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12 June, 2020

Digital China Holding (861 HK)

Ride on the China digitalization trend: Initiate Buy with PT of HK$5.8

Digital China Holdings (DCH, 861 HK) is a leading integrated IT service provider in China. The company principally engages in 1) System integration; 2) Software development & technical services business; 3) Logistics services; 4) E-commerce supply chain service; 5) Sales of properties. DCH has developed a horizontal and integrated IT solution in China through the construction of 120 smart cities for e-government operations. It combines cloud services and big data to serve smart industry chains, fintech, smart manufacturing, smart agriculture and quantum communication etc.

1Q20 results beat. Digital China reported an approx. 24% YoY growth of revenue in 1Q20, thanks to the increase in the revenue of the Smart Industry Chain Business with 22% YoY growth, and 62% growth in contracted amount from e-commerce business. During the COVID-19 outbreak, Digital China quarterly turnover had no negative impact on the revenue, given a surge in online shopping demand. We believe DCH is undergoing a transition to a mature phase and eventually come out in a better shape among peers which are suffering a quarterly loss.

We see positive catalysts in E-commerce supply-chain and logistic service segments. The total revenue contribution of these 2 segments was 31% in 2019, while we believe it would further climb to 45% in the upcoming interim results. Having considered that the COVID-19 outbreak has already changed the consumer habits towards online activities in China and the online-to-offline (O2O) data platform of DCH gains stream in China. As a result, DCH's IT logistics output per hour jumped 31% YoY, and IT logistic daily B2C volume increased 40% YoY. Management guided the bottom-line of the logistic service to ~RMB 0.1 bn in upcoming years which we think is a reasonable prediction.

Big data service market leader in China. China is a well-known country that is noted in apps on creating a super map of social connectivity, in which restaurants serve better food, couriers always deliver on time, stronger communication platform via 5G. DCH develops a big data technology of Yan Cloud DaaS to build a pipeline of data and seamless integration of functions, thereby effectively breaking information silos and achieving system interconnection and data sharing. This product is a core platform to create smart cities and Fintech development in China, which helps local governments accumulate data, such as Beijing, Changchun, Fujian, etc. The GPM of relevant projects with local government is 40%, while maintenance of the IT system is 30%. We think that is a sustainable business of DCH.

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Anli Research 12 June, 2020

Being a potential logistic partner with one of the global electric vehicles automotive. DCH are undergoing a discussion with one of the global EV automotive in providing logistic service of car parts. The targeted EV automotive already constructed a factory in China, and car production is under schedule. We are looking forward to more updates to stimulate the revenue growth of DCH’s logistic service business.

We have a BUY view on Digital China Holdings with a PT of HK$ 5.8 per share, implying a 30% upside, attributed by 1) Undemanding valuation compared with its peers and A-shares subsidiary; 2) 1Q20 results beat consensus estimates during the COVID-19 outbreak; 3) Sustainable and stable FCF from operations of smart city; 4) Strong growth driver from logistic services, ramping up earlier than expected; 5) Potential subsidiary spin-off on STAR market. Key risks include deteriorating ROE, staff cost increasing, economy slowdown.

Industry Overview

To offset the economic impact of the pandemic and achieve sustainable growth, China introduces "new infrastructure" to boost industrial upgrade and unleash economic growth potential by facilitating innovation and developing future network. New infrastructure projects, involving the construction of 5G networks, internet of things, industrial internet, cloud computing, blockchain, data centers, smart transportation, etc., are strongly backed by RMB3.75tn (vs RMB1.6tn in 2019) special local government bonds which to be issued later this year. As of mid-April, 13 provinces and municipalities have issued investment plans for key new infrastructure-related projects this year, in which 8 of them amount to more than RMB33tn total investment. With the multiplier effect from the upstream and downstream of the industrial chain as well as in other areas, batches of related industries will be benefited from the support of the government.

Big-data strategy is getting increasingly essential for all corporate management activities. In light of the heightened China-US tension, independent technology innovation tends to be more localized and strengthened especially in the financial industry. As the PBOC promotes fintech development and aims to achieve internationally leading position, it lays out in “Fintech Development Plan (2019-2021)” to fully establish a safe, controllable, advanced and efficient Fintech application system, we expect the market size of banking IT solution will grow at 18-20% CAGR and reach RMB80bn in 2022E.

GBA is definitely one of the highlighted regions that need for financial reform. The "Opinions on Financial Support for the Construction of the Guangdong-Hong Kong-Macao Greater Bay Area" published by PBOC reinforces the strategic importance of GBA construction as financial integration among the region, as a result, laying down the demand for strengthening IT system. And we expect the model, once proved to be successful, will be rolled out in other regions in China.

New infrastructure as China new growth drivers

Fintech Sector



Smart Cities The rapid development of the Internet of Things (IoT), cloud computing and other technological development has laid a solid footing for the construction of smart cities in China. According to data from China Smart City Working Committee, the market size of China smart cities is expected to grow from RMB7.9tn in 2018 to RMB25tn in 2022E.

