SOUND GLOBAL LTD. (SGL, 967)

Principal activities | Major shareholder/s | Integrated wastewater treatment solutions provider | Mr. Wen Yibo | Financial highlights (RMB mln) – 31 December | | 2009 | 2010 | 2011 | 2012 | 2013 | Sales | 1293.48 | 1765.67 | 2287.58 | 2652.26 | 3139.50 | Pretax profit | 292.99 | 349.07 | 481.21 | 503.41 | 566.18 | Net profit | 281.87 | 289.10 | 413.83 | 427.51 | 423.35 | Adjusted net profit | 281.87 | 289.10 | 413.83 | 427.51 | 423.35 | | | | | | | Depreciation | 2.93 | 3.15 | 3.98 | 4.53 | 5.15 | Finance cost | 13.63 | 36.82 | 108.20 | 173.61 | 285.21 | | | | | | | Current assets | 1971.48 | 3501.69 | 3701.94 | 5008.19 | 6337.75 | Current liabilities | 923.03 | 1356.49 | 2064.15 | 1763.28 | 2568.60 | Fixed assets | 611.30 | 848.61 | 1254.25 | 1830.93 | 2459.53 | Return on equity (%) | 17.92 | 14.99 | 18.04 | 16.17 | 13.79 |

Latest paid-up | | 1st half | 30/06/2013 | 30/06/2014 | 1,506 mln @ HK$0.01 each | | HKD mln | | | Market Cap | | Sales | 1474.64 | 1634.74 | HK$9.93 bln @ HK$6.59 | | Pretax profit | 229.77 | 304.43 | 2013 P/E ratio | | Net profit | 173.41 | 239.61 | Around 19 times @ HK$6.59 | | Finance cost | 143.13 | 145.63 |

BUSINESS SUMMARY & HIGHLIGHTS
The forerunner of the Company, Beijing Sound Environmental Technology Development Company, was established in 1993 by Mr. Wen Yibo and his wife. The company started with design and construction of wastewater treatment plants through EPC model. On 06-Oct 2006, the Company was listed in SGX-ST under the name of to “Epure International Pte. Ltd.”. The company entered into O&M (operation and maintenance) business with local governments in China. On 05-May 2010, the Company was renamed “Sound Global Ltd.” and listed by way of introduction on the main board of The Stock Exchange of Hong Kong. The company delisted from the SGX-ST in 2013.

The group is primarily engaged in three operating segments:
(1) Turnkey projects and services. This is an integrated service encompasses the design, procurement, engineering and construction of turnkey facilities for the treatment of municipal and industrial wastewater. As of 30-June-2014, this segment revenue (only calculate external sales) is around 91.65% of total revenue.
(2) Equipment manufacturing. The company manufactures standard and customized water and wastewater equipment mainly for use in its own projects. So the external sale is only 0.48% of total revenue as of 30-June-2014.
(3) Operations and maintenance of water and wastewater treatment facilities. This segment is management’s focus for future development. The company operates and maintains water and wastewater treatment facilities for governments. As of 30-June-2014, this segment revenue is around 7.86% of total revenue.

Share ownership
Mr. Wen Yibo and his wife, Ms. Zhang Huiming owns 50.56% of the group.

Connected and Related Party Transactions
The company incurs quite large related party transactions with its two subsidiaries, Beijing Sound and Beijng Epure in 2012 and 2013. The dividends receivable from Beijing Sound were both Rmb 294.75 million in 2012 and 2013. For Beijng Epure, the dividends receivables were Rmb 293 million and Rmb 618 million in 2012 and 2013 respectively. This arrangement is possible for tax avoidance. Beijing Sound is a Sino-foreign joint cooperative company located in Beijing Zhong Guan Cun Science Park. As it has successfully applied as a high-and-new-tech enterprise in 2011 for a period from 2011 to 2013, Beijing Sound was entitled to enjoy a preferential tax rate at 15%. Beijing Epure is a foreign investment enterprise located in Beijing Zhong Guan Cun Science Park. As a company established in a test zone, Beijing Epure was exempted from income tax for each of the years ended December 31, 2007, 2008 and 2009, and is subject to income tax at 7.5% for each of the years ended December 31, 2010, 2011 and 2012. In addition, Beijing Epure was entitled to enjoy a preferential tax rate at 15% from 2011 to 2013 as it has successfully applied as a high-and-new-tech enterprise for an effective period. Other related party transactions are mostly construct contracts, sale of goods, and design services with other subsidiaries. The amount of transaction is small, and is not special since the group is an integrated service provider.

