China Rail Sector:Diverging outlook,diverging stocks

Outperformance of equipment suppliers over constructors to continue

    Since we published our FITT report "A change of track" at end-July, at whichpoint we switched our preference from rail constructors to equipment suppliers,we have observed more evidence to support our thesis. While constructors'new orders remained robust in 1H17, the order momentum has sharply fadedheading into 2H, due to stiffening headwinds associated with PPP projects andlackluster railway projects (combined forming >50% of their construction orders).Conversely, thanks to stronger-than-expected EMU procurement, equipmentsuppliers' order intake has picked up strongly from 2H this year. Managementsof equipment makers are also getting more upbeat on the outlook, whileconstructors started toning prospects down. The share prices of equipmentmakers have outperformed constructors by, on average, c.20ppts (vs. HSCEI:

    +8% ) since August. While the P/E premium of the former group has increasedfrom a historical low of 3x in end-July to 5x lately, it remains below the historicalaverage of c.6x and peak of c.10x (Figure 1). With a clearly diverging outlook, weexpect the former group to continue to outperform the latter, leading to furtherexpansion of the P/E gap. Top Buy picks: Zhuzhou CRRC and Hollysys; Hold onCRG and CRCC.