Among which, the largest sub-sector is intelligent transportation which has a wide range of applications. For example, cameras to capture license plates and driver’s faces on highways and provide real-time data on traffic conditions, allowing authorities to better manage congestion. China’s intelligent transportation catches up an international advanced level in terms of integrated applications. First-tier cities like Beijing, Shenzhen have built intelligent transportation management systems. In particular, the highway electronic service system (ETC) is currently the only application in China that has independent IP rights and uniform standards. As of 1H19, 29 provinces, municipalities, and autonomous regions have opened ETC corridors and built more than 20,884 ETC lanes.

Smart Logistics Smart supply chain and logistics become indispensable to the economy in the future under the rise of e-commerce. As the outbreak of the COVID-19 shut most people at home across China, online sales of goods in Q1 reached over RMB1,800bn, up 5.9% YoY. The change of consumer shopping behavior will drive the average daily order delivery market to grow 18.1% CAGR from 2020-23E according to iResearch. In fact, China’s smart logistics investment has been expanding to meet up the ever-increasing e-commerce demand, investment in e-commerce services 1Q20 increased by 39.6% YoY according to NBS. Nevertheless, to be the industry winner, a resilient and smarter supply chain mechanism plays an important role.

Fig 1: Market size of China smart cities could grow to RMB25tn in 2022E

Source: China Smart City Working Committee, Anli Research Source: iResearch , Anli Research

Fig 2: Average daily orders for China delivery market is expected to grow 18.1% CAGR in 2019-23E



Company Overview

Source: Company data, Anli Research

Digital China Group was founded in 2000. It developed from a single-business IT company to five listed companies including Digital China Holdings (DCH 861 HK), Digital China Information Service (DCITS, 000555 SZ), Digital China (000034 SZ) (not held by DCH but Chairman & CEO Mr. Guo Wei hold 23.66%), Digiwin Software (300378 SZ), HC Group (2280 HK). While Fintech, Smart city, smart industry chain are the main businesses under the DCH structure.

Fig 3: DCH's business structure

Source: Company data, Anli Research

Fig 4: DCH has expanded in >120 cities in China by providing comprehensive Sm@rt City solution service



DCITS rides on the trend of banking IT system upgradeDCH is holding a 40.43% equity stake of DCITS (000555 SZ) which is consolidated in DCH’s book as it possesses the power to participate in the operations of DCITS. DCITS provides software development, industry cloud construction and operations services to a wide range of industries like financials, telecommunication, agricultural and governmental entities. As the IT leader in the banking industry in China coupled with the rapid development of distributed architecture technology and data centers, we believe the demand for banking’s core IT system upgrades is likely to rise significantly in the next few years. IDC estimates the overall IT investment of China banking industry to grow 11.2% CAGR in 2018-23E. Besides, DCITS’s internally developed scenario payment platform could help the financial institutions to expand payment services.

Source: IDC, Anli Research

Fig 5: China banking IT investment has been on a steady rise trend in recent years

Source: CIConsulting, Anli Research

Fig 6: DCITS is actively engaging in a rapidly-developing smart agriculture market

Advantages of developing smart agricultureOther than the financial industry, DCITS has been actively engaging in the national-level agricultural industry chain digitalization projects and promoting the implementation of finance in rural area. The projects include national apple big datacenter, tea industry big chain data center, national rubber industry chain center pilot project, and Yantai apple big data center. Based on the huge database, equipments, talents accumulated over the past 20 years, DCITS has assisted the government in improving land use, activating rural land resources. Its independent R&D platform has become a land management platform designated by the Ministry of Agriculture to be used across China.

Steadily growing in New Infrastructure PlanDCITS has successfully won the bids for "Beijing-Hangzhou Trunk Route”, “Wuhan-Guangzhou Trunk Route”, “Guangdong-Hong KongMacao Greater Bay Area Trunk Route” and the quantum-scured metro network projects in key cities, we believe DCH's close relationship with government can help secure more bids in the future and help solidify the leading position in quantum communication field.



Source: Company data, Anli Research estimates

Fig 8: The proportion of Sm@rt city and smart industry chain are expected to increase in the coming years

Covid-19 + Supportive Policy = OpportunityAs per Sm@rt city and Smart Industry Chain business, we believe the Covid-19 has brought a great opportunity for DCH. Revenue for Sm@rt city, smart industry chain and other businesses rose 24% in 1Q20. Big data plays an important role during the virus outbreak, and it is expected the virus prevention and control work will remain in place in the rest of the year, coupled with the “Strengthening the new infrastructure construction” in the government work report, we believe governments will accelerate digital transformation and smart city construction.