MANAGEMENT ANALSYSIS
Wen Yibo is the founder of the Group. He is currently the Executive Director and Chairman of the company. Mr. Wen has strong backgrounds in both environmental research and industry. He graduated with a bachelor of environmental engineering from the Lanzhou Railway College (currently known as Lanzhou Jiaotong University) in July 1986. In December 1989, he graduated from Tsinghua University with a master degree in environmental engineering. In 2012, he began his PhD studies in engineering in Tsinghua University. Between 1989 and 1990, Mr. Wen worked as a lecturer in the environmental engineering department of Tsinghua University. From 1990 to 1993, he was a senior engineer at the Planning and Design Institute of the Ministry of Chemical Engineering. Mr. Wen was and is retained as a part-time professor in Tongji University, Tianjin University and Lanzhou Jiaotong University, a part-time researcher in Tianjin University and a mentor of Sound Post-Doctoral Research Centre. In November 1993, Mr. Wen and his wife, Zhang Huiming, co-founded Beijing Sound Environmental Technology Development Company and Mr. Wen has served as its chairman since then. Mr. Wen is also the chairman of another listed company, Sound Environmental Resources Co., Ltd., which is listed in China A-share market and specializes in solid waste treatment business.

Zhang Jingzhi was appointed as the Executive Director and Chief Executive Officer of the company on March 4, 2013, and is responsible for the overall management of the company. After finished MBA at Renmin University of China in April 2001, he joined the company and served as an assistant to the president. From January 2004 to March 2011, he served as a director and as a general manager and an executive general manager of Sound Environmental Resources Co., Ltd.

INDUSTRY ANALYSIS

Water Resource in China
According to Frost & Sullivan, China is one of the 13 most water-deficient countries in the world. In 2011, China’s average freshwater per capita was 1,730 m3, which was less than one-third of the global average. Pollution has further aggravated China’s water shortage. The current quality standard for ground water was introduced in 1994 by the Ministry of Environmental Protection. This classifies the quality of ground water into Grade I to V. Grade I to III are unpolluted or near unpolluted, which are suitable for drinking water. Grade IV means lightly polluted which is mainly for agricultural and industrial use and can be used for drinking after appropriate treatment. Grade V is moderate polluted, which is not suitable for drinking and may be used for other purposes. Grade V+ means heavily polluted, which is not suitable for any purpose. On average, around 29% of main rivers in China are polluted according to the Ministry of Environmental Protection. – see Table x. The situation is more severe in northern China, with half water is polluted (Songhua River, Liao River, Hai River, and Yellow River). From 2011 to 2013, the total proportion of groundwater rated in the “bad” and “very bad” categories rose from 55.0% to 59.6%, according to the Ministry of Environmental Protection.

Table x: Pollution level of main rivers in China by 2013 River | Grade I - III | Grade IV- V | Grade V+ | National | 71.7 | 19.3 | 9 | Songhua River | 55.7 | 38.6 | 5.7 | Liao River | 45.5 | 49.1 | 5.4 | Hai River | 39.1 | 21.8 | 39.1 | Yellow River | 58.1 | 25.8 | 16.1 | Huai River | 59.6 | 28.7 | 11.7 | YangTze River | 89.4 | 7.5 | 3.1 | Pearl River | 94.4 | 0 | 5.6 |

Opportunities in China’s Waste Water Treatment Industry
Chinese government attaches great importance to the growing threat of water shortages and pollution, evidenced by ambitious goals in the 12th Five Year Plan (FYP) (2011 to 2015), bringing huge opportunities to waste water treatment industry in China. – see Table x.

Table x: Waste water treatment investment target in 12-FYP Waste Water Treatment (WWT) Industry | 12-FYP Target Investment (RMB bn) | Increase from 11-FYP (2006 to 2010) | Pipeline infrastructure | 244.3 | 3.30% | Adding WWT capacity in cities and towns | 104 | 32.80% | Upgrading WWT plants | 13.7 | 0.70% | Reclaimed water utilisation facilities | 30.4 | 162.10% | Sludge treatment and disposal facilities | 34.7 | -5.20% | Total | 427.1 | 13.40% |

However, till the end of 2013, there is quite a lot remaining investment, especially in plants upgrading, sludge treatment and reclaimed water utilisation. – see Table x.

