVID-19 situation evolves in Mainland China, Hong Kong and Macau, and the potential lifting of travel restrictions between these regions in the future.

Potential Beneficiary Of Railway Pricing Reform

Looking beyond COVID-19, Guangshen Railway is a potential beneficiary of the ongoing railway reform in China, first initiated in 2013. Notably, South China Morning Post reported in April 2020 that the Chinese government "has vowed to deepen market-oriented reform in key sectors of the economy," according to new policy guidelines released.

As part of the ongoing railway reform in China, the Beijing-Shanghai High Speed Railway (not operated by Guangshen Railway) announced in October 2020 that passenger fares will no longer be fixed starting on December 23, 2020. Instead, passenger fares for the Beijing-Shanghai High Speed Railway will be determined based on market factors such as passenger traffic going forward.

There are expectations that Guangshen Railway could also implement market-oriented passenger fees for its high-speed railway services soon (similar to the Beijing-Shanghai High Speed Railway), followed by the company's conventional railway lines in a few years' time. In other words, the company could possibly witness an increase in its profitability if it could charge market-oriented passenger fees on all its railway lines in time to come. Currently, passenger fees for most railway lines in the country are set by the Chinese authorities and have been kept artificially low for years (in spite of inflation), as railway services are perceived as public goods.

Competitive Dynamics In The Chinese Railway Market

Guangshen Railway noted in its FY 2019 annual report that "competition within the railway industry will also gradually increase" with the "commencement of operation of the State’s high-speed railway network." The company also added in its FY 2019 annual report that it will "proactively apply to competent authorities of the industry to add new long-distance trains in areas not yet covered by high-speed railways" as a way to deal with market competition risks. In other words, Guangshen Railway acknowledges that high-speed rail is a key competitive threat for the company.

For example, the Guangzhou-Shenzhen-Hong Kong Express Rail Link, a new high-speed railway line which started operations in late 2018, is expected to be the "fastest option for land-based, cross-border transport between Hong Kong and the Mainland," according to a South China Morning Post commentary. Those using the Guangzhou-Shenzhen-Hong Kong Express Rail Link can expect to travel between Hong Kong's West Kowloon and Guangzhou in less than an hour. Specifically, Guangshen Railway's Canton-Kowloon Through Trains, an inter-city railway service between Guangzhou and Hong Kong's Kowloon, is likely to continue to see declining traffic in time to come as high-speed rail expands across the country.

Valuation And Dividends

Guangshen Railway trades at consensus forward FY 2021 and FY 2022 P/E multiples of 17.4 times and 12.7 times, respectively based on its share price of HK$1.50 as of November 11, 2020. The company is expected to be loss-making for FY 2020. The stock is also valued by the market at 0.34 times P/B.

Guangshen Railway offers consensus forward FY 2020 and FY 2021 dividend yields of 2.3% and 3.8%, respectively. Although it is expected to be in a net loss position for this current fiscal year, sell-side analysts still expect the company to pay out dividends (albeit cut by half according to consensus estimates) for FY 2020. Guangshen Railway's dividends are supported by its net cash balance of close to RMB550 million as of September 30, 2020.

Risk Factors

The key risk factors for Guangshen Railway are a longer-than-expected for the company to return to profitability, a delay in the implementation of China's railway pricing reform initiatives, and the negative impact of high-speed rail competition being worse than expected.

Note that readers who choose to trade in Guangshen Railway shares listed as ADRs on the OTCBB (rather than shares listed in Hong Kong) could potentially suffer from lower liquidity and wider bid/ask spreads.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.