July 6,2006 Shanghai Municipal Raw Water (600649.SS) Gao Hua Securities Investment Research 1 July 6,2006 COMPANYUPDATE Shanghai Municipal Raw Water (600649.SS) Asset injections provide further upside catalyst What's changed We think continued injection of tap water assets is positive for the company’s fundamentals. The company has recently announced its second asset swap with Shanghai Chengtou (the investment and development arm of the Shanghai government) in order to boost its assets in the tap water business. Subject to the final approval of the regulatory body, it will transfer the Huangpu river raw water system and pay Rmb60mn to Shanghai Chengtou in exchange for the 100% ownership of Shi Nan (“City South”) tap water asset. We expect the transaction to close in October this year. Soon after the close, we expect tap water tariffs to rise by about 50%. Implications Subsequent to the asset swaps of MinHang and City South, Chengtou plans to inject further tap water and sewage treatment assets into the company next year. We also expect the company to expand its reach beyond Shanghai. By the end of this year, we expect the company to no longer engage in the raw water business but focus on the tap water and sewage treatment businesses which should offer more value-added opportunities for shareholders. Although we maintain our Neutral rating on the stock, we are becoming more positive on the stock. Within our coverage of the water utilities, we think this company has the best momentum in fundamentals in terms of asset and earnings growth. Valuation We have raised 12-month DCF-based target price by 18% to Rmb6.00. We think there are upside risk to our valuation should the future asset injection turn out to be more earnings accretive than expected. Key risks Lower-than-expected tariff increases and water volume sold. INVESTMENTLISTMEMBERSHIP Neutral Coverage View: Neutral China: Water Growth Returns * Multiple Volatility Volatility Multiple Returns * Growth Investment Profile: Shanghai Municipal Raw Water Low High Percentile 20th 40th 60th 80th 100th * Returns = Return on Capital For a complete description of the investment profile measures please refer to the disclosure section of this document. 600649.SS Asia Pacific Utilities Peer Group Average Key data Current Price (Rmb) 5.34 Price target (Rmb) 6.00 Market cap (Rmb mn / US$ mn) 10,062.7 / 1,257.4 Foreign ownership (%) -- 12/0512/06E 12/07E 12/08E EPS (Rmb) New 0.200.220.270.32 EPS revision (%) 0.04.912.631.9 EPS growth (%) (13.0) 10.621.817.9 EPS (dil) (Rmb) New 0.200.220.270.32 P/E (X) 26.724.119.816.8 P/B (X) 22.214.171.124.5 EV/EBITDA (X) 14.514.911.09.4 Dividend yield (%) 126.96.36.199.0 ROE (%) 188.8.131.52.8 Price performance chart 4.0 4.2 4.4 4.6 4.8 5.0 5.2 5.4 5.6 5.8 6.0 6.2 Jul-05 Oct-05 Jan-06 Apr-06 2,000 2,200 2,400 2,600 2,800 3,000 3,200 3,400 3,600 3,800 4,000 4,200 Shanghai Municipal Raw Water (L) FTSEXinhua 600 Index (R) Share price performance (%) 3 month 6 month 12 month Absolute (10.3) (3.6) 11.5 Rel. to FTSEXinhua 600 Index (31.1) (36.4) (34.0) Source: Company data, Goldman Sachs Research estimates, FactSet. Price as of 7/05/2006 close. Franklin Chow, CFA +86(10)6535-3012 | firstname.lastname@example.org Beijing Gao Hua Securities Company Limited Qi Zhou +86(10)6535-3054 | email@example.com Beijing Gao Hua Securities Company Limited Beijing Gao Hua Securities Company Limited and its affiliates do and seek to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For analyst certification, see the text preceding the disclosures. For other important disclosures, contact your investment representative. Beijing Gao Hua Securities Company Limited Investment Research July 6,2006 Shanghai Municipal Raw Water (600649.SS) Gao Hua Securities Investment Research 2 Shanghai Municipal Raw Water: Summary financials Profit model (Rmb mn) 12/0512/06E 12/07E 12/08EBalance sheet (Rmb mn) 12/0512/06E 12/07E 12/08E Total revenue 1,010.61,011.71,484.31,668.7 Cash & equivalents 921.5936.3720.4982.9 Cost of goods sold (366.1) (359.6) (582.2) (620.3) Accounts receivable 243.1184.5270.6304.2 SG&A (28.3) (69.6) (128.1) (116.8) Inventory 22.7164.0335.0320.7 R&D -- -- -- -- Other current assets 424.4200.0200.0200.0 Other operating profit/(expense) 2.199.9180.8116.0 Total current assets 1,611.61,484.81,525.91,807.9 EBITDA 618.3682.5954.81,047.6 