Table x: The status of waste water treatment construction in 2014-2015 | Target at 2015 | Completed at 2013 | Remaining work in 2014-2015 | Remaining as % of Target | Adding WWT capacity in cities and towns (million ton/day) | 45.69 | 26.91 | 18.78 | 41.10 | Upgrading WWT plants (million ton/day) | 26.11 | 10.78 | 15.33 | 58.71 | WWT capacity in cities and towns (million ton/day) | 208.00 | 165.00 | 43.00 | 20.67 | Pipeline infrastructure (thousand km) | 159.00 | 80.30 | 78.70 | 49.50 | Sludge treatment and disposal facilities (million ton/year) | 5.18 | 2.25 | 2.93 | 56.60 | Reclaimed water utilisation facilities (million ton/day) | 26.75 | 8.00 | 18.75 | 70.10 |

On the region distribution of WWT capacity, the municipal wastewater treatment rate in cities has reached 82.3% by the end of 11-FYP, whereas the treatment rate in counties was 60.1%. According to 12-FYP, China’s municipal wastewater treatment rate in urban areas will reach approximately 85.0%, the wastewater treatment ratio in counties is target to be over 70.0%. So the growth of newly-built treatment capacity in cities is expected to slow down, especially in the developed regions, whereas small cities and rural areas will have much higher growth rates. In fact, 12-FYP WWT capacity increase in county towns is 49.3%, compared with cities’ increase of 25%. – see Table x. Although there is no statistics of WWT capacity in small towns in 2010, the total capacity increase in small towns is almost equivalent to county towns, indicating a huge market opportunities in rural areas.

Table x: The increase of WWT capacity in cities and towns in 12-FYP (Ten thousand ton/day)

| Cities | County Towns | Small Towns | | 2010 | Increase in 12-FYP | % Increase in 12-FYP | 2010 | Increase in 12-FYP | % Increase in 12-FYP | 2010 | Increase in 12-FYP | Beijing | 364.7 | 108.3 | 29.7% | | 0 | | | 11.3 | Tianjin | 204.9 | 45.5 | 22.2% | 10.9 | 14.5 | 133.0% | | 0 | Hebei | 491.8 | 65.1 | 13.2% | 218.8 | 11 | 5.0% | | 68.7 | Shanxi | 176.3 | 34.1 | 19.3% | 96.8 | 30 | 31.0% | | 11.5 | Inner Mongolia | 155.8 | 58.9 | 37.8% | 57.3 | 20.8 | 36.3% | | 25.2 | Liaoning | 503.1 | 118 | 23.5% | 33.6 | 27 | 80.4% | | 36.5 | Jilin | 216.2 | 65 | 30.1% | 13.5 | 4 | 29.6% | | 22 | Heilongjiang | 244.1 | 152 | 62.3% | 10 | 29 | 290.0% | | 22 | Shanghai | 679.7 | 80 | 11.8% | | 30 | | | 0 | Jiangsu | 929.6 | 129.4 | 13.9% | 80.5 | 115.6 | 143.6% | | 48 | Zhejiang | 561.9 | 173.2 | 30.8% | 177.8 | 17.3 | 9.7% | | 53.6 | Anhui | 328.5 | 145 | 44.1% | 118.5 | 56 | 47.3% | | 26 | Fujian | 277.2 | 93.8 | 33.8% | 61.7 | 28.7 | 46.5% | | 52.8 | Jiangxi | 202 | 59 | 29.2% | 80.9 | 124 | 153.3% | | 25 | Shandong | 759.4 | 92.8 | 12.2% | 220 | 43.3 | 19.7% | | 48.4 | Henan | 472.4 | 77.2 | 16.3% | 193.5 | 36.7 | 19.0% | | 76.4 | Hubei | 421.4 | 141 | 33.5% | 31 | 20 | 64.5% | | 86 | Hunan | 376.7 | 110 | 29.2% | 161.8 | 100.4 | 62.1% | | 24.5 | Guangdong | 1422.9 | 232.5 | 16.3% | 57.8 | 5 | 8.7% | | 70 | Guangxi | 220.5 | 136.7 | 62.0% | 110.9 | 40.2 | 36.2% | | 11.7 | Hainan | 64.5 | 55.3 | 85.7% | 11.5 | 6.8 | 59.1% | | 15.3 | Chongqing | 187.3 | 33.3 | 17.8% | 51 | 20.9 | 41.0% | | 52.1 | Sichuan | 333.4 | 113.7 | 34.1% | 62.8 | 56.2 | 89.5% | | 23.5 | Guizhou | 122 | 54.8 | 44.9% | 48.5 | 34.9 | 72.0% | | 34.9 | Yunnan | 196.7 | 46.3 | 23.5% | 40 | 22.8 | 57.0% | | 43.5 | Tibet | 0 | 11 | | 0 | 6.5 | | | 0.5 | Shanxi | 190.3 | 64.4 | 33.8% | 45 | 30.3 | 67.3% | | 35.8 | Gansu | 99.4 | 36.7 | 36.9% | 4.8 | 25.4 | 529.2% | | 16.1 | Qinghai | 19.8 | 10 | 50.5% | 6.6 | 8.4 | 127.3% | | 4.1 | Ningxia | 56.5 | 8 | 14.2% | 2.2 | 13 | 590.9% | | 7.9 | Xinjiang | 157 | 44 | 28.0% | 32.3 | 16.3 | 50.5% | | 1.7 | Xinjiang Production and Construction Corps | | 13 | | 0 | 11 | | | 0 | Total | 10436 | 2608 | 25.0% | 2040 | 1006 | 49.3% | | 955 |

