Lowering FVE After Country Garden Services' Profit Warning; Impairments and Pandemic Costs Weigh

We lower our fair value estimate of no-moat Country Garden Services, or CGS, to HKD 42.50 from HKD 61.00, as the company’s profit warning indicates impairments and COVID-19 costs will hurt 2022 earnings, while the demand for value-added services, or VAS, has been weak. We have also raised our weighted average cost of capital to 10.4% from 8.8% on a higher market risk premium. CGS expects pretax profit and net profit to decline by around 34%-40% and 51%-57% year on year, respectively. We estimate the impairment charge, which is triggered by a weaker outlook for acquired businesses, to be around CNY 2.1 billion for 2022. Excluding this, CGS' core net profit is still down around 25% in 2022, with operating margin likely sliding to 13.9% from 19.9% in 2021—and lower than our original estimate of 17%. However, we view the bulk of the uptick in expense and the impairment to be one-off items, and expect earnings to rebound in 2023, but we do factor in a slower recovery in demand for VAS. Our fair value estimate reflects a gradual recovery in the sector with China’s policy shift to a progrowth stance. Market reaction to the news is negative, with CGS shares down almost 6% as of midday in Hong Kong trade, but we think most of the negatives are reflected in the current share price level. For investors looking ahead the next six months, we anticipate a much improved second-half 2023 for CGS, especially given the lower bar set for 2022.