DCH’s Yan Cloud “anti-epidemic” product series, which won the first prize of the National Science and Technology Invention Award, has procured and adopted by several regional governments in fighting the virus. Also, the ‘deep penetration” model and “Xiangyun big data” project in Jilin Province have contributed to the positive results in 1Q20, the revenue of Sm@rt city business rose approx. 83% YoY%. As the market leader in China's smart city business, we expect DCH to pose explosive growth in such area this year

On the other hand, due to the surge in online shopping demand during the epidemic, DCH’s contracted amount of commerce business to rise 62% YoY and the revenue of the smart industry chain increased by approx. 22% YoY in 1Q20. Besides, DCH is one of the few domestic enterprises that can simultaneously provides B2B/B2C integrated services. Together with “human-robot 3.0” , “Jieyunbo” AloT technology, and Kingkoo Big data analysis system, we believe DCH has the potential to expand its logistics services to other fields, especially automotive. With the opening up of the China auto market, DCH can participate in the automotive supply chain by providing logistic service to auto makers especially foreign ones which rely heavily on domestic supply chain system, it could be another growth driver for DCH’s smart industry chain business.

Fig 7: Smart Industry Chain and Sm@rt City businesses are entering into fast-growing period

Source: Company data, Anli Research estimates



Future Highlight

Source: Bloomberg, Anli Research

Potential to list on STAR marketThe value of the two major businesses of DCH (smart city business and smart industry chain) is gradually manifested. Having considered that many software and information technology companies listed on the Sci-Tech Innovation Board (STAR) in Shanghai, we believe that DCH will spin off these two businesses in the near-term.

The favorite stock of Mainland investorsDCH has been consistently occupying the top three positions of Stock Connect Southbound Shareholding for years. CCASS data shows the southbound shareholding rose from 44.03% in Jun 2019 to 45.6% in Jun 2020. Given th fact that there are very few peers listed in Hong Kong and DCH being the market leader in terms of market cap. We believe DCH is favorited by Mainland investors and the southbound shareholding will continue to rise.

The DCH’s major shareholder is "GZ Investment" (a large SOE wholly-owned by the Guangzhou Government and focuses on urban infrastructure investment and financing, construction, operation and management). GZ Investment has engaged in the construction of “Guangzhou-Qingyan modern logistic industry city” in the “GZ-QY special cooperation region”, and such project is considered to be Greater Bay Area (GBA) industrial cooperative development base, we estimate that DCH can leverage on its experience of promoting Smart City in Guangzhou, it has great opportunity to participate in the smart city projects in GBA in the future.

Fig 9: Guangzhou government is the substantial shareholder of DCH

Major shareholder advantages



Valuation

Digital China Information Service Company (DCITS, 000555 CH) is a subsidiary of DC Holdings, is a leading integrated service provider for the entire Fintech industry chain in China, ranked as 1st in the core banking business and channel management solution market for seven years. DCH is the main shareholder of DCITS, which holds 40.14% of company’s equity interest. Digital China is currently trading at 13.62x P/E vs. DCITS's current P/E of 37.4x, representing a 35% discount over last trading price.

In our view, the current valuation of Digital China is undemanding with attractive valuation because of: 1) Current P/E valuation below its historical P/E 22.35x, also trading below industry average of 81x; 2) Positive gain of total revenue in 1Q20 results; 3) “Yan cloud big data” project have been procured and adopted by local governments, which would further enhance Digital China’s market share in China IT service industry; 4) Enjoy valuation gap premium between H-share & A-share market.


Fig 11: DCH and DCITS share price performance


Source: Bloomberg, Anli Research estimates

Fig 10: DCH is trading 36% valuation discount with DCITS

Fig 12: Valuation comps

Key Risks1. Staff cost increases larger-than-expected2. Economy slowdown3. Deteriorating ROE



Digital China Holdings (861 HK): Financial Summary

Source: Company Data, Anli Research estimates


Important legal disclosures


General DisclosuresThis research report is prepared and distributed by Anli Securities Limited (“ASL”) in the conduct of business of regulated activity in Hong Kong. This report or any part thereof may not be distributed, reproduced or disclosed to any other person without the prior written approval of ASL. In particular, this research report is not intended for distribution to, or use by, any person or entity in the United States of America, Canada, Australia or any jurisdiction or country where its distribution would be in breach of applicable laws, rules and regulation. The information, data, materials, forecasts, estimates or opinions contained herein are for information only and subject to change without prior notice. ASL makes no representation or warranty (whether express, implied or otherwise), with respect to the fairness, correctness, accuracy reasonableness or completeness of the information, data, materials, forecasts, estimates, opinions as above but has used its best endeavor to obtain information, data, materials from sources which are believed to be reliable. ASL makes no representation, undertaking, warranty or guarantee as to the update, completeness, correctness, reliability or accuracy of information, data, materials, forecasts, estimates or opinions. The opinions herein are made without taking into consideration of specific financial position, investment objective, investment experience or other need and it is therefore expected that investor shall not make investment decision in reliance on information, data, materials, forecasts, estimates or opinions herein without seeking professional and independent advice. ASL accepts no liability and responsibility whatsoever for any direct or indirect loss or damage which may be suffered by any person arising out of or in connection with the information, data, materials, forecasts, estimates or opinions provided herein. In any event, this research report does not constitute or form part of and shall not be construed as any offer for sale or subscription or solicitation or invitation of any offer to purchase or subscribe for any securities and investment products in any jurisdiction.

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