According to Discharge Standard of Pollutants for Municipal Wastewater Treatment Plant (GB18918) effective since July 2003, the highest standard for treated wastewater is Class I Standard A, followed by Class I Standard B and below. At the end of 2010, only 15.4% WWT facility has reached the Class 1 Standard A. – see Table x. With possible upgrade of discharge standard of pollutants for municipal wastewater treatment plants from Class I Standard B or lower to Class I Standard A, the upgrading and renovation of existing wastewater treatment plants could also be a driver of the industry. The increase of unit processing costs from grade 1B to 1A could be around Rmb0.2, implying an increase of 29.2% from a current unit treatment cost of Rmb0.68/t. Following cost-plus mechanism, therefore the WWT tariff is likely to increase from Rmb0.92/t in 2013 to Rmb1.11/t in 2015, representing a two-year CAGR of 10%. Even the 1A standard is not able to meet the requirements of Grade V of the groundwater standard. That is to say, the treated waste water could still pollute the environment, and further upgrading of treatment facility is still needed in the future.

Table x: Waste water treatment plants breakdown by treatment standards Standard | No. of plants (%) | Capacity (%) | 1A | 20.7 | 15.4 | 1B | 57.7 | 48.0 | 2 | 17.3 | 28.4 | 3 | 0.9 | 0.4 | others | 3.1 | 7.8 |

In addition to standard upgrade, the price increase is another important industry driver. Waste water treatment fee is quite low in China now. In China, the average sewage treatment fee (in 10 major cities) is 0.98 (Rmb/ton), and the average tap water price is 2.36 (Rmb/ton). Structurally, the waste water treatment fee is just 45% of the tap water price on average. – see Table x.

Table x: Waste water treatment fees vs tap water price in major Chinese cities as the end of 2014 (Rmb/ton) | Waste Water Treatment Fee | Tap Water Price | Sewage Treatment Fee / Tap Water Price | Beijing | 1.36 | 3.43 | 39.7% | Tianjin | 0.90 | 4.00 | 22.5% | Shenyang | 0.60 | 1.80 | 33.3% | Shanghai | 1.53 | 1.92 | 79.7% | Wuhan | 1.10 | 1.52 | 72.4% | Guangzhou | 0.90 | 1.98 | 45.5% | Shenzhen | 0.90 | 2.30 | 39.1% | Chongqing | 1.00 | 2.40 | 41.7% | Chengdu | 0.90 | 2.04 | 44.1% | Xi'an | 0.65 | 2.25 | 28.9% | Average | 0.98 | 2.36 | 44.7% |

Every year, Global Water Intelligence conducts its global tariff survey of combined municipal water and wastewater tariffs. The 2014’s survey reports the tariff for domestic customers in 355 worldwide cities. – see Table x. The global average waste water treatment fee (including sales tax) is 6.33 (Rmb/ton), which is 6.5 times higher than China’s average. The global average tap water price (including sales tax) is 7.40 (Rmb/ton), which is 3.1 times higher than China’s average. More importantly, the global pricing structure shows the waste water treatment fee is 86% of tap water price, compared with China’s 45%. This indicates waste water treatment fee has much higher potential to increase in China.

