2021 results slightly missed our expectations

Shanghai Environment announced its 2021 results: Revenue grew 57.41% YoY to Rmb7.10bn; attributable net profit reached Rmb687mn, implying an EPS of Rmb0.61 （up 9.77% YoY）， slightly missing our expectations. We believe earnings disappointed as new projects had yet to reach their full capacity. Profit growth was slower than revenue growth, mainly because the firm recognized revenue and cost of low-gross margin （GM） public-private partnership （PPP） projects under new accounting standards.

Commissioning of new capacity drove up revenue; accounting standard changes dragged GM. 1） Revenue from solid waste segment surged 144% YoY to Rmb4.98bn and that from wastewater treatment segment rose 52% YoY to Rmb0.61bn. Solid waste segment saw a sharp YoY increase in both revenue and cost mainly because the firm allotted the recognition of revenue and cost from PPP projects to the solid waste segment under the new accounting standards. 2） Revenue from engineering business fell 34% YoY to Rmb1.09bn mainly due to declining construction contracting business in 2021. In terms of profitability, the implementation of new accounting standards led to a 4.77ppt drop in blended GM to 23.66% in 2021. GMs of solid waste, wastewater treatment and engineering businesses fell 12.77ppt, 4.82ppt and 2.12ppt YoY to 24.45%, 56.12% and 11.8% in 2021.

Overall expense ratio up; operating cash under pressure. In 2021, the firm’s overall ratio rose 0.26ppt YoY to 10.8%, mainly because the commissioning of new capacity drove up selling and financial ratios 0.09ppt and 0.35ppt YoY to 0.11% and 4.44%. We believe high revenue recognition under new accounting standards weighed on the firm’s overall expenses. Operating cash flow fell 45.15% YoY to Rmb573mn mainly because construction expenditure of PPP projects was partly recognized as operating cash outflow. According to the firm’s announcement, its operating cash flow grew 31.82% YoY to Rmb1.38bn under the old accounting standards.

Trends to watch

Business model innovation to bolster upgrades of corporate strategy. In 2021, the firm saw its earnings grow steadily with its cumulative power generation up 29.95% YoY to 5.05bn kWh, and on-grid power output up 29.12% YoY to 4.21bn kWh. In addition, the firm explored a new business model by combining its wastewater treatment business and photovoltaic （PV） technology, and key equipment of its advanced wastewater treatment system （e.g. recoil pumps and wastewater pumps） was entirely powered by clean energy following the commissioning of its 1.69MW Phase I PV project at Zhuyuan Wastewater Treatment Plant 1. For hazardous waste and medical waste treatment businesses, in 2021, the firm invested Rmb665mn in the construction of Phase I Hubei resource utilization project with an annual waste disposal capacity of 105,000t. We expect the firm, as the leading player in the solid waste industry, to continue its business model innovation to bolster the upgrades of its corporate strategy of “environmental governance +” （integrating three asset-light and three asset-heavy businesses to generate synergies）。

Financials and valuation

Considering the firm has yet to reach its full capacity, we trim our 2022 net profit forecast 6% to Rmb774mn, and introduce our 2023 earnings forecast of Rmb867mn. The stock is trading at 15.5x 2021e and 13.9x 2022e P/E. Considering the potential boost to long-term earnings from business model innovation, we maintain an OUTPERFORM rating and our TP at Rmb14.00 （20.3x 2022e and 18.2x 2023e P/E）， offering 30.7% upside.

Risks

Wastewater treatment fees drop; disappointing progress of projects.