Fundamental, Industry, Thematic, Thought Leading
Deutsche Bank Company Research's Investment Policy Committee has deemed
this work F.I.T.T for investors seeking differentiated ideas. Despite the overall
positive macro environment, we believe the market has generally become too
optimistic on valuations for the China water sector. We initiate coverage on Tianjin
Capital and China Everbright with SELL ratings. We maintain our BUY on
Guangdong Investment but see only moderate upside given solid recent
performance.

The top down drivers are quite clear. China is facing a water crisis which has
resulted in positive policies including tariff hikes and aggressive targets to add
new infrastructure. This has improved the return outlook across the sector and
facilitated significant investment opportunities for listed companies. This top down
picture is however not new (although the urgency for change may be increasing).
…..but largely in the price.
In our view, the positive industry outlook is largely in the price of the companies
we cover in the sector. China Everbright is up 154% this year and up 783% since
the beginning of 2006. Tianjin Capital has also been a strong performer – up 123%
since the beginning of this year.
Valuations generally look steep (although GDI still offers moderate upside)
Our target prices are based on DCF and imply 37% & 18% downside for China
Everbright and Tianjin Capital respectively. These stocks have re-rated sharply on
P/E multiples relative to their historical trading ranges and now trade on FY08E
multiples of 35x and 38x respectively. High 2007E P/BV multiples of 5.0x and 2.4x
also look hard to justify in light of ‘07E RoEs of 9.5% and 6.9%. Guangdong
Investment stands out as offering moderate upside in our view. Our target price of
HK$5.25 is also DCF-based and the stock trades at 2008E P/E of 18x (a large
discount to peers).
Too much optimism for new projects…..
Given the massive amount of investment targeted for the industry it is likely that
established players secure new projects. However, new projects are typically
secured through bidding which is increasingly competitive given a large number of
well capitalized players (some with hurdle rates that look low to us).
…..and too much optimism on tariffs.
True, tariffs are generally on the rise however we think we’re already being quite
aggressive by assuming 3%-5% tariff hikes (well above our assumed operating
cost increases). A more upbeat tariff profile is possible, but we think unlikely,
given keen interest among investors to invest in new projects (mostly on the
assumption that tariffs merely keep pace with costs). Furthermore, rising concerns
regarding general inflation, and specific regulatory guidance on returns, are likely
to cap the upside.

Table of Contents
Executive summary ........................................................................... 3
China’s water crisis…. ..............................................................................................................3
….looks to be largely reflected in share prices .........................................................................3
Key risks...................................................................................................................................3
Valuation tables.........................................................................................................................4
China’s water crisis ........................................................................... 5
Key points ................................................................................................................................5
China is facing a serious water shortage ..................................................................................5
Urgent response required .........................................................................................................9
Typical water supply project fundamentals.............................................................................12
Wastewater treatment.................................................................... 15
Key points ...............................................................................................................................15
Aiming for a turnaround in the sewage treatment industry.....................................................15
Wastewater project fundamentals (we prefer water supply)..................................................17
Recycled water business ................................................................ 19
Industry overview ...................................................................................................................19
Tianjin Capital .................................................................................. 20
China Everbright Int'l ...................................................................... 46
Guangdong Investment .................................................................. 68
Appendix A: Other China water plays ........................................... 77
Summary................................................................................................................................77
Beijing Capital .........................................................................................................................78
Shanghai Municipal Raw Water ..............................................................................................80
China Water Affairs .................................................................................................................83
Epure International ..................................................................................................................86
Veolia Environment .................................................................................................................87
NWS Holdings and Suez (through Sino French Holdings).......................................................88
Shanghai Industrial (through General Water of China Co.) ......................................................90
Hong Kong & China Gas .........................................................................................................91