Table x: Global average water tariff breakdown Average tariff breakdown | US$/ton | Rmb/ton | Wastewater sales tax | 0.05 | 0.31 | Fixed wastewater cost | 0.28 | 1.76 | Variable wastewater cost | 0.68 | 4.26 | Water sales tax | 0.07 | 0.44 | Fixed water cost | 0.26 | 1.63 | Variable water cost | 0.85 | 5.33 | Total | 2.19 | 13.73 |

The exit of government-run WWT projects will accelerate industry consolidation and contribute to further growth of the industry. Over 50% of WWT plants were under government operation by end-2010. Rising local government debt will serve as a catalyst for the exit of inefficient government-run WWT operators. By transitioning inefficient WWT projects via TOT contracts to private operators, especially listed companies, local governments could generate the liquidity required to help pay back debt and lower their financial leverage. In addition, due to the absence of profit-making incentives, government-run WWT companies are rarely profitable. Therefore local governments are willing to exit the WWT business and let experienced water operators take over.

Operations in China’s Waste Water Treatment Industry

The waste water treatment industry in China is comprised of four main players: water treatment plants, water supply companies, local governments, and wastewater treatment plants. – see Figure x. Urban customers pay a unified water tariff, which is made up of the water resource tariff, the environmental tariff, the water supply tariff, and the infrastructure tariff, to the water supply companies. The water supply companies retain the water supply tariff and the infrastructure tariff, with the remainder of the unified water tariff being distributed to local governments. The local governments or authorised departments (normally the bureau of finance) then allocate a portion of the unified water tariff received, plus a certain amount of funding from municipal authorities, which is known as the wastewater treatment fee in aggregate, to wastewater treatment plants. However, in rural areas, the payment of water tariff could be a challenge especially in poor regions, as the local customers may not wish to pay all tariffs.

Figure x. Operation structure of China’s Waste Water Treatment Industry

There are several operating models of waste water treatment industry adopted in China:

Build, Operate, and Transfer (BOT Model): A form of project financing, wherein a private entity receives a concession from the government to finance, design, construct and operate a facility stated in the concession contract. Upon the expiry of the concession arrangement, investors return the project to the government or its designee. During the concession period (usually 20 to 30 years), the concessionaire receives regular payments from the government to recover its costs as well as to make a reasonable profit.

Transfer, Operate, and Transfer (TOT Model): The government or its designee grants a concession right to operate a facility to the concessionaire for a certain amount of consideration. The concessionaire then recovers the full investment and gets a reasonable return through operation of the facility in the concession period. Upon the expiry of the concession arrangement, the concessionaire returns the project to the government or its designee.

Build, Own and Operate (BOO Model): The contractor constructs and operates an industrial project based on the concession conferred by the government without handing over the project to the public sector.

Operation and Maintenance (O&M Model): Clients delegate the wastewater treatment projects whose construction has been completed or nearly completed to third-party professional wastewater treatment operators for operation and maintenance by paying the corresponding operating expenses.

In recent years, the BOT and TOT models, together referred to as the service concession arrangement model, have been widely implemented in the PRC. This is due to local governments have weak finance and still want to keep the ownership of WWT projects.

Technologies used in the Waste Water Treatment Industry
Wastewater treatment involves physical, chemical and biological processes to remove suspended substances and reduce COD (Chemical Oxygen Demand), BOD (Biochemical Oxygen Demand), phosphorus, and nitrogen levels. The first stage of treatment usually involves a physical process that includes settling. The second stage involves biological treatment, where the activated sludge process and other technologies are introduced to reduce COD and BOD levels. The third stage involves advanced treatment, which may include phosphorus and nitrogen removal, coagulating sedimentation, sand filtration, carbon absorption and other technologies.

In China, biological treatment technologies currently make up more than 90% of all methods for municipal wastewater treatment, with the remainder being physical, chemical and physical-chemical treatments. All these technologies are quite mature and are able to meet the current highest 1A standard. So the R&D is not especially important to the operators.