Net PP&E 3,906.16,100.96,130.85,893.1 Depreciation & amortization (233.0) (241.1) (290.7) (318.4) Net intangibles 183.9180.0176.0172.1 EBIT 385.3441.4664.1729.2 Total investments 837.2778.4719.6660.7 Interest income 5.911.714.615.0 Other long-term assets 0.00.00.00.0 Interest expense (7.9) (14.3) (35.9) (43.0) Total assets 6,538.98,544.18,552.38,533.7 Income/(loss) from uncons. subs. (14.0) 0.00.00.0 Others 184.108.40.206.1 Accounts payable 10.019.731.934.0 Pretax profits 447.4513.9717.8776.3 Short-term loans 200.0405.9448.7339.0 Income tax (70.3) (96.8) (210.0) (177.7) Other current liabilities 262.31,209.3763.5763.5 Minorities 0.00.00.00.0 Total current liabilities 472.31,635.01,244.11,136.5 Long-term debt 0.0613.8713.6457.7 Net income pre-preferred 377.1417.1507.8598.6 Other long-term liabilities 0.00.00.00.0 Preferred dividends 0.00.00.00.0 Total long-term liabilities 0.0613.8713.6457.7 Net income (pre-exceptionals) 377.1417.1507.8598.6 Total liabilities 472.32,248.81,957.61,594.2 Post tax exceptionals 0.00.00.00.0 Net income 377.1417.1507.8598.6 Common stock & premium 3,963.63,963.63,963.63,963.6 Other common equity 2,103.02,331.72,631.12,975.9 EPS (basic, pre-except) (Rmb) 0.200.220.270.32 Total common equity 6,066.66,295.36,594.76,939.5 EPS (basic, post-except) (Rmb) 0.200.220.270.32 Minority interest 0.00.00.00.0 EPS (diluted, post-except) (Rmb) 0.200.220.270.32 DPS (Rmb) 0.100.110.130.16 Total liabilities & equity 6,538.98,544.18,552.38,533.7 Dividend payout ratio (%) 50.050.050.050.0 Free cash flow yield (%) 2.7 (6.7) (2.2) 8.0 BVPS (Rmb) 3.223.343.503.68 Growth & margins (%) 12/0512/06E 12/07E 12/08ERatios 12/0512/06E 12/07E 12/08E Sales growth 4.00.146.712.4 ROE (%) 220.127.116.11.8 EBITDA growth (5.4) 10.439.99.7 ROA (%) 18.104.22.168.0 EBIT growth (4.4) 14.650.49.8 ROACE (%) 22.214.171.124.0 Net income growth (13.0) 10.621.817.9 Inventory days 21.194.8156.4192.9 EPS growth (13.0) 10.621.817.9 Receivables days 66.577.156.062.9 Gross margin 63.864.560.862.8 Payable days 126.96.36.199.4 EBITDA margin 61.267.564.362.8 Net debt/equity (%) (11.9) 1.36.7 (2.7) EBIT margin 38.143.644.743.7 Interest cover - EBIT (X) 193.2169.731.226.1 Cash flow statement (Rmb mn) 12/0512/06E 12/07E 12/08EValuation 12/0512/06E 12/07E 12/08E Net income pre-preferred dividends 377.1417.1507.8598.6 P/E basic (X) 26.724.119.816.8 D&A add-back 233.0241.1290.7318.4 P/B (X) 188.8.131.52.5 Minorities interests add-back 0.00.00.00.0 EV/EBITDA (X) 14.514.911.09.4 Net inc/(dec) working capital (44.3) 1,098.4 (690.8) (17.3) Div yield (%) 184.108.40.206.0 Other operating cash flow (55.9) (21.6) (33.8) (19.5) Cash flow from operations 510.01,735.074.0880.1 Additional metrics 12/0512/06E 12/07E 12/08E Capital expenditures (249.7) (6,739.6) (282.9) (57.2) Volume output -- -- -- -- Acquisitions 0.00.00.00.0 Demand growth (%) -- -- -- -- Divestitures 1.64,329.20.00.0 Total capacity (MW) -- -- -- -- Others 57.858.858.858.8 Attributable capacity (MW) -- -- -- -- Cash flow from investments (190.2) (2,351.5) (224.1) 1.7 Peak demand (MW) -- -- -- -- Utilization rate (%) -- -- -- -- Dividends paid (common & pref) (188.4) (188.4) (208.4) (253.8) Reserve margin (%) -- -- -- -- Inc/(dec) in debt 100.0819.8142.5 (365.5) Weighted average tariffs ($k/Wh) -- -- -- -- Common stock issuance (repurchase) 0.00.00.00.0 Unit fuel costs -- -- -- -- Other financing cash flows (6.8) 0.00.00.0 Cash flow from financing (95.3) 631.3 (65.9) (619.2) Total cash flow 224.514.9 (216.0) 262.6 Note: Last actual year may include reported and estimated data. Source: Company data, Goldman Sachs Research estimates. Analyst Contributors Franklin Chow, CFA firstname.lastname@example.org Qi Zhou email@example.com July 6,2006 Shanghai Municipal Raw Water (600649.SS) Gao Hua Securities Investment Research 3 Implications: Strengthening fundamentals via transformation Becoming the tap water/sewage treatment powerhouse in Shanghai. Subsequent to the asset swaps of MinHang and City South, Chengtou plans to inject further tap water assets into the company next year. Chengtou also owns 100% of City North and 50% interest in the JV with Veolia, among other water-related assets. However, these have not been incorporated in our forecast as there is insufficient data. Proposed tariff increase is critical to the success of asset injection.2005 gross margin of the outgoing