The Little Chinese Railway That Could

05/08/2008 12:00 am EST

Focus: STOCKS

Jim Trippon

Editor-in-Chief, China Stock Digest

James Trippon, editor-in-chief of China Stock Digest, says Guangshen Railway has great growth prospects in the country’s booming southern region.

On the heels of a blockbuster profit report, we are delighted to recommend Guangshen Railway (NYSE: GSH).

The company [recently] announced a staggering 92.4% increase in net profits, yet its American Depository Receipts hardly responded, creating an excellent buying opportunity.

Guangshen is a little-known company among Americans, [but] it’s considered the “most modernized” railway in China, and demand continues to grow as the Chinese government permits the flow of passengers between Mainland boomtowns and the Hong Kong special administrative zone.

Guangshen provides both passenger and freight services on its small but vitally important 147-km line between Guangzhou and Shenzhen. In conjunction with the Kowloon-Canton Railway, the company also offers service to Hong Kong. It operates high-speed passenger trains intended to be as convenient and frequent as buses. State-owned Guangzhou Railway (Group) Company owns a 67% controlling stake in Guangshen Railway.

Passenger transportation is Guangshen’s largest business segment, accounting for 72.7% of its total revenues. Revenue from the company’s freight transportation accounts for 21.3%. Guangshen also engages in other businesses principally related to its railroad transportation business, [which represent] approximately 6% of the company’s total revenues.

China’s plan to spend almost $13 billion to upgrade its railway network has helped fuel a rally among railway stocks, and we believe the long-term trend will continue. Demand is high, because railway transportation is considered one of the great bottlenecks in the Chinese economy.

Guangshen operates the most modern fleet of trains in China with some of its rolling stock able to travel at 200 miles per hour. Guangshen should be able to increase efficiency by separating high-speed passenger lines from trains carrying slower freight loads.

The company’s expansion plans and its favorable geographic position indicate that Guangshen will be a major beneficiary of China’s continued economic growth. The company is building more lines, acquiring more high-speed trains and buying up regional railroads. Although the company is constrained by price controls, its profit picture indicates an ongoing control of costs. Guangshen’s profit margin is 17.86%.

Although Guangshen’s P/E ratio, above 20x, is slightly higher than the industry standard of 18x, Guangshen is growing much more rapidly than its peers. Consequently we’re recommending GSH as a Buy at $29 or less. (It closed below $28 Wednesday—Editor.)

The company’s share price has become volatile since our recommendation, and we recommend purchasing [the ADRs] with a limit order. Our target sales price for GSH is $45 and our stop-loss profit protector is $20. We don’t believe the stock has much downside risk as its book value is above $20 per share and earnings are growing.

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