Competition Landscape
According to Frost & Sullivan, China’s wastewater treatment industry is highly fragmented. There are currently three main groups of participants: (i) state-owned enterprises (the “SOEs”), (ii) privately-owned companies, i.e. companies which are owned by non-state-owned enterprises or individuals and a majority of whose operations focus on the PRC market, irrespective of its place of incorporation, and (iii) foreign companies. The municipal wastewater treatment industry is currently dominated by the SOEs, who have 68.9% capacity in operation. In contrast, private companies have 23.5% capacity, and foreign companies only have 7.6% capacity.

Another study by H2O-China, an industry consultancy in China, which looks at WWT projects not operated by governments, also find the market is very fragmented. According to the report, the top three WWT treatment companies only have 14% market share in 2012. The industry leader, Beijing Enterprise Water, has just 6.53% market share. The top 10 companies total market share is around 25%. A brief search on listed companies in China shows there are at least 20 firms now operating WWT projects in China.

PAST PERFORMANCE
Growth
The group has achieved a compounded annual growth rate of 24.82% in revenue from 2009 to 2013.– see Figure x. Profit growth tends to be more stable. But due to high administrative expenses and finance cost, net profit growth is much smaller compared with revenue growth. – see table x.

Figure x: SGL annual revenue (Rmb in mln)

Table x: Growth (Year-on-year in %) | 2010 | 2011 | 2012 | 2013 | 1H 2014 | Revenue | 36.51 | 29.56 | 15.94 | 18.37 | 10.86 | Gross Profit | 42.78 | 34.67 | 10.85 | 19.72 | 38.08 | EBITDA | 24.78 | 51.06 | 14.58 | 25.31 | | Profit from Ops | 25.86 | 52.74 | 14.87 | 27.45 | 15.41 | Net income (adjusted) | 2.57 | 43.14 | 3.31 | -0.97 | 38.17 | EPS (fully diluted) | 6.12 | 46.66 | 3.29 | 3.16 | 26.73 | BVPS | 44.09 | 24.85 | 15.23 | 19.77 | 21.82 |

Looking at the three main business segments, the group has clearly changed its business strategy in recent years, by focusing more on O&M, and less on turnkey projects and equipment manufacturing. – see table x. In fact, as the group conducted less turnkey projects for external customers after 2011, it also sold less equipment, resulting lacklustre revenue growth. Looking forward, we expects the group’s growth in turnkey projects and services will become even slower as the remaining waste water treatment markets are in rural areas, which have much smaller size. O&M will remain strong due to its lower base.

Table x: Segment revenue breakdown (HKD in mln) | 2009 | 2010 | 2011 | 2012 | 2013 | 1H2014 | Turnkey projects and services | 1162.42 | 1610.62 | 2169.61 | 2445.96 | 2882.94 | 1498.3 | Growth rate (%) | | 38.56 | 34.71 | 12.74 | 17.87 | 9.84 | Equipment manufacturing | 125.38 | 124.41 | 58.19 | 111.99 | 63.76 | 7.89 | Growth rate (%) | | -0.77 | -53.23 | 92.46 | -43.07 | -79.42 | Operations and maintenance | 5.68 | 30.65 | 59.78 | 94.31 | 192.81 | 128.56 | Growth rate (%) | | 439.61 | 95.04 | 57.76 | 104.44 | 77.99 |

Margin Analysis
The group has recorded stable profit margins over the last several years. This is because its core business, Engineering, procurement and construction project business (EPC), is quite standard. The costs can be easily transferred to customers through the fixed contract price. Projects typically take between six and eighteen months to complete. In fact, turnkey projects and services maintained gross margin from 24% to 25% in the last four years.

The group’s administrative expenses increased significantly from 2009 to 2011 due to labour costs and the granting of stock options.