Yangtze and Huangpu raw water segment was 39%. Conversely,2005 gross margins of the incoming Minhang and City South tap water segment was a combined -7.4%, respectively. Nonetheless, raw water segments will be burdened by investments worth billions of Rmb in reservoirs aiming to stabilize supply of quality water. As these reservoirs do not directly generate incremental revenue, they could crush company margins. On the other hand, our assumed 50% tap water tariff increase should boost gross margins for the tap water segment to around 30%. Our assumption of a 50% increase is in the mid-range of the company guidance of between 40% and 60%. Further investments in the sewage treatment business. The company expects Chengtou to inject sewage treatment assets in order to broaden its exposure in this segment. However, details of these possible injections are not available yet. Expansion beyond Shanghai is imminent. Armed with the management and operational experience as well as capital, the company intends to embark on projects outside its home turf. We suspect that the company has already begun discussions on those projects. We think these expansions are particularly important for earnings growth given that we do not believe the company can rely on continuous tariff increases and there is likely limited volume growth after all the asset injections in Shanghai are completed. We are increasingly positive on the company due to its improving prospects. We have adjusted earnings (+5% for 2006E and +12% for 2007E) to incorporate the asset swaps with estimated tariff increases and fine-tune other assumptions. We maintain our Neutral rating on the stock. Valuation: Raised target price by 18% 18% rise in target price as we roll forward to 2007 data and incorporate asset swaps. We have raised our 12 month DCF-based share price target to Rmb6.00 from Rmb5.10. Of this 18% increase, about 10% is due to the new assumptions involving the asset swaps. Although this implies only a 12% upside, we think there may be upside risk to our valuation should the future asset injection turn out to be more earnings accretive than expected. Higher P/E multiple is attributable to the positive catalysts surrounding the company prospects. The new target implies a 2007EP/E of 22x which is the highest among our coverage of the four water companies (10x to 20x for others). However, we also think this company has the best momentum in fundamentals in terms of asset and earnings growth. Gao Hua Securities acknowledges the role of Stephen Oldfield and Christopher Wong of Goldman Sachs in the preparation of this note. July 6,2006 Shanghai Municipal Raw Water (600649.SS) Gao Hua Securities Investment Research 4 RegAC I, Franklin Chow, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. Investment profile The Goldman Sachs Investment Profile provides investment context for a security by comparing key attributes of that security to its peer group and market. The four key attributes depicted are: growth, returns, multiple and volatility. Growth, returns and multiple are indexed based on composites of several methodologies to determine the stocks percentile ranking within the region's coverage universe. The precise calculation of each metric may vary depending on the fiscal year, industry and region but the standard approach is as follows: Growth is a composite of next year's estimate over current year's estimate, e.g. EPS, EBITDA, Revenue. Return is a year one prospective aggregate of various return on capital measures, e.g. CROCI, ROACE, and ROE. Multiple is a composite of one-year forward valuation ratios, e.g. P/E, dividend yield, EV/FCF, EV/EBITDA, EV/DACF, Price/Book. Volatility is measured as 30-day historical volatility, annualized and adjusted for dividends. Quantum Quantum is Goldman Sachs proprietary database providing access to detailed financial statement histories, forecasts and ratios. It can be used for in- depth analysis of a single company, or to make comparisons between companies in different sectors and markets. Disclosures Coverage group(s) of stocks by primary analyst(s) Franklin Chow, CFA: China Utilities. China Utilities: Beijing Capital, GDPower Development, Guangdong Electric, Guangdong Investment, Shanghai Municipal Raw Water, Shenergy, Tianjin Capital. 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