Table x: Margins and expenses Margins (% of revenue) | 2009 | 2010 | 2011 | 2012 | 2013 | 1H 2013 | 1H 2014 | Gross Profit | 29.03 | 30.36 | 31.56 | 30.18 | 30.52 | 30.12 | 30.61 | EBITDA | 24.79 | 22.66 | 26.43 | 26.12 | 27.65 | | | Profit from Ops | 23.70 | 21.86 | 25.77 | 25.53 | 27.48 | 27.21 | 28.33 | Net income (adj) | 21.79 | 16.37 | 18.09 | 16.12 | 13.48 | 11.76 | 14.66 | | | | | | | | | Expense as % of revenue | | | | | | | | Sales & distribution | 0.84 | 0.73 | 1.07 | 1.41 | 1.22 | 0.88 | 0.90 | Admin | 2.94 | 4.49 | 5.18 | 4.45 | 4.20 | 4.26 | 4.45 | Total SG&A | 3.78 | 5.21 | 6.26 | 5.86 | 5.43 | 5.14 | 5.35 |

Table x: Segment GP margin breakdown (% of revenue) | 2010 | 2011 | 2012 | 2013 | Turnkey projects and services | 25.67 | 24.35 | 24.85 | 24.03 | Equipment manufacturing | 22.27 | 89.36 | 6.70 | 15.37 | Operations and maintenance | 71.45 | 45.33 | 35.63 | 61.04 |

Dupont ROE and ROCE Analysis
The group’s ROE are relatively stable over the last 5 years. – see table x. However the declining net margin is offset by the increasing leverage since 2010. we forecast the ROE will not be able to pick up in the foreseeable future as the leverage has reached a very high level. On the net margin side, since the most profitable segments, O&M, is still small, it will not help the net margin to improve significantly. ROCE is more stable over the years – see table below.

Table x: Dupont ROE | 2009 | 2010 | 2011 | 2012 | 2013 | Adj Net income/sales (%) | 21.79 | 16.37 | 18.09 | 16.12 | 13.48 | Sales/assets (beg of year assets) (%) | 55.19 | 68.36 | 52.58 | 53.51 | 45.90 | Assets/equity (beg of year) (%) | 148.99 | 133.92 | 189.63 | 187.46 | 222.75 | ROE (%) | 17.92 | 14.99 | 18.04 | 16.17 | 13.79 |

ROCE | 2009 | 2010 | 2011 | 2012 | 2013 | Gross Debt | 987.15 | 990.84 | 2414.04 | 2651.52 | 4184.61 | BV of Equity | 1356.56 | 1591.94 | 1936.26 | 2304.67 | 2654.51 | Capital Employed (Gross Debt + BV of Equity) | 2343.71 | 2582.78 | 4350.30 | 4956.18 | 6839.13 | Op Income (tax adjusted) | 306.60 | 385.90 | 589.40 | 677.02 | 862.86 | ROCE (beg period capital) (%) | 13.08 | 14.94 | 13.55 | 13.66 | 12.62 |

Cash Flow and Dividends Analysis
The group’s free cash flow turned negative in 2010 and remains negative ever since. – see table x. This is because of the decline in operational cash flow as the group started more BOT projects after 2009. Under the scope of IFRS 12 Service Concession Arrangements, the group recognizes construction revenue in connection with BOT projects under construction period, which is also reflected in service concession receivables. Since such construction revenue brings no cash inflow, the service concession receivables will be deducted from operational cash flow. In 2013, the group acquired three BOT companies instead of building more BOT projects itself. So its operational cash flow turned positive in 2013, but the capex increased a lot. we expect the group’s free cash flow will remain negative in the near future, as BOT business will consume quite a lot of cash either through construction or acquisition.

Because of poor cash flow generation, the group is not interested to pay dividends. – see table x. In fact, the group hasn’t pay any dividend after listing in Hong Kong.

Table x: Free Cash Flow and Dividends (Rmb in mln) | 2009 | 2010 | 2011 | 2012 | 2013 | CF from Operations | 391.68 | -228.60 | -244.88 | -105.73 | 117.01 | Capex | -3.26 | 0.44 | -1.86 | -4.78 | -130.43 | FCF (Op CF - capex) | 388.42 | -228.16 | -246.74 | -110.51 | -13.42 | | | | | | | Regular DPS (SGD) | 0.00 | 0.01 | 0.01 | 0.00 | 0.00 | Div payout rate (%) | 0 | 22.86 | 16.17 | 0 | 0 | Total Div/FCF (%) | NM | NM | NM | NM | NM |

Capital Raising and Debt Analysis
The group proposed to issue equity to Sound Environmental Resources in November 2014. The deal is still under review of CSRC. Other than that, there is no further equity issuance after the group listed in Hong Kong in 2010. The group’s net debt to equity increased rapidly after the group entered into BOT business, which is very capital intensive. – see table x.

Debt (Rmb in mln) | 2009 | 2010 | 2011 | 2012 | 2013 | 1H 2014 | Net debt (cash) | -246.86 | 386.69 | 577.09 | 1272.54 | 2189.44 | 1843.84 | Net debt/equity (%) | -15.51 | 19.97 | 25.04 | 47.94 | 71.22 | 47.31 | Gross debt | 990.84 | 2414.04 | 2651.52 | 4184.61 | 5722.99 | 5597.11 | Gross debt/equity (%) | 62.24 | 124.68 | 115.05 | 157.64 | 186.16 | 143.61 | Net debt/EBITDA (%) | -76.97 | 96.63 | 95.46 | 183.71 | 252.24 | |

STRENGTHS AND WEAKNESSES
Strengths
The company’s SMART technology is specifically designed for WWT in small towns, which is the biggest potential market. Such technology is very cost efficient, and has been successfully adopted in several provinces through the supported from Asian Development Bank. This demonstrates the company has some technology advantages against other competitors as the company has a lot of experience in engineering and equipment manufacturing.

The company has changed its strategy to focus more on BOT/TOT. In fact, the company is now in the process of acquiring WWT assets from the parent company, which could boost its growth in the near future. After such restructuring, there should be no competition with its parent group.

Recent rate cuts by PBOC may benefit the company more as its finance cost is among the highest in the industry with 9% effective interest rate.

Weaknesses
The company’s reputation in the capital market is not quite good. On 4-Dec 2014, SFC publicly criticised Mr. Wen Yibo for acquiring shares in Sound Global within 6 months after the close of an offer at above the offer price in contravention of Rule 31.3 of the Takeovers Code. Although the event is not severe, it reflects a lack of internal control within the firm.

The latest report by a short seller has driven down the share price by more than 20%, raising concerns on its accounting. Although the company has refuted those charges, its construction segment does look opaque for investors.

Most of the company revenue is still from construction, which is difficult to grow in future considering the high WWT ratio in cities. Its highest growing segment, O&M, only contribute less than 8% of revenue in 1H2014.

PROSPECTS
WWT market in China still has high potentials to grow in the future. Firstly, the water pollution is very severe in China, especially in northern China. Secondly, the Chinese government is determined to invest more in environmental protection with other supportive policies, such as the increase of sewage treatment fees. Thirdly, the current treatment capacity and standard are well below the global standard, especially in small cities and rural areas. Fourthly, the Ministry of Finance of the PRC has announced an official definition of Public-Private-Partnership (PPP) for the very first time in September 2014. This policy encouragement paves the way for listed firms to participate more into the industry restructuring.

Entry barrier to this industry is actually not low. First of all, the industry is very capital intensive. A typical BOT or TOT project requires large commitments of capital in advance. Secondly, good government relationship is important to get a service concession agreement. New industry entrants may have more difficulty in winning trusts from the government. Thirdly, WWT is natural monopoly: the transportation cost of waste water is very high due to the lack of long-range pipelines in China. In addition, it’s difficult to combine different waste waters to transport in one pipeline due to possible chemical reactions. So the distribution of WWT plants has to be evenly across the region.

Despite such a good industry prospect, the main business model (BOT/TOT) is too capital intensive. Companies have to borrow a lot to invest, resulting negative free cash-flows. Almost all future payoffs of such large investments rely on local governments’ creditworthiness. In addition, the competition is quite intensive: at least 20 listed companies now competing in the industry. Despite Sound Global has technology advantage, the remaining big market for the company is only small towns. Governments at town level may have less healthy finance.

VALUATION and RECOMMENDATION
Sound Global has a long experience in waste water treatment industry. The company focuses more on construction business in the past, and accumulates much engineering and technology experience. But plant construction is a one-off gain business, so the company has difficulty in achieving a long-term high growth with the increasing WWT treatment ratio across China. The company has expanded into BOT/TOT in recent years, but with the increasing competition, the growth looks challenging.

The group is currently trading at around 16 times estimated 2014 P/E and 1.74 times 2013 Price to Book. we believe such a high valuation is not justified. The construction revenue growth will shrink quickly, the BOT business will pick up but still in a relatively small base. Thus the profit growth will not be high. The company’s focused market, small towns in rural area, is promising, but also with concerns on local government financial soundness and creditworthiness.

For the reasons discussed above, we rate